Gap on the Block

With Gap exploring its options, private equity looks to be a more likely bidder than many of its rival retailers

Gap shareholders have finally gotten what many on Wall Street have long awaited: some hint that the clothing chain could be hunting a buyer. But Gap's putting itself on the block is no guarantee that the long-troubled retailer can actually find an acquirer and start to turn itself around.

Shares of Gap (GPS) jumped 7.25% to $20.26 on Jan. 8 after cable channel CNBC (GE) reported that Gap had hired Goldman Sachs Group (GS) to pursue "strategic alternatives." Despite more than two years of lackluster financial performance that has recently worsened, Gap shares have remained relatively stable in the last few months in part because many shareholders have been hoping that Gap may put itself up for sale (see, 1/5/07, "Sales Gap at the Gap").

A Gap spokesman said the company doesn't comment on "rumors and speculation" and added the company "has a relationship with a number of top banks," including Goldman. A Goldman spokeswoman declined to comment.

Potential Buyers

For San Francisco-based Gap, the largest of the specialty-apparel retailers, finding a buyer could be a somewhat arduous task. It's highly unlikely that any existing retailer would want Gap, several analysts said. The major department-store chains already have their hands full with recent acquisitions.

The specialty-apparel chains likely would not want to assume a company as large as Gap, which as of October operated 1,338 Gap-brand stores, 514 Banana Republic locations, and 1,008 Old Navy stores in North America. "I have trouble imagining any other retailer wanting Gap," said Stifel Nicolaus analyst Richard Jaffe, who downgraded Gap shares to "hold" on Jan. 4.

If Gap were to find a buyer, that acquirer would more likely be a private equity or other investment firm. Those kinds of firms, groups such as Blackhawk Partners, Apollo Management, Cerberus Capital Management, and Texas Pacific Group, have been aggressively buying up retailers (see, 7/5/06, "Private Equity Takes a Shine to Retail"). Among the chains purchased by private equity firms in the last year or so are Burlington Coat Factory, Michael's Arts & Crafts, Linens & Things, and Petco. One of private equity's success stories in retail is clothier J. Crew Group (JCG), which was one of last year's highest profile initial public offerings.

Brand Decline

Some retailers who have found buyers to go private were growing companies with clear financial potential upside. But Gap is a shrinking company with a litany of so-far intractable problems that could frighten off suitors, analysts say. For starters, the company has virtually already saturated the U.S. market with stores.

At the Gap brand, despite a string of recent design and marketing initiatives, such as ads featuring Audrey Hepburn, sales have been dropping. At Old Navy, offering higher quality goods made of leather and silk hasn't helped sales. Companywide, profits have been declining. "The brands don't mean anything" to consumers, says Mark Montagna, analyst at C.L. King & Associates, adding that the Gap chain and Old Navy in particular these days have to discount merchandise heavily to attract customers. Any buyer would face the huge task of reconnecting with the chains' largely teenage and twentysomething consumers, both fickle markets.

Other company initiatives aren't having much impact. Gap recently launched an online shoe store and is cutting deals with foreign retailers to open overseas franchises. Gap's 268 existing overseas stores aren't translating well; so far this year, sales at stores in Asia and Europe have declined.

The company is also expanding Forth & Towne, a year-old chain of stores for boomer women. Sales at Forth & Towne, which operates about 20 stores so far, are barely a blip on the radar screen at Gap, which is expected to post 2006 sales of $16 billion (see, 9/20/05, "Forth & Towne: The Store's the Thing").

Plenty of Room for Improvement

Most recently, on Jan. 4 Gap announced worse-than-expected December sales, reporting a decline of 8%, including a 9% decline at the Gap brand and a 10% drop at the Old Navy chain. It also cut its earnings projection for 2006 and hinted at the possibility of high-level changes. "Given that we did not gain the traction we had expected, the management team, with the active involvement of our board of directors, is currently reviewing Gap and Old Navy's brand strategies," Chief Executive Paul Pressler said in a statement.

That board of directors includes Donald Fisher, Gap's founder; his wife, Doris; and his son Robert, who is Gap's chairman. The Fisher family controls about a third of Gap's 810.6 million outstanding shares. About a year ago, Donald Fisher publicly stated his support for Pressler to counter talk on Wall Street that the board was dissatisfied with Pressler's performance. Since then, as the company's performance has further deteriorated, Fisher hasn't made public statements about Pressler or Gap.

Amid the pessimism among many Wall Street analysts, some observers still have hope for Gap. "Even with its problems, they're still making $1.7 billion to $1.8 billion in EBITDA," said Gilbert Harrison, chairman of retail advisory firm Financo. "It has a lot of cash. I have a high respect for what it has achieved and believe that whatever its problems are, they will be fixed."

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