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Executive Summary
Rating
HOLD Sector/Industry
Consumer Discretionary/Specialty Retail
Company
Gap Inc. Ticker
GPS
Date
12 December 2016
Company Update
Price at 12 Dec 2016 (USD) $25.86
Target Price $18.13
Cash Flow and Growth Valuation Worst Base Best DDM $15.94 $21.73 $33.62 Cap Earns $36.58 $44.63 $48.71 H-‐Model $15.94 $21.94 $34.10
Relative Valuation Worst Base Best Target PE $3.91 $6.33 $11.50 Target Price $11.98 $18.13 $30.57
Company Data Price ($) 25.86 Date of Price 12/12/2016 52 Week Range 17.00 -‐ 30.74 Market Cap 10.32B Volume 4,218,217 EPS 2.41
Highlights Based on my own financial research and different analysis method being applied to the company, I am suggesting a HOLD status for Gap Inc. With my valuation, I am confident to say that the target price for Gap is $18.13. The current stock price is being traded at $25.86, indicating this stock is overvalued.
Growth Factors: • Closing down underperform stores and shift strategic
plan to E-‐commerce market will help Gap to boost sales and cost efficiency.
• Focus on U.S. and China industry as Gap is generating most of its revenue from the two countries.
Risk Factors • Rise in labor costs could cause suppliers to raise
costs, causing higher expenses for the company • Buyer power is strong, consumer preferences shift
quickly. Fail to realize this factor could cause Gap to have excessive inventory leftovers and low sales.
From my valuation using various approaches, it implies that the firm is being traded fairly. The firm struggle recently to improve in its growth. However, the company has remain a stable, low growth, over time which is normal for Gap Inc. The market is predicting for the sector/industry to have stronger growth in the near future. I could see Gap to increase in its growth. Therefore, I am confident with my recommendation to HOLD.
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Industry Analysis Apparel Market Overview
The U.S. apparel industry consumed $300.9 billion in revenue for 2015, creating a total compound annual growth rate at 3.2% from 2011 to 2015. The U.S. industry has remains a stable growth in the trend line for recent years and is predicting to continue with a moderate growth up to 2020. (See Table 1)
The U.S. apparel industry is classified as a large, fragmented and a mature industry. The market environment for the Apparel Retail Industry is highly competitive and experienced pricing pressures, whether domestic or international. Stock prices for this particular industry fluctuates as it depends on consumers’ needs, when and how much they’re willing to spend. Fashion trends change quickly, apparel companies need to be highly efficient and must adapt to the industry environment as it changes constantly.
Apparel Industry Definition The apparel industry, under Consumer
Discretionary sector, contains companies that sell
clothing, footwear and accessories. The industry consists a wide range of products from basic wears such as T-‐shirts (ex: Gap, Aeropostale, Hollister’s) to more luxury goods such as designer handbags (ex: Michael Kors, Coach, Kate Spade). The industry operates two main types of businesses, which are wholesale and retail.
Wholesale operations Wholesale consist of companies who produce and sell products to retailers such as department stores, specialty shops and discounters. Wholesalers often import products from developing countries for lower labor costs. Wholesalers also purchase licenses to produce goods under multiple brand names, as well as advertising these brands. Brand name products often bring in profit for wholesalers for its good reputation as well as high-‐end quality. A wholesaler would have the competitive advantage over its peers if they consume multiple brand-‐names.
However, if the economic is not in a good condition, it could be tough for the wholesalers with brand name products. More than likely, consumers would not be able to afford high-‐price products. They would rather prefer to switch products to private-‐label goods. Private-‐label goods are goods being sell at discount prices, often at department stores or discount stores. Though private-‐label goods are being sell at cheaper prices, they are more profitable than brand name products.
Wholesalers consisted of 27% overall value in 2015. (See Table 2). The wholesale market use year-‐to-‐year sales rather than quarterly based due to seasonal sales. We also look at operating margin and profit margin performance for this business.
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Retail operations Retail focused on where stores are dedicated
to a single brand name, create better flexibility for a company to monitors its own products and have better control over its brand and items. Retailers are often more profitable and have more advantage over wholesalers, by dedicating the store to its own brand, a company can excludes third party costs and raise profits.
As the market has become more technology based, more retailers are also focusing on selling the products via the internet. Online retail stores increase efficiencies and allow consumers to access the store anywhere without having to go to a direct location. Online retail stores are also often more profitable due to little to none staffing and also low equipment requirements.
Sales for retail, like wholesale, are also very highly seasonal. Majority of sales often were influence by holiday-‐based or back-‐to-‐school event. Retailers compare sales through year-‐to-‐year analysis to predict trend lines. The retail market uses “comparable-‐store” sales to indicates performance of stores locations and also “sales-‐per-‐square-‐foot” is another metric being use to indicate how efficiently are the business being operated base on its space. Retailers consisted of 66% overall value in 2015. (See Table 2)
Apparel category segmentation
In 2015, the womenswear segment took the majority share of the industry at 52% reported revenue of $157.4 billion in 2015. This segment consists of specialized products for misses, juniors, plus-‐size and maternity clothing with 30% composed of selling tops, 20% bottoms, and 50% other specialized products such as dresses, outerwear, underwear, etc.
Menswear segment holds 31% of the market, reported revenue of $92.5 billion in 2015 with 38% in casual wear, 20% formal wear, and 42% in other specialized products such as accessories, sportswear, etc.
Childrenswear holds 17% of the apparel industry with more than half sales came from girls’ clothing at 55%. Boys’ clothing were reported at 21% and the rest were others including infants’ and toddlers’ clothing.
Geography segmentation The United States holds 24% of the overall
global industry. Asia holds the largest % share at 37% and Europe at 28%. The Asia segment has a compound annual growth rate of 7.3% respectively, remains at a stable growth over time. Thought Europe segment has larger % share in the industry than the U.S., its compound annual growth rate is slightly lower at 1.3% year over year. (See Table 4)
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Top 5 Major Players The top 5 companies with well-‐performed revenues in 2015 are:
• Nike, Inc. • The Gap, Inc. • H&M Hennes & Mauritz AB • Nordstrom, Inc. • The TJX Companies, Inc.
Nike, Inc. (NKE) NIKE, Inc. sells athletic footwear, apparel,
equipment and accessories worldwide. The company operates through three segments, womenswear, menswear, and also childrenswear. In 2015, the company’s revenue grew 10% at $30 billion with gross margin increased 120 basis points.
The Gap, Inc. (GPS) Gap sells products in various locations,
globally. The company also operates under Gap, Banana Republic, and Old Navy, Piperlime, Athleta,
and Intermix brands. Each brand sell products under their own channel and online websites. In 2015, the company owned 3,280 retail stores. Gap sells clothing accessories and personal care products for men, women, children and babies through its stores. The revenue reported in 2015 was $16.4 billion, remained in line with previous year at $16.1 billion.
H&M Hennes & Mauritz AB (H&M B) H&M is a company headquartered in
Stockholm, Sweden. It is a leading retailer selling fashion apparel, cosmetics, accessories and footwear for women, men, teenagers and children, globally. In 2014, the company reported with 3,511 stores. Revenue reported for H&M in 2015 was $26.3 billion, increased from previous year at $17.6 billion.
Nordstrom, Inc. (JWN) Nordstrom is one of the major companies in
fashion specialty retailers in the US. The company has two business segments, which are retail and credit. Nordstrom sells apparel, footwear, cosmetics and accessories for men, women and children. The retail segment has 263 stores in total, including an online store. Nordstrom revenue increased slightly in 2015 reported at $13.5 billion.
The TJX Companies, Inc. (TJX) TJX retail stores sell apparel including
footwear and accessories, home fashion merchandise such as furniture, décor, and home accessories. The company has more than 3,200 stores open, globally. The company increased in revenue reported at $29.1 billion in 2015 versus 2014 at $27.4 billion.
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Porters Analysis Buyer Power
Overall: Strong
Buyer power takes a big role in the apparel industry. Shoppers typically do not have a direct power on controlling the prices, however they have options to choose where to shop and are open to multiple shopping locations rather sticking with one particular company. Therefore, consumers hold an indirect bargaining power.
However, buyers are only powerful if buyers are being concentrated. If there are more suppliers and only few buyers, buyers will have more advantage. With today’s market, suppliers have a significant large number of costumers, therefore, with a loss of one customer will not have a tremendous impact on the company’s revenue. This cause has weakens the buyer power.
Though the buyer power has weakens over time, we must not neglect the consumers’ demand as the fashion trends change rapidly. Apparel companies must be aware of the news and social media to keep up with the change and to meet customers’ expectation. Overall, buyer power is rated strong.
Supplier Power
Overall: Moderate
The industry suppliers are mainly wholesalers and manufacturers. As the apparel market always fluctuates depending on consumer’s needs, suppliers have little control over pricing and costs. Majority of products were exported from third world country for low and inexpensive labor costs. This caused it to be more difficult for suppliers to increase pricing and costs.
For larger companies, they produce and sell their own products, being their own suppliers. These companies look to have their manufactures to be outside of the U.S. for cheaper costs. Some issues they might experience could be time efficiency and legal issues.
More manufacturing companies have been raising labor costs due to regulation. This could be a concern in the near future as it could potentially increase product costs.
Overall, supplier power is rated to be moderate in today’s market.
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Competitive Rivalry
Overall: Strong
The apparel market is highly competitive as there are many companies out there selling similar products. The industry also runs by popularity of brands, which created the possibility for high-‐end companies to sell their products at much higher rates, gain competitive advantage over other unknown brand companies.
Product innovation is an important key to differentiate a company from its peers. Many companies have tried diversified themselves to other categories other than just apparel products. H&M, for example, launched beauty products and home goods to expand its target audience rather than focus solely on just clothing.
Customers have options of where to shop based on fashion trend and products prices. This cause price sensitivity and increase the intensiveness of rivalry. Overall, the apparel market is highly competitive and is rated strong.
Threat of New Entries
Overall: Strong
Many international retailers are aiming to expand their businesses to the United States. Primark, for example, a low price retailers from Europe is planning to open its stores in the U.S. To differentiate itself from its peers, their core business will be focusing on low costs and operations to provide products with low prices to consumers.
It’s not hard for a new business to enter the market if they keep up with the constant fashion trends and know how to differentiate themselves from their competitors. Especially for foreign companies, which already have an existing business, will be easier for those type of firms to enter the market. Think Primark for example, as a new company entering the U.S. market, if it has competitive strategies, the firm could possibly could compete with existing players such as H&M, New Look, Forever21, etc.
However, to remains stable in this industry could be difficult. The business would really have to be unique in their products and services to maintain in the apparel industry. Overall, threat of new entries is strong in the apparel market.
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Threat of Substitutions
Overall: Weak
The threat of substitution in the apparel market is little to none. There is not yet another way to substitute clothes with. Substitution in this industry is more competition and rivalry. Or an option would be for consumers to directly buy products from manufacturers through online channels without having to go through retailers or shopping stores. Home-‐made clothing is also being sell through online channel but this segment is relatively small and doesn’t have a significant impact to the market. Overall, threat of substitution force is weak for this industry.
Five Forces Rating Buyer Power Strong Supplier Power Moderate Competitive Rivalry Strong Threat of New Entrants Strong Threat of Substitutions Weak
*Porters Analysis Graphs ranking from 0 to 5 with 0 being the weakest to 5 being strongest.
*Graphs retrieved from Marketline with minor changes to my own inputs and judgement.
Porters Competitive Strategies
Competitive Advantage
Compe
titive Scop
e Lost Cost Higher Cost Broad Target
Cost Leadership
Differentiation
Narrow Target
Cost Focus Differentiation Focus
In this industry, there are two core strategies which are:
• Low price-‐ a strategy that relies on setting an appropriate price, either comparable or slightly lower price than competitors to provide competitive advantage.
• Differentiation-‐ a strategy that can distinguished a company with its peers based on quality, product innovation, marketing, etc. to provide competitive advantage.
For example, Nike has become one of the largest sports brand globally. It outperformed competitors such as Puma, New Balance, and Reebok. Adidas is considered to be the major rival against Nike, as it shares the same audience target and business focus. Nike was able to differentiate itself from its peers by using famous athletes for marketing, to advertise its line of products.
Nike paired up with Michael Jordan to expand its brand name. Michael Jordan is an iconic basketball player with the most successful shoe lines dedicated towards basketball shoes. This created exclusivity for Nike as it generates high returns for the company, as well as high reputation towards its name and quality.
Another example, H&M practices low-‐costs strategy and differentiation to help stands out from its main competitor, Zara. H&M paired up with famous designers to produced high-‐end styles, however was
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still able to provide affordable prices to young consumers with age ranges from 16-‐25.
Recently, H&M did collaboration work with Balmain to generate a high-‐end collection with limited inventory. Balmain is a French fashion company with apparel price ranges from $1,000 to $5,000 per item. Through the collaboration, Balmain has made its products, which sells through H&M, at lower prices ranges from $500 and under. This attracted many customers from all locations, to line up before open hour in order to buy these expensive design products at cheaper prices. Through this collaboration work, H&M was able to distinguish itself from competitors, generate more sales and also increase its brand name.
For firms that are focused and committed to these strategies, they are more likely to have competitive advantage over its competitors. With low price strategy, a firm can sells products at a comparable rate and perform their tasks more efficiently than its peers. By differentiated itself from competitors, a firm can provide unique quality and activities such as designs, customer-‐service that can attract more consumers and can sells their products at a premium price.
Trends and Issues Inventory Management Fashion trends are highly based off seasonal sales and it is very unpredictable to what type of new products will come out next. Fashion fads also don’t last long in the industry, usually only last 6 months to a year. The product cycle for this industry is a challenge due to styles being constantly evolved. Retailers have to work quickly to sale off the inventory by using discounted prices in able to meet their profit margin.
Another challenge that ties into the product cycle issue is historical data is also being affected by the fluctuations of locations, pricing, new product, season, marketing. Therefore, when new items are
being generated, firms would have no historical data to base off for projection.
Economic Trends Economic trends take an important role in the fashion industry. The increased in price for materials and rising in labor costs has cause profit margins to decrease slightly for most retailers. In today’s economic trends, many retailers would partner up with each other to broaden their customers’ target, and they’re also participate in merger and acquisition to grow their share.
Technology has also become more of a challenge for the apparel industry as more people are joining the workforce and less personal time to physically go shopping at local location, they’d prefer to browse the internet for pricing comparison as well as shopping through online retail sites. This is more difficult for companies to study the customer behaviors and their preferences. Though there will be a solution to this issue in the near future for apparel companies to move toward technology and internet based, the companies would have to constantly adapt to the fast pace environment and conduct research on a daily basis to improve and keep up with the market.
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Macro Analysis Demographics Demographics take a major role in the apparel market. Studying the industry’s demographics help understand different preferences of individuals to promote and increase marketing and sales strategy towards specific audience. We will be focusing on the two main segments of the industry which are womenswear and menswear.
Womenswear segment The revenue for the womenswear segment has been declining over years, largely come from low to middle income households. This target group has been more conscious of their spending. However, wealthier households are more likely to spend money on luxury goods, which will be the main driver for the industry growth.
Spending based on households income For households with average income less than $30,000 a year, consumers often only purchase good when necessary needed. This segment has decreased over time, more consumers are price conscious and choose to lean towards discount department stores.
Households with income between $30,000 and $70,000 took 28% over the segment revenue. Consumers under this category tend to shop for more goods that are trendy and currently in styles, whether branded or unbranded. Large count of the consumers often shop through online retailers. Revenue for this segment has been stable.
Consumers with income $70,000 or above are able to purchase for more high-‐end products at premium prices. Consumers in this segment are expecting to increase over time and will help to creates growth for the womenswear segment.
Age group Women between age group from 20 – 39
years old are the key demographic for the women segment. However, the industry is expecting a slow increase in age group of women from 20 – 64 to be the main demographic for this segment.
Locations The Southeast region has the largest
population in the U.S. With that, this region holds the largest share of the industry in 2016, reported at 26.2%.
The Mid-‐Atlantic region holds 18.8% share of the industry. The average income for this region is reported at $72,800 a year. This region is an opportunity to focus on profitability for high-‐end products aiming toward wealthier consumers.
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The Western region holds 15.8% in 2016. This region focus on small clothing boutiques, new entrepreneurs and new fashion designers.
Menswear segment Revenue for this segment is expecting to have a slow growth up to 2021 (Based off IBIS World). Male consumers are now more favorable towards online shopping, indicated that there will be changes in the near future for this segment. Demographic changes As older generation is retiring and younger males will join the workforce. Men’s clothing retailers will shift its target audience towards the younger age group. Many industries now allow business casual instead of formal wear dress code will also causes the preferences and styles to change in this segment.
Incomes The lowest income consumers accounts for 20.8% of the revenue. Consumers in this category tends to work in uniforms and casual wear work environment, less needed for formal suits. They typically shop at discount stores or affordable fashion retail outlets.
The middle income accounts for 37.1% of the revenue. Consumers in this category have higher demand compare to the lower income consumers.
The wealthy income consumers account for 42.1% of the segment revenue. These consumers will more likely to purchase luxury goods and premium brand suits. Over time, this category has slowly increased the share of the total industry.
Locations The Mid-‐Atlantic region and New York State hold the most corporate offices, which increase consumer’s demand for formal suits and office attires. This region is also large in population, leading more sales and generate growth for the segment.
Wages The U.S. apparel industry mainly get it resources and products made out of the country, large amount are being produced from countries based in Asia. In 2016, minimum wages in the industry for these countries continue to increase.
On average, Asia experienced over 5% increase in minimum wage. The demand for an increase in minimum wage are due to various reason. Workers are working full-‐time, over 60 hours a week, felt that they should get pay higher for the labor that they provided. Also governments in these region are demanding for more safety enforcement for employees.
Wages accounts for 13.9% revenue in the womenswear segment and 15.7% for menswear segment for retail stores. Majority of jobs offered are part-‐time sales associates, merchandising and customer services staffs. Retailers often raise number of staffs when holidays and special occasions are near.
The requirement to increase wages could lead to an increased in manufacturing costs and this could potentially hurt these specific regions as it will causes more competitions within suppliers as companies will aim more for other locations who can provide cheaper costs. An example would be that more apparel companies are moving out of China towards other countries such as Cambodia and Vietnam for manufactures due to inexpensive and cheaper labor costs.
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Industry Forecas
Based off Statista, the industry in the U.S. is expected to increase from $225 billion in 2012 to $285 billion in 2025 with a compound annual growth rate at 2%. Globally is projected at $1,105 billion in 2012 to $2,110 billion in 2015 with a compound annual growth rate of 5%.
Retailers are predicting for a stronger growth in the upcoming years as the assumptions of more consumers demands will increase over the year due to the economy picking on in jobs and wages. As well as with technology evolving, the market is predicting for more online retail sales to rise.
Conclusion By reviewing the analysis, I believe that the apparel retail industry will experience low growth for the upcoming years, but will remains a moderate growth in the long run.
Apparel industry is difficult to predict as it is based on consumers’ needs and economic factors. During good economic time, more people would choose to
do their shopping and spend money on items that are leaning towards non-‐essential items, unnecessary goods. If the economic is declining or experiencing recession, consumers would cut back on unnecessary goods.
However, with today’s economy, unemployment rate remains low at 4.9% and more jobs are being added to the workforce. More people are getting jobs which help them to afford purchasing clothing items, accessories, home goods, etc.
More people joining the workforce indicates that people has become more productive and busy for their personal life activities. This lead to less time going out shopping for clothes, grocery, etc. People have been preferred to shop through online retailers, browsing internet for items and prices. Technology has taken a big role into the apparel industry.
If apparel companies can keep up with constant changes in the market, it will be able to produce
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growth over time. Adapting to the environment is the main key to remains stable in this industry.
Company Analysis About Gap Inc. Gap Inc. was founded in 1969 by Doris and Don Fisher, in the state of California and went public in 1976 with an offering of 1.2 million stock shares at the time. Gap Inc. is headquartered in San Francisco, California with approximately more than 150,000 employees and an estimate of 3,300 company-‐operated stores and 400 franchise stores globally.
Gap Inc. is a globally-‐leading apparel retail company. The company provides apparel, accessories, and personal care products for women, men, and children. Gap Inc. operates under multiple brands, which includes the Gap, Banana Republic, Old Navy, Athleta, and Intermix brands.
The company’s key products include:
• Apparel • Handbags • Shoes • Jewelry • Personal care products • Eyewear • Accessories
The company operates its stores in North America, Europe and Asia.
Gap Inc. as of today, has a market cap of $8.86 billion. The company reported revenues of $16.4 billion in 2015 with the United States being the
company’s largest geographic market; it accounted for 77.1% of the company’s total revenue.
Gap Gap brand focuses on casual style leaning towards comfortable, classic and modern clothing. Gap brand is operated in 1,700 company-‐owned and franchise retail locations, globally to around 70 countries.
Banana Republic Banana Republic was founded in 1978 to which Gap Inc. in 1983 later acquired it. The brand offers luxurious goods, high-‐end design clothing and accessories. The brand operates an online channel and over 750 retail locations worldwide.
Old Navy Old Navy was founded in 1994. The brand reached annual revenue of $1 billion, becoming the first retailer to achieve the highest of sales in less than a four year of operation. The brand offers casual style clothing and seasonal fashion wears. Old Navy is one of the largest apparel brands in the world with online and more than 1,000 stores worldwide.
Athleta The brand focused on women’s sport wears segment. Athleta designs fashionable sport attire for the gym and studio. It first opened its full-‐sized store in 2011.
Intermix Intermix was founded in 1993 then was acquired by Gap Inc. in December 2012. The brand is a multi-‐brand fashion retailer, focused on a mix of different types of high-‐end trends with several of designer products. The brand operates through an online retail site and more than 30 boutiques in the United States and Canada.
Management Art Peck Chief Executive Officer, Gap Inc.
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Art Peck joined Gap Inc. in 2005 and has experienced various senior leadership positions within the company prior to become CEO. He graduated from Occidental College in Los Angeles, California, and achieved his MBA from Harvard Business School.
From 2008 to 2011, Art served in the Outlet division, leading the team to deliver strong sales, expand the division globally and to have the first-‐ever Outlet store openings in Canada and Europe.
From 2012 to 2015, he served as President of the company’s Growth, Innovation and Digital division, focusing on making strategic plans for Gap’s e-‐commerce sales across 80 countries. He has added value to the growth of the emerging brands, which allowed him to acquired Athleta in 2008 and Intermix in 2012.
Art later served as executive vice president of Strategy and Operations. He launched the company’s first franchise business, now increased to 400 franchise stores open worldwide.
Sabrina Simmons EVP and Chief Financial Officer, Gap Inc.
Sabrina Simmons joined the company in 2001 and was appointed CFO in January 2008. Prior to Gap, Inc. she has held positions at Levi Strauss & Co., Hewlett Packard Company, and KPMG. Her role at Gap Inc. is to manage and oversee real estate, loss prevention and all global financial departments.
With her position, Sabrina has shown a well-‐developed financial discipline throughout the organization and has helped strengthen the company’s capital structure that helps increase shareholder distributions.
Sabrina graduated from the University of California, Berkeley, with a Bachelor’s in Finance. She later received her MBA from the Anderson School at the University of California, Los Angeles.
Michael Yee EVP, Global Supply Chain: Sourcing and Production, Gap Inc.
Michael has been with the company for four years. Under his management, the global sourcing team has been establishing the company’s category sourcing model, enabling faster and more efficient decision making, streamlining brand interactions and expanding its relationships with factories and mills.
Michael received his Bachelor’s from the University of British Columbia and his MBA from the University of Western Ontario.
Sustainability Strategy Gap Inc. key part of their vision of success is:
“…creating opportunities for the people and communities touched by our business throughout the world.”
The company strategy has three focus which are creation, integration and impact. Gap Inc. strategy is to focus on its people and external and internal environmental issues, to create changes that can help benefit the company, people, and the communities.
Some of the company’s strategies are:
• Aiming to enforce more safety practices at their work environment, to create incentives that can guide employees to be more productive and create better quality products.
• Collaborate and work with stakeholders and engage them in the company’s strategy.
“When we improve working conditions and create opportunities for the people who make our clothes, we enhance our ability to deliver great products to our customers. Our sourcing and sustainability teams work together seamlessly to bring benefits to everyone, from our partners to the people whose
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lives we touch in communities throughout the world.”
-‐Sonia Syngal, EVP, Global Supply Chain & Product Operations
The company believes that by focusing on its people and the environment first, the company can then, be able to deliver high-‐quality products and services to its customers.
Competitive Position
Gap Inc. is one of the major players in the U.S. apparel market, however they’re only accountable for less than 5% market share, due to the market being so diverse with multiple apparel retailers being out there. For example, Macy’s held 9% and Wal-‐Mart held over 7% market share of the U.S. market.
Gap Inc.’s main competitors would be American Eagle Outfitters (AEO), Aeropostale (AROPQ), and Abercrombie & Fitch (ANF). Gap Inc. has a larger market share compared to its competitors. AEO, AROPQ and ANF combined only made up close to 2% of the total market share. Competitors like Zara and Forever21 are privately held, therefore, there are no data towards their market share.
As Table 1 shows, Gap Inc. total market share has been decreasing over time from 5.1% to 4.7%. Though with market share decreasing, Gap Inc.’s
position in the apparel market still remains strong compared to its competitors.
However, Gap Inc. could see a potential competition growth against the “fast-‐fashion” retailers such as Zara and Forever, as consumers’ preferences are shifting towards these trends rather than casual styles.
Risk Factors Apparel trends and changes in consumer preferences Gap Inc.’s success is mainly dependent on the ability to provide the right products and services to consumers to meet their expectations in a timely manner. The global apparel industry fluctuates due to different seasonal changes and consumers’ preferences, which causes the difficulty to produce products that are suitable for certain local markets. This could cause the company to not be able to deliver their product in time, compared to its competitors. If the company fails to keep up with apparel trends and consumer preferences, it could affect its sales and excess inventory could potential affect operating results.
Inventory management Linked to the above risk factor, the fluctuations of the global apparel market could impact the inventory of the company. For retailers, merchandise must be ordered in advance before the selling peak happens, which usually occurs during seasonal changes, holidays, or when the fashion trends start to shift. If the company sales do not meet the market expectations, this could cause excess inventory leftover, leading to large amount of markdowns to sell off the inventory, and will eventually results in lower margins.
Data security risks Cyber-‐attacks have been aiming for retail industry and Gap Inc. is concerned towards not having enough resources to prevent any types of cyber-‐
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attacks, if this potential risk occurs. Actual attacks can cause damages towards the company’s technological capabilities, and Gap Inc. may have to incur increasing costs, which includes costs for additional personnel and protection technologies, train employees, and engage third-‐party experts and consultants.
International expand might not be successful One of the company’s strategies is to continue the expansion of their brand around the world. Gap Inc. is planning to open company-‐owned stores as well as franchise and online stores to multiple countries. However, they’re limited in experience towards some locations and might face difficulties competing with already established businesses. Consumers’ preferences and trends may differ in certain locations and could results in unexpected sales and margins.
Failure to maintain our reputation and brand image Gap Inc. has a wide recognition towards their brand reputation and products quality. To maintain a positive recognition is very crucial to the company. If failure to protect their reputation occurs, the company’s image could be impacted negatively, affecting the results of operations.
SWOT Analysis Strength
Expansion globally
Gap Inc. is operated in various geographies. Gap operates company-‐owned stores in the US, Canada, the UK, France, Ireland, Japan, China, Hong Kong, Italy and Taiwan. The company also has franchise agreements to operate in Asia, Australia, Europe, Latin America, the Middle East, and Africa. Gap also operates its online retail sites available to
90 countries. In 2015, the company’s e-‐commerce revenues reported at $2.5 billion.
With global operations, Gap Inc. can diversify its business risk by not focusing mainly on one region such as the UK, and US but was able to have a large customer base globally.
Well diversified brands
The company operates various types of brands and operation segments that help it expand and attract different types of customer groups. For example, Gap brands focused on casual style, operates not just at retail level but also through outlet and factory stores, offering similar styles but at a lower price, targeting lower income consumers. Banana Republic sells more office and formal attires for women and men, at higher prices, however also do offer outlet and factory stores to sells products at lower prices.
Well-‐developed Omni-‐channel
Gap serves order-‐in-‐store, reserve-‐in-‐store, find-‐in-‐store, and ship-‐from-‐store to provide several of services to consumers, making their shopping more efficiently.
Weakness
Dependence on outside vendors
Gap depends on outside vendors for manufacturing its products, the company itself does not own any factories. Gap uses outside sourcing from more than 1,000 vendors. Only 2% of its merchandise purchased was from the U.S., the 98% were from other countries with China being the largest suppliers out of all. This limits Gap the ability to have control over the products being purchased. This could affect the brand’s reputation negatively if
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the quality of the products does not meet consumers’ expectations.
Expansion to emerging market
Gap has not made any further progress into operating its company in the emerging markets. This could limit its opportunity for growth and expansion.
Opportunities
E-‐commerce expansion
E-‐commerce market has been growing at a fast pace as people are more dependent on technology. The US e-‐commerce retail sales increased from $169.3 billion in 2010 to $297.2 billion in 2014, resulting in a compound annual growth rate of 15.1%.
More retailers are preferring to use E-‐commerce market due to lower operational costs and low maintenance. Customers’ preferences are also leaning towards online shopping as it is more convenient for them.
Positive improvement for apparel industry in the US and China
According to MarketLine, the US apparel industry has been increasing and is predicting to grow 22% from 2014 to 2019 in sales. As the economic is
improving, it will lead to a higher demand of consumer spending.
For China, the market is predicting to grow 63% from 2014 to 2019 in sales. By expanding more stores in China, the company can expect a high growth for this geographic segment.
Opportunity to grow in luxury retail market
The luxury retail market has been growing globally, driven by emerging markets from Latin America, Asia Pacific and Africa. Developed markets also increasing on the demand for luxury products. By expanding its brands to luxury market could help the company diversified its segments and business operations.
Threat
Rise in labor costs
The US has been increasing in its labor costs as government demand to raise minimum wages. Overtime, the US has been increasing its minimum wages above $8 an hour in many states, compared to $6.55 per hour in 2009 and $7.25 per hour in 2010.
Europe and China has also been increasing its minimum wages steadily over time. With China being the largest suppliers to Gap Inc. This could impact the company’s operating cost and affect its margins.
SWOT ANALYSIS TABLE Strength
• Expansion Globally • Well-‐diversified brands • Well-‐developed Omni-‐channel
Weakness • Dependence on outside vendors • Expansion to emerging markets
Opportunities • E-‐commerce expansion • Positive improvement for apparel industry in
the U.S. and China • Opportunity for grow in luxury market
Threats • Rise in labor costs • Counterfeit products
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Counterfeit products
More counterfeit products have come in to the market as the substitution for high-‐end price products such as designer handbags, sunglasses, footwear, etc. These products can be found at local flea markets and have become popular over time as it offers cheaper prices. China reported them as the main source for counterfeit goods.
The existence of counterfeit products could impact the company negatively by bringing in misleading quality products and dilute the brand image.
Conclusion Gap Inc. has been decreasing in its sales over time. Though despite the drop, the company still remains strong, being one of the major players for the apparel market.
With the company being well diversified in brands that produce different types of apparel products, which target different types of consumer groups, I think that Gap Inc. has the potential to rise back up in its sales. The company focuses on multi-‐geography segments and operates through several other countries, which helps the company’s brand recognition to be better known, worldwide.
By looking for opportunities such as expanding into more geographical segments can help increase its brand names to be more well-‐known for consumers; aiming towards e-‐commerce sales as more consumers are shifting to online shopping could lead to a positive impact on the company’s sales and operation costs.
The firm also has a sustainable strategy, which focuses on creation, integration, and impact. This drives the company to seek for innovation, provides effort to bring benefits for both its company and its’ customers.
Though the company has some competitive advantages over its competitors based on size and segmentations, however, consumer preference changes and fashion trends can be a major risk towards the company. More customers are leaning towards fashionable retailers such as Zara and Forever21, this could dilute the sales grow for Gap Inc. over time.
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Fundamental & Ratio Analysis
This section will focus on the company financial analysis comparing to its competitors. I will be discussing over the two important assessments which are short-‐term viability, cover liquidity and solvency and long-‐term growth outlook, focusing on turnover and margins. The company’s historical data could go back as far as 1995 to most recent 2015 financials.
Assessment of Short-‐Term Viability With short-‐term viability, I will be focusing on liquidity and solvency.
Liquidity
Liquidity ratios focus on determining the sources and uses of cash of the company, to avoid any unexpected issues that could occur causing the company to borrow more debt.
CFO vs. EBIT
Gap reported compounded annual growth rate (CAGR) at 1.75% overtime while their earnings before interest and taxes (EBIT) trends downward at -‐0.50%. Overtime, CFO and EBIT remained in line together except despite 2013 drop in CFO due to various taxes factors such as timing of tax payments, income taxes payable, and other tax-‐related items, results in a decreased of $231 million compared from 2012 to 2013 CFO.
With CFO and EBIT moving along together most of the time, this proves that the earnings are more a
results of economic rather than being supported by accounting accruals.
Cash from operation decreased in 2015 primarily due to a decrease in net income due to lower revenues and a decrease in other current assets and other long-‐term assets resulting from the company’s credit card program with different timing payment that lead to increase in cash inflows at a later time.
Though the company CFO and EBIT trends downward for 2015, the important factor to take in consideration is that they’re both trends along together and CFO still perform slightly higher than EBIT.
Net Working Capital Requirements
Working capital assets has remained higher than working capital liabilities for Gap Inc. Working capital assets CAGR reported at 1.91%, while working capital liabilities CAGR reported at 0.04%. Thisis mainly due to inventories on hand that the company has to stores.
This is typical for retail industry as it depends on its operating cycle. Retail companies often spend money on inventory in advance to get ready for its next sales cycle such as holiday seasons. With working capital assets reported higher than working capital liabilities, this indicates that Gap’s net working capital requirements to be a use of cash, as the company use cash to purchase more inventory for advance sales.
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Free Cash Flow
It’s important to consider the company’s free cash flow as it determines the amount of cash that is available on hand by the company.
Gap Inc. cash dividends paid in 2015 reported at $377 million with CAGR of 6.48% overtime. The company increased its dividend from $0.88 per share in 2014 to $0.92 per share in 2015 and planned to pay out dividend at $0.92 per share in 2016. By increasing its dividend paid, I assumed that the company management is confident in its liquidity.
The company has a net shareholder outflows of $1,009 million in 2015. The company took in more debt in 2015 to buy back its stock repurchase, results in an increase in shareholders’ value.
Cash Conversion Cycle
Cash conversion cycle is a measurement determines how fast and efficient can a company be towards using its short-‐term assets and liabilities to generate cash. The lower the number, the better it is for the company.
Gap Inc. has increased in its cash conversion cycle since 2008. The firm cash conversion cycle reported at -‐24.20% in 2008 to -‐2.21% in 2015. This is mainly due to the increased in cost of goods sold. Though the company has increased in cash conversion cycle
number, it still remains low, which indicates that the firm is still using its short-‐term assets and liabilities efficiently to generate cash.
Solvency
Solvency ratios determine how much debt a firm is holding and the firm’s ability to handle the debt.
Time Interest Earned
This ratio is a measurement of the firm’s ability to make its interest payments. The higher the ratio, the greater ability the firm will be able to pay its interest payment as due time come.
In 2015, Gap Inc. reported time interest earned at 22.96, lower compared to 2014 at 27.84 and 35.51 in 2013. This was due to lower revenues in 2015 compared to previous years. Time interest earned for Gap Inc. has been staying low overtime, despite the soars in 2008 – 2010 due to lower interest expense and higher taxes and net income.
Debt-‐to-‐Equity Ratio
The company debt-‐to-‐equity has been going up from 0.45 in 2014 to 0.68 is in 2015 with total debt CAGR reported at 65.92% since 2008. The company is highly levered. This could be worrisome as the company is taking in more debt recently. The company entered into a 15 billion Japanese Yen un-‐secure term loan for its plan to invest more in the Japan market.
I think this is a concern that the company is increasing in its debt. Though I believe that the company takes in more debt for its business strategy and plan to expand to multiple countries. However, overtime I do not think that they should continue to take more debt to fund for more business expansions as they’re already highly levered.
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Recent reports also showing that Gap has been shutting down Banana Republic stores in the UK, this indicates that their plan did not turn out to the way they were hoping for. Gap should keep a tight watch on its debt.
Combined Financial Leverage
From the graph shown, Gap Inc. combined financial leverage is actually going at a steady rate, slightly increasing overtime with CAGR of 7.31%. Though Gap Inc. combined financial leverage is higher than Aeropostale in 2015, the company still stayed rather similar to its historical data and did not increase much higher.
Credit Ratings
As of January 30, 2016, Standard & Poor’s, Moody’s and Fitch rate Gap Inc. BBB-‐, Baa2, and BBB-‐.
However, due to weak sales during the summer season, as of May 2016, S&P downgraded Gap to BB+ and also Fitch downgraded to BB+ with outlook stable, as this grading will remains for a while.
This brought the company down below investment grade. Changes with credit ratings could results the company in change in interest expense if draw on the credit facility given.
Summary of Short Term Viability
Through multiple of metrics to analyze the company’s liquidity and solvency, I think that there’s a slight concern going on with the company financial leverage as the company is taking in more debt over time, whether for business expansion or to buy back stocks, I think the company needs to be on a watch more often with its performance and activities.
Overall, in a long-‐term run, I would not be too worry as the market is predicting to go back up for consumer discretionary sector and that more customers are willing to spend more money on discretionary products.
Assessment of long-‐term growth outlook For long-term growth outlook, I will be discussing over the top and bottom line growth of the firm.
Turnover
Revenue growth
In 2015, Gap Inc. revenues decreased to $15.7 billion compared to previous year at $16.4 billion. From 2008 – 2015, revenue CAGR stayed at 1.21%, which is very low. Though revenue decreased in in 2015, this was mainly due to the impact in foreign
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exchange and economy condition for the year, as consumers are cutting down on discretionary spending, results in a revenue deduction for the retail industry in general.
Asset turnover ratio (ATO) for Gap Inc. reported at 2.12 in 2015, remained in line with 2014. The retail industry tends to have the highest ATO among the sectors due to small asset bases and high sales volume. Compares to its competitors, Gap ATO has been higher than American Eagle and Abercrombie & Fitch but remained lower than Aeropostale overtime. Gap ATO has remained over the median of the industry.
This indicates good sign as the company is using its assets efficiently relative to its sales. I think the company turnover is performing strong through my analysis.
Margin
Gross Margin
Gross margin remained in line closely with previous years, slightly decreased by 2%, reported at 36.2% in 2015. Compared to the industry gross margin, the company perform well overtime. Gap gross margin has been higher than Aeropostale since 2011 when Aeropostale gross margin started to decreased.
Net Margin
Gap Inc. net margin dropped in 2011 to 10% then pick back up in 2013 at around 13%. I can see that Gap net margin is falling again down to 9.74% in 2015 as the company experience low sales. However, Gap net margin still remains in good standing that I do not think that it’ll be a problem in a long-‐run.
Gap has higher and positive net margin while Aeropostale dropped down to negative margin, reported at -‐8.18% in 2015.
ATO * Margin
For long-‐term growth outlook, Gap has outstanding margins. The company ATO times Net Margin follows tightly to Net Margin trend overtime, remain positive at 20.58% in 2015. Gap Inc. outperform its competitors, Aeropostale. Aeropostale ATO times net margin also follows its net margin, continue to drop into the negative.
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Return on Equity
Gap ROE reduced from 42.3% in 2014 to 36.1% in 2015. I believe this is mainly due to the drop in net margin as revenues and EBIT decreased. Though ROE didn’t increase, I believe that it will remains stable overtime and eventually will increase back up, but at a slower pace.
The graph indicates that Aeropostale ROE skyrocketed in 2015. Typically, higher ROE means that a company is profitable. However, with Aeropostale ROE soars into such high percentage due to assessing ROE when stockholder equity is negative. This is actually not a good sign for Aeropostale as the company is actually losing money rather than generating profit.
Overall Summary
After the analysis with multiple metrics and ratios to assess Gap financials, I come to a conclusion that the company will remain in a positive condition in the near future.
On the short-‐term viability, the firm can be a slight worrisome due to being highly levered and their CFO CAGR remains low overtime. However, I do not think that it should be much of a problem as the company is using its cash for working capital needs and have excess cash on hands in case for any unexpected business downturns.
For long-‐term growth outlook, the company has remained stable overtime and I think the company will continue to outperform year-‐over-‐year. Though top and bottom lines didn’t have a strong growth, the company still remains positive and either outperform or remains in line with the industry trend.
Overall, I think the company is in a good condition that can be improve in the future. With more expansion to emerging markets, the company can see higher growth in the long-‐run.
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Forecasting
Revenue
Revenue is a very important factor to take in consideration when projecting a company’s growth. Gap Inc. is a mature firm that has been established in the industry for a long time. The company generates stable revenue overtime and remains positive with it financials. By forecasting the firm’s revenue, this can help my analysis to predict the growth for the company in the future.
I predict that Gap will experience revenue growth over the next few years, however, will be growing at a much slower rate. Recent earnings did not look impressive for Gap as demand for Old Navy and Banana Republic has been trended downward.
Gap revenues is being affected by other retailers such as H&M and Zara as consumers’ preference shifted towards lower price and fast-‐fashion products.
Buyer power takes a big part into the sales growth of the company as demand for casual clothing styles has been decreasing. Gap might face a challenge in the near future if the firm cannot increase product innovation to attract its consumers back to the business.
However, a factor that can help Gap to increase in its sales growth is to expand its Omni-‐channels such as ship-‐from-‐store, online-‐pick up services. Also focusing on online-‐site can help its revenue to go back up as this create more efficiency for the consumers as well as cutting down extra costs for the company.
With revenue forecast, I predict that Gap will have 1% growth in new stores, 1% growth Omni-‐channel, and 1% growth in revenue per square foot.
Margins
Gap gross margin has been declined slightly from 2014 to 2015 due to low sales for the year. However, I predict gross margin to remain in line closely to its historical data.
Historically, gross margin has been average about 37%, therefore I’ll trend and give gross margin of 1% growth until 2018 when it reached 39% and decreased 1% back to 38%.
Compared to gross margin in percentage, the dollar amount is expecting to increase slowly year over year, forecasted up to 2020. Gap is aiming to close more underperforming stores and will mainly focus on regional stores in North America. The company shifts its strategy plan to channelizing its resources
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right and appropriately to the changes within the fashion retail industry.
EBIT
EBIT Margin (Table 14) is forecasted to rise in 2016 to 2018 at estimate of 12.4%, then will eventually slightly decreased back to 11.0%. With positive margins and revenue growth, I predict that EBIT will maintain a stable growth in the futur. The company will likely to generate high revenue for the next few year with positive margins as operating expenses stay fairly average with historical data.
Net Income
Net income in 2015 for Gap didn’t perform too well, they actually had a decreased from $2,129 million in 2014 to $1,549 million in 2015, with a CAGR of -‐0.71%. Though my forecast is predicting for revenue growth to increase, as well as margins, however, I am not expecting net income to increase at a fast pace in the future.
Low net income results from lower sales for the year due to Gap announcement in early 2015 that the firm closed down the Piperlime brand, including its online and stores in New York. Cost of goods sold and operating expenses were also affected by strategic actions that management has that year, causing COGS to increase about 2% and operating expense increased 1% as a percentage of sales.
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Balance Sheet
Assets
Gap total assets has remains low overtime. The main drivers for the firm’s total assets are cash and cash equivalent, inventory, and PP&E.
With the current strategy actions that Gap is planning to close down underperform stores, PP&E is not expecting to grow strong in the future, and I set my prediction at a flat rate of 31%.
Inventory is expecting to rise, this is understandable as a retail company, Gap would need an appropriate amount of inventory on hand for advance sales.
With the company strategy plan to focus on mainly North America segments, I do not think that their total assets will grow as fast since they are not planning to expand anytime soon. Therefore, my forecast indicates that Gap total assets, though
increase, will remains low compare to its historical trend.
Income Statement
Accounts payable and other short-‐term liabilities are projects to increase from 2016 – 2020. I used the percentage of cost of goods sold and expenses, which average to 15%, used as a flat rate.
As stated with Gap planning to focus on regional segment only, I expect for the company debt to be lower in the future as they do not have any expansion any time soon, this can help reduce costs and reduce their debt. With the forecast, average Debt to Equity ratio is at 0.38, 2015 reported ratio at 0.68. Based off that information, I predict the debt to reduce to 0.58 overtime.
Ratios
Asset Turnover
Compared to its competitors, Gap has a strong asset turnover in 2015, as well as remain above industry average overtime. I predict that this trend will maintain stable at a rate above 2.50 for the next few years unless new strategy plan takes place such as new acquisition or new expansion, which most likely will not happen any time soon for Gap.
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ATO * Margin
As forecasted asset turnover to stay moderately stable and net margin slightly decrease, I would predict ATO times margin to decrease slightly as well. Though it will increase between 2015 and 2018, it will continue to drop after. As the growth isn’t as strong, it still being forecasted higher than its historical trend.
Return on Equity
Gap’s ROE has been steadily rising over the year, following the trend of its historical data, I predict for ROE to also continue to increase for the next few years.
Gap maintains a stable tax impact overtime, reported at around 62% in 2015, compared to Aeropostale which tax impact was reported above 100%. A stable tax impact will lead Gap to an increase in ROE in the future.
Earnings per Share
Earnings per Share also an indicator of the firm’s profitability. The higher the share, the more the stock will be worth that can results in higher value for the company. With Gap EPS has been increasing, I predict for its EPS to continue to rise and remains above 3.00
Dividend per Share
The company paid out dividend of $377 million in 2015, a $8 million decreased from 2014. I predict the company to continue paying out dividend in the
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future. Dividend paid out will continue to decrease in 2016 and will eventually increase back up.
Forecast Overall
Based off the forecast, Gap looks like it is going in a good direction for future growth. After management strategy planned to shut up down underperform stores, this can actually help boost up the company growth by cutting down costs and perform a more efficient management that could lead the firm into a fast growing pace compare to its slow growth at the moment.
I also believe that the consumer discretionary sector will rise back up as more consumers will have excess cash, which willing to pay for more discretionary items.
Overall, I think Gap Inc. is still in a good standing and has the potential to growth. A factor to take into consideration is the buyer power, as the company is depending on consumers’ preference and needs in order to outperform its growth.
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Discount Rate
In order to perform a valuation on a company, I must first determine the discount rate. The most common method used is called Capital Assets Pricing Model (CAP-‐M). CAP-‐M is comprised of three factors:
1. Risk-‐free Rate 2. Market Risk Premium 3. Beta
I will be discussing these three factors in this analysis.
Risk-‐free Rate (3.86%)
The Risk-‐free Rate determines the rate of return the investor is able to receive without being affected by any risk. Two common ways to determine the Risk-‐free rate is to use the current 10-‐year treasury yield or the normalized approached.
The 10-‐year treasury yield has been low at around 2%. I decided to use the normalized method, as I believe it will provide more of an accurate result for the risk-‐free rate as it considers productivity, labor growth, and expected inflation.
The Current Treasury Yield has been too low compared to its average overtime of 5% or higher. By using low risk-‐free rate, I believe it could result in a higher valuation towards the company.
Normal Real Rate (3.0%)
The Normal Real Rate is equal to the Expected Real GDP growth, which contained expected productivity and expected labor growth.
I will give an estimation for 2% for expected productivity, considered that productivity has been
in a slow pace and was also reported with a reduced rate in the third quarter of 2016.
Expected productivity and expected labor growth usually offset one another, with productivity declining, labor might see potential growth. However, I still believe that expected labor growth rate to be at 1.0%.
Expected Breakeven Inflation (1.86%)
By bootstrapping the 10 year and 5 year treasury yield given from the Federal Reserve to the Forward 5 year Nominal and TIP, the expected breakeven inflation would be calculated at 1.86%.
Normalized Risk-‐free Rate (3.86%)
Normalized risk-free rate can be computed by:
= (Normal Real Rate + Expected Inflation) – 1%
Adding Normal Real Rate and Expected Inflation together and less 1% will results in a normalized risk-‐free rate of 3.86% compared to current 10-‐year treasury yield of 1.83.
Market Risk Premium (3.04%)
The market risk premium applies to all stocks on the market, to determine the return the investor is able to receive being exposed to the stock market risk.
According to Dr. Damodaran’s article on Equity-‐risk Premium (ERP), there are three approaches to go about calculating ERP. However, they can also result in different values.
• Surveys • Historical Premium • Implied Approach
Surveys: This method is being calculated by asking investors and analysts for their opinions of what they think the future stock returns would be and
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then net out the risk-‐free rate to get the result. Dr. Damodaran disagrees with this method and I also do not believe this approach can generate accurate information. The surveys approach represents more of the past rather than the future and also investors or analysts could be optimistic, leading to more hopes more than expectations of wha\t the actual future stock returns could be.
Historical Premium: This approach uses historical data to predict the premium earned by investing in stocks over a risk free investment. I will not be using this approach as I believe by basing our assumption solely on just historical data will not give us an accurate valuation. The rise in globalization and rules changed overtime, historical data will not take the new rules into consideration.
Implied Premium: This approach is being calculated based upon the price pay and the expected cash flows on stocks, dividends and buybacks. I think the implied approach makes the most sense out of the three. The calculation is being computed at future numbers (expected cash flow) and it is also based off the money paying for stocks today. Therefore, I believe that this approach will give me a better valuation and better results.
Implied approach
Market risk premium can be calculated by using the implied approach:
= Expected Return on Stocks – The Risk Free Rate
Expected Return on Stocks
Expected return on stocks can be calculated by:
= Current Dividend Yield + Expected Earnings Growth
Current dividend yield is based off the market. Therefore, I will be using the S&P500 (SPY) current dividend yield at 2.04%.
Expected earnings growth is the Nominal US GDP Growth, which consisted of Productivity (2%), Labor Growth (1%), and Inflation (1.86%), results at 4.86%.
Adding two factors together will give the expected return on stocks at 6.90%.
With expected return on stocks at 6.90% and the risk-‐free rate of 3.86%, I calculated the market risk premium to be at 3.04% (6.90% -‐ 2.04%).
Beta When determining a company’s beta, there are four key factors to take into consideration:
• Revenue Sensitivity • Operating Leverage • Financial Leverage • Historical Data
Revenue Sensitivity
Based off the revenue chart above, Gap seems to react alongside with many financial impacts overtime. For example, revenue dropped during the 2007-‐2009 recession. This is understandable as consumer discretionary sector is highly sensitive to the market. When the economy condition is not performing well, consumers will cut down on unnecessary needs and vice versa.
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I will assume that Gap will have a high level of revenue sensitivity, more likely with beta above 1, indicating a cyclical stock.
Operating Leverage
Gap has high fixed costs, which includes a large amount of furniture and equipment, lands and buildings, and construction in-‐progress. The firm has a decent gross margin standard deviation rank in the top 37.4% with net margin standard deviation rank in the top 27.3%. Gap’s gross margin standard deviation reported at 2.68 compared to the market at 3.70. Net margin standard deviation reported at 3.02, also lower compared to the market at 5.87.
Smaller standard deviations indicate a good sign as the data are being clustered, closer to the mean, which is more reliable. I would give an estimate for beta to be 1.
Financial Leverage
Looking at Gap debt to equity, the firm currently holds a lower debt compared to the market, reported at 45.36 vs. the S&P500 at 57.88. This indicates that the company isn’t as highly levered compare to the market benchmark. I would conclude the beta for this to also be at 1.
Historical Data
I computed a Rolling 3 year Beta from Gap Inc.’s historical prices. From the graph below, we can see that the beta has been alongside with the historical data, slightly above 1 from 2005 to present. Based off the historical beta, I would estimate the beta to be slightly above 1.
Beta Assumptions
Revenue Sensitivity Above 1 Operating Leverage 1 Financial Leverage 1 Historical Above 1 After analyzing all the key factors and taking into consideration the level beta for each, I will conclude my assumption for base, best, and worst scenarios.
Base (1.15) For base scenario, I would assume Gap Inc.’s beta to stay above 1. I would give an estimate of the beta to be 1.15
S&P 500GPS UN Equity Rank
Median 3.70 2.68 37.4%90 Precentile 14.78 10th Percentile 1.17 Table 38
S&P 500GPS UN Equity Rank
Median 5.87 3.02 27.3%90 Precentile 79.38 10th Percentile 1.54 Table 39
Gross Margin Standard Deviation (%)
Net Margin Standard Deviation (%)
S&P 500GPS UN Equity
Rank
Median 57.88 45.36 42.9%90 Precentile 267.87 10th Percentile -‐ Table 40
Debt to Equity
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Best (Low at 1) Best case scenario is when the beta is low, indicating that the firm is not highly levered. I would give the lowest beta assumption to be 1.
Worst (High at 1.55) Based off the historical data, Gap has experience high degrees of beta before reaching beta of 1.50 or even above 2 back in 1990. I would assume the worst case scenario beta could rise to 1.55
Discount Rate Combining Risk-free Rate, Market Risk Premium, and Beta together will results us in Discount Rate Normalized below:
SCENARIOS DISCOUNT RATES BEST (1) 6.90% BASE (1.15) 7.36% WORST (1.55) 8.57%
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Growth Rate Determination and Valuation
Three models I will be using to determine the stock value:
1. Dividend Discount Model (Gordon Growth Model)
2. Capitalized Earnings Model 3. H-‐Model
I believe these three models are suitable for Gap stock valuation due to the company pays dividends and these models will be taking dividend and EPS into consideration.
In previous section, I have determine the Discount Rates for three scenarios which are:
SCENARIOS DISCOUNT RATES BEST (1) 6.90% BASE (1.15) 7.36% WORST (1.55) 8.57%
I will be using the assumed discount rates and also several more assumptions for the company valuation.
Growth Rate
Before valuating the company, I will discuss the short-‐term and long-‐term growth rate for the three scenarios.
In previous section (Industry Analysis), the U.S. apparel industry reported CAGR of 3.2% from 2011 to 2015. The industry has remain a stable growth for recent years and is projected to increase moderately up to 2020. Based off my industry forecast, I believe that retailers are looking for stronger growth in upcoming years due to higher consumer demand. Globally speaking, the apparel industry is looking at a CAGR of 5% or above.
Historically, Gap has reported CAGR of 1.75% overtime, this is relatively low. However, they still report positive earnings with stable growth overall.
Short-‐term Growth Rate: To calculate the short-‐term growth rate, I will considered three approach:
• PEG Ratio • Sustainable Growth • Historical Growth
PEG Ratio: Using Trailing P/E Ratio of 14.90 (yahoofinance) and PEG Ratio of 3.02 (yahoofinance), calculating that together will give a short-‐term growth rate of 4.9% (14.90/3.02).
Sustainable Growth: Sustainable growth rate can be determine by calculating ROE * Retention.
The firm’s company ROE reported at 36%. Retention can be calculated by using Dividend paid and EPS. The Company’s dividend is 0.92 and EPS is 2.41. Retention would be 61.8% (1-‐0.92/2.41).
ROE * Retention = 22% sustainable growth.
Historical Growth: Using Bloomberg trailing 12 months EPS and calculating it at 3, 5 and 10 years growth, the graph shows that EPS growth for Gap remained stable overtime. The historical data indicates that Gap EPS
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growth reported in the 7% to 13% growth range.
The firm reported CAGR of 1.75% overtime from 2011 to 2015. However, the firm is predicting to have a moderate growth in the next few years as the industry is also expecting for higher growth.
I would assume the company short-‐term growth rate to be at 4% at base scenario. I would give short-‐term growth rate of 1.5% for worst case scenario if the company underperform due to drop in consumer demand. Best case scenario would predict to be at 6% if the economy condition is performing well and more consumers are willing to spend on apparel and accessories products.
Long-‐term Growth Rate For long-‐term growth rate, it’s usually can be predicted by using the same rate to match Nominal GDP rate. However, I would assume that Gap Inc. long-‐term growth rate will be lower due the slow growth in the industry overall as well as the company’s slow growth on sales. I would assume the rate to be at 3% base growth to match the Nominal GDP Growth. I will also give a worst case of 1.5% and best case of 4.5%.
Time period from ST to LT Growth Gap has been consistent with their growth overtime. The apparel market also performs moderately, remain in trend line with their historical performance. I will give an assumption that it would take 2 years to get from ST growth to LT growth. That would results in a half life of 1 year.
BEST BASE WORST RF 3.86% 3.86% 3.86% ERP 3.04% 3.04% 3.04% BETA 1.15 1 1.55 KE 6.90% 7.36% 8.57% ST GROWTH 6% 4.0% 1.5% LT GROWTH 4.5% 3% 1.5%
Dividend: $0.92 EPS: $2.41 Inflation: 1.86% H: 1 year
Models
Dividend Discount Model This model works well for Gap as the firm pays out dividend. The DDM only assume one growth rate thus I believe this wouldn’t be a problem for Gap as the firm has a stable growth over time.
Dividend Discount Model = (Div0 * (1 + LT Growth)) / (ke – LT Growth)
Best Case: $33.62
Base Case: $21.73
Worst Case: $15.94
Capitalized Earnings Model This model was proposed by Professor Ronald Sweet to assume a firm pays out all earnings and retain 0%. However, this model assumes to grow with only inflation and does not take ST growth and LT growth into consideration. I am disagree with this model as I believe it might not be as accurate if only depends on inflation.
Capitalized Earnings Model = (EPS0 * (1 + Inflation)) / (ke – inflation)
Best Case: $48.71
Base Case: $44.63
Worst Case: $36.58
H-Model The H-‐Model approach assumes both ST and LT growth into its formula. The model expected to ST growth to be at a fast pace and high growth, then will eventually slow down and remain in line with
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the economy for its LT growth. This model seems to work well for Gap as the apparel retail stocks remain stable throughout time based on its historical data.
H-‐Model= (Div0 * (1 + LT Growth) + Div0 * H * (ST Growth – LT Growth)) / (ke – LT Growth)
Best Case: $34.10
Base Case: $21.94
Worst Case: $15.94
Gap Valuation Best Base Worst DDM $33.62 $21.73 $15.94 Cap Earnings $48.71 $44.63 $36.58 H-‐Model $34.10 $21.94 $15.94 Median $34.10 $21.94 $15.94 Average $38.81 $29.43 $22.82
Current Price (as of 12/1/2016): $25.67
Recommendation After evaluating the stock using the three models, the DDM and H-‐Model indicated that Gap Inc. to be slightly overvalued. The price reported at $25.67 (as of 12/1/2016), which is more expensive than the base price for DDM and H-‐Model.
As stated above that I disagree with the Cap Earnings model because I believe that by taking solely inflation into account will not be able to provide an accurate valuation. And we can see from the Cap Earnings model that base price is $44.63, which indicates that Gap Inc. stock price is actually cheaper.
Based on the three models, I would recommend to hold the stock. However, more valuations will be discuss further in later sections to conclude a sound recommendation.
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Relative Valuations
To go more in detail and to better our valuation of Gap Inc., I’ll be focusing on relative value analysis. Relative Value Analysis is an approach to compare the current measure value of a company to certain underlying fundamental factors. This is to help comparing the company’s value to the overall market value, to determine which companies within the industry are “cheap” or “rich”, and where Gap Inc. stands in the ranking model.
I will be comparing Gap Inc. ratios to the S&P 500 index, the S&P Consumer Discretionary index and the Specialty Retail and Textiles, Apparel & Luxury Goods industry.
To value the companies within the sector, I will be using the ratios below to address and compared whether Gap Inc. is overvalued or undervalued relative to the industry and the market overall.
• Price to Earnings • EV to Sales • Price to Cash Flow
Price to Earnings Looking at the historical PE ratio of Gap Inc. compared to the S&P 500 index, we could see that before the financial crisis in 2008-‐2009, Gap Inc. was above the market trend. However, during the crisis, the firm PE ratio dropped significantly lower than the market. This is reasonable due to consumers were cutting down on spending overall.
Gap Inc. PE ratio rose back up in 2012 as the economy started to go into the recovery, however from 2013 to present, the PE ratio has been
underperform compared to the market. This indicates that Gap Inc. is being undervalued compared to the overall market.
The graph below shows the firm PE ratio in comparison to the consumer discretionary sector and the apparel retail industry. In 2008, the consumer discretionary sector reported at a high PE ratio, however, this is not from the apparel and clothing industry. The high PE ratio was from auto parts & components segment.
Looking at Gap compared to the apparel retail industry PE ratio, Gap actually performed better during the financial crisis. However, overtime, the firm still underperform compared to the sector and
industry ratio.
From previous analysis, Gap, although has positive earnings, has actually been decreasing slightly on revenue overtime and are forecasting for either
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slow growth or stable growth for long term. With the PE ratio underperform compared to the industry and overall market, I am confident to say that the stock is not being undervalued by the market.
EV to Sales Gap Inc. has EV to Sales reported lower than the overall market overtime. With recent years from 2013 to 2016, the market EV to Sales has actually been increasing. However, compared to the market, Gap Inc. is actually slowing down on its EV to Sales. This could be a sign that the company’s forecast revenues could potentially decrease in upcoming years rather than increasing.
Post financial crisis, Gap Inc. did not remain in the trend line with its sector and the industry. During 2009, Gap EV to Sales dropped while the sector and industry were rising. Up to 2016, Gap still being undervalued significantly low compared to the industry and sector, overall.
Price to Cash Flows
Gap Inc. has remained in line with the overall market up until 2014 when the company performed lower P/CF compared to the market. This could indicates that the company was being traded fairly, however transitioning to being undervalued for the recent years. For company that pay dividend yield
like Gap, it’s important to take cash flows into consideration as investors pay attentions for a strong cash flows.
Comparing to the sector and the industry, the firm has remained in line for the historical data and declined from 2013 going forward. The sector and industry also appeared to be declining in the recent years for its price to cash flows. This could mean that other firms are also looking into their cash balance to pay their investors as the firm cash flows did not meet expectation in able to pay the
investors.
Ranking Model
For my analysis, I will be using the ranking model to evaluate Gap Inc. against the market to determine if the company is being value as cheap or rich stock.
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I retrieving data from Bloomberg with approximately 90 companies under the Special Retail and Luxury Goods Industry. To create the ranking model, I took in fundamental, risk, and
valuation factors.
• Fundamental contained Asset Turnover,
EBITDA Margin, and Sales 3 year Average growth.
• Risk contained Total Debt to EBITDA, Bloomberg 5 year Default Probability, and Volatility 90 Days.
• Valuation consisted of PE Ratio, EV to Sales, and Price to Cash Flow.
Instead of running a regression analysis, I analyze my model by using correlation to rank my model
against the market ranking model. I also used Solver in Excel to seek for an optimize solution for the weighted ranking. The correlation came out to 86%, which is equivalent to about 74% R-‐Squared.
For fundamental, the model is really favorable of EBITDA Margin, which it weighted this factor heavily at 52%. Allocation for risk factors scatter and is not weighted high due to the industry is low on debt overall. Lastly, the model is really in favorable of EV to Sales, which weight it at 80%. Based off my model, Gap rank at 53, while the market placed it at 55.
The graph above is based off my model, which indicates the y-‐axis to being my ranking and x-‐axis to be the market ranking. Companies that are above the line are indicate to be cheaper stocks and
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companies under the slope are to be indicate as expensive stock.
Gap Inc. remained above the line, the graph shows that the company is being undervalued slightly compared to the market.
Forecast P/E To calculate the target P/E, I will be using the formula:
Target PE = Payout/(ke – g)
I will be using the same ke and terminal growth from the Discount Rate Determination section to calculate the target prices for three different
scenarios.
I used 5-‐year EPS of $3.26 which is being forecasted in previous section to indicate the target price for Gap Inc.
From the chart above, the base target price is expect to be at $18.13 for Gap Inc. The firm is currently being traded at $25.67 (12/1/2016). In the near future, I would assume the company stock price to decrease. However, best case Gap could increase to $30.57, or worst to $11.98
Valuation Based off my relative analysis, I can see that Gap is slightly being undervalued by the market when comparing the key fundamental factors. However, with my growth rate valuation, my calculation is
indicating that the stock is being traded a little higher than the market.
Relating to the relative analysis, Gap Inc. hasn’t been having a fast growth within its earnings. The firms performed stable overall thus with very slow growth overtime. The historical data shows that Gap has remained underperform compare to the market, which is normal for the company.
I am confident to say that Gap Inc. is actually being traded fairly comparing to the market. Gap stock price is not cheap nor rich, therefore, my recommendation would be to hold, taking my forecast into consideration that the market is expecting for stronger growth within the consumer discretionary sector in the futures upcoming years.
Keys Base Best WorstPayout 28% 28% 28%ke 7.36% 6.90% 8.57%Growth 3.00% 4.50% 1.50%Target PE $6.33 $11.50 $3.915Y EPS $3.26 $3.26 $3.26Target Price $18.13 $30.57 $11.98
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Technical Analysis
Daily Moving Averages
The graph above is retrieved from Bloomberg using daily moving average of 50, 100, and 200 days based off 3 years historical data. For the moving averages, it will suggests a buy opportunity if the firm price is above 50 day average which is above 100 day, 100 day to be above 200 day average and if all are rising. On the other hand, if the 50 day crosses under the 100 and 200 day, a strong sell would be suggested.
Prior to June 2015, the daily moving averages fluctuated with the 3 averages remained closely to each other. Starting from June 2015 to end of March 2016, the 50 day moving averages has been below the other two moving averages, showing a strong sell recommendation for the company. The price dropped from approximately $42 in June 2015 to about $25 in March 2016.
From November 2016 till present, Gap price is currently under the 50 day average and above the 100 and 200 day average. The company price has been flat from September 2016 till now and I would assume that the company will remain flat for some times as I do not see any changes soon for the trend.
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I would suggest to hold the stock for the moment because the trend line is neutral.
Relative Strength Index (RSI)
RSI is another method for technical analysis, to measures the speed and change in price movement of the company’s stock. RSI is range between 0 and 100, this method considered a stock to be overbought when is above 70 and oversold when below 30.
During 2015, Gap’s RSI has remained near the 30 trend line until 2016 where it fluctuates more. During March to August of 2016 where it range above 70 and dropped down to below 30 at another month, then went back up to above the 70. This could be based on seasonal and holiday sells.
From September 2016, the company has remain on the 70 line, indicating that the stock is being overbought. Currently in December 2016, Gap is dropping down from its overbought status, staying between the 30 and 70 range. This indicates a neutral signal.
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Ichimoku Clouds
The last method I will be using is the Ichimoku Clouds. This method follow a trend that focus on the Cloud (blue shaded area) and momentum signals focus on the turning and base lines.
Based off stockcharts.com, some bullish and bearish signals to look at within the Ichimoku Clouds method are:
Bullish Signals:
• Price moves above Cloud • Price moves above the Base Line • Conversion Line moves above the Base Line
Bearish Signals:
• Price moves below Cloud • Price moves below the Base Line • Conversion Line moves below the Base Line
In the beginning of 2016, during February till beginning April, the price remained above the Cloud with its conversion line (purple line) stayed above the base line (yellow line). However, in April through June, I can see that Gap price dropped, moved below the Cloud with Conversion line moved under Base line, showing bearish signal.
From October till November 2016, Gap price has moves above the cloud showing a bullish signal. Currently, the company price actually moves within, slightly above the Cloud. However the Conversion line moves below the base line triggered a bearish signal.
Conclusion:
From the three technical analysis, it has shown that Gap Inc. is neither showing a bullish or bearish signal on the average trend. I would assume that Gap is neutral at the moment as it doesn’t show a strong momentum for a buy recommendation nor sell, it has moves within the range for three analysis.
For technical analysis and based off the valuations, my recommendation is to hold the stock.