In our previous note “Here’s Why We Think Gap Inc Is Worth $50 – Part 1“, we discussed the company’s receptivity to customer preferences and potential expansion in the U.S. as the key driving factors for Gap Inc’s (NYSE:GPS) stock price. We’ll continue our analysis in the following note with a focus on the retailer’s targeted international expansion strategy and its strong direct-to-consumer business.
As the company offers its three main brands at different price points, it’s looking to target their expansion to those international markets that are best suited to their pricing strategies. For instance, expanding a luxury or a premium brand in a market that mainly holds value conscious customers does not make sense. On the other hand, focusing on an affordable brand in a market where customers hold some affinity for expensive products is an opportunity missed. Aware of this fact, Gap Inc. seems has identified different markets for its affordable and premium brands. This way, the company should be able to realize more full priced sales, and subsequently, push its international business towards its true potential.
Gap Inc is continuously working towards the improvement of its direct-to-consumer channel (mainly e-commerce), which has done reasonably well so far. Given the bright outlook of the online apparel retail industry and the retailer’s strong brand image, e-commerce holds big promise for Gap Inc’s future growth. With its higher EBITDA margins, this channel will assist the company in generating better cash flows, which should have a positive impact on its stock price.
Our price estimate for Gap Inc is at $50, implying a premium of about 30% to the market price.
Targeted International Expansion Strategy
International expansion allows a retailer to reduce its dependence on the U.S., where economic growth right now is sluggish and the competition is high. Gap Inc already enjoys some presence in key global markets, which has allowed its international operations to outgrow their domestic counterparts. Indeed, the company is continuing to expand abroad by identifying the most lucrative markets for its brands.
During the recently concluded quarter, Gap Inc opened about 18 stores in mainland China, bringing its store total in that market to 73. Although this market is currently struggling with weak consumer spending, it does hold huge potential from long term perspective. China was able to sustain its economic growth with rising income levels even during the global economic crises of 2008-2009. Disposable income of Chinese buyers is likely to increase in the future due to growing urbanization and increases in minimum wages. Prior to 2011, the region’s apparel sales were growing at an average annual rate of about 16%.  The apparel market stood at $110 billion in 2009, grew to $140 billion in 2012, and is expected to touch $220 billion by 2016.  eMarketer forecasts online retail sales in China to increase from $110 billion in 2012 to $440 billion in 2016.  This is why several apparel retailers have started taking China seriously. Gap Inc’s counterpart, Guess (NYSE:GES), has grown its Greater China business by almost 75% over the past two years.
Gap Inc is also planning to add its affordable luxury brand Banana Republic in China, encouraged by the success of high-end players such as Coach (NYSE:COH). A McKinsey report suggests that while Chinese consumers represented only 1% of global luxury spending in 1995, they accounted for 27% of the spending in 2012. By 2015, China is estimated to have one-third share of the global luxury market.  Therefore, it makes sense for the company to expand Banana Republic in the region.
Also, the retailer introduced its Old Navy brand in Japan at the beginning of last year and ended the third quarter with 14 stores. Gap Inc plans to take this count up to 20 by the end of the fiscal year 2014. Japan is a huge market for apparel players with annual sales of more than $100 billion.  Though longer than anticipated economic crises weighed on the market’s growth for over a decade, it somewhat recovered in 2012 (+0.4%) due to increased consumer spending. Biggest gainers from this rebound were the top 100 specialty apparel chains (+5.2%) who hold more than half of the apparel market share in Japan.  The region is an important market for affordable brands since Japanese buyers have been buying longer-lasting value focused products. This trend is likely to persist in the future as a consumption tax is expected to go up this year.  Moreover, Japanese shoppers have been preferring casual clothing over formal attire due to the government’s Cool Biz campaign that urges companies to limit air conditioning and set warmer temperatures.  All these factors bode well for Old Navy since it offers a wide range of casual products at affordable prices.
Strong Direct-To-Consumer Business
Gap Inc has seen strong growth in its direct-to-consumer revenues over the past few years, which has boosted its results. During 2009-2012, this business grew at an average annual rate of more than 20%. As a result, its revenue contribution has gone up from 9% to 14% during the same time. While the revenue contribution might seem insignificant, this segment constitutes close to 25% of the company’s value due to its high margins.
Going forward, we expect the channel’s revenue contribution to reach 22% over the course of next five-six years, backed by industry growth and Gap Inc’s individual efforts. According to eMarketer, online apparel sales in the U.S. are expected to reach $90 billion by 2016, up from $45 billion in 2012.  In addition to the U.S., the outlook for the online industry in European markets (where Gap Inc has its maximum international presence) is also very encouraging. Forrester forecasts that Europe’s online retail sales are expected to grow at a compound annual growth rate of 11% for the next few years.  Given the trend in the U.S., we believe that online apparel sales growth in Europe will exceed overall online retail sales growth.
Gap Inc’s mobile apps and mobile-optimized websites have played a vital role in strengthening its Direct business. Its ship-from-stores service, which allows the fulfillment of online orders through store inventories, has enabled the company to not only offer a greater variety of merchandise over the Internet, but to enhance delivery responsiveness and increase store traffic as well. During the third quarter of fiscal 2013, Gap Inc launched its “Reserve in Store” service in all Banana Republic stores and more than 200 Gap stores. This service allows a customer to reserve up to five items online to try in stores. Since buying clothes is a personal experience and online shopping provides convenience, this new program offers customers the best of both channels. We believe that this too will help the company drive greater store and web traffic.Notes:
- From Mao to Wao: Winning in China’s Booming Apparel Industry, McKinsey, Jan 2011 [↩]
- China’s apparel retail market: $218 industry by 2016, Trans World News, Aug 3 2013 [↩]
- B2C Ecommerce Sales Climbs Worldwide, as Emerging Markets Drive Higher Sales, eMarketer, Jun 27 2013 [↩]
- Chinese shoppers ‘biggest spenders on luxury goods’, South China Morning Post, December 13, 2012 [↩]
- Overview of the retail apparel market, United Arrows [↩]
- Japan’s Apparel Market Is Growing Again, The Business Of Fashion, Dec 10 2013 [↩]
- Apparel in Japan, Euromonitor, Jun 2013 [↩]
- Japan ‘Super Cool Biz’ Campaign Urges Businessmen To Shed Suits, Save Energy, Huffington Post, Jan 8 2011 [↩] [↩]
- US Online Retail Sales To Reach $370B By 2017, EUR191B in Europe, Forbes, Mar 13 2013 [↩]