|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|
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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.
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.
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
borrow at 7%
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.
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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