Banana Republic RTW Fall 2016

Fitch Ratings downgraded The Gap Inc.’s debt to below investment grade as the analyst lost faith in the retailer’s ability to stem the bleeding sales.

“We put the company on a negative outlook a couple of months ago with the thought they could produce flattish to slightly negative comps,” said analyst David Silverman, “The company has been slipping from that.”

Fitch dropped the default rating to BB+ from BBB- as Silverman laid out a laundry list of problems that Gap is facing and unlikely to resolve in the near term.

The sales declines just don’t seem to be letting up at the Gap. The fourth-quarter 2015 sales comps dropped 7 percent and then fell another 5 percent in the first quarter. “Gap’s outsized declines are an indication that customer loyalty is waning as product continues to disappoint,” said Silverman.

Fitch had assumed that merchandising changes made in 2015 would have shown up in 2016, but they have lost confidence in that happening. Fitch thinks that the best comps might be are a negative 1 percent to 2 percent by the fourth quarter of 2016 and then remain negative thereafter.

Gap hasn’t had the product at a price that shoppers want and as a result has had to resort to high markdowns. Old Navy had been the bright spot, but it succumbed to poor sales as merchandising issues did not inspire shoppers to spend. “The story for Old Navy is that it’s a promotional place, but starting last fall, everyone was promotional,” said Silverman.

Silverman had high hopes that Gap’s gross margins would improve, but that hasn’t been the case. “Gross margins have fallen from a peak in the 40 percent range in 2009-2010 to the mid-36 percent range in 2015,” said Silverman. He now believes gross margins could fall to the 35 percent level for the full year.

That Gap is relying on its real estate portfolio and cost reductions to protect earnings is a negative in Fitch’s eyes. While moving to close stores is a positive thing, the fact that the Gap is continuing to rely on these types of actions is a negative.

On the plus side, Gap has strong liquidity with an unused $500 million revolver and cash equivalents of $1.4 billion as of January 30, 1016. Gap still generated $500 million after dividends last year. That is expected to be directed towards repayment of the $400 million term loan due this year and share repurchases. Fitch doesn’t believe the company will need to tap its $500 million revolver.

Of course as bad as business seems, it could always turn on a dime. “At least with retail, there’s always next season,” said Silverman.

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