Foundation and Development

The Gap (GPS) was founded in 1969, when Doris and Don Fisher opened the first Gap store in San Francisco. Today, the Gap is one of the world’s largest specialty retailers, with about 3,100 stores and annualized sales running at about $14.5 billion. Gap stores offer an extensive selection of relatively high quality, casual apparel at moderate price points. Products range from basics, such as denim, khakis, and t-shirts, to fashion apparel and accessories for men and women. The company entered the children’s market with the introduction of GapKids in 1986 and babyGap in 1989. The first GapBody stores, offering women’s underwear, sleepwear, loungewear, and sports apparel, were opened in 1998. The Gap designs all of its in-store goods and most of the products sold on its Internet sites.

The company acquired Banana Republic in 1983, which at that time, consisted of two stores. This upscale chain features sophisticated, fashionable collections of both casual and tailored apparel, shoes, and personal products at higher price points than the Gap. Meanwhile, in order to address the market for value-priced family apparel, the company launched Old Navy in 1994.

The Internet business began in 1997 with Gap Online, and the company added Web sites for Banana Republic and Old Navy over the next three years. The latter includes a plus size line not found in stores. The retailer’s last two domestic Internet sites feature exercise-related apparel for women, footwear, jewelry, and handbags. The International division consisted of 334 stores 11% of the total) at July 31, 2010. International also sells goods to unaffiliated franchises operating in 25 countries.

Past Financial Performance Relative to Other Retailers

The Gap’s results over the past five years have generally been lackluster, while earnings in  the  last three years have bested those of most specialty apparel retailers. That is, its sales in fiscal 2009 were 11% below fiscal 2005’s level, while profits were about at the same level. During this period, the store count increased by only 1%. Earnings fell 25% in 2006. Under a new senior management team, they improved steadily through fiscal 2009, despite same-store sales declines in each of the last three years. The key catalyst was margin expansion, which was fueled by an employee-count reduction of 20,000 (13%) over the two years ended January, 2008 and a three percentage point jump in the gross margin in fiscal 2009. The latter was triggered by easy comparisons, a significant drop in in-store inventory, and a more effective merchandising strategy. By contrast, average earnings in 2008-2009 at apparel retailers Abercrombie & Fitch (ANF), AnnTaylor Stores (ANN), Charming Shoppes (CHRS), Chico’s FAS (CHS), Limited Brands (LTD), Talbot’s (TLB)  were well below their 2006-2007 levels. The best performance in this sector was generated by Aerpostale (ARO), where earnings have advanced in each of the past five years; its fiscal 2009 tally was more than three times the 2005 level. This was achieved through a 9% compounded annual increase in the store count and about a 50% rise in the operating margin during this period.

Near-Term Prospects

The Gap’s sale and share earnings are likely to advance about 2% and 15%, respectively, this year. The estimated differential reflects margin benefits from recent operating efficiencies and a lower share count. The company repurchased some 52 million shares (7.7% of fiscal 2009’s closing level) for $1.1 billion in the first quarter of fiscal 2010. This ongoing program is funded with cash flow, net of an increased capital budget ($575 million, up over 70%) and dividends, running at $1 billion per annum and cash assets, which recently stood at $2.1 billion. The capital budget is mainly earmarked for renovations of  Old Navy units, international store openings, and online launches in the United Kingdom and Canada. Our projections indicate healthy earnings advances in each of the following three years, which, we believe on a risk-adjusted basis, would prove superior to most of The Gap’s peers.