By and  on January 5, 2007

It's bad news on top of bad news for Gap Inc. — and with no turnaround in plain sight.

The struggling retailer reported Thursday that December sales dropped 8 percent on a comparable-store basis, after a 9 percent decrease in December 2005. Total sales for the five-week period ended Dec. 30 fell 4 percent to $2.34 billion, compared with sales of $2.44 billion for the same period ended Dec. 31, 2005.

Based on the poor holiday performance, the chain lowered its fiscal 2006 guidance to full-year earnings per share of 83 cents to 87 cents versus previous guidance of $1.01 to $1.06. Full-year operating margins are now expected to be about 7 percent, and free cash flow is now expected to be about $650 million for the year.

The holiday news is glaring, considering other specialty retailers were either positive or slightly negative for the month, and because Gap has been working hard to turn itself around. Second-half marketing has been intense, with high-profile campaigns promoting everything from Audrey Hepburn-inspired slim pants to the socially-conscious Gap (RED) campaign. Now the group's emphasis is on clearance, with markdowns up to 75 percent off.

The latest same-store results compound the pressures on Gap Inc. president and chief executive officer Paul Pressler, whose contract expires in the fall, and triggered a dire statement by Sabrina Simmons, the firm's senior vice president of corporate finance. "Given our holiday sales results, the management team along with the active involvement of our board of directors is reexamining our go-forward product and merchandising strategies and tactics," Simmons said. "We expect to provide an updated view of our approach to 2007 no later than our year-end earnings conference call scheduled for March 1."

The company's one bright spot was Banana Republic, where comparable store sales for December were positive 2 percent, versus negative 5 percent last year. However, Gap North America was negative 9 percent versus negative 10 percent last year, and Old Navy North America was negative 10 percent versus negative 10 percent last year. The international division was negative 8 percent versus negative 3 percent last year.

"Although Banana Republic continued to make good progress in its turnaround, we continued to experience negative traffic trends at Gap and Old Navy," said Simmons. "Given the weak traffic trends, we needed to take significant action on promotions and markdowns at these two brands, which drove Gap Inc.'s overall merchandise margins significantly below last year. We expect continued margin pressure into January as we work to clear remaining holiday product at Gap and Old Navy."In a research note, Jennifer Black, president of Jennifer Black & Associates, said, "It's no surprise that once again Gap reported dismal results for the all-important holiday season. Neither the shopping experience nor product is compelling, with the exception of Banana Republic. Furthermore, the competition is moving ahead and the Gap has been unable to distinguish themselves. The stock does not appear expensive, but there needs to be a catalyst to move the stock. We believe the catalyst could be changes at the upper management level or the emergence of a potential buyer of the company. We could envision a potential buyer being a consortium of private equity money with a talented ceo in hand."

Black said later that the company is not doing a good job conveying a strong identity and what they stand for. Inside the Gap stores, "It's a little of this and a little of that."

One equity analyst, who asked for anonymity, said that if you read between the lines of Gap's statement, it suggests the board is reviewing the company's strategy "more closely."

Cowen and Co. analyst Lauren Cooks Levitan said in a research note that Gap's December results "suggest the delayed turnaround of the Gap and Old Navy brands."

"While we are encouraged by management's indication that they are considering changes to the brand strategies for these struggling businesses, we believe the potential near-term impact of any such changes is already reflected in the current valuation," Cooks Levitan said. "As such, we continue to rate the shares 'neutral.'"

Richard E. Jaffe, analyst at Stifel Nicolaus & Co., said in a note, "After two years of efforts, Gap has failed to improve the offerings sufficiently to stem the decline of sales and traffic at both the Old Navy and Gap divisions. While Banana Republic's results have improved significantly, the victory is hollow, as BR comprises approximately 15 percent of Gap Inc. sales. In addition, the challenges which faced BR were not nearly the magnitude that face both Gap and Old Navy. BR's success does not readily translate into a blueprint for a turnaround at either one of the other divisions....What turned the Gap from a market leader to a market share donor? Product, of course. Why couldn't management fill the stores with attractive product? We believe management failed to recognize the necessity of empowering the merchants to take risk, to allow them to seek to inspire the consumer to buy, by anticipating what the consumer wants before they know that they want it."While we do not doubt the opportunity," at Gap, "today we have no visibility how or when management will begin to realize the potential at Gap and therefore downgrade the shares to hold. We are also trimming our 2007 EPS estimates to $1.00 from $1.25 and establishing a 2008 EPS estimate of $1.20."

Shares of Gap closed the day up 0.62 percent to $19.43. The stock's 52-week high is $21.39 and the low is $15.91.

"We are committed to turning this business around," said a Gap Inc. spokesman. "There is a lot of resolve. If you talk to people in Banana Republic, they feel pretty good about the direction they are headed. The same would be true at Gap Direct, Piperlime and Forth & Towne. There is a great deal of commitment to delivering the results we believe we can deliver. Obviously, there's a recognition that the numbers are not what we hoped."

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