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DRESSED FOR SUCCESS

I looked up the Gap (ticker: GPS) during my lead-gathering period in the summer of '97. I went to http://quote.yahoo.com and scanned for the ticker symbols of all the companies that I purchased products from. I was rewarded with a handful of promising companies with excellent long-term histories, one of which was the Gap.

Although not the best place to shop if you're on a tight budget, Gap clothing is well made, comfortable and simple. Along with great clothing, the Gap has keep expansion costs low, margins adaquate and have made very few fashion mistakes (the bane of all retailers). The Gap has maintained a superior level of economic performance that has benefited both the Company and its shareowners.

Background

The Gap is an international specialty retailer that operates The Gap, Gap Kids, Banana Republic and Old Navy clothing chains. They sell casual clothing to people of all ages and walks of life.

Created in 1969 by Donald Fisher and his wife Doris, the store initially started out by exclusively selling Levis Jeans. As Gap expanded, they slowly cut down their dependency on Levis by creating their own Gap brand name label. As the label grew in popularity, the Gap expanded not only by introducing more Gap stores, but also by creating GapKids/BabyGap (targeting children and young teens), Banana Republic (safari-type clothing and higher-prices leather items) and Old Navy Clothing (an economical version of the Gap).

As of February 28, 1998, there are 2,143 Gap, Gap Kids, Banana Republic and Old Navy clothing stores in Canada, France, Germany, Japan, UK and US.

Net Income

According to the Value Line Investment Survey, net income of the Gap in 1981 was roughly $US 12 million compared to the $US 407 million report in 1996. This represents average annual increase in net income of over 20% per year.

Net income fell twice in the last 17 years. The first drop was in 1984 when earnings fell to $US 13.5 million from $US 21.8 million a year earlier, and again in 1992 when it dipped to $US 213.4 million from $US 230.9 million in 1991. In both cases, the Gap quickly got their act together and rebounded the following year.

According to Hoover's Handbook of American Business 1997, the loss in fiscal 1993 was attributed to higher rents and lower margins. Lower margins were the result of an extremely unpopular fall merchandise line. Prices were slashed and much of the inventory wound up on sale racks.

Same Store Sales

Comparable store sales (or same store sales) increased by 5% in 1996, 0% in 1995 and 1% in 1994. In addition, net sales per square foot totalled $441 in 1996, $425 in 1995, and $444 in 1994. The decline in sales from 1994 to 1995 was attributed to the expansion of the Old Navy line which carries lower priced merchandise.

Debt/Equity

If anything, the Gap has kept an extremely tight reign on debt with Debt/Equity always near, or below, the 0.1:1 mark.

Also unusual for a clothing retailer is the Gap's impressive ability to not only create cash, but to avoid loading up on debt when trying to expand. The Gap had $428 million in cash over long-term debt in 1996 and $288 million in 1997. This is an impressive amount overall, but negligible on a per share basis.

Profitability

The Gap has extremely impressive gross margins. Sales cleared operating expenses by a hefty 37% in 1995, 36% in 1996 and 38% in 1997.

A statistic that I found a tad disturbing was the Gap's administration costs which consistantly amounted over 20% of sales. One wonders if this large amount is really necessary.

Net profit margins have increased from 3% in 1981 to a point where they are now hovering around the 8% mark. Needless to say, the introduction of the Old Navy division hasn't hurt margins as much as some people feared.

To Be Continued...

In general, the Gap's historicals are superior to almost all clothing retailers. The only other retailer that I found that could actually stand toe-to-toe with the Gap was Nautica, but that's another story.

After having taken a quick look at the Gap's balance sheet we can now turn our attention to the question on whether or not it's stock is trading at a fair price. In my next article on the Gap we will examine what the Gap is currently priced at compared to what it is intrinsically worth^*.

^*The intrinsic value study of the Gap will not be forthcoming in the immediate future. However, a brief review of the Gap's intrisnic value is calculated in the Toronto Investment Club Handbook. For those who are interested, it's intrinsic value was calculated to be roughly $28 per share.

Cheers,
Jim