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Gap's Story Still Has Holes

Marc Lichtenfeld

Nine words spoken on Gap's (GPS Quote) conference call Thursday evening confirmed to me the company is nowhere near a turnaround. Despite management saying the right things in many instances -- more risk-taking in the creative area, reigning in expenses, etc. -- nine words fully explained the problem at the company.

The issue? The company doesn't know who its customers are.

Marka Hansen, the new head of Gap North America, was full of confidence and passion as she outlined the goals she fully expects the company's namesake brand to achieve. Early in the call, Hansen described the problems Gap ran into regarding its marketing. She discussed how the various marketing messages were confusing because they appealed to various target demographics.

That's when she uttered the nine words that told me Gap doesn't have anything figured out yet.

"... we haven't landed on a specific target customer today...," Hansen said. She told investors the target will lie somewhere in the 18 to 35-year-old range but will clearly not be the 18-year-old. OK, so now we're talking the 19 to 35-year-old range. Hey, that's a start.

Knowing your customer is vital for most businesses, but it is especially critical in the ultra competitive apparel industry. Chico's FAS (CHS Quote) and Coldwater Creek (CWTR Quote) are well aware that teenyboppers are not the ones spending money on Animal Craze Desiree Jackets. Abercrombie & Fitch (ANF Quote) designed its Hollister stores so that any 30-year-old would be sent scampering back to his cubicle from the scornful looks of the hip teens in the shop.

I also question Gap's decision to convert 45 Old Navy outlets into regular stores. Management said the outlets already have a mix of products including regular-priced merchandise, so it won't be such a drastic change for the brand. There will be a cost savings associated with the modification, as a distribution plant in Kentucky will be closed.

But with Old Navy traffic in the dumps, why would management want to take away a reason that people actually visit an Old Navy? There are some shoppers who love outlets. Bargain hunters hoping to find cheap merchandise at an outlet may be pleasantly surprised by what they see for full price at the store. But taking away the "outlet" tag will drive away some shoppers while doing nothing to attract new ones. If Gap were simply closing the locations, I would understand. But to convert them to what I have to believe is a less popular store is curious.

Interim CEO Robert Fisher spent time on the call detailing what has gone wrong over the years. One aspect he is trying to fix is a centralization of the company meant to control costs. However, Fisher said, it added a layer of bureaucracy that stifled the independence of the company's brands. Some areas, such as finance and IT will remain consolidated, but while the move makes sense, it reverses some of the cost efficiencies the company had hoped to institute.

The Bottom Line

I don't believe you can own Gap here. Taking a look at the top 23 ($1 billion-plus market-cap) apparel retailers, Gap trades in line on a price-to-earnings ratio and a forward P/E basis to its peers. However, its projected long-term growth rate of 11.14% (not including any analyst revisions over the past 24 hours) badly lags the average 17.05%. Gap's 1.89 price-earnings-to-growth, or PEG, is very rich compared to the average 1.3 times growth.

In order for its shares to become interesting, Gap needs to offer either a growth or value story. Right now, growth is out of the question, as the company stated that 2007 earnings will be lower than last year. At some point, Gap may become a growth story again, but for now we have to wait until it becomes a better value.

I don't believe Gap becomes a value play until it's trading at least in line with its peers on a PEG basis, which brings the stock down to about $14.50, and maybe even lower. Perhaps over the next year, a catalyst changes that formula. But until there's a reason to be excited about Gap's prospects, there's no reason to pay a premium. In fact, like its decreasing number of customers, you should demand a markdown.