Bear Stearns: Gap convertible offers attractive risk/reward profile

By Ronda Fears

Nashville, Tenn., March 11 - The Gap Inc. convertible offers an attractive risk/reward profile and gives investors who like the stock story an opportunity to get paid while waiting for the fundamentals of the company to improve, along with some downside protection and good liquidity, said Bear Stearns & Co. analysts.

Gap's 5.75% convertible bond due 2009 (Ba3/BB+) was trading on Friday at 110.25 against a stock price of $14 and a conversion premium of 27%. At this level, it offers a current yield of 5.2%, which is 460 basis points more than the underlying common, which pays a dividend yield of 0.63%.

"For investors who would like exposure to the stock, but who would like to be paid to wait while the fundamentals of the company develop, we propose the 5.75% convertible bond," said Yaw Debrah, head of convertible research at Bear Stearns, in the report.

"On a price appreciation and depreciation basis, the convertible is currently showing 70% movement with the underlying equity. When you couple this together with the high current yield of 5.2%, you get an attractive risk/reward profile. We estimate that for a 25% rise in the equity over the next year, the convertible will give you 75% participation, on a total return basis. On the other hand, if the equity was to drop 25% over the next year, we estimate that the convertible will only participate in about 40% of the equity loss."

Dana Telsey, retailing analyst at Bear Stearns, has an attractive rating on the shares. She believes that Gap is still struggling to find its balance in its merchandise assortment and target customer in order to return to full price selling. She continues to believe that Gap's superior real estate, brand equity, advertising power and competitive sourcing advantages could allow it to return to an improved level of operating margin performance, the convertible research report noted.

While Gap may never return to the heights of its mid-teens operating margins, a significant improvement in full price sell through could move the margin meaningfully. Telsey's 12-month target price for Gap is $15-$17 per share, which she believes arrives with consistent improvement in sales and margin trends. She believes that stock price movements can occur in turnaround stories with any signs of modest positive change.

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