Gap Inc. (GPS 1.47%) and Old Navy are breaking up.

Gap, which is also the parent of Banana Republic, Athleta, and smaller brands Intermix and Hill City, said it would spin off Old Navy as a separate publicly-traded company. The discount chain has been Gap's best-performing retail banner of late and is by far the biggest, making up nearly half of the company's revenue.

The move elicited cheers from investors, who sent Gap stock up 16% on Friday. The divorce unlocks the company's best asset, essentially cleaving the apparel company into a growth brand and a suite of struggling legacy brands facing comparable sales declines and hundreds of store closures.

The news also marks the clearest sign yet that Gap, the brand that's defined American style as much as any other over the past generation or two, is in desperate need of a new strategy.

Gap has fallen behind fast-fashion competitors like H&M, Uniqlo, and Zara, while some customers have shifted to upscale brands like Lululemon or lower-priced options like Old Navy. In the same announcement, management said it would close 230 Gap brand stores over the next two years.

Gap Chairman Robert Fisher explained the decision to divide the company, saying, "Following a comprehensive review by the Gap Inc. Board of Directors, it's clear that Old Navy's business model and customers have increasingly diverged from our specialty brands over time, and each company now requires a different strategy to thrive moving forward."

A woman shopping for jeans.

Image source: Getty Images.

A diamond in the rough 

The Gap brand and Banana Republic have faced a rising tide of competition in both the online and in-store channels in recent years and have done little to evolve or differentiate themselves. By contrast, Old Navy has carved out a unique brand and a clear leadership position in discount apparel, operating at a price point that gives it significantly fewer direct competitors that offer the breadth and style of apparel that it does.

Old Navy has more than 1,100 stores, nearly all of them in North America, and makes up more than half of Gap's company-operated real estate. The discount brand just finished the year with 3% comparable sales growth, following 6% comp sales growth in 2017. At Gap brand stores, comps fell 5% in 2018 after a 1% decline the year before. 

Old Navy brought in $7.9 billion in revenue last year, or 47% of the company's total. Considering its faster growth, it would be the more valuable of the two companies if the split were to happen today. 

Check out the latest earnings call transcript for Gap Inc.

A question mark for Gap

While the separation should help streamline and speed up decision making at Old Navy, it's less clear how the move improves the Gap brand's prospects. Reinventing a 50-year-old brand won't be easy, especially in the highly competitive and oversaturated mid-market apparel sector, where a number of competitors, including H&M, have been forced to close stores. 

Management said it intended to revitalize the Gap brand, and planned to close nearly 50% of its "specialty" stores over the coming years, which doesn't include the better-performing factory and outlet locations. Closing stores should help free up capital to invest in remodeling the remaining stores and growing Gap's e-commerce business. That strategy appears to borrow from more successful omnichannel retailers like Nordstrom. The company also plans to make marketing investments to elevate the brand once again.

A win for investors 

As the stock's surge indicates, the split will unlock value for shareholders, as Old Navy's growth had been buried among Gap's larger woes. It will also offer investors a choice between a growth stock in Old Navy or a turnaround play in Gap and its other brands, which the company is calling "NewCo" for now. With Old Navy on an increasingly divergent path from Gap Inc., separating the two companies makes sense for both investors and the business. The split is expected to take place in 2020.