What Can Gap Do to Avoid Falling on Its Face?

Gap's monthly sales have been a roller coaster of success and failure -- is there anything it can do to smooth the ride out?

Jul 13, 2014 at 9:30AM

After a surge in popularity and a return to its roots in 2012, Gap (NYSE:GPS) has sputtered. The company's three major brands -- Old Navy, The Gap, and Banana Republic -- never seem to be quite lined up, and the company confirmed with its June sales report that the misfires are continuing. Comparable sales grew below the market's expectations and the stock took a small hit.

Gap's struggles have kept it from dominating the teen market in the way that seemed possible just a year and a half ago. Tighter wallets and more competition have certainly played their parts in the company's lackluster results. Does that account for Gap's high highs and low lows, or do we need some other explanation?

Gap's fundamentals remain strong
One reason I've always liked Gap is the strength of its management. Even in its current state, the company has held on to solid fundamental positions: Its debt-to-equity ratio is low, its cash on hand continues to give it flexibility, and it pays out a consistent and relevant dividend. With that solid foundation, the company has also felt comfortable taking on new businesses and trying new things.

Its most relevant supplementary brand is Athleta, Gap's answer to lululemon athletica (NASDAQ:LULU). As Lululemon has fallen apart over the last year, Gap has grown Athleta to take advantage of the market opportunity. The business, which had just 30 stores at the end of 2012, is on track to have 100 locations by the end of the year. That has given Gap a chance to jump on Lululemon's falling comparable sales, declining margins, and overall brand weakness -- all thanks to some sheer pants.

In short, Gap has all the pieces to be a consistent brand. It has a solid business backing a huge brand -- the 100th most valuable in 2013, according to Interbrand -- and an eye on future growth with Athleta. So why can't it hold it together?

Gap's failure in June
Looking at June's sales result, it's clear that something isn't right. The Gap and Banana Republic both had a 7% drop in comparable sales, while Old Navy managed a 7% increase. That's not a good overall position to be in. Across its brands, Gap's comparable sales fell 2%; the market was expecting a small increase, according to Thomson Reuters.

The market is the easy explanation for the problem. Wage growth in the U.S. has been stuck in the low single digits for years, causing parents to tighten their purse strings and leaving teen retailers out in the cold. Gap has fared better than some, but it's still not making waves. This is one of the rare cases in which the easy answer might actually be the right answer.

In a "normal" fashion cycle, companies rise quickly but fall relatively slowly. As new lines become popular, they jump up the ranks. Afterward, when the new hot thing is determined, there's a hangover effect. Latecomers will still move in and the brand will slowly die off. In the current setting, though, there isn't money available to support a falling brand. There's still a jump to popular brands, but the falloff is much sharper as brands flicker in and out of fashion.

Gap has been unable to keep all of its brands hot at any one time. Old Navy did well in April and June, but Banana Republic took the lead in between in May.

Gap's problem is consistency and its inability to smooth out its falls. To improve, it needs to do a better job of pre-emptively phasing in marketing and promotions to keep its falloffs smooth instead of sharp. If it can manage that, then it just might ride the highs of this current cycle without risk of bottoming out. All the pieces are there, it just needs to use them in a more consistent manner.

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Andrew Marder has no position in any stocks mentioned. The Motley Fool recommends lululemon athletica. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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