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Potential turnaround plays are enticing investments that make all traders drool in anticipation of making huge, outsized returns. You buy a struggling company below its fair value (and the FV is depressed due to its struggles in the first place) and then you sell when the company completes its brilliant turnaround and becomes a major growth story, its share price not only recovering to fair value, but going far beyond it as investors become willing to pay for rapid future growth.

The problem with most turnaround plays is that you’re often dealing with a pernicious combination of bad management, hemorrhaging of red ink (or at best declining earnings), high debt loads, weak balance sheets, stronger competitors, a weak product mix, etc. Most companies collapse under the weight of the “Pernicious Combination” and the turnaround never happens. Fortunately, not all companies engaged in a turnaround suffer from these maladies; some are profitable and financially strong, and are just losing market share to competitors. One such company is the Gap (NYSE:GPS).

The Gap has been struggling as of late, with its earnings growth on the decline for several quarters now, a decline in brand equity amongst younger buyers and the recent failure of its “Forth and Towne” Brand, an effort to reach women in the 35-45 demographic. However, the company has a solid balance sheet:

• ROA: 8.14%
• ROE: 13.46%
• LTM EBITDA $1.68B
• Total Cash: $2.74B
• Debt/Equity: 0.096

The bad data point is the 26.40% YOY earnings growth decline [LTM]. Still, the company is profitable, has a good amount of cash on hand and very little debt.

For a company in need of engineering a major turnaround, things could be a lot worse. When speculating on turnaround plays it’s always good to have some actual profitable companies in your “Turnaround Portfolio” to go along with the companies flirting with bankruptcy. However, before we make the decision to invest in the Gap as a wager on its future, let’s understand what went wrong.

The common story is that Gap has simply failed to position itself as a “Hip, Edgy Retailer” in the same vein of Abercrombie (NYSE:ANF), American Eagle (NYSE:AEO) and other successful clothing retailers like J-Crew (JCG). However, the bigger question is: “Why?” I could probably write volumes on this, but I think the answer comes down to a couple of rather simple factors:

1) The parents of the consumers Gap desires often shop at their Gap and Banana Republic stores. I’m barely 30 and grew up shopping at the Gap and Banana Republic, with Abercrombie not really coming onto the scene until I was in college. The thing is, when I was a young teen shopping at the Gap, college students and those fresh out of college were shopping there as well, back when Gap was a rapid growth story. Now those same consumers are in their 40s and are still shopping there while their kids excuse themselves to go to the part of the mall where Abercrombie is. You can’t be an edgy clothing retailer when you’re selling large volumes of goods to your desired market’s parents.

2) People my age primarily buy their work clothes at the Gap & Banana Republic and their casual clothes somewhere else. That fact is probably what has enabled J-Crew to thrive all this time, despite not necessarily changing or having the hipster credentials of ANF, as it has managed to retain its status of the provider of high-quality, but casual clothing. From a brand perspective, this positions Gap as the provider of “Uniform Clothing”, your standard khakis, suits, skirts, dress shirts, slacks and sweaters that you wear to the office. From a young person’s perspective, it makes Gap and Banana Republic a place they’re not interested in shopping for their “fun fashions”, unless they need to wear professional clothing to work. It’s worth nothing that neither Abercrombie nor American Eagle carries professional clothing.

3) Old Navy has been positioned as a discount retailer. Each commercial, despite its attempts to be kitschy and hip, has Old Navy competing on price. Meanwhile other retailers are offering somewhat similar, but more upscale versions of a similar type of fashion. As a result, young consumers are more likely to aspire to shop at Abercrombie, American Eagle, Guess (NYSE:GES) and the like. Building a strong clothing brand means that shopping at your store needs to be an aspiration, as opposed to being a form of utility due to low prices.

4) Lack of a brand identity: Whether you’re talking about the company as a whole or its individual brands, there isn’t a clearly defined brand identity, that’s backed up by their advertising, the look and feel of the stores and its products. A few years ago, the Gap went from using Sarah Jessica Parker as a pitch woman to Joss Stone, which begs the question: Who are you marketing to this week? Women in their late 30s or teenagers? The company needs to establish an articulate brand identity for each brand and back it up with the product mix.

Based on the product mix, Gap seems to vary from being trying to be hip to selling casual professional wear. Banana is the more upscale brand, that seems to vary between being a notch or two above Macy’s to maybe wanting to compete with Kenneth Cole. In short, brand needs to make choice identity wise and then create a feeling around each one of its brands.

So what would be the signs of a Gap turnaround?

1) Reestablishing the brand, with the first key being the company behaving as if it’s in touch with the customers it wishes to court.
2) A new attempt to court the female shopper in the 35-45 age range, only with them sticking with it this time around and getting the job done.
3) A stronger and more stable product mix that appears in tune with the Gap’s efforts to rebuild its brand.
4) Breaking of their pattern of selling “uniform” clothing and offering a wider and more diverse product mix.

So what’s an investor to do? Currently trading at roughly 21X earnings, vs. 15 and 15 1/2 for Abercrombie and American Eagle respectively, the company‘s stock looks a little pricey, particularly when you consider that both of its competitors are actually growing profits (albeit not at the same rate as in years past). However, the current price is in line with its 200 day moving average, meaning that over the last couple of quarters, weak earnings reports haven’t done much to depress the stock, so there shouldn’t be much downside at current levels.

My suggestion is to watch the company and watch for signs of them addressing their key issues; view the company as a potential buy at its current levels and a strong buy if it dips below the current price. As mentioned before, a strong balance sheet gives a company the luxury of time while it’s trying to figure it out, the question offered is: does the Gap actually understand its problems?

Disclosure: Author has no position in GPS

GPS 1-yr chart

gps

Source: Can The Gap Turn Things Around?