Gap's Suggested New Strategy: Secede From The 'Boring Middle'
Sep. 24, 2019 1:00 AM ET
About: The Gap, Inc. (GPS)
Long only, value, special situations, event-driven
Summary
At this point, investment in Gap is about observable changes in product, pricing and marketing/customer relationships, not about financial engineering.
GPS enjoys a level of operational excellence that has mitigated many of their merchandising and design missteps.
Gap is still a mixed portfolio of brands with varying levels of merchandising and design execution.
GPS has a path to redemption, but they must finally take the next evolutionary steps beyond the changes initiated in Spring 2016.
This discussion will be about the under-performing Gap (NYSE:GPS) division. I noted in the Spring of 2016 that Gap had made what I thought was a seismic shift in their merchandising and product strategy. It was, but in my opinion they have neglected to build on what was a good decision at the time. I then returned from over a year in China to observe in the Spring of 2018 that Gap was still seeking their groove. The groove is proving to be elusive. Yes, I have seen improved focus and clarity at Banana Republic. Yes, there is every reason to be optimistic about Athleta’s future (spin-off or not). And yes, I am completely scratching my head at the logic behind and the speeches about the Old Navy spin-off. Maybe there is a perfectly good financial engineering explanation for it. Maybe it attracts or frees up capital. But it doesn’t make Old Navy smarter and it doesn’t make 800 new stores any easier in the context of a highly competitive market.
That leaves the Gap division. Never mind my opinion, their own numbers say they are floundering. While they have returned to some of the merchandising and design practices that worked in the past, that was the distant past. This is 2019 and the competition is wildly different, and I don’t just mean Amazon (NASDAQ:AMZN) and e-commerce. Customers have heightened expectations about product and shopping experiences. This article talks about observable changes that could change the way customers view Gap.
The sales and earnings numbers below are taken from Gap's annual reports. Sales in 2003 were $15.8 billion and sales in 2017 were $15.8 billion - that’s 14 years with no growth. New stores open, old stores close; brands grow and brands shrink; new brands emerge. Add it all up and no growth. Factor in inflation and the business has been shrinking. GPS is losing market share. And there are lots of opinions about why and to whom.
At first glance one could say, “Okay…no growth. But e-commerce is taking market share and the market is brutally competitive, and they are making money. They are actually surviving the ongoing market turmoil better than most.” True, they are surviving better than some. They have a healthier balance sheet than some. But the fact is that they are losing ground and must do something to stem the market share erosion.
The chart above profiles the Return to Shareholders for GPS versus the Dow Jones US Apparel Retailers. Investors will argue that this retailer is due for a strategic reset.
Risk as a differentiator
Yes, there are a lot of moving parts to this dynamic. Every brand and retailer are (or should be) working on the clarity and focus and direction of their Brand Promise (customer/product/experience alignment). Every brand and retailer are working hard on planning, merchandising and design, looking for the differentiating competitive edge. They are all working on it, but here I would argue that some retailers, including the Gap division, have decided that the right bet in this market is simply be “safe.” They have taken refuge in “boring.” A picture of their store today would be difficult to distinguish from a picture taken 2 to 5 to 12 years ago. In this volatile market, they have stopped taking risks. And here I submit that risk can be a retailer’s best friend if properly managed. Risk is a differentiator and every retailer needs some level of differentiation from the rest of the mall. Otherwise, the only tool left is price and the race to the bottom is on.
There is a lot of conversation now about “experiential” retailing, and again there are plentiful opinions about what that means. For simplicity’s sake, let’s acknowledge that the mall has a role for some experiences and the store has a role for others. And let’s forget AI and VR and other tech toys for the moment. What can the store do within the parameters of product and marketing to provide an “experience”? Simple…”treasure hunt.” Provide an ongoing flow of new and fresh products and create a sense of anticipation with the customer. Surprise and delight. Centuries old thinking but it’s still what drives customers to reach for their wallet (or phone).
This is where I think Gap is disappointing the shopper. They look “okay.” Sometimes they look “good.” But they do not surprise and delight. And now it’s to the point where “NEW” and “Save 40%” appear in the same email. “New” used to be when product sold at full margin ticketed price. Now “new” just means it wasn’t on the floor yesterday, but it’s 40% off just like everything else.
Here I propose a possible solution for Gap. New thinking about gross margin, product and promotion. Secede from the Race To The Bottom. Secede from the “boring middle.” The middle does not have to be boring. Learn how to “Surprise and Delight” again. Trade up, not DOWN.
Chase Gross Profit Dollars, not margin %. Explore and chase lower than normal margin % business
Approach gross margin % from a different merchandising angle. Too many ticketed prices are placeholders these days. They are a set-up for a % savings story. They no longer represent the real or perceived value of the item. This is not a sweeping condemnation of all brands and retailers, but enough brands and retailers have this practice that it deserves to be called out. It might not be possible to change the entire merchandising and marketing strategy overnight, but steps in the right direction can be made.
First some simple math. Let’s say an item has an LDP (landed duty paid) cost of $18. Retailers may ticket that item anywhere between $29 and $75 depending on their pricing and marketing strategy. At $75, the initial mark-up at the ticketed price is 76%. But the item is very quickly promoted at 40% off. Now the selling price is $45. Then 50% off… $37.50. Then 60% off… $30. The item will go through various promotional windows, BOGO’s and finally a clearance sale. The item finishes its selling life with an average selling price of $32. With an $18 cost, that’s a maintained margin for the life of the item of 43.8%. No, it did not start at $75. It started at $45. And after all the promotional activity and clearances were over the item had an Average OutThe Door retail of $32 and a margin of 43.8%. The 76% margin at the ticketed price of $75 was never real. It was simply setting up the promotional life that lay ahead for the item. And finally, with an $18 cost and an AOTD retail of $32, the Gross Profit Dollar (GPD) contribution of that item was $14 per unit sold.
If that item represents the margin profile of the whole store, this retailer is maintaining a gross margin of 43.8%. That’s not bad in the grand scheme of USA mall retailing. American Eagle Outfitters (AEO) has had gross profit in the range of 36-38% for the last 3 years. Abercrombie & Fitch (ANF) has been in the range of 60-61%. Chico’s FAS (CHS) has ranged from 36-38%. Gap had a gross margin in the range of 36-38% for the last 3 years.
From those real-world examples and the example of the item as described above, let’s create a scenario where the retailer in question has a maintained gross margin of 38%. Their ticketing and promotional strategy start with initial margins in the 70s, but it comes out at 38%. How can this retailer change their thinking and strategy to create a new, heightened integrity for their Brand Promise - a new, heightened value proposition, and a new heightened sense of “treasure hunt” in the eyes of the customer? By creating a new “Limited Edition” group of products that operate under a different set of margin rules than the balance of the store.
Create and Manage Scarcity
If $60 is a typical retail for the store, then $15 would be the ‘allowable’ LDP cost under the old rules of 75% initial ticketed margin. What if, under the new rules, the allowable LDP for that item is now $30? 50% initial margin at the ticketed price. A $30 cost item is going to provide a lot more quality than the $15 cost item. It is going to be a lot more special. It is going to give new meaning to the term “treasure hunt” within the walls of this mall store. This new item is “Limited Edition.” It is bought to sell out. The logic is about creating and managing scarcity. It is not about being afraid to sell out. That is actually precisely the whole point. The next “Limited Edition” item is ready to hit the floor. “Limited Edition” is not included in all the ongoing promotions. The quality and value of the item are supposed to be so obvious that the customer does not need a huge POS sign with a % savings to get their attention. And yes, there may still be some clearance markdowns, so the AOTD selling price is $54 with a 44% gross margin and a GPD contribution of $24, significantly better than the $14 of the old rules item.
Best Use of Space... Maximize Productivity
A note about the very real constraint in brick & mortar retail… space. It’s finite. It only holds “X” amount of inventory at any given moment, with some variance depending on category and fixtures. If the retailer under-buys an item, and sells out leaving a bare shelf, then both the item and the space have gone underutilized. Not good. But if an item sells out and is immediately replaced by a new item, then no problem. The first item was not maximized, so what? The space was immediately re-invested, and the space continued to be productive. There was no under-utilization of the space. No problem. So, it is not necessarily about maximizing any given item, it’s about maximizing the productivity of the space. “Best Use of Space” as I call it. If there is an item or category that operates at a lower than “normal” gross margin % but can maximize the Gross Profit Dollar contribution in a given space, then the scenario that puts more dollars in the bank would seem to be the way to go.
The “Limited Edition” example as offered is meant to break the momentum of chasing what feels like high margin business, but in reality, has created a vicious cycle of race to the bottom promotional activity based on % savings. The customer still believes this kind of promoting but this thinking is not sustainable, not on the retailer’s part and not on the customer's part. (Yes, we all still remember the pain associated with the strategy J.C. Penney (JCP) put in motion several years ago. The execution of this new strategy must be little more nuanced than what JCP did.) “Special” and “quality” and “value” and “differentiated” are sustainable and in fact are necessary for a long-term healthy retail business. This “Limited Edition” changes the rules on how margin is viewed, and it chases Gross Profit Dollars rather than gross margin %.
And now I expect to hear how difficult if not impossible this would all be to execute in the context of today’s mall retailing environment. I will simply say, something has got to give. Changes in legacy thinking are years overdue. AI and VR and BOPIS and next shiny new object are all going to have their role, but the customer ultimately buys the product. And chasing GPD with “Limited Edition” product is a vehicle for improving the retailer/customer relationship on many levels.
One last note. I was in the Primark store in Danbury, Connecticut, on September 12, 2019, and the boot display below stopped me in my tracks. It was the precise boot I had been shopping for… almost. I saw versions of this boot for $150-400 from various brands. And now I’m looking at a boot for $27? Okay, it’s made from polyurethane. My excitement quickly abated. What if they had offered a leather boot for $99? I would surely have been a customer.
This would be a great scenario to compare GPD outcomes. I am not a boot maven so I will make a complete guess on the LDP cost of the item just to tee up the thought process. I’ll guess that Primark is working on 30% initial margin at the ticketed price, so the cost is $18.9. Gross Profit Dollars per unit = $8.10. At the higher retail of $99 let’s say Primark works on 25% margin in order to hit the $99 price point. Cost = $74.25. GPD = $24.75. Obviously, it becomes about the ratio of sales between the two items. At one third the GPD contribution per item, would the polyurethane item outsell the leather item by 3:1? Very possible. A head-to-head test would be most illuminating. But what about attracting new customers? Am I ever going to buy a polyurethane boot no matter how good the price? I doubt it, but I used to say that about polyurethane jackets and there are now some pretty amazing PU jackets on the market for $50–75. If it had been a leather boot for $99, I’d be wearing those boots today. Maybe $99 leather boots are considered to be outside of Primark’s price domain. But maybe.
The real moral of the story here is that using new thinking and logic regarding gross margin % and pricing strategies opens the door for chasing Gross Profit Dollars that exceed what current assortments can deliver. And give the business new product attributes that can change the customer's perception of the brand.
Primark, Danbury CT USA 9/12/2019
Conclusion
Invest based on observable change on the selling floor, not speeches. Invest based on observable differentiation from the competition, not ever higher profile promotional activity. GPS has great brands and enjoys operational excellence. The Gap division can be the flagship it once was. They need to compete in today's market, not the market of two decades ago.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Articles I write for Seeking Alpha represent my own personal opinion and should not be taken as professional investment advice. I am an experienced apparel merchant, not a registered financial adviser. This article endeavors to give timely and ongoing color to the unfolding retail experience, not financial advice.
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Geez - I gotta get out to Danbury this weekend.
24 Sep 2019, 02:30 AMReply0Like
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@Jeff Sward Rhetorically bright article. I would also appreciate if you could touch on Gap's customer demographics (next time). ANF/AEO definitely capture the younger crowd (teens/university students), Chico's captures the mature female demographics but Gap is "somewhere in between" or "across the board". Gap is a brand that can do "jack of all trades" (currently with BR, Athleta, Old Navy etc..) but really, is it profitable to be an apparel brand for everyone? Also, the aforementioned brands do not capture kids. So really, Gap has become a household brand for the family like P&G's Crest toothpaste. But Gap is in fashion. It would be interesting to ask - "if a teenager's parents are buying a pair of jeans/t-shirts from Gap, how will that impact the ANF/AEO demographic's likelihood of buying a pair of jeans from Gap?" If I were to put myself into the university student's mentality, I'd be turned off by the clothes donned by the mature demographics. So really, going back to the author's point, this is a marketing question for Gap. Lastly, Gap's sizes are somewhat off - too big. :$
24 Sep 2019, 01:33 AMReply1Like
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Author’s reply »
Thanks @Drink DT, I appreciate your comments and questions. This article was really a simple exercise in math and margins in order to explore new thinking that can give the designers and merchandisers some broader latitude in HOW they populate the store with WHAT new product in order to change the customers perception of the Gap. You ask the perfect question...to what demographic? Gap used to be shopped by grandparents, parents, teens and toddlers. It worked for everybody. Not sure that still works. My hunch is that they now need to skew a little older. Teens and university students are gravitating to more Instagram-able product. It really boils down to a reset of the Brand Promise. Is it still possible for a retailer to enjoy the breadth of appeal that the Gap enjoyed in its peak years? I suspect not.
24 Sep 2019, 11:11 AM Edit/DeleteReply1Like
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