Fitch Ratings said the laundry list of recent changes at Gap Inc. are “collectively of concern in regard to current and future business trends.”
The retailer has recently unveiled disappointing margin guidance, management departures and a $400 million term loan that will be used to buy back shares.
The debt watchdog said Gap’s “BBB-minus” rating reflect the retailer’s “strong free cash flow, expense management, and real estate discipline but are limited by its inconsistent success introducing new product lines across its brands.”
Gap stands at a critical juncture, just one level above noninvestment grade or junk bond status. If the company’s debts were downgraded, it would become more expensive for it to raise money.
Fitch noted that the company’s third-quarter gross margins are expected to decline by 300 basis points from a year earlier, following declines of 200 basis points in the second quarter and 100 basis points in the first quarter.
“While [year-to-date] declines are partially related to the strong U.S. dollar, Fitch believes they are the result of higher inventory-clearing markdown activity,” the rating agency said. “Weak margins highlight continued difficulty connecting to customers with compelling, trend-right fashion.”
Gap has also seen several high-level executive changes, including Old Navy global president Stefan Larsson, who decamped to Ralph Lauren Corp., and Banana Republic’s creative director Marissa Webb, who will now be a creative adviser to the brand.
“While Fitch does not expect significantly positive sales growth from any of Gap’s brands, a slowdown at Old Navy would have negative EBITDA [earnings before interest, taxes, depreciation and amortization] implications if the Gap branded stores did not improve concurrently,” the rating agency said. “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.”
As for the term loan to buy back stock, Fitch said it “generally views as negative a company’s decision to increase leverage during times of operational difficulty.”
Fitch stressed that Gap is expected to have “ample liquidity” and improving EBITDA, but said, “a worse-than-expected holiday or lack of sales momentum into spring 2016 could trigger a negative ratings outlook or downgrade.”
Fitch Solutions noted earlier this month that the departure Larsson at Old Navy division seemed to prompt a significant boost in the cost of insuring Gap’s debt from default.