Description

I think that GAP is a short as 1) it’s a supermarket facing well known industry pressures, 2) EBITDA doesn’t even cover sustainable Cap Ex, and 3) is on track to burn $180 million annually (north of $5/share)

Regrettably, the company is quite liquid and can last for several years. GAP is in the process of a slow self liquidation that’s a downward spiral. They have just completed a $250 million asset sale initiative (selling better assets, keeping worse) and have $242 million of liquidity on their new credit facility. At some point, I predict that they hit they wall and file for Ch. 11.

Capital Structure (as of 11/29/03, except for stock price)

Debt $701 million
Equity $310 million (38.5 mil shares @ 8.04)
EV $1011 million

Cash $90 million (215 of cash, less 125 of bank overdrafts (checks not yet cashed )

3Q Results and my 2004 estimates (in millions)

3Q (12 wks) 2004

EBITDA 39 210
Cap Ex 33 290
Interest Exp 17 75
Taxes - 25

FCF -11 -180

Note: Depreciation was $58 mil in 3Q03 and is estimated at $260-270 for 2004.

Liquidity

In addition to the cash balance of $90 million, the company has $242 million of availability under it’s revolver, which was recently renegotiated (cut by $25 mil in exchange to release security to permit sale leaseback). They are also planning on doing sale-leasebacks of $100 million on some of their remaining owned facilities (they own very few of their locations). Some cash in needed in the business, but they’re liquid for at least 18 months. Beyond that, they probably can continue to sell bits of the business in a protracted self-liquidation, prolonging the optionality of the equity.

Why the stock rallied 25% on the earnings

GAP stock rallied 25% on Jan 9th, when they reported earnings. The two positive factors that management focused on what EBITDA had stopped falling (helped by FX, as 30% of revs come from Canada) and same store sales were rebounding. While these developments are positives, the key issue is margins not top line growth and they expect the current brutally competitive environment to continue keeping margins tight. They also announced that they could not longer afford to be underspending D&A in Cap Ex, so they would be spending north of D&A on Cap Ex. They announced a new credit facility and the sales-leasebacks to fund all the cash burn needed for the reinvestment. I’m still surprised by the stock’s reaction to this news.

Where we can get hurt

The clearest places we can get hurt, other that temporary stock fluctuations, are a rebound in margins (industrywide or company specific) and on the asset sale front.

With 1.5% EBITDA margins, these are industry low margins. I view the low margins as indicative of the quality of their assets and, thus, a negative. Given the razor thin margins, however, a percentage point improvement is a big deal. Given the industry headwinds, I don’t think this is likely, however they do several initiatives in place including 1) spending a lot of Cap ex on their Michigan stores 2) Labor negotiations to decelerate employment cost growth and 3) closing unprofitable locations.

On the asset sale front, the most sellable asset would be their Canadian operations (retail and wholesale) which is profitable with net income of around $40 million. These assets are thought of as their best operations and could fetch a 15x PE multiple for proceeds of $600 million. In addition, they have sold off units that were EBITDA breakeven to other local chains, generating cash w/o taking away cash flow, as well as closing stores and recapturing some working capital. The next most sellable asset would be the NYC Food Emporium chain. The bulls argue that NAV if they sold the business in pieces is higher than the current stock price and this may even be true, but the cash burn and exit costs from the rest should be an anchor around their neck.

I think it’s likely to be a bumpy ride, but we’ll be happy with the destination.

Catalyst

Hard to predict...continued cash burn perhaps.