Apparel retailer Gap Inc (GPS -0.46%) is already down 55% this year. All of retail is having a tough go of it. The S&P Retail Select Industry Index is down about 30%. Like many retailers, Gap has a glut of inventory, but it may have additional deep-seated issues that could persist. Let's take a closer look at where the inventory issue comes from, what other challenges the company is facing, and what all this means for investors. 

Inventory woes

Pandemic stimulus and near-zero interest rates fueled consumer demand in the U.S. from the second half of 2020 through 2021. Suppliers couldn't keep up, especially as the world dealt with continued shutdowns due to recurring COVID waves. This mismatch created bottlenecks in the global supply chain, slowing down delivery and causing shortages all over the globe. 

But, even as demand outpaced available supply, big buyers like Gap were able to get the inventory they thought they wanted. That all changed, though, when 2022 came around. Beginning in the first few months of the year, the Federal Reserve reversed its accommodative stance and began to raise interest rates to cool the red-hot U.S. economy. 

Two shoppers carrying bags down an escalator.

Image source: Getty Images.

That timing looks to have been perilous for Gap. By the end of its first quarter, the company had accumulated the highest inventory level in its history. To make matters worse, Gap has the added challenge of having to sell that extra inventory at a time when the Fed is attempting to curtail consumer spending. The task will be tough, especially considering that much of the first-quarter inventory likely included spring fashions that will be trickier to sell in the summer season.

Inventory issues aren't only affecting Gap, though. Early in June, Target (TGT -0.88%) warned its investors that it had too much inventory. The company said it would make additional markdowns, remove excess inventory, and cancel orders. After accounting for its inventory issues, Target management issued updated guidance, forecasting that the second-quarter operating margin would be about 2% -- down from the 5.3% originally anticipated in the company's first-quarter results. 

In its first-quarter report, Gap struck a similar tone, admitting that inventory levels were "quite higher" than management had hoped. In response to its overflowing inventory, the company slashed its full-year guidance for adjusted operating margin from a range of 6% to 6.5% to a range of 1.5% to 2.5%. Then things got worse. On July 11, Gap CEO Sonia Syngal stepped down without a permanent replacement. Management again cut operating margin guidance, down to a range of zero to slightly negative.

Deeper issues

While both Target and Gap are plagued with oversized inventories, the two companies are taking different approaches to solve the problem at hand. In a press release to investors, Target said it would mark down items, remove excess inventory, and cancel orders. Gap, on the other hand, told investors that it planned to hold inventory until next year. Holding inventory could be risky because fashions change rapidly and the excess inventory may not be in style in a year's time.

This approach appears especially worrisome as Gap has recently ventured into some other unsuccessful campaigns. For instance, Gap tried to add extended sizes to its repertoire last summer with the launch of Old Navy's BODEQUALITY campaign. Ultimately, the store was left with too much unsold extra-small and extra-large apparel and too little inventory in more popular sizes. In its first quarter earnings call, Syngal said that problems with this campaign, along with others at the Old Navy brand, were dragging down diluted earnings per share (EPS) for the 2022 fiscal year by approximately $0.90 and $1, but noted that the company expects to "rightsize the assortment" and have the issue resolved by the end of the year.

Gap also missed the mark this spring when the Omicron variant cases plummeted and shoppers focused more on social-focused clothing instead of the sweatpants and stay-at-home apparel that Gap had in stock. Syngal later admitted that the company was "defining customer trends too early" and suffered from "excess inventory" in "less relevant styles" as a result.

To account for these flubs, Gap's revised guidance now looks more conservative. But until a new CEO steps in and fills Syngal's spot, investors are left wondering if the company has a serious strategy to address recent managerial mishaps. 

Now what?

The effects of inflation are wearing on Gap's financials and impacting its brands differently. In the first quarter, net sales of $3.5 billion were down 13% across all brands compared to the same period last year. While higher-end outposts Banana Republic and Athleta both saw year-over-year increases in net sales, management cited inflationary pressures as a reason for Old Navy and Gap's struggles. Old Navy's $1.8 billion in net sales was down 19% compared to the year prior, while Gap's $791 million represented a year-over-year decline of 11%.

Inflation in May clocked in at 8.6% and again rose to 9.1% in June. If inflation persists or a recession occurs in the U.S., Gap may have a rougher road ahead than other retailers, and returning to profitability could prove elusive. With so many stocks being beaten down this year, long-term investors may have plenty of great opportunities. Gap might not be one of them.