Fitch: Gap's Debt Issuance & Other Recent Announcements Raise Concerns

CHICAGO--(BUSINESS WIRE)-- Recent announcements by Gap Inc. (Gap) do not have a near-term impact on the company's credit rating, according to Fitch Ratings. However, the announcements, which have included disappointing margin guidance, management departures, and new debt issuance, are collectively of concern in regard to current and future business trends.

Gap's current 'BBB-' ratings reflect its strong free cash flow, expense management, and real estate discipline but are limited by its inconsistent success introducing new product lines across its brands.

Management has indicated that Q3 2015 gross margins are expected to be close to those of Q2, which is typically Gap's lowest margin quarter due to summer product clearance. The Q3 2015 gross profit margin is now expected to decline nearly 300bps vs. 2014, compared to declines of 100bps and 200bps in Q1 and Q2 of 2015, respectively. While YTD declines are partially related to the strong US dollar, Fitch believes they are the result of higher inventory-clearing markdown activity. Weak margins highlight continued difficulty connecting to customers with compelling, trend-right fashion.

Gap has announced several key management departures, most prominently the president of Old Navy, currently Gap's most successful brand (and most sales generative at 40% of FY 14 company revenue). Fitch is concerned the president's departure could lead to a slowdown in comp momentum for Old Navy, given that current strength at Old Navy is mitigating sales weakness at Gap (38% of sales) and Banana Republic (18% of sales).

While Fitch does not expect significantly positive sales growth from any of Gap's brands, a slowdown at Old Navy would have negative EBITDA implications if the Gap branded stores did not improve concurrently. Additionally, the departure of Banana Republic's creative director suggests that weak trends in that business will likely continue at least for the next six to nine months, as product lines under her direction have not resonated well with customers.

Gap has also announced a $400 million two-year term loan, with proceeds intended for share repurchases. While the new facility has only modest implications (10bps) on leverage, Fitch generally views as negative a company's decision to increase leverage during times of operational difficulty. However, Gap is expected to end 2015 with approximately $1 billion of cash and full revolver availability and anticipates free cash flow (post dividend) generation around $400 million annually beginning 2016, providing Gap ample liquidity.

Fitch currently rates Gap 'BBB-', predicated on its operational discipline and free cash flow generation. The company has shown willingness to address its cost structure and real estate, most recently through this year's closure of approximately 15% of North American Gap brand stores. Moreover, Gap has also been an innovator in omnichannel capabilities, which should support market share as shopping behaviors continue to change. EBITDA growth, and therefore leverage metrics, has been held back by the company's inconsistent track record merchandising trend-right assortments, leading to weak comp store sales growth and erratic gross margins.

Fitch's negative ratings sensitivities include sustained EBITDA at or below $2.3 billion and leverage of 3.5x. Fitch currently expects 2015 EBITDA of close to $2.2 billion and leverage of 3.5x, assuming recent product challenges continue into the holiday selling season, yielding slightly negative Q4 comps and year-over-year gross margin declines similar to Q3. These estimates fall well below management's most recent earnings guidance as of Aug. 20.

Fitch currently anticipates EBITDA improving to $2.4-2.5 billion over the next three years, resulting in leverage of 3.3-3.4x following repayment of the $400 million term loan. The EBITDA rebound is predicated on slightly positive comps and 100 - 150bps gross margin improvement from 2015, resulting in margins 50 - 100bps below 2014. Positive comp momentum is expected to begin with better product acceptance in Spring 2016, which should benefit from early 2015 changes to management and merchandise processes. A worse-than-expected holiday or lack of sales momentum into spring 2016 could trigger a negative ratings outlook or downgrade.

Fitch currently rates Gap Inc. as follows:

The Gap, Inc.

--Issuer Default Rating 'BBB-';

--$500 million senior unsecured revolving credit facility 'BBB-';

--Senior unsecured notes 'BBB-'.

The Rating Outlook is Stable.

Additional information is available at 'www.fitchratings.com'.

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View source version on businesswire.com: http://www.businesswire.com/news/home/20151019006244/en/

Fitch Ratings
Primary Analyst
David Silverman, CFA
Senior Director
+1-212-908-0840
or
Secondary Analyst
Monica Aggarwal, CFA
Managing Director
+1-212-908-0282
or
Media Relations:
Alyssa Castelli, +1 212-908-0540
[email protected]

Source: Fitch Ratings

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