WRITE-UP BY JONATHAN DANIELSON
Gap Inc. (GPS) is a company everyone should be familiar with: they’re an apparel retailer that specializes in ‘casual classics’. Meaning, jeans, khakis, polos, button downs, etc. The Company is headquartered in San Francisco and was founded in 1969. Gap Inc. has acquired and launched several brands over the years, but its main ones currently are: Old Navy, Gap Brand, Banana Republic, Intermix, and Athleta. GPS has increasingly become an Old Navy company over the years as consumers have flocked towards value brands and have deserted higher end specialty brands so it wasn’t too terribly surprising when they announced at the end of last quarter their intentions of separating into two companies. Interestingly enough, Old Navy will be the RemainingCo operating as a stand-alone business while Gap Brand, Banana Republic, Athleta, and Intermix will be spun off.
Based on consolidated metrics, GPS appears to be an interesting situation. When I pull the company up on QuickFS.net I see a company that has 10 year averages of:
● Gross margins: 38%
● EBIT margins: 11%
● ROE: 29%
● ROIC: 34%
All for a P/E of 10 and an EV/EBITDA of 6-ish. Not bad for a retailer. In fact, I was expecting much, much worse. If you pull almost any of their peers up and measure them on the same metrics you get an entirely different picture. More specifically, I looked at Guess, American Eagle, and Abercrombie and Fitch. Let’s just say when you pull those company’s financials up it looks like they have been existing in an era where questions are being raised about the viability of the brick and mortar retail business models. So, perhaps there’s an interesting situation here after all. Gap Inc. only grew revenue at a 1.8% CAGR over the past 10 years. However these are consolidated numbers and Old Navy is being spun off, remember? And Old Navy has been growing faster than the rest of Gap. Inc’s brands. Additionally, the “peers” I listed above most likely aren’t peers - not for Old Navy at least. The companies I previously listed are closer to Gap Brand and Banana Republic. The closest peer for Old Navy is probably somewhere in between Ross and H&M. Ross has been able to maintain healthy margins and growth while it appears H&M has struggled of late. Nonetheless, both companies look much healthier than any of the specialty-type brands previously listed.
We might have a compelling thesis on our hands if Old Navy is all that management cracks it up to be. The answer, as typically the case, isn’t so clear as one would hope. After all, GPS is operating in an environment that’s been dubbed the retail apocalypse. We’re living in the age of Amazon, how is your classical brick and mortar retailer churning out 34% returns on capital? Is Old Navy really that good? Well, I have my suspicions that it might not be the case. I’ll walk you through the numbers, show you how great of a business management tells us Old Navy is, and why I think it most likely is not all sunshine and rainbows over there in SF.
Why the Spin?
But first, we have to discuss the reason we’re all here - the Spin-Off. The reason that GPS wants to separate into two distinct entities is very straight forward. That is, Old Navy has become the real company behind the Gap name. In fact, Old Navy now accounts for more total revenue than Gap Brand and has much healthier growth than either Gap Brand or Banana Republic. Banana Republic has comps that have ranged between +2% and -10% since 2014 as the brand has gone from 18% of total sales to closer to 14%. Similarly, Gap Brand has seen comps decline has much as -6% over the same period while shrinking from 40% of total sales in 2014 to less than 33%. Conversely, Old Navy has maintained robust growth has the brand has not seen negative comps since 2014 and has grown from 38% of total sales to approximately 45%.
Additionally, the Company for the first time disclosed segment-specific operating margins at an investor conference hosted by Goldman Sachs in 2016. Management reported operating margins for each brand as:
● Old Navy: 14%
● Athleta: 11%
● Banana Republic: 8%
● Gap Brand: 2%
Which brings us to the consolidated EBIT margins of ~11%. This definitely looks like it confirms the narrative that Gap brand is dead or in the process of a very slow death and Old Navy continues to maintain a healthy financial position.
Aside from Old Navy maintaining healthier comps and achieving robust growth, another reason why this spin makes so much sense is cannibalization. This is a concept I’ve rarely seen talked about in the media, other write-ups, or the company itself. In the same investor day I referenced above, management declared they were pursuing a new strategy: to rationalize their specialty fleet and grow Old Navy, Athleta, and their Factory stores. Their factory stores are essentially off-price value stores of the Gap Brand and Banana Republic brand. This strategy makes sense on the surface because consumers in general have been fleeing specialty stores in favor of value stores - so it makes sense that the factory stores have been outperforming. But as soon as you turn Gap Brand into just another value store then I’m not sure how consumers are supposed to differentiate between Gap and Old Navy. To me, this was management admitting that Gap and Banana are in essence, dead. Which makes all the more sense why the company is spinning them off.
A preliminary valuation of Old Navy makes Gap Inc. appear to offer compelling value. Old Navy did $7.9 billion in total revenue in 2018. So if we take the disclosed operating margins of 14% then we can infer the Old Navy segment did approximately $1.1 billion in operating profit. Ross is probably the most comparable company to Old Navy. They trade at around 15x operating earnings. If we use a very conservative 10x multiple of operating earnings then that would imply Old Navy alone is worth more than the entire current market cap (which is about $9 billion). Is the market really attributing negative value to Gap’s remaining portfolio of brands? Let’s have a closer look.
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