Friday, 01 Nov 2013

Relative Valuation of Gap Inc.

Friday, 01 Nov 2013

Gap Inc.

Price: $36.99

12mths Target: $50.67

STRONG BUY

A. Brief Summary of Apparel Industry, Gap Inc. and Comparable Companies Global Apparel Industry Overview
After an easing off of the financial crisis in America and the relatively positive financial environment in Europe, global retail has seen a gradual upsurge. Growing consumer confidence and increasing incomes have allowed sales to swell however results have been tempered by global increases in the costs of raw material, manpower and logistics. This is also a phase of increased and heightened competition as firms try and tap consumer interest leading to firms focusing on improved design, innovation and brand building to maintain a competitive advantage.

Gap Inc.
Headquartered and listed in the United States of America, Gap Inc. (the Company and Gap) is a global clothing and accessories retailer. Its market cap is US$ 17.3 billion as at 12:00pm 1st Nov 2013. Operation segments: Retail Stores Segment (88% of revenue in 2012); and Online stores and Direct Sales Segment (12% of revenue in 2012) Geographic segments: United States: 67% of revenue in 2012; Rest of the World: 33%.

Comparable Companies
After careful analysis, we have identified five companies that are comparable in terms of business, operations and market capitalization. These 5 companies are TJX Companies, Ross Stores, Nordstrom, Urban Outfitters, and American Eagle Outfitters. i. TJX Companies Inc. is an apparel and home fashion retailer with market cap of US$43.4 billion. Operation segments: Retail stores Segment (90% of revenue in 2012); and Home Fashion Segment (10% of revenue in 2012) Geographic segments: United States: 76% of revenue in 2012; Others: 24%. ii. Ross Stores Inc. is a chain of off-price department stores with market cap of US$ 16.8 billion. Operation segments: Retail Store Segment (100% in 2012) Geographic segments: United States: 100% in 2012.

Friday, 01 Nov 2013 iii. Nordstrom Inc. is an American upscale fashion retailer with market cap of US$ 11.8 billion. Operation segments: Retail Store Segment (98% of revenue in 2012); and Credit Card Segment (2% of revenue in 2012) Geographic segments: United States: 100% in 2012. iv. Urban Outfitters Inc. is a retailer of clothing, footwear, accessories and housewares with market cap of US$ 5.6 billion. Operation segments: Retail Segment (94% of revenue in 2013); and Wholesale Segment (6% of revenue in 2013) Geographic segments: United States: 87% of revenue in 2013; Others: 13%. v. American Eagle Outfitters is an American clothing and accessories retailer with market cap of US$ 3.0 billion. Operation segments: Retail Stores and Direct Segment (100% in 2012) Geographic segments: United States: 90% of revenue in 2012; Others: 10%. Further information on Gap and these 5 companies is listed in Exhibit 1.

B. Relative Valuation Horizontal Valuation between Comparable Companies

We have arrived at a target price of $50.62 based on trailing EPS of $2.71 and an average of 18.68x from trailing P/E ratios of the 5 companies in the target segment. Alternative methods to arrive at the price are P/B and P/S ratios but after consideration they were discarded for the following reasons: Despite operating in the same industry and space, profit margins across the companies selected range from 6.1% to 9.0%. Given this range it is unclear whether $1 in sales will yield the same or largely similar contribution to the bottom line. As a replacement we have used Price-to-Sales per Square foot ratio (which will appear later). The Debt-to-Equity ratio is a measure of the capital structure of these companies. The range of this metric varies from 0.0 to 153.7 across the selected companies. This implies that the cost of equity is different for every company and book value may not be the best measure of profitability on shareholder capital. For example a company with a higher leverage (TJX Companies and

Friday, 01 Nov 2013 Nordstrom) will have higher liability, a lower book value and a higher P/B this high leverage does not indicate profitability. Other factors may deteriorate the quality of relative valuation: Gap Inc. has a larger exposure to the consumer industry outside the United States (33% of revenue in 2012) as compared to its peers (0% - 24% outside US) that may limit its short-term profitability growth (arising from leveraging the current strong recovery in the local market). Gap is consistently increasing its investment in the Direct-to-customer and Online Store Segments (9% of revenue in 2010, 11% in 2011 and 12% in 2012) as compared to its peers. This may indicate a lower shelf inventory and in-store service cost in the long run, and may also incur a higher return of goods & chance of legal disputes. We should securitize this segments performance and make further adjustments as required.

Vertical Valuation using Historical Ratios

Please refer to Exhibit 2, our target price is in line with the price estimated by vertical valuation. The historical ratio indicates a price of $50.70, which is the multiple of forecasted earnings of $3.00 and simple average of past four years P/E ratios at 16.90x. Assuming there has been no material change of industry structure, this price and P/E ratio reflect that consumer confidence has partially recovered to pre-financial crisis levels (19.65x P/E in 2007 and 15.11x in 2008).

Valuation using Sales per Square foot

Sales per Square Foot (SSF) is an industry indication to measure retail sale success and a factor that drives operating margins, including return on investment in retail store and shelf turnover rate. As seen in Exhibit 3, we have gathered all companies SSF and used a simple average of the last 5 years as reference. Thereafter, we arrived at another reference price point of $45.32 based on Gaps Price-to-SSF of 0.11x and an industry average SSF of $419. This is still in line with our estimation and buying suggestion however the quality of SSF ratio valuation may be less important with the increase of online sales taking place in the target segment.

C. Conclusion and Recommendation

Given the above valuation, we issue a strong buy recommendation for Gap Inc. at current price level.

Friday, 01 Nov 2013 Exhibit 1: Basic financial and segment information of Gap Inc. and its comparable companies Trailing 12mths Revenue (US$ billion)

Company Name

Market Cap (US$ billion)

Trailing 12mths Profit Margin

Most Recent Quarter Debt-to-Equity

% Revenue Operation Segment

% Revenue Geographic Segment

TJX Companies

43.4

26.8

7.47%

33.1

Apparel 90% Home Fashion 10%

US - 76% Others - 24%

Gap

17.3

15.7

8.00%

36.1

Retail Store 88% Direct 12%

US - 67% Others - 33%

Ross Store

16.8

10.1

8.34%

7.8

Retail Store 100%

US - 100%

Nordstrom

11.8

12.5

6.09%

153.7

Retail Store 98% Credit 2%

US - 100%

Urban Outfitter

5.6

3.0

9.00%

Retail Store 94% Wholesale 6%

US - 87% Others - 13%

American Eagle Outfitters

3.0

3.4

6.40%

Retail Stores Direct 100%

and

US - 90% Others - 10%

Source: Yahoo Finance, 12:00pm 1ST Nov 2013

Friday, 01 Nov 2013 Exhibit 2: P/E, P/B and P/S ratio

Company Name

Market Cap (US$ billion)

Profit Margin

Stock price (US$)

Trailing P/E

Forward P/E

Current P/B

Trailing P/S

TJX Companies

43.4

7.47%

60.79

22.35

18.76

11.19

1.61

Gap

17.3

8.00%

36.99

13.65

12.29

5.10

1.09

Ross Store

16.8

8.34%

77.35

20.09

17.42

8.66

1.65

Nordstrom

11.8

6.09%

60.47

15.95

14.71

5.81

0.94

Urban Outfitter

5.6

9.00%

37.88

21.04

17.14

3.69

1.90

American Eagle Outfitters

3.0

6.40%

15.49

13.95

14.08

2.48

0.87

Simple Average (excluding Gap)

18.68

16.42

6.37

1.39

Source: Yahoo Finance, 12:00pm 1ST Nov 2013

Friday, 01 Nov 2013 Exhibit 3: Price / Sales per Square Foot Sales per Square Foot (SSF) (US$) Company Name 2012 2011 2010 2009 2008 Simple Average for Last 5 years (US$)

TJX Companies

370

345

332

320

309

335

Gap

364

337

342

329

336

342

Ross Store

355

338

324

311

298

325

Nordstrom

470

431

397

368

388

411

Urban Outfitter

610

588

588

545

553

577

American Eagle Outfitters Simple Average (excluding Gap)

489

438

422

422

452

445

419

Source: Yahoo Finance, 12:00pm 1ST Nov 2013; Urban Outfitter data: http://www.trefis.com/company?hm=URBN.trefis&driver=0656#