FYI, James.
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FOOL'S DEN
Is Gap a Value Play?
After a weak quarter and a terrible August sales report, shares of Gap Inc. have plunged to multiyear lows, causing lots of pain for shareholders. Then again, some people see the swoon as an opportunity to pick up shares of the tarnished Rule Maker for cheap. Motley Fool Research Analyst Bob Fredeen offers his opinion on Gap as a value play.
By Bob Fredeen (TMF Bobdog)
September 19, 2000
Twenty-three bucks a share. There was a point a week or so ago you could have bought shares of apparel retailer Gap Inc. (NYSE: GPS) for $23, down 57% from its 52-week high. For folks defining value as the distance between the current price and the 52-week high, Gap looks rather enticing.
Let's not get carried away. As much as I like Gap, it has earned its current share price. After discussing the recent problems, I'll cover what hope investors have for Gap to be a turnaround play.
Debt, inventory, management
A big problem dogging Gap for the last couple of years has been increasing debt. The major reason for this increase in debt has been Gap's aggressive expansion plans. At the end of the Q2 fiscal 1997, Gap had 1,984 stores and no long-term debt. Three years later, it has 3,284 stores and over $1 billion, or almost $800,000 in debt per new store. To be fair, not all of that money has gone to new stores. The company has improved its inventory management system, distribution centers, corporate headquarters, and other infrastructure systems. Also, Gap has used debt to buy back its own stock, spending $161 million in Q2 '00 alone.
Sticking to balance sheet concerns, inventory has been growing faster than sales for the past eight quarters. Inventory management is one of the keys to successful retailing, and it seems that Gap has been failing this test. Part of the reason for this seems to be Gap's focus on inventory per square foot as opposed to total inventory measures. Again, this problem seems to be a by-product of the recent expansion.
Gap's free cash flow for the first half of 2000 was negative $725 million, compared to negative $255 million the year before. This number is directly related to Gap's expansion plans, since the simple definition of free cash flow is cash from operations minus capital expenditures. The rising inventory levels hurt cash from operations while expansion forces high capital expenditures.
Recent problems at Gap's new distribution centers have made inventory levels even worse. Essentially, too many orders came in at once, and the centers couldn't process the merchandise quickly enough. This kept the back-to-school merchandise from being delivered to Old Navy stores until this month, instead of in August. No doubt this was a factor in Gap's abysmal August sales report.
Another concern for the company has been the loss of several senior managers over the past year. The president of the Gap Brand, Robert Fisher, left that post, and CEO Millard Drexler took over management of the brand. The president of Banana Republic and Gap Online, Jeanne Jackson, left to take over Wal-Mart.com, leaving that brand in the hands of a triumvirate, while Ron Beegle stepped up to take over the online division. Most recently, John Wilson, chief operating officer, resigned and the position was removed. His responsibilities were divided among three managers. The additional duties taken on by the remaining senior managers put a lot more on their plates.
Throw in the towel?
With all those problems, Gap investors should throw in the towel, right? Not so quickly. Yes, Gap has problems, but it is also the biggest mover in its industry. It owns three of the most valuable apparel retailing brands, and they are led by some of the most capable managers in the industry. So, how do they turn this ship around?
The first thing investors need to see is a focus on generating cash flow. The problems that investors, including the managers of our own Rule Maker Portfolio, are most upset about relate directly to free cash flow, or the lack of it. Going forward from the next one or two quarters, Gap needs to aggressively target generating free cash flow if it wishes to be considered a good investment. Probably the easiest way to accomplish this is slower expansion.
The connections between recent expansion efforts and Gap's biggest problems seem pretty strong. Slowing down expansion and the stock buyback plan would allow the company to hold off issuing new debt. As Gap is already over $700 million in the hole for the year, it will be almost impossible to be free cash flow positive in fiscal 2000. In 1999, Gap was down $255 million halfway through, but ended the year with $199 million in free cash. To achieve a similar result this year, Gap would need to generate almost $1 billion in cash over and above the approximately $1 billion it still plans to invest. Frankly, I don't see this happening, due to both the magnitude of the amount and the company's recent distribution problems.
The distribution center disaster brings us to another way Gap can improve its cash flow: sell its inventory even if it has to aggressively mark down prices. Sounds basic, but it seems that management has lost track of the forest while focusing on the trees. The forest here is overall inventory growth, while the trees are the management of inventory based on inventory per square foot. Focusing on the inventory per square foot makes a certain amount of sense. As the company increases its overall store space 30% this year, it needs to make sure there is merchandise available in that space. However, its approach to inventory management has resulted in a huge increase in inventory, a trend that must be reversed immediately.
Despite all of these problems, there is one very powerful ray of light for this company: its management team. The brightest point is the leader, Mr. Drexler. He has come across as a very honest, capable leader each time I've heard him speak. Commenting on a recent Wall Street Journal article, he mocked the idea that he had ever loosened his control over the company, allowing his underlings to make mistakes. Instead, he noted that he was "a partner in every mistake we made." It would have been easy to say nothing and let others take the lion's share of the blame; instead, he made sure that everyone knew it was his mistake. A moment later, he said he was "pissed off and wasn't making any excuses" for the company's recent blunders. The rest of the presentation (available at 1-800-GAPNEWS, then dial 5) was about how Gap intends to fix its problems going forward.
Beyond Mr. Drexler, the company is led by much of the same group of managers that led the company to where it is currently. Some seem to believe that Old Navy is a lost cause, but the same core people who created the brand lead it today. These are people who took Old Navy from zero to $1 billion in sales in record time.
Looking forward
First, there is some bad news to get out of the way. As I mentioned in my Motley Fool Research Report on Gap, the next couple of quarters are going to be difficult. Or, more bluntly, the third quarter will most likely be very painful as the company recovers from the inventory debacle, and the fourth quarter will probably feel some impact as well. During these quarters, I expect to see some signs that the company's business is improving and expansion is slowing.
After the next six months or so, I expect things to start looking up. Stocks are priced according to what investors believe future profits will be. Focusing on Gap's performance over the last year is bound to be disheartening. However, there are some similarities to Gap's position today and the slow sales and anemic comps growth that plagued it in 1994 and 1995. It was able to catapult from its smaller position to the biggest player largely through the efforts and innovation of the management team. Yes, I am placing a great deal of trust in this management team. My willingness to do that is based on my belief that the management team understands what mistakes have been made, has been honest about those mistakes, and is working to fix those mistakes.
Gap currently faces some major problems managing its debt and cash flow. It faces some short-term problems in inventory management as well. However, all of these problems are fixable and I fully expect them to show signs of improvement over the next 12-18 months.
There is no denying that Gap is going to face some difficult times over the next year. However, no major retailer gains prominence without overcoming some problems. This company has handled similar difficulties before. Despite these problems, Gap owns three of the strongest retailing brands in existence and I expect the company to fix its problems and build on its strengths. Perhaps this is fertile ground for value investors after all. |
