Fitch Cuts Gap, Inc. (GPS) to Junk Status
Fitch Ratings has downgraded the Long-Term Issuer Default Rating for The Gap, Inc. (NYSE: GPS)(Gap) to 'BB+' from 'BBB-'. The Rating Outlook is Stable. A full list of rating actions follows at the end of this release.
The downgrade reflects Fitch's reduced confidence in stabilization of sales, expectations of continued gross margin volatility, and belief that Gap will need to continue using real estate actions and large-scale cost reduction programs to protect EBITDA in the face of sales declines. Fitch expects EBITDA to decline to the $2 billion range in 2016 versus $2.3 billion in 2015 and a peak of $2.7 billion in 2014, with leverage expected to remain in the mid-3x range.
The rating continues to reflect positive aspects of Gap's credit story, including its capital discipline, positive free cash flow (FCF), scale, and investments in omnichannel capabilities.
KEY RATING DRIVERS
Weak Sales Continue
Gap's comparable store sales (comps) continue to be weak, with -5% comps in first quarter 2016 (1Q16) following -7% comps in 4Q15, despite significantly easier comparisons and an assumed benefit from sourcing and merchandising changes made in 2015. Gap continues to see material declines in traffic, and while traffic declines are an issue across the mall space, Gap's outsized declines are an indication that customer loyalty is waning as product continues to disappoint.
Gap operates in a challenging mid-market apparel sector, which has been characterized by lack of a strong product cycle and sales bifurcation to higher-end aspirational brands and lower-end fast fashion and off-price channels. Gap and its peers have seen volatile sales results and have needed to use significant omnichannel investments and higher-than-expected markdowns to drive sales.
Old Navy's (42% of 2015 revenue) recent weakness is of particular concern, given that the brand has mitigated sales declines at the Gap and Banana Republic brands for several years. Old Navy had not seen a quarterly comp decline since 4Q11 but produced comps of -8% and -6% in 4Q15 and 1Q16, respectively. Old Navy's value-oriented positioning should benefit sales in a period of trade-down but it appears that broader market discounting, and potential merchandising issues are causing weak sales trends.
Fitch previously assumed that merchandising changes made in 2015 would begin to show improvement in 2016, yielding flattish comps by the end of the year; weak 1Q trends have diminished confidence in this expectation. Fitch now believes comps could improve to the negative 1% - 2% range by 4Q16 and remain modestly negative thereafter.
Gross Margins Still Volatile
Fitch previously anticipated gross margins improving in 2016, predicated on improving sales trends, reduced inventory buys and a faster product cycle. Gross margins have fallen from a peak in the 40% range in 2009 - 2010 to the mid-36% range in 2015. Fitch projects that weak sales exacerbated by merchandise misses have caused 1Q16 gross margin erosion of 250 - 300 basis points (bps; to approximately 35%), leading to an EBITDA decline of around 30% vs. 2015.
As a result of 1Q weakness, Fitch is less confident that the company's process changes and reduced inventory position can improve gross margins this year. Fitch now believes gross margins could be down around 150bps to the 35% level for the full year.
EBITDA Protection through Expense Management Continues
Gap announced it will seek additional opportunities to streamline its operating infrastructure and will evaluate its international real estate fleet (primarily Old Navy and Banana Republic) to offset weak sales. Fitch has generally viewed these moves positively, including the 2015 closure of around 15% of North American Gap brand stores. However, the Gap's continued reliance on transformational cost management programs to protect EBITDA as sales decline is a negative.
Although details of the announced cost savings are expected to be shared on the company's upcoming 1Q earnings call, Fitch has assumed that SG&A could decline 2% - 3% in 2016 and modestly thereafter, following a 3.5% decline in 2015. As a result, Fitch expects 2016 EBITDA to decline approximately 15% to $2 billion even with a projected $100 million of net expense reduction.
While the company could realize modest SG&A and occupancy declines beginning 2017 due to the slowdown of international expansion, store closures, and other restructuring activity, the resulting income benefit could merely offset anticipated sales declines. As a result, EBITDA could remain range bound in the low $2 billion range.
KEY ASSUMPTIONS
--Comp sales are expected to be negative 3% - 4% in 2016, and modestly negative beginning 2017. Revenue growth approximates comp sales due to lack of unit expansion.
--EBITDA declines from $2.3 billion (14.4% of sales) in 2015 to $2 billion (13.1% of sales) in 2016, reflecting around 150bps of gross margin decline and 2% - 3% SG&A reduction, and remains in the low $2 billion range thereafter.
--Annual FCF after dividends of $400 million- $500 million, which will support the company's share repurchase program. In 2016 the company will use FCF and existing cash to pay down the $400 million term loan issued in 2015.
--Adjusted leverage remains in the mid-3x range over the next three years, assuming flat rent expense.
RATING SENSITIVITIES
An upgrade would be predicated on a combination of the following:
--Stabilized comp trends, defined as several consecutive quarters of flattish comps;
--Modest year-over-year gross margin improvement and SG&A leverage on a sustained basis, yielding EBITDA trending from the $2 billion level in 2016 toward $2.5 billion;
--Leverage trending to the low-3.0x range, based on the above EBITDA trend and paydown of the company's $400 million term loan.
Future developments that may, individually or collectively, lead to a negative rating action include continued sales weakness driving EBITDA to around $1.7 billion and adjusted leverage towards 4x.
LIQUIDITY
Gap has maintained strong liquidity, with an unused $500 million revolver and cash and cash equivalents of $1.4 billion as of Jan. 30, 2016. The company generated FCF after dividends of $500 million in 2015 and Fitch expects FCF to range from $400 million- $500 million annually over the next three years. Fitch expects FCF to be directed towards the repayment of the company's $400 million term loan in 2016 and towards share repurchases thereafter.
The company may also use some of its excess balance sheet cash for share repurchases, but is nonetheless expected to retain sufficient cash to handle its seasonal working capital needs without having to tap its $500 million revolver maturing May 2020.
FULL LIST OF RATING ACTIONS
Fitch has downgraded the following ratings:
The Gap, Inc.
--Long-Term IDR to 'BB+' from 'BBB-';
--$500 million senior unsecured revolving credit facility to 'BB+/RR4' from 'BBB-';
--Senior unsecured notes to 'BB+/RR4' from 'BBB-'.
The Rating Outlook is Stable.