By  on August 18, 2006

NEW YORK — Gap Inc., struggling to win back customers and showing few signs that turnaround efforts have begun to have an impact, posted more than a 50 percent fall in net profits and a 5 percent decline in comparable-store sales in the second quarter.

Net income fell 52.9 percent to $128 million, or 15 cents a share on a diluted basis, from $272 million, or 30 cents a share, for the same period last year. Total sales were $3.7 billion, which were flat with a year ago.

"The second quarter continued to be challenging, as we aggressively cleared inventory to prepare for fall merchandise, and we invested in marketing and stores to improve second-half performance," said Gap Inc. president and chief executive Paul Pressler in a statement Thursday.

"Each brand is at a different stage in its turnaround," continued Pressler. "We are encouraged by improved performance at Banana Republic and our online division. And while we are making progress at Gap and Old Navy, we know it will take several seasons of consistent product, marketing and store improvements to win back our customers. We remain committed to the strategies at each of our brands and to our growth initiatives."

Gap will be tested severely in the second half and is pulling out all the stops, remaking product by reviving classic looks and signature Gap items, remodeling stores and ratcheting up marketing and in-store labor expenses to drive greater shopping — hopefully at full price — for fall and for the holiday season.

In the meantime, the steep clearances and lack of traffic in the stores are driving comps and margins down, as well as the company's forecast for the year. Gap revised its guidance for fiscal year earnings per share to between $1.08 and $1.12, from $1.23 to $1.27, based on disappointments in the second quarter and monthly sales. Executives also said August sales were trending below expectations.

Gross margins declined 4.4 points in the second quarter, and operating margin was 5 percent. Operating margins were also revised downward for the year from about 10.5 percent to 8.5 to 9 percent.

In a conference call, executives acknowledged they were disappointed the company overall didn't see traction in the latest quarter from turnaround efforts."We are at the beginning of a long-term strategy to win back customers," said Gap brand president Cynthia Harriss, during the call.

At Gap Inc.'s North American operations during the second quarter, Gap brand comps were down 6 percent, while total sales came to $1.2 billion.

Same-store sales at Old Navy, the largest division, were down 5 percent, while total sales were $1.6 billion.

Banana Republic's comps slipped 1 percent, and sales totaled $571 million.

International sales, on a comp-store basis, fell 11 percent and totaled $339 million.

On the call, Pressler cited improved product assortments at Banana Republic, healthier margins and a better balance of basics and fashion items. He said handbags have been a successful product extension and noted that in September, the division is launching a new personal care line including five fragrances.

Old Navy, he said, has seen some response to "elevated knits, graphic T-shirts and woven bottoms in women's, but men's and kids are more challenging."

Denim continues to underperform, but "trend right" denim was introduced on July 20 at Gap brand, the division undergoing the most aggressive changes, ranging from remerchandising to remodeling and stepped up marketing. The remodeling includes distinct in-store shops for denim and T-shirts. At the end of the quarter, nearly 100 stores had the updated look.

Despite the disappointments with the overall operating results, there were some positives during the quarter. Banana Republic regained some momentum. Group cash flow was strong at $2.8 billion in the second quarter, dividends and share repurchase strategies remain in place and online sales grew 27 percent in the quarter. Online gains were see at all three brands.

During the second quarter, the company repurchased six million shares at a cost of $111 million, completing the $500 million authorization that was announced at the beginning of the fiscal year. In addition, the company said on Aug. 3 that its board authorized an additional $750 million for its share repurchase program. The company paid an 8 cent-per-share dividend in the second quarter, which is nearly double the quarterly dividend for the same period last year.

There has been some speculation that Gap Inc. is being eyed by private equity firms, but analysts said the results don't enhance its takeover appeal. The second quarter report "calls into question the possibility of a private equity takeover of the company," said Mark Montagna, vice president, specialty retail, at C.L. King & Associates. "The company's top and bottom lines are declining. Its year-end cash flow projections keep declining. Management should consider preserving cash and canceling its share buyback. This does not make an appealing proposition for today's private equity shops."We continue to believe the overall company is in the midst of a long-term downhill slide that is being exacerbated by a 40 percent rise in the doors of its competition over the past five years," added Montagna. "Additionally, those competitors are far more relevant to today's consumer, while Gap and Old Navy are becoming commodity products."

A more positive outlook came from Jennifer Black, president of Jennifer Black & Associates, who wrote in a research note: "Gap will likely experience another tough month or so, but a turnaround is under way…we expect improvements to come to fruition over time, not instantaneously. Initial fall product has now been infused into stores and we find it to be on trend and more appealing than what we have seen in Gap stores for a very long time. Our checks have suggested that both customers and employees are more enthused about the product in all three divisions this year. However, checks also continue to reveal sluggish traffic trends abound." She attributed weak traffic to customers' lack of knowledge of new Gap products and overall shifts in fashion impacting retailers.

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