Rising Star Buy: Gap

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"You pay a very high price in the stock market for a cheery consensus."
– Warren Buffett

I'm not really the kind of guy that throws old saws around a lot. You're more likely to hear me spouting quotes from movies. ("It's all ball bearings nowadays!" Remember Fletch?) But Buffett's quote got me thinking about a company that has been taken to the shed recently. I'm talking about Gap (NYSE: GPS  ) .

What's up?
On May 19, Gap's stock price closed at $23.29, and things were looking pretty good. But after the market closed and management released first-quarter earnings, the stock sank like a stone in after-hours trading. In fact, it's been cut by almost 25% since then, and I think that's a little much even for the fickle retail market.

Gap should be a familiar name to most. The company's brands include Old Navy, Banana Republic and Athleta (and of course, Gap) among others. Gap was founded in 1969 by Doris and Don Fisher with a single store when Don couldn't find a pair of jeans that fit right. Today, the company has more than 3,200 stores worldwide, and I think the stock presents an interesting value proposition.

Here's what's wrong
Cotton is king: Management recently made a key mistake in assuming that cotton prices had peaked. Because March through May represents its heaviest buying months for the holiday season, the company got caught holding the bag, and higher cotton prices have cut into initial earnings estimates.

Tough environment: Thanks to the recession and its aftermath, retailers have lost what pricing power they had, and consumers are looking for deep discounts. This isn't just a Gap-specific problem, though. Competitors like Abercrombie & Fitch, Express (NYSE: EXPR  ) , Polo Ralph Lauren (NYSE: RL  ) and Guess? (NYSE: GES  ) all have to deal with the same problem to some extent.

Why it could get better
Cycles: It's worth remembering that cotton is cyclical. According to Cotton Incorporated's Supply Chain Insights bulletin, this year's record-high cotton prices should move farmers to produce a healthy harvest next fall, which should in turn ease prices for retailers, helping them cut production costs and improve margins and earnings.

Stagnant fashion: Sales have been hurting for a while, and management recently fired its star designer after it became obvious that problems run far deeper than they initially thought. Other recent organizational changes indicate management's trying to meet these issues head on in an effort to steer the company back on course.

Bad news banana: There's already a lot of bad news out there in the form of lowered guidance, lower margins, negative same-store sales, and higher inventories. However, management is making a conscious effort to control expenses, and the business still generates a ton of free cash flow. I'm starting to think that much of the bad news is already baked into today's stock price.

Why it could get worse
Again, cotton is king: If cotton prices don't ease up, retailers in general could be stuck in a world of hurt.

Debt issues?: Management just issued $1.25 billion in low-interest notes due in 2021 for "general corporate purposes including share repurchases." I'm usually not terribly enthusiastic about debt for share repurchases, but in such a low-interest environment, it's understandable to take advantage of cheap money. The $2.5 billion in cash on the balance sheet gives more than a little wiggle room. But if management proves to be less than responsible here I won't hesitate to cut ties and walk away. Given that insiders still own 16% of the shares outstanding, I'm willing to give it a shot.

Ch-ch-ch-ch-changes: If recent organizational changes and new designers fail to right the ship, Gap could be looking at more than just an extended period of poor sales. There's a long-term reputational risk at play here, and in the fickle retail market that can be extremely difficult to overcome.

It's on sale?
Gap's stock is trading for less than 10 times trailing earnings and 3.4 EV/EBITDA. Going back 10 years, these numbers have averaged 22 and 7, respectively. I also put together a DCF model with some pretty modest revenue and margin assumptions along with a 12% hurdle rate (fashion's fickle). Tack on the net cash of a little more than $2 per share and I can see shares being worth $24 to $26 -- a decent upside from today's price.

Making sartorial sense of it all
Gap caught my eye because of bad news, and it seems rather unloved. In fact, it only garners two stars in CAPS, the Fool's free investing community. However, sometimes these situations can lead to good value propositions. I'm going to give it a chance and invest $750, or 4.5% of my original capital, in the hopes that management can get this ship turned around. If that works, it might just be Old Navy for everyone. Make sure to swing on by my discussion board to chat about this latest addition.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).

Stock Advisor analyst Jason Moser owns no shares of any companies mentioned. The Motley Fool owns shares of Google and Guess?. Motley Fool newsletter services have recommended buying shares of Google and creating a modified stock repair position in Guess?. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 20, 2011, at 2:05 PM, TMFFoolEd wrote:

    Nice!

  • Report this Comment On June 20, 2011, at 7:55 PM, chris12tom wrote:

    They should be fine. All of retail seems to have been beaten down due to rising cotton prices but I'm sure GPS will persevere in the long run.

  • Report this Comment On June 21, 2011, at 3:39 AM, Clint35 wrote:

    I have to disagree on this one. I bought shares of Gap around 1998 when TMF was calling it a rule maker. Shares were around $20 at the time. Look where they are now. It might seem like a good value but to get Mr. Market excited about Gap again will probably take a retail miracle. That little bitty dividend isn't helping either.

  • Report this Comment On June 21, 2011, at 9:44 AM, Fringlish1 wrote:

    Not buying Gap-it is like most companies now and everything sold there is made overseas.

  • Report this Comment On June 21, 2011, at 10:44 AM, TMFJMo wrote:

    @Clint35

    I understand where you are coming from. I don't know that I would ever put Gap under "rule maker" status; they are a retailer. And you're right, if you held from 1998 to today on then you pretty much are right where you started.

    That said, I don't know that I will be holding on to the stock for as long a period as some others. Retail in general is very cyclical as we know and this is a value proposition more than anything else. I see the stock as being undervalued to my estimates. If/when it bounces back toward what I would consider to be a fair value, chances are decent I will close the position (unless there is a compelling reason to hold onto the shares).

    Foolish best,

    Jason

  • Report this Comment On June 23, 2011, at 8:06 AM, falvesdasilva wrote:

    The GAP is a well established brand that has been around for several years and the company is still 30% controled by the Fisher Family (founders). The company's net sales hasn't moved much in the past years, and have actually declined. Despite this, the company was able to grow EPS at an 8.6% and 19% CAGR in the past 5 and 4 yrs respectively (prior to the recent earnings report): this was due to cost management, increase in online sales (less costly), closing down of less profitable stores and mainly to share buybacks. The company has been buying back its shares aggressively, repurchasing 30% of its shares in the last two yrs, and having a board authorization to buyback an additional $2bn (15% mkt cap). For the future I don't see much sales growth for the GAP & Old Navy brands, even though the company says it will expand internationally (opened stores in Italy and China in 2010). In my opinion increase in EPS will come in part from share buybacks and marginally from growth in the Athleta brand. In my opinion the stock is trading at low multiples, and lower even if compared with competition, this despite the solid earnings growth it has experienced. The cons are that the stock really hasn't done much in the past 8 yrs, and despite the EPS rise and healthy balance sheet, investors might just keep on avoiding the name, as in MSFTs case! The rising costs of cotton will eventually fade with either cotton price decreasing or passing higher costs along to costumers. My real concern is the rising labour cost in China. If this becomes a persistent problem they can always shift manufacturing to another country (Mexico's labour is getting cheap again when compared to China)

    Disclamer: Long GPS / Long MSFT

  • Report this Comment On June 27, 2011, at 4:33 PM, Bert31 wrote:

    I think GPS is dead money, unless the undergo some major changes in their target audience. An Old Navy recently closed in a strip mall by me and re-opened in the mall nearby. Very good move, but what I noticed is that the new place was packed with mom's buying summer clothes for their kids, from newborn to 11-12 years old. No teens or adults were buying clothes for themselves there. If they could change their focus to infants/toddlers they may do well. There is alot of demand in that category; teen/young adult retailing is too difficult and Old Navy/Gap is not hitting it. Also, they should really consider trying to change their ticker symbol to GAP.

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