Wachovia analyst says use caution on Gap

By Ronda Fears

Nashville, Tenn., May 23 - With much-needed turnaround efforts still under way, the resignation of Gap Inc.'s top executive puts a wrench in the works. Thus, Wachovia Securities convertible analyst Sri Nadesan warns investors should use caution.

Traders said there was a small amount of buying in the Gap 5.75% convertible due 2009 early Thursday, after the bonds had fallen some 12.5 points Wednesday on the news that Millard Drexler was leaving the CEO post at Gap.

Gap's convert was quoted up 1.25 points at 112.125 bid late in the session, with the stock at $13.82. The Gap shares were also rebounding, and closed up 30c to $13.85.

"For the next couple of quarters, given that they have adequate liquidity, the credit should hold up," Nadesan said.

"But they have a lot of things to do. On top of everything else, they are faced with finding a new CEO. That should make people, including bond investors, cautious."

The uncertainty at the top could lead to a more extended recovery process for the retailer.

During a conference call Wednesday to explain his resignation and assuage investor concerns, Drexler insisted that his decision to resign was a personal one and that the company's turnaround was "around the corner." He said fall and holiday merchandising decisions have been made and the company has made a lot of progress in fixing its problems.

Drexler said he will stay "until a new CEO was found" even if that ends up taking a year.

"It sounded to us that he is committed to staying at least toward the end of 2002 or until the new CEO is found," Nadesan said in a report Thursday

Drexler, who does not have a non-compete agreement with Gap, said he does not have any specific plans on his retirement even though it sounded as though he wanted to be a merchant again without the responsibilities that come with being the CEO of a large retailing and apparel company.

"We are cautious about the implications of the CEO's departure on Gap's recovery plan coming as it does at what we think is a critical time for the company," Nadesan said in the report.

"We believe it is likely to cause delays in what Gap needs to do to 'right-size' the company, improve merchandise selections, reduce costs and reduce inventories."

The company's insistence that it does not see the need to close stores and, thus, reduce store square footage even in the face of horrendous same-store sales declines "strikes us as unrealistic and will likely postpone the company's eventual recovery until such time that the company gets serious about rationalizing its size," Nadesan said.

"I think the company is in a little bit of denial about what it's going to take to turn this company around," he said.

The company's current cash and equivalent balance of $2.3 billion gives it some breathing room. But Nadesan feels the company needs to close stores and that inventory cuts help but won't go far enough.

It appears the company's current valuation appears to discount a substantial part of the expected recovery, for which success is still uncertain in terms of timing, Nadesan said in the report.

"The stock is discounting a recovery," he said. "I'm not sure the current valuation is a little bit ahead of the turnaround."

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