Gap Bear's Den
by Louis Corrigan ([email protected])

I love the Gap. I would love to fall right into it. In fact, if I had bothered to learn anything from Peter Lynch, I would be a happy Gap owner today. I'm frankly embarrassed that I'm not.

The percent of my wardrobe purchased from Gap-owned stores seems well into triple digits, if that's possible. While Old Navy is cannibalizing a bit of my Gap shopping for basics like T-shirts and jeans, I find I spend twice as much there than at the flagship store because everything seems so inexpensive. And for reasons I haven't been able to pinpoint, most of my marginal purchases that once went to J. Crew or Abercrombie & Fitch or Structure have found their way to Gap stores. Power of branding? Maybe. But the brilliant rollout of Old Navy has created a value pyramid for Gap that should continue to pay off.

Gap's ads, of course, have been terrific for a long time. What other mass market retailer would have the good taste to run spots featuring Luscious Jackson? But the new khaki swing and skateboard ads are simply the coolest on television. My friends and I stop talking to marvel at them. It truly astonishes me how these guys can transform the most boring piece of apparel on the planet into something so hip. I mean, these are ads so joyful and happening that I can't wait for them to appear again. (And I still want to know how they do that camera movement.)

So what's not to like about the Gap? Well, if your investment horizon is measured in decades, probably not much. Shorter term, though, I think the swelling valuation has got buttons popping and seams ripping.

When Yi-Hsin last wrote about the company in March, the stock was at $47. Her suggestion to give Gap a look was a great call. Shortly thereafter, with the stock at $46 1/4, the Cash-King Portfolio took the stock to the cashier for checkout. Another great call. With the stock now over $66, the price has been marked up over 40% in just three months. It's doubled since the beginning of the year. The clearance rack this ain't.

Granted, the company's been hitting the cover off the ball, slamming it again and again into that gap in left center field, scoring double-digit gains. June sales were up 36%, with same-store sales up 15%, more than any other major retailer. For the year, sales are up 40%, with same-store sales up 18%. These numbers are as awesome as the company's ads, which have obviously had the masses doing backflips to dance away with new clothes.

But the current valuation chafes me like a forgotten price tag. The Gap now trades at a price-to-earnings multiple of 46! It's valued at 38.8 times the consensus $1.71 per share estimate for FY98 ending next January and at 32.7 times the FY99 estimate of $2.03. Even using the high-side estimates of $1.77 and $2.15, we're looking at forward P/E multiples of 37.5 and 30.9, or 32% annualized growth over the next three quarters and 26% annualized growth over the next seven quarters. These numbers are well in excess of the 21% annualized sales and EPS growth seen over the last three years and above even the analysts' high-side 23% estimate for long-term growth.

Using the most aggressive numbers possible, the YPEG fair value on FY99 estimates is just $49. At $66, the Gap has an enterprise value of $26.5 billion, or 3.8 times sales. Even though the Gap enjoys a terrific 33% return on equity, that price-to-sales ratio is pricey for a retailer with 8.4% net margins.

Also, apparel sales run up against that fashion thang. If you're like me, you buy clothes (let's say khakis) in bunches. Once you've got 'em, you don't need more for a while. These are boom times again for Gap basics, which bring more customers back into the stores and pump up sales. How long can this last? The swing between basics and fashion is cyclical. But the Gap has repeatedly proven it's got two left feet when it comes to fashion. The moves look fine, they just don't translate into the mega-sales seen when America goes shopping for the great Gap basics.

So I think that 32% growth rate will head back toward the mean. Supporting this view is the fact that imported clothes (the bulk of what the company sells) are about as cheap as they're ever going to be thanks to the strong dollar vis a vis the Asian currencies. So not only is demand strong, but gross margins are high. These two favorable conditions won't last forever.

What's interesting, as well, is that the Gap is spending aggressively on branding type advertising. The company's ad spending has increased from $64 million in FY95 to $96 million in FY96 and $175 million last year. Ad spending is expected to top $225 million this year, or more than 3% of sales. (The Wall Street Journal recently reported the price tag will be closer to $300 million or 4% of sales). In the Gap's case, I think brand advertising is a smart move. Its business depends on claiming high margins through a combination of brand and service on what are essentially commodity products.

However, such spending makes it harder to turn a fat profit if sales don't remain wrinkle free. In fact, this increased ad spending has steadily bumped up operating expenses, from 22.9% of sales in FY95 to 24% in FY96 to 25.1% last year. In the first quarter, operating expenses were up to 27.4% of sales versus 25.3% for the first quarter of '97. Moreover, had the company's tax rate not been sliced from 39.5% in '96 to 37.5% last year, FY97 net margins would have fallen below 8% for the first time since 1993. So all this ad spending is costing the company more than it might seem if you just check the net margins.

Is the Gap worth paying up for? Sure. But with the stock trading at a multiple more than double its long-term growth rate, I'd rather wait for a markdown.

Next: The Bull Responds