Gap Inc. said Thursday that third-quarter net income dropped by almost a third to $193 million from $303 million in the year-ago period, and warned that margins will be under pressure in the fourth quarter.

This story first appeared in the November 18, 2011 issue of WWD. Subscribe Today.

Diluted earnings per share in the third quarter ended Oct. 29 were 38 cents, down 21 percent from last year. Comparable-store sales fell 5 percent, while total sales decreased 2 percent to $3.59 billion, compared with $3.65 billion for the third quarter last year.

Margins at the $14.7 billion specialty chain were squeezed by rising cotton prices and markdowns, and there were some price miscalculations at Old Navy, where Gap chairman and chief executive officer Glenn Murphy said the “value proposition was not strong enough.”

But Murphy underscored what seems to be the root of Gap’s ongoing poor sales performance. “The shortcoming of our team in 2011 is hitting the sweet spot of optimistic American casual style,” Murphy said during a conference call. “When we go after the optimistic American casual style, customers resonate with the brand. There is an association and definitely a demand.…The company has not executed this year the way I would have liked.”

Murphy also said the company “may face our greatest merchandise margin pressure in the fourth quarter.…We all believe it’s going to be a very aggressive fourth quarter.”

While the company again ran negative domestic comp-store sales, Murphy did mention some positives, including a strong performance at the stores in China, though it will be awhile before they start making money due to startup costs and heavy marketing. He noted the company is ramping up the pace of openings to 30 next year. There will be 15 stores operating in China by the end of this year. “China is definitely our longest term investment, dilutive this year and likely dilutive next year, but we are pleased with our store performance,” Murphy said.

He also said he was “encouraged” by some progress at Banana Republic though the division still showed negative comps, and was most pleased by e-commerce, which soared ahead 21.3 percent, while North American stores were negative 7 percent on average. “Finding the balance between online and store business is critical,” Murphy said.

He said he saw opportunities in continuing to roll out active merchandise and the GapBodyFit line and on accessories, “It’s not anything we would say is the strength of the business, but there will be some greater emphasis in the assortment in the spring. It’s a huge opportunity for Gap brand. We are looking for certain key categories under accessories that we don’t deliver now. There may be an opportunity for third-party brands,” which are being tested in some stores. “That may be part of the overall shift in our merchandising model, they got to pace it in. We see a little in the fourth quarter and more in 2012.”

Gap officials also said that underlying cotton prices are down from the holiday peak but still up in spring 2012 versus 2011.

Gap said it’s continuing to invest in long-term growth opportunities, such as overseas stores and new divisions such as Athleta, and also maintaining “strong expense discipline” and returning cash to shareholders.

The company also revealed a new $500 million share repurchase program, effective immediately. Year-to-date, the company has repurchased about 107 million shares for $2 billion.