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Magic Formula Stock: The Gap (GPS)

August 29, 2011 | About:
Paul Andrews

Paul Andrews

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The Gap (GPS) is one of the great retailing stories of the past 20 years. Starting with just one store in 1989, the Gap grew into one of the darlings of Wall Street, reaching almost $13.7 billion in sales and over $40 billion in market cap by the turn of the century. With their three famous brands (Old Navy, Gap, and Banana Republic), the best retailing CEO in the world (Mickey Drexel), and a fast growing international presence, it seemed Gap was ready to take over malls throughout the world.

But then something went wrong. The company started to stumble, growth slowed and then faltered, and Mickey Drexel was soon ousted. The company has ambled along for ten years, unable to figure out a strategy to fight off fast growing upstarts like Abercrombie & Fitch (ANF) or American Eagle (AEO).

Today, the company has about the same amount of revenue as it did ten years ago. Shares trade for almost 1/3 the price they did at the turn of the decade, and because of share repurchases they trade for almost 1/5 the market cap. Sounds like a company on the verge of death, right?

Not quite. The Gap is still generating huge cash flows, and cost cutting has caused profits to actually increase despite the stagnant sales. Combine the increase in profits with the long decline in the shares, and it’s no surprise that the company has managed to end up on the magic formula screen.

Valuation

So just how cheap is the Gap? EBITDA for the trailing twelve months have come in just under $2.35B. With a market cap of under $8.7B and a little over $500m in net cash, the company trades for under 3.5x EV / EBITDA. As a matter of fact, the Gap has averaged EBITDA of $2.13B over the past five years, so it currently trades for under 3.9x EV / average five year EBITDA.

Clearly, that’s incredibly cheap. It’s rare to find any company trading at those levels, especially a company with as long a history of profitability as the Gap. But just how cheap is it?

To answer that quickly, let’s take a look at its competitors. Two of their direct teen competitors, Aeropostale (ARO) and American Eagle, trade for between 4.5-5x EV / EBITDA. Both of those are suffering from the same sales weakness the Gap is. Two of their competitors who are faring a bit better, The Buckle (BKE) and Abercrombie, are trading for 6.75x and over 10.6x, respectively. In other words, the Gap trades for a moderate discount to even its competitors who are just as beleaguered as they are, and a huge discount to what it would trade for if it could finally turn itself around.

Returns on Capital

By now you probably agree the Gap is cheap. But maybe it deserves to be this cheap. Maybe it's like most Japanese banks, which trade at unbelievably low ratios because they employ huge amounts of capital at horrendous rates of returns and, despite the poor returns on capital, continue to plow almost all their earnings back into their business.

Nothing could be further from the truth with the Gap. Returns on capital have remained steady throughout the decade... Actually, they've been a bit volatile, but if anything, they've actually increased throughout the decade.

Currently, the Gap employs a bit over $8B in tangible assets. With trailing EBIT coming in at just under $1.9B, that gives it returns on capital of over 23%. In other words, even without adjusting for their huge excess cash balance, the Gap is generating returns on capital better than 75% of the S&P 500.

Catalyst

There could be a catalyst on the horizon for long beleaguered shareholders. There's been chatter about an LBO on the horizon for the Gap, and with private equity's noted interest in retail, the Gap's strong cash flows, and the Fisher family owning approximately 35% of shares, it's not hard to imagine that happening. A deal would likely have to come in at least in the mid-20s, a great pop for today's investors, and it wouldn’t surprise me to see a bidding war by LBO firms that could drive the price to the low 30s or even higher.

If you're looking for magic formula stocks with similar risk/return characteristics, then why not check out GuruFocus' own Microcap Magic Formula Newsletter. Each month, we find one undiscovered microcap with magic formula characteristics, do in-depth and detailed research, and add it to our microcap portfolio.


Rating: 3.1/5 (20 votes)

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