Gap Rejects Junk Label as Swaps Beat Limited: Corporate Finance

A Customer Carries A Gap Inc Shopping Bag
Gap Inc. is poised to recapture an investment grade from both major ratings firms for the first time since 2006, credit derivatives show, as the biggest U.S. specialty apparel retailer posts its best sales in five years. Photographer: David Paul Morris/Bloomberg

Gap Inc. is poised to recapture an investment grade from both major ratings firms for the first time since 2006, credit derivatives show, as the biggest U.S. specialty apparel retailer posts its best sales in five years.

Credit-default swaps linked to the second-most indebted U.S. apparel company are trading at the lowest level in 15 months with an implied investment-grade rating of Baa3, one level above Standard & Poor’s junk ranking, according to Moody’s Corp.’s capital markets research group. Swaps on retailers have risen eight basis points on average this year.

Gap, which operates more than 3,000 namesake, Banana Republic and Old Navy stores worldwide, has seen a resurgence in its North American business as it boosts digital marketing, adds new executives and partners with top designers from Trina Turk to Diane von Furstenberg for exclusive collections. The cost to insure against default on Gap’s debt relative to bonds of Victoria’s Secret owner Limited Brands Inc. plunged 147 basis points since January, according to prices compiled by Bloomberg.

“The CDS market has recognized the significant improvement in Gap’s underlying risk profile,” Mark Pibl, head of credit strategy at broker-dealer Cortview Capital Securities LLC, said in a telephone interview. “A lot of it is merchandising; if you walk into a Gap store today, you’re probably going to buy something.”

Sales Rise

Revenue at the San Francisco-based company jumped 5.6 percent to $3.58 billion in the three months ended July 28 and by 5.8 percent to $3.49 billion in the first quarter, aided by merchandise from colored denim to jean shirts at the namesake brand and “desk-to-dinner” wear at Banana Republic. The sales figures were a five-year high for each period.

Same-store sales, which tracks stores open more than a year and online purchases, rose 4 percent in both quarters for the best first half since 2003, according to data compiled by Bloomberg. Gains in North America offset declines internationally, helping Gap’s recovery from a 4 percent drop in the year ended Jan. 28.

Investment-grade credit ratings are important to Gap as they “give us more operating flexibility in terms of everything we do with our capital structure,” Stacy Rollo, a spokeswoman for the company, said in a telephone interview. “The improvement in our operating performance has the greatest impact on our credit profile, so that’s our goal in the business.”

BBB rated bonds yielded 3.7 percent yesterday, Bank of America Merrill Lynch data show. BB rated bonds had a yield of 5.65 percent.

Risk Profile

S&P’s BB+ rating on Gap is one grade lower than the Baa3 from Moody’s Investors Service and BBB- from Fitch Ratings. Questions from clients prompted S&P to publish a report last week explaining its credit level.

The grade reflects the hazards of an intensely competitive industry where it’s difficult to predict fashion trends, even though the retailer’s financial risk profile is consistent with an investment-grade rating using metrics such as leverage, Helena Song, an analyst at S&P in New York, said in a telephone interview.

S&P demoted Gap to junk in November 2006, after the retailer reported its fifth-straight quarter of falling profit amid declining sales at its Old Navy unit and a $513 million debt load.

Gap’s Leverage

The company’s leverage, or ratio of total debt to earnings before interest, taxes, depreciation and amortization, was 2.4 times as of July 28, according to S&P’s Aug. 17 report. Gap had $2.1 billion of cash and related items as of July 28, Bloomberg data show.

S&P may upgrade Gap if the company maintains positive same-store sales with improving margins, including in the fourth-quarter holiday season, Song wrote in the report.

Credit-default swaps are showing that derivatives traders aren’t waiting. Contracts on Gap, which traded 95 basis points higher than those linked to Limited Brands on Jan. 20, have plummeted 125 basis points since then to trade 53 basis points below its Columbus, Ohio-based competitor, according to prices compiled by Bloomberg. It costs an average 422 basis points to insure the debt of retailers from RadioShack Corp. to Wal-Mart Stores Inc.

The swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Bond Yields

Gap was among retailers squeezed by record cotton prices last year that cut into profit. The company’s debt has rallied as cotton costs declined, with its $1.25 billion of 5.95 percent bonds due in April 2021 gaining 17.3 cents since Oct. 11 to 108 cents on the dollar yesterday, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Those bonds yielded 4.8 percent yesterday, Trace data show, 83 basis points less than the average 5.64 percent yield among BB rated U.S. debentures maturing in seven to 10 years, according to Bank of America Merrill Lynch index data.

While Gap’s stock is up 89 percent this year to $34.97 through yesterday, touching the highest since August 2000 earlier this month, derivatives traders waited for the second quarter to see margins improve and to get a better read on consumer spending, said James Lee, the senior high-yield analyst at Bethesda, Maryland-based Calvert Investment Management Inc. The firm manages about $13 billion. Shares rose for the first day in five to $35.13 at 11:56 a.m. in New York.

Gross Margin

“Gap has done a very nice job of turning around their operations,” Lee said in a telephone interview. “They’re selling more at full-price, and the big fear that they couldn’t contain their cotton input costs seems to be overcome.”

The company’s gross margin has improved to 39.7 percent in the past two quarters from 38.2 percent a year earlier, as the cost to make products declined and Gap was able to sell merchandise at higher prices, according to an investor presentation on Aug. 16. In the second-quarter, the rate rose 300 basis points, or 3 percentage points, to 39.9 percent, a “dramatic improvement,” according to Lee.

Chief Executive Officer Glenn Murphy, who joined Gap in 2007, has spent most of his tenure growing international and online sales and shrinking or closing stores at home. He began reemphasizing North America last year, which most recently generated 85 percent of the company’s $14.5 billion of annual revenue.

Digital Marketing

Gap has boosted digital marketing efforts by partnering with fashion blogs and has sponsored music festivals such as Lollapalooza and Bonnaroo in the U.S. to appeal to Millennial customers.

Last week, Gap said it hired U.S. designer Narciso Rodriguez as an adviser for Banana Republic. Earlier this year, the company hired back J. Crew Group Inc. executive Tracy Gardner for a similar creative advisory role at Gap and Nike Inc.’s Jill Stanton to work at Old Navy.

“A specialty apparel company like Gap is competing with everybody, they’re competing with department stores, other specialty apparels, discounters; it’s very competitive,” according to S&P’s Song. “They really have to have on-trend merchandise to attract and gain customer traffic.”

Gap cut its total debt to zero in 2009, returning to the bond market last year for the first time since 2002 with its $1.25 billion offering, Bloomberg data show. The debt has returned 16.6 percent this year, almost twice the average gains among high-yield retailers in 2012 through Aug. 22, according to Barclays Plc index data. Investment-grade peers have returned 5.3 percent.

“A lot of times agencies take a while to catch up to the realities of current credit metrics, and that seems to be what’s going on in this case,” James Goldstein, an analyst CreditSights Inc. in New York, said in a telephone interview. “They have investment-grade credit metrics at the moment.”

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