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Gap's long-awaited turnaround may hinge on fixing this problem

Gap store
Kuni Takahashi | Bloomberg | Getty Images

Gap's same-store sales topped analysts' expectations in June, reversing a 14-month stretch of declines with a 2 percent rise and giving a strong boost to its shares, which popped 5 percent.

But while that number suggests things are getting better, a deeper issue is lurking at the purveyor of classic American fashions — one that can't be explained away by unseasonable weather, ill-fitting clothes or any of the other excuses it's floated past investors over the past several months. Its initial prices — the ones shoppers see when they flip over an item's price tag — remain too high.

CEO Art Peck addressed this structural concern with investors in May, saying the starting prices on its merchandise are "absolutely" something the company has been looking at. In some cases, changes have been made, Peck said. Yet the problem isn't as simple as slapping a new dollar amount on the items. Because such a sweeping shift would require a massive overhaul to the company's supply chain, it's something that could take years to correct, Credit Suisse analyst Christian Buss told CNBC.

And that's if Gap makes it a priority. One of Buss' broader concerns about the company's elusive turnaround is that under Peck's leadership, it has spoken more about designing stylish product than fundamental issues with its supply chain, he said. Namely, it is operating on a dated retail model that its lower-priced fast-fashion competitors have left behind, Buss said.

Retailers have historically placed big bets on designs a year before they hit stores, and marked those pieces up to allow for price reductions every few weeks. This method has allowed them to move through less-popular merchandise while keeping up their margins. But what companies including H&M and Zara have figured out is that if they cut that time down to three to six months, they can "mitigate that risk dramatically," Buss said. That means they don't have to price their items at the same initial markup as traditional players like Gap.

"The end result is that they undercut people like Gap," Buss said.

For Peck, a turnaround needs to come fast. Since he took the reins at Gap in February 2015, the company's stock price has slumped roughly 45 percent, and is now trading near $23.

Not priced for perfection

Under the leadership of his predecessor, CEO Glenn Murphy, speeding up and otherwise improving the supply chain were two key priorities. Peck hasn't abandoned those fundamentals, and has taken steps to allow the retailer to make smaller upfront bets on product, and place additional orders for popular items once it sees what's selling. Peck has likewise reiterated that Gap is working to make its supply chain faster and more nimble. When he speaks to improving the company's product, that includes the processes that go into making it, a source said.

"I'm not going to tell you what yard line we're on or give you a numerical score, but we are making significant and rapid progress," Peck told analysts in February. However, given the string of merchandise missteps across its brands, Peck's main talking points have focused on improving its aesthetics. That means infusing more color into the Gap brand and making it fit more consistently.

Analysts agree that bringing life back into the Gap label is an essential piece of the company's turnaround. Yet some are concerned that design changes will not be enough to bring back shoppers, or get them to pay full price for its products.

The company does not publicly report pricing changes on a product or category level, a Gap spokeswoman told CNBC. But on its May earnings call, an analyst asked Peck whether the retailer would consider cutting its initial ticket prices. The CEO responded by saying it has made some adjustments across the Gap, Banana Republic and Old Navy brands, "where we felt like the initial tickets, given where our competitive out-the-door pricing was, just were not real at the end of the day."

Indeed, Buss' pricing analysis picked up on a broad-based reduction in starting prices at Old Navy in October 2014, under the leadership of former President Stefan Larsson. The Credit Suisse analyst contends, however, that the move did not come with enough supply chain changes to support those price cuts.

In November 2015, when the brand lapped those price declines, its comparable-store sales declined "precipitously" — reversing a six-month stretch of gains and falling 9 percent. Since November, Old Navy's comparable sales declined or were flat every month until June, when they rose 5 percent.

"You always get a one-time benefit when you lower prices but without speed so you can continually innovate and get new product to market it's very hard to lap those price declines. And that's exactly what we saw," Buss said.

After its June sales report Thursday, Gap CFO Sabrina Simmons said in a press release that the company was "pleased to see better performance across the portfolio this month, partly driven by an improvement in June traffic trends, particularly at Old Navy."

In May, Peck told analysts that the recent missteps at Old Navy were "much less about product" and more about mistakes in its assortment, which skewed too fashionable and was often "duplicative." Peck likewise blamed a weak marketing strategy, saying he feels "much better" about the brand's prospects in the third quarter.

Tightening the belt on discounts

Yet the broader company's pricing problems extend beyond its initial prices. Even as it has dialed back on the amount of merchandise it has in stock, analysts note that the company's three main labels remain heavily discounted. During its second quarter to date, both the Gap and Banana Republic brands have been more promotional than they were over the same period last year, according to research by Wells Fargo. Old Navy is similarly promotional, the firm found.

In May, Peck told analysts that Gap and Banana Republic were taking steps to "tighten up" their discounts, following 18 to 24 months of product misses that forced the brands to take unnecessary promotions.

"If you are a subscriber to our emails or in our stores or on our website, you'll notice that it is real, it is not easy, but we are working in terms of the depth of promotions, the promotional frequency and the breadth they cover," he said.

Management indicated that starting in February, more shoppers who have visited its Gap stores for women's apparel have made a purchase, and sales on those items were less driven by promotions, Stifel analyst Richard Jaffe said in a research note. Nonetheless, those trends are still happening "at a slower pace than planned for by management," Jaffe said.

Ed Yruma, an analyst at KeyBanc who upgraded the company's stock to "overweight" from "sector weight" in April, told CNBC the company's level of promotions remains "way too high." Nonetheless, he has a more bullish outlook on Gap.

"One of the things that has impressed me about Art is [he's] really trying to think deeply about who the Gap customer is," Yruma said, referring to Peck's focus on returning the Gap brand to its colorful American roots. He added that the company is doing a better job of testing its products before they hit the shelves — to mitigate the risk of a fashion miss — and is making strides in its efforts to work faster.

"Recent moves to add fast capabilities allowed Gap to successfully chase trending items, placing several hundred thousand units in roughly six weeks," Yruma told investors following a recent meeting with the company's management. "Transformation work is also looking to better leverage [Gap's] scale, and tools are being implemented to allow more frequent product flows."

Yet for Buss, who has an "underperform" rating on Gap's stock, change won't occur until the company is able to consistently and "dramatically" speed up its processes.

A customer browses sweaters at a Gap store in San Francisco.
David Paul Morris | Bloomberg | Getty Images
A customer browses sweaters at a Gap store in San Francisco.

While trends at the Gap brand improved year over year during the first quarter — as well as the first two months of the second quarter — analysts question whether it's a true sign of a turnaround. That's because, despite heading in the right direction, they remain negative.

Meanwhile, sales at the company's higher-priced Banana Republic label, which targets a working man or woman, continue to bleed. The brand reported a 4 percent comparable sales decline in June. Though that's an improvement from May's 11 percent drop, the label hasn't reported a single month of positive same-store sales in a full year.

This string of poor results has caused some analysts to question the relevance of the brand, which is positioned in a tough place in the market. Not only has its competitive set lost shoppers to cheaper fast-fashion labels, but the American workplace has gotten more casual. In a note to investors after the company's May sales results, Jefferies analyst Randal Konik referred to the label as "a Banana Boat that's sinking," adding he would like the company to sell the brand.

Of its three major labels, analysts are most optimistic about Old Navy, which targets the thriving value shopping space. Trends swung positive at the label in June, prior to which they deteriorated for only seven months — a flash in the pan compared to roughly two years of woes at Gap and Banana Republic.

Meanwhile, the small but fast-growing Athleta brand — Gap's competitor to Lululemon — remains "underappreciated," Yruma said. Gap does not break out sales for Athleta, but the KeyBanc analyst estimates it's pulling in some $600 million in revenue each year.

'We need to do more, faster'

Despite choppiness across all three of its major labels, the fact that it plays in so many categories is one of Gap's advantages, said David Berliner, who leads the business restructuring and turnaround services practice at BDO. That's because it is somewhat insulated from the ebb and flow of consumer tastes, such as the shift away from T-shirts to athletic wear.

Yet the company is not immune to broader challenges plaguing the retail industry, including customers' recent preference for dining out and travel. And because of the speed with which its fast-fashion competitors can duplicate popular styles — or sell lower-price versions of the basic T-shirts Gap built its brand upon — hitting on a popular trend is no longer enough to guarantee consumers will come to its stores.

"If someone has a product that's a hit that's selling off the shelves, all of their competitors are going to have that copied pretty quickly," Berliner said. "It's really hard in apparel to have some kind of unique item that no one else has."

The retailer is not resting on its laurels. Along with making improvements to its products, the company has also announced plans to shutter a swath of stores. The latest of these announcements came in May, when Gap said it would close 75 stores in an effort to save $275 million annually.

Yet despite promising an inflection point at the Gap brand in spring, that label and the broader company have continued to struggle. While Gap Inc.'s comparable sales swung positive in June, rising 2 percent, that lift followed a 5 percent decline in the first quarter and a 6 percent drop in May.

"I am pleased with the work," the CEO told analysts about its product in May. "But clearly, we need to do more, faster."

Correction: An earlier version of this article misstated Gap's stock movement since Art Peck took over as CEO.