Can Old Navy Really Add 800 Locations?

When Gap (GPS -2.76%) spins off Old Navy, the latter plans to add about 800 new locations. That's a major increase for the retailer, which currently has about 1,300 stores.

In this segment from Industry Focus: Consumer Goods, Fool.com contributor Daniel Kline joins host Dylan Lewis to talk about expansion plans for the chain and whether they make sense. They also discuss whether Old Navy has a strong digital strategy and if it should be focusing more on that area.

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This video was recorded on Oct. 8, 2019.

Dylan Lewis: The one thing that gives me a little pause when I'm looking at Old Navy is, they have over 1,100 locations. It might even be 1,200 at this point. The plan over the next few years is to open 800 stores. From a growth perspective, that sounds awesome. To really meaningfully grow your top line by adding more locations is great because then you have not only the growth that's coming from same-store sales growth, you also have all this other growth coming as well. But 800 stores is a big jump from where they are now.

Dan Kline: That doesn't worry me that much because of the general contraction in department stores. They're adding 800 stores. Yes, there's other companies growing, but most of those are discounters. TJ Maxx companies, Marshalls, T.J. Maxx, HomeGoods, Ross Dress for Less, Five Below. Those are growing retail companies. This is a uniquely positioned fashion brand that works in almost every market. If a parent used to buy their kids clothes at Sears, Old Navy is a very logical substitute for a Sears with a more predictable inventory than many of those stores that I just listed out. Look, I don't know exactly how many malls and retail areas are appropriate in the country, but 2,000 to me doesn't seem crazy when you look -- we have an Old Navy here in West Palm Beach that draws locally. We could probably support one in three or four other towns here. In other, more densely populated areas, I could see there being a few. These aren't stores that you're necessarily going to travel far to go to. There is just a demand in almost every middle class or higher community, and maybe even a demand in some struggling communities, because it is decent stuff that's not very expensive.

Lewis: My reason for pause is just that so much of the growth story is built on them building out that footprint. I look over at Madewell, and I see, they have around 130 stores; the plan is, for every year, to add about 10 to 15 stores. That's not a crazy growth rate when it comes to your physical locations. The comps are doing well. You're growing over 20% based on just that 10 to 15 per year pace. That's pretty solid.

Kline: There's also a bit of a digital disconnect here. It's worth it for a company that's making $50 on a $100 pair of jeans to deal with occasional returns and eating that cost, even to eat the cost of shipping overall. Old Navy, which does have a website, doesn't really push their digital business that much because, if I'm buying four items and it's a $45 sale total, you run into some difficult margins when you get into who bears the cost of a return, or, do I have to then go to a store to return it. It's not a super digital-friendly model, especially when some of its customer base is a growing, changing size, its merchandise turns over somewhat quickly. They could definitely do better with things that are wardrobe perennials like jeans. They've sold the same model of jeans for a lot of years. They could make it easier to buy those online and make it more a part of their model. Maybe they wouldn't need as many stores. Certainly, their stores should do everything they can to embrace omnichannel with buy online pick up in store, and buy online return in store. A return where you can try something else on and leave satisfied is much better than repeating the delivery cycle.

Lewis: Now, Dan, investors cannot get shares of either of these businesses yet. We are talking hypothetically. Neither one has actually been fully spun out. Is there one of these businesses that you look at and say, "Yeah, I'd prefer to own shares of that one," if either?

Kline: The honest answer is, I don't like any of these companies enough to own them. If I had to buy one, it would absolutely be Old Navy because I see a bigger customer base. We don't know what the ceiling is for these boutique, expensive brands. Warby Parker, UNTUCKit, Madewell. There are obviously only so many people who can buy $100 jeans or $150 jeans. We've seen top-tier jeans brands -- True Religion as a recent example -- go white-hot and then go ice cold. I don't like that.

I wouldn't bet against the Gap making a comeback. But I do think they're facing pricing issues at what they're charging. J.Crew, that one seems like almost the worst of them. Old Navy, my mom can shop there for my son, my son can shop there for himself without too big a budget, my wife and I might pick up things that we're going to use in incidental ways. It has a broader audience. It's a much more casual spend. To run to Old Navy and buy a pair of jeans and some socks won't cost you $50. That's accessible to a lot of people. I think accessibility for a retail store is going to be pretty important when you're talking about 2,000 locations.

Lewis: Yeah, I think you're absolutely right. I think folks that are interested in retail should definitely take note of what Madewell is doing. I think that their model here, and being digital native, is going to be the one that a lot of other brands follow. Their connection to their customers, their loyalty and rewards program, all of that kind of stuff is so important for being able to push people to your website so that you can have a retail footprint and have that showroom and be in the big places in all these major cities; but then also be accessible across the globe.

Unfortunately, when I look at the numbers for that business, the valuations that I've seen thrown around -- we don't know for sure yet -- is somewhere between $2.4 billion and $3 billion. At the low end, that puts them at like 45X trailing earnings, which is a bit rich for me, especially because this space is so fad-driven.

Kline: Yeah. As an investor, this is a final warning, we don't know how these companies are going to assign value to each piece they spin off. The number that's been reported, but it means nothing, is that Old Navy is going to be about 80% of the total value of Gap. But don't buy into the parent company just so you can get a piece of the other one. Wait until they've actually set these numbers, then do an evaluation. Also, look at what the added costs are going to be from splitting this stuff up. This is a very preliminary, "are these good brands," not, "are these good investments." Until you know the underlying numbers, you really can't tell if they're a good investment.

Lewis: Yeah. I think, if anyone wants a good visual on the lightning in a bottle effect of retail, take a look at the stock charts from Urban Outfitters or Gap over the last 10 to 15 years. There are those clear moments where the concept caught on, people were really loving it. And there are clear periods where they fell out of favor. Unfortunately with a lot of these types of brands, that's just the nature of the business. It's hard to stay on top for an extended period of time. Pretty much, there's always a brand new thing that gets people excited.

Kline: It's sort of inevitable. Old Navy is somewhat insulated from that, but they're not insulated from competition and other people seeing their success at a lower price point and going after it. You're seeing that to an extent with the Target owned and operated brands. And it wouldn't shock me if some other fashion retailers spun off or created, call them value brands.