2006 in Review: Gap

Many investors have long awaited a turnaround at Gap (NYSE: GPS  ) , but it just didn't happen in 2006. Rivals like American Eagle Outfitters (Nasdaq: AEOS  ) and Abercrombie & Fitch (NYSE: ANF  ) seemed to hold all the charm for consumers, while Gap continued to stumble around.

Let's start with Gap's fiscal fourth quarter, reported in February 2006. My Foolish colleague Seth Jayson dubbed it a dismal showing, with only an increased dividend to offset sales and margin declines, free cash down 20% year over year, and no sign of a turnaround in sight.

Gap's first quarter delivered more of the same -- net earnings down 17%, sales down 5%, and same-store sales decreasing by 9%. Seth rightly predicted that summer wouldn't fare much better.

The fiscal second quarter, in fact, led Seth to proclaim that Gap rhymes with something. (Take a guess.) Sales were flat, comps fell 5%, and margins continued to plummet. Seth voiced a common sentiment: For all its executive defection this year, maybe Gap still needs new management -- specifically in the CEO's chair.

That brings us to Gap's most recent period, the third quarter. Though I sometimes tire of beating up on Gap, I took a turn examining its earnings announcement. Net income fell 11%, sales were flat, and same-store sales fell 5%. Gap also cut its earnings expectation for the year (for the second consecutive quarter), and the company said it would lower its cash balance target to $1.5 billion from $2 billion in order to fund its business, increase its dividend, and repurchase shares. I thought that was a sorry consolation prize for the company's inability to turn itself around, but at least Gap investors are seeing a little bit of tangible benefit from that strong balance sheet people like to rave about.

As you might gather, several Fools think Gap's shown little proof of turnaround potential. (Others disagree; after all, Gap's been recommended by both our Motley Fool Stock Advisor and Motley Fool Inside Value newsletter services.)

Although yet another year has passed with more bumbling and little progress from Gap, its investors seem to be following an entirely different company. Gap's shares have increased 16.3% in the last three months alone (and 10.2% over the last year). Rumors are circulating that Gap might get bought up amid the currently trendy leveraged-buyout craze. That might save Gap shareholders from their current malaise, but it's also a pretty lousy hook for any Foolish investor's hopes, much less an investment thesis.

Clearly, I'm not crazy about investing in Gap. Let's see how it fares in the CAPS community:

CAPS Rating *

Total Bulls

118

Total Bears

107

Bull Ratio

52%

Bear Ratio

48%

Numbers as of Dec. 22, 2006.

There's a slightly higher percentage of bulls than bears, but not by a long shot. That dismal one-star rating probably reflects that nearly half of the All-Star CAPS players who have rated Gap expect it to underperform. I wouldn't say CAPS has handed Gap a landslide victory.

Most CAPS pitches on Gap appear to be from the bears, but I ran across one interesting bullish pitch from Nashhole:

"I think Gap is an underestimated player. Yes, I do agree with the negative statements made by others, saying that 'Gap is old and dying.' However, we must remember that this company is an INTERNATIONAL company. So far, all of the feedback I have read has been reflecting the market in America, not the rest of the world. I know that they have a large following in Japan. Japan is a culture that is constantly redefining itself. With every new generation, the ways of the old culture die more and more. For the most part, they are still a generation or more behind us. It is because of this that I think Gap still has some life left. Let us not forget the American culture that likes to imitate the Japanese culture."

Personally, I think Gap's lost its way -- and tarnished its brands to boot. It faces plenty of strong rivals for the younger and older demographic alike, with Ann Taylor (NYSE: ANN  ) , Talbots (NYSE: TLB  ) , and Chico's (NYSE: CHS  ) gunning for the latter. But Gap bulls see its strong balance sheet as a selling point, and they haven't given up on the power of its brands.

2007 should be an interesting year indeed, as investors see whether Gap can finally pull itself together -- and out of the doldrums. If it doesn't, it might face extremely unhappy investors, left wondering whether they're waiting for a turnaround that might never come.

Bridge the Gap with further Foolishness:

Check out the other companies featured in "The Motley Fool's 2006 in Review and 2007 Preview" special.

Our market-beatingMotley Fool Stock AdvisorandMotley Fool Inside Valueservices both selected Gap for their respective portfolios. To learn why, follow the preceding links to try either newsletter free for 30 days.

American Eagle is also a Stock Advisor selection.

Alyce Lomax does not own shares of any of the companies mentioned. The Fool has a disclosure policy.


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