It's Not Yet Time to Fall Into the Gap

The retailer may offer hope in its report, but a turnaround is a long way away.
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I so want to go against the grain and call

Gap

(GPS) - Get Report

a good contrarian play.

The retailer is hated on both Wall Street and Main Street. About the most positive thing analysts seem to be able to say about the company these days is that the merchandise in its Banana Republic chain is not hideous.

Nevertheless, overwhelming negative sentiment alone is not enough to zig when others zag and go long in the face of such pessimism. There needs to be a catalyst, something that can make investors believe that things are turning around, even if the rest of Wall Street doesn't acknowledge it yet.

Many investors are hoping that Gap's earnings release and conference call after the closing bell Thursday will offer some beacon of hope that such a turnaround is imminent. The company is expected to provide an update on its plans for its flailing Gap and Old Navy brands.

But don't hit the buy button just yet. It could be a while before Gap is pointed in the right direction.

Out of Fashion

While the company may detail turnaround efforts for its namesake brand, don't expect consumers to flock to Gap stores anytime soon. According to UBS analyst Meredith Love Kent, Gap's spring product line is not as stylish as competitors

Abercrombie & Fitch

(ANF) - Get Report

,

American Eagle Outfitters

(AEOS)

and

J. Crew

(JCG)

.

In a recent report, Kent writes the color palette of the women's line "did not feature the bright sherbet hues that are expected to be popular; instead it was heavy on faded colors like light green, yellow, and gray." She also believes Old Navy has the wrong product mix, missing opportunities in athletic-inspired apparel.

That's no surprise to Stevan Buxbaum of consulting firm Buxbaum Group in Calabasas, Calif. He points out that it takes roughly 18 months to turn over the merchandise pipeline.

Under recently ousted CEO Paul Pressler, same-store sales figures were solid for the first year and a half. Shortly thereafter, the company hit a rough patch in which same-store sales failed to grow in 27 of the next 28 months. So even though new Gap stores president Marka Hansen, the former head of Banana Republic, is expected to improve the merchandising, her impact may not be felt for some time.

But it's not just the clothes that are the problem. Buxbaum says the whole shopping experience at Gap needs to be reworked.

"Gap stores still feel like 1992. They need to bring it into to the 21st century," he says.

Buxbaum suggests that Gap get more in line with Abercrombie & Fitch from a store-design standpoint. "Walking into an Abercrombie is like walking into a night club," he says. "Gap is still behind the curve on shopping experience, even if they get the merchandise right."

Richard Hastings, senior retail sector analyst at Bernard Sands, also believes that merchandise isn't the company's only problem.

"Gap's asset base is much too large for cash flows," he says. "Its No. 1 problem is that it has too many stores."

Hastings suggests Gap needs to shut 75 stores in addition to the 19 Forth & Towne stores that

will be closed. Hastings also believes that Gap should simply discontinue the Old Navy concept. "Old Navy is significantly troubled," he says.

The Earnings Call

From a financial results perspective, there shouldn't be too many surprises in Gap's earnings release. Gap has already announced revenue of $4.9 billion for the fourth quarter, and it has projected full-year earnings of 89 cents to 91 cents a share. Same-store sales for the quarter fell 7%.

I'm not sure what management can say on the call to lift investors' spirits, short of a radical change or more upheaval in the executive suite. As stated above, merchandise needs time to work its way through. Any kind of redesign of the stores, while a long-term positive, will cost a lot of money and hurt earnings in 2007 and 2008. Announcing the closure of more stores may be the only way to appease Wall Street in the near term.

Keep in mind that Gap is still a profitable company that generates cash.

However, with the stock trading at around at 19 times 2008 projected earnings, it's no bargain, especially compared with Abercrombie at 15 times and American Eagle at 16 times.

Perhaps Gap will pull a rabbit out of its hat this evening and surprise us all with some good news. But even then, I'd wait until both the stock comes in and there is more evidence that a turnaround is in place before taking a position.

In keeping with TSC's editorial policy, Lichtenfeld doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.

Marc Lichtenfeld was previously an analyst at Avalon Research Group and The Weiss Group and a trader at Carlin Equities. He holds NASD 86, 87, 7 and 63 licenses. His prior journalism experience includes being a reporter/anchor for On24 in San Francisco and a managing editor of InvestorsObserver, a personal finance Web site. He is a graduate of the State University of New York at Albany. He appreciates your feedback;

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