What Premium Brands’ Weakness Can Do To Gap Inc’s Value

-26.81%
Downside
24.69
Market
18.07
Trefis
GPS: Gap logo
GPS
Gap

Apparel vendor Gap Inc (NYSE:GPS) is one of the few apparel retailers in the U.S. that did not struggle amid an edgy retail environment until last year. The retailer was able to grow its revenues even when buyers across the industry were beginning to shy away from casual apparel brands in search of fashion-forward products. However, last year, Gap Inc’s growth finally faltered as its namesake brand and Banana Republic could not keep up with changing fashion trends. Comparable sales for both brands fell significantly and company-wide EBITDA margins declined by close to 60 basis points.

We currently forecast the company’s margins to recover marginally in the coming years before stabilizing at 25%. However, there exists a possibility that the company will continue to usher heavy markdowns on its premium brands in order to attract customers or it may adopt more aggressive pricing. Apart from subduing growth in revenue per square feet metrics, this could have a negative impact on margins, which in turn could pave the way for the following scenario, where Gap Inc’s value can potentially decline by 10%.

Our price estimate for Gap Inc is at $47, implying a premium of about 20% to the market price.

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See our complete analysis for Gap Inc.

In the aftermath of the economic downturn, U.S. consumers have become extremely cautious about their spending. In search of value-for-money products, buyers have restrained themselves from spending on relatively expensive basic merchandise from Gap and Banana Republic. Instead, they have diverted their spending to equally expensive but relatively fashion forward products from Zara and Forever 21. The has resulted in a significant drop in demand for Gap Inc’s premium brands. In the wake of sluggish growth last year, the retailer has deployed some strategies to revamp its namesake brand and Banana Republic in order to get their growth back on track. We currently project that the revenue per square feet for these brands can improve gradually going forward driven by an improvement in product design and pricing strategies, as well as a higher contribution from online sales, thanks to several ongoing omni-channel initiatives.

However, consider a scenario where the company is unable to match customer expectations in terms of this design-pricing balance, which would constrain the growth of these brands. We currently project Banana Republic’s revenue per square feet to increase from $546 in 2014 to $591 over the next five-to-six years. For the scenario under discussion, we pull the long term forecast down to $566 from $591. In turn, for Gap, we pull down long term revenue per square feet forecast slightly from $494 to $478.

With weaker topline growth and growing penetration of online sales, which is by nature a low margin business, Gap Inc’s EBITDA margins may decline. Our current forecast for the retailer’s EBITDA margins takes it from 24.7% in 2014 to 25% after five-six years. In the context of the aforementioned scenario, we pull down the figure 25% to 23%. The cumulative impact of change in revenue per square feet and EBITDA margins forecast translates into a downside of about 10% to our price estimate for Gap Inc.

This scenario is highly plausible considering that causal apparel retailers haven’t seen much success for their portfolio transition efforts so far. To make things worse, competition from fast fashion players is continuously getting fierce. Due to this, the entire casual apparel industry remains extremely promotional. It may as well remain the same way in the near future, which can turn the aforementioned scenario into a reality.

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