Fitch Ratings has affirmed the 'BBB-' Issuer Default Rating (IDR) for The Gap, Inc. (Gap). The Rating Outlook is Stable. The company had $1.4 billion of debt outstanding at fiscal year-end Feb. 1, 2014.
KEY RATING DRIVERS
The rating is supported by Gap's improved operating results over the past two years, strong free cash flow after dividends (FCF), and growth opportunities in its online business, emerging markets and newer retail concepts. These factors are balanced against its mature businesses in North America, declining mall traffic, and some underlying fashion risk.
Gap posted a second year of solid results in 2013, when comparable store sales were up 2%, following a 5% increase in 2012. This growth reflected strong customer response to the company's apparel offerings and healthy 21% growth in online sales offsetting weakness in the company's international results due primarily to declines in the Canadian Dollar and Japanese Yen.
Comp sales growth slowed to 1% in the second half of 2013, and will likely track at or near that level in 2014, driven by double digit growth in online sales (which is currently adding approximately 3% to the consolidated comp), and modestly negative store level comps.
Top-line sales will also be driven by square footage growth of around 2.5% in 2014, which represents the second year of expansion (0.8% growth in 2013) following square footage declines from 2008 - 2012 when the company rationalized its North American store base.
Expansion is focused in Asia and emerging markets, with the planned addition of 30 new Gap stores in China, 25 Old Navy stores in Japan, as well as 30 new Athleta stores in the U.S. Fitch expects Gap will continue to grow its square footage at a low single digit pace going forward.
Gap's gross margin rate declined by 40bps (basis points) during 2013, reflecting difficult competitive conditions in the second half, and particularly during the holiday season. This was offset by a 130bp reduction in the SG&A ratio as the company tightly managed its operating expenses. The result was a 90bp improvement in the EBIT margin to 14.0% from 13.1% in 2012, and Fitch expects EBIT margins will be relatively flat at around 14% in 2014.
Financial leverage (adj. debt/EBITDAR) was flat at 2.9x at year-end 2013, as growth in EBITDA to $2.7 billion from $2.5 billion in 2013 was offset by modestly higher adjusted debt levels due primarily to higher rent expense (which is capitalized at 8 times). Leverage is expected to be relatively steady going forward at around 3x as growth in EBITDA is expected to offset the impact of higher rent expense from international expansion.
Gap has maintained solid liquidity, with an unused $500 million revolver and cash and cash equivalents of $1.5 billion as of year-end, compared with management's stated cash target of $1.2 billion. In addition, the company generated strong FCF after dividends of $714 million in 2013. Fitch expects FCF to range from $700 - $800 million in 2014, and that it will be directed to share repurchases.
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.