Most companies strive to increase their scale and grow larger, but Gap (NYSE:GPS) has decided the best path forward is to go smaller. In February 2019, the company announced it will be separating into two entities: Old Navy and a yet-to-be-named company with the remaining brands (Gap, Athleta, Banana Republic, Intermix, and Hill City).
The transaction, which is expected to happen at some point in 2020, is a major step in Gap's long-running effort to restructure its business and turn around disappointing results.
Old Navy stands out from the pack
Why would Gap want to spin off Old Navy? The answer has a lot to do with growth. Specifically, Old Navy is the company's only brand that is showing meaningful growth. As you can see in the table below, Old Navy has put up positive same-store sales growth for the past three years, while the rest of the brands reported mixed or negative comps.
|Old Navy sales comps||1%||6%||3%|
|Gap sales comps||(3%)||(1%)||(5%)|
|Banana Republic sales comps||(7%)||(2%)||1%|
|Total company sales comps||(2%)||3%||0%|
Old Navy's strong performance speaks to shifting consumer preferences toward shopping at discount retailers versus more expensive specialty retail brands like Gap and Banana Republic. For context, Old Navy was started in the early 1990s as a more affordable version of Gap stores. The Old Navy brand has exploded in popularity and now generates roughly $7.8 billion in annual sales compared with $8.7 billion in sales for the rest of the company.
This divergence in performance between discount and specialty retail isn't unique to Gap. Discount retailers such as TJX Companies and Ross Stores have prospered in recent years, while specialty brands such as Gap and Abercrombie & Fitch have suffered.
At Gap, this is not only reflected by the divergence in comparable sales but also in store counts. Old Navy is the company's only major brand that is still growing its store base. The difference is even starker than the table below suggests, when factoring in the recently announced plan to close an additional 230 Gap stores over the next few years.
|Old Navy store count||1,056||1,080||1,154|
|Gap store count||1,319||1,278||1,242|
|Banana Republic store count||650||621||601|
|Other brands' store count||175||186||197|
Old Navy's massive success has created a situation where its business has very different needs and priorities than the rest of the company, which is focused on slowing sales declines and improving margins. On the fiscal fourth quarter earnings call in February, Gap CEO Arthur Peck commented:
Old Navy's value creation levers, business model, and customers have increasingly diverged from our specialty brands. That divergence to me is now clear, and we think the best way for each company to grow and meet the evolving needs of our customers is to allow them to pursue tailored strategies separately.
In other words, it makes less sense to keep Old Navy in the stable with the other brands, because it requires a different management approach. Gap wants to free Old Navy to reach its full potential, while it continues to focus on making the mature brands more profitable by closing stores and rationalizing costs.
A "gap" in valuation
Spinning off a faster-growing business is a common strategy to "unlock the value" in a subsidiary hidden in a larger umbrella of businesses. For several years now, Gap has delivered underwhelming performance, and as a result, investors have punished Gap's stock. However, Old Navy has done a lot better than its sister brands. If Old Navy were to trade independently, it could be valued at a much higher multiple than the combined entity, closer to what other discount retailers are seeing with similarly strong growth metrics.
The difference between Old Navy's earnings being valued at 20 times versus less than 10 is a significant amount of shareholder value creation. Closing this valuation gap is a good enough reason on its own to proceed forward with the breakup.
The Old Navy business has really stood out from the rest of the company as a shining star that needs room to grow. It has the potential to flourish with a separate management team and board that is focused on accelerating growth rather than store closures and damage control.
It's always interesting when a company comes to the conclusion that it's worth more in parts than kept together as a single entity, but there's still a strong case for such a major restructuring at Gap and Old Navy.