Should You Buy Gap Stock Ahead of the Old Navy Split?

Gap (GPS -3.68%) -- the parent of its namesake clothing company as well as Banana Republic, Athleta, and Old Navy -- is splitting up. Specifically, Old Navy is leaving the multibrand apparel conglomerate behind. And for good reason: Old Navy is a growing company hitched to a slowly hemorrhaging clothing enterprise.

The announcement sent shares higher by double digits, giving investors hope that Old Navy -- which will be nearly as large on its own as the rest of the company -- will get a higher price tag once the separation is complete. Given the current situation, that's a likely scenario. The problem? The remaining brands that will form the new Gap company (Gap, Banana Republic, Athleta, Intermix, and Hill City) don't look so good. Patience could be a good strategy here. 

Check out the latest earnings call transcript for Gap.

Why buying now might make sense

At first glance, 2018 was a pretty good year for the company. Global growth from Old Navy and newer brands like Athleta more than offset substantial declines at the Gap business. Paired with share repurchases and lower taxes due to U.S. corporate tax reform, earnings notched a nice advance.

Data source: Gap. Chart by author. YOY = year over year. Ppt = percentage point.  

The Gap business lost more foot traffic and closed dozens of stores in fiscal 2018 to try to stop the bleeding. It plans to close another 230 stores over the next two years. That will mean lost sales, but will ultimately free up money that the company can use to bolster online sales and support expansion in its smaller growth brands. More share repurchases are on the way, too -- to the tune of $1 billion: a sizable sum, considering that the company's market cap is roughly $10 billion.

But why separate Old Navy from the rest of the business? Staying together keeps operating costs down, so the resulting new enterprises could be somewhat less profitable than they were as a single company. However, as my fellow Foolish contributor Billy Duberstein pointed out, the separate concerns could independently search for better synergies with other clothing companies. (As if to confirm that viewpoint, Gap announced last week that it will acquire Janie and Jack, a premium kids and baby clothing company.) Furthermore, investors would gain better insight on the companies, which could lead to a higher valuation, particularly for the fast-growing Old Navy brand.

Thus, buying now could mean that investors end up with two solid apparel companies -- a growing discount clothier in Old Navy and a premium, niche multibrand operator headed up by Gap.

Image source: Getty Images.

Why you should wait

Still, there's limited visibility into the two companies structured as they are, including how much profit each generates. Here's what we do know, though. The new Gap will have roughly $9 billion in annual sales, and Old Navy about $8 billion. Total free cash flow between the two last year was $676 million compared with $715 million in 2017. Expected earnings in 2019 should be $2.11 to $2.26 per share, or $2.40 to $2.55 when excluding costs related to Gap's accelerated store closures. So earnings are set to fall compared to fiscal 2018.

It's also worth noting that while Old Navy grew again last year, it was at a slower pace than in years past. Old Navy's slowdown occurred even as the clothing and apparel industry's growth accelerated. Granted, total sales for Old Navy were up 8.6% in the U.S., despite there being one less week in fiscal 2018 than in the previous year. However, comparable sales at existing locations increased only 3%, compared to 6% growth in fiscal 2017. According to the U.S. Census Bureau, clothing and accessory store sales surged 4.8% in 2018.

If Old Navy's growth continues to decelerate, optimism about it achieving a substantially higher valuation could fade. Meanwhile, there's not a lot to be excited about with the remaining businesses. The sluggish-at-best Gap and Banana Republic brands would make up nearly 90% of the new company's sales.

Of course, a lot could change between now and 2020, and that's why I'm preaching caution. The current Gap company is a mixed bag, but the overall business is trending down after a particularly busy year for the clothing industry. Shares aren't particularly cheap either, trading for nearly 15 times free cash flow. Thus, I'd wait until at least closer to the actual split before pulling the trigger on Gap stock.