Credit analyst sees Gap in risky gambit with little upside

By Ronda Fears

Nashville, Tenn., Feb. 27 - With Gap Inc. (Ba2/BB+) results sliding and no major restructuring program in sight, Gimme Credit analyst Carol Levenson said it is a risky situation with little upside. Moreover, she said the new $1 billion convertible will help get a revised bank facility but the new bank financing itself will likely disadvantage unsecured creditors and further burden the retailer.

"The proposed $1 billion convertible offering, something the banks would like to see happen before closing the new credit lines, would help Gap get through its first three quarters, when it likely will be consuming cash," Levenson said in a report Wednesday.

"Almost any kind of new bank agreement would eliminate our most pressing concern - meeting most or all of Gap's seasonal funding needs - although almost inevitably it will both disadvantage unsecured bondholders and place greater financial and operating restrictions upon the company."

With Gap's comparable store sales declining for the past 22 months, including a 17% drop month-to-date, a 930 basis point drop in gross margin in fourth quarter, increased operating expenses as a percent of sales, higher interest expense, a fairly tight liquidity situation and no major restructuring program in sight, the analyst said Gap apparently is betting everything on regaining its merchandising prowess this year.

"We consider this an extremely risky gambit, and we see little upside in this name," said Levenson, director of research for Gimme Credit, an independent research firm for institutional investors.

"Apparently the speculated major restructuring program to revive the profits of faltering specialty retailer Gap isn't going to happen. There were more questions during (Tuesday's) fourth quarter earnings call about whether or not Gap would offer pleated khakis in addition to flat-front ones than about its financial situation. This should tell us something, but we're not sure exactly what. Even excluding unusual items, Gap lost $20 million on $4 billion in sales in its fourth quarter. Perhaps this calls for something more drastic than a 'back to basics' theme in its apparel mix."

As for the questions of most interest to bondholders, the analyst said there were few answers. A week ago, Gap announced it has received commitments from major commercial banks for a new two-year, $1.3 billion secured bank facility. On Tuesday, Levenson said management refused to elaborate on the new bank facility, except to assert that it will be sufficient to replace $1.45 billion in bank lines and $1.55 billion in letter-of-credit backup facilities.

"This is particularly miraculous in light of the fact that last year its peak commercial paper and letter of credit outstandings totaled nearly $2 billion," Levenson said.

The company reported virtually no short-term debt at the end of January and just over $1 billion in cash. Whether or not this was because the company was unable to borrow in the short-term, the analyst said, will probably never be known. However, on the good news front, she noted that net debt fell by $400 million for the year and was the first annual reduction since the mid-1990s.

Although few cash flow numbers were dispensed, Levenson estimates cash flow from operations in the fourth quarter, despite a $300 million negative swing in earnings, was only $200 million less than last year, helped considerably by a sizable drop in inventories. Free cash flow, which provided funds for net debt reduction, actually improved slightly in the quarter, thanks to a dramatic drop in capital spending, she added.

Gap anticipates an even lower capital spending program this year, she noted, increasing net square footage by only 3% compared with 16% last year. Gap said it will close about the same number of stores this year as it closed last year, and management went to great pains to point out the "vast majority" of the company's stores are cash flow positive before headquarter allocations.

"If you were looking for dramatic store closing news, you'd be disappointed," Levenson said in the report. "They might want to take a hard look at that cash flow negative minority."

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