Monday, January 08, 2007

A Word on Gap

The news was hard to avoid. As the markets were nearing the closing bell, CNBC dropped the bomb - that Gap had perhaps hired Goldman to pursue strategic alternatives. The ongoing prediction is that Gap, which has struggled recently, may go private and join the ranks of other retailers that have decided a sale to deep pocketed private equity players may be the best (and only) option. To be sure, CNBC reports that a Fisher family buyout could be viable as well.

The market, as can be expected, reacted quickly and deliberately. The stock was up about 7% today and traded up in the aftermarket.

On the face of it some of the numbers look somewhat feasible for a LBO to take place.

With about $2.5 billion in cash and only $513 million in debt, we're looking at about a $13.4 billion enterprise value franchise. Assuming a reasonable premium, you're talking a $14 billion deal (there was already a slight premium embedded with today's jump). This would be a large deal, but nothing that would cause the big players to get nervous about. Now suppose the buyer uses $3 billion in equity and the rest in debt to fund the transaction. With $11 billion in debt, we are talking over 5x EBITDA in terms of debt load (GAP had $2 billion in EBITDA last year. EBITDA has been declining every year for the last several years). So either a buyer would have to either put more skin in the game or assume that they will be paying junk-type rates on any debt . Now, Gap could conservatively make $1.2 - $1.5 billion in free cash flow next year, which, in theory should be able to swallow the interest expense from $11 billion in debt, but there isn't much of a cushion.

Of course the biggest question is how to fundamentally improve Gap's business, which has been on the decline for years? Could a new owner turn around the firm's business instead of just cutting expenses? It's tough to say, but it won't be easy.

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