Buyback Champion at a reasonable price?? - Gap Inc

GAP, Inc (GPS)

Highlights:

Asset Light Business: The Company has a net equity of $2.6 billion, produces $1.4 billion in annual free cash flow with a Return on Equity of more than 50% with a modest financial leverage.

Great Brand image: The Company owns brands like Gap, Banana Republic, Old Navy, Athleta, and Intermix.

Emerging Market Growth: The Company has franchise agreements and huge growth plans in emerging markets, especially in China. They are likely to fuel the revenues and cash flow growth.

Management: Incentivized/long tenured management in place to take advantage of the opportunities. Fisher Family owns more than 26% of the shares outstanding.

Market Price: The Company is selling in the market for 8 times of their current annual free cash flow which translates into 12% initial free cash flow yield.

Stock Buyback: The Company bought back more than 55% of their shares outstanding in past 10 years and 35% in past 5 years.

Dividend: The current dividend yield is about 3.3% with ~30% payout ratio.

Business profile:

Gap Inc. is a leading global apparel retail company which offers apparel, accessories, and personal care products for men, women, and children under the Gap, Banana Republic, Old Navy, Piperlime, Athleta, and Intermix brands. Portfolio of distinct brands across multiple channels and geographies gives them a competitive advantage in the global retail marketplace. In January 2015, The Company announced their decision to close the Piperlime brand due to the return on capital employed not being sufficient.

Revenue distribution by Geography and Brands ($ millions):

	2014	2013	2012
United States	$12,672	$12,531	$12,194
Canada	$1,137	$1,128	$1,095
Europe	$917	$891	$870
Asia	$1,502	$1,397	$1,310
Other	$207	$201	$182

	2014	2013	2012
GAP	$6,165	$6,351	$6,254
Old Navy	$6,619	$6,257	$6,112
Banana Republic	$2,992	$2,868	$2,890
Athleta, Intermix	$729	$672	$395

Selected historical Financials ($ millions):

	2014	2013	2012	2011	2010
Net sales	$16,435	$16,148	$15,651	$14,549	$14,664
Net income	$1,262	$1,280	$1,135	$833	$1,204
Total assets	$7,690	$7,849	$7,470	$7,422	$7,065
Stockholders’ equity	$2,983	$3,062	$2,894	$2,755	$4,080
Total long-term debt	$1,332	$1,369	$1,246	$1,606	$ —
Weighted-average number of shares	435	461	482	529	636
Cash dividends paid	$383	$321	$240	$236	$252
Earnings per share	$2.90	$2.78	$2.35	$1.57	$1.89
Operating Cash flow	2,129	1,705	1,936	1,363	1,744
Cash used for purchases of property and equipment	$714	$670	$659	$548	$557
Free cash flow	$1,415	$1,035	$1,277	$815	$1,187
Number of Company-operated store locations	3,280	3,164	3,095	3,036	3,068
Number of franchise store locations	429	375	312	227	178
Total number of store locations	3,709	3,539	3,407	3,263	3,246

The company has been growing revenues and profits nicely. The company is great at allocating capital by going through franchising business model in emerging markets, which essentially reduces the capital at risk. The number of franchised stores has been growing at 25% for the last 4 years. Online sales have been growing at double digits. They also have used their free cash flow to buy back their shares aggressively as the shares have been selling cheaply for last few years. The Company has bought back more than 55% of their shares outstanding in last 10 years and 35% in last 5 years. The shares outstanding are currently at 410 million as of June 2015. As of August 1^st, the company has $695 million authorized for share re-purchases.

Management & Partners:

Arthur Peck, 59, Director and Chief Executive Officer since February 2015 after Glenn Murphy; President, Growth, Innovation, and Digital division from November 2012 to January 2015; President, Gap North America from February 2011 to November 2012; Executive Vice President of Strategy and Operations from May 2005 to February 2011; President, Gap Inc. Outlet from October 2008 to February 2011;

Fisher family collectively owns about 107,500,000 (26%) of the shares outstanding. With their large ownership, as the famous saying goes ‘They eat their own cooking’. Eddie Lampert (Sears Holdings chairman) used to own 5% of the company and sold out as the share prices appreciated last year. Now, he is starting to buy again as the shares are in bargain territory. He owns more than 2 million shares now.

Valuation ($M):

Market Cap	11,400	Market Cap/ FCF	8.1
Net Debt	0	Interest Expense	75
Enterprise Value	11,400	Enterprise Value / EBITDA	4.6
EBIDTA	2,460	P/E	9.80
FCF	1,400	Interest Coverage	32.80

The company has ample cash interest coverage ratio (33 times) and it trades for 8 times the free cash flow.

Major shareholders:

Shareholders	No of Shares	Percentage
Fisher Core Holdings LP	107,500,000	26.22%
Vanguard Group, Inc.	16,283,881	3.97%
Goldman Sachs Asset Management, L.P.	14,089,987	3.44%
J.P. Morgan Investment Management Inc	11,305,884	2.76%
State Street Corp	10,773,611	2.63%
Glenview Capital Management LLC	5,994,495	1.46%
ESL Investments	2,057,403	0.50%

Potential Risks:

Ø  Miss on the fashion trends in one or more of their brands may threaten their free cash flow generation in short term.

Ø  Management/leaders of divisions leaving for better opportunities may cause temporary transition issue within the management.

Conclusion:

The company is a great cash flow machine relative to their assets and equity. Free cash flows are used to pay dividends and repurchase the shares as they don’t need lot of reinvestment in their assets to grow further. The company’s shares are selling in the market for 8 times the free cash flow, which yields about 12% shareholder return initially. The buyer of shares at these prices ($28/share) will be rewarded greatly in the long term ownership of this business.

Disclosure:

I / partnerships that I manage own shares of Gap Inc. This is not a recommendation to buy or sell above mentioned securities. Please conduct your own research to make any investment decisions.