Skip to main content

This holiday season,


(GPS) - Get Gap, Inc. (GPS) Report

trotted out singers like Sheryl Crow and Seal to pitch its duds. In the stylish TV ads, the musicians sang lines from the Supertramp hit

Give a Little Bit.

But even the modest ambitions expressed in that song are proving to be too much for Gap to achieve.

In November, same-store sales, which measure activity in shops open at least a year, dropped an astonishing 25%, and they are expected to have declined between 10% and 20% in December when the company reports same-store sales on Jan. 10.

On Wednesday morning, US Bancorp Piper Jaffray downgraded Gap from neutral to underperform, saying it expects same-store sales to decline between 15% and 20% in December and citing low visibility for a recovery.

For much of 2001, Wall Street waited for Gap to get its act together. Months passed, promises went unfulfilled and same-store sales kept contracting. If it wasn't clear at the beginning of last year, it certainly is now: Gap is in crisis.

Simply put, Gap is running out of money, has too many stores and sells clothing that isn't grabbing customers. Among other problems, critics say the company has abandoned its roots as a seller of basics in favor of cutting-edge fashions. The result has been a series of fashion missteps that have turned away consumers. At the same time, the company has opened stores at such a feverish pace in recent years that many say that new stores are starting to cannibalize sales at older ones.

"They think they can continue to expand and open up more and more stores instead of consolidating the market share they have and preserving the customer base," says Louis Nevaer, an economist who last fall published

Into -- and Out of -- The Gap: A Cautionary Account of an American Retailer

, an unauthorized account of the rise and fall of Gap.

Nevaer initially set out to write his book in 1998, when Gap was still successful and he had the support of company management. That slowly changed. "I realized it couldn't be a vanity piece because it was becoming a troubled company," he says.

TheStreet Recommends

Fall Into the Gap
Gap's same-store sales growth steadily declined in 2001

Source: Gap Stores

While Gap's stock has rebounded from its lows following Sept. 11, it hasn't done so as strongly as its peers and is still trading well off its 52-week high of $34.98. Since Sept. 17th, GPS is up 20% but S&P's retail apparel sector is up 30%. Despite its lackluster performance, the company is still trading at a hefty 43 times next year's estimated earnings.

And late last month, just as the company was suffering through perhaps its worst holiday shopping season ever, research outfit Grant's Investor sparked a controversy when it published a report saying Gap, which runs the Gap, Old Navy and Banana Republic clothing chains, could be in danger of violating its debt covenants. Grant's said that if the company's EBITDA, or earnings before interest, taxes, depreciation and amortization, a measure of cash flow, falls below $1.084 billion when its fiscal year concludes at the end of January, it would violate its debt agreements. Those agreements require a certain ratio of cash flow to debt (the company has about $2.2 billion to $2.3 billion in debt).

Gap responded with a press release saying that Grant's "mis-estimated" the level of EBITDA needed to meet its agreements, and it said it needs only $730 million to $770 million in EBITDA by the end of the year to be in compliance, a level the company says it will achieve. In addition, rating agency Moody's Investor Service has said Gap's liquidity remains "acceptable." Gap declined to comment for this story.

Some big investors are buying Gap's take on the issue, but say they will watch the balance sheet closely this year. "Every way I crunch the numbers, I don't think there's any way that

cash flow will be a factor when they report the fourth quarter," says Kevin Rendino, a senior portfolio manager at Merrill Lynch Asset Management, who manages the $9 billion Basic Value Fund. Rendino started buying Gap shares late last year on the belief that "things couldn't get any worse."

Many on Wall Street are willing to put the balance sheet issues aside for now and hope, along with Gap's management, that a few decent fashion seasons can save the day. In November, the company raised $700 million through a bond offering, a deal that "saved the day" for Gap's liquidity, says Richard Jaffe, an analyst at UBS Warburg and one of the few remaining Gap bulls on the sell side. "It bought them a year," he says. Jaffe has a buy rating on the stock, and his firm hasn't had a banking relationship with Gap.

The question is whether Gap, long a great-guns growth story, has grown to the point of no return, right into the teeth of a recession. If sales keep plunging the way they have in recent months, then the company's overhead -- operating all those stores, paying all those workers, servicing all that debt -- could become such a burden that Gap will need to seriously rethink what it's doing, and either sell businesses, close stores or both.

Too Big for Its Britches?
Gap has been adding stores rapidly despite slowing sales

*As of the end of the third quarter.
Source: Gap Stores

Even as its sales were slowing markedly, the company opened more than 600 new stores last year -- bringing its total to about 4,150. And while the company is scaling back expansion plans for 2002, it is still expanding. It plans to open as many as 280 new stores in 2002.

"Structurally, the Gap needs to clean up its real estate and close stores," Todd Slater, an analyst at Lazard Freres, wrote in a recent research report. "Second, it needs to design clothes that its customers can wear, not clothes that its designers like." Slater lowered his rating earlier this year from buy to sell, and his firm doesn't have a banking relationship with the company.

Now the company's in a position where it's critical that it regain its fashion sense. "The Gap name still means something in the marketplace to the consumer," says Rendino, the portfolio manager at Merrill Lynch. "If the balance sheet issue is not a problem, it comes down to the merchandise. Can they get the merchandise right? I think they can."

After more than a year and a half of declining same-store sales, the clock is ticking.

"2002 is really going to be perhaps the most crucial year for Gap," Nevaer says. has a revenue-sharing relationship with under which it receives a portion of the revenue from Amazon purchases by customers directed there from