"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
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
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.