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other set of principles, can still serve as the starting point. All the analyst needs to do is apply clean
surplus accounting in his/her forecasts. That much is not only easy but is usually the natural thing
to do anyway.
11. It is important to recognize that when the analyst uses the “indirect” cash flow forecasting
method, undetected accounting biases can influence not only future earnings forecasts but also fu-
ture free cash flow forecasts. In the current example, since accounts receivables are overstated, the
analyst will assume that they will be collected as cash in some future period, leading to a higher
future cash flow estimate.
12. Refer to research on real options.
The Gap, Inc.




B renda Curtis, a buy-side analyst focusing on retail stocks, has
watched her favorite industry suffer through turmoil and retrenchment during 1991. But
while the industry faltered and Macy™s ¬led for bankruptcy, one retailer”The Gap”was
busy generating an almost-unheard-of ROE of 40 percent for the year ended January
2
1992. This San Francisco based marketer of casual clothing was labeled as “the nation™s
Business Analysis and Valuation Tools


hottest retailer” by Business Week (March 9, 1992, cover story). Curtis has decided to
take a harder look at The Gap to see what all the fuss is about.
The Gap™s lofty P/E ratio of 35 and price-to-book ratio of 12 (based on a price in the
$55 range) suggest that investors expect even more good things from The Gap in the fu-
ture. Duff and Phelps analyst Carol I. Palmer labels The Gap a “buy,” noting that relative
to 1993 earnings forecasts, the P/E multiple was not unusually high, and yet ¬ve-year
12 earnings growth was forecast “conservatively” at 17 percent, well above the 13 percent
forecasted growth rate for the market as a whole. In speaking about The Gap™s valuation,
Prospective Analysis: Valuation
Implementation
Palmer notes the following:
Discounting only ¬ve years of Gap cash ¬‚ows (using a weighted average discount
rate) and adding the residual value (present value of cash ¬‚ows from 1996 on) and
subtracting debt, we obtain a fair market value of $30 per share. However, since
we feel strongly that The Gap is a long-term growth company, it is, therefore, ap-
propriate to discount years beyond the next ¬ve, using a weighted average dis-
count rate, into the “fair price”; a ten-year time frame yields a fair market value
of $55 per share. Note also that our forecast of fundamentals is conservative by
the standards of both consensus opinion and the Company itself.1
Palmer™s optimism about the long run is buttressed by her view of The Gap™s position
within the industry. Few if any retailers had been so successful in recent years in execut-
ing their strategy and establishing their “look”:
The Gap has established itself as a trend-setter in casual wear, at good prices, for
younger consumers. Excellent management, systems, and merchandising support
a continued leadership position. . . . We think the Company has mastered the right

.........................................................................................................................
Prepared by Professor Victor L. Bernard, with the assistance of Elise Kartchmar. This case is based upon publicly
available information. It was prepared as a basis for class discussion and is not intended to illustrate either an
effective or ineffective management of a business situation.

1. Duff and Phelps Company Analysis (April 1992). Duff & Phelps does not disclose the cost of capital estimate used in
their model. However, analysts estimate The Gap™s beta at approximately 1.30. Intermediate-term government
bonds are yielding approximately 6.3 percent.




484
485
Prospective Analysis: Valuation Implementation




12-25 Part 2 Business Analysis and Valuation Tools




mix of value-added, fashion merchandise and quality staples. This mix, combined
with highly focused image-management (advertising, store layout, and locations),
has made The Gap the de¬nition of correctness in casual wear for a broad demo-
graphic group.2
Ironically, The Gap™s notable success may be its greatest source of concern. Business
Week notes that:
. . . plenty of rivals are regrouping to compete. Department store executives
preach to employees about the need to “Gap-ize” the colors, ¬bers, and display
of their wares. . . . Giorgio Armani is looking to skim The Gap™s biggest-spending
customers with its new A/X Armani Exchanges, which offer stripped-down fash-
ions with a European look at prices much lower than those at the top of Armani™s
line. . . . The Limited Inc. has Gap-like “relaxed ¬t” jeans, sold in some stores with
a sales tag whose design is strikingly like The Gap™s. . . . Dayton Hudson is exper-
The Gap




imenting with a chain called Everyday Hero that will have a distinctly Gap-like
approach.3
Despite concerns about competitive forces in the retail industry, analyst Curtis is in-
trigued enough by Palmer™s optimism to press on with her investigation of The Gap. The
following paragraphs summarize the information at her disposal.


BUSINESS AT THE GAP
The Gap, Inc. is a specialty retailer of casual and active apparel for men, women, and
children. Incorporated in 1969 as a retailer of Levi™s jeans, records, and tapes, The Gap
The Gap
was restructured in 1984 under the guidance of merchandiser Mickey Drexler. Under
Drexler, The Gap sought to provide stylish yet affordable apparel, primarily for the 20-
to 45-year-old customer. GapKids was introduced in 1986 to serve the market for boys
and girls aged 2 through 12. Selected GapKids stores include “babyGap” sections offer-
ing clothing for infants and toddlers. The Gap also owns Banana Republic, Inc., another
specialty retailer emphasizing rugged and casual men™s and women™s apparel.
Gap, GapKids, and Banana Republic stores are located primarily in shopping malls
throughout the U.S. As of April 1992, there were 1226 such stores, 1176 of which were
located in the U.S. The remainder were located in Canada and the U.K.
Drexler™s motto for The Gap is “Good style, good quality, good value.” Analyst
Palmer characterized The Gap™s formula this way:
. . . mostly staple/commodity apparel, with some differentiated fashion merchan-
dise, at highly competitive prices (given the reliable quality), in convenient loca-
tions; while the s.k.u. count is limited, the inventory is deep. To summarize, using
The Gap™s self-description: “intensely focused.” 4

.........................................................................................................................
2. Ibid.
3. Business Week, March 9, 1992. pp. 63“64.
4. Duff and Phelps Company Analysis (April 1992)
486 Prospective Analysis: Valuation Implementation




12-26
Prospective Analysis: Valuation Implementation




The Gap™s formula begins with its own New York designers, Lisa Schultz and John
Fumiatti, who attempt to anticipate consumer desires for clothing that is stylish but
basic, and faithful to The Gap “look.” The Gap relies more on the vision of its designers
and quick market tests than on quantitative consumer research. Designs are created ap-
proximately one year in advance of sale, in suf¬cient numbers to assure that Gap stores
will receive a new collection of styles every two months; older clothing still unsold at
that point is moved out quickly by slashing prices.
All clothing is manufactured under The Gap™s private label, by over 450 suppliers. To
control manufacturing quality, The Gap establishes speci¬cations for each order and
maintains a staff of 200 inspectors at the factory sites. In 1991, 38 percent of the clothing
was produced domestically, and the rest in Hong Kong and other foreign countries. No
single manufacturer accounted for more than 5 percent of the supply.
The Gap maintains little replenishment merchandise at the retail outlets. Instead,
large inventories are maintained in distribution centers in California, Kentucky, Canada,




The Gap
the U.K., and (beginning in 1992) Maryland. Point-of-sale scanners permit tracking of
inventory needs at each retail outlet, so that distribution centers can replenish stock
quickly.
Gap stores are usually leased in shopping malls and are company-controlled, not
franchised. Most Gap stores tend to be small by industry standards”often no more than
4000 square feet”but many of the newer outlets are larger: about 7000 square feet.
They are more sparse than some specialty clothing outlets, but are well-lit, clean, and
“shopper friendly,” with wide aisles and readily accessible merchandise. Store layout
and operations are controlled tightly by the corporation; one observer states that “there™s
no more room for creative expression at a Gap store than there is at a McDonald™s”
maybe less.”5 Each week, store windows and displays are rearranged, according to a
speci¬ed company design, to maintain a fresh, new look even to frequent customers.
The Gap “look” is reinforced through advertising in lifestyle and fashion magazines,
and in various outdoor media: bus shelters, mass transit posters, telephone kiosks, and
so forth. Advertising campaigns are designed by The Gap™s own in-house staff. The ads
feature such well-known faces as Spike Lee, Joan Didion, and James Dean. Some of the
black-and-white prints used in this campaign have won advertising awards. In 1991, The
Gap kicked off a black-and-white television ad campaign, and intended to expand this
campaign in 1992. Advertising costs were 1.5 percent, 1.2 percent, and 1.4 percent of
sales in ¬scal 1989, 1990, and 1991. Comparable amounts for direct competitors, such
as the Limited, are not available.
Growth at The Gap has been phenomenal. Sales, which stood at about $850 million
in 1986, rose to $2.5 billion in 1991. Over that same period, annual earnings rose from
$68 million to $230 million. In 1991, The Gap brand became the Number 2 private label
in the clothing business, behind Levi Strauss.
Much of the sales growth at The Gap has resulted from new store openings; the num-
ber of stores rose from 960 in 1989 to 1092 in 1990, and to 1216 in 1991. In addition,
however, much growth is attributable to enhanced utilization of existing ¬‚oor space.

.........................................................................................................................
5. Business Week, March 9, 1992, p. 61
487
Prospective Analysis: Valuation Implementation




12-27 Part 2 Business Analysis and Valuation Tools




Sales per square foot increased from $250 in 1986 to $481 in 1991; comparable store
growth (i.e., growth ignoring the effects of new store openings and expansions) has been
much higher than that of competitors. Below is a comparison of growth at The Gap with
each of two competitors, The Limited and Petrie Stores. The Limited Inc. (owner of The
Limited Stores, Express, Lane Bryant, Victoria™s Secret, Structure, and others) was the
second-fastest growing specialty retailer in ¬scal 1991, behind The Gap. Petrie Stores
(owner of Petrie™s, Marianne™s, Stuarts, and others), was among the more slowly grow-
ing ¬rms in the specialty retail category.

Sales per Comparable
Sales ($ billions) Square Foot ($) Store Growth
........................................ ........................................ ........................................

Gap Limited Petrie Gap Limited Petrie Gap Limited Petrie
..................................................................................................................................................
The Gap




1991 2.519 6.281 1.355 481 302 N/D 13% 3% 3.5%
1990 1.933 5.376 1.282 438 309 N/D 14% 3% 1.7%
1989 1.587 4.750 1.258 389 323 N/D 15% 9% 2.0%
1986 0.848 3.223 1.198 250 277 N/D 12% 18% N/D
..................................................................................................................................................
N/D = not publicly disclosed




INDUSTRY CONDITIONS AND COMPETITION
The Gap™s performance in the early 1990s was highly unusual within the retail sector.
Retail businesses were hit hard by weak consumer con¬dence and a slowly growing
economy. In real terms, sales declined from 1989 to 1990, and again from 1990 to 1991.
Particularly hard hit were department stores, which experienced “probably the most try-
ing period in [their] history.”6 Performance by general merchandisers was stronger, but
still not overly impressive; ROEs for a composite of general merchandisers (K-Mart,
Penney™s, Sears, and Wal-Mart) averaged about 12 to 15 percent over the 1987“1991 pe-
riod, not much different from the average for U.S. corporations in a typical year. Pro¬t-
ability at speciality retailers was highly variable, but healthy on average. ROEs for a
specialty retailer composite (Gap, Limited, Melville, Nordstrom, and Petrie) ranged
from 20 to 23 percent in 1987“1991.
Those ¬rms who managed to ¬nd paths to pro¬tability were the so-called “power re-
tailers” or “New Wave retailers.”7 Included in this category were some specialty retailers
(e.g., The Gap, The Limited, and Toys-R-Us) and other general merchandisers, includ-
ing discount retailer Wal-Mart. The innovations that made these ¬rms successful were
varied, and included higher-margin niche strategies as well as everyday low pricing

.........................................................................................................................
6. Standard and Poor™s Industry Surveys, June 4, 1992, p. R77.
7. Ibid., p. R81. The term “New Wave” retailer is attributed to Dr. Carl Steidtmann, Chief Economist of Management
Horizons, a division of Price Waterhouse.
488 Prospective Analysis: Valuation Implementation




12-28
Prospective Analysis: Valuation Implementation




(“value pricing”) strategies. Most success stories, however, involved high inventory
turns and high sales volume per square foot.
The Gap™s 1991 10-K characterizes the specialty retail industry as “highly competi-
tive,” and acknowledges that the success of the Company™s operations has increased the
likelihood of imitation. Indeed, Fortune magazine states that “If imitation is the sincerest
form of you-know-what, then The Gap is in the middle of an outright lovefest.”8
On the subject of competition within the industry, Gap Chairman and CEO Donald
Fisher says, “We don™t worry. We have a distinct advantage in our name, our merchan-
dise, and the number and location of our stores.”9 Is President Drexler worried? “Sure,
but hey look, there aren™t too many secrets in this business. It™s just going to make us run
a little harder.”10


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