Brazil is not a new market for the retailer as it has been offering its products through duty-free channels in the region. However, the decision to open its branded stores will help the retailer expand further and take advantage of the untapped market potential.

Brazil is the largest economy in Latin America and the fifth-largest country in the world, which offers good market potential for the U.S. retailers. 

Moreover, the lack of competition from Gap's U.S. counterparts, such as Abercrombie & Fitch (ANF), American Eagle Outfitters (AEO) and Aeropostale (ARO), works in Gap's favor. With this decision, the retailer will look to strengthen its international presence. Apart from Brazil, Gap has a presence in Panama, Columbia, Mexico, Chile and Uruguay.

International expansion is one of Gap's main strategies

Gap has emphasized international expansion as one of its main growth strategies. The retailer's stores are located in prime international markets such as Canada, the U.K., France, Ireland, Japan, and recently it entered China as well. Gap opened four outlet stores in China during the third quarter of fiscal 2012, and the results have been good so far.

In addition to its own stores, Gap has a significant international footprint via its franchise business. The retailer opened its first franchise store in 2006 and currently operates around 300 such stores in 40 countries across Europe, Asia, the Middle East, Australia and Latin America.

As far as Brazil is concerned, the retailer will be opening its first Gap store in Sao Paulo (the largest city in Brazil) in fall 2013. Apart from its namesake brand, the retailer will also offer other brands such as GapKids and babyGap through its stores. Gap is looking for a strong foothold in the region within the next five years.

Why is Brazil a lucrative market for Gap?

Gap already has a presence in five Latin American countries and entering Brazil will help the retailer further strengthen its foothold in the continent. As one of the major emerging markets, Brazil can provide a large base of fashion conscious customers with higher disposable incomes in the future.

We note that Wal-Mart's Brazilian operations have been growing rapidly. For the past two quarters, its revenues have increased by 11% and 10%, respectively, while comparable store sales have grown by 6.6% and 5%. Although the comparison of an apparel retailer with Wal-Mart is not exactly valid, it can be regarded as a measure of confidence that the customers have in brands that offer good quality products at compelling prices. Even if Gap's closer competitors plan to enter the market in the future, Gap will still have the first mover advantage.

Assuming that Gap is able to add 150 Gap stores in the next five years, any upside to our estimated stock price will be negligible. However, this decision enables the retailer to strengthen its position in Latin America and reduces its dependence on the sluggish U.S. economy.

The Trefis price estimate for Gap Inc. at $39, implying a premium of about 20% to the market price.