GAP

Business Context and Reporting Period

Company: The Gap, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: August 2, 2003 (Second Quarter of Fiscal 2003)
Business Overview: The Gap, Inc. operates a global network of apparel and accessories stores under the Gap, GapKids, babyGap, GapBody, Banana Republic, and Old Navy brands. The company reported 4,230 store concepts and 3,095 store locations as of the period end.

Key Financial Metrics

Note: Total Debt includes Long-term debt ($1,528.6M) and Senior convertible notes ($1,380.0M). Current maturities of long-term debt were $0 as of August 2, 2003.

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 13% in the second quarter and 14% year-to-date compared to the prior year. Comparable store sales rose 10% in the quarter and 11% year-to-date, reversing declines seen in the prior year.
• Profitability: Net earnings surged 269% in the quarter and 341% year-to-date. This was driven by improved merchandise margins (up 0.9 percentage points in the quarter) and lower occupancy expenses as a percentage of sales.
• Expense Management: Operating expenses as a percentage of net sales decreased to 25.2% in the quarter from 28.2% in the prior year, aided by insurance recovery proceeds of $21.6 million related to World Trade Center store losses.
• Liquidity: Cash and equivalents decreased from $3.39 billion to $1.91 billion. This reduction was primarily due to $1.24 billion of cash being reclassified as "Restricted Cash" to back new letter of credit agreements.

Guidance, Outlook, and Risks

• Store Strategy: The company expects a net decline in square footage of approximately 2% for fiscal 2003. Plans include closing 90-100 store concepts and 75-85 store locations, with specific reductions targeted in Gap U.S. and Banana Republic.
• Capital Expenditures: Capital spending is projected to be between $300 million and $325 million for the fiscal year. Year-to-date spending was approximately $110 million.
• Interest Expense: Expected to be approximately $240 million to $245 million for fiscal 2003, down from $249 million in fiscal 2002.
• Tax Rate: The effective tax rate is expected to be approximately 39% for fiscal 2003, with a potential range of 38% to 40%.
• Debt Covenants: In June 2003, the company replaced a $1.4 billion credit facility with a new $750 million revolving facility and secured $1.2 billion in letter of credit capacity. These agreements contain financial covenants regarding leverage and fixed charge coverage ratios. Violation could trigger defaults and acceleration of debt.
• Legal Proceedings: The company faces various lawsuits, including class actions regarding wage and hour laws. Management does not believe current actions will have a material adverse effect on financial position.

Investor Verification Checklist

• Restricted Cash: Verify the impact of the $1.24 billion restricted cash balance on liquidity ratios and the terms of the new letter of credit agreements.
• Store Closures: Monitor the execution of the planned store closures (90-100 concepts) and the associated sublease loss reserves ($103.8 million remaining).
• Comparable Sales Sustainability: Assess whether the 10-13% comparable store sales growth across all divisions (Gap U.S., International, Banana Republic, Old Navy) is sustainable given the competitive retail environment.
• Debt Ratings: Track credit rating changes, as interest rates on $700 million of outstanding notes are variable based on the company's credit rating.
• Insurance Recoveries: Confirm the timing and finality of the $21.6 million insurance recovery proceeds included in operating expenses.