This week, Gap (GPS -2.33%) made the unexpected announcement that it was planning to split its business in half. In this week's episode of Industry Focus: Consumer Goods, host Jason Moser and Motley Fool contributor Asit Sharma explain why. Learn how Gap makes its money now, which of Gap's brands have the most potential, why it makes sense to spin off some of the brands, what it will mean for the two new companies, and which one will probably be the better buy after this goes through. Also, the guys talk about a potential IPO coming out of longtime consumer favorite Levi's; and a couple of stocks to add to your watchlist this week.

A full transcript follows the video.

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This video was recorded on March 5, 2019.

Jason Moser: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market each day. It's Tuesday, March 5th, and we're talking Consumer Goods. I'm your host, Jason Moser. Joining me in the studio via Skype is Asit Sharma. Asit, good to see you again! How's everything?

Asit Sharma: Everything's great on my end! We had a really chilly morning here in Raleigh. I'm looking for a really hot discussion today to warm up these old bones. 

Moser: [laughs] Well, I think we have a couple of things that should warm you up. Today's show, we're going to dig into Levi Strauss' decision to make another go of it as a publicly traded company. 

But first, we're actually going to talk about another well-known and already publicly traded retailer that's considering breaking up with itself. We're talking about Gap. Gap, the retailer known for brands like Gap, Old Navy, Banana Republic and Athleta, has decided to spin off the Old Navy business and become two separate companies. Late last week, Asit, we get a tweet from listener @DeathStripMall. That's pretty cool tag, I have to say. He asked, "Can you help me understand how Gap creates value for itself by spinning off Old Navy? Won't get be less valuable without one of its best assets?" 

I could have gone into the weeds last week, Asit, and answered that question. But you know what? I'm going to call him out on this and say no. You have to wait and listen to the show, and that's what we're doing. So, Asit, let's get this conversation started!

There's a lot to unpack here. Generally speaking, we're looking at Gap becoming two companies. One of them will be Old Navy, the other one will be everything else. Go into a little bit of the weeds here for us. Tell us what this deal is about. What were your initial reactions? 

Sharma: Sure, Jason! That was so great to see on Twitter last week because I was already interested in that topic and it set the stage for this exciting convo. Let's jump right into the weeds!

This is actually going to be a spin-off of the traditional assets. The Gap brand, Banana Republic, Athleta, Intermix, and a newer brand called Hill City brands -- they call it technical sustainable menswear. We can talk about that in a little bit. All of these brands are going to be the ones that are spun off into an as-yet-unnamed company. Together, these brands have annual sales of almost $9 billion. Old Navy will actually be the remaining stand-alone company, and it has annual sales of about $8 billion.

This is going to take some time to consummate. The company expects the transaction to happen in 2020. It will be a tax-free distribution of shares, as these spin-offs often are. The interesting thing is that current shareholders of Gap will get one share of the new company for every share that they own. You basically have a twofer going on here. We'll get into that in a moment. 

As for leadership, Art Peck, who is currently the CEO of Gap Incorporated, is going to lead the new company. He's going to lead the spin-off. And Sonia Syngal, who's current president of Old Navy, will remain now as CEO and president of the newly publicly traded Old Navy. 

Before flipping this back to you, I wanted to give an overview to listeners of what the company says its rationale for this split-up is. They basically have four bullet points they issued. I'm going to read through these nearly verbatim, not totally verbatim. Here they go. Separation creates two independent companies with sharpened strategic focus and operating structure. The second point is that the spin-off will enable each company to capitalize on their respective unique business models, growth plans, and customer bases. Third, compelling and distinct financial profiles, tailored operating priorities, and unique capital allocation strategies. What that last point means is basically, each company can then decide if it wants to take on some more debt or perhaps raise some equity through new share offerings and allocate that into whatever kinds of investments they see fit. And finally, this better positions the two new companies to create significant value for customers and shareholders and opportunities for employees. 

So, there you have it, Jason! These are the details of the deal and the stated reasons for it. Curious on your thoughts!

Moser: This is certainly not the first time something like this has happened. We see it happen frequently. Sometimes it's seemingly two businesses that are very similar splitting themselves up. Sometimes it's two businesses that aren't necessarily doing the same thing splitting themselves up. In this case, obviously, it's the former. Looking back in history, looking at some companies that have done something like this before, the one example that came straight to mind was when Kraft Foods decided to spin out its snacks division. That's where we got Mondelez, and then Kraft went on its own way. And then Kraft and Heinz got together, and we all know the story about that at this point in the game, especially if you're a Kraft Heinz shareholder. 

You can look at it on the surface, big picture, yes, Kraft and Mondelez, both food companies. But one is a packaged goods company, one is more of a snack company. They are the same, yet they are different. I think oftentimes, you can see where businesses that seemed somewhat similar on the surface do actually require different strategies when you get right down to it. They may require different capital requirements, they may require a different marketing focus. Certainly, they are for different audiences. That's where you could see something like this happen. We can look at Gap and say, "They're all clothing companies," but they're not necessarily all the same. Old Navy stands out among all of those brands as the value offering, don't you think? 

Sharma: Yeah, absolutely. In fact, the retail strategy is different, as well. While most of the Gap outlets traditionally have been found in malls, Old Navy is located closer to big box stores and is not quite as embedded in the leases, so they have a little more flexibility there. If you look at some of these new brands, like the Hill City brands, Athleta, these are geared toward a slightly higher-value customer. They lend themselves to new retail, which is selling this omnichannel strategy, selling online, appealing to millennials' purchasing preferences. The old assets, the Gap assets, plus these new brands, certainly have a distinct strategy that's different than Old Navy. 

But Old Navy, it's the growth vehicle, has been the growth vehicle that has kept Gap a viable investment over the last 10-year period. Now, we should say, if you're holding shares of Gap, you know that over the last five years, it's actually lost about 35%. For me, this becomes a question of, What is the potential for splitting up? I've got some thoughts on these two companies separately. 

I want to throw out another example before I do that, which is the split that eBay engendered when it spun off PayPal. You had something similar going on in that both were part of this whole which formed a marketplace company. PayPal was responsible for the payments, and it was a stepchild of the company. It took care of payments in the marketplace and made some forays into other businesses. eBay said, "Look, to really compete with some of these other online retailers, we probably should focus management on that marketplace and other opportunities. To realize the potential of payments, we ought to spin off PayPal." Now, interestingly, it was the same type of transaction, tax redistribution. If you held a share of eBay, you got a share of PayPal. And we all know what's happened to PayPal since. It's gained about 150%, rough numbers, at the same time that eBay -- since that July 2015 spin-off -- has gained about 35%. 

You would have had appreciation with both, but the question in investing becomes, you have earnings, you have cash flows that you generate, and you have the market's perception of those cash flows and their ability to generate those cash flows. PayPal's potential was only uncovered when a dedicated management team could focus on that and go off to the races. In the same way, eBay has grown slightly. It's a slower-growth company.

Having said that, I do want to talk in a moment about how the two companies look differently. But let me put it this way, you're a warrior on cash, Jason.

Moser: [laughs] Yeah. 

Sharma: Maybe a little hyperbolic. But any parallels that you see?

Moser: I subscribe a little bit more to the cashless view of the society. Yeah, I like the eBay example. You see two companies there that are on their own -- eBay probably would drag down PayPal if they were still together. It gave PayPal a chance to go about its own way, and eBay has still done OK. You look at the other example we talked about, Kraft and Mondelez, if you look since that split, Mondelez has actually worked out pretty well for investors thus far. Who would have figured? We all like our snacks. But Kraft has had a little bit of a tougher go of it. You could probably attribute that to management and pursuing that Heinz strategy. We've seen what happened recently with the Kraft Heinz writedown there, with Warren Buffett and 3G Capital. 

It's not to say that it will always work out well for one and not so well for the other, or well for both. It just gives each brand or company the opportunity to go pursue their own strategy. When I look at retail, when I look at fashion in general -- listen, I'm not the most fashionable guy in the world. I think I have the sartorial sensibilities of maybe my dogs at home. With that said, I am a dad, and we've given a lot of money to Old Navy through the years. Old Navy has been a great place to shop for kids' clothes. And, hey, I've got a few of those shirts in my drawer, too. I'd probably lean a little bit more to the Old Navy side just because that's what I know. But with that said, giving each business their own focus could really unlock value on both ends of the spectrum.

Sharma: That's such a fascinating point you just brought up. You're a dad, and you've given your share of dollars to Old Navy. I protect this like a trade secret, my age. I'm 40-something, let's leave it at that. I won't tell you what side of 40 I'm on. 

Moser: [laughs] We don't need to go any further.

Sharma: When I was a teen, there was a time in life where you went to the mall, to the Gap and Banana Republic also, and if you had a little extra cash, you got an upgrade on your clothing vs. your standard Levi's or whatever else you could afford. It had a certain cachet. As I've progressed, I've seen both sides of that. 

To get to our question on Twitter, which I want to really dive into here, if you're taking all the older assets -- the Gap and Banana Republic assets with a few growth brands -- and spinning that off into a new company, how can that particular bucket grow?

One thing I wanted to point out is, it's going to start with a lower baseline of expectations and it's going to be a slower-growth company. The good side of that coin is that if they can figure out how to jigger some growth, the multiple that the market assigns to them is probably going to increase. While it's still this whole ball of wax for the next year, Gap is cutting down the number of specialty stores it has. It started with 725 at the beginning of 2018 and cut that down to maybe 650. It's going to cut that number in half again by closing underperforming stores. The company says that will ding it for about $625 million in revenue, but it'll add $90 million pre-tax to Gap's bottom line.

Now, by the time Gap sees that money, it will be in a separate holding company, and that will have a much greater effect on its P&L than if it was still in this big company, which has almost $17 billion in sales. So, that's one really smart way that a company can actually show some growth in the part that's being spun off, and that's simply by making some really smart cuts.

Other strategies they have are to pour more money into brands like Athleta. I was surprised, Jason. Since Gap hasn't performed well, I haven't followed it closely for a number of years. I was surprised that Athleta has grown at a 30% two-year comparable sales clip as of this last quarter. That's pretty good.

One other thing to note about these newer brands is Athleta -- I think you pronounce it differently?

Moser: Yeah. I'm not sure which one it is. I would imagine both are acceptable at this point.

Sharma: Maybe I'll flip between them to be fair. Athleta is a certified B corp. If you know anything about B corps, basically they're a sustainable type of corporation. You have to have a sustainable bent, be more than just about the bottom line. That's a cachet for millennial purchasers. 

Moser: Absolutely!

Sharma: I think that the Gap company, Gap brands, with these newer brands, is going to push that, especially their online sales. So there is some earnings potential here for what looks like a drag on earnings.

Moser: I guess we'll see. One of the things I always look at with the retail space in general -- obviously, when we say "retail," that's very wide-reaching -- when it comes to fashion in particular, as an investor you look at this market and you think, What are the competitive advantages? Are there any? I don't know that there really are. Maybe the brand is the biggest competitive advantage a fashion retailer can actually possess. And then, obviously, they have to maintain that brand. 

I think Gap and Banana Republic have held their own through the years. I'm not sure that they're brands that warrant a whole heck of a lot of pricing power going forward, but I think that the Athleta brand could be that. There's something with that athleisure wear, we're seeing that market growing, we're seeing Nike pursuing it a little bit more, the success that Lululemon has had. I know that Under Armour is trying to test those waters as well. So I think there's the opportunity there, and that would probably be the brand that I would be most excited about at this point.

Old Navy is always going to be a value offering. That's not to say that's a bad thing, but you have to remember how that plays out on the bottom line. They're probably not going to be growing their top lines, either company, at extraordinary rates. But I do think that splitting them up gives them a chance to focus on what they do well, right-size their cost structure, streamline the businesses. 

As we always say with retail, these, to me, at least, are not buy-to-hold investments. You need to buy these retailers when the pessimism is high, the stocks are cheap, and you need to have a clear path toward why that changes. If you can have a thesis that really tells why you think that narrative changes, then you can potentially realize a value investment there, where you buy in at a good price and you sell out at a good price. 

Definitely a difficult market to get. I certainly don't profess to be a market timer by any stretch, and I don't think you do, either. 

Sharma: No, not at all. Last point I want to throw in about Old Navy. Let's look at that possible scenario of the stocks splitting up. Maybe we get a market downturn. Pessimism is running high, as you say. If you're looking to pick up Old Navy, what would be your reason to buy into this stock? If you look at Gap's current financials, it has the greatest comparable sales growth of any brand in the company. But that's pretty meager. It's usually 3% or 5% in a quarter. However, when you put these companies in different buckets, they each have a fairly decent balance sheet that's not that encumbered. 

The potential for Old Navy really is in some unit growth, some smaller stores. They've looked at this in the past and have had decent expansion. But being part of this multibrand animal, the resources haven't really been there for Old Navy to expand in any significant way. So one lever they could pull is a little bit faster unit expansion. They still profess to feel underpenetrated in the value sector. That might be some reasoning investors can employ if you do see -- as Jason's pointing out, as we see all the time with retail stocks -- if it happens to get to a point where it looks attractive to you, that might be a rationale to pick up a few shares.

Moser: One last question and we'll wrap this up. This is a bit of a hypothetical, but I'd be interested in your answer here. You, Asit Sharma, will be the CEO of one of these two businesses. You get to choose. Which one are you choosing and why? 

Sharma: Interesting question because the CEO of the current company made a point in the last earnings call just last week to say, "I'm going with the old assets. I'm going to run Gap and these other brands. But, oh, I love Old Navy just as much! This was a hard decision for me!" [laughs] He went out of his way.

Moser: [laughs] I don't know if it was.

Sharma: He's a very diplomatic guy, but you and I don't have to be so diplomatic. I'm going to give a contrarian answer to maybe what you'd expect. I'm actually going to go with the Old Navy brand. It's got limited potential in terms of ever growing at that fast a clip. Actually, the potential, as you point out, might be in the Gap brands with Athleta and Hill City. At least those can grow with online sales. But, I like this idea that Old Navy isn't as well-represented. I would go out, cut some more costs, I'd do another bond offering. I might have a secondary stock offering in a year. I would plow into as much as I think the market could bear. Then I would trumpet that to shareholders every quarter. I'd focus on unit growth, not on those comps that are still 3% to 5%. 

That would be my strategy. It's not a very risky strategy. There's some obvious value there to unlock. I don't have the chops as a CEO to go in and grow the fashionable brands and explore those online strategies that are so necessary to compete today. 

Let me flip the question back to you, my friend! Jason Moser, investor extraordinaire, consummate dad, really smart guy, you have a choice and you have to choose. Which door is it? 

Moser: Either from an investing perspective or from a CEO perspective, I think I'm going Old Navy either way. I agree with you. I think there is a consistency there that would be a lot easier to continue with moving forward. I think that Old Navy through the years has done a very good job of marrying a good brand recognition -- I think there is some brand equity there -- with the value offering that it proposes. We see these commercials constantly. They've done a great job of marketing that name through the years. I think that would be a fun one to keep that ball rolling. 

We'll see. We're talking about 2021, this actually plays out. You still have some time. I'm sure there will be an arbitrage play or two out there being proposed, as well. 

Let's flip it over a little bit here and talk about Levi's. Given your age and my age, I think we grew up at the same time, this is brand that you and I are very familiar with. I got a couple of pairs of Levi's jeans at home still. When I think of jeans, I think of Levi's. That really is the only brand of jeans I will buy, and I've been doing that for 40-some-odd years, let's just say. [laughs] 

We're talking about Levi's looking at giving it another run as a public company. Why do you think that is? What's your take on this business? Is it even worth us looking at it as investors?

Sharma: I think it might be. The company has been around since the 1850s. It started its jeans business in the 1870s. Has done very well over the centuries, crossing of centuries. This is a company that's got a tremendous amount of brand equity. It was a public company between 1971 and 1985, but the controlling shareholders, the family who owned most the shares, pulled it off the markets in the '80s. The company slumped through a number of factors. Tastes were changing, but management did not have a cohesive strategy to run the company.

Fortune started to turn around, interestingly enough, around 2011. This is when Levi's brought in a Procter & Gamble executive. Procter & Gamble is an amazing learning laboratory for anyone in the consumer retail business, so you really get a deep education in how to market a brand, how to manage costs, supply, chains, etc. So, they hired this CEO, Chip Bergh, in 2011. Since then, sales have rebounded. They had reached the $4 million to $5 million level after nearly hitting $10 million. Since Chip Bergh has taken over, sales have grown. Again, they were $5.6 billion last year, which represented a 14% improvement over the prior year. It's interesting. 

We should mention, though, the jeans business is getting hot and crowded. I was reading the conference call transcript from Gap from last week. The CEO said, "We're going to lead with denim in the Gap brand. We've always done that and we're going to continue to do that." The Wrangler and Lee Jeans business, that's owned by a company called VF Corporation, which is next door to me in Greensboro, North Carolina, they're spinning off their jeans business, which has just under $2 billion in sales, so that that business can compete more in the marketplace.

I think this is an interesting company to look at because it's an iconic brand and because the CEO has really changed a lot of the culture of the company. It's a more focused company now, more in tune with contemporary marketing. He's expanded their global footprint. He's also cut a lot of costs. Interestingly enough, Levi's doesn't need the money. Jason, a couple of shows ago, you and I were talking about our preference for companies -- this was the Beyond Meat episode -- when they go public that they're not struggling for cash. This is certainly the case here. Levi's has a pretty solid balance sheet. Its placeholder IPO filing says it's going to raise $100 million, but that's just a placeholder number. Most estimates I've seen say they're going to raise between $600 million and $800 million, which they don't have an immediate need for. That signals to me that they want to expand more globally, they want to expand more into the retail stores they've built. That footprint is one where they can control their product, control the distribution, make a higher margin. 

Those are a few interesting nuggets sprinkled through the S-1 that makes me want to look into this company once it goes public. What are your thoughts on Levi's as an investment?

Moser: You and I look at the use of proceeds immediately when we go through S-1s. It's nice to see that they don't need the money to pay down debt. They have about $1 billion in debt on the balance sheet, but it's easily serviceable from the operating earnings that they're bringing in, it seems. There's a lot of nostalgia there that makes me want to take a closer look, just because I've known the brand for so long. I fall back to the lessons learned in retail investments, and again, I have to remember to check myself before getting too attached. But, it's one that I would like to learn more about, at least, and see what the strategy is going forward. It's a brand that still resonates not only very well here domestically, but clearly globally. They're pushing a lot of revenue through that model every year, and I think it is the type of company that is adopting very well in a direct-to-consumer world. So, yeah, we'll be watching that one, certainly, as it comes out. It will be yet another opportunity out there for investors to consider. 

I want to read an email today that we got from a listener. Before I do that, I wanted to also make a note here. A lot of folks out there may note that today, Target earnings came out. We're not talking about Target today on this show. Clearly, it's in our purview, but you can get that information over on Market Foolery today, so just go to that podcast app you have on your phone, click on today's episode of Market Foolery, and let Chris Hill and Abi Malin tell you all about the good, the bad, and the ugly of Target's quarter.

Going to read an email here really quick from Ben Hargis. I had to read this on today's show because it goes back to a show that you and I did recently, Asit. Ben says, "Hi, Industry Focus team. I just listened to the Beyond Meat episode. I'm a little behind. I thought it was very interesting. I can imagine increasing demand for this kind of food in the near future. I'm sure I'm not the first one to think of this, but it seems like the protein producers might be a good way to invest in plant-based food products since any company like Beyond Meat will depend on them. Anyway, thanks for the good work you guys do. I discovered Motley Fool podcasts about four years ago, joined Stock Advisor and Rule Breakers about three years ago, and it's changed the way I approach investing and company research." He says here, Asit, "As an example, I can't believe I'm thinking about pea protein producers. Keep it up. Thanks, Ben Hargis."

Ben, thanks so much for the email! Asit and I had a lot of fun doing that show. I'm glad to know that we are having such an impact on the way you do your research. It's a great point! One investing idea can breed so many new ones. You think about all of the companies that are involved with that value chain, all sorts of opportunities upstream and downstream. Keep up the great work, man, and thanks for listening!

OK, Asit, we want to wrap this week up here giving our listeners a couple of stocks to keep their eyes on. What's one stock you've got your eye on these days?

Sharma: I'm looking closely at Wayfair. I just added that to my Motley Fool Caps collection. If you're not familiar with the Caps, it's an online stock investing game. Check it out! It's a really great way to learn. People like Jason, knowledgeable people who you respect, will put pitches, and you can see why a person wants to buy a particular stock, or why they think it's a thumbs-down, might go down versus the S&P. I love playing Caps, and I added Wayfair. This is the online retailing furniture company. Longtime listeners may remember, we talked about this on a show, feels like a couple of years ago now. What an interesting concept it is. Wayfair is trying to basically compete against companies like Amazon, but just in the furniture market for now. It's doing so by going after as much market share as it can. 

Here's my pitch. I really like Wayfair, even after recent earnings, the stock has shot up to all-time highs. It's expanding its European logistics network and concentrating on Germany. Now, you won't see many companies do this. When you hear CEOs talk about global expansion, they're like, "We're going in China! We're going in Europe! We're going in Africa! And yeah, we're going into Latin America, folks!" I really like Wayfair's approach. They are concentrating on Germany, which has a total addressable market that's even bigger than Canada, which is the second market the company entered. They're developing a true platform for sellers, furniture wholesalers and manufacturers, which actually gives data back to the sellers and lets them know which pieces consumers preferred. 

This is hard to do in the furniture business, but they have a distribution logistics network that will take a piece of furniture from basically the manufacturer's door all the way to your living room. It's a proprietary network. Has two components. One is called CastleGate, that's more their logistics arm, and WDN is their last-mile delivery network. They are doubling down on these facilities in the U.S. in major metropolitan areas this year, grabbing as much market share as possible. Yes, they're running at losses, but this is an Amazon-like company. They will have time in the future to pull back a little bit if they need to and show some profit. 

I am a terrible market timer. It is trading at an all-time high. But when I see a company that is really going after and conquering a market, rather than try to time it, I like to buy it and just ignore the volatility. 

Now, folks, please don't send me tweets next week or the week after. "Hey, Asit, I bought Wayfair at $150. It's at $120. What do I do?" I won't know what to tell you. I'll probably tell you, just hold and ignore the volatility. That's my two-, maybe three-minute pitch. There you go!

Moser: Talk about businesses that have gotten a few of my dollars, Wayfair is another one. I tell you, I like it, too. It's that retail company in this day and age, it all really is just a network. They don't carry any inventory on that balance sheet, and it gives them an opportunity to connect buyers and sellers. That's a good one!

I'm going to go a little bit more the traditional route this week. Costco has earnings coming out on Thursday, March 7th. That's before the market opens. We were in Austin, Texas, this past week at a Fool event. I got to talk a lot about businesses like Costco and Amazon and Wayfair. It's neat to see how Costco is still doing so well as a traditional retailer in what is becoming very quickly an e-commerce world. It's a membership model, and the focus on really just making sure they give their customers a big, wide selection and the lowest prices possible, it seems to still resonate in this day and age. It has a very loyal base of members that just keep re-upping. And if you remember, they did increase that membership price a couple of years ago back in 2017. Those increases take about two years to fully run their way through the books, so I wonder if we won't hear in the next call or two, maybe they're pondering perhaps another small little membership fee raise. They've proven they can do that, and members won't even bat an eye because they get so much value from it. 

A well-managed business, one that has done very well for a lot of our investors through the years here. That's the one I'll be looking at this week. 

Looks like we've got ourselves set up here. Looking forward to the next time we get to do this, Asit!

Sharma: Awesome! Looking forward to it, Jason! Thanks, everyone!

Moser: All righty! As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Today's show is produced by Austin Morgan. For Asit Sharma, I'm Jason Moser. Thanks for listening! And we'll see you next time!

Check out the latest earnings call transcript for Gap Inc.