Rumors are swirling that Motley Fool Inside Value selection Gap
The ousting of CEO Paul Pressler is expected to come with any sale. And while a sale and the short-term pop in stock price that will come with it might sound attractive on the surface, I have a hard time envisioning how that works out as the best deal shareholders can get over a period of a few years, versus just a few months.
Pressler did take on a company with financial difficulties and led it to a much stronger balance sheet. However, he has also consistently stumbled as a merchandiser, and as my Foolish colleague Rick Munarriz wrote yesterday, sales have consistently disappointed.
Some rough guesstimatesDespite news earlier today that Fitch had downgraded the company's debt to junk, the latest balance sheet shows current debt due and long-term debt outstanding to be $513 million. Of course, the company is still on the hook for operating leases, but those aren't interest rate-sensitive. The move by Fitch mostly affects the company's chances of raising additional debt at a reasonable cost.
Gap also shows more than $2 billion in cash in its coffers, and through October generated more than $1.2 billion in free cash flow. Given that sales continue to disappoint, cash flow could decline in the near future, but as long as Gap is judicious in its use of capital, it's not in any imminent danger.
For all of Gap's faults -- and it has many -- it still generates heaps of cash flow and has a strong balance sheet. In other words, Gap is fixable, and there's nothing that says a company in Gap's position has to sell itself to fix its problems. Instead, why can't the company simply get a new management team to right the ship? Last time I checked, that's what many companies do when the current management team isn't getting the job done. It's also worth noting that Limited Brands
There certainly is risk in turning Gap around. However, I believe that today's share price accurately reflects that risk. At $20 a share and with $1.2 billion in cash flow and an 11% discount rate, the company has growth of around 1% to 2% in cash flow priced in forever. Yes, there may be a decline in cash flow in the short term, but the cash flow results over the past 12 months are still below the $1.9 billion the company reported in fiscal 2004, and the weighted average of diluted shares outstanding has also decreased by 13% since 2004. A share price of $25 growth of just above 5% is priced in for 10 years and only 3% thereafter.
What ultimately happens with Gap will have a lot to do with what the Fisher family, which holds approximately 25% of the shares, wants to happen. That said, I think shareholders should be vocal if a cash takeout offer isn't at least in the $28 to $30 range, because with the company private and focused on a turnaround, it's not hard to imagine that cutbacks in expansion, capital expenditures, and continued closures of underperforming stores would push cash flow up near historical highs. Match that with the more optimistic valuations that always get assigned to companies when things are going well, and an IPO two to three years down the road at $35 to $40 wouldn't be out of the question. If current shareholders won't be a part of such a plan, I think they should push for a juicy offer.
For more on the Gap saga, check out:
Bargains come in all shapes and sizes. And Philip Durell is looking for all that he can find. To see how he's beating the market, take a 30-day free trial to Inside Value, where Gap is a current recommendation. Gap is also a Stock Advisor selection.
At the time of publication, Nathan Parmelee had no financial interest in any of the companies mentioned. The Fool has a disclosure policy.
