No-Moat Gap’s Problems Are Undeniable, but Old Navy and Athleta Align With Market Trends

Business Strategy & Outlook

The Gap’s family of brands lacks an intangible asset or cost advantage that would provide an economic moat. The company has experienced years of inconsistent results and has recently suffered major merchandising and supply chain woes. Still, Gap has fair liquidity, and its Old Navy chain as a solid business. According to Euromonitor, Old Navy is the largest individual apparel brand by retail sales in the United States, and, despite ongoing issues, the Gap’s goal of $10 billion in annual sales for the label (up from $9.1 billion in 2021) as achievable in 2026. Old Navy, though, faces considerable competition in the discount apparel space from wide-moat Amazon, other e-commerce, outlet stores, and discounters like narrow-moat Ross Stores. Meanwhile, Old Navy already has more than 1,250 North America stores, so much of its future growth is expected to come from stores in smaller, unproven markets. As there is a wary of the potential of these markets, one cannot view Gap’s stated goal of 2,000 Old Navy stores in North America as reasonable. Rather, one can forecast it will have about 1,500 locations in 10 years. No one can believe Gap’s once-powerful Gap and Banana Republic brands have competitive advantages, either. According to a 2019 presentation, Old Navy was generating about 80% of Gap’s operating profit even before the pandemic. Now, with scores of Gap and Banana Republic stores slated to be closed, the brands are permanently diminished. Moreover, while a necessary move, that downsizing will improve Gap’s overall margins very much. The firm says that it can reach 10% operating margins in about three years, but Gap’s long-term operating margins at just 8%.

Further, one does not think fast-growing Athleta has achieved a competitive advantage. Athleta grew to more than $1.4 billion in sales in 2021 from $249 million in 2012. However, at less than 10% of Gap’s sales, Athleta is not large or old enough to provide a moat for Gap. Moreover, while the brand benefits from a strong “athleisure” trend, it lacks the pricing power of direct competitor narrow-moat Lululemon.

Financial Strengths

One cannot think Gap has any liquidity concerns even though its free cash flow dropped significantly in 2020 and 2021 due to the COVID-19 crisis and it suffered an operating loss in 2022’s first quarter. In 2021’s third quarter, the firm issued $1.5 billion in new debt that matures in 2029 and 2031 ($750 million each) at interest rates of 3.625% and 3.875%, respectively, and subsequently paid down $1.9 billion in higher-interest debt. After these transactions, it closed March 2022 with $845 million in cash and investments and $1.8 billion in debt. Given that its earliest significant maturity is now seven years away, one cannot view Gap’s debt as a concern. Under normal circumstances, the firm generates significant cash flow, including more than $700 million in free cash flow to equity in 2019. Gap suspended dividend payments and share repurchases during the crisis but resumed both in 2021. The firm has signaled that it will continue to issue dividends despite recognizing a loss in 2022’s first quarter. The expect it will return around 30% of its earnings to shareholders as dividends over the next decade. Gap has also been a consistent purchaser of its own stock, having reduced its share count by about 47% between 2008 and 2021. As per the forecast average yearly repurchases of about $500 million over the next 10 years. The repurchases as prudent when executed at a discount to the assessment of the firm’s intrinsic value, as has recently been the case. The Gap’s capital expenditures to average 4% of sales over the next 10 years, in line with the 10-year historical average. Gap intends to open Old Navy and Athleta stores and continue to invest in digital capabilities and its supply chain to keep up with competitors.

Bulls Say

According to Euromonitor, Old Navy is the largest apparel brand in U.S. It competes in the discount apparel sector, which has been healthier than other areas of apparel retail.

Athleta has established itself in the fast-growing women’s athleisure market, one of the bright spots in North America apparel. The number of Athleta stores will nearly double over the next decade.

Gap’s e-commerce accounted for more than $6.4 billion in sales in 2021, 39% of its total sales. COVID-19 has accelerated e-commerce growth for Gap and others in the apparel space.

Company Description

Gap retails apparel, accessories, and personal-care products under the Gap, Old Navy, Banana Republic, and Athleta brands. Old Navy generates more than half of Gap’s sales. The firm also operates e-commerce sites, outlet stores, and specialty stores under various Gap names. Gap operates nearly 3,000 stores in North America, Europe, and Asia and franchises about 600 stores in Asia, Europe, Latin America, and other regions. Gap was founded in 1969 and is based in San Francisco.

(Source: Morningstar)

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