By and  on January 10, 2007

Amid a whirlwind of speculation about what will happen at Gap Inc., from asset sales to going private to executive departures, two things are certain — there is no easy fix and it won't be an easy business to sell.

Gap soon will disclose that it is seeking strategic alternatives or significant executive changes. According to a source, the company held an unscheduled board meeting in San Francisco Tuesday, raising expectations that a critical announcement could be coming soon.

Gap stock dipped slightly Tuesday on the New York Stock Exchange to $20.19, from Monday's close of $20.26 on reports the retailer had hired Goldman Sachs to explore a possible sale of all or part of the company. Trading remained heavy, with 15.5 million shares traded Tuesday, compared with the daily average of about 6.7 million.

Gap Inc.'s senior unsecured debt was cut to junk status on Tuesday by Fitch Ratings, which cited weak sales over the holiday period and shrinking profit margins. Fitch said in a statement it cut its rating on about $513 million of Gap's senior unsecured notes to "BB+" from "BBB-," the lowest investment grade level.

Fitch Ratings said Gap's liquidity position remained strong, with $2.4 billion of cash and short-term investments as of Oct. 28, 2006 — which could make it an attractive target.

But according to market experts, selling the struggling retailer might be difficult for several reasons. The Fishers, Gap's founding family, won't sell their shares cheap; a buyer faces a major task fixing the various divisions; the group's core businesses are mature, with too many stores that are too large and no owned real estate; the management team seems to be hemorrhaging, and analysts continue to speculate over the future of Paul Pressler, Gap's president and chief executive officer, who is under increasing pressure from Wall Street. That pressure, sources said, was likely to remain, since analysts predict Gap is going to have another tough year.

"I think Paul Pressler will not be on the fourth-quarter conference call," said one analyst, who requested anonymity. Pressler's contract expires in September.

According to sources, there was a string of executive departures this week, including Ivy Ross, executive vice president of product design and development at Old Navy; Christopher Hufnagel, vice president, Gap brand store experience, and Kyle Andrew, vice president of Gap Marketing. Sources said Andrew was headed to Kenneth Cole, and that Hufnagel is joining Under Armour. There was no word on Ross' future. Gap officials could not be reached to comment on the departures or about any board meeting.Ross was like a white knight at Old Navy, riding into the business in 2004 with a ton of new ideas to polish the image and elevate the product. She created an in-house blog and brought in organic products. Hufnagel was a key figure in creating Gap store prototypes that bowed in the Denver area two years ago. Elements of it continue to be adopted at Gap stores.

Regarding who would buy Gap Inc. or pieces of it, such as Banana Republic, the likely suitors are the ones with the money: the private equity firms, which are flush with at least $200 billion in cash. Circling Gap alone or in a consortium, the possible scenarios of a private equity buyout are intriguing. Here are a few:

  • Texas Pacific Group, which owns Neiman Marcus with Warburg Pincus, and, as TPG Advisors II Inc., is the largest shareholder of J. Crew Group, could link with another private firm in a bid to snatch up Gap Inc. Or, TPG could buy just Banana Republic and tuck it into the operations of J. Crew, which is run by Millard "Mickey" Drexler, Gap's former ceo. TPG's most recent deals include grabbing Harrah's Entertainment for $17.2 billion with Apollo Management, and buying Biomet, in a consortium of private equity firms, in a deal worth $10.8 billion.

  • Kohlberg Kravis Roberts, which has flirted with bids in the retail sector for the past two years, might lead a consortium to buy Gap Inc. Other possible members of the consortium could include Bain Capital, which partnered with KKR in the $21.2 billion deal for HCA last July, and the Blackstone Group, which partnered with KKR in the Biomet deal. Both Bain and Blackstone were said to be eyeing several retail and apparel firms over the past year, including Jones Apparel Group.

  • Banana Republic might be a good fit for Cerberus Capital Management, which previously picked up Mervyn's Inc., Rafaella Apparel Group and Sports Brands International (owner of the Fila and Ciesse brands). The private equity house could leverage some of its sourcing, operations and merchandising strengths from other investments with Banana Republic. But Cerberus, while on the prowl, has not made a fashion-retail purchase in a few years.
  • Given Gap's stock valuation; low, long-term debt, and strong operating cash flow, which is about $1.8 billion for the trailing 12 months, Edward Lampert, chairman of Sears Holdings and founder of ESL Investments, could make a run at Gap Inc. From Lampert's perspective, the retailer's huge cash flow could be diverted from paying dividends and making investments to making derivatives investments. Lampert tripled earnings at Sears Holdings, to $196 million, in the most recent quarter on a 2.1 percent sales decline, by making investments in derivatives. There was widespread market speculation last year that Lampert was eyeing Gap, along with Home Depot.
"The Gap is a big fix and for one this size, management would be a critical issue in a sale. Most equity groups would prefer to have a strong management in place when they buy a company, but there are some that would want to bring in new management for change," said one private equity executive. "Another issue is, this business has to be dramatically sized down. Gap has way too many stores. The most attractive thing about this company is the amount of cash flow it throws off."

And the equity in Gap's various brand names remains strong and those brands are internationally recognized. But as Emmanuel Weintraub of the consulting firm bearing his name said, "Gap has no or few hard assets."

Weintraub added that because of the work needed to restructure the different divisions, he believed a leveraged buyout would be at a market discount on the stock price, representing a take-under at possibly between $10 billion to $13 billion. Gap Inc.'s market capitalization is around $16.4 billion, and its enterprise value is about $15 billion.

"There is a broader issue on how specialty stores continue to reinvent themselves," added Christina Johnson, a partner and managing director of retail and consumer investments at NRDC Equity Partners. "Many of the small specialty formats that rose in the Seventies, Eighties and Nineties aren't working that well, such as the Gap, Limited, Ann Taylor and Talbots. The only one that is working is J. Crew. However, there is a whole generation of specialty stores appealing to a younger, more contemporary audience. H&M, Zara, Forever 21 — they're all working."(As reported in WWD Tuesday, there is speculation that Limited Brands might be considering a spin-off or sale of the group's apparel retailing operations, Express and Limited Stores.)

Mark Montagna, analyst at CL King & Associates, believes a Gap takeover is unlikely. "The hiring of an investment bank could be a positive for the stock. However, we do not believe a transaction will occur," he said in a research note Tuesday. "Transactions are never guaranteed and the negatives with Gap from a financial and strategic standpoint are quite onerous."

Jones Apparel Group hired Goldman Sachs last year to seek a possible investor, but the move resulted in a failed auction. Eddie Bauer Holdings Inc., which also hired Goldman, ended up being a take-under in which the purchase price was lower than the trading range of its stock.

Montagna added that Gap Inc. does not have the store growth opportunities that other acquisitions in its sector had. When Dress Barn purchased Maurices, Talbots' acquired J. Jill and Chico's bought White House-Black Market, they had room to grow. "A declining apparel brand is far more risky than a purveyor of steadily predictable revenue such as pet supplies at Petco or arts and crafts at Michaels."

Some market experts believe Donald Fisher, Gap's chairman emeritus and founder, could decide to take the company private, thereby eliminating investor pressures and public scrutiny.

But something must happen soon, observers predicted.

"Next year, things are going to get worse overall for Gap," Montagna warned. "The poor performance has actually accelerated. While Gap is still able to drive a lot of profit dollars to the bottom line, they have perpetuated a cycle of training customers to buy on sale. Effectively, they're a discount apparel retailer in the mall. Banana [Republic] is starting to head in that direction also. Gap needs to make a decision on what they should stand for."

Goldman Sachs analyst Margaret Mager on Tuesday reiterated her firm's "sell" rating on shares of Gap in a research note. "While there are numerous strategic options, at current prices the upside from here is limited. Beyond a buyout, the Gap could attempt to rationalize one of its units (e.g., Banana Republic) through a sale or public offering, or it could break the company up into multiple traded parts, but we see little hidden value in a breakup. We think a buyback or special dividend designed to return excess cash to shareholders is the most likely event," Mager wrote in her report.She also pointed out that the problems confronting Gap are structural and would challenge any management team, stating that a financial restructuring or even a sale of the company is not a panacea.

Standard & Poor's Ratings Services on Tuesday said that its ratings and outlook on Gap at "BB+/Stable/--" are not immediately affected by weak fourth-quarter sales, lower earnings guidance and talk that it might go private.

S&P said in a statement, "We had lowered the ratings to speculative grade on Nov. 17, 2006, due to the company's protracted record of disappointing sales and declining profits over the past two years, and had anticipated a weak fourth quarter. In response to the poor fourth quarter and the challenges each of its concepts face, Gap's management has announced they are reviewing their strategies for Gap and Old Navy. Although the company has not confirmed that it is looking at strategic alternatives, which may include going private, other sources have indicated the possibility. If a leveraged buyout develops, it would have a negative impact on the financial profile of the company and Standard & Poor's would place Gap's ratings on CreditWatch with negative implications."

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