A Reality Gap

Gap reversed a string of same-store drops last year and is making improvements in some key areas. Still, the problems it created for itself in 2000 and 2001 can't be fixed overnight. Heavy debt, a huge store base, and new management create questions in shareholder LouAnn Lofton's mind about whether to cheer Gap's revival.

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By LouAnn Lofton (TMF Bling)
February 6, 2003

When Gap (NYSE: GPS) reversed its long and horrible same-store-sales slide back in October of last year, the buzz began that America's quintessential retailer was finally righting itself. Comps for October rose 11%, and for the third quarter, Gap saw a 2% comps increase.

Pretty sweet, right? Well, no. Come on, people! Gap's comps had nowhere to go but up after being buried for the last two years. And we're not talking just-barely negative numbers here, but double-digit negatives in 2001 on top of a string of 'em in 2000.

Ugly stuff... almost as ugly as some of the company's atrocious fashion miscues over the last couple of years. (Remember those fuchsia capri pants from spring 2000? I do, and I still get the shakes from those creepy West Side Story ads.) 

Hey, don't get me wrong. If anyone wants to see Gap return to its former glory days as a cute denim-and-khaki hawker, it's me. I've owned shares for nearly five years now, but I find the current optimism surrounding the company a little premature.

Gap lovin'
Let me give Gap some love, though, before I get into why I think it still has a long road ahead. A few things really have improved over the last year.

Fashion-wise, the company has gotten its old soul back. Gone are the trend-chasing duds that fell flat with shoppers. In their place are familiar denims, khakis, polos, and oxfords.

Gap's also stuck with its renewed goal of greater brand differentiation. It wants customers to associate Banana Republic with high-end apparel, full of luxe fabrics and beautifully tailored suits. Gap's the place for anyone and everyone to shop for classics. And Old Navy remains focused on clothes for the entire family at affordable prices.

On the advertising front, Gap seems to be finding its way, as well. The spring 2002 black-and-white campaign, with spots directed by the Coen brothers, Roman Coppola, and Cameron Crowe, was gorgeous. I dug the fall denim ads, too, but I admit ambivalence toward seeing my favorite cowpunk, Ryan Adams, crooning in them. The message, though -- "Gap: For every generation" -- communicated what I think the company wants to (and, indeed, must) get back to.

Gap's inventory situation has also vastly improved over last year. Remember when you could go into a store, find something you wanted, and then just wait for it to go on sale? Well, no more. Inventory per square foot was down 24% in the first half of fiscal 2002, as the company made a concerted effort to stop its previous inventory bloat.

In its most recent quarter, total sales rose 9%, while inventory levels dropped about 1%, year over year. Gap intends to increase its inventory more in the coming quarters now that it's again finding some merchandising traction. It's encouraging to see the company get a handle on this so margins can start improving. (And they have improved, with gross margins in Q3 up to 36% from last year's 29%.)

Gap has also shown restraint in expansion over the last year. Its store growth has slowed dramatically, and Gap predicts its net square-footage growth for fiscal 2002 to be around 3%. The company is focused now on fixing its existing stores, a merciful change from how it operated in 2000 and 2001.

Gap's challenges
With all the rah-rahs out of the way, let's get into my concerns about Gap now. There's been quite a management shuffle recently. I don't view this as inherently bad, but the clean-slate effect in top management creates a lot of uncertainty.

Former CEO Mickey Drexler's departure last year was a good thing -- of that I am certain. The thing about Drexler is he's a merchandising god, not an operational guru. He deserves his spot in retailing lore, but he and his team left Gap a mess, like a bunch of pocket Tees strewn about a dressing room.

After all, it was on his watch that Gap spent $4 billion between 1999 and 2001 to expand the store base 93%. All the while, comps tanked, and the company's debt load more than doubled.

Now, there's a new chief, Paul Pressler, who came from Disney (NYSE: DIS). He was head of Disney's theme parks and resorts division, and brings with him a focus on branding and operations.

John Lillie, who as vice chairman reported directly to Drexler, resigned in November. Heidi Kunz also recently resigned as chief financial officer. Byron Pollitt, who worked directly for Pressler at Disney, is taking her place. (Whew, you follow all that?)

There's no way to predict how the new management will shake out. Pressler says he wants to focus on branding and building customer loyalty, and will leave the merchandising decisions to the heads of the three store divisions. Will it work? Will Pressler fill the gap? We might have some idea after the company reports its fourth-quarter earnings later this month, as that will mark his first full quarter on the job. But still, this bears watching.

Further, and not to harp on the Drexler issue, but the company really is saddled with a load of debt -- nearly $2.9 billion worth. Moody's and Standard & Poor's think Gap's debt is weighty, too, as both lowered their credit ratings in May 2002 from stable to negative. Servicing that debt at higher interest rates is the result of those downgrades and is an increased drag on the business.

My biggest concern with Gap, though, is just how deep in the hole it still is. Thirty straight months of same-store sales declines can't be scaled quickly. And the giant store base hangs there like an albatross.

Yes, I realize the company posted a $0.15-a-share profit for the third quarter, versus a loss of $0.21 last year. I get that both total and same-store sales are inching upward. Comps will continue to do so -- it's hard to imagine them going any lower than they were.

But the fact remains that Gap had a bad fiscal 2000 and a wretched fiscal 2001. Digging out from under that is going to take a long time. The company didn't just slip up one quarter -- it slipped up over and over and over. Let's not get ahead of ourselves with the accolades.

Things aren't compelling on the valuation side, either. Shares are trading at a P/E of around 67 and an enterprise value-to-sales ratio of 0.99. If you're looking to invest in a retailer, many aren't operating under a cloud, like Gap, and are trading at better valuations.

I love a turnaround story as much as the next person, especially when I own shares of the company. Gap still has a long way to go, though. I want to be a believer -- really, I do -- and I hope the company shows me good things in the coming quarters. There's a lot to feel encouraged about so far, but it's a little early yet to step into the Gap.

LouAnn Lofton hates to be a party pooper. To see the rest of her holdings, click here, as part of The Motley Fool's super-cool disclosure policy.