Make a Leap From Limited to Gap

One of the most successful specialty retailers in the U.S. — or anywhere else, for that matter — is Limited Brands (NYSE:LTD), owner of both the Victoria’s Secret and Bath & Body Works brands. Same-store sales are jumping, and that has Limited’s stock bumping up against its 52-week high. Morgan Stanley believes LTD will�outperform�during the upcoming holiday season. There’s no reason to think it won’t. However, in a contrarian pick, I’ll tell you why now is the time to sell Limited Brands stock and buy Gap (NYSE:GPS) instead.

International Expansion

By the end of 2012, Limited Brands�expects�to have 880 stores open overseas. Its plans include opening two company-owned locations in the United Kingdom, and its franchise partner in the Middle East, M.H. Alshaya Co., intends to open Victoria’s Secret stores in some of its markets.

At Limited�s annual meeting Oct. 19, investors peppered the company with questions about why it didn’t have a more concrete plan for international growth. Especially when you consider that most of its international expansion to date is its 463 La Senza franchise locations outside of Canada. According to the company, its international stores (outside North America) totaled 580 as of the beginning of 2011.

Let’s assume this is correct — although I challenge you to figure out how Limited arrived at this number, because I can’t. It means the company will have to open 300 stores in 17 months to reach its stated goal for 2012. That’s an average of 18 store openings per month. It’s certainly doable, but the lack of detail provided at the annual meeting raises doubt that it will happen. Evidently, the company has enough business in North America to keep it busy. We’ll see.

Future Growth

Limited�s chairman and CEO, Les Wexner, is a brilliant businessperson. There’s no doubt about it. Going slowly and making sure the right management team is in place in the 10 or so international markets where Limited wants to do business — that�s all well and good. What is a problem is expecting that you can afford to take your time �rolling out overseas because your U.S. and Canadian stores are doing so well. Consumers are a fickle bunch, and although their discretionary income is flowing generously into Limited�s stores now, it might not always be this way.

Wexner suggests the company�s U.S. stores could hit $18 billion (a 100% increase) in revenues within five years. That’s a lofty figure. Any bit of bad news would seriously impede Limited�s ability to reach that goal, and without a fallback plan for international markets, LTD could deal shareholders some serious surprises. With the exception of Coach (NYSE:COH) and Tiffany & Co. (NYSE:TIF), Limited Brands’ enterprise value to EBITDA is one of the highest in retail. It might not make you sell, but it should make you stop and think.

Gap’s Future

Amid all the bad economic news, Gap�s international�expansion, combined with a booming e-commerce business, could deliver a three-pronged retail model that ultimately strengthens the company, not weakens it.

On the international front, it now has stores in the U.K., France, Ireland, Italy, Poland, Japan and China. These stores contributed 15% of revenue in the second quarter of 2011, and e-commerce another 9%. All told, Gap�s North American stores generated 76% of its overall revenue, while international stores and e-commerce generated 24%.

With the reduction in the number of Gap stores in the U.S. to 700 by 2013, along with the company’s plan to shrink the size of its Old Navy stores, Gap�s North American business will be more appropriately sized given its sales volume. At the same time, by the end of 2012. the company will open its first Old Navy store in Japan, 30 more Gap stores in greater China (to go with the 15 already there) and its first Banana Republic store in Paris. When all of this is done, Gap should generate over 20% of its revenue from international sales.

On the e-commerce front, the company plans to generate $2 billion in revenue by 2014, up from $1.3 billion in 2010. More important, its operating profit from that revenue will be approximately $500 million, or 25% of sales. That’s double any of its retail stores.

Along those same lines, Gap plans to open 50 Athleta stores by the end of 2013. Until this year, Athleta was an online-only alternative to rival Lululemon (NASDAQ:LULU). Now that Gap is opening brand-specific stores, it can further chip away at Lulu’s dominance. Don’t be surprised if this is what brings Gap back from the brink.