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The Future of Gap, Inc.

The Future of Gap, Inc. Analysed by: Emmanuel Ofobeze David Müller Sofia Klum 21 January, 2011

Analysed by:

Emmanuel Ofobeze David Müller Sofia Klum

21 st January, 2011

Supervised by:

Prof. Claire Prurvis Global Business Management Strategies Faculty of Business University of Applied Sciences Fulda

Contents

  • 1 Executive Summary

2

  • 2 Introduction

2

  • 2.1 Initial Problem .........................................................................................................................

2

  • 2.2 GAP’s History and Development

3

  • 3 Financial Analysis of Gap’

4

  • 3.1 Overview of Gap’s Financial Statements and Important Key Ratios

4

  • 3.2 Dupont Analysis (2009)

7

  • 4 Recommendations

8

Work Cited

10

1

EXECUTIVE SUMMARY

The purpose of this report is to give an overview of the company Gap Inc. Furthermore there will be an analysis about the financial situation and finally some recommendations will be made. The outcomes of the analysis show that Gap Inc. has some priorities for the fiscal 2010 which are that Gap is consistently delivering product that aligns with its target customers, with an overall objective of improving its sales trend while delivering healthy margins. Moreover they want to keep their focus on cost management and return on invested capital and also want to generate strong free cash flow and returning excess cash to shareholders. Finally, they want to invest in the future while maintainig the growth in its income. Furthermore they are focusing on regaining market share in North America and to achieve this, they are planning to expand internationally with the following steps. First they want to open their first Gap stores in China and Italy and expand Banana Republic in Europe. Additionally they are planning to open additional outlet stores in Canada, Europe, and Asia and want to introduce online shopping to their customers in Canada and Europe.

Our recommendations for Gap, Inc. are as follows. Firstly, they could think about changing their lobbying practices and improving their factory working conditions abroad. Furthermore they should change their company strategy and expand its business from not only a retail company to a manufacturing enterprise. Totally owned subsidiaries would also align very close with their Corporate Social Responsibility initiatives and provide customers with more confidence and trust of Gap’s efforts and commitments to improve factory conditions. Another recommendation is that they should hire more local employees who know the country well. Generally speaking, Gap should improve its working conditions.

  • 2 INTRODUCTION

    • 2.1 INITIAL PROBLEM

In 2006, GAP Inc., a special retailer offering clothes, accessories and personal care products for adults, children and babies, found itself in a crucial situation where some changes needed to be made. Despite the fact that Paul Pressler, the CEO of the company, had implemented some cost-cutting strategies, the net profit had declined. The main problem however was the fact that GAP was losing customers.

2.2

GAPS HISTORY AND DEVELOPMENT

Gap Inc., was a specialty retailer operating retail and outlet stores, divided into four basic divisions: Gap, Old Navy, Banana Republic, and Forth & Towne brands. Old Navy’s main target was cost conscious customers, who would like to spend money on casual-styled clothing. Gap, on the other hand was offering classical-styled clothes at moderate prices but yet, higher than those of Old Navy. The Banana Republic brand was aiming at more sophisticated consumers and Forth & Towne at women over 35. Below are a short information of Gap’s important product segments.

Gap

Gap was initially founded by Donald Fisher in 1969, as a store in San Francisco offering Levi’s jeans. The basic “look” of Gap during this time was blue jeans and cotton white T- shirts. Fisher was selling its clothing at prices regulated by Levi’s and earned heavy margins. It was then until 1976, when a new law was passed, by which the manufacturers couldn’t determine the retail prices.

Competition was mounting, which induced Fisher to offer some other private labels. This didn’t help however to increase the margins. It was in 1983, when Drexler as a CEO introduced Gap as a clothing brand.

Gap was controlling everything from manufacturing to marketing, offering casual clothing at moderate prices. The brand became a part of the American pop culture and soon earnings began to increase.

Banana Republic

Banana Republic was founded by Mel and Patricia Ziegler as an adventure lifestyle store offering items that one might need when going on a holiday. Earnings increased during the early 1980s when the “safari fever” was spreading across the U.S. In 1983, the store was bought by Gap.

Gap transformed Banana Republic from a catalog-based retailer to physical retailer. Offering lifestyle apparel, the Banana Republic brand operated high revenues. When the “safari” fashion was out of trend, modern-casual styled clothing was introduced in the market.

Old Navy

Old Navy started in 1994 as a brand, mainly focused on price conscious customers. It was using a different fabric, keeping its manufacturing costs low.

Due to this fact, the brand was offering basic clothes at about two-thirds of Gap’s prices. It became eventually the biggest contributor to the parent company’s growth.

Inspired by the fast-growing revenues, Drexler opened 282 Old Navy stores in the next four years. The brand was a real success, counting 41 % of Gap’s total sales. In 2000, Old Navy shifted to focus on teenagers and the young crowd went crazy on them.

  • 3 FINANCIAL ANALYSIS OF GAP’ INC.

    • 3.1 OVERVIEW OF GAPS FINANCIAL STATEMENTS AND IMPORTANT KEY RATIOS

Below are selected financial data of Gap, Inc., which includes the company’s consolidated statements of operations, cash flows and shareholders’ equity for the ended fiscal years (December 31) from 2009 to 2007.

Gap transformed Banana Republic from a catalog-based retailer to physical retailer. Offering lifestyle apparel, the Banana

Table 1: Key financial data of Gap, In. in millions except EPS (fiscal years 2007 – 2009) 1

  • 1 SEC (Retrieved on 15.01.2011)

As seen in Table 1, Gaps net sales for fiscal 2009 were $14.2 billion compared with $14.5 billion for fiscal 2008, and comparable store sales in 2009 decreased 3 percent compared with a decrease of 12 percent in 2008. Ironically, net income for fiscal 2009 increased 14.0 percent to $1.1 billion, or $1.58 per share, compared with $967 million, or $1.34 per share for fiscal 2008. This effect is as a

result of the consistent cost reduction and profit improvement measures in 2009 and also as result of the facts that Gap acquired all of the outstanding capital stock of Athleta, Inc. (a womens’ sports and active apparel company), for an aggregate purchase price of $148 million in September 2008. 2

Gap’s cash balances and cash flows from operations is believed to be sufficient for the foreseeable future. Gaps business and financial priorities for fiscal 2010 were as follows:

Gap is consistently delivering product that aligns with its target customers, with an overall objective of improving its sales trend while delivering healthy margins

maintaining a focus on cost management and return on invested capital

generating strong free cash flow and returning excess cash to shareholders

and investing in the future while delivering earnings growth.

Gap will continue to focus on regaining market share in North America in fiscal 2010, to achieve this, Gap is planing to expand internationally through the following:

opening our first Gap stores in China and Italy

expanding Banana Republic in Europe

opening additional outlet stores in Canada, Europe, and Asia

and introducing its online shopping experience to customers in Canada and Europe.

Graph 1 (below) illustrates the comparison of yearly cumulative total return on Gap’s common shares against the yearly cumulative total return of the companies listed on the Standard & Poor’s 500 Stock Index, and the Dow Jones U.S. Apparel Retailers Index. We assume $100 invested on January 29, 2005 in the common shares of Gap, Inc., S&P 500 Index, and the Dow Jones U.S. Apparel Retailers Index, including reinvestment of dividends, through December 30, 2010.

  • 2 SEC (Retrieved on 15.01.2011)

Graph 1: Shareholder return Performancein in comparison (2004 – 2009) It is important to note that

Graph 1: Shareholder return Performancein in comparison (2004 – 2009) 3

It is important to note that the performance of Gap’s share seemed lower in comparison because of the unsystematic risk effect which is inherent to any single share. The performances of the 2 indexes were relatively higher due to the diversification effect (or portfolio effect). By a closer look at the fluctuations, one will see that Gap's share is closely correlated to the shares of the both indexes, which implies that Gap’s operation and performances is highly susceptible to the general market effects and economic variables, such as earnings, prices, cost of raw materials and so on.

In order to get a distinct view and understanding of Gap’s operational ability, we decided to calculate the key ratios of its financial statements from 2007 to 2009. As mentioned above, the gross margin for fiscal 2009 was aprproximately 40% compared with 37.5% for fiscal 2008, however, inspite of the 3% decrease in net sales of 2009. The margin improvement was primarily as a result of Gap’s continued cost reduction and profit initiatives.

The constant increasing profit margins, return on asset and equity in Table 2 is an indicator that Gap’s general operations from 2007 to 2009, was a great success.

3 SEC (data retrieved on 15.10.11, Graph by us)

Table 2: Key financial ratios (fiscal years 2005 – 2009) With the Current and Quick ratio

Table 2: Key financial ratios (fiscal years 2005 – 2009)

With the Current and Quick ratio of 2,2:1 and 1,2:1 respectively in 2009 compared to 2007 and 2008 is an indicator that Gap’s ability to pay off its short-term debt obligations is increasing with the time. The company’s total liability to its total shareholders equity ratio (Debt to Equity ratio) of 2009 is 0,63 to 1 compared to 0,72 and 0,83 in 2008 and 2007 respectively, which show that the company is becoming less leverage with the time. Gap’s debt to asset ratio was 0,39 to 1 in 2009. This is an indicator that the Gap’s operations are less dependent on leverage.

  • 3.2 DUPONT ANALYSIS (2009)

Usually, a high return on equity ratio of 22,5% in 2009 is a good indicator that Gap, Inc is a company worth investing in. This, however, can be misleading, because a firm may boost its ROE by taking on new debt at the expense of the shareholder. By going further beyond the façade of Gap’s financial practices, we attempt to provide more reliable and, therefore, safe ROE calculations for investors by applying the Dupont Analysis.

With the Dupont analysis, we intend to breaks down Gap’s return on equity in 2009 by analysing how efficient its assets were utilized (turnover ratio), as well as its operating efficiency and financial leverage.

From the below expressed equation, the profit margin is the ratio with the lowest impart on the return on equity (ROE), followed by the equity multiplier and then the asset turnover as the ratio with the greatest impact on the ROE.

Return on Equity (ROE) =

Net profit

Sales

x

Sales

Assets

x

(Profit margin)

*

(Asset turnover)

*

Assets Equity (Equity multiplier)

=

$ 1.102 Mio $ 14.197 Mio

(0,08)

Impact on ROE:

+

x

$ 14.197 Mio $ 7985 Mio

(1,78)

+++

$ 7985 Mio

x

$4891Mio

(1,63)

22,5%

++

With the above equation, we come to the conclusion that Gap’s strongly relies on its turnover stategy to improve its shareholders’ return (ROE). The Gap’s top notch distribution channel strategies and its continuous improving new fashion designs contributed to the higher turnover ratio. However, the price war among the competitors in the clothing industry attributed to the fact that Gap’s products were sold at a lower profit margin.

Gap’s debt apetitite is rather not moderate. This therefore has positive impact on the ROE, however, exposing Gap’s shareholders to risks associated with high leverage. Nevertheless, by closer observation of Gap’s balance sheet, one could see that Gap has a trend of reducing it debt obligations by the time, which means that they are really doing something in reducing the leverage risk.

4

RECOMMENDATIONS

One recommendation for Gap, Inc. could be, to change their lobbying practices. Well, it is not forbidden to influence governments, but it is only legitimate when it is done responsibly. The focus on trade and tariff policies with China is one of the Gap's corporate political strategy. These strategy is aimed at removing trade barriers. Many view this lobbying campaign as irresponsible and contradictory, because by concentrating only on this policy change seems, that Gap, Inc. is only trying to take advantage of low wages. Acording to Kofi Annan said, the former United Nations Secretary-General:

“Business must restrain itself from taking away, by its lobbying activities, what it offers through corporate responsibility and philanthropy.” 4

  • 4 New York, 24 June 2004 - Secretary-General's closing remarks at the Global Compact Leaders Summit

To improve factory working conditions abroad is one of Gap´s corporate responsibility initiatives. By eliminating quotas and trade barriers with China, an increasing production in low wage countries like China is likely to occur, but then lots of people would lose their jobs in America. Gap, Inc. should focus in more responsible lobbying methods which is in line with the concepts of Corporate Social Responsibiliy.

Another recommendation for Gap, Inc. could be, to change their company strategy and expand its business from not only a retail company to a manufacturing enterprise. Instead of subcontracting all of their factories, we think it would be much better, if Gap, Inc. actually purchases at least one factory in each country where they currently contract factories. This would save Gap a lot of money and it also would serve not only as a production site, but also as a site for research and development.

Totally owned subsidiaries would also align very close with their Corporate Social Responsibility initiatives and provide customers with more confidence and trust of Gap’s efforts and commitments to improve factory conditions. The media would understand this as a really unexpected move by Gap, Inc. so it would cause a lot of public attention. This also would increase consumer’s awareness and change the negative perspetives of Gap.

In addition, we recommend, that Gap, Inc. should hire more direct employees from these countries who know the country well. So they would get an advantage by understanding the different economics and cultures. It also creates more opportunities to build better relationships. These relationships would allow Gap to have a competitive advantage in the future as policies and consumer expectations change.

Gap also should try to improve working conditions, because poor living conditions leads to poor working conditions. They should commit to help these communities as a whole. To build and start up a day-care center where children could go during the day might be a great project and would provide a good service to workers and the community. Another idea would be improve the transportation opportunities for workers. It is a big disadvantage that Gap, Inc. does not currently commit to community service overseas and doing so would show a huge commitment. Instead of just giving money, however, to other companies or institutions, Gap, Inc. would be praised more for motivating its internal employees to get directly involved in some way. This would also help to gain more trust overseas with factory owners, factory workers, governments and communities and would make transitions in future much easier for Gap, Inc.

WORK CITED

Book(s):

Wheelen – Hunger; “Strategic Management and Business Policy – Achieving Sustainability”; Pearson 2006; International Edition; Page 797 - 807

Internet:

Gap’s Coorporate Website (retrieved on 29.12.2010) :

http://www.gapinc.com/public/Investors/inv_financials.shtml

U.S. Securities and Exchange Commission (SEC): Gap, Inc. 10-K · For 12/31/09 (retrieved on 16.01.2011): http://gapinc.com/public/Investors/inv_fin_sec_filings.htm

Yahoo Finance: Gap Inc. (GPS) (retieved on 15.01.2011): http://finance.yahoo.com/q?s=GPS