Twenty-eight and counting. That was the milestone apparel giant Gap ( GPS) hit Thursday in its streak of monthly same-store sales declines. Gap reported an 8% decline in stores open at least a year, worse than the roughly 6% drop many expected. And while the company had some good news for investors -- it raised its second-quarter earnings estimate by a penny and named a new head of its U.S. Gap stores division -- the fall in comparable store sales underscores how early the company still is in its turnaround plans, even if a slew of Wall Street analysts have declared the company back on track, a number of observers say. The company still has a mountain of debt, a lame-duck CEO and, with its debt rated junk, little access to the capital markets. The company's plan has been a return to basic fashion, and that is what it has done; the company's fall line is heavy on denim and its colors are muted. When Gap did a $700 million bond deal last fall, the company bought itself about a year before liquidity could be a problem. But the clock is ticking, some Gap bears say, and many feel a radical restructuring is inevitable.
Perhaps Gap's biggest problem is that it went on a debt-fueled expansion that left it with too many stores. Virtually everyone agrees with this except Gap itself. "We feel that the company expanded too quickly," says Elaine Francolino, who follows Gap for ratings agency Moody's. "That's just our opinion. There's no reason to think Gap believes that." Francolino revised her outlook on Gap from stable to negative in May after CEO Mickey Drexler announced his intention to retire, on the prospect that his departure could lead to "changes that could require expenditures, charges or revisions in the company's operations." San Franciso-based Gap, which operates the Gap, Banana Republic and Old Navy chains, has slowed its store growth plans. But to the consternation of many observers, the company is still expanding. At the end of the first quarter in May it operated 4,228 stores, up from 3,850 in the year-ago period. It plans to grow its square footage by about 3% this year, with the majority of that having come in the first and second quarters. Gap stock lately traded up 4 cents at $11.19, but is off about 19% on the year. Despite its troubles, it still trades at a pricey 35 times this year's estimated earnings, more than double its projected growth rate of 15%. This makes it much more expensive than rivals American Eagle Outfitters ( AEOS) and Abercrombie & Fitch ( ANF), two companies with better growth rates and cleaner balance sheets. American Eagle trades at 10 times this year's earnings, while Abercrombie's P/E ratio is 11. Both companies are expected to grow at an annual rate of 20% over the next five years. Part of the reason Gap's valuation has stayed high is because many analysts have been quick to latch on to the company's turnaround efforts. The company has enjoyed several analyst upgrades this year, and indeed has made some improvements: the rate of same-store sales declines has moderated, it unexpectedly inched into the black in the first quarter and many are eagerly awaiting a new CEO with an operational background. Drexler is seen as a top-notch merchant, but someone who is out of touch with the day-to-day operations.
But Gap has many doubters as well. "The underlying earnings power doesn't justify being in the stock," says Donald Trott, of Jefferies. "We don't see any rational reasons to be in the stock." (He has a hold rating on Gap, and his firm does not have a banking relationship with Gap.) Of particular concern to investors should be Gap's balance sheet. Most say the company won't face any liquidity issues until 2003, but avoiding such problems rests largely on a second-half turn in the business. The company's debt load is mounting: It had $3.4 billion of long-term debt at the end of the first quarter, almost triple the $1.27 billion of a year ago. The company's cash also grew, from $663 million to $2.3 billion, but in March, Gap had to secure a $1.4 billion secured credit facility, a type of financing reserved for financially weak companies. It also has more than $5 billion of noncancelable lease obligations, which don't show up as debt on the company's balance sheet. Gap has said it is not being forced to mark down merchandise to the degree it has in the past, but some early signs from its fall line are not promising. On Thursday, Gap announced a new marketing campaign, dubbed "For Every Generation," that is centered on denim. But just this week Gap sent a coupon to its online customers good for $10 off every purchase of a pair of jeans through Aug. 23. "The $10 off thing is just a sign that they will have to mark down their prices," says one Gap bear. "That turnaround is not occurring." Some say that Drexler's replacement will be forced to resort to a restructuring plan that will include closing stores and perhaps spinning off one of its divisions. "I think the new CEO will have to undergo some sort of restructuring," Jefferies' Trott says.