Wed Aug 25, 2004

NEW YORK (Reuters) - U.S. apparel chains, which are already suffering from slow back-to-school spending, on Wednesday saw their shares take a hit from a rating downgrade of industry leader Gap Inc. (GPS.N: Quote, Profile, Research)

Merrill Lynch downgraded clothing retailer Gap to "neutral" from "buy," saying the San Francisco-based chain faces a myriad of near-term challenges, including uncertainty about the appeal of its fall merchandise.

In early trading, Gap shares fell more than 3 percent on the New York Stock Exchange, where they were among the top percentage losers.

"We're cautious ahead of (Gap's) August 'comps,"' said Kimberly Greenberger, director of U.S. equity research at Smith Barney, referring to the company's comparative-store sales for August, which Gap is due to report next week.

A dearth of advertising in August, with the company's latest campaign starring Sarah Jessica Parker and Lenny Kravitz not kicking off until this weekend, hurt the company, while consumers' search for bargains drew them away from Gap and toward other retailers like J.C. Penney Co. Inc. (JCP.N: Quote, Profile, Research) , Greenberger said.

Still, "we would recommend buying the stock on dips," Greenberger said, adding that the company's balance sheet and free cash flow still look solid.

The Gap downgrade came after closest rival Abercrombie & Fitch Co. (ANF.N: Quote, Profile, Research) was pummeled by a couple of negative calls by Wall Street brokerages. Pacific Growth Equities cut its rating to "equal weight" from "over weight" on Wednesday, a day after Prudential downgraded it to "neutral" from "overweight."

Abercrombie's stubbornness in maintaining relatively high prices, shortfalls in hot-selling items like denim, and strong competition from companies like American Eagle Outfitters Inc. (AEOS.O: Quote, Profile, Research) and Aeropostale (AER.N: Quote, Profile, Research) have cut into its sales, analysts said.

Abercrombie & Fitch's shares fell 1 percent to $29.49 on the New York Stock Exchange.

BROADER INDUSTRY CONCERNS

Broader concerns about the industry weighed on shares of other clothing retailers like AnnTaylor Stores Corp. (ANN.N: Quote, Profile, Research) and May Department Stores Co. (MAY.N: Quote, Profile, Research) in early trading, but many rebounded modestly by the end of the session.

The dip in stocks reflected uneasiness about apparel retailers' near-term outlook as high gasoline prices and rising interest rates squeeze budgets, forcing even discounters like Wal-Mart Stores Inc. (WMT.N: Quote, Profile, Research) to warn this week of poor sales trends.

Merrill Lynch analyst Mark Friedman said in a research note that Gap faced the possibility of registering a 4 percent to 6 percent decline in August sales from stores open at least a year, or same-store sales.
Without a rebound in same-store sales, he said Gap stock should have little reason to outperform.

"At 12.5 (times) our 2005 estimate we believe the stock requires healthy (same-store sales growth) and strong earnings growth to drive multiple expansion," Friedman said in the note.

In addition, he said there was also uncertainty about Gap's fall merchandising plan as its stores "right now look somewhat uninspired."

"The color story is not as strong as we would like ... we do not think the stores highlight the best items as well as they could," Friedman added.

After an upbeat start to the year, Gap -- which owns its namesake casual clothing chain as well as Banana Republic and the lower-priced Old Navy stores -- recently broke a 20-month string of same-store sales gains as selling through June and July slowed.

September, according to Friedman, could prove to be Gap's toughest month yet. Same-store sales rose 13 percent in the same period last year due to strong product offerings and ideal weather in key markets.

He said he forecasts Gap's September same-store sales to reflect growth ranging from flat to 2 percent higher.

Gap's shares ended Wednesday's session down 40 cents, or 2 percent, at $19.52.

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