Why The Market May Be Concerned About Gap?

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Gap

Our price estimate of $43 for Gap Inc (NYSE:GPS) is almost 60% higher than its current market price. While we expect the company to improve its revenues and maintain profitability over the next few years, the current market price appears to be discounting Gap’s potential. We acknowledge that Gap faces serious competition from fast fashion brands such as Zara and Forever 21, which have a very high inventory turnover. Due to a longer production cycle, Gap’s time to market has been relatively slow and it is losing to these brands, resulting in an inventory pile up. However, we expect Gap to grow its revenues through international expansion and by leveraging omni-channel and online retailing. We also expect the retailer to maintain its profitability by consolidating underperforming stores.

See our complete analysis for Gap Inc.

Piling Inventory Main Cause Of Concern For Gap

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The time taken by a company to turn its inventory into sales is measured by Days Sales of Inventory. This number was 64 days for Gap for the year 2011 and increased to 80 days in Q1 2015. To clear this piling inventory and make room for fresh stock, this inventory is sold at discounted rates which adversely impacts revenues and margins. Fast fashion brand Zara, on the other hand, has a just-in-time production strategy, where advance production is limited and 50% of its clothes are designed and manufactured in the middle of the season. Zara’s inventory management software allows store managers to communicate customer feedback to the designers. Designs are modified based on this data and small batches of new stocks are sent to the stores twice a week. This inventory optimization strategy ensures that less popular stock is not accumulated and customers get to see new designs very frequently. Zara’s production facility has built in flexibility to address peak customer demand. Gap is losing to this efficient model since it has a longer product development cycle and thus a longer time to market.

Market Maybe Pessimistic About Gap’s  Near Term Growth And Profitability

Our price estimate for Gap assumes that Old Navy, Banana Republic and its namesake stores will maintain their EBITDA margins above 24% over the forecast period. Furthermore, we expect a moderate increase in revenue per square foot for all these divisions, primarily due to growth in international markets. Banana republic continues to expand domestically.

Gap’s market price has declined nearly 25% in the last three months, primarily due to weak Q2 2015 results, where Gap reported a 2.1% decline in net sales and a decrease in EPS from $0.52 to $0.75 from the year ago period. Considering recent results and growing competition, the market appears to be uncertain about Gap’s competitiveness. The current market price suggests that the market may be expecting the company’s EBITDA margin to fall by more than 500 basis points for all its divisions and revenues per square feet to decline by $50 or more for each of the divisions.

EBITDA margins can decline if the online and omni channel expands rapidly but ineffectively, as margins in a direct to customer business are lower. Decline in revenue per square foot is possible if customers continue to shift their preferences to other brands such as Zara and H&M and are not enticed by Gap’s new brands. However, we expect Gap to capitalize its omni channel retailing strategy, its successful Old Navy brand and its smaller brands such as Athleta to gain popularity.  Thus, we remain bullish on Gap ( Read Two factors that support our bullish outlook for Gap Inc).

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