Friday, February 9, 2007

I Think It Might Be Time To Go To The Gap

So how do we know when a stock has bottomed? Thursday morning retailers reported January same stores sales. This is "the" metric most people follow to determine the health of a retailer. While I fall into "profits are more important than sales" camp as espoused by Eddie Lampert at SHLD (read it here) and Julian Day, formerly of SHLD and currently CEO of Radio Shack , it is important to understand the effect this metric has on a stock.

Most retail analysts view this number as gospel. A good number is good and a bad number is bad, period. If your same store sales are increasing your health as a retailer is increasing and vice versa. Get the point? Back to Thursday. Industry results were released for January and the results were good, increases virtually across the board except for Gap (GPS). Here is the rub though, people were actually happy with Gap's number because while negative, it was not as negative as they thought it would be. People were expecting a drop of over 7% and only got 6%. Because of this the stock traded up over 2.5%. We now have a situation were a company is performing worse than its peers and because it's results were not as bad as expected, this is good. Can you imagine what would have happened if they actually reported good news? The question now begs us, "What would Gap have to do for the stock to drop much lower?" It would almost take an enormously negative event. This is intriguing and makes Gap worth a closer look.

What happened to Gap? In short, it is too easy to get their stuff. When Gap was becoming popular there was a certain cache or "trendiness"to their products. People clamored for their products and were willing to pay high prices for them and Gap obliged by building stores everywhere. Is there a mall anywhere that does not have a Gap in it? When your products become too easy to get and everyone has them, they cease to be trendy. When you try to sell those now non trendy clothes at trendy clothes prices, people will not buy them (and they haven't). People drifted to their low price, low margin Old Navy brand. Reason? Same clothes better prices. Again in my situation, why would I go to Baby Gap or Gap Kids and pay $30 for pants I can get at Old Navy for $7? Answer? I won't and obviously neither are most people when you consider Old Navy sales are about 20% higher than Gap brand's are. Do my 4 year olds care if their clothes say Gap or Old Navy on them? If they do I am failing as a parent. (Disclaimer: If this conversation is Red Sox over Yankees then this must be important to them or I am obviously failing). Let's put aside the parental duties argument. They do not care if the say Old Navy or Gap nor will they when they are 14 or even 24. That, in a nutshell is Gap's problem. They have a value brand and a premium brand and in order to sell the latter they must price it like the former.

As a result, Gap's stock has essentially been flat for the past 5 years bouncing around $20 after hitting a high of $50 in 2000. Recently fired CEO Paul Pressler's reign is largely viewed as a failure. Lets take closer look at some numbers though. Under Pressler Gap grew earnings from 54 cents a share in 2003 to $1.27 last year before dropping to about 89 cents this year, causing his ouster. In what shape did he leave Gap? Not bad really. Total shares outstanding have decreased by 90 million in the last year and (this is a big one) debt went from $3.4 billion down to $500 million. He did this while maintaining the $2.5 billion Gap has in the bank. This means debt for Gap is now essentially irrelevant.

Numbers: We need to break everything down to per share amounts. Why? You pay your price for the company on a per share basis, we need to find out what you are getting for that money by the same metric. Currently Gap has 900 million shares outstanding and roughly $2.5 billion in cash (this amount has typically risen after the holiday season but we will use "what is" rather than "what could be"). That gives us $2.77 per share in cash. It's property is valued at $7.2 billion or $8 a share (this is carried at an undervalued level, I will use it though so as not to be accused of fudging numbers to make a point, again, "what is"). Profits will be about 85 cents a share and the dividend is 32 cents a share. At this profit level, investors are paying 23 times 2007 earning (16 times the $1.25 they earned in 2006). The total value of the cash, property, earnings and dividends is $11.94. Sales look to be about $16 billion this year or about $17.80 a share.

Let's say I have the cash to buy all of Gap (the market values it at $16 billion). For the $20 a share I would pay I would immediately receive $2.77 a share in cash (it's in the bank, I own it now) plus the $1.17 in earnings and dividends for a total of $3.94. That gives me an immediate return of 19%. Not bad! Remember, this does not even consider the value of its assets which we conservatively valued at another $8 a share. This would be the reason you may have read rumors about people wanting to buy Gap. For comparison, if we did the same calculations for Target we would get a return of 7%.

Brands: Gap has strong brands (Gap, Old Navy, Banana Republic). They have no quality issues and there is no negative stigma attached to them. Currently they are watered down, not tarnished and that is a huge difference. By contrast, Kraft ruined its brand with its association to Phillip Morris (Marlboro). Gap just diluted it by making its product to common. This can be fixed.

What to do? This is really simple. Gap is overextended, time to shrink in the US. Follow the Lampert / Day model. Close / sell under performing stores now. Sales will fall, but profits will rise (isn't that the name of the game?). Take the excess inventory and transfer it to other stores. This will decrease expenses this year, yup, more profits. Take the money in the bank and buy back shares. If you take $2 billion of it you could buy back another 100 million shares. Assuming all thing being equal (revenue and profits) that adds another 10 cents or 12% to 2008 eps and 12% to the dividend with no additional cash outlay for it over last year. Too much you say? Not really when you consider that cash flow from operations will add another $1.5 billion to the till. This also does not take into effect the extra cash from Christmas that will be reported soon. The decrease in expenses from store closures will add to that and make more cash available for? Yup, more buybacks. You could easily buy back $2 billion worth of shares this year and still have another $2 billion available at the end.

As for the brand, the less common it is, the better. Gap's commercials portray it as a cool and hip brand and this contradicts reality in which there is a Gap in every mall. Hipness needs to be something you seek out, not trip over. For an easy example see its Banana Republic brand that is much less omnipresent and is performing quit well. Closings stores and reducing the brand dilution will accomplish this.

In review, we have a business that is fundamentally strong, has lots of cash, no debt, producing quality apparel, trading at a great value to its assets who watered down its brand and it's stock is stagnant. This is an easy fix and the results could be very profitable and if they take the fix I prescribe, they produce gobs of cash to reward those who own shares.

I am not buying shares of Gap now nor do I currently own any. I want to hear what the new CEO says first. If they just continue the same path and try to jazz it up through more advertising, I do not see a resurrection of the Gap brand. In that scenario I believe they are in for another five years of mediocrity. But, any hint of them closing unprofitable locations and I am jumping in as I think we'll have a ValuePlay.

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