Should Rule Maker investors be worried about the Gap (NYSE: GPS)?

Last week, the San Francisco company said it would miss second-quarter estimates, and the stock now trades near a 52-week low. We've also seen declining same-store sales at the company's flagship outlets and at Old Navy, its fastest-growing chain.

I'm not concerned with analyst estimates or the current stock price. Rising interest rates have made 2000 a tough year for retailers, and rivals such as The Limited (NYSE: LTD) and American Eagle (Nasdaq: AEOS) are struggling, too.

I don't really understand why investors in companies like Gap worry about rising interest rates and a slowing economy. Actually, I do understand it. It's just not sound reasoning, since it's short-term thinking. I don't want to see the economy growing 5% a quarter, since it's not sustainable. Better to throttle back growth to the 3% range, a good platform for steady progress. This is a marathon, not a 100-yard dash.

What about same-store sales? (Check out this primer on same-store sales in the Motley Fool Research area.) Some of the reasons for Gap's struggles aren't related to the market.

Mickey Drexler, Gap's chief executive, addressed it in the Q1 conference call. The company strayed from jeans, T-shirts, and khakis too far into the world of teen fashion. This won't get fixed for another quarter or two.

Keep in mind that bumps in the road are nothing new. Even as Drexler increased Gap sales to $11.6 billion in 1999 from $1.9 billion in 1990, boosted its total number of stores to 3,018 from 1,092, and increased sales per square foot to $548 from $438, the company faced plenty of challenges. Check out the volatility of Gap's comparable-store sales growth from 1989 through 1999:

Fiscal year     Increase in stores     Comps
   1989                  7%             15%
   1990                 14%             14%
   1991                 11%             13%
   1992                  7%              5%
   1993                  5%              1%
   1994                 10%              1% 
   1995                 11%              0%
   1996                 10%              5%
   1997                 15%              6%
   1998                 14%             17%
   1999                 22%              7%
The big dip occurred in 1993, 1994, and 1995. These were tough years, as Gap worked hard to control expenses, manage inventory, and introduce Old Navy, its highly successful discount store concept that helped position the company for rapid growth. Old Navy capitalized on consumers' sudden yearning for discount apparel. More importantly, it made discount shopping easier and less depressing than sorting through bins at traditional discounters.

The question is, what will Drexler have to do to put the flash back in Gap and re-ignite sales at Old Navy? In Q1, Gap's domestic stores and Old Navy reported negative sales growth. In 1999, growth at Gap outlets flattened. Weak sales at domestic Gap stores are a trend, while it's still hard to say what's happening at Old Navy.

In terms of fashion, marketing trends, and splash, I have no idea what the company should do, though I'd be happy to see it open fewer domestic Gap outlets until comps improve. Either way, it will be hard for Gap to increase its stores as rapidly over the next five years.

It's times like these I'm happy a guy like Drexler is steering the ship, since he's the one who turned Gap into a dominant consumer brand. For a great story about how he did so, check out this 1998 article in Fortune.

I am, however, unconvinced Gap can become as widespread a consumer brand as Coca-Cola (NYSE: KO), and yet that's Drexler's vision. It may be foolish to say this, since it took Coke more than 70 years to achieve this goal and Gap has been at it for less than three decades.

Nevertheless, this vision has driven Drexler to expand the Gap concept rapidly -- in smaller towns and in greater numbers than most people initially expected. It has worked great so far, but where's the ceiling? Investors should ask themselves when saturation will become a problem in the U.S. Are we already seeing it in flagging Gap comps? Others argue that Gap's ability to diversify with new concepts such as GapBody will keep it ahead of the curve.

Old Navy may hit a ceiling faster than Gap. Keep in mind how much bigger Old Navy stores are than Gap outlets. Gap outlets are built in malls, while Old Navy stores are warehouse-style facilities built in shopping centers. At the end of the first quarter, there were 1,812 domestic Gap stores and 546 Old Navy outlets. But, in terms of square footage, the two are much closer, with 10.6 million square feet of Gap space and 9.8 million square feet of Old Navy.

In addition, while Gap is the top brand in the traditional apparel industry, Old Navy faces very tough competition from companies like Wal-Mart (NYSE: WMT) and Target (NYSE: TGT). These companies may not have Old Navy's specialization or industry-specific brand name, but both are growing fast and understand the inventory management game. Wal-Mart is the top apparel retailer in the country.

Don't get me wrong, I think Gap is well-positioned to succeed in the long run. I'm happy it's part of the Rule Maker portfolio, since you could argue it's tougher to unseat a consumer brand king than a technology powerhouse. But, I'm very skeptical it will be able to beat the market over the next 10 years as easily as it has the last 10.

For a much closer look at Gap, check out analyst Bob Fredeen's report in the Motley Fool Research center. Also, Gap reports Q2 earnings August 10 and Zeke Ashton will take a look at the numbers Friday.

Your Turn:
Is Gap facing another turning point or just a bump in the road? Post your thoughts on our Gap Discussion Board.

Related Link:

  • Gap Warns and No One Panics, Fool News, 7/07/00