Markets & Finance

Gap's Debt Makes Investment Grade


Standard & Poor's Ratings Services raised its corporate credit and senior unsecured debt ratings on San Francisco-based Gap (GPS) on Feb. 10 to BBB- from BB+. The move puts Gap's ratings in the

investment grade category. The ratings outlook is stable.

The upgrade reflects Gap's good operating performance over the past three years, its strengthened balance sheet, and Standard & Poor's expectation that cash-flow protection measures will remain solidly characteristic of investment-grade levels. The new rating also takes into account Gap's solid business position in casual apparel, as well as its geographic diversity and strong cash flow. These factors are offset, in part, by management's challenge to continue improving its three brands in an intensely competitive industry.

Management's initiatives to improve product quality and assortment, store execution, and inventory management, as well as the rationalization of the store base, have resulted in significantly improved operating performance over the past three years. Operating margin rose to 22.4% in the trailing 12 months ended Oct. 30, 2004, from 21.5% in the prior-year period and a low of 14% in 2000.

WEARING IT WELL. Standard & Poor's believes operating performance will remain relatively stable over the next few years, because Gap has more management depth and has instituted processes and controls that greatly reduce the likelihood of a deep and protracted decline.

S&P Ratings Services also anticipates that Gap will improve store productivity over the next few years through brand extensions, reallocation of product mix (making for a greater percentage of sales from higher-margin products), and further rationalization of its store base.

Nonetheless, intense price competition, apparel deflation, an increasing mix of lower-margin sales from Gap's Old Navy division, and the inherent fashion risk of the industry will make it difficult for Gap to materially increase its operating margins. In addition, profitability is also vulnerable to shifts in same-store sales, as Gap's store base isn't expanding. Same-store sales were flat in 2004, and comparisons will be tough in the first half of 2005.

Gap's cash-flow-protection measures are solid for the rating. Earnings before interest, taxes, depreciation, and amortization (EBITDA) coverage of interest was 5.5 times in the trailing 12 months ended Oct. 30, 2004, and funds from operations to total debt was 44%. Debt leverage is moderate, with a total debt to EBITDA ratio of 1.9 times at Dec. 31, 2004. We expect leverage to decline this year, as Gap's $1.4 billion convertible notes are callable in March and in the money (i.e., investors would realize a profit by converting the notes into Gap common stock). If the notes are exchanged for equity, leverage would decline to about 1.5 times. Gap completed its $1 billion stock-buyback program in 2004's fourth quarter.

Liquidity:

Over the near term, Gap should maintain an excellent liquidity profile. S&P estimates that it generated more than $1 billion of free cash flow in 2004, as cash needs are relatively small aside from fixed and working capital requirements. This estimate doesn't take into account debt repurchases. Gap generated almost $3 billion of free cash flow in the prior two years. It ended the third quarter of 2004 with $2.7 billion of unrestricted cash and cash equivalents, compared with $2.5 billion of funded debt on the balance sheet.

Gap has seasonal swings in its working capital needs (generally peaking during the third-quarter inventory buildup for the holidays). These needs are expected to be funded with internally generated funds and existing cash on the balance sheet. Liquidity is further enhanced by a $750 million secured revolving-credit facility and letter of credit facilities totaling $1.2 billion.

The letter of credit facilities mature in 2006, and the $750 million revolver matures in 2009. As of Oct. 30, 2004, Gap had $861 million in trade letters of credit outstanding and no cash borrowings under its revolver.

Outlook:

The stable outlook reflects S&P's confidence that Gap will maintain its strong business position in the apparel sector despite intense competition. Moreover, its efforts to improve store productivity and customers' overall shopping experience should help mitigate a business decline during a poor economy. Capital spending and common-stock buybacks are expected to be commensurate with the rating. From Standard & Poor's Ratings Services


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