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4-Page Memo

Full Memo

"Make everything as simple as possible, but not simpler." In an effort to adhere to this, I'll only be posting the 4-pager. If you have any questions, they are hopefully covered in the full memo. Would recommend reading via the pdf - had some problems converting it over to VIC. All the appendix / visuals come through properly there. 

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Elevator Thesis:

1. The street is falling victim to attribution/self-serving bias. This bias is most prevalent in infrequent circumstances, including the unprecedented two-year retail cycle. This has led to meaningful mispricing and skewed R/R for Gap.
2. Short-term/transitory headwinds have obscured fundamental changes that have led to significant margin improvement.
3. Material optionality created by above-industry ecommerce growth is not well-understood by the Street.
4. Multiple catalysts – FY’23 guidance, upward revisions, cost-cutting measures progress – will help us get paid.

In a sentence: Unprecedented industry conditions have led GPS to trade near its two-decade low (~$8) but inflecting sentiment as obscured improvements are better understood will lead to 150%+ stock price appreciation with less than ~35% downside (4x R/R).

Association & Self-Serving Bias:

In life, when we see people succeed, we may be tempted to chalk it up to situational factors (good family, wealthy, ect.). When they fail, however, we are more likely to blame the person (bad work ethic, lousy personality). This psychological tendency is known as attribution/self-serving bias. Why is this relevant? Because I believe this bias is why Gap is trading near its two-decade low.

Industry Dynamics:

Let’s step back. In the last two years, retail saw a boom/bust cycle at an unprecedented pace. Pent-up demand and supply-chain shortages in FY’20 led to an unexpected super-year in FY’21. The retail sector grew 10% (from FY’19) after growing at a ~1.5% CAGR before that. Retailers had a phenomenal year, and some cite a “record-low discounting” environment. Seeing such strong demand, many retailers – being severely under inventoried through FY‘21 – extrapolated linearly and locked-in inventory purchases for ‘22.

Then, in FY’22, inflation soared, interest rates shot up, and macro-conditions worsened. Apparel sales fell -2% and consumer tastes shifted, and retailers who locked-in inventory early were caught holding the bag.

The Streets View:

In the last two years, Gap has experienced good and bad. The mispricing of Gap stems from the Street attributing the good to the situation (macro), while attributing the bad to the company itself (mgmt & execution). I believe this is self-serving bias at its clearest.

The good: In FY’21, Gap achieved record GMs of 40%, nearly 200 bps above its average (38%). The street attributes this to the “record-low discounting environment,” and therefore models mean reversion (38% GMs) by FY’24.

The bad: In FY’21, the difference in EBIT margin vs peers grew from a historic 200 bps to 800 bps. The street attributes this to the “operational issues” and “mismanagement” and therefore extrapolates the discrepancy in margin forward (500 bps ∆) through FY’24.

Our calls with analysts confirm this sentiment: “FY’21 was an perfect storm” | “FY’21 was an outlier” | “Gap in particular has executional issues” | “The company has a track record of operation mis-steps”

Debunking The Street:

1. Claim #1: “Gap’s Gross Margin expansion was attributable to a strong retail environment”

While many specialty retailers (American Eagle, Abercrombie, Urban) experienced record low-discounting in FY’21, department stores (Macys, Kohls, Ross) did not. Large parts of their assortment for in-person and dressy social events remained low with delta/omicron.

When you properly weight by revenue split (Old Navy being 50% of revenue), Gap should’ve only seen 60 bps of consolidated GM improvement vs FY’19. Yet, Gap’s GM expanded 240 bps.

After adjusting for sector-wide & Gap-specific headwinds – costs from increased e-commerce penetration and supply-chain problems in 2H21 – implies only 150 bps of Gap’s GM improvement due to pricing, while over 300 bps of idiosyncratic change. I believe the lionshare of that change is explained by: athleta mix shift, banana republics successful rebranding, and store rationalization. By choosing the easy explanation (strong retail), the Street neglects many of these underlying changes and thus models mean reversion. (Figure #1, #2)

2. Claim #2: “Discrepancy against peers can be blamed on management & poor execution”

Traditional retailers sacrifice flexibility (long lead-times) for a superior cost-structure (outsourcing to far away nations). And because fashion cycles have historically been steady (5-10 years), and retail growth stable (2-4%), traditional retailers have performed well.  However, in periods of highly volatile demand, they perform disproportionately worse as they lack flexibility to adapt quickly to changing sentiment/consumer tastes. However, once the cycle stabilizes, their performance recovers quickly.

The last three years has therefore truly been some of the worst environments for a traditional retailer like Gap. While locking-in inventory seasons in advance is typically harmless, in the constantly changing fashion regimes that COVID-19 induced, Gap was caught flat-footed. COVID-19 hit just as the orders from FY’19 came in, causing over inventory. Then, the FY’21 upcycle hit just as depressed inventory orders from FY’20 came in, causing under-inventory. Then, the FY’22 downcycle hit as the FY’21’s inflated orders came in, leading to again being over-inventoried.

Our analysis indicates Gap has lead-times of ~280 days (vs peers of just 150 days). It is no wonder that they performed disproportionately worse, and the EBIT delta grew as they incurred incrementally higher supply-chain and discounting costs. For instance, the Old Navy meltdown can be largely attributable to their large lead times, after an amazing FY’21 selling plus-sized merchandise, Gap incorrectly extrapolated FY’22 demand. (Figure #3)

With supply-chain woes in 2H21, if Gap was truly executing worse, you’d expect Gap’s led times to grow disproportionately. They didn’t – their lead time increased at the same pace as peers (30%). Thus, while Gap’s EBIT delta vs peers has remained elevated throughout FY’20, ’21, ’22, the Street misunderstands root cause – the unprecedented volatility in the last three years. Rather, the street believes Gap is simply inferior at execution, and therefore projects the delta forward. In reality, once demand volatility subsides, Gap’s EBIT % delta should shrink dramatically vs peers.

The Four Drivers of Variance:

As explained previously, Gap experienced 300 bps of idiosyncratic margin expansion since FY’19, unrelated to the macro environment.

1. Driver #1: Athleta’s outsized growth has led to 110 bps of blended GM expansion and will contribute 50 bps by FY’24. (Figure #4)
   1. Qualitatively: Management has stated that Athleta is the “most profitable brand,” having AURs of $60. Though this is well understood, analysts I spoke with claim “they don’t know the exact amount because disclosure is shotty.”
   2. Quantitatively: The best public peer is LULU.
      1. To achieve an apple-to-apples comparison, non-product COGS needs to be stripped out. Using Gap as a baseline, and then adjusting for LULU specific expenses (higher ROD expense, hides R&D, Distribution Center expenses), I can estimate the Product COGS of LULU. Backchecking this using disclosed obligated purchases implies a lead-time of 3-6 months. My estimated LULU Product GM is about 70-80%.
      2. Assuming Athleta is priced 25% lower, I can back into Athleta’s Product GM (65-70%), along with the rest of Gap (45%). Simple algebra implies about 100 bps of GM improvement, driven from Athleta expanding from 5 to 9% of the overall business mix. By FY’24, it will drive another 50 bps, even with conservative Athleta growth assumptions (~4% CAGR). Altogether, Athleta contributes to a 150 bps of variance.
   3. Our Checks:
      1. Amazon Copycats – with the same ingredient mix as LULU – are priced at $25. Given these companies need to cover overhead as well, the raw material costs must be low ($15-20). This supports a 70-80% GM.
      2. Online bloggers independently confirm ““I’ve spent an inordinate amount of time reading breakdowns from all over the Internet about how much it costs Lululemon to make their leggings. That number is … $3-5 per pair.”
      3. The raw materials (Lycra, Nylon) are reasonably priced on amazon / fabric websites ($8-10 for 60x36 inch).
2. Driver #2: Banana Republic pricing has grown amid successful rebranding efforts, leading to 80 bps of GM expansion. (Figure #5)
   1. Qualitatively: Management has guided that Banana Republic AURs are “significantly higher than they’ve been, both ticket as well as discount.” This has been driven by their safari-themed rebranded starting March FY’21. They further elaborate that BR rebranding success has helped their ability to “be less discounted.” The question, again, is the magnitude.
   2. Our Checks:
      1. Google search data (which has >.75 correlation across % q/q, % y/y, absolute) suggests that BR has seen the largest inflection in growth out of all peers (6 other higher-end specialty).
      2. Since 1Q’21 (beginning of rebranding), BR has taken market share in the premium clothing space, growing 5-10% higher y/y than public competitors (Nordstrom, Ralph Lauren, PVH).
      3. Multiple external bloggers and viral TikTok’s reaffirm the rebranding efforts.
   3. Quantitatively: Our data scraping work implies about 45% AUR price increase across both men and women clothing since FY’19. Assuming a 20% shift toward higher-end materials (silk/leather), I project a 15% AUC increase to match the rebranding. Altogether, Banana Republic’s rebranding contributes about 80 bps of variance.
3. Driver #3: Shuttering underperforming stores has driven 110 bps of GM expansion, with 20 more bps by FY’24. (Figure #6)
   1. Qualitatively: Management has been shuttering underperforming stores since FY’19, closing 500/3000. In FY’19, they provided some guidance on the cost-cutting (625M lost revenue, 90M saved in EBIT for closing 280 stores). Qualitatively, the cost drag is likely due to low revenues, but average fixed costs, translating in negative EBIT margins. Stores that can’t achieve scale.
   2. Our Checks:
      1. The numbers implied by management suggest average sales/store of 2.7M vs company-wide 5M sales/store. Check.
      2. Average cost/store of 3.1M, matches company-wide average cost/store.
      3. Assuming average COGS expenses (ROD & Product) implies wage/head of ~38K, which also matches company-wide
   3. Quantitatively:
      1. Our checks imply these are average sized stores, with average cost-structures. I therefore assume average ROD, Product, and SG&A costs per store. The math suggests that the 500 closes stores represented 8% of total revenues, and have a GM of 25%, vs the normal stores having 40%. The delta is driven by the lack of operating leverage that these stores got on ROD & SG&A costs, which are fixed. Since it now represents 0% of revenue, I estimate about 110 of GM drag that no longer persists. They plan on closing 80 more stores, driving an 20 bps by FY’24, totaling to 130 bps of variance.
   4. Variance:
      1. Though the street understands the strategy qualitatively, they don’t how it flows through. Most of the leverage comes the store have an abnormally low GM (from ROD, fixed rent, but low sales). But when asked about it:
         1. “We don’t focus on rent expense”
         2. “We don’t physical look at ROD”
         3. “Honestly don’t have that number broken out in my model.”
      2. Sell-side only projects a single SG&A line and notes they “bake in store rationalizations” but that its offset “by operational inefficiencies” (dragging the delta vs peers forward). This is lazy and allows bias to obscure the embedded changes.
4. Driver #4: Covid safety measures that bloated costs are no longer mandated, will lead to 60 bps of SG&A reduction. (Figure #7)
   1. Note – this is separate from the GM variance. This is simply an extra SG&A lever that isn’t fully appreciated.
   2. Qualitatively: In 2H’20, Mgmt stated they had about 100M in safety costs. They guided that these costs would stick with them through 1H’21. Realistically, however, given the Delta/Omicron waves (Sep ’21, Dec ’21), it is likely that these costs stayed with them, and contributed to an artificially bloated SG&A line. These costs are already abating in FY’22.
   3. Our Checks:
      1. Our calls with former employees suggest that the main cost-drivers are providing masks (to employees & customers), along with sanitization efforts. They elaborated that providing free masks continued through FY’21.
      2. Tracking the Gap website using Wayback machine suggests they only removed providing free-masks in April ’22.
   4. Quantitatively:
      1. Start with retail sales. Mgmt guided AUR * 1.5 for basket size. Assume 1 out of 5 people who come into the store buy something (20% conversion is really good for retail, so this is a conservative assumption). Now we have total FY’21 visits. Assume 3.5/10 customers take a mask (former employee said 4/10). The price of a mask is now 10c, but using old articles, pieced together a weighted average price of about 17c through FY’21 during peak covid-waves. Altogether, I estimate that providing masks to customers alone contributed 100M in costs, or about 60 bps in variance.

Altogether: Athleta mix (100 bps + 50 bps future) + BR Rebranding (80 bps) + Store Rationalization (110 bps + 20 bps future) + Safety Costs (60 bps) = 420 bps of variance vs the street by FY’24 (Figure #8).

Optionality:

Will keep this short, but mgmt (CFO + Interim CEO) has provided tons of convincing commentary that they understand a) how bloated the cost structure is and b) how they plan on bringing it much lower. They said this in 2Q22. In 3Q22, they initiated 250M in cost-cutting (200 bps) and emphasized there is more to come. Clearly there is intent.

There is also capacity; Gap’s disproportionate shift towards e-commerce (1400 bps penetration increase vs 700 bps for peers) creates larger room for cuts. This is because ecommerce sales are 4x as employee efficient as retail sales. My analysis on Gap’s revenue/employee & sales efficiency indicates a large discrepancy vs peer (20%) that could be cut down significantly. If this gap were to close, Gap would see 500 bps of leverage! (Figure #9)

Valuation & Risk/Reward (Figure #10):

The most attractive part of this thesis is the setup, with all of Wall Street hating the stock and clear catalysts in sight for FY23. At just $12/share, implied fwd. multiples and earnings are at trough levels. Even if GPS were to trade down to ~$7.5, a level hasn’t traded down to in two-decades, the downside would be -37.5%, as opposed to >150% upside. Point is: the worst-case scenario is priced in due to psychological pitfalls presented above.

In my base case, I see ~$2.50 EPS by FY’24 as achievable. That output underwrites a) ~15.5B in sales and b) 7.2% EBIT margins.

1. 15.5B in sales underwrites a significant slowdown relative to FY’21 (-6%) due to a moderate recession. We are $800M below the street. For context, even ’08 only led to -7% 3y comps, and that was before Athleta came into the picture, which should provide a cushion.
2. 7.2% EBIT margins in FY24 imply 270 bps above FY21 levels. The street is at 4.5% EBIT margins by FY’24. My work suggests 420 bps of variance, but because I’m more conservative on the top-line (triggers deleverage), I am ultimately only about 200 bps above.

Applying a 12x fwd. P/E multiple (median of ~13.5x historically) gets us to a ~$30 in FY’23 in our base case, equivalent to ~150% upside. This translates to a ~4x R/R, with a bear case being a hard-landing recession, driving operating deleverage (1.20 eps capitalized at a 6x fwd P/E). The bear case is limited, 1) a ~$7.5 two-decade long price support 2) inflation would moderate in a recession 3) employee cuts are more feasible in a recession 4) ~200M in annual dividends (8-10% dividend at ~$7) ~500M in buybacks (25% of SO at ~$7).

Risks:

1. Recession risk / soft consumer market makes GPS a bad name to hold given range of negative outcomes
   1. The bear case accounts for this, with a -6% reduction in growth by FY24. 15.5B sales.
   2. I’d rather hide in Gap and short competitors, which are trading at elevated consensus #s. The street has the margin delta widening.
   3. In the case of a recession, there is some equal hedging out of wage inflation / commodity prices declining.
2. Wage inflation, due to a tight labor market, will further crimp margins
   1. This is baked into the base case 6%/5%/3% wage inflation despite inflation data already turning downwards
   2. If it gets worse, probably means an insubstantial recession (hence top-line protection), so less deleverage.
3. Old Navy is a huge portion of the business, and its recovery is uncertain
   1. Not structural + new mgmt. GPS was caught flat-footed by the environment. Plus-size worked in FY’21 and it was extrapolated.
   2. Baked into the base-case, with significantly lower growth for next 2-3Ys as it tries to find its footing.
4. Banana Republic Rebranding might not be sustainable
   1. Fashion cycles typically come in waves, and will last another 1-2 years, which is enough for catalysts to trigger
   2. Pricing moderation is baked into the base case. We can also monitor this closely.
5. Athleta is losing to LULU
   1. No one is models Gap as a SOTP. LULU preannounced 4Q22 and tanked ~9%. GPS is still up 3%! No readthroughs here.
   2. The streets growth rates for Athleta in the next 2 years are quite low (4%, 11%, 13%), compared to a 3Y trailing CAGR of ~20%.

Other Considerations:

1. Shareholder base is long-biased. Tons of value investors who are likely playing for FY’23 catalysts. Won’t sell on a bad quarter. Shorts are sizing into the Q, likely not structural. Will likely cover if anything about longer-term fundamentals appears.
2. Shipping rates & commodity prices are declining, but not modeled in
3. Franchising efforts are increasing (15% to 20% of stores) could drive 25-50+ of further bps expansion.
4. Shares have been bought back from 700M in ’09 to 350M now. EPS #s are easier to hit

Appendix:

Had a hard time uploading the screenshots onto VIC. See the PDFs above. 

Catalyst

1. Upward Sell-Side Revisions/Upgrades
   1. Most of sell-side is still neutral on the stock (18/21), but seem ready to flip the switch on any positive signals:
      1. “we see stock risk to the upside on announcement of a well-known CEO … or any clarification of a willingness to pursue value creation initiatives.”
      2. “any signs of sustained merchandise traction could warrant a higher P/E from here, even after the recent stock run.”
      3. “What Do We Think From Here? A tanker shifting course, stock has likely bottomed, we remain sidelined.”
   2. My own calls with sell-side analysts confirm this is the general sentiment:
      1. “Any single reason it can get back to this historic ebit level [~9%]. If they can just show… anywhere near there, then it’ll definitely shoot up.”
      2. “Recent results are more encouraging. Recent #s, GAP should keep it up. Seems to be moving in the right direction.”
   3. JPM upgraded (1.18.23) and the stock was up 3% when beta-adjusted implied -1.5% move.
2. Mgmt Retracted FY23 Guidance + Medium-term Margin Guidance
   1. Mgmt plans on reinstating guidance for FY’23 on normalized EBIT margin. Stating “more to come on that” – probably after 4Q22.
3. Incremental Cost Cutting Guidance
   1. “Putting in place real action against working that SG&A level down to a more appropriate level. So more to come on the levers we will take.” – 2Q22 Earnings
   2. “We will provide clarity on those actions as they happen … the overhead actions in the third quarter and then more to come.” – 2Q22 Earnings
4. Upcoming CEO Announcement
   1. Hard to call good / bad but seems they will pick a cost-cutter, given Bobby/Katrina’s mindset & mgmt compensation (favors EBIT $)