Wachovia: Gap's stabilizing same-store sales could point to near-term credit stability

By Ronda Fears

Nashville, Tenn., Sept. 13 - Early signs of stabilizing same-store sales at Gap Inc. could be a harbinger of near-term credit stability, according to a report Friday by convertible analyst Sri Nadesan at Wachovia Securities.

"After 28 straight months of negative same-store sales figures, Gap Inc. appears to be showing some improvement in this key metric over the past three months. Although same-store sales figures continue to be negative, they were less negative in June, July and especially August," Nadesan said in the report.

"Although we do not think smaller negative same-store sales numbers are in themselves sufficient to change our previous cautious stance on the Gap convertible, the recent trends follow some changes in merchandise strategy, fiscal 2001's costcutting program, a reduction in inventory, drastically lower capex and a reduced store opening program."

August same-store sales were negative 2% versus negative 17% a year earlier. In July, they were negative 8% versus negative 12% a year earlier. And in June, they were negative 6% versus negative 7% a year earlier.

The company reported its merchandise margin rose in August, continuing an improvement seen in the fiscal second quarter, despite heavy promotional activity.

"If the trend in comp sales continues into September, October and the holiday quarter, some of the pressures on the company's credit rating would lessen, we believe," Nadesan said.

Currently, Gap's senior unsecured credit rating stands at Ba3 from Moody's Investors Service, BB+ from Standard & Poor's and BB- from Fitch. All three agencies have a negative outlook on Gap.

"The key to Gap's near-term credit direction is the company's same-store sales figures over the next few months. If they continue the trend seen in the past few months and actually turn positive, then we believe it is unlikely that the company would face a credit downgrade." Nadesan said.

"The company's current credit statistics are in line with a BB- type of senior unsecured ratings, in our view."

With $2.4 billion in cash and equivalents, $1.4 billion of available credit and manageable debt maturities, he said, Gap has adequate liquidity over the next year or so, even assuming the company has to close a few hundred stores in addition to those closed due to the non-renewal of leases. But the larger issue of the optimal size for Gap is still an open question, he added.

"The Gap 5.75% convertible bond due 2009 was quoted around 105.25 versus $12.14 on Sept. 12. At this level, the current yield is 5.5% and the conversion premium is 39.8%. The implied credit spread is about 720 bps," Nadesan said.

"We do not consider the convertible cheap on a hedged fair value basis, but the current yield and premium are attractive, and there is a reasonable chance that improving comparable-store sales could stabilize the credit for the near term."

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