Overview -- U.S. specialty apparel retailer Gap Inc. reported strong operating performance in recent quarters, with meaningfully increased operating margins and consistent, positive same store sales. -- We are revising our outlook on Gap to positive from stable. -- At the same time, we are affirming our ratings on Gap, including the 'BB+' corporate credit rating. -- The positive outlook reflects that we could raise the ratings if Gap continues its positive operating performance trend, with expanding margins and positive same store sales, warranting a change in our assessment of Gap's business risk profile. Rating Action On Nov. 20, 2012, Standard & Poor's Ratings Services revised its outlook on San Francisco-based specialty apparel retailer The Gap Inc. (Gap) to positive from stable. At the same time, we affirmed our ratings, including the 'BB+' corporate credit rating on the company. Rationale The rating on Gap reflects Standard & Poor's Ratings Services' assessment of the company's "fair" business risk profile and "intermediate" financial risk profile. Gap's business risk profile reflects our view of Gap's good market position in casual apparel, strong brand name, and geographic diversity. We also believe Gap has demonstrated some improvement in product merchandising and regaining customer traffic in recent quarters, as same-store sales turned positive in the first three quarters of 2012. Our analysis is tempered by the intensely competitive nature of apparel retailing. We also believe that specialty apparel trends will continue to be difficult to predict, and that Gap will remain vulnerable to changes in fashion. As a result, the company's performance could be uneven because of the timing of consumer buying and changing fashion trends. We expect margins to expand in the remainder of 2012 and in the first half of 2013, as commodity pressure eases and sales continue to improve. Following significant margin deterioration in fiscal 2011, primarily because of higher commodity prices (especially for cotton), margins have started to recover in recent quarters. As of Oct. 27, 2012, EBITDA margin for the last 12 months was 17.2%, comparable with 17.5% a year ago. Our forecast for the company's operating performance is as follows: -- Revenue rises modestly, reflecting flat to low-single-digit positive comparable sales and continuing unit growth internationally; -- EBITDA margins improve to about 18.8% at year-end 2012 and then to about 20% in fiscal 2013; and -- The company continues to generate solid free operating cash flows (FOCF) in the $900 million area in fiscal 2012 and we believe it will fund its shareholder initiatives primarily with FOCF. We view Gap's financial risk profile as intermediate, reflecting its consistent good cash flow generation and credit measures that are in line with an intermediate financial risk profile. As of Oct. 27, 2012, total debt to EBITDA was 2.1x and funds from operations (FFO) to total debt was 41%. We believe Gap' short average store lease tenor makes our adjusted credit ratios appear somewhat stronger than they would be if longer lease tenors were used. Still, we believe that credit metrics will improve moderately in the remainder of 2012 and in 2013, and remain in line with an intermediate financial risk profile. Liquidity Gap's liquidity profile is "strong," in our view. The company should be able to withstand substantially adverse market circumstances over the next 24 months while maintaining sufficient liquidity to meet its obligations. Our assessment of Gap's liquidity profile incorporates the following expectations, assumptions, and factors: -- We expect liquidity sources to exceed uses by 1.5x or more over the next 12 months. Even over the next 24 months, we believe the measure will remain above 1.0x. -- We also expect net sources to be positive, even with a 30% drop in EBITDA. -- Covenant compliance would also survive a 30% drop in EBITDA. -- The company appears to have well-established, solid relationships with its banks and a generally high standing in credit markets. As of Oct. 27, 2012, Gap had $1.7 billion of cash and ample availability under its $500 million revolving credit facility due 2016. The company's share repurchase activities have moderated in fiscal 2012, with year-to-date repurchases of $467 million, significantly less than the $2.1 billion in fiscal 2011. It generated over $800 million in FOCF in fiscal 2011 and we believe that free cash flow generation could rise above $900 million in fiscal 2012. Cash on hand, cash flow, and availability under the revolver provide adequate liquidity sources to fund the company's capital spending, dividends, and share repurchases. Gap's revolving credit facility contains financial covenants (leverage and fixed-charge ratios). It was in compliance with these covenants as of Oct. 27, 2012, and we expect covenant cushion to remain adequate. Recovery analysis For the complete recovery analysis, see Standard & Poor's "https://www.globalcreditportal.com/ratingsdirect/showArticlePage.do?object_id= 7041717&rev_id=6&sid=982065&sind=A&", published Dec. 15, 2011, on RatingsDirect. Outlook The outlook is positive. We could raise the ratings if Gap continues its positive operating performance trend, with expanding margins and positive same store sales, including the fourth-quarter holiday season. This performance could warrant a change in our assessment of Gap's business risk profile. We could revise the outlook to stable if the company is unable to maintain positive same store sales and margin expansion in the next several quarters. We could also revise the outlook to stable if the company adopts more aggressive financial policies--for example, if it increases debt by about $1.7 billion to buy back shares. Related Criteria And Research -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 Ratings List Ratings Affirmed; Outlook Action To From The Gap Inc. Corporate Credit Rating BB+/Positive/-- BB+/Stable/-- Ratings Affirmed; Recovery Rating Unchanged The Gap Inc. Senior Unsecured BB+ Recovery Rating 3 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. 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