Fitch Affirms Gap Inc.'s IDR at 'BBB-'; Outlook Revised to Negative

NEW YORK--()--Fitch Ratings has affirmed the Long-term Issuer Default Rating for Gap Inc. (Gap) at 'BBB-'. The Rating Outlook has been revised to Negative from Stable. A full list of rating actions follows at the end of this release.

KEY RATING DRIVERS

The Negative Outlook reflects the continuation of weak operating trends across Gap's brands and Fitch's reduced confidence in the company's ability to drive flattish comparable store sales (comps) to resume EBITDA growth. Fitch expects 2016 EBITDA to be $2.1 billion, compared to $2.3 billion in 2015 and approximately 20% below the $2.7 billion peak in 2013. As a result of EBITDA declines, 2016 adjusted leverage is expected to trend in the 3.5x range, above the 3.0x range seen during 2012 - 2014.

Gap faces operating challenges both near term and long term. The company is struggling alongside other mid-tier apparel retailers, as the industry has seen sales bifurcated to higher-end aspirational brands and lower-end fast fashion and off-price channels. This industry challenge is exacerbated by a lack of a strong product cycle and Gap Inc.'s inability to connect with customers with compelling, trend-right fashion (particularly at the Gap and Banana Republic brands).

Over the past year, the company has fought through the additional headwinds of West Coast port labor disputes, a strong U.S. dollar, management departures and unsupportive weather patterns. Some of these issues should provide tailwinds in 2016 but the benefits are expected to be mitigated by further industry and internal fashion concerns.

Gap's 'BBB-' ratings have been predicated on a number of credit positives, including strong cash flow, expense management, and real estate discipline. The company has shown willingness to address its cost structure, real estate, and cash flow generation, most recently through 2015's closure of ~15% of North American Gap brand stores and 10% reduction in 2016 capex to $650 million.

The company is generally disciplined with regard to its capital structure, and as an example will pay down its recently issued $400 million term loan in 2016. Moreover, Gap has also been an innovator in omnichannel capabilities, which should support market share as shopping behaviors continue to change.

These positives, however, have been mitigated by Gap's inconsistent success introducing new product lines across its brands. Comps trends have been generally negative for the past two years, worsening to -7% in the fourth quarter of 2015. Weak comps have led to significant gross margin declines and a negative EBITDA trend.

KEY ASSUMPTIONS

Gap would need to achieve Fitch's base case assumptions, as follows, for us to stabilize the Rating Outlook and maintain an investment grade rating:

--Comp sales of negative 1% - 3% in 2016, and flattish beginning late 2017 and through the next several years. Revenue growth approximates comp sales due to lack of unit expansion.

--EBITDA declines from $2.3 billion (14.6% of sales) in 2015 to $2.1 billion (13.7% of sales) in 2016, reflecting SG&A deleverage on negative comps, and increases toward $2.3 billion thereafter.

--Annual FCF after dividends of $500 - $600 million, which will support the company's share repurchase program. In 2016 the company will use FCF and existing cash to pay down the $400 million term loan issued in 2015.

--Adjusted leverage is flat at around 3.5x over the next three years.

A downgrade would therefore be warranted if comps remain in the negative 1 - 3% range beyond 2016, resulting in EBITDA trending to $2 billion or potentially lower.

RATING SENSITIVITIES

To stabilize the Outlook, Gap would need to produce improving comps to the flattish level by the end of 2016, increasing confidence in EBITDA growth in 2017 towards the $2.3 billion to $2.4 billion range.

Future developments that may, individually or collectively, lead to a negative rating action include EBITDA deterioration to the $2.0 billion range or a more aggressive financial posture, yielding sustained leverage above the mid-3.0x range.

LIQUIDITY

Gap has maintained strong liquidity, with an unused $500 million revolver and cash and cash equivalents of $1.4 billion as of Jan. 30, 2016. The company generated FCF after dividends of $500 million in 2015 and Fitch expects FCF to range from $500 - $600 million annually over the next three years. Fitch expects FCF to be directed towards share repurchases, and in 2016 the repayment of the company's $400 million term loan issued in 2015.

The company may also use some of its excess balance sheet cash for share repurchases, but is nonetheless expected to retain sufficient cash to handle its seasonal working capital needs without having to tap its $500 million revolver.

FULL LIST OF RATING ACTIONS

Fitch has affirmed Gap Inc. as follows:

The Gap, Inc.

--IDR at 'BBB-';

--$500 million senior unsecured revolving credit facility at 'BBB-';

--Senior unsecured notes at 'BBB-'.

The Rating Outlook has been revised to Negative from Stable.

Additional information is available on www.fitchratings.com

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form
https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1000115

Solicitation Status
https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1000115

Endorsement Policy
https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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Contacts

Fitch Ratings
Primary Analyst
David Silverman, CFA, +1-212-908-0840
Senior Director
Fitch Ratings, Inc.
33 Whitehall St.
New York, NY 10004
or
Secondary Analyst
Monica Aggarwal, CFA, +1-212-908-0282
Managing Director
or
Committee Chairperson
Shalini Mahajan, CFA, +1-212-908-0351
Managing Director
or
Media Relations, New York
Elizabeth Fogerty, +1-212-908-0526
elizabeth.fogerty@fitchratings.com
Hannah James, + 1-646-582-4947
hannah.james@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
David Silverman, CFA, +1-212-908-0840
Senior Director
Fitch Ratings, Inc.
33 Whitehall St.
New York, NY 10004
or
Secondary Analyst
Monica Aggarwal, CFA, +1-212-908-0282
Managing Director
or
Committee Chairperson
Shalini Mahajan, CFA, +1-212-908-0351
Managing Director
or
Media Relations, New York
Elizabeth Fogerty, +1-212-908-0526
elizabeth.fogerty@fitchratings.com
Hannah James, + 1-646-582-4947
hannah.james@fitchratings.com