Gap’s Intermix Buy Is No Reason to Go Short

by Will Ashworth | January 4, 2013 11:05 am

We’ve barely started trading in 2013, and already the acquisitions are flying off the shelves. First, Hormel (NYSE:HRL[1]) announced it’s buying Skippy peanut butter for $700 million. Then Gap (NYSE:GPS[2]) said it’s paying $130 million for Intermix, a bricks-and-clicks retailer of luxury goods. The deal takes Gap’s offerings to a price-point higher than its Banana Republic brand.

Does this deal make sense?

In mid-December, Gap announced that it was working on a partnership with Intermix that would allow the luxury retailer to benefit from Gap’s infrastructure and global reach. While no one was suggesting a buyout was imminent, in hindsight it does seem to make a lot of sense.

In fact,[3], which covers the business of fashion, believes this is only the beginning and that Gap is on the prowl for a significant acquisition beyond Intermix. That’s an interesting theory, but where would it get the cash?

I’ll get to that.

But first … Brian Sozzi, chief equities analyst for NPG Productions, appeared on Yahoo Finance‘s (NASDAQ:YHOO[4]) Breakout program[5] Thursday morning suggesting the acquisition is a telltale sign that Gap’s margins have maxed out. He recommends investors short its stock because the payroll tax hike is going to kill its business.

In fact, Sozzi trots out every reason under the sun why Gap is a short, including suggesting that it’s resorting to a stock buyback because it has no other methods available to improve its earnings.

Sorry, Brian, the buyback isn’t anything new. Gap has been repurchasing shares by the boatload since 2005. In the last eight years, it’s reduced its share count by 50% to 491 million. If that’s not enough of an argument against Sozzi’s case to short, might I remind investors that Gap continues to beat analyst expectations. CEO Glenn Murphy and his team continue to deliver the goods. I dare you to go ahead and short.

Now, back to the cash question. In the trailing 12 months through the end of October, Gap generated free cash flow of $1.37 billion. From that it has paid out $237 million for dividends and $550 million in share repurchases. That left it with $583 million to use as it pleased, which it did by repaying $400 million of its long-term debt while giving it more than enough to pay for Intermix. At the end of the third quarter it had $1.3 billion in long-term debt and $1.7 billion in cash.

Given Gap’s free cash flow generation, it should be able to carry out its entire $1 billion share repurchase authorization in 2013, along with its annual dividend payout, and still have $200 million available for debt repayment. In the trailing 12 months, it has paid approximately $91 million in interest on its debt. That’s just 5% of operating income. For Nordstrom (NYSE:JWN[6]) that percentage is around 12%. Gap can afford an acquisition worth billions.

If Gap has any looming problem, it’s somewhere else entirely.

It’s long been my belief that Old Navy is holding back the rest of its business. Just not in the way you might think. Its growth in revenue and operating profits has been more than satisfactory. The hiring of H&M veteran Stefan Larsson as its president in the fall confirms the brand’s global ambitions.

In the time Larsson spent at H&M, the business grew from operations in 12 countries to 44 with revenue of $17 billion. He’s an excellent choice to take the brand global. Up until July, Gap hadn’t opened an Old Navy outside the U.S. and Canada. It now has a store in Tokyo with more to come.

My objections with Old Navy have to do with real estate and price point. Despite having a similar number of stores as the Gap brand, it has 69% more real estate in terms of square feet. Even though the rent at Old Navy stores is generally less than those at the Gap, it’s a huge amount of square footage.

That in itself wouldn’t be a problem if Old Navy were an entity on its own. The problem is that Gap can’t lower its prices too far for fear of overlapping those at Old Navy. In difficult economies, Gap has less wiggle room in terms of promotional pricing without affecting its discount brand. Adding Intermix to the price-point continuum doesn’t exacerbate the problem, but it does put a spotlight on the need for Old Navy’s independence.

Trefis values Gap’s stock at $39 per share. It estimates that Old Navy accounts for 27% of that valuation[7]. Given the 491 million shares outstanding, I’ll assume that a starting point for any Old Navy sale would be at least $5.2 billion and more likely as high as $7 billion, considering its potential in Asia. That’s a lot of cash that would become available to build Gap’s remaining brands.

Alternatively, Gap could spin off Old Navy by issuing shareholders one share in the new company for every four held in the parent. Old Navy would be able to carry on with management already in place, and Gap could focus on some of its newer brands.

Even if none of this comes to pass, Gap’s acquisition of Intermix could hardly be considered fodder for shorts. Instead, most industry experts will consider it a shrewd move. I know I do.

As of this writing, Will Ashworth didn’t own any securities mentioned here. 

  1. HRL:
  2. GPS:
  4. YHOO:
  5. Breakout program:
  6. JWN:
  7. Old Navy accounts for 27% of that valuation:

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