Bear Stearns recommends Gap on recent sell-off

By Ronda Fears

Nashville, Tenn., June 25 - In light of the recent sell-off in Gap Inc. shares, Bear Stearns & Co. convertible analysts are recommending the convertible for exposure to the retailer.

The analysts suggest the 5.75% due 2009 with an 80% delta hedge for arbitrage investors.

"We are recommending the GPS 5.75% notes for the outright investor for its equity sensitivity and skewed risk/reward profile," said analysts Rao Aisola, Sarah Gallagher, Matt Hempel and Thomas Sugiura in a report Tuesday.

"For the swap investor, the option is a compelling value even at the distressed swap levels that GPS is trading at in the credit markets.

"The selloff in GPS over the last few months, in our view, represents a unique buying opportunity in one of the strongest franchises in apparel retail."

While the merchandising mix problems of last year were significant, the analysts said they believe The Gap has and is returning to the core merchandising strategy that made it a high flier in the 1990s.

Bear Stearns retail analyst Dana Telsey met with Gap management and noted the company is making small incremental steps to improve its merchandise assortment, thus increasing the chances for full price selling.

Recent initiatives such as cost cutting, better cash management and reduced square footage growth should be catalysts in driving operating margin going forward, Telsey said.

Telsey also said the merchandise assortment at Old Navy, Gap and Banana Republic seems very clear and discernible.

"Gap's superior real estate, brand equity, advertising power and sourcing advantage make it a compelling retail name," the report said.

"While we recognize the CEO overhang and potential execution issues, we are confident that GPS is returning to basics with a clear strategy that caters to a well defined audience in each of its divisions.

"While retail is traditionally weak through the summer, we believe now is an attractive entry point to gain exposure to this name given easier comparisons going into fall."

The analysts also pointed out that other retailers like AnnTaylor Stores Corp. have been through similar fashion misses but survived and rebounded by refocusing on their core strategy.

Bear Stearns has a price target of $19 to $20 for Gap shares.

The convertible is an attractive way to gain equity exposure, the analysts said.

Assuming 35% volatility in the stock and a spread of 500 basis points over Treasuries, the notes are a point cheap. As a reference, 100-day volatility is 54%, 12-month volatility is 62% with equivalent listed calls at 59% implied volatility.

However, the analysts noted that the default swap market is pricing in a 570 basis points spread over Libor, "which in our view is overdone." The analysts said, "at these enhanced spread levels, the notes model 3 points rich with an implied volatility of 40%."

With cash balance of $2.3 billion, long-term debt at $3.36 billion and $750 million maturing over the next two years, the analysts anticipate no liquidity issues for the firm despite the negative credit watch by the ratings agencies.

There are some key risks that need to be recognized and monitored, the analysts noted.

"Any delay in hiring a new CEO would create market uncertainty and lead to a sell off," the analysts said.

But the analysts said a possible ratings downgrade "is already priced into the market, and a one notch downgrade to BB could actually be a plus."

Gap convertible senior notes due 2009

Convertible Price: 115

Stock Price: $14.26

Conversion Premium: 30%

Conversion Price: $16.12

Current Yield: 5.0%

Yield-to-Maturity: 3.25%

Spread: 500 bps over Treasuries

Delta: 73.3%

100-day Vol: 54.65%

Call Price: 102.46

Years to First Call: 2.74

Credit Ratings: Ba3/BB+

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