The Gap could hardly get worse

By Robert Walberg

Investors have been conditioned to expect poor performance from The Gap (GPS, news, msgs). That's why they're likely to shrug off the latest bit of bad news.

Last night the company said quarterly net income had plummeted by 35% to $219 million, or 27 cents per share. Same-store sales fell 8% at Gap stores and 9% at the company's Old Navy chain. Yet because the company is perceived as a turnaround or takeover play, the news that it struggled yet again is relatively meaningless.

What matters is that The Gap's management team is changing -- Paul Pressler's brutal tenure as CEO mercifully came to a close in January -- and that the company seems to understand serious steps need to be taken to reverse its fortunes. Subtle changes to merchandise and splashy, expensive, celebrity-based ad campaigns won't cut it anymore.

For now, anyway, The Gap is likely to get a free pass from lousy news as the focus shifts to management's plans. On that front, there was only a little information in last night's post-earnings conference call: namely that square footage will grow by nearly 1% this year, considerably slower growth than normal but not the downsizing that many on Wall Street want.

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Personally, I'm OK with the company not shrinking its square footage, at least for now. The Gap has a bigger problem than too much space: the merchandise that occupies that space. For too long the retailer has been trying to recapture the magic of the 1980s and 1990s, when it dominated the specialty retail space for 20- to 30-year-olds with T-shirts and khakis.

Unfortunately, consumers of that age no longer find The Gap's merchandise very appealing. Stores such as American Eagle (AEOS, news, msgs), Abercrombie & Fitch (ANF, news, msgs), Pacific Sunwear (PSUN, news, msgs), Aeropostale (ARO, news, msgs) and Buckle (BKE, news, msgs) are all doing a much better job of capturing that marketplace.

Neither in nor out of style

So it's time to downsize the footprint of new Gap stores and go after the 35- to 55-year-old set that isn't worried about wearing the latest fashions but wants solid, dependable, well-made clothes that place them neither in nor out of style. These are the people who were buying Gap clothes 20 years ago and still want to buy there today. Especially for men, there aren't many other options for such clothing besides department stores.

Let Old Navy be the brand that goes after teens and 20-somethings. Its price points are better suited to compete, and by differentiating the target market the two chains would be less likely to cannibalize each other. In fact, product differentiation between brands has to be a primary focus for new management or The Gap will continue to flounder.

In addition to smaller, better-defined stores, The Gap needs to address its pricing practice. There's no better time than the present, as investors are less focused on the here and now, and more on the promise of tomorrow. The retailer needs to stop slashing prices to move merchandise. Better inventory-management practices combined with better merchandising decisions should help alleviate this pattern of margin destruction.

• Video: What's next for The Gap?

Around 19 times estimated earnings, Gap stock isn't cheap, particularly given that management projects net income to decline again in the current fiscal year (the third consecutive year of declines). Nevertheless, the stock has held up reasonably well over the past couple of months and, considering the potential for a turnaround or, less likely, a takeover, the additional downside risk should be limited to support in the $18-to-$17.50 range.

Long-term speculative investors might want to use any news or market-related decline to this area as a buying opportunity, as the new Gap management team can't conceivably do any worse and the comparison periods are certainly weak enough to exaggerate the impact of any positive decisions. Over the next 24 months, the stock has upside to the mid-$20s.

At the time of publication, Robert Walberg did not own or control shares of any company mentioned in this article.