Essentials of Strategic Management

The Quest for Competitive Advantage

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 6
Case
Gap Inc.: Can It Develop
a Strategy to Connect
with Consumers in 2017? * Teaching Note

Overview
Gap became a household name in the 1990s through its clever advertising and merchandising strategy that made
it largely responsible for making the jeans-and-t-shirt style ubiquitous during that decade. The company’s strat-
egy led to large and regular increases in net sales, which increased from $1.9 billion in 1990 to $11.6 billion in
1999.1 Its net sales by the end of the decade were almost double the $6.6 billion in 1997.

The company’s sales growth declined dramatically in the 2000s as its merchandise became stale. The decline
in sales growth had become a decline in total sales by 2015. Gap CEO Glen Murphy was replaced by Art Peck
in February 2015 and charged with reversing the company’s long-running lackluster performance and recent
sales decline. Peck had joined GAP in 2005 and had held various executive positions with the company where
he spearheaded the company’s franchising initiative, executed its outlet store strategy, and led its digital and
e-commerce division. Exhibit 1 presents a financial and operating summary for Gap, Inc. for 2011 through 2016.

The sales decline between 2015 and 2016 was reflected in every geographic region except Asia and every brand
except Old Navy, which experienced a 1 percent increase in sales in 2015. When compared to 2011, net sales
across brands had only increased from $14.5 billion to $15.8 billion in 5 years. Exhibit 2 shows Gap Inc. sales
by brand and region for 2013 through 2015.

Comparable store sales declined 3 percent for the company between 2015 and 2016, with the greatest decline at
10 percent for Banana Republic. Comparable store sales for Gap stores declined by 6 percent and Old Navy store
comparable store sales increased 1 percent between 2015 and 2016. Driving the decline in comparable store sales
was the fall off in the company’s sales per square foot, which had fallen from $365 in 2013 to $361 in 2014 to
$337 in 2015 to $334 in 2016.

Faced with increased competition and a changing demographic amidst a shifting shopping landscape, Gap CEO
Art Peck needed to reverse Gap Inc.’s current trajectory and consider alternatives to improve sales. Complicating
the turnaround, however, would be the increase in shopping mall vacancies, as well as the increased competition
in retail. While higher-end malls continued to see improvements in foot traffic in 2016, consumers decreased
shopping at lower-end malls, where empty storefronts were becoming common. Further, as shoppers became
comfortable with online shopping, larger percentages of retail sales were occurring through e-commerce. Yet,
companies such as the Inditex Group, known for its Zara brand, continually increased sales and expanded
locations regardless of these environmental factors. Peck pondered how Gap could defend against unfavorable
external factors and craft a strategy well-matched to the retail environment of the late-2010s.

*This teaching note primarily reflects the thinking and analysis of Professor John D. Varlaro, Johnson & Wales University. We are
most grateful for his insight, analysis and contributions to how the case can be taught successfully.
Gap Inc. 1999 10-K.
1

– 297 –
298 Section 6 Instructor’s Manual for Essentials of Strategic Management

Suggestions for Using the Case

Students are likely to have great interest in the Gap case and are also likely to have strong personal opinions
about the company’s value proposition and competitive positioning. The case introduces GAP Inc as the
epitome of the mall-based retailer; best seen in the explosive growth in the 90s. But, asks students to consider
the issues GAP Inc currently faces; declining sales, declining popularity of malls, yet increased competition
by Inditex Group, which has successfully competed through what is referred to as fast fashion and online
sales. After reviewing other competitors and providing information on the current state of malls, the case asks
students to consider the future steps GAP Inc.’s leadership may need to take to reverse the declining sales it has
experienced over the past several years.

We recommend positioning the case in your business strategy module since the case does an excellent job of il-
lustrating concepts presented in Chapters 3-5. As this case specifically addresses industry characteristics, it lends
itself well to discussions of industry, competitive analysis and competitive positions for both new and incumbent
competitors in clothing and retail. There is ample material presented in the case to allow students conduct a
Five-Forces analysis, assess macro-environmental characteristics and industry economic characteristics, exam-
ine strategic positioning through the use of a strategic group map, and evaluate industry key success factors.

Videos for Use with the Gap, Inc. Case There are two videos that you can show in class (or have students
view on their own):

n A 1:38-minute 2015 video concerning “Why Is Gap Closing 175 Stores in North America,” that can be
accessed at https://www.youtube.com/watch?v=TdARiQIrFgE.

n A 2:01-minute 2015 video titled “Gap Inc. to Open Store in India” that can be accessed at https://www.
youtube.com/watch?v=NvTFvw6E53Y

In our experience, it is quite difficult to have an insightful and constructive class discussion of an assigned case
unless students have conscientiously have made use of pertinent core concepts and analytical tools in preparing
substantive answers to a set of well-conceived study questions before they come to class. In our classes, we
expect students to bring their notes to the study questions to use/refer to in responding to the questions that
we pose. Moreover, students often find that a set of study questions is useful in helping them prepare oral
team presentations and written case assignments—in addition to whatever directive question(s) you supply for
these assignments. Hence, we urge that you provide students with assignment questions—either those we have
provided or a set of your own questions—for all those aspects of a case that you believe are worthy of student
analysis or that you plan to cover during your class discussion.

To facilitate your use of assignment questions and making them available to students, we have posted a file
of the Assignment Questions contained in the instructor resources section of the Connect Library for the 6th
Edition

Utilizing the Guide to Case Analysis. If this is your first assigned case, you may find it beneficial to
have class members read the Guide to Case Analysis that can be found in the instructor resources section of
the Connect Library. The content of this Guide is particularly helpful to students if your course is their first
experience with cases and they are unsure about the mechanics of how to prepare a case for class discussion, oral
presentation, or written analysis.

Suggested Assignment Questions for an Oral Team Presentation or Written Case Analysis. The
case can be used effectively for a written assignment early in the term, but we advise against using the case for
group presentations scheduled just prior to finals since the issues are relatively easy to sort out and address. Our
recommended questions for written assignments are as follows:

1. GAP Inc. is considering you for an entry-level brand management position. You have been asked to prepare
an analysis of the apparel industry as part of the selection process. Please prepare a 5-6 page report that
includes a description of the industry’s strategically relevant macro-environmental components, evaluates

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 Section 6 Case Teaching Notes for Chapter 6 299

competition in the industry, assesses drivers of change and industry dynamics, and lists industry key success
factors. The company’s management also asks that you propose the basic elements of a strategic action plan
that will allow the company to improve its competitive position.

2. As a new member of the Inditex Group brand management department, you have been asked to prepare an
analysis of the apparel industry. Your 2-3 page executive summary should list strategic issues confronting
Inditex Group and its portfolio of brands and make recommendations to address such issues. The executive
summary should be supported by your analysis of the industry. Exhibits such as a Five Forces model, macro-
environmental characteristics, key success factors, drivers of change and industry dynamics, and a strategic
group map should be attached to your report.

Assignment Questions
1. What are the strategically relevant components of the U.S. Retail, Family Clothing Stores industry macro-
environment?

2. What is competition like in the family fashion industry? Which of the five competitive forces is strongest?
Which is weakest? What competitive forces seem to have the greatest effect on industry attractiveness and
the potential profitability of new entrants?

3. What does your strategic group map of the family clothing retail industry look like? Is Gap Inc. well
positioned? Why or why or why not?

4. What do you see as the key success factors in the market for family clothing?

5. What key factors may determine the success of GAP Inc.?

6. What recommendations would you make to GAP Inc. to improve its competitiveness in the market while
mitigating any current and future risks?

Teaching Outline and Analysis

1. What are the strategically relevant components of the U.S. Retail, Family Clothing Stores
industry macro-environment?
Students should be able to identify the following from within the case:

n Market size and growth. Students may discuss any number of the characteristics of the market presented
in the case, specifically in exhibits 5-8. For example, as presented in the case, estimated revenues were
over $100 billion among competitors in this industry, yet annual growth for the industry has been below
2%. Students should, however, compare this to the continual growth of e-commerce, and recognize that
although a mature market, sales continue to shift to computer and smartphones, as opposed to malls.
Students should be able to connect how these trends could be potential threats to competitors with weak
e-commerce strategies.

n Segmentation: Students may reference exhibit 7 and 8 in their discussions concerning segmentation.
In summary, students should identify how both women and younger consumers compose the largest
segments, which may be linked to the trends supporting competitors utilizing a fast fashion-style of
competition, while potentially limiting those retailers whom are more family oriented, and not focused
on fashion and trends.

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300 Section 6 Instructor’s Manual for Essentials of Strategic Management

n Scope of rivalry. Rivalry in the industry could be considered global. Further, students should recognize
how trends and brand names drive rivalry as competitors compete in both brick-and-mortar and
e-commerce.

n Decline in popularity of malls. The decline in mall foot traffic is another factor students should be
able to observe, given both the rise of technology, the comfort and ease of shopping online, as well
as the changing trends among younger demographics in regards to free time and in-person or virtual
socializing.

2. What is competition like in U.S. Retail Family Clothing Industry? Which of the five competitive
forces is strongest? Which is weakest? What competitive forces seem to have the greatest
effect on industry attractiveness and the potential profitability of new entrants?

Substitutes for
Retail Family Clothing

Competitive pressures coming from the

market attempts of outsiders to win
buyers over to their products

Rivalry
Among
Competing Sellers
Suppliers of Competitive of Family Clothing Competitive
Materials and pressures pressures
Inventory stemming stemming Buyers of
Used in the from Competitive pressures from Retail Family
Retailing of supplier-seller created by the seller-buyer Clothing
collaboration jockeying collaboration
Family Apparel
and bargaining of rival sellers for and bargaining
better market position
and competitive
advantage

Competitive pressures coming

from the threat of entry of new rivals

Potential New
Entrants into the
Retail Family Clothing
Industry

n The bargaining power and leverage of buyers—a strong competitive force

Although not acting as one buyer, consumers have tremendous bargaining power as they are not forced to
shop at one or another clothing store. Consumers have a multitude of choices to purchase apparel. Thus, with
complete freedom to shop and choose, consumers make decisions based on convenience (location), style,
and/or price. However, it is not a defining feature of this industry. Customers have zero switching costs, and
some can also design and make their own clothing.

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 Section 6 Case Teaching Notes for Chapter 6 301

n The bargaining power and leverage of suppliers—a moderate competitive force

Most clothing brands outsource their production of clothes. As production occurs overseas, while a
competitive force, it does not represent a significant threat to profitability. Other competitors, such as Inditex
Group, produce some apparel in-house, thus circumventing any potential competitive pressures experienced
by companies whom outsource production. Tight labor markets can raise the cost of hiring staff to run retail
operations.

n Threat of substitutes—a weak competitive force

Any and all apparel could be interpreted as substitute products, as the only potential differentiator in this
industry would be the brand name, or even the source, style, and material. As stated earlier, consumers can
design and make their own clothing, but without the prestige associated with a branded product label.

n Threat of entry—a weak competitive force

Owing to the high costs of starting a globally recognized brand and supply chain, threat of entry may be
analyzed as low. In the online retail age, investments in technology and customer acquisition are quite likely
to be capital intensive.

n Rivalry among competing sellers of clothing—an intense competitive force

Rivalry among clothing retailers is strong and shows no sign of abating. This may be attributed to both the
established competitors and the even more rapid growth of online shopping with the decrease in mall foot
traffic. While competitors primarily compete on brand name, price-conscious shoppers may decide to buy
a different brand if the price is lower, or shop through online channels or visit flash sale sites. Discounts
offered through online shopping and/or brick-and-mortar stores increases competition. The unabated rise of
“mega” non-traditional competitors, such as Amazon and Alibaba in China, further intensifies competition.

3. What does your strategic group map of the family clothing retail industry look like? Is Gap
inc. well positioned? Why or why or why not?.
Strategic group maps can be beneficial for determining relative company placement in the industry. A good
strategic group map should utilize two strategic variables that differentiate the various competitors in the
family clothing retail marketplace. The case provides competitor profiles that can aid thinking about where
Gap Inc.’s rivals are currently positioned as well as whether they might be likely to move next.

Students can choose among any of several strategic variables to divide the family clothing retail industry
into strategic groups and illustrate the different market positions that industry rivals occupy. We have chosen
to employ supply chain approach (in terms traditional vs. fast fashion) and the type(s) of distribution channel
used to accessing individuals who buy/wear performance such apparel marketed by Gap inc., Inditex,
Abercrombie & Fitch, Amazon, and other independent retailers. Other possibilities for axes might include
scope of geographic coverage and image/reputation/brand name recognition—however, no one single
strategic group map is necessarily best.

A representative strategic group map is shown in Figure 1.

Once students have come up with a map, then we think you should press them for their evaluation of what
we learn from the map. Any of the following questions can be posed to help draw out their views:

n How well is Gap Inc. positioned?

n Which other industry members are well positioned?

n Which industry members are weakly positioned?

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302 Section 6 Instructor’s Manual for Essentials of Strategic Management

The point here is that students should not end their analysis with just drawing a strategic group map. The
most important part of strategic group mapping is to draw some conclusions about the story the map tells.

The first step in drawing conclusions is to create profiles of the major players in family fashion that justify
their positions on the strategic group map:

Abercrombie and Fitch

l Was not a fast-fashion retailer
l Relied upon a traditional logistics channel
l Featured brands such as Abercrombie & Fitch, Hollister, Gilly Hicks, and abercrombie kids
l Discontinued Gilly Hicks branded stores in 2014 and 2015
l Operated 961 stores in 2015, 932 stores in 2016, and 898 stores in 2017, a decline of nearly 7
percent (case exhibit 8)
l Closed 50 of its other branded stores in the United States in 2016
l Experienced a 13 percent decrease in net sales between 2011 and 2015, and another 5 percent
decline in 2016.
l Achieved revenues of $3.3 billion and net income of $4 million in 2016 (Case exhibit 9).

Amazon
l Helped drive online retail sales increases in 2014 by 20 percent to $840 billion.
l Reportedly accounted for 60 percent of the growth in 2015 online sales on its own
l Benefitted from increases in online purchases for some categories from 30 cents to 70 cents per
dollar spent between 2000 and 2015
l Profited from shift toward increasing consumer confidence in online shopping was evident in the
sale of clothing and clothing accessories
l Derived a majority of its revenues from providing cloud computing and web services for other
online retailers.

Gap Inc.
l Employed a traditional supply chain approach, assuming the consumer wished to purchase and
maintain the clothing for a longer period of time
l Operated 3,721 stores in 2016, of which 446 were franchised
l Closed 237 stores in 2015 and continued closures of underperforming stores in 2016 to improve
operating costs, affecting Banana Republic, Gap stores in North America and Europe, and Old Navy
stores in Asia (case exhibit 3)
l Experienced declines in comparable store sales of 3 percent between 2015 and 2016—greatest
declines were with Banana Republic (-10 percent), Gap stores (-20 percent) but Old Navy store
comparable store sales increased 2 percent.
l Achieved revenues of $15.8 billion in 2015 and net income of $920 million (case exhibit 1)

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 Section 6 Case Teaching Notes for Chapter 6 303

Inditex
l Pioneered fast-fashion retail
l Deployed a vertically integrated design and manufacturing strategy
l Closely monitored new fashion and style trends to create new lines as often as every month
l Used a tightly managed global logistics network that included 658 fabric manufacturers and 4,136
factories.
l Had a supply chain of 1,725 suppliers and 6,298 factories in 2015
l Operated over 7,013 locations in 88 countries and 29 online markets in 2016
l Featured brands such as Zara, Pull & Bear, Massimo Dutti, Bershka, Stradivarius, Oysho, Zara
Home, and Uterqüe
l Achieved revenues of $26.3 billion and net income of $3.6 billion in 2016 (case exhibit 7).

Other (chains and independents, primarily bricks-and-mortar)

l Employed a traditional supply chain approach, assuming the consumer wished to purchase and
maintain the clothing for a longer period of time
l Witnessed massively shifting buying habits of the consumer since the growth of the Internet in the
1990s, as well as with smartphones in the mid-2000s
l Enjoyed channel sales grew by 111 percent (vs. 185 percent for online sales)
l Experienced annual growth averaging 1.8 percent between 2011 and 2017, which was expected to
grow by 1.6 percent annually between 2016 and 2021 to reach $110.4 billion
l Depended on levels of per capita disposable income and demographic trends
l Depended on sales of clothing to women who made up the majority (60 percent) of industry sales
(case exhibit 5)
l Relied on Gen X and Gen Y for 58 percent of sales, with baby boomers a distant second at 24% of
sales (case exhibit 5)

On the whole, we like Inditex’s position on the map because its supply chain and distribution channel
strategies are distinct from those of its key rivals. It is the only designer-marketer of family fashion with
its own chain of company-owned retail stores and a relatively strong (and improving) Zara brand-name
reputation and image. It is unknown whether Amazon, a retail giant, pursues a fast-fashion approach, but it
has the prowess and clout to do so while enjoying the benefit of being both an online portal and a distribution
channel for other brands and retailers. Companies pursuing a traditional approach like Abercrombie & Fitch
and Gap Inc. appear to be competitively disadvantaged. While there is a “buy local” movement and location
close to the customer is quite likely a key success factor in this industry (as we will see in the next question),
only those retailers with a unique and innovative fashion mix or deeply discounted clothing (as at Old Navy)
are likely to survive the transition from bricks-and-mortar to what the case terms as the “hyperconnected”
marketplace for retail clothing. As both Abercrombie & Fitch and Gap Inc. are closing stores at what appears
to be an increasing rate, neither appears well poised for a turnaround, in our estimation.

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304 Section 6 Instructor’s Manual for Essentials of Strategic Management

FIGURE 1
A Representative Strategic Group Map of the Branded
Family Fashion Retail industry

Internet-only
family fashion
retailers

GAP
Amazon

Company-
owned
Distribution Channel(s)

family
fashion
retailers
w/websites
A&F

Indexit

Independent
brick-and-mortar
family fashion
reatilers
Other

Traditional Fast Fashion

Supply Chain Approach

4. What do you see as the key success factors in the market for family clothing?
Class members who have done some good strategic analysis and thinking should be able to make a convincing
argument for why one or more of the following qualify as being key success factors in the marketplace for
family clothing:

n Unimpeachable product design and styling capabilities—competitors will have to stay on the cutting
edge in using high performance fabrics that are of good quality, that are comfortable to wear, and that
have appealing, fashionable, and stylish designs. Management of the supply chain to assure quality
control is a very high priority for rivals. These are part and parcel of the fast fashion concept.

n Strong distribution capabilities—having good access to the buyers of family clothing is a must. This
can mean having a sizable chain of company-owned retail stores in locations near where consumers live
or being able to attract buyers to the company’s website or some combination of these.

n Capabilities in building and maintaining a strong brand image and reputation—many buyers of such
apparel are brand-conscious and brand-loyal.

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 Section 6 Case Teaching Notes for Chapter 6 305

n Capabilities to increase geographic coverage—becoming a market leader in or even staying relevant

in the family clothing retail industry will require gaining national coverage in the United States and
then expanding into additional country markets, with the aim of eventually approaching global market
coverage.

5. What key factors may determine the success of GAP Inc.?

Factors that are necessary for competitive success for GAP Inc. may be identified as the following:

n Improvement of Online Presence and Growth of e-commerce. Students may identify how GAP Inc.’s
strategy may have been over-reliant on mall traffic, and was caught in a situation where their consumer’s
buying habits had changed. Instead, GAP Inc. may now need to invest heavily not only in a strong
online presence, but an omnipresent approach which recognizes consumers’ shopping experience both
in reality and online.

n Brand image. GAP Inc.’s strong brand image in the 90s did not appear to be resonating with the styles
consumers desired in 2017. Students may discuss how GAP Inc. will need to invest in improving its
style and meeting consumer desires.

n Increased cycle times for fashion. Inditex Group and other fast fashion retailers were very successful at
a faster supply chain and quicker apparel turnaround. GAP Inc. may need to consider making the same
changes to not only meet consumer demands, but be competitive with other fast fashion retailers.

6. What recommendations would you make to GAP Inc. to improve its competitiveness in the
market while mitigating any current and future risks?
Students will most likely come up with myriad recommendations for Gap Inc. Some might argue that the
retailer is living off its past glory and may soon become irrelevant, regardless of which actions CEO Peck
chooses to undertake. Others might recommend one or more of the following five proactive strategies:

n Make substantial and meaningful investments in e-commerce to increase/improve its traffic online and
social media
l Tactics such as using multimedia online marketing tools as well as engaging social media “brand
ambassadors” are likely to be raised by students.
l Acquiring the capability to analyze or mine” big data is a worthwhile step in the right direction to
accomplish target marketing on the Internet

n Cut costs by consolidating bricks-and-mortar locations of all branded outlets to franchises in upscale,
high-traffic malls in order to improve profitability and market presence
l Divesting company-owned stores reduces fixed costs and lowers operating leverage.
l Transferring ownership to franchisees will lower company staff counts, but the tradeoff is loss of
local operating control.
l Note that closing and opening stores can be costly.

n Revamp fashion/styles on offer, and attempt to “localize” styles to meet diverse geographical needs.
l This will require investments in R&D and alluring marketing programs to win back customers lost
to Zara and/or to other bricks-and-mortar competitors

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306 Section 6 Instructor’s Manual for Essentials of Strategic Management

n Invest in “fast fashion” supply chain practices

l Note that in-store employees would need to be involved in trend-spotting and identifying which
styles need to be stocked and what styles need to be produced.
l Supply chain improvements would also necessitate speed, from identifying trends, to production
and sales.

n Explore a sale of underperforming brands to another family fashion retailer

l Accelerates the company’s transition out of slower-growth, less-profitable brands, reduces inventory
carrying costs.
l Sudden revenue drops accruing to divestiture of underperforming units and loss of prior brands may
send out a negative signal to investors, reduce the value of the enterprise, and decrease Gap Inc’s
stock price.

Wrapping up the Class

The Gap Inc. case can provide instructors with an important “bridge” to strategy execution concepts covered in
later chapters, so we would encourage you to conclude by foreshadowing the material in those chapters (noted
below) and by making the following points:

n Companies like Gap Inc. need to establish investment priorities that focus resources on the most
attractive business units: (This will be covered in Chapter 6)
l Pursue rapid-growth strategies via putting resources into the most promising lines of business in the
most promising global markets. (This will be covered in Chapter 7).
l Initiate profit improvement/turnaround strategies in weak-performing businesses that have potential
l Possibly divest businesses or lines of business that are no longer attractive, that face intense head-
to-head competition from its rivals, or that simply do not fit into management’s long-range plans.

n CEO Peck needs to weigh among possible implementation steps to boost the combined performance of
Gap Inc.’s portfolio of brands: (This will be covered in Chapter 8)
l Sticking closely with an existing business lineup and pursuing opportunities presented by these
businesses
l Retrenching and or restructuring to provide a narrower scope by divesting or closing poorly
performing businesses
l Broadening the scope of diversification by entering additional lines or geographical regions, in
order to put a whole new face on the company’s business lineup.

n This company is a reasonably good example of why good strategy execution requires continuously
building and upgrading an organization’s resources and capabilities: (This will be covered in Chapter
10)
l Superior strategy execution capabilities will enable Gap Inc. to react more quickly to market
changes and beat other firms to the market with new products and services
l Filling key management slots from the outside may be necessary to rebuild an organization

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 Section 6 Case Teaching Notes for Chapter 6 307

l Insiders may not always recognize that organizational changes are needed
l Hiring managers from the outside—who are ready to get on with the change process — can jumpstart
a turnaround strategy.

Epilogue
According to the company’s 8-K filing on August 17, 2017:

SAN FRANCISCO—August 17, 2017—Gap Inc. (NYSE: GPS) today reported results for the second quarter
of fiscal year 2017. On a reported basis, Gap Inc.’s second quarter fiscal year 2017 diluted earnings per share
were $0.68. On an adjusted basis, the company’s second quarter fiscal year 2017 diluted earnings per share were
$0.58, excluding a $0.10 benefit from insurance proceeds related to the fire that occurred on the company’s
Fishkill distribution center campus in fiscal year 2016 (the “Fishkill fire”). Please see the reconciliation of
adjusted diluted earnings per share, a non-GAAP financial measure, from the GAAP financial measure in the
table at the end of this press release.

“With a third consecutive quarter of comp sales growth, we are seeing our investments in product, customer
experience, and brand equity begin to pay off,” said Art Peck, president and chief executive officer, Gap Inc.
“Based on the strength of the first half, we are pleased to increase our full year earnings guidance.”

Peck continued, “As we continue to focus on long-term growth, we are accelerating our strategies that put
the customer at the center of everything we do - including a focus on product categories where we have clear
differentiation, continued investment in our online and mobile offerings, and taking advantage of our operating
scale to drive speed to market, responsiveness to customer demands and efficiency.”

Second Quarter 2017 Comparable Sales Results

Gap Inc.’s comparable sales for the second quarter of fiscal year 2017 were up 1 percent versus a 2 percent
decrease last year. Comparable sales by global brand for the second quarter were as follows:

n Old Navy Global: positive 5 percent versus flat last year

n Gap Global: negative 1 percent versus negative 3 percent last year

n Banana Republic Global: negative 5 percent versus negative 9 percent last year

Net Sales Results

Net sales for the second quarter of fiscal year 2017 were $3.80 billion compared with $3.85 billion for the
second quarter of fiscal year 2016. The translation of foreign currencies into U.S. dollars negatively impacted
the company’s net sales for the second quarter of fiscal year 2017 by about $37 million.1

Investment Analyst’s comment

According to a Morningstar Equity Analyst report dated August 18, 2017, consumer preference has shifted to
value over brand in general apparel retail, and competition has flooded the space, namely through fast-fashion
retailers H&M, Zara, and Uniqlo. Gap’s adjusted return on invested capital declined from 18% in 2013 to 13%
in 2016.

The challenge the company now faces is to minimize fashion misses and inventory mismatches through a
responsive supply chain, become more technologically sophisticated for younger consumers, and maintain a
differentiated and relevant brand identity in the face of growing fast-fashion competition. The company has been
rightsizing its store base while expanding its online presence, shedding about 4% of its square footage since
2014 and increasing e-commerce to north of 16% of sales.

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308 Section 6 Instructor’s Manual for Essentials of Strategic Management

However, cost reductions will not reinvigorate top-line growth, and we are concerned that company investments
in a responsive supply chain, omni-channel capabilities, geographic expansion, and better design have had
little effect in sustained same store sales growth. Although some recent weakness can be attributed to cyclical
weakness in apparel, with clothing and accessory store sales growth of only 1.5% on average annually over the
last three years (versus 2.7% total average retail sales growth), fast-fashion competitors appear to be taking
market share, posting positive comparable sales versus a 2% average annual decline at Gap. We still believe
that Gap’s plan to pursue a pull-based supply chain would address the weakness, but we have seen few signs that
management has been able to successfully execute on this strategy.

Gap’s second-quarter results in FY 2017 delivered a third consecutive quarter of comparable sales growth (up
1%) and a fourth consecutive quarter of adjusted gross margin expansion (up 120 basis points to 38.9%). That
said, the company is not out of the woods yet, with two of the three major brands still posting comparable sales
declines (Gap Global comparable sales, contributing 32% of sales, were down 1%, while Banana Republic
Global comps, contributing 15% of sales, were down 5%). Additionally, the company is still short of its leverage
point (which we estimate to be low- to mid-single-digit comparable sales).

Gap Inc.’s gross margin has declined from a peak of 39.4% in 2012 to 36.4% in 2016. Conversely, companies
with cost advantages that enable them to offer more attractively priced apparel have increased sales and
maintained margins. Revenue at off-price retailers TJX and Ross has grown in the mid-single-digits on average
annually over the past three years, while growth at fast-fashion retailers Inditex and H&M has averaged in the
low-double-digits.

Furthermore, we still think the company lacks a sustainable competitive advantage and that performance will
be volatile as it hits or misses fashion trends. Therefore, we expect to increase our $26 fair value estimate by
just 1%-2% to reflect performance through the second quarter tracking ahead of our expectations (our full-year
estimate currently calls for flat comparable sales), but we still think average annual revenue growth over the next
five years will be flat to up 1% and that adjusted operating margin will decline from 9% in 2016 to under 8% in
2021 on deleverage, as the firm faces intense competition in an industry where switching costs are nonexistent.

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