Description

GPS ($18.52) Gap, Inc. ($ in millions except per share amounts)

GPS is currently undervalued by at least 25% relative to what a private buyer would be willing to pay for it. I am talking about a rational and cost of capital-conscious private buyer.

GPS, a well-known leading apparel retailer, has 3029 stores with 37.1 million sqft of retail area, as of July 2005. It was posted on VIC about a year ago. It is worth revisiting because it is much cheaper now. A year ago, the EV of GPS was $16,730 ($18.73/shr X 1003 dil shrs – $2057 net cash). Currently, the EV is $14,740 ($18.52/shr X 905 dil shrs - $2023 net cash). Importantly, revenues and profitability are about the same as they were a year ago. While the business is not doing great, it is not going down either. Retail area seems to be stagnant around 37 million sqft since 2002. However, revenues and profitability have kept on growing. I will talk more about the business later.

In exchange for $14,740 you get a company that generates $16200 of revenue, $2000 of EBIT, $2200 of Ebitda-Capex, $1200 of net income, and $1200 of cash from operations less capex. The respective multiples are 0.9x, 7.4x, 6.7x, 12.3x, and 12.3x. These multiples are very attractive for a company of this size, profitability, and prominence. Disenchantment with the stock seems to emanate from a lack of growth; at least the level of growth rates for which the stock was priced a few years ago.

Ok, how do you justify a private buyer paying a 25%+ premium? Private buyer acquires 100% of GPS for $20,950 using $10,950 of cash and $10,000 of debt (3x Ebitda of net debt at the company after the transaction). Maintaining this capital structure, private buyer obtains a 10.4% FCF yield:

Ebitda-Capex $2200
Interest @6% 480 (6% on $8000 net debt)
Taxes @38% 580 (38% on Ebit of $2000 minus interest)
FCF $1140

Before touching on other important issues, let me discuss the likelihood of GPS being sold to a private buyer. The founding family owns 25% of the stock and has controlled the company during its 35 years of existence. Thus, it is unlikely that GPS would be subject to a takeover or other form of unfriendly pressure. However, the founders, smart and rational business people, are probably concerned with the stock performance because of three problems. First, the stock price has a direct effect on their wealth. Second, they are suffering important dilution. During the last five years, GPS has granted millions of options with an exercise price below that of the stock price five years ago. Third, there is a problematic effect on the motivation of those receiving options on a stock that goes nowhere. Therefore, as it seems unlikely that the founders would sell the company at the current price, the best private buyer of GPS would be the founders. I know, “will they put absolutely all their eggs in one leveraged basket?” May be not, but they could easily partner with a private equity firm. In any event, a leveraged recapitalization would unlock substantial shareholder value.

Let’s review the capital structure now that you talk about intelligence and rationality. This is not rocket science. Despite a meaningful share repurchase program, why would the controlling shareholders sponsor such a large and unproductive cash balance? Either GPS needs that much money just to survive or it has bigger fish to fry. If you look at history, you would be inclined to favor the latter. During the nine years to 2002, GPS increased its retail area from 7.5 to 37.3 million sqft and book value per share from $1.15 to $4.18 (and to $5.94 most recently). It sounds like instead of doing an LBO, the Fishers would rather put money to work into GPS’ new growth leg called Forth & Towne. Given their long-term track record, I don’t blame them.

It is very difficult to assert whether Forth & Towne will be successful. Forth & Towne is a brand/concept targeting women over 35. The space is very competitive, but so was the space for Old Navy. After all, Old Navy competes with WMT! Excuse my being cynic, but on Wall St every time there is suspicion that someone may compete with WMT (or vice versa) in a given niche, that someone is assumed to be dead. Well, Old Navy has been quite successful.

The bigger issue with GPS is the Gap brand not being able to compete effectively with the likes of ANF, AEO, URBN, etc. It has lost the cool factor and it is probably not recovering it in the short term. However, the Gap offers good value to its customers. And I believe that should macro-economic factors start to hit consumers’ pockets, there might be a good number of people trading down to Gap and Old Navy.

I am not suggesting that there is no downside. Evidently, management has recently done a poor job. Not only did they fail to anticipate competition from ANF, AEO, et al but also failed to react effectively. Most recently, at the Gap they made the mistake of appointing an image person that was the wrong person for the target market. This, to me, is just an example of how out-of-step they are with their target market. That is why it is possible that they may continue running to just stand still. Even if fixable, this situation will take time to remedy. On the other hand, one has to recognize the good job done in areas like supply chain and working capital management. This can be summarized as poor strategy (bad CEO) but good execution (good COO). Given the economic pain the controlling shareholders are enduring, I would not be surprised if there were management changes.

Despite having been less than successful in its international expansion efforts to date, GPS still has a huge opportunity there. Two key assets should allow it to be successful: a world-class supply chain and a highly recognized brand. It would be hard to argue that its supply chain is not on-par with that of FL (recently posted on VIC), Spain’s Zara, or Sweden’s H&M. Further, I would argue that its brand is much stronger than that of these players, which are good examples of successful international expansion. I believe that with a strategy twist, GPS could do a lot better internationally. I think centralization has been at the center of their international failures like the one experienced in Germany. It seems like GPS might now be doing the right thing in Japan by decentralizing some key functions.

Bottom-line, may be there is someone out there who can objectively demonstrate why this time GPS will not be successful despite its long-term track record of profitable expansion. In the absence of such a demonstration, GPS consequently offers an attractive reward/risk proposition: cheap if it just maintains cash flow generation or a great investment if it is successful once again.

Catalyst

Continued strong cash flow generation
Signs of success of its new concept/brand
Improved international performance

Catalyst

Continued strong cash flow generation
Signs of success of its new concept/brand
Improved international performance