Mind the Gap

In the enthusiastic advertisements for Gap Inc, the slender, trendy-looking models sing in cowboy boots, dance on ice skates or just go plain khaki-happy. But Gap executives have little to smile about these days, and shareholders don't find the company's recent results entertaining at all. Last week the company that sold America blue button-down shirts and khaki pants for years, reported a 6 per cent decline in second-quarter profit and warned for the fourth time in three months that future earnings won't meet analysts expectations.

In the enthusiastic advertisements for Gap Inc, the slender, trendy-looking models sing in cowboy boots, dance on ice skates or just go plain khaki-happy. But Gap executives have little to smile about these days, and shareholders don't find the company's recent results entertaining at all. Last week the company that sold America blue button-down shirts and khaki pants for years, reported a 6 per cent decline in second-quarter profit and warned for the fourth time in three months that future earnings won't meet analysts expectations.

This is the first time since 1996 that the retailer - parent of the Gap, Banana Republic, a preppy, casual line for twenty- and thirty-somethings, and lower-priced Old Navy chains - hasn't beat its previous performance. Profits fell to $183.9m in the second-quarter, or 21 cents a share, from $195.8m, or 22 cents per share a year ago. Sales in the quarter ended July 29 rose 20 per cent to $2.95bn from $2.45bn.

Shares of the retailer, based in San Francisco, hit a new 52-week low after the earnings shortfall was announced, and are down 41 per cent this year, losing more than $23bn in market value, after returning gains of 23 per cent, 18 per cent and 78 per cent in the previous three years.

Gap executives have also warned that if retail market conditions continue, its third-quarter earnings might fall to or below last year's level of 35 cents a share. Fourth-quarter results might also be at risk, says Heidi Kunz, the company's executive vice-president and chief financial officer. "We are in an uncertain retail environment," she says. "We do see risks." So what's exactly the problem? Like a bad mid-life crisis in full throttle, Gap went after the young. "When we get tricky, when we get young, when we get gimmicky at the Gap, we kind of lose it," says the Gap chief executive Millard S Drexler, known to the retail world as "Mickey".

Kurt Barnard, president of Barnard's Retail Trend Report in Montclair, New Jersey, says: "Every time Gap has tried to liberate itself from what made it famous - the blue jeans, blue shirt and things that went with it - it has failed." This year's roster of deviations included red leather pants at Gap Kids, shirts with asymmetric hems at Banana Republic and Hawaiian print T-shirtsat Old Navy.

Distribution problems at Old Navy, its quirky, low-priced chain, a management exodus, constant markdowns and strong competition only exacerbated the problem. Add to that damaging cocktail a slowdown in US consumer spending because of rising interest rates, and unseasonably cool and rainy weather in America that crimped spending on summer items, say analysts.

Gap's pursuit of young and trendy also took hold at Banana Republic, a chain designed to cater to office workers aged 26 to 36. But the spring collection featured items that were cut much slimmer and priced higher than before, another turnoff for consumers.

"The clothing seems more geared to the type of people you see in their ads," says William Dawson, 29, a frequent Banana Republic shopper from Queens, New York. And then there's the problem with severe discounting to move out merchandise. "One week I buy something for $50 and two weeks later its on sale for $10." The waning love affair consumers have with the Gap family of stores is reflected in the numbers. July same-store sales overall fell 1 per cent, below analysts' expectations of 5 to 7 per cent growth. Same-store sales were up 10 to 12 per cent at Gap domestic, flat at Banana Republic and down 17 to 19 per cent at Old Navy.

Industry watchers note that the handwriting on the wall began appearing late last year. Two years ago the popularity of khaki pants boosted Gap to 17 per cent growth in same-store sales. But analysts began to report that Gap Inc was cannibalising itself as Old Navy stole customers from the core Gap stores with lower prices for similar merchandise. This year the problems are across the company. From February through June, same-store sales for the core Gap stores and both its offshoots fell about 2 per cent from a year earlier.

But most industry watchers say the biggest culprit in this spate of problems is Old Navy. The company took a strategic risk, focusing on notoriously fickle teens at its Old Navy stores. Parents came in to shop for their children, but found nothing for themselves.

"We knew that appealing to teens at Old Navy would have its positives and negatives," says Mr Drexler. "Now we're feeling the negative. After five years of extraordinary growth, we're experiencing growing pains at Old Navy."

Last year, Old Navy was moving full steam ahead, showing double-digit same-store sales, while the Gap stores floundered. Sales at Old Navy stores open at least a year declined by about 8 per cent during May and June, and 1 per cent in July, compared with a gain of 2 per cent in the year-earlier period, according to analysts.

They say it was impossible for Old Navy to maintain its incredible pace of growth. "When you're one of the hottest things with teenagers, you can only get less hot or cool off," says Mr Drexler.

Retailers in general are struggling. Tommy Hilfiger, whose clothes were hot last year with urban youth, showed a profit decline in the latest quarter to $9.7m from $38.7m last year.

Analysts say consumers aren't spending as much on clothes, particularly at speciality stores. Six interest-rate increases by the US Federal Reserve since June 1999 has dampened shopping enthusiasm, and consumers say a lack of new fashions is also keeping them out of the stores.

Then, an inventory glitch at Old Navy caused shipments to come in one after the other, causing a backlog of stock that now has to be severely discounted and cleared out before the crucial back-to-school buying season.

More recently, competitors such as Abercrombie & Fitch and J Crew have moved in on the company's young domain. And while the Gap has said that store traffic is slowing down, retail analysts say traffic numbers at a handful of retailers including Abercrombie & Fitch are marginally higher than last year. Given that there are some signs of life at some retailers, analysts also question whether Old Navy is suffering from brand fatigue and could be losing its appeal, as did Tommy Hilfiger.

Though Mr Drexler has a reputation as a merchandising wizard, the recent series of missteps has some Wall Street analysts wondering if he can right the wrongs. Last week, Goldman Sachs removed Gap from its US Recommended for Purchase List.

And, as if temperamental teens, poorly timed shipments and competitive pressures weren't enough to deal with, Mr Drexler has also been battling management defections. Four top managers have left the company in the past seven months, including John Wilson, who was chief operating officer of Gap Inc, and Jeanne Jackson, former chief executive of Banana Republic.

Mr Drexler had taken on more responsibilities as executives exited the company. When Robert Fisher, son of the chain's founder, resigned last October as president of Gap stores, Mr Drexler assumed direct oversight of the chain and its product development in addition to overseeing the rest of the company.

His next strategy is back to basics. The Gap is unveiling a snappy new line of basic jeans, khakis, and shirts this month, representing a complete return to the Gap's original formula. But fashion experts warn that returning to plain vanilla clothes while the trend moves toward flashier looks could be damaging to Gap.

Instead of the usual minimalist fare, women are opting for more glamorous garments such as embroidered jeans and halter tops - items that just don't fit into the Gap formula. And discount chains including Target and Kmart are increasing their khaki offerings, posing more competition. Mr Drexler also promised a return to the old at Old Navy, which was originally positioned as a family store. "We have to get back to family and value," he says, hoping that adults won't leave the store empty-handed. That task may be harder than it sounds. Not only are teens fickle about fashion, but they don't usually want to shop where their parents shop.

To his credit, Mr Drexler has quieted his detractors before. Shortly after taking over the CEO spot in 1995, he bailed Gap out of another downturn by ramping up the rollout of the Old Navy chain and by refocusing Gap stores on more basic merchandise.

And while some analysts are quick to point out that the company is larger and more complex today, others are still optimistic.

"Gap gets credit for recovering a number of times in the past decade, and management gets a lot of credit for that," says Jeffrey Klinefelter, retail analyst at U.S. Bancorp Piper Jaffray. "In the fashion industry, it is very dangerous to have all your bets in one concept.

"We think one of the strengths of Gap is that Old Navy and Banana Republic will trend up one year; the next year, they'll be down and the Gap will be trending up. So investors can rely on a more consistent return." Undaunted and focused on the long term, Mr Drexler is continuing an aggressive expansion plan. The company has 3,284 stores, approximately 24 million square feet of retail, with plans to open more.

It opened 296 new stores in the first half of the year, increasing its square footage by 32 per cent. It will increase that by a further 30 per cent this year, opening about 700 stores. It expects to add 20 per cent more in 2001. But where? Since it's already in the choicest retail locations, busy shopping malls, it's unlikely to open in out-of-the way spots.

The company has also looked at expansion plans overseas. That could mean more Gap stores popping up on British high streets. "The popularity of Gap among UK consumers has been a major driver of our international growth," says Jack Dougherty, a spokesman for Gap. Executives told analysts there's plenty of room for expansion since several communities still have no Gap, Banana Republic or Old Navy. That kind of aggressive expansion helped boost profits by 37 per cent in the most recent fiscal year, to $1.1bn, on overall sales of $11.6bn, a gain of 28 per cent.

But the Gap has been unable to stage an encore performance of such successes. In fact, over the past five quarters, the rate at which Gap increased revenues dragged from 32 per cent to 20 per cent, and growth in store space rose from 22 per cent to 31 per cent. Analysts say that such high-octane expansion at this leg of the economic cycle can be dangerous.

Then Mr Drexler must woo Wall Street. If Gap's share price is any indication of Wall Street's vote of confidence, he has his hands full. The stock is lingering near $26, after bottoming out at a 52-week low of $25 in June. It once traded as high as 52 7/8 in early February.

Last Friday, he hosted a cocktail reception for the company's analysts at the Rainbow Room, a posh restaurant that sits atop New York's famed Rockefeller Center. The occasion gave Gap executives an opportunity to spread the Gap turnaround gospel to Wall Street analysts even as their stock tumbled.

"We see these as logistical and seasonal problems that can be corrected in the long-term," says Richard Jaffe, retail analyst at PaineWebber.

Mr Drexler is confidently increasing the number of weeks merchandise is displayed at full price before it is marked down, which could be a big turnoff for consumers. Though Gap would not reveal all their plans for the big back-to-school season, Mr Drexler indicated in a recent meeting with analysts that there would be more emphasis on work clothes, given the big move toward casual business wear in America. The men's collection is likely to be beefed up, with woven shirts and gaberdine pants. Banana Republic is expected to loosen its fit and return to more usual pricing.

Another leg of the strategic plan is to re-introduce Old Navy's best-known ad character, Carrie Donovan. Old Navy will also try to bring back parents and other adults with a new line called Old Navy Collection. At Gap stores, Drexler is pulling the plug on television advertisements until Christmas and is using a shop card promotion that give shoppers a coupon for $20 off when they purchase more than $100-worth of goods.

Does Mr Drexler have the magic touch to turn Gap around again? The company's greatest competition may be its own stellar record. Between 1997 and 1998, sales grew 57 per cent. Between 1998 and 1999, they were up 38 per cent. This year, sales are projected to increase only 19 per cent.

That poses a formidable challenge for Mr Drexler, who needs to return Gap to its previous glory and, for a change, give investors something to sing and dance about.