VINCE FARRELL
PRINCIPAL
SCOTSMAN CAPITAL MANAGEMENT

STOCK: Gap, Inc. (NYSE: GPS)
PRICE: $ 17.17 (as of 4 p.m. yesterday)
52-WK RANGE: $15.90-$22.70
MARKET CAPITALIZATION: $14.93 billion

Vince Farrell is a principal of Scotsman Capital Management. Gap Incorporated operates the Gap, Banana Republic, and Old Navy brands, and has more than 3,000 stores worldwide. Mr. Farrell spoke to David Dalley of The New York Sun and explained why he believes Gap is set for a comeback.

Gap’s performance over the last few years has been disappointing. What have they been doing wrong?
Gap is a retailer that’s fallen on some very hard times. It’s a big, well-known name that everyone’s given up on. They did a lot of store expansions in the late ’90s and accumulated a huge amount of debt. And even worse, they completely hit the wall on the merchandising side – they just had the wrong stuff on the shelves.

You’re a value investor. Why is Gap attractive from a value perspective?
One of the things that we look at is the P/E [price-earnings] ratio compared to the growth rate. The stock is currently trading at about 13 times estimated earnings. In the year just ended, they earned about $1.15 per share, which is down a few cents from last year. We expect a bounce this current fiscal year to $1.29 [i.e. an increase of just over 12%]. For a value investor, if your P/E ratio is within a coffee cup visit of your growth rate, that’s a formula for a very low-risk investment, and that’s what we like.

Why is it good for a stock to have a growth rate similar to its P/E ratio?
It’s just something we’ve found – that empirically, if the P/E and the growth rates are close, you get low volatility.

Why is now a good time to get in?
Gap’s current P/E ratio is basically the lowest it’s been for the last 10 years (apart from last year when it fell to 12 times earnings). We like that. We look for things that meet our fundamental criteria but that happen to be out of favor. It’s not really a contrarian view, it’s just about finding a good entry point.

What about management problems?
Over the last few years the company’s management has been financially very prudent. They’ve paid down almost all of the debt, which got to be over $3 billion, and they bought back enormous amounts of stock. Plus they’ve got terrific cash flow from the 3,000 stores. So fundamentally, the company is strong. Problem is, they still haven’t got the merchandising right, and the stock won’t do anything until they do. That’s key. They need to freshen up the stores, and they have to accurately figure out trends. Once they do – once they work out merchandising – we expect earnings to improve dramatically. And it comes down to the basics. They need denim not khaki on the shelves if denim will be attractive to consumers.

What are the risks?
Well, if the next comparison of same-store sales worsened, the stock would suffer. The other attack on my theory is to say that, okay, the management might be financially astute, but are they astute in merchandising? That hasn’t been proved, and that’s a risk. But merchandising isn’t rocket science, and I’m confident they’ll get it right.