Gap May Be Dressing for Success


By Gene Marcial It sure is hard to picture Gap Inc. (GPS), one of the biggest market losers recently, as a real bargain. And you wouldn't get the impression that it is if you polled the 32 analysts who follow the specialty-apparel retailer that owns and operates Gap, Banana Republic, and Old Navy Clothing stores.

But one highly respected retail industry analyst -- Jennifer Black of Wells Fargo Securities, who had turned bearish in July, 2001, when Gap was trading at 32 -- argues that now's the time to grab shares of the Big Board-listed company.

The stock, which traded as high as 44.28 on Apr. 10, 2000, has been in a downspin since then, to as low as 11.40 on Sept. 21, 2001. It has dragged itself up a bit, to 15.67, by Apr. 8, 2002. That was one trading day after Black upgraded her rating on the stock to a strong buy from a "market perform," which basically translates to hold.

"VIABLE ENTRY." What's behind Black's change of heart? "The company is now on the verge of a turnaround," says the analyst. Gap's current stock price, argues Black, represents "a viable entry point" for investors who don't want to miss the boat -- ahead of what she expects to be a major rebound (see BW Online, 12/17/01, "How Gap Could Climb Out of Its Hole"). "We are confident in the management team's ability to turn things around," says Black, who adds: "I am constantly in the stores of the companies that I follow, so I get to notice every little bit of change that occurs."

She notes that Gap has acknowledged that its decision to divert its focus to fashion merchandise from its basic core products -- casual shirts and dresses, khakis, and the like -- was a "disastrous mistake." Now, says Black, "Gap is well on its way to remedying its fashion mishap, as we are beginning to see improved product, with a more basic flair trickling into all divisions."

Earnings in fiscal 2002 ended Jan. 30, plunged to 14 cents a share from $1 in fiscal 2001. Sales in 2002 of $13.8 billion were almost flat with 2001's $13.6 billion. In fiscal 2003, Black expects earnings to rise to 35 cents a share and sales to ease to $13.4 billion.

BASIC INSTINCTS. Gap's return to basic apparel, she says, is just beginning, "but we're pleased with the way in which the company is merchandising it." With its new window displays, Gap is again luring in customers who had previously given up on it. The company isn't investing a lot more money in its return-to-basics strategy, notes Black. It's making do with what it has -- TV ads and promotional pricing, to attract attention.

Gap's comparative store sales have "hit rock bottom and should sequentially improve," she says. The company plans to drastically slash its capital expenditures, to $400 million in fiscal 2003 from $1 billion in fiscal 2002. Part of that will result from the drop in Gap stores' square-footage growth rate, according to Black. Also, the number of stores will increase only slightly this year and next from 2,298 in fiscal 2002 and 2,079 in 2001. These don't include overseas outlets, which totaled 634 in 2002, up slightly from 2001's 529. In fiscal 2003, Black expects Gap to increase that number only to 667.

The number of its Banana Republic and Old Navy stores will also increase just modestly: Banana will add 15 next year to its 2002 count of 441 stores. And Old Navy's 666 in 2002 will go to 856 in 2003.

HIGHER TARGET. Black argues that Gap's stock is "substantially undervalued." It has a five-year history of trading at an average of 2.2 times sales. Right now, Black thinks the stock should climb to a 12-month target of 30 -- based on just 1.7 times her fiscal 2004 revenue estimate of $14.8 billion.

The analyst thinks at this stage, price-earnings ratio isn't an appropriate valuation measure. The company's earnings are at a low point, notes Black, so valuing the stock based on p-e "wouldn't make sense." Based on its five-year trading norm, Gap sells at an average p-e of 35.5. So at its current price of 15, the stock is trading at a 42.8 p-e.

Black says she uses the price-to-sales measure because in Gap's case, sales are the more important benchmark, in part because it's regarded as a growth stock. As such, GAP has always traded at quite a high price-sales ratio. And earnings should rebound as sales continue to rise -- as Black expects they will. Marcial is BusinessWeek's Inside Wall Street columnist


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