(GPS) Gap Analyst Assigns Neutral Recommendation

We maintain our Neutral recommendation on Gap Inc. (GPS). Gap is one of the leading players in the highly fragmented specialty retail sector offering a diverse range of clothing, accessories and personal care products for men, women, children and babies. Its flagship brands include Gap, Banana Republic, Old Navy, Piperlime and Athleta. Gap’s globally recognized brands complement one another, enabling it to leverage its position in the sector.

Moreover, in a drive to boost international operations, Gap consolidated its foreign business under one division from London. Lackluster sales in North America compelled the company to explore markets overseas. In order to counter the domestic market saturation, Gap is aiming to generate 30% of total sales from its overseas operations and online business by 2013.

To achieve this end, Gap has opened stores in China, Italy and Australia and has launched its e-commerce business in more than 90 markets, which are expected to further strengthen its top- and bottom-line performance, moving forward.

To optimize its capital structure, Gap has entered into a new $500.0 million revolving credit facility maturing in 2016 with a syndicate of banks comprising BofA (BAC) Merrill Lynch, Citigroup (C) Global Markets and JPMorgan (JPM). The new credit facility will replace the existing $500.0 million revolving credit facility.

Moreover, the company will get a five-year term loan facility of $400.0 million. This will help in achieving the target of expanding its international presence.

Also, Gap has established a track record of conservative capital management and cash returns to shareholders in the form of consistent dividend payout and share repurchases. During second-quarter 2011, the company utilized a total of $820.0 million and $60.0 million, respectively, toward share buybacks and dividend payments.

On the flip side, Gap operates in a highly fragmented market and competes with national and local department stores and discount stores,American Eagle Outfitters, Inc. (AEO). and The TJX Companies, Inc. (TJX), which offer products at fire sale prices. To retain the existing market share, the company may have to reduce its sales prices, which could affect its margins.

Moreover, Gap’s business is seasonal in nature and generates a high proportion of sales during the fourth quarter, which is characterized by the crucial holiday season. The company ramps up its merchandise levels in anticipation of the season, exposing  itself to significant risks, if the season fails to deliver expected operating performance.

Besides, the international market exposure renders Gap vulnerable to currency fluctuation. The weakening of foreign currencies against the U.S. dollar may require the company to either raise prices or contract profit margins in locations outside the U.S. An increase in product price may have a direct impact on consumer demand.

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