On February 28, 2019, Gap, Inc. (NYSE: GPS) announced that the company plans to spin off its Old Navy business, a category leader in family apparel. The yet-to-be-named parent company will consist of the iconic Gap brand, Athleta, Banana Republic, Intermix and Hill City. The separation, which is expected to be tax-free to Gap Inc.’s shareholders, is expected to be completed in 2020, and is subject to final approval by Gap’s Board of Directors, receipt of a tax opinion from counsel and the filing and effectiveness of a registration statement with the SEC.
As part of a broader reorganization, the company announced plans to close approximately 230 Gap specialty stores over the next two years. The closings are expected to reduce annual sales by approximately $625 million while generating pretax costs of $250-$300 million. Annualized pretax savings are expected at roughly $90 million.
Following the separation, the parent company is expected to generate approximately $9 billion in annual revenue, leveraging improved results at Gap, Banana Republic and Intermix, while capitalizing on the momentum of B-Corp certified Athleta and newly-launched Hill City. Separately, management announced a program to restructure the Gap brand specialty fleet in order to enhance the profitability of that channel.
As the Gap brand has been challenged as part of a broader decline among for brick and mortar retailers, the lower-priced Old Navy brand has resonated with discount shoppers. Old Navy is one of the fastest growing apparel brands in the U.S., with approximately $8 billion in annual revenue. The business has historically been a major driver of sales and earnings, accounting for approximately 50% of the company’s total revenue in 2018. As GPS shares have struggled, having declined 24% in 2018 (versus a 4% decline for the S&P 500 over the same period), the the spin-off is expected to unlock incremental value for Old Navy.
After a comprehensive review by Board of Directors, Gap determined that Old Navy’s business model and customers have increasingly diverged from the remaining specialty brands over time, necessitating different strategies moving forward. In recent quarters, the Gap brand has been challenged as part of a broader decline among for brick and mortar retailers, while the lower-priced Old Navy brand has resonated with discount shoppers. Investor perception has also characterized the Gap brand as having fallen out touch with its core customers. The three largest brands were intended to be complimentary: with Old Navy targeting families with discounts, Gap resonating with high school and college students and Banana Republic positioned as a ‘go-to’ for young professionals. However, this strategy has faltered in recent years, as the Gap brand in particular has come under increasing pressure amid complaints about its fashions and messy stores. In the company’s most recently reported quarter, the holiday period — Old Navy’s same-store sales were flat, while Gap and Banana Republic posted negative same-store sales growth. Accordingly, Gap shares have 24% in 2018, versus a 4% decline for the S&P 500 over the same period.
As a starting point for estimating earnings for Old Navy and post-spin GPS, we forecast modest revenue growth of 3% at Old Navy, which incorporates low single digit comp sales growth and net store expansion, while we forecast a 7% decline in revenue at the parent company. The 7% decline, which results in roughly $600 million loss in revenue, is in line with guidance for lost sales from the closure of the underperforming retail stores. We estimate that Old Navy EBITDA margins are 15% while the parent company’s are closer to 10%; for context the company had been operating on a consolidated basis at ~12.7% in recent years. Under these assumptions, Old Navy would earn $1.2 billion of EBITDA while the parent company would earn $809 million in EBITDA.
Peers to GPS’s core specialty retail business could include American Eagle (NYSE: AEO), The Buckle (NYSE: BKE), Express Inc. (NYSE: EXPR), L Brands (NYSE: LB), Urban Outfitters (NASDAQ: URBN), and Zumiez (NASDAQ: ZUMZ), amongst others, which on average trade at about 5.5x 2016E EBITDA, with a range of 4.7x – 6.3x (excluding outliers). The peer set for the post spin entities will largely be the same. However, given the current business trends and margin profiles, we would expect that Old Navy, with an estimated mid-teens EBITDA margin, increasing comparable store sales, and location expansion opportunities, to see multiple expansion from GPS’s current 5.1 x consensus 2019 EBITDA. Notably management did comment on its conference call that Old Navy produces industry leading margins. As for the parent company, current sales trends at GAP, the planned fleet rationalization (store closures of about 230 over two years), and yet to be proven ability to drive higher margins by shifting sales from retail to online, will probably not see much change to its post-spin trading multiple. In fact, investors more interested in the growth story from Old Navy may exit their GPS positions, thus cause multiple compression in initial post spin trading.
Industry leading margins at Old Navy likely necessitate a higher multiple versus the current combined GPS multiple. Assuming Old Navy’s multiple approximates the higher end of the peer group at 6.0x, as a standalone company, Old Navy would be fairly valued at $7.3 billion on an enterprise basis. Conversely, assuming the parent entity’s multiple remains at the current GPS multiple of about 5.0x, post-spin GPS would be valued at $4.1 billion on an enterprise basis. Incorporating net debt of $168 million, and shares outstanding of 383 million, a preliminary fair value estimate of $29 per share is derived. In after hours trading last night, GPS shares were trading at $31.75, up 25% from the closing price of $25.40.
