Gap: The Short Case

| About: The Gap, (GPS)
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Gap Inc. (NYSE:GPS) is a apparel retailer that operates under the Gap, Old Navy, Banana Republic, and Forth & Towne brands. The Company’s products include denim, khakis, and T-shirts, fashion apparel, shoes, accessories, intimate apparel, and personal care products. GPS operates about 3,000 stores in the United States, Canada, the United Kingdom, France, and Japan.

Investment Rationale

GPS hired Goldman Sachs (NYSE:GS) on Monday, January 8th, 2007 to explore strategic alternatives, a move that essentially means the Company is for sale. The stock rose about 7% on the announcement but the majority of analysts has been unimpressed in light of the announcement and has recommended investors sell GPS ahead of any potential buyout. Based on valuation and precedent transactions, the analysts look like they could be right and GPS could be an interesting short at these levels given the limited upside for a buyout.

Pros to Short

Limited Strategic Buyer Interest: M&A activity in the retail industry has been robust in recent years and has included both strategic and financial buyers. M&A activity between strategic participants in the retail industry has generally been between like entities as opposed to one retail format/style purchasing different formats/styles. With some exceptions, many mall-based retailers have been acquired by LBO firms and these buyers will probably show more interest in GPS than strategic buyers.

The Company’s flagship stores sell fairly generic items so a strategic buyer will not be acquiring much except a tired brand and a collection of mall leases. Since its products are mostly basic apparel items, GPS “competes” with just about every mall-based apparel retailer in some form or another without being a direct competitor. Retailers like American Eagle Outfitters (AEOS) and Aeropostale (NYSE:ARO) may sell similar items but they aren’t a true GPS competitor because AEOS and ARO have stronger brand images and apparel designs. The same can be said for Limited Brands’ (LTD) Express and Limited stores as well as AnnTaylor Stores (NYSE:ANN). While they may offer similar products to the Company’s Banana Republic stores, they are not necessarily a direct competitor to the entire company.

The Company’s main product lines are most directly comparable to apparel carried by Target (NYSE:TGT) and Wal-Mart (NYSE:WMT) which does not make the Company very attractive to most strategic buyers. Finally, outside of anchor tenants like Federated Stores, there are not many potential strategic buyers that can realistically finance a $16 billion deal for a struggling, diluted brand retailer.

Limited LBO Interest: Private equity firms will be the most likely buyers assuming strategic buyers quickly pass on GPS and the market is betting mostly on an LBO. GPS would be one of the largest LBOs in the retail space and financial sponsors may be reluctant to make such a large purchase given the fundamental problems facing the Company. Appendix I (located at the end of this report) lists the leveraged buyouts that have occurred in the retail sector over the past few years and Table I presents the median and average transaction multiples based on retailer format.

table 1 valuation mentrics of retail leveraged buyouts

The Company currently trades for about 7.3x EV/EBITDA while mean and median transaction comps are in the mid 8.0x EV/EBITDA range, not offering much upside. A LBO at 8.6x EV/EBITDA would value the shares at $23.05, 15% above where GPS closed today (01/10/07). This may appear to be acceptable upside given that a deal could occur within 3-6 months and represent a quick gain but the problem is that even with leverage at typical LBO levels of 70% debt to capital, there will be little room for a sponsor to do much more than pay cash interest expense. Table II provides a sensitivity analysis based on possible takeover premiums.

Table II GPS Buyout Analysis

While a financial sponsor will aim to reduce CapEx significantly, even if the $600 million in CapEx is slashed to $300 million, GPS will have just $600 million or so to cover working capital needs and cash taxes. Also, the estimated average interest expense of 8.75% is probably understated as the amount of leverage in this deal could offer a combination of B loans, Senior Unsecured Notes, and High Yield with most of the debt tilted towards higher interest high yield bonds. The lack of a cash cushion might not matter that much to the buyer but it will to the lenders.

Table III shows fixed coverage ratios for an LBO of the Company. Fixed coverage ratios are important in that they are used in setting bond covenants. Even with aggressive financing markets, pumping out over $10 billion in debt for a struggling retail business with no asset coverage with fixed coverage ratios this low at deal close is challenging. The Fixed Charge Coverage ratio is also overstated because no mandatory debt payment has been factored into its calculation. Financing for this deal would have a small portion of bank debt most likely structured as a B Loan which would have a tiny amount of amortization on an annual basis (1% of principal usually). While this mandatory debt payment would be a small amount, the high level of cash payments would make even a small addition something to consider.

TAble III GPS LBO Fixed Charge Coverage

While a deal at $23.00 could occur, financial sponsors may want to wait it out another 6 months or longer since the Company has struggled over the past few years. Since 2004, total revenue growth has not kept pace with inflation and gross profit and EBITDA margins have declined over 300 basis points. From 2004 to 2005, EBITDA declined 12% and current reports indicate that the Company’s 2006 holiday performance won’t do much to change this declining trend. While a buyer may be comfortable paying a valuation metric of 8.0-9.0x EBITDA, the buyer might wait for EBITDA to fall a bit more.

This has been typical of retail buyouts of struggling assets such as Brookstone and Eddie Bauer (EBHI), which have higher transaction valuations because profitability metrics are depressed. The valuation multiples are slightly higher but the total transaction size is much smaller. Referring back to EBHI, its 2004 and 2005 EBITDA figures were $146.1 million (13% margin) and $111.9 million (10.6% margin) respectively. Margins had declined during that time but if Sun Capital Partners (SCP) and Golden Gate Capital (GGC) paid 8.0x EBITDA off 2005 figures, the total transaction size would have been $1.2 billion. Instead, EBHI continued to struggle and the sponsor group was able to purchase EBHI for $615 million, 9.3x LTM EBITDA, but more importantly just 0.6x sales. These valuation multiples will probably look even lower once the deal closes because the transaction was announced just before the start of the holiday season.

The EV/Sales multiple is really where a sponsor group will have trouble justifying a buyout currently north of 8.0x EBITDA for GPS. The Company is currently trading at 0.9x sales which appears high against the averages and medians in Table I. If one examines the transaction set in Appendix I, it’s clear that premium businesses have traded for over 1.0x sales. These are businesses such as Michael’s Stores, Neiman Marcus, and Yankee Candle Company. Michael’s Stores is the dominant player in the arts and crafts space, Neiman Marcus caters to an affluent customer base that is seen as somewhat recession proof, and Yankee Candle Company has a record of generating EBITDA margins in excess of 25% (with CapEx usually running at 5% of sales). In comparison, GPS is not in a similar position to command the same EV/Sales multiple that these other businesses have and as the premium rises, the EV/Sales metric begins to look unreasonable.

Looking at the other transactions in Appendix I, it appears as though an argument could be made for GPS to eventually exchange hands at a lower sales multiple. Businesses like Toys R Us, which had the benefit of owning real estate, were sold for 0.6x EV/Sales, as was Sports Authority and Burlington Coat Factory. Like GPS, these businesses could be seen as below average to average, and did not command the type of EV/sales multiples that premium businesses do.

Given this disconnect between EV/Sales and EV/EBITDA, it would make sense for a financial buyer to continue to sit on the sidelines as the Company’s operations continue to deteriorate. It’s been fairly evident that the Company’s strategy of massive cost cuts did little to drive store traffic which should result in further declines in sales and EBITDA. If a potential sponsor waits for final year results to come in, it may be able to purchase the Company for a cheaper price than investors may be hoping for.

Table IV outlines a possible scenario based on estimated fourth quarter results (internal estimates in red). Analysts are just forecasting $15.8 billion in 2006 sales and LTM EBITDA margins are at 12.3%. From 2004 to 2005, EBITDA margins declined from 16.6% to 14.8% so expecting margins to come in around 11% off a $16.0 billion sales number is not inconceivable.

Table IV GPS EV-Sales Buyout Analysis

A buyout price of $19-$22 per share seems to make more sense based on Table IV provided that operating results continue to deteriorate. In fact, the 1.0x EV/Sales and 9.1x EV/EBITDA multiples off 2006 year-end results corresponds to the 1.0x EV/Sales and 8.2x EV/EBITDA multiples off current LTM figures. With that expectation a buyer would want to wait on the sidelines for speculators and investors to lose patience with the stock and let it float back to normal levels before bidding again. At the highlighted range in Table IV, leverage is still aggressive enough that a sponsor group will be able to generate the returns it is seeking.

Up until now this entire analysis has focused on the feasibility of a takeover of GPS from a valuation and financing perspective. However, the key reason a sponsor group would purchase the Company would be to generate an impressive IRR. Because the Company’s operating growth is declining, a sponsor group will need a significant amount of leverage to engineer its returns. Table V illustrates a back of the envelope IRR analysis for what a sponsor group could realize if a buyout closed at the end of 2007 and was subsequently sold at the end of 2012.

Table V Sponsor Returns Analysis

The 2012 EBITDA multiple assumes that the sponsor group can grow EBITDA at a compound annual growth rate of 8.5%, which could be challenging, especially since the first year will bear the impacts of turnaround efforts. The $4.8 billion investment is based on the 30% equity investment a sponsor would make at a 1.0x EV/Sales multiple off internal estimates of 2006 year-end sales (see Table IV 1.0x EV/Sales column). While the resulting IRR figures look impressive, most financial sponsor models look for returns greater than 20% so that when unexpected obstacles occur that may require a longer time horizon before selling the business, the sponsor can still be patient with the knowledge that the returns will still be acceptable. Despite a lot of attention on the risks of leveraging businesses, LBO firms are very cognizant of these risks and look for a margin of safety in terms of return profiles.

The real returns as presented in Table V come from multiple expansion which is difficult to forecast and more importantly, difficult to rationalize with a business like GPS. Because GPS does not generate significant cash flow after the cash interest expense and maintenance capex, there will still be a significant amount of leverage in 2012. With little growth expected, the Company won’t be able to aggressively delever which would make a future buyer cautious with paying 9.5x EV/EBITDA for this business. Consequently, assuming a sponsor group can turn GPS around and grow EBITDA, the best case scenario is realistically a 25% IRR. In contrast, other businesses can be purchased by these firms that require far less work and due to their strong cash flows can delever much faster, resulting in a much strong IRR relative to GPS.

Recent LBO Retail Challenges: LBOs of retailers have reportedly been struggling. Linens N’ Things and Toys R Us have experienced difficulties over the past year which has not been lost on the credit markets or buyers. The sale of GPS may very well follow how the Jones Apparel Group (NYSE:JNY) sale went – without a buyer. Like GPS, JNY’s stock had languished over the years. Revenue growth had been fairly stagnant and EBITDA margins had also steadily declined from 16.6% in 2001 down to about 12% by 2006. One could argue that JNY had better brands and opportunity for a buyer relative to GPS with its various brands including Anne Klein, Nine West, and Barneys New York. At the very least, these were different formats which a buyer may have been able to spin off/sell separately.

In March 2006, JNY put Nine West on the block and followed up a few weeks later announcing the entire company was for sale. During that time the stock rose about 24% but just about 8 weeks later the stock had given back half of its gains. Another item of note is that only two groups appeared interested in JNY and by June only Bain Capital remained with a bid that the board did not accept. At the time JNY was trading at a valuation of about 8.5x EV/EBITDA and 0.9x EV/Sales. During the auction period the stock had given back nearly all of its gains and once the board passed on the offer the stock dropped back to its pre-auction levels. Since that time JNY’s stock has recovered but skeptical short sellers that made the right entry generated gains. The same could happen with GPS and the benefit is that a short seller’s maximum upside and downside in this instance is realistically about 20-25%. This 1:1 loss/reward ration is not a great trade off for long positions but for a short sale a return band this tight that can realized within a few months is appealing.

GPS chartCons to Short:

Easy Capital Markets: Despite the analysis of why GPS would not be the best LBO target around and the limited downside to short selling, the massive liquidity makes a lot of deals that are questionable easy to execute. A large enough sponsor group that has conviction in its ability to staff GPS with the right team and execute a turnaround may be willing to pay what might seem to be a stupid price for the Company.

Deep PE Rolodex: PE firms have deep benches and can recruit top executive management to their portfolio companies. The talent level of the executives is one thing, but then PE firms tie management’s compensation directly to operating performance which drives results. If the right executive is available with confidence in a turnaround, PE firms will look to partner with him/her and execute a buyout of the Company.

Disclosure: Author manages a hedge fund that is short GPS

Click to enlarge:
retail LBOs