Rule Maker to Sell Gap

After more than a week of consideration, the Rule Maker managers have decided to sell Gap, which continues to struggle with key issues such as higher debt, weak cash flow, inventory management problems, and tough competition. The Rule Maker team got together for a roundtable chat to decide the issue. Motley Fool Research analyst Bob Fredeen, who has been covering Gap since March, joined the discussion. Perhaps more important than our decision, or even how it turns out, is the thought process behind selling.

We'll sell our 83 shares of Gap (NYSE: GPS) within the next five business days and discuss what to do with the proceeds in future articles. This will be the first Rule Maker company to be sold since this portfolio's inception in February, 1998.

Here's a look at what the Rule Maker managers were thinking as they reached their decision:

TMF Gibson (Rich McCaffery): Okay guys, we're here to make a decision on Gap (NYSE: GPS). Sell or hold? Zeke, start us off.

Centaur TMF (Zeke Ashton): My proposal is to sell Gap. There are three reasons. First, Gap's financials are deteriorating, in particular the Cash King Margin and cash-to-debt ratio. Second, just at the moment when we're trying to increase our standards by making the net margin target higher, Gap is failing five of six criteria. Third, I feel there's a long-term opportunity cost to carry Gap in our portfolio when there are probably 25 companies we could come up with in the space of an hour that have better business quality and stronger expanding possibilities.

TMF Verve (Matt Richey): Zeke, you've lived in Europe. Tell us your experience with the Europeans' acceptance of Gap.

Centaur TMF: Well, my anecdotal experience can't be taken as gospel, but from what I've seen, Gap is most successful in the U.K., especially Baby Gap. But on the continent, by which I mean Germany, Switzerland, and Italy, the "American" look of Gap is just not big, and never will be.

TMF Gibson: I'd like to jump in on the international sales issue, since this is the key to the company's future in my view. I was surprised to see how strong Gap's international sales have been over the last three years. As a percent of revenues international sales increased to 11.3% in 1999 from 9.7% in 1997.

International sales are growing at a 44% compound annual growth rate, and pretax earnings are growing at a 64% CAGR [compounded annual growth rate]. Also, Gap international is the company's fastest growing division. I'm not convinced Gap can grow in the European mainland, countries like Germany and France, but the company is focusing on the U.K., Canada, and Japan. It's a smart move and I'm optimistic results will improve.

Centaur TMF: The real problem with Gap, in my opinion, is how they are funding that growth. It just strikes me that Gap is growing for growth's sake, and the balance sheet is taking an awful beating because of it.

TMF Grape (Phil Weiss): Not just the balance sheet. There's all that off balance sheet debt as well. Leases are increasing in both cost and number.

TMF Bobdog (Bob Fredeen): I would point out that one of Gap's core brand values is convenience and one of the ways Drexler makes the brand convenient is to put a bunch of stores out there for people to go to. Beyond that, some areas have very dense population densities and may be able to support several stores.

Centaur TMF: And of course, in retailing, how important is inventory management? It's probably the most important thing to get right. And Gap's Foolish Flow Ratio is getting worse and worse.

TMF Verve: I think the deteriorating financial condition is indicative of a Rule Maker that has been tweened -- by the likes of J. Crew, Abercrombie & Fitch (NYSE: ANF), and others.

TMF Grape:The problems with inventory management show up in the days inventory outstanding calculation as well. It's increased for at least each of the last seven quarters. On an annual basis it's increased every year since fiscal 1994 as well.

TMF Gibson: Granted Gap's inventory management was poor this year. CEO Mickey Drexler was frank about this in a recent conference call. I expect it to improve based on the focus his team is placing on better prices, and a return to the companies core strength: denim, khakis, and other casual wear.

Centaur TMF: Here's the real problem with Gap. The fourth quarter will make or break the year, so it makes it very hard to evaluate the deterioration until that fourth quarter is over. I'm opposed to buying companies that have to generate enough cash flow in one quarter to make the year. It's a risky way to do business.

TMF Bobdog: The one point that we've missed has been the strength of the brands Gap owns. Gap is unique in its reach in the apparel industry. I don't know of any other company that has the same reach in terms of mind share, market share, brands, and price points. Right now, Gap sells about 5% of all the apparel in the U.S. Old Navy has something like 98% recognition in the U.S., as well. Sure, they have problems right now, but I believe that these problems are short-term in nature, and very "fixable."

TMF Grape: That works well for basics, but how well does it work for everything else. I'm not an expert on the industry, but it seems that a large segment of what's sold here is based on the latest styles and fashions. That leaves much to whim and fancy.

The problems may be fixable, this is a good company. It's overcome problems like this before in 1994, 1995, but that doesn't mean it's a Rule Maker.

TMF Verve: Yes, retail apparel will always be a fragmented industry, with no clearly dominant Rule Maker. There will always be room for a J. Crew or Abercrombie to also work its way up to 5% of the market.

Centaur TMF: Let's look at Gap from a Rule Maker standpoint. They have a great brand, that is uncontested. But will they ever have 50% gross margins? No. Will they have 10% net margins? No. Flow Ratio under 1.25? Maybe, but only one quarter out of the year. Cash King margin? It's negative.

And the debt has been piling up. Debt is something that goes on quickly, but getting it paid down takes years. How can we consider keeping the company when it only meets one of our Rule Maker statistical criteria? And the one it does meet, it doesn't do so in a fashion that creates shareholder value.

TMF Gibson: I think it has yet to be proven that Gap's debt is destroying value. It's ugly from a Rule Maker perspective, but I view that as just a starting point for investigation. I think Gap knows what it's doing: funding expansion with debt rather than equity.

TMF Verve: Here's how I look at this situation. It's ultimately a question of competing opportunities. At best, Gap is a very marginal Rule Maker. Why should we devote our investment dollars to a marginal player when there are a number of first-class Rule Makers in our portfolio that are more worthy of those investment dollars?

TMF Grape: I think we can all pretty much agree that Gap's not a Rule Maker by our financial criteria. Can anyone make a case that it ever will be? If not, then shouldn't it be booted on that basis?

TMF Bobdog: Slowing growth is inevitable for Gap in the near future, which will improve its cash generation. More importantly, a large amount of the recent capital expenditure has been going to building infrastructure in the U.S. and abroad. These are not investments that will be made at these levels every year.

Centaur TMF: Sure, but what are Gap's expanding opportunities? We are looking for companies that can grow their intrinsic value by 100% every four or five years. Can Gap do that?

TMF Bobdog: Expanding opportunities start with taking Old Navy international, set to happen this year or next. There is still plenty of room to grow Banana Republic, both at home and abroad.

TMF Grape: Before I wrote my article last week, I was against selling because I was concerned about how it would be perceived. We have a long-term focus and should have low turnover. But, when I dug in and really kicked the tires, I was left with a strong feeling that this company just doesn't belong in a portfolio with our investment approach. It may well be a value play or a turnaround play, but in my eyes it's NOT a Rule Maker.

Centaur TMF: And it's not like we're in a recession. There are some other companies in the sector that got taken out and shot by the stock market, but that did not compromise their balance sheets or cash flow nearly as much as Gap did. I want our Rule Maker companies to hold up better than the competition in an industry downturn, not get hammered worse. And I mean that from a business perspective, not from a stock price perspective.

TMF Grape: That's exactly why we like companies with a cash hoard. That's what's supposed to help them fare better in troubled times. Gap doesn't have the cash, so it's suffering.

TMF Gibson: I expect Gap's financials to improve. It's cash problems are the result of inventory struggles and weak sales issues. These aren't separate problems, but ones that feed on each other, and, I believe, are short term.

TMF Bobdog: This is probably key, the fact that these problems are short term in nature.

TMF Grape: It's going to take a long time until all the debt disappears and it approaches our cash to debt standard again. It may never get there.

TMF Verve: Even if its problems are short-term, it's a sad fact that Gap's continued success relies upon constant renewal of its brand and fashions -- all against a headwind of smart and well-positioned competitors. I don't think Gap's ubiquity is a huge competitive advantage, either. Fashion is one of those areas in life where "different is cool."

TMFBobdog: Actually, I don't think Gap's brand is up against all of the fashion retailers out there. It never was a fashion brand, and largely fell flat on its face when it played the fashion game. Sure, its competition is all about fashion trends; Gap isn't nearly as exposed.

TMF Verve: As Phil said, Gap may be a turnaround play at some point, but it's just not a Rule Maker. And, we KNOW quite certainly of other companies in our portfolio that are Rule Makers and that have clear expanding opportunities, supported by strengthening competitive advantages.

TMF Gibson: OK, let's wrap it up. Let's hear your votes and a last comment if you have it.

TMF Verve: Sell. Gap has been tweened by competitors who do the basics just as well if not better. J. Crew, in particular, is beating Gap at its own game.

TMF Bobdog: Hold. Gap is still the biggest and best collection of brands in its industry and its problems are largely short-term in nature.

TMF Grape: I hate to say it, but I think we should sell. Whether I look at the financial statements or the qualitative side of the equation, I just don't view Gap as a Rule Maker. It doesn't belong in a portfolio dedicated to our style of investing.

Centaur TMF: My vote is to sell. Gap is clearly not a Rule Maker, and may compete in an industry that does not even allow a company to become a Rule Maker. There are just too many companies that offer much stronger qualities and meet our standards much better than Gap to keep it.

TMF Gibson: Hold. I changed my mind after looking at the strength of Gap's international sales, hearing Drexler's honest assessment of the company's troubles and plan to focus on international markets where Gap can really compete. I think it will find a way to make its denims, khakis, and T-shirts a staple in key markets worldwide, and I believe it's created an enduring franchise.

TMF Gibson: By majority vote, the rule maker will sell Gap. Bob, your vote doesn't count since you're not a manager, but we certainly appreciate your comments and insight!

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