4 Reasons Why Gap Wants to Split Up Its Brands

Gap's (GPS -3.83%) recent announcement that it will split into two separate companies next year caused a temporary spike in its stock price. In the following segment from Industry Focus: Consumer Goods, host Jason Moser and Fool.com contributor Asit Sharma break down management's rationale for the move.

A full transcript follows the video.

This video was recorded on March 5, 2019.

Jason Moser: 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 a 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 Gap 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?

Asit 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!

Check out the latest earnings call transcript for Gap Inc.

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.