I am recommending a long position in Gap, the largest specialty apparel retailer in the US.
Investment Summary: With 3100+ stores, GPS has minimal square footage growth opportunities. The stock has languished over the years as the company consistently missed fashion which led to poor SSS and margin compression. The key to the story is whether the company can show SSS growth and whether op margin can recover from the current trough 7% to historical range of 12%+. Current consensus is that Gap and Old Navy had lost touch with the customers and will NEVER recover. The few bulls left are mostly counting on a quick exit via LBO.
While NT results may continue to be weak, I think current price has already reflected much of the bad news and I see limited downside to $16-17 (or 15x trough earning + $2 in cash). If GPS does turn around, the stock has EPS power of $1.5-$1.75 based on 10-12% op margin, which should lead to a $26-30 stock. While I cannot predict when the recovery will take place, recent CEO change and easier SSS comparison could serve as catalysts. I am not betting on a quick LBO or outright company sale, which I think has a low probability (20%) of occurrence, although in such a scenario, GPS could fetch $23-25 for decent upside in a short time frame (Mar 1 conference call)
Significant Op Margin opportunity: Merchandise misses and poor execution had led to 2 years of negative SSS and margin compression. However, this creates an opportunity for margin expansion story as current op margin at 6.8% is 600bps below 12.8% just 2 years ago, or 15% in the late 90’s. While I do not see margin recover all the way to prior peak, I see EPS power of $1.5-$1.75 based on 10-12% op margin, vs. current earning of $1.00. Of the 600bps margin compression, 400bps were from gross margin (mostly lower merchandise margin due to higher markdown) and 200bps were from SG&A deleverage. So my thesis of margin recovery is predicated on better merchandise that will lead to higher full-price sell-throughs and better SSS, and eventually better margins.
GPS has never disclosed margin information on division level, and my best guess is that Old Navy (44% of sales) and Gap (34% of sales) currently operate at ~5-7% op margin while Banana Republic (14% of sales) operates at close to 10% op margin. In terms of competitors, women’s apparel retailers with BR’s sales productivity have average op margin in 12-15%. Teen retailers such as ANF/AEOS (closest comps to Gap) have op margin around 20%. Even ARO/KSS (closest comps to Old Navy) have op margin at 11%. So based on historical and peer comparisons, there is nothing structurally preventing GPS from obtaining a double digit op margin again.
Hated stock: Current consensus is that Gap and Old Navy had lost their cache for good. While I acknowledge that competition is fierce and the brands had some impairment over the years, it should be noted that merchandise miss and subsequent turn-around happens all the time in specialty retail space. I would argue that the competitive landscape was just as competitive 2 years ago when GPS posted op margin of 13%, or even just one year ago, when GPS was at 10.5%. Therefore, it seems that the problem was more of internal execution vs. external competition. Gap still has considerable brand equity, and as demonstrated by the recent RED campaign, people will still shop at Gap if the merchandise and marketing are done right.
Sell side sentiment is very negative on the name. Earning estimates have continued to come down for Q4 and ’07. A few long-term bulls had recently given up and downgraded the stock. Yet the stock price had been resilient even with the downgrades and donward estimate revision, a possible sign that the stock had reached a bottom.
Mgmt Change a big catalyst: Recent announcement of CEO Paul Pressler stepping down is a positive and could be a major catalyst. The board will look for a candidate “with deep retailing and merchandising experience”. Contrary to recent rumors, Mickey Drexler, ex-CEO of GPS and current CEO of JCG, would not return. However, there should be a number of qualified candidates out there, especially if GPS does some kind of restructuring and breaks up the company. My best guess is that ’07 will be a transition year, and the market will give the new CEO some time to work his/her magic. On the flip side, there is zero expectation for GPS this year, and there is the potential that results could surprise to the upside.
LBO possible, but not likely: An LBO or outright sale is possible, but I am not counting on it. Theoretically, one can make the numbers work in an LBO scenario, assuming steady margin expansion and significant cut-back on capex. My model shows 5-year IRR of 20% at a take-out price of $23 (20% premium to current price) under those assumptions. But I think the possibility of a take-out is low given significant operational challenges and the perceived “fashion” risk. I think there is a 20% probability that a deal gets done, which will provide decent upside in a relatively short time frame.
A perennial rumor was that Eddie Lampert at Sears Holding may buy the company. One of my sources tells me that Mr. Lampert is a friend of the Fisher family, but I am skeptical of such a deal as I do not see obvious synergy, although Mr. Lampert is a master at shrinking business, improving margins, cutting capex and running the company for FCF (which GPS certainly fits the bill).
On the other hand, some kind of restructuring is quite likely, which may involve spinning off/selling one or more divisions (Banana Republic the most likely), shutting down non-core business lines such as Forth & Towne, and using the proceeds to do a major stock buyback/tender (ala LTD a few years ago). I don’t think such financial engineering will necessarily unlock any “hidden value”, as Banana Republic is unlikely to fetch a higher multiple than current GPS’s multiple. However, it will reduce the size of the company, and makes the job of the new CEO much more manageable -- always easier to manage fewer brands/division.
Strong B/S and FCF generating capability: GPS has $2.5 in net cash/share. Even at depressed margin this year, the company will still generate $650M in FCF. Of the $600M capex in ’06, $270M was for new stores, and $200M was for existing store remodeling, both of which could be cut substantially if mgmt faces reality and starts to run the business for FCF rather than the elusive growth. I think true maintenance capex is around $300-400M, and GPS should generate $1-1.2B in FCF with normalized margins, which could be used to improve dividend payouts or increase stock buybacks.
Stock does not look particularly cheap at 19x ’07 EPS, but looks attractive at 11-13x recovery earning power of $1.5-1.75. Applying a 15-16x multiple and add the $2.5 net cash gives an upside target of $26-30. For a recent turn-around example, AEOS was trading at 19x forward earning est at trough margin before turning into a 6 bagger.
EV/Sales, which is often a better valuation metric for recovery story, is at the lower end of historical range. Also an LBO analysis supports a target price of $23-25 that could still generate satisfactory IRR for financial sponsors.
Risks: The biggest risk to my buy thesis is the Old Navy division, which continues to face secular pressure. When Old Navy first started in 1994 with the concept of “value fashion” and cheap yet chic apparel, there was virtually zero competition, which allowed the company to reach $1B in sales in just four years. However, this space has become increasingly crowded with competitors like TGT and KSS. It is reasonable to conclude that strength at KSS and TGT over the last 3 years has at least partially come at the expense of Old Navy (and maybe even Gap). Even more telling is the traffic story. Over the last 25 months, Old Navy had seen just one month of positive traffic pattern, and despite heavy ad spending this fall and holiday season, traffic actually deteriorated in the last 2 months over very easy YoY comparisons.
1. New CEO
2. Some form of corporate restructuring, ranging from sale of the whole company to spinoff/sale of one or more divisions, major share buyback.