(FORTUNE Magazine) – AND JUST EXACTLY HOW did "Old Navy" get picked as the name for the clothing-store juggernaut that is even now rumbling noisily across the blasted landscape of retailing, reverberating in our weary consumers' brains?

By chance, really. Millard "Mickey" Drexler, CEO of Gap Inc. (Old Navy's parent), began wrestling three years ago with the cultural problem afflicting the fashion business: it had become hip not to spend money on clothes. He converted 48 underperforming Gap stores into down-market outlets and called them Gap Warehouse. Wanting a name with a bit more imagination, Drexler hired an outside firm to work up some other possibilities. The top two suggestions came back: Forklift and Monorail. He hated them. Then on a trip to Paris he and some executives were walking around the city and came upon a building with the words "Old Navy" written on the side. "We just thought, 'That's a great name for a business,' " recalls Drexler. "And it just stuck."

Well, sure. Old Navy Clothing Co.: euphonious, unpretentious, suggestive of canvas and discipline. There are now 131 Old Navy stores in 27 states selling low-cost clothes, and the plan is to roll out as many as 75 a year for at least the next several years. Drexler, 51, runs a $4.4 billion company with all the resources in the world at its disposal, but it's still a clothing business, and in the end it all comes down to...touch.

As Drexler is fond of saying, there are no secrets in retailing. The minute something new--a store or a look--is created in this industry, it is instantly visible, there for all the world to examine and replicate. With the Gap stores, Drexler took items as unremarkable as blue jeans and T-shirts, had a Gap label sewn into each one, and by dint of clever advertising and attention to quality and design, elevated the Gap name to the status of a brand. Sales soared from $480 million when Drexler joined in 1983 to $2.5 billion in 1991. Fashion magazines began granting the clothing generic status, referring to Gap T-shirts with the same familiarity we talk about Jell-O or Xeroxes. But by the early 1990s the rest of the world had caught on, and Gap knockoffs were suddenly being offered everywhere from the runways of high-priced designers like Giorgio Armani and Donna Karan to the aisles of Kmart. By 1992, sales growth had slowed to 17%--down from 30% the year before--and profits had fallen 8%, the first decline since 1984.

About the same time it became clear there was a whole universe of customers the Gap wasn't serving: Everyone could wear these clothes, but not everyone could afford to. "We were hearing from our own employees that the clothes were getting too expensive," explains Robert Fisher, chief operating officer and son of Donald Fisher, founder and chairman.

And so the plunge down-market with Old Navy. Once again it's not an especially new idea--shopping as theater, with big stores, low prices, loud music, concrete floors, exposed pipes, and whimsical displays--and it is rolling out at a particularly brutal moment for retailing. Nor is Old Navy exactly going after an undiscovered customer: J.C. Penney and the resurgent Sears have long courted the lower-price-apparel shoppers and have been spending lots of money sprucing up stores and improving merchandise selections to keep them loyal. It even seems that Old Navy might be arriving at the party a little late. When asked if this business should have been started earlier, Drexler pauses ever so slightly before answering, "Yeah, maybe a year or two sooner."

And yet, people who watch the Gap are sanguine about this new division. "It's the most innovative retailing format of the 1990s because it gives consumers low prices and ambiance, rather than goods thrown on tables and blue-light specials," says Alan Millstein, president of Fashion Network Report, a retail consulting firm. Richard Baum, a retailing analyst at Goldman Sachs, says, "Old Navy is the most exciting concept out there." And listen to Janet Kloppenburg of research firm Robertson Stephens: "No other retailer combines low prices, quality merchandise, and an absolutely fun atmosphere to shop in the way Old Navy does."

Their enthusiasm is benignly misplaced, of course. It isn't the format or the concept or the atmosphere that would move a betting person to wager on Old Navy, it's Drexler and his crew.

The Gap, based in San Francisco, doesn't break out numbers for any of its divisions, but analysts figure Old Navy rang up sales of around $385 million for the fiscal year that ended February 3 and had profits of around $20 million. That's not yet enough to have a meaningful impact on the Gap's bottom line--which analysts estimate at $334 million for the fiscal year--or its stock price, which has recently been trading at around $50 a share. Says analyst Richard Baum: "We believe that Old Navy will not significantly impact Gap's earnings until 1998, so we don't expect it to affect the stock price all that much over the next 12 months." Still, the results are no small change for a new business.

How can Old Navy make money in this game when so many others are rending their garments? For one thing, its stores aren't in malls, where the company's other divisions--Gap, GapKids, and Banana Republic--are. Drexler realized early on that the new customer he was after--the millions of households with annual incomes between $20,000 and $50,000 that collectively spend about $75 billion a year on apparel--would more likely be found shopping in strip centers. That's the kind usually anchored by a Wal-Mart, Target, or some giant category killer like Toys "R" Us, and that's where most Old Navy outlets are built.

THIS STRATEGY helps shield Old Navy from an obvious menace: cannibalization. Explains COO Fisher: "It doesn't take a brain surgeon to figure out that we're either going into the strip centers to capture a new customer or else we're going to keep putting new businesses into the mall and cannibalize ourselves." Furthermore, life outside the mall translates into rent and occupancy costs about 40% lower than those for Gap stores, which helps Old Navy keep prices low and still make money.

But low prices are only half the battle. In the early days of Old Navy, Drexler headed up weekly meetings, trying to flesh out an identity for the stores. He pulled together a team to discuss what the stores should look like, the kinds of display fixtures they should have, even how big the Old Navy signs should be. Drexler gave ten employees $200 apiece and told them to go shopping. Each was assigned a particular store and a category of merchandise to buy. Like soil samples examined after an archeological dig, everything the group brought back was analyzed in painstaking detail. Drexler wanted to know how the clothes fit and what kind of fabric was used and how it held up to washing. "We asked shoppers if it makes a difference to them if the price ends in .98 or .99," Drexler says. "They told us it doesn't really matter."

He also gathered intelligence on the overall shopping experience. With the exception of Wal-Mart, service among the discounters isn't anything to brag about. Drexler wanted to know how they could improve upon it. One of the answers that came back: Keep the checkout lines moving. Something as obvious as that, they discovered, did wonders for keeping customers happy. So today, shoppers in an Old Navy store pay for their goods at wide, supermarketlike checkout counters that let them get through quickly.

Old Navy stores, at 15,000 square feet or so, are almost double the size of typical Gap outlets. Under one roof you can find $8 baby body suits, kids' cotton turtlenecks for $7.50, economy jeans for $16.50, and men's boxers for $7.50 (two for $13). About 80% of the merchandise at Old Navy sells for $22 or less.

One of the more obvious ways Old Navy keeps prices down is by using less expensive fabrics and fewer details, say in the buttons or stitching. For example, right before Christmas, in the men's department, the stores carried a display of deliciously soft dark-gray sweaters priced at $24. A similar-looking sweater at the Gap would go for $38. The difference? Mainly the materials used. The little tag inside the Old Navy sweater says it is 70% acrylic and 30% wool; the Gap tag would read 100% merino wool. The Old Navy sweater is cheaper than one from the Gap, but it looks and feels better than the all-synthetic sweaters often found at similar prices at the discounters. The wool gives the sweater body, while the acrylic--a higher grade than what most discounters use, though not significantly more expensive--makes it soft instead of scratchy.

Old Navy is also less strict than the Gap's other divisions when it comes to consistency in the colors and sizes of its merchandise. The seam allowance, for instance, in a pair of Gap jeans is one-quarter inch. That means that if you turn them inside out and look at the seam, it will be no wider than that. In Old Navy jeans the seam allowance is up to one-half inch. Now, that might not sound like much, but it can mean a shopper has to try on several pairs of jeans in the same style and size to find the one that fits best.

A trip to the Old Navy store in Colma, a 20-minute drive from downtown San Francisco, provides a few other examples. In the middle of the store is a table of denim shirts. They are advertised as the Item of the Week and sell for $15, rather than the regular price of $17.50. "See how some shirts are dark and some are light?" asks Jenny Ming, senior vice president of merchandising for Old Navy. "That's because we wash the Old Navy shirt once, and the shades aren't as consistent." Gap shirts are washed three times, which Ming says makes the shading more uniform.

Do customers notice these differences? Back east in the Wayne, New Jersey, Old Navy store, Jennifer Zoschak is shopping for her two sons, Matthew, 4, and Brendan, 15 months. "I think the quality of the clothes is fine and the stores are clean and roomy," she says, searching through a pile of red turtlenecks for Matthew's size. "My kids outgrow their clothes so fast, I can't see spending a fortune on them."

Because Old Navy merchandise doesn't carry the same hefty markups as Gap and Banana Republic clothing, robust sales volume is the name of the game. Robert Buchanan, an analyst with NatWest Securities in New York City, figures that gross margins at the Gap run between 35% and 40%, while Old Navy's are between 25% and 30%. Says Warren Hashagen, Gap's chief financial officer: "The discount-store industry typically has sales of around $200 to $250 per square foot. If we can't get a premium to that with all we offer in Old Navy, we have no right being in this business."

HUBRIS? Possibly. But there is clearly imagination at work here. An old Chevy truck near the entrance of each store serves as a sort of funky display case, overflowing with sweats, shirts, and baseball caps bearing the Old Navy name. Come summer, it will be filled with surfing wear and beachwear. In some stores, meat scales are laden with Old Navy sweatshirts, and T-shirts are shrink-wrapped like packages of pork chops.

Should a shopper need help, it's simple to spot a salesperson. Just look for the headsets--they're all wearing them. Drexler figured that to keep service levels high without the expense of putting a lot of bodies on the floor, those bodies need to communicate with one another easily. If you've ever waited half-dressed in a fitting room while a salesperson roams the store trying to find you another size, you'll appreciate this.

Amazingly, the sight of these (mostly) Generation Xers running around with their headsets doesn't convey the dorkiness of, say, a fast-food drive-up-window worker. Dressed in their black Old Navy T-shirts with staff written in big white letters on the back, they look a little hipper, bringing to mind Madonna on tour rather than McDonald's on the highway. Drexler says he got the idea a few years ago while interviewing someone for a job. "Somehow we got around to talking about headsets, and I just said, 'Let's try headsets in the stores,'" he recalls.

The ability to act quickly on new ideas is a quality that flows throughout the company. Says Kevin Lonergan, director of stores for Old Navy: "It's so easy to find a reason why an idea won't work." For instance, customers are handed oversize black-mesh bags when they enter Old Navy stores, to carry their merchandise around. When shoppers in the New York City store began asking if they could buy the bags, Lonergan says, "within 30 minutes we had tags made up and were selling them for $5." Some people at the company, however, worried that selling the bags could be a problem. After all, they told him, how could salespeople figure out which customers actually purchased the bags on previous visits to the store and which customers were simply stealing them? A valid concern, but not enough to keep from selling the bags. "In a new business you can talk yourself out of trying anything," says Lonergan, who was formerly director of stores for discounter Target. "We hope people aren't stealing the bags, but if someone accidentally takes one without paying for it, what's the worst thing that happens? They walk around town promoting Old Navy."

It's that kind of touch that Drexler must cultivate in his people if Old Navy is to live up to early expectations. In September, chairman Fisher made him CEO of the company (Drexler keeps the president's title). "I'm thinking more long term now," Drexler says, "and I'm delegating more at the operating level, holding the presidents more accountable for their business units. I'll run Old Navy myself for the first couple of years while we roll it out, but eventually we'll have a president for that too." Then after a beat he adds: "It's definitely been an adjustment, this sort of having to grow up in your job. It's like with your kids. You'd love to do everything for them, but if you do, they won't learn."