More Than Just a Bad Patch at Gap

Rising debt and a falling credit rating are taking a toll

For the past couple of years, critics have lambasted Gap Inc. (GPS ) for its lousy fashion sense. But the naysayers may soon have something else to focus on: a balance sheet that's becoming increasingly threadbare.

The next two quarters will be critical for Gap. While no one yet expects the San Francisco-based specialty chain to file for Chapter 11 bankruptcy, as Kmart Corp. just did, there are enough red flags popping up--credit downgrades, increasing debt, and upcoming talks with nervous bankers--to heighten uncertainty about Gap's future. Says Conor D. Reilly, a bankruptcy partner at Gibson, Dunn & Crutcher: "If you asked everybody who follows retail to name five companies that could have serious problems in the next six months, I'd be shocked if Gap wasn't on the list."

CEO Millard Drexler has long expressed confidence that Gap will get back on the right merchandising track, which would do much to ease its financial ills. But Gap's holiday selling season was disastrous: Sales at stores open at least a year fell 11% in December compared with a year ago--when the chain's stores posted a 6% drop. Indeed, Gap has been posting declines every month since April, 2000. Meanwhile, an ambitious expansion plan and long-term store leases had made it hard to cut costs. The result: Analysts project a fiscal 2001 net loss of $22 million on $14 billion in sales, versus $877 million in profits last year on sales of $13.6 billion. That dismal performance has sent Gap's stock, which fell 57% in the past year, reeling.

To add to the gloom, Gap's long-term debt has ballooned from $780 million to $2 billion in the past year. Much of that was for new stores, but a big chunk--$700 million--was to refinance commercial paper. Gap's commercial paper was later downgraded, effectively shutting it out of that market. In the first three quarters of fiscal 2001, interest costs rose 60%, year-to-year, to $77 million. Like most retailers, Gap also carries off-balance sheet lease obligations. They total $5.5 billion through 2025. On Jan. 14, Moody's Investors Service downgraded Gap's long-term debt, to just above junk status.

That poor credit rating will make it tough to renegotiate a $1.3 billion bank credit line that matures in June. Without access to commercial paper, that credit line is crucial, but the bankers will be wary. "Now that Kmart has filed for Chapter 11, our concern is about the appetite that banks have to provide retailers in general with large credit facilities," says Moody's analyst Elaine E. Francolino.

Other measures of Gap's creditworthiness have also deteriorated. Its ratio of EBITDA (earnings before interest, taxes, depreciation, and amortization) to interest payments, a measure of how easily a company can cover those payments, was 5.4 last November--down from 8.3 a year earlier. Gap has $800 million in cash on hand, but as of the end of the third quarter it wasn't generating enough cash to finance operations and pare debt. Gap Treasurer Sabrina Simmons says that free cash flow in the fourth quarter will be positive, partly because Gap is cutting back on store openings.

Gap's expansion is a sore spot among credit analysts. Over the past few years, Gap added square footage at a rate of 13% to 31% a year and is piling on an additional 5% this year. "Who in their right mind would have expanded like the Gap in the face of such terrible results?" asks Howard Davidowitz, chairman of retail consulting firm Davidowitz & Associates Inc. But Gap may be coming around. It says it has signed no new leases beyond 2002.

So what's the best-case scenario? Gap's bankers, including Fleet National Bank and Wells Fargo (which either didn't return calls or declined to comment), will refinance its facility, but with higher interest rates or covenant restrictions that could include securing the line with inventory. "They'll have to give up something," says Gerald Hirschberg, an analyst at Standard & Poor's. Simmons acknowledges that terms for new bank credit will likely be harsher.

And as for the worst case? Well, that's something Gap doesn't want to even think about.

By Louise Lee in San Mateo, with Nanette Byrnes in New York

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