Gut Check: Can The Gap Get Back on Track?

Not only is Gap(GPS) promising consumers a hip spring clothing line, but it's also promising Wall Street a complete makeover.

The Gap File

Current P/E: 24.5

52-Week Range: $53.13- $18.50

Change From 52-Week High: - 53.51%

Opening Price on March 6: $25.25

Source: Baseline, Morningstar

After achieving stunning growth in the mid- to late-1990s, the clothing retailer's recent sales figures have been disappointing. The Gap today reported that while February sales increased 8% to $784 million from a year ago, same-store sales -- a key benchmark that looks at sales at stores open for at least a year -- declined 11%, compared to a 4% increase in February 2000. This comes on the heels of a 12% decrease in same-store sales in January.

Given Gap's powerful brand and dominance as the No. 1 apparel retailer in the U.S., its proven ability to regain its footing after other fashion faux pas and a new slate of top executives, though, several analysts and fund managers tell Gut Check they believe Gap is fully capable of regaining its footing. Skeptics, on the other hand, wonder if the khakis king, whose stock declined 44.4% in 2000, has overextended itself and is headed for the same fate as The Limited(LTD), which was all the fashion rage in the 1980s but has had to close a quarter of its stores over the past six years.

Whatever side they're on, experts agree that for the Gap to even come close to its stunning 138.4% stock run-up in 1998 and 23.2% rise in 1999, the company will have to deliver exciting goods, improve same-store sales and grapple with inventory overhang. A cumulative 83% increase in the chain's square footage over the past three years was the primary driver behind the stock's tremendous ascent, they agree, but now that Gap has nearly saturated the country with more than 3,700 stores, it cannot continue to rely on a bigger footprint to perpetuate its average 26% sales growth of the past four years.

Gut Check on the Gap
Pros	Cons
With 3,700 stores, 6% market share and aggressive expansion plans, Gap is -- and should continue to be -- the No. 1 U.S. apparel retail chain.	Gap clothing failed to inspire shoppers in 2000, resulting in a decline in earnings of 22% and a decrease in same-store sales of 5%.
Gap's sales have grown an average of 26% over the past four years, against an industry average of 9%.	Gap sales growth slowed to 13% in 2000, and some believe this may portend the future.
Gap has promised that its new slate of key merchandising and marketing executives will turn things around.	The positions of product designer at Banana Republic and merchandising director at Gap -- Gap's two most critical positions, according to CEO Mickey Drexler -- are still open.
Source: The company, Lazard Freres, analysts.

GPS, which opened at $25 on March 7, may be 54% below its 52-week high of $53.13, but it still has a P/E of 25, vs. an average of 19.9 for other specialty retail stores. It also faces much stiffer competition from such casual dresswear and upscale sportswear retailers as Abercrombie & Fitch and AnnTaylor.

For shoppers to once again "fall into the Gap," the experts say, Gap clothes have simply got to become cool once again.

On the company's year-end earnings call March 1, CEO Millard "Mickey" Drexler told analysts that a failure to produce exciting clothes and to differentiate its three brands -- the Gap, Banana Republic and Old Navy -- turned 2000 into an "extremely disappointing" year. "The stores have been boring, unexciting and dull," Drexler said. "Even our marketing became a little tired."

Gap's net income for fiscal 2000 declined 22% from the previous year to $877.5 million and same-store sales fell 5%. Same-store sales could continue to be negative in the first half, Drexler warned. However, improved merchandise and lower prices should boost Gap sales in the second half of the year, he said.

Nevertheless, Donald Trott, an analyst with Jefferies & Company who has a hold rating on GPS, says GPS' year-end earnings call reaffirmed his view that Gap is "indeed, a troubled company."

Getting Out of the Gap The number of funds holding GPS has declined slightly in the past year.
Date	Number of Domestic Equity Funds Owning GPS	Percent of Domestic Equity Funds Owning GPS
Jan. 1, 2000	371 out of 2,648	14.0%
Jan. 1, 2001	312 out of 2,911	10.7%
Source: Morningstar

One of Trott's and other cynics' primary concerns is that Gap's three brand lines have been tripping over one another, possibly even stealing market share from one another. As Todd Slater, retail analyst at Lazard Freres, who also has a hold rating on GPS, puts it: "The Gap's mantra over the past year seems to have been, 'Let's be Banana Republic at a price,' and Old Navy's mantra has been, 'Let's be the Gap at a price.' The stores have been cannibalizing each other."

Another overriding concern of the skeptics is the Gap's expansion plans. The Gap increased square footage an aggressive 25% in 1998, 28% in 1999, 30% in 2000 and had planned to expand another 30% in 2001. But on the earnings call, Gap said it would trim that back to 17% to 20% in 2001 with an additional 550 to 630 new stores and to expand 15% in both 2002 and 2003.

"I think they are taking the right steps in bringing the square footage down," says Dan Prislin, portfolio manager of the (TPVIX)Transamerica Premier Value fund. With 3.66% of its $30 million of assets invested in GPS, this fund has the largest percentage holding in the Gap of any fund. Nonetheless, Prislin says, he will continue to keep his eye on Gap's expansion plans to make sure the chain doesn't overextend itself.

Slater, on the other hand, believes that even a 15% square-footage increase a year is too much Gap, noting that the typical clothing chain grows 6% to 7% a year against an average sales growth of 9%. Over the past three years, for example, Wal-Mart expanded its square footage an average of 6.7% and Talbot's grew by 6.6%, Slater says.

Slater points to one fundamental that could portend continued difficulties for GPS in coming months. The Gap's inventory yield -- or revenue divided by inventory investment, which is a reflection of margin and product turnover -- declined to 8.1% in 2000 from 9.2% in 1999 and 10.1% in 1998, Slater says. "This is the lowest and least productive level -- 23% lower than its peers -- since the Gap went public," he says. The last time Gap's inventory yield fell that low, to 8.2% in 1992, the stock underperformed the S&P 500 an average of 59% for three years from the beginning of 1992 through the end of 1994, he says.

Finally, Slater points to the tremendous departure of a number of top merchandising, marketing and advertising executives at Gap over the past year and the negative impact these vacancies have had on Gap's merchandise and sales.

The bulls, on the other hand, buy into Gap's staunch belief that with only a 6% market share of the extremely fragmented U.S. clothing market, there is tremendous growth potential for the chain's three lines for the foreseeable future.

GPS investors are also greatly encouraged by the creation of two new key jobs at Gap, a vice chairman and a chief marketing officer to oversee all three brands. With John Lillie now in place as vice chairman, CEO Mickey Drexler will be able to return to hands-on inventory and store oversight, says Pedro Verdu, director of research and an analyst on the (ILCAX)AmSouth Large Cap fund, which has about 1.6% of its $100 million of assets in GPS.

"After 30 years of following the retail business, I've learned that the head guy has to have his eye on what in the stores, what's moving and that it's all going in the right direction," Verdu says. Drexler is well-regarded in the retail industry for his merchandising touch, a belief a number of analysts have reiterated following GPS' most recent earnings call.

Minding the Gap These funds have made big commitments to the Gap
Fund	Total % of Fund	Date of Portfolio Report
(TPVIX)Transamerica Premier Value	4.66%	Oct. 31
(SRYIX)Stein Roe Young Investors	3.28	Oct. 31
(RYRIX)Rydex Retailing	3.05	Sept. 30
(KARDX)Kayne Anderson Rudnick Large Cap	3.02	Dec. 31
(ISTLX)Lepercq-Istel	2.55	Dec. 31
Source: Morningstar

"Gap has periodically gone through 12 to 19 month periods where they have lost their direction, like in late 1994 and early 1995," Verdu adds. But Gap recovered after that, and now, with virtually a new slate of talent in place, Gap should return to setting fashion trends, Verdu says.

Others say that Gap's existing, prime real estate almost ensures its success -- provided it gets the right merchandising mix. If there's one thing Gap has done well, it's been putting down stakes in highly trafficked areas. "Gap is primarily a mall-based store. The traffic is there. They just have to get them to walk through the door," says Jennifer Hanson, a research analyst on the (FIGCX)Firstar Growth & Income fund, which has 0.32% of its $800 million of assets in GPS.

Jonathan White, portfolio manager of the (FIEQX)Stratevest Large Cap Core fund, brushes off Gap's missteps in 2000 as simply part of being in the trendy, cyclical fashion business. "The problems in 2000 were not major concerns because these are recurring problems for companies like Gap, and those missteps ultimately make it a buy," says White of the stock, now trading 54% below its $53.13 52-week high. Stratevest Large Cap Core has 1.51% of its $42 million assets invested in GPS.

"Gap is a top-quality retailer that has an international franchise of considerable power," White concludes.

Fashion Victims These funds sold big stakes in GPS over the last year.
Fund	Shares Sold	Date of Portfolio Report
(FMAGX)Fidelity Magellan	4,000,000	Sept. 30
(JWGRX)Janus Adviser Worldwide	561,000	Aug. 31
(PWKAX)PaineWebber Strategy	535,000	Aug. 31
(JGORX)Janus Adviser Growth	255,000	Aug. 31
(FBALX)Fidelity Balanced	250,000	July 31
Source: Morningstar

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