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How Gap can turn things around in 2017

2016 was a difficult year to be a large, store-based retailer like The Gap, Inc. (GPS).

With mall attendance rapidly declining amid e-commerce disruption, an expansive physical empire like Gap’s has become less of a competitive advantage and more of a burden. The company has a market cap of roughly $10 billion, down significantly from its 2000 high of $40 billion.

“While the assortment at Gap has improved under the helm of new management, regaining traffic in retail is a tough task,” JPMorgan (JPM) equity research analyst Matthew Boss wrote in a November research note, calling the mall “a battlefield” in the wake of capacity issues, off-price expanding and fast fashion.

However, 2017 could see the Gap poised for a turnaround, according to several retail analysts — though it may necessitate some difficult decision-making by Gap CEO Art Peck, who took over last year.

To start, Gap may have to consider turning away from its heavy discounting strategy and transition back to full-retail pricing, according to UK retail analyst Richard Hyman.

Much of Gap’s need to discount results from oversupply — a problem of such ridiculous proportions that Stifel analyst Richard Jaffe called a recent fire at a New York distribution center a “fortuitous reduction in inventory.”

While discounts might seem like they would appeal to customers and reduce that supply at the same time, in reality frequent sales could end up damaging a retailer’s brand and leading to falling margins because customers will just wait to buy items until they’re on sale.

“The issue with Gap is how early in history they succumbed to widespread discounting and in the process, educated their customers to only buy at marked down prices,” Hyman told Yahoo Finance. “A drug addict can only beat the addiction by going cold turkey and the retailer hooked on price cuts has to do the same thing — there is no alternative.”

Committing to full pricing would likely alienate some of Gap’s existing customers who have been attracted to the company’s discounts, Hyman acknowledges. It would also necessitate abandoning weaker stores and editing the products it offers.

“It’s painful but that is the price that must be paid,” Hyman said. “Gap is not owed a living in this market.”

The company is also operating with excess stores in an online driven market, though it has been trimming its over-supply problem in recent years. Fifteen years ago, Gap was operating just over 1,500 domestic stores. In 2016, the company started the year with 866 Gap North America stores.

Eliminating its discounts won’t be the only way for the Gap to turn itself around, though. Gap must find its competitive advantage in a world where its old ones — size and price — aren’t as helpful as they used to be, retail analyst Simeon Siegel of Nomura Securities said in an interview.

“Gap needs to solve its broader challenges, such has how to to get the customer to buy their product at margins that are not uneconomical,” Siegel said. “The question of finding the right balance of international growth and maintaining the general profitability of your own company…it needs to focus here.”

Keeping a product consistent with consumer desires is a must in a market where companies like H&M can sell apparel for considerably less money.

To Gap’s advantage, it has seen faster than anticipated turnaround in its Gap and Banana Republic brands since the advent of new management two years ago, RBC Capital markets analyst Brian Tunick wrote in a Nov. 17 note following earnings. The company also saw a considerable increase in its merchandise margin that Tunick attributes to Old Navy’s better product reception.

Gap also has the athletic wear brand Athleta under its umbrella, which JPMorgan sees as well positioned as Americans continue to put Fitbits (FIT) and designer water bottles in their shopping carts.

Ultimately, Gap must grapple better in 2017 with its image and relevance. Garrett Bennett, former retail executive and one of the founding partners of Merchandising Metrics, called Gap’s move to inject fashion into its basic strategy a “disaster” in an interview with Racked earlier this year.

“Gap needs to prove itself by re-establishing brand and price trust with its core customers,” Hyman told Yahoo Finance. “It remains to be seen whether it now has the leadership team with the vision and courage to bite the bullet and face facts.

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