How Gap Could Climb Out of Its Hole


By Amy Tsao "Give a little bit. Give a little bit of your love to me." So goes the holiday jingle featured in Gap's latest ubiquitous ad campaign. How apt. The fast-growth retailer that Wall Street loved in the 1990s is trying awfully hard to rekindle the old flame.

Things sure have changed. Today, "it's awfully easy to hate this company," says Richard Jaffe, an analyst at UBS Warburg. Harsh words. But for the past 18 months, San Francisco-based Gap (GPS) has been disappointing the Street, mainly because it faltered on the most critical piece of the apparel-retail puzzle -- fashion. With so many competitors selling the kind of snappy casual clothes that Gap and its Banana Republic and Old Navy offshoots were famous for, the retailer decided it was time for a new approach. But the trendier offerings seemed to turn off mainstream shoppers. Now, the majority of some 29 analysts who cover the company have hold or sell ratings on the stock.

However, patient investors might want to look past the dismal news in the next several months and instead focus on how Gap will do next year, say a handful of analysts who recommend its stock. These Gap followers believe that the worst may be over for the retailer because the company is getting a handle on costs and inventory -- and has some appealing new fashions for fall 2002. The stock look cheap enough, trading around $13 a share -- the lowest since late 1997.

BRIGHTER FALL? Over the next 12 months, the clothing retailer will likely have to pull back even more on expansion plans, close underperforming stores, and shrink the size of its larger stores. Gap's management team, headed by retailing guru Mickey Drexler, has publicly acknowledged these weaknesses and the necessity to make changes. Even as many lament the company's recent decline, some analysts still have faith in Drexler's ability to turn Gap around.

"I believe in the viability of the brands and the opportunity in the next 12 to 18 months to demonstrate incremental improvement in results," says UBS Warburg's Jaffe. He expects the company's fall 2002 lines to show significant improvement from the too-trendy offerings that will still litter the shelves for most of next year. Jaffe says Gap's ability to tweak offerings to appeal to a broader population is probably still intact.

The past several quarters of fashion misfires have been hard lessons for Drexler. But Gap appears to have become more disciplined in ways that will help it get through a few more quarters of disappointing sales. "Into the late '90s, Gap didn't have much use for operational controls. But now that product is falling off, they do," says Kindra Devaney, an analyst with Fulcrum Global Partners.

TRIMMING GROWTH. Gap declined to comment for this article. The company, which operates more than 4,000 stores nationwide, used to stuff its shelves with inventory, but it has been paring back over the past year, Devaney says. Its balance sheet has become stronger, as cash flow has increased as less is spent on inventory. "Gap is healthier today than it was 12 to 18 months ago," she says. By some in mid-2002, she expects the stock to rise to her price target of $16 a share, a 23% jump from where it trades now, as sales at comparable stores (same Gap-owned stores open at least a year) improve and margins start picking up.

Gap also is addressing criticism that it has opened too many new stores. It's pulling back substantially -- to 5% to 7% store growth in 2001, from a previously promised 17%. The company expects similar growth in 2002. "They've been taking a look at the big stores and trying to maximize production and downsize their selling footage," Devaney says. Capital expenditures, mainly used for new-store growth, have also come down -- to about $1.1 billion this year, from $1.8 billion last year. Gap projects a $650 million capital-spending budget for 2002.

If Gap follows through on these plans, momentum in the stock could build quickly. As the biggest specialty-apparel retailer, with a market cap of $11 billion-plus, a lot of investors are waiting to jump back into it. "Obviously we're keeping an eye on it. I think it has the potential to be a really interesting story," says Angela Auchey Kohler, portfolio manager at Federated Investors.

HUGE DISAPPOINTMENT. She's not ready to buy Gap stock just yet, but she's encouraged by the company's ability to control inventory and its brand identities. Kohler says she's waiting to see one month of improved comparable-store sales: "That's all it takes for the stock to shoot up."

The going could still be rough in the near term. Gap's fiscal third-quarter sales, ended Nov. 3, were a huge disappointment, declining 17% at stores open at least one year, vs. an 8% decrease during the same period last year. The company's reported net loss for the quarter of $46 million before a special charge of $131 million was driven by a decline in gross margins and weaker sales. Compare that to last year's third quarter, when the Gap earned $186 million or 21 cents a share.

The fourth quarter, the most important for most retailers, will likely be ugly too, if November is any indication. Total sales for the month fell 14%, to $1.2 billion, compared with last year's $1.4 billion. On average, analysts are expecting Gap to lose 11 cents per share in the fourth quarter.

FOREIGN INVASION. Eric Jemetz, senior equity analyst at New Amsterdam Partners, wants to see a turnaround at Old Navy, the Gap unit that has slipped the most in sales, before he considers buying Gap stock again. He also wants to see that Gap can compete abroad and against international retailers moving into the U.S. For one, Swedish-based H&M, which has opened stores in the Northeast, will increase its presence in the states substantially in 2002. "We want to see [Gap] acknowledge that they have this competition coming," Jemetz says.

Will Gap be able to reverse its course? Some analysts think the jeans and casual-wear giant is on the right track to reclaiming its place in mass-market apparel. No, it's not a sure bet -- far from it. UBS Warburg's Jaffe, who rates the shares a buy, still cautions that the company is in a precarious position. "It's a high-risk gamble," he says.

But if Gap gets its fashion knack back and keeps costs under control, investors with a horizon of several years could be rewarded as the retailer gets back on its feet. Tsao covers financial markets for BusinessWeek Online in New York


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