Three Simple Reasons to Buy This Retailer

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Back in 2011, no one would have pegged clothing retailer The Gap (NYSE: GPS) as a growth stock. The company’s product lines were becoming stale, sales growth was sluggish and the stock had gone nowhere for a decade. Gap was fading into the past as an icon of the 1990s and its omnipresent stores, peppered all over malls and outlets in America, deflated its brand appeal.

Then out of the blue, cost-cutting initiatives, acquisitions and international expansion began paying off. 2012 would be a year to remember for San Francisco, California-based Gap Inc.

Shares surged more than 70% by the end of the year, outperforming all of its industry peers:

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GPS data by YCharts

After that kind of rally, there are likely only two questions on investors’ minds right now:

  • Can Gap continue to rally into 2013 despite macro problems at home and abroad?

  • Should I buy shares now or wait for a pullback?

In my opinion, Gap is still fundamentally cheap. Let’s see how it measures up to five of its retail competitors - American Eagle Outfitters (NYSE: AEO), Aeropostale (NYSE: ARO), Abercrombie & Fitch (NYSE: ANF), Nordstrom (NYSE: JWN) and Ralph Lauren.

<table> <tbody> <tr> <td> <p><span><span><span><em><strong>Company</strong></em></span></span></span></p> </td> <td> <p><span><span><span><em><strong>Trailing P/E</strong></em></span></span></span></p> </td> <td> <p><span><span><span><em><strong>Forward P/E</strong></em></span></span></span></p> </td> <td> <p><span><span><span><em><strong>5-year PEG Ratio</strong></em></span></span></span></p> </td> <td> <p><span><span><span><em><strong>Return on Equity</strong></em></span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Gap Inc.</strong></span></span></span></p> </td> <td> <p><span><span><span>15.7</span></span></span></p> </td> <td> <p><span><span><span>12.5</span></span></span></p> </td> <td> <p><span><span><span>1.6</span></span></span></p> </td> <td> <p><span><span><span>24.4</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>American Eagle Outfitters</strong></span></span></span></p> </td> <td> <p><span><span><span>21.6</span></span></span></p> </td> <td> <p><span><span><span>13.2</span></span></span></p> </td> <td> <p><span><span><span>1.1</span></span></span></p> </td> <td> <p><span><span><span>11.0</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Aeropostale</strong></span></span></span></p> </td> <td> <p><span><span><span>12.1</span></span></span></p> </td> <td> <p><span><span><span>17.4</span></span></span></p> </td> <td> <p><span><span><span>1.4</span></span></span></p> </td> <td> <p><span><span><span>16.5</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Abercrombie & Fitch</strong></span></span></span></p> </td> <td> <p><span><span><span>36.7</span></span></span></p> </td> <td> <p><span><span><span>13.4</span></span></span></p> </td> <td> <p><span><span><span>0.9</span></span></span></p> </td> <td> <p><span><span><span>6.8</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Nordstrom</strong></span></span></span></p> </td> <td> <p><span><span><span>16.7</span></span></span></p> </td> <td> <p><span><span><span>13.8</span></span></span></p> </td> <td> <p><span><span><span>1.3</span></span></span></p> </td> <td> <p><span><span><span>34.4</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Ralph Lauren</strong></span></span></span></p> </td> <td> <p><span><span><span>22.5</span></span></span></p> </td> <td> <p><span><span><span>17.6</span></span></span></p> </td> <td> <p><span><span><span>1.5</span></span></span></p> </td> <td> <p><span><span><span>19.6</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><em>BEST VALUE:</em></span></span></span></p> </td> <td> <p><span><span><span>Aeropostale</span></span></span></p> </td> <td> <p><span><span><span>Gap</span></span></span></p> </td> <td> <p><span><span><span>Abercrombie & Fitch</span></span></span></p> </td> <td> <p><span><span><span>Gap</span></span></span></p> </td> </tr> </tbody> </table>

Gap still tops its competitors in forward P/E and Return on Equity (with the exception of Nordstrom), which means the stock's best days may still be ahead. 

Here are three simple reasons I think Gap is a top retail stock for 2013.

Reason 1: Strong Comparable-Store Sales Growth

Investors were impressed by Gap’s strong comparable same-store sales growth, which measures sales growth at stores open for over a year. The company attributed its robust results to successful holiday promotions and increased discretionary spending in North America. Comparables and net sales both rose 5%, a marked improvement over the previous year.

<table> <tbody> <tr> <td> <p><span><span><span><strong>(North America)</strong></span></span></span></p> </td> <td> <p><span><span><span><em><strong>Comp Growth</strong></em></span></span></span></p> </td> <td> <p><span><span><span><em><strong>Net Sales Growth</strong></em></span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>December 2012</strong></span></span></span></p> </td> <td> <p><span><span><span>+5%</span></span></span></p> </td> <td> <p><span><span><span>$2.08 billion</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>December 2011</strong></span></span></span></p> </td> <td> <p><span><span><span>+4%</span></span></span></p> </td> <td> <p><span><span><span>$1.98 billion</span></span></span></p> </td> </tr> </tbody> </table>

Gap has now posted six consecutive quarters of comparables growth. This was the primary catalyst for the stock’s unprecedented 70% rally in 2012.

Gap operates three flagship brands - a common sight in malls across North America - Old Navy, Gap and Banana Republic. Old Navy is its lower-end retailer, Gap’s namesake stores offer mid-range apparel, while Banana Republic sells higher-end apparel for young professionals.

A quick look comparing Gap’s three flagship brands reveals a preference for cheaper apparel over the holiday season. All three segments reported positive growth, with Old Navy emerging as a clear growth leader.

<table> <tbody> <tr> <td> <p><span><span><span><strong>(North America)</strong></span></span></span></p> </td> <td> <p><span><span><span><em><strong>December 2012 Comp Growth</strong></em></span></span></span></p> </td> <td> <p><span><span><span><em><strong>December 2011 Comp Growth</strong></em></span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Old Navy</strong></span></span></span></p> </td> <td> <p><span><span><span>+13%</span></span></span></p> </td> <td> <p><span><span><span>-4%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Gap</strong></span></span></span></p> </td> <td> <p><span><span><span>+2%</span></span></span></p> </td> <td> <p><span><span><span>-4%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Banana Republic</strong></span></span></span></p> </td> <td> <p><span><span><span>+1%</span></span></span></p> </td> <td> <p><span><span><span>-2%</span></span></span></p> </td> </tr> </tbody> </table>

Before we get ahead of ourselves, however, it’s worth noting that Gap didn’t fare as well overseas. Its international segment posted a decline of 6% in comparables, in line with the prior year’s results, due to ongoing macro problems in Europe and Asia.

We should also remember that although Gap’s December numbers were strong, its gains were not necessarily unique. Its industry peers, Ross Stores and Nordstrom also posted respective 6% and 8.6% growth in December comparables.

Reason 2: Intermix Acquisition

Gap recently acquired Intermix, a high-end women’s boutique, for $130 million. Intermix, which carries apparel from Herve Leger, Yves Saint Laurent, Rag & Bone and other high-end designers, rose to fame after being frequented by celebrities such as Kim Kardashian. The boutique does not produce any of its own clothing.

Intermix only operates 32 stores in North America, but its presence could grow exponentially with the aid of Gap’s massive distribution network. Adding Intermix to its brand portfolio gives Gap a luxury brand far pricier than Banana Republic, which increases the range of its tiered pricing spectrum.

Some analysts, notably NBG Productions Brian Sozzi, claim that the acquisition is more experimental than an earnings accretive move. Sozzi, who is bearish on Gap, noted, “Gap is trying to gain intelligence on how it could bring pricier, trendier merchandise in a more affordable way to its other divisions.”

However, Gap has a strong record of making smart acquisitions and putting them to good use. Yoga apparel retailer Athleta, which Gap acquired in 2008 for $150 million, has emerged as a strong challenger to market favorite Lululemon. Although Athleta has a limited brick and mortar presence, its strength lies in e-commerce and promotions through Gap’s distribution network.

Meanwhile, its subsidiary Piperlime, which specializes in “affordable luxury” through a large e-commerce presence, has been prominently featured on Lifetime’s “Project Runway,” which also catapulted fashion designer Michael Kors to international stardom.

Therefore, Intermix should be less of an experiment, as Sozzi suggests, and more of an attempt to grow a niche market into a mainstream brand. Judging from the past, Gap is unlikely to invest heavily in Intermix’s brick and mortar expansion, but rather start with online expansion and linked promotional activities from its other stores and websites.

Reason 3: Stock Buyback and Dividends

Last but not least, Gap’s board of directors recently approved a new $1 billion share repurchase plan. Since the beginning of January, Gap has already repurchased approximately 17 million shares, worth $539 million. Gap’s dividend has increased annually since 2009, and currently yields 1.56%. Although the share repurchase plan and possible upcoming dividend boost won’t attract pure income investors, they show that Gap is committed to maximizing shareholder value.

Bottom Line

In my opinion, Gap is a sleeping giant that just woke up. Management has shown that it is committed to shaking off the perceptions of its past and focus on controlling costs through concentrated e-commerce initiatives. The company’s product lines are smartly and cleanly compartmentalized, and its tiered pricing system gives it much needed flexibility in uncertain macro times - a quality that many of its industry rivals sorely lack.

Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of Aeropostale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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