August 31, 2004 - 2:49pm EST by
2004 2005
Price: 18.73 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,873 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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  • Retail
  • Apparel
  • Asset Play


Surveying the carnage that is retail right now, I find one Gap (GPS), a company that virtually everybody knows but very few people seem to appreciate – sometimes.

Everything you need to know about how investors evaluate this company, and the entire retail apparel space, is evidenced by this weirdly bizarre 52 week high and low list for the past 5 years:

Price High and Low
2003 23.5 to 12.0
2002 17.1 to 8.4
2001 35.0 to 11.1
2000 53.8 to 18.5
1999 53.8 to 18.5

Ok, there's the crux of my buying thesis here - the stock trades for the low of 1999 yet the company has recovered from its problems, has a real pretty balance sheet today and trades for some low multiples.

Sure, comps may bounce this way and that way and there's no guarantee a lower stock price won't result, but eventually you have to pick a point and say, "Hey, this looks interesting" and go from there. Plus, management has lots of opportunities to do something smart with their money. They can choose a dumb road and mess up the entire story but at least there’s a nice pot of cash to help them overcome any mistakes.

Here is the rest of the short and skinny, and because GPS is such a well-known company this profile doesn’t go into gory detail, some of which I’d be unable to provide as an obscure money manager with few ties to civilized life. There are many other places to get opinions so here is the stuff that I focus on and consider most important:

In case you don’t remember, GPS operates 2,999 stores as of July 04 in the Gap US (1352), Gap Intl (347), Banana Republic (447), and Old Navy (853) brands.

GPS, a former fast grower, is now an asset play. The sqft growth went from double digits for the past hundred years or so (seems that way, though they celebrate 35 years in 04) to up 1% two years ago and down 3% last year. Stores are 2999 end of Q2 vs. 3095 a year ago. The 2003 annual report is laced with such exciting messages as:

- build infrastructure for growth
- gain consumer insights
- improve supply chain and technology
- evolving how we work
- restoring our investment grade credit ratings

With very little about store growth, GPS has entered the land of saturation - short of a dynamic 4th concept - and has the financial profile to fit that.

Balance Sheet
The 03 balance sheet had 4.7 Billion in cash vs. 5.6b in TL. SE was up 1.1 Billion with a 38% rise in cash (some restricted). The Q2 BS shows a 1.2 Billion increase in cash and a 1.3 b increase in SE yoy. Along with reduced or negative sqft growth comes far lower CapEx, leading to debt reduction and cash increases.

Cash Flow and Valuation
Cash flow (net income + depreciation) in 03 totaled 1.694b, with trailing 12 month at 1.746b. At 18.73, the cap is 18.73b, so the pe is 16.6x (based on 1.12 eps, including all items) and the pcf ratio is 10.7x. PB is 3.5 and it pays a nominal dividend (9c). Trailing CapEx was 322m.

Why I am Interested in this Company
Recently downgraded (it doesn’t matter who) based on negative comps for July and the proverbial “lack of visibility” along with a slowing trend in overall retail sales (partially due to the difficult tax rebate comparisons vs. last year and higher gas prices this year, both of which will anniversary in -- oh -- Aug 05), the stock has dropped from recent highs and now trades for almost less than 10x cash flow.

If the company did nothing but spend a 150-250m in CapEx for the next few years and experienced flat margins, GPS would generate more than 5 billion in total cash flow in 3 years and 8 to 9 billion in five. Management is currently paying down debt and should be finished with that task by the end of 2005. This will leave open multiple options, including increasing the dividend, buying shares, or funding a dynamic new 4th concept which is nowhere in evidence right now.

What Has to Happen for the Company to Succeed
Maintain margins and use cash flow wisely. Margins have fully recovered to 2000 levels and this year will show if the 8 to 9% net margins of the mid 90s are achievable again despite competition, quota issues, and/or the fact that GPS will never be the new kid on the block (see the bloom on ARO and URBN right now) again – short of a another concept.

The Pitfalls that Stand in Its Path
The brands are pretty much saturated and the turnaround that began a couple years ago has largely succeeded. Plus, same store sales comparisons have been negative for two straight months and face another 10 positive comparisons (4, 13, 1, 6, 1, 3, 12, 8, 3, 6) in the next 10 months. A single poor comp is enough to drove the stock’s valuation down at least a billion dollars and more, regardless of what caused the shortfall. Analysts in this area, especially in something as visible as apparel retailing, are notoriously quick to downgrade at the slightest shortfall, causing the sort of 52 week highs and low previously listed for this stock.

I believe the best way to approach this sort of companies is with a scaling approach that considers additional buys at 20% increments while completely ignoring the day by day price variances otherwise. Plus, it can help to focus on book value changes instead of earnings fluctuations in a business as flaky as this one. Lastly, GPS is at heart a pure commodity company, selling stuff that you can buy almost anywhere else. Thus, the first sign of trouble is often magnified as the death-knell of the brand even though nothing of the sort is occurring. Still, you can’t deny that apparel retailing is a vastly profitable business and there is no shortage of competitors, so any investment in a business like this should be kept reasonable in light of that.

Corporate Governance
In recent years options have been 2-3% of the diluted share count but with very high levels of cancellations too. Insiders own 25% of the shares though this is concentrated in Chairman’s family.

Value Line shows 1.50 for next year with an 8.6% margin expectation (8.3% expected this year, sans charges for early debt retirement) which is an 11% increase in eps on an expected flat share count.

My rating.
I believe in this idea but frankly don’t run a concentrated portfolio, especially now with this many names trading at 12 to 18x earnings. Thus, I have 3-5% of my portfolio in GPS which represents my core position size. I would rate many, many other retailers at 6 right now but would assign “7” to this one because sometime in the next three years it is likely that GPS will become a bit more popular with analysts again and the price should spike, especially since GPS visibility leads to extreme stock price movement. I will next consider increasing my position at $15.


One good comp report along with intelligent use of capital by management
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