Gap Still Has Holes to Fill

Last week Gap (GPS - commentary - Cramer's Take) made news when, after a four-month search, it named Paul Pressler, chairman of Disney's (DIS - commentary - Cramer's Take) theme parks and resorts, as its new chief executive and president. Pressler succeeds Millard "Mickey" Drexler, who said in May that he would retire once his replacement was hired.

During the 1990s, Drexler seemed to know just what consumers wanted in casual clothing, and the San Francisco-based retailer of oxford shirts and khaki pants posted consistent growth in sales and earnings.

But net income peaked at $1.1 billion in 1999, and it's been downhill ever since. For the latest fiscal year, Gap lost $7.8 million on $13.8 billion in revenue. On Tuesday the stock closed at $10.11, off 70% from its high.

So now that Gap is under new management, do you buy this fixer-upper?

Financial Risk

My first step -- always -- is to estimate the debt repayment period, or DRP. The DRP is the number of years a company needs to repay debt and debt equivalents based on its current level of enterprise defensive profits. In Gap's case, net debt is $3.6 billion, including capitalized operating leases, and enterprise defensive profits for the four quarters ended Aug. 3, 2002, totaled $827 million.

With a DRP of four years, Gap's financial risk appears modest. However, I believe the company's performance over the last four quarters' performance isn't sustainable, at least in the short term.

First, capital spending is $540 million, while depreciation is $817 million. Generally, capital spending and depreciation offset each other, which means capex has to rise or depreciation has to fall to reach equilibrium. Either scenario reduces Gap's free cash flow.

Second, Gap's working capital has dropped by $300 million in the last year. Although a negative investment in working capital is a good thing because it's a source of funds, it's generally not a recurring item. (A notable exception is Dell (DELL - commentary - Cramer's Take), which for many years financed its robust sales growth on the backs of customers and vendors.)

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Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].