Gap: Back on Track?

Gap shows higher profits, sets another $1.5 billion in stock buybacks, and gets good reviews for its fall campaign. But will shoppers return?

by Ben Steverman

Gap (GPS) may be making a comeback, even if most of its target customers don't know it yet.

Shares of the U.S.'s leading specialty retailer were up 5.3% to $18.32 at midday Friday after the chain, which owns the Gap, Banana Republic, and Old Navy stores, announced second quarter earnings.

For investors looking for profits, the news was good: Gap reported earnings of 21 cents, vs. 15 cents a year ago and well above analysts' estimates.

Much of the profit increase was the result of cost-cutting at the Gap, especially at its corporate headquarters. In the first half of the year, Gap eliminated about 2,200 positions. That includes 550 jobs lost at its now-closed Forth & Towne chain.

Also, the chain raised its guidance for earnings in the rest of the year. That's welcome news in a time when other specialty retailers are cutting guidance amid worries that housing and credit issues could hurt consumer spending.

But investors will still have to wait for signs that Gap's once popular brands are winning back U.S. consumers. The chain's long slide in sales continued in the last quarter. Total sales were down 1% to $3.69 billion, while same-store sales fell 5%.

Gap's trouble in winning back customers has a variety of explanations. According to Standard & Poor's equity analyst Marie Driscoll, Gap's large size has made it tough for the retailer to adapt to changes in fashion trends. Gap's casual image hasn't fared well moving from the "casualization of the workplace" in the 1990s to the "recent period of heightened fashion sensibility," she wrote. (S&P, like BusinessWeek, is a unit of the McGraw-Hill Companies.)

Gap's turnaround plan includes, as Deutsche Bank (DB) analyst Gabrielle Kivitz summarizes it: getting "the product and environment right at Gap and Old Navy"; cutting costs by simplifying and streamlining operations; and recruiting the "right talent level with innovation and creativity."

Leading this effort is Gap's new chairman and chief executive Glenn Murphy, hired last month. He was previously head of a Canadian drug store chain.

"We have a lot of work ahead of us," Murphy said in a statement, "but we have great brands with enormous potential, and I feel confident that our creative talent and dedicated store employees will help fuel our progress."

Sales at Banana Republic stores were actually up 4% in the quarter, but sales at Gap stores were down 6% and Old Navy sales plunged 9%. International sales, just 10% of the total, were up 3%. The chain has been closing Gap stores but opening Old Navy and Banana Republic locations.

Several analysts seem to like Gap's new fall sales offerings, which it is calling the "Classics Redefined" campaign. Gap merchandise is more "age appropriate" and "shows significant improvements in quality," Needham analyst Christine Chen wrote Friday.

But will customers buy the new duds?

"It takes time to win back customers who have been disappointed for three years," Chen wrote. She added: "It will likely take at least a few more quarters of consistent execution and improved merchandise before customers are convinced that Gap is back." Expect the first signs of a turnaround in Spring 2008 at the earliest, she says. (Needham expects to seek banking business from Gap, and members of Needham's research staff own shares in the firm.)

Patience may be necessary, but there are signs of optimism, at least among the chain's executives. Gap announced late on Thursday that it would buy back $1.5 billion in stock. About $250 million will be purchased from members of the Fisher family, who founded the chain.

The "renewed share repurchase program signals management's growing confidence," Jefferies (JEF) analyst Timothy Allen wrote Friday.

And perhaps the stock will be revived if Gap's clothing catches on. "We believe [Gap] has limited downside and substantial upside potential, making the risk-reward attractive," Deutsche Bank's Kivitz wrote. (Deutsche Bank makes a market in and owns Gap stock and securities.)

Steverman is a reporter for BusinessWeek's Investing channel.