Project Description

Gap – Old Navy Spin-Off Quick Summary

Overview

On February 28, 2019, Gap (NYSE: GPS $23.32) announced plans to create two independent publicly traded companies:  Old Navy, a family apparel brand, and a yet-to-be-named company (“NewCo”), which will consist of the Gap brand, Athleta, Banana Republic, Intermix and Hill City.

On March 4, GAP announced that it purchased Janie and Jack, a leader in premium children’s fashion, from Gymboree Group Inc. for $35 million. Gap expects to effect the separation through a spin-off that is intended to generally be tax-free to Gap Inc.’s shareholders for U.S. federal income tax purposes.   The transaction is currently targeted to be completed in 2020.

NewCo has about $9 billion in sales while Old Navy has about $8 bn. The spin-off announcement accompanied the fiscal year- end earnings report which gave a broad outline of important restructuring plans. The spin-off and the restructuring plan were greeted by a sharp upward move in Gap’s stock price. However, Many analysts see the restructuring as a very positive move to deal with underperforming GAP stores and to embrace online sales more aggressively. The Old Navy separation is seen as a move that will unlock value. Management has yet to give guidance on expected margins, leverage, hoped for expense levels and savings, and customer overlap.

Background

Gap has suffered at the hands of its competition for many years with significant deterioration in its sales, profit and cash flow since 2014. Apparel buyers have become more value oriented and less devoted to brands. The stock has been a poor performer, down about 50% from its peak in 2014. However, the Old Navy brand has been a star performer. It accounts for almost half of sales and ¾ of profits. Their clothing is affordable, fashionable, and their plus size offerings fill a niche that is a $20 billion underserved market. The company believes that “the spin-off will enable each company to maximize focus and flexibility, align investments and incentives to meet its unique business needs and optimize its cost structure to deliver profitable growth”. Sonia Syngal, President and Chief Executive Officer of Old Navy since 2016, will continue to lead the brand as a standalone company. Art Peck, CEO of GAP, will continue as CEO of NewCo.

Recent Results

The key reported numbers from the Q4 earnings report shown below are clouded by the fact that the fiscal year ending on February 28 last year included a 53rd week. Nevertheless, weakness at Gap Global cannot be masked. On a comparable basis, the company’s sales declined 1%. Sales growth for Q4 by brand was as follows:

  • Gap Global: negative 5%
  • Old Navy Global: flat
  • Banana Republic Global: negative 1%

For the full year comparable sales comparisons for the company were flat with brand results as follows:

  • Gap Global: negative 5%
  • Old Navy Global: positive 3%
  • Banana Republic Global: positive 1%

Nevertheless, earnings advanced on a lower share count, a favorable currency effect and a significantly lower tax rate. The details of the earnings report are also clouded by the restatement required by a new accounting pronouncement. The restatement does not have a material effect on reported operating income, net income, and earnings per share.

Source: Gap Investor Relations

Same-store sales missed across all brands in Q4 due to traffic declines. Softer sales caused markdowns to get rid of excess inventory. This hurt gross margin. This is likely to persist in the first half of the new fiscal year as the company unwinds excess inventory. Improving the product assortment remains key to driving better sales.

Gap expects softness in 1H, down mid-teens year-over-year. Improvement is expected in 2H.

Restructuring

A restructuring plan was announced during the earnings call that includes the following:

  • Closure of about 230 underperforming Gap specialty stores over the next two years
  • Annualized sales loss of approximately $625 million
  • The company estimates pre-tax costs associated with these actions to be about $250 million to $300 million
  • Annualized pretax savings of about $90 million
  • Resulting in a healthier channel mix after the restructuring, with nearly 40% of sales coming from online

Last year they bought back $398 million of stock and ended the year with 378 million shares outstanding. They announced a new $1 billion plan to buy back more stock, superseding an existing authorization.

Guidance

For fiscal 2019 they guided for diluted earnings per share to be in the range of $2.11 to $2.26. Excluding restructuring costs, the guidance was $2.40 – $2.55. Expectations prior to the call had been $2.64. Clearly higher wages, markdowns, technology investments and marketing remain headwinds to margin, though double-digit online sales growth is encouraging.

Valuation

Gap looks cheap in comparison to other apparel retailers. Surely Old Navy will command higher multiples, but the NewCo businesses could well be depressed further. Athleta, with $1.1 billion in sales, and growing quickly, will be an attractive component of NewCo and may account for most of its value, but will be only a fairly small part of revenue. NewCo could well adopt the Athleta name as its corporate name, ridding itself of the Gap image. 

In 2019, consensus expects GPS to generate $1.8BN of EBITDA. Old Navy represents approximately 75% of this or $1.35BN and Gap RemainCo represents the remaining 25% or $450MM. Let’s assume Old Navy has to take on $100MM of recurring costs to establish itself as an independent public company. So 2019 EBITDA goes from $1.35BN to $1.25BN.

Let’s assume Old Navy deserves to trade at a 8.0x multiple, a premium to Gap’s current multiple of 4.9x, but still a discount to better positioned retail companies such as TJX, LULU, and ROST (these companies trade at a median EV/’19 EBITDA multiple of 11.9x).

These assumptions would yield a $10.0BN enterprise value for Old Navy.

Let’s assume Gap RemainCo deserves to trade inline with Abercrombie and Fitch and Urban Outfitters, retailers that are struggling (these companies trade at a median EV/’19 EBITDA multiple of 3.9x).

These assumptions would yield a $1.8BN enterprise value for Gap Remainco.

Adding the two parts up and we get an expected enterprise value of $11.8BN. Gap has no net debt so enterprise value should approximate market cap. Gap’s current market cap is $9.3BN, implying significant upside.

We are going to dive deeper in the coming months, but it looks interesting.

What do you think?

Do you think this transaction will unlock value? Comment below.

Company Resources

Transaction Site

Gap Transaction Fact Sheet

Gap Transaction Investor Presentation – February 28, 2019

Q4 2018 Earnings Presentation

Q4 2018 Webcast and Presentation

Investor Relations Contact: Tina Romani

Other Resources

Bloomberg: Gap’s Old Navy Can Now Get the Multiple it Deserves – March 1, 2019

Barron’s: Gap Spin-off of Old Navy Could Unlock the Value of Both Stocks – March 2, 2019