July 07, 2011 - 10:06am EST by
2011 2012
Price: 18.94 EPS $1.51 $2.17
Shares Out. (in M): 550 P/E 12.5x 8.7x
Market Cap (in $M): 10,417 P/FCF 14.4x 7.8x
Net Debt (in $M): -1,221 EBIT 1,450 1,760
TEV ($): 9,196 TEV/EBIT 6.3x 5.2x

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Gap is a "no-growth retailer" that produces a lot of free cash flow.  No growth retailers are like a special category to me - they have often worked out quite well bought at this kind of price, but they are always controversial because they appear to have no catalyst to make the stock price go up.  Paraphrasing Graham, when you buy cheap enough, they just do.

 There are a number of ways to look at valuation, if you believe the current six month period from now to year end is not representative.  I'll get into that below.  Market cap is $10.5 billion.  Subtract $0.8 billion of cash in excess of debt (taking out the cash paid for shares repurchased between quarter end and filing of the 10-Q) for an $9.7 billion enterprise value.  Free cash flow in 2010 was just below $1.2 billion.  This figure, conveniently, almost exactly matches the average free cash flow the business has produced for the last eight years.  So there are a couple of ways to see a 12%+ free cash flow yield.

The EBIT margin will be down this year due to cotton prices (and to a lesser extent Japan).  To own this you need to be comfortable that margin rebounds to 12-13%.  In 2009 EBIT margin was 12.8%, in 2010 it was 13.4%.  Those were NOT good years for apparel retailers - these margins were on down sales for Gap as well - so I suspect there may be more upside here than I am underwriting to.

 The company looks like a potential LBO in the mid-high 20s.  Management is buying back a lot of stock, for the first time borrowing to do so.  Even better than an LBO would be if the company does 1/3 of one below 20, which they are well on their way to doing.  More on that later.
Our target price is $25-30.
Wall Street will tell you nobody shops there, but somehow Gap sells more apparel than any other specialty retailer in the U.S.  Everybody wears something from Gap, and whether I talk to adults or teens or kids it has mindshare among all of them.  Not trendy, not cool but also not untrendy, not uncool.  Reasonably priced, but decent quality.  Easy to shop, easy to find.  Perfect baby gift.  Few consumers describe it as their favorite though.   
The company used to be a great growth company, but peaked out upon reaching oversaturation in the late 90s.  It took them a long time to admit maturity and stop it with the desperate stabs at fashion.  Leather, purple, fake fur, purple leather, celebrity ads, purple fake fur.  It was ugly for years, but the company always made money.
 In 2007-2008 they made a major management change, to CEO Glenn Murphy and CFO Sabrina Simmons, who are comfortable doing what needed to be done running a mature business.  They are managing a cash cow and making it a really good cash cow.  Murphy came out of the unglamorous world of Canadian drug retail.  Simmons was an internal promotion.  We like her a lot.
 The company is at a very interesting stage in the cash cow management cycle.  First, they got really serious about margin and profitability even in the depths of the recession.  Management comps to global best in breed competitors (H&M for example) not on growth rate, but on EBIT margin.  Gap has never been an acquirer and has high return on capital, so a low growth strategy produces a lot of free cash flow, even before Murphy and Simmons took over.  They have used the cash flow primarily to buy back 44% of the company at attractive prices.  In the last seven years, Gap has taken its share count from 987 million (adjusting for debt that converted to stock in 2004) to the current level of 550 million, while paying a dividend.  The balance sheet still has a net cash balance.  Since the end of 2009 the share count is down 18%, and there is no reason that can't fall another 10-15% in the next 9 months just doing what they say they are going to do.
So far I've only mentioned the balance sheet in passing, but that is what is changing.  Management is taking the stealth LBO to the next level.   Management's language in the latest 10-Q was:
"In the first quarter, we made the strategic decision to issue debt. Given favorable market conditions and our history of generating consistent and strong operating cash flow, we felt it was the right time to pursue a slightly more optimal capital structure. The Company has generated annual cash flow from operations in excess of $1 billion per year for the past decade and ended fiscal 2010 with $1.7 billion of cash and cash equivalents and short-term investments on its balance sheet. We continue to target a cash balance of $1.2 billion which provides not only for our working capital needs, but also a reserve for unexpected business downturns. We remain committed to maintaining a sound financial policy, strong credit profile, and a focus on liquidity. Proceeds from the debt issuance will be used for general corporate purposes including share repurchases."
 (I checked with the company, that $1.2 billion cash balance is an absolute target, not a net of debt number.) 
 In the first quarter they borrowed for the first time in years, finishing the quarter with $2.4 billion of cash alongside $1.2 billion of debt.  My best guess is that they will be buying back stock until that cash level is around their $1.2 billion target. If they are paying $18, that would retire another 12% of shares outstanding before even thinking about free cash generation.  What has changed in the last six months is that they stopped clinging to the cash and started showing signs they are willing to go in the direction of a leveraged recap.  There is no reason why this company can't have net debt.  They still haven't gone that far, but they have made a first step and it positions them to buy back a lot of stock at cheap prices in the coming quarters.  The recent drop in the stock may turn out to be a value creator for long term investors in the company.
 An overlooked catalyst for Gap is who its two largest owners are.  The first, with 32% ownership at year end is the Fisher family, the widow (7%) and three sons (25%) of founder Don Fisher, who passed away in 2009.  Doris Fisher, the widow, has been selling stock, presumably for estate planning.  The sons have not, and thus have seen their ownership grow as a result of share repurchase.  It is highly interesting to me in the context of the balance sheet changes and the valuation what two of the sons do with their free time when they are not sitting on the Board of Gap.  They are both involved in private equity.
The largest outside investor is Ed Lampert's ESL, which purchased 6% of the company at the beginning of 2011 for approximately $20 per share.  If there is one investor known for buying no growth retail cash cows who buy back a lot of stock it is Ed Lampert.  Autozone is the quintessential example.  Lampert is also known for influencing managements, and this was already a management who liked buying back stock.  Since his purchase of a large position, management made the move to borrow for the first time to buy back stock.  I have to believe he is talking to them and they are listening.
We believe we are looking at a stealth LBO here where management has a number of capital structure levers to pull.  Though we think we would be fine if they do nothing except execute the billion or so of repurchases they plan for the rest of this year, it would not surprise us to see a full LBO.  Analysis gets us to mid-high 20s based on a return to normal margins, debt of 4x EBITDA and a return to equity holders of 18%.  There are also options to go partway there including a Dutch Auction for 20 or 25% of the stock.
To put some numbers on this, we are projecting a return to closer to normal margins of 12% next year on flat sales, and looking at a range of buyback scenarios.  Case 1 is doing nothing.  Case 2 is doing what they have said they will do.  Case 3 is a 25% Dutch Auction at 21.

                                                2009                2010                2011E              2012E              2013E

Revenues                                  14,197             14,664             14,664             14,664             14,664

            growth                                                                          0%                   0%                   0%


Operating Income                     1,815               1,968               1,450                1,760             1,760

            margin                          12.8%              13.4%              9.9%                12.0%              12.0%


Interest Expense                       0                      0                      75                    75                    75


Pretax                                     1,815                1,968              1,375              1,685              1,685

Taxes   39%                             714                  778                  536                  657                  657

Net Income                              1,101             1,190                839                  1,028              1,028


Case 1:  No More Repurchase                                                                                

W.A. Shares Outstanding         699                  641                  559                  550                  550

EPS                                         $1.58               $1.86               $1.50               $1.87               $1.87


Case 2:  Doing What They've Indicated.  Repurchase FCF + another $1.2BB over two years
WA Shares Outstanding                                                             554                  474                  410
EPS                                                                                         $1.51               $2.17               $2.51
Case 3:  Dutch Auction at $21 for 25% of the stock, then future buybacks with FCF*

borrow at 7%                                                              

WA Shares Outstanding                                                              486                  388                  350
EPS                                                                                         $1.60               $2.34               $2.59
*for Dutch auction case annual interest expense is $275mm/year                       
So now let's look at why the stock dropped on May 20th.  Cotton prices went nuts the first two quarters of 2011, rising from their historical norm of 75 cents/lb. to a futures contract print of a little over $2.00 in early April.  Since the peak, the spot price has fallen to about $1.55 and futures out to December are at $1.15.  Gap management on the conference call was adamant that they are looking at a price spike in cotton that will correct and they are managing the company to that analysis.
Why did this hurt Gap?  Because apparel in stores today was sourced six months ago and prices locked in.  Kind of like looking at the light of a star several light years away.  The price spike into March/April pushed into 2011 back to school purchasing, and was starting to push into Christmas.  This didn't hurt Gap so much, but it buried their low priced brand Old Navy because low priced apparel is more raw materials intensive than higher priced apparel.  There is about half a pound of cotton in a tee-shirt, perhaps a little more for a high quality Banana Republic shirt and a little less for a low quality Old Navy shirt.  The prices for that tee-shirt would be roughly $25 at Banana Republic, $20 at Gap and $15 at Old Navy.  Doing the math, that 60-65 cent change in the price of a half pound of cotton has a much bigger impact on the margins of Old Navy than a higher-end product, especially if you consider that Banana Republic's gross margin is probably north of 50% and Old Navy's is probably 35%.  The core Gap brand is most likely somewhere in between. 


Gap (Old Navy) had three choices, all of them bad.

1)         Reduce quality.  If you've ever worn an Old Navy tee-shirt you know that physics dictates you can't make them any thinner if its going to make it through the washing machine five times.  Management looked at the prototypes of products they could buy at the prices they were used to and realized that would not serve their customer or their brand well.

2)         Increase price.  They chose not to do this because they think they are looking at a six month price spike and don't want to risk their value oriented brand.  If cotton prices stay high they can always try this option.

3)         Eat it.  That is what they chose.  They chose to think long term for the brand and sacrifice a couple quarters of earnings. 


That's what I would have done if I owned this whole company and there were no Wall Street analysts.  That choice took the stock down 17% in a day, but I don't think management sounded at all stupid on the conference call.  They were in a really tough negotiation with suppliers and if they had preannounced they would have ceded what bargaining power they had.  On the conference call, sell side analysts tried to make management sound stupid for not foreseeing this.  Management foresaw it, but they were busy running their business and negotiating with suppliers.  Wonder what the "analysts" were doing - were they not aware Gap buys cotton?


To conclude, what do I know now that I didn't know when this name was posted on VIC in the past, or when it was trading at this level last year?  First, I know that management is using their balance sheet more aggressively to buy back stock at very attractive prices.  Second, I know Ed Lampert's price at which he got very serious was about $20, and we have him in the stock possibly as an activist.  (Something tells me he wasn't the guy selling on May 20th.)  Third, we have a debt market favorable to an LBO.  Fourth, the founder passed away in 2009.  I am not suggesting that I know that Donald Fisher was an impediment to a sale of the company in 2007, but that is a possible explanation for why GPS is still public.  And last, it is cheaper - net income is comparable to what it has been in the past, but the share count is much lower.

 If you were thinking of LBOing your company what would you be doing?  Buying back as much stock as possible below that price.  And maybe leveraging the balance sheet yourself to buy back stock at that price before you have to pay a premium to everybody.  The Board has been acting on this script.
  • 1. Aggressive share repurchase
  • 2. Possible LBO
  • 3. If even by the random chance of a drunk taking three steps in the same direction this company strings together three consecutive good comp numbers


The views expressed are those of the author and do not necessarily represent the views of any other person. The information herein is obtained from public sources believed to be accurate, reliable and current as of the date of writing.  The author will not undertake to supplement, update or revise such information at a later date.  The author may hold a position in the securities discussed.


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