Mind the Gap: Why to Avoid Buying Shares of the Troubled Retailer
It has been a dismal year for apparel stocks, as a never-ending list of woes plague the sector.
Stocks plunged as companies missed their already-conservative analyst estimates for the first quarter, citing myriad reasons including unseasonably warm weather, increased competition and the continuing rise of e-commerce superstar Amazon.
And then came the Brexit, which has given a solid pounding to practically every sector of the market.
Apparel retailers have been hit hard by the surprising result of the U.K.'s referendum vote. The S&P 500 Apparel, Accessories and Luxury Goods Index, which consists of seven stocks -- Coach,Hanesbrands, Michael Kors,PVH, Ralph Lauren, Under Armour and VF -- lost its year-to-date gains almost immediately.
This downbeat trend has investors looking for any bright spots in the sector. So when Gap (GPS) - Get Report announced an improvement in same-store sales in June after a 14-month losing streak and expectations of a decline, many came rushing in, grabbing shares with both hands.
The stock soared by more than 5% during on Friday as investors placed bets on an imminent turnaround for the company and perhaps the apparel sector as well.
But investors shouldn't be too hasty.
One month of better sales is certainly an improvement, but Gap hasn't proven that this is sustainable. In fact, it may actually take years for this company to correct one of its biggest problems.
Sales online and at stores that had been open for at least a year increased by 2% in June.
The rise was led by Old Navy, Gap's low-price apparel brand, which accounts for 40% of the company's business. Old Navy saw a sales gain of 5%, compared with forecasts for a 3.3% drop.
Although the two other brands belonging to the company still saw declines in sales -- Gap by 1% and Banana Republic by 4% -- these decreases were better than the expected 2.6% drop for Gap and 10.3% decline for Banana Republic.
However, as Credit Suisse analyst Christian Buss pointed out, Gap uses an outdated pricing strategy that could hold the company back.
Simply put, Gap's merchandise is too expensive.
The company relies on a traditional pricing structure that builds a year into each piece of clothing, from design to final clearance sale. Then the company keeps a schedule of markdowns from that original price.
Each design is basically a one-year bet. However, newer discount retailers such as Sweden's H&M work at a faster pace, bringing goods in and out the door quicker with less mitigated risk and at far cheaper original tag prices.
For Gap to modernize its business to keep up with these less-expensive retailers, it would need to overhaul its supply chain process, which would be costly and time consuming in and of itself.
Can Gap afford such a makeover? Maybe not in this difficult environment.
So remain cautious on Gap. Time will tell whether the recent uptick in sales was due to consumers returning to the retailer's mall stores or if it was a one-month fluke sparked by an agreeable combination of sales and the need for cheap Old Navy flip-flops.
Until then, hold off on jumping into the buying frenzy on this apparel stock.
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This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.