Gap: 2 Bad Businesses Are Hiding 2 Good Ones

Summary

• On a consolidated basis, Gap looks cheap, trading at barely 6x EBITDA and 11.5x the midpoint of FY18 EPS guidance, and deservedly so given margin pressures and weak growth.
• But Old Navy alone appears to be driving as much as three-quarter of total profit - and on its own could support the entire enterprise value here.
• Athleta offers another growth driver, while Gap brand and Banana Republic cloud the picture.
• SOTP valuations suggest reasonable upside - but there are questions and risks toward unlocking that value.

I was a long-time bear on Gap (NYSE:GPS) for some time, even shorting the stock back in 2016. Few companies seemed more at risk from sector-wide pressures on mall retailers and a noted move away from corporate brands toward local and unique (a shift happening not just in apparel, but in food & beverage as well).

But my tone has softened of late, even as GPS stock rose from 2016 lows below $18, settling in the past few months around $30. Despite earnings pressure, I think CEO Art Peck has done a nice job and at the least owned up to the challenges facing the industry, and the business, something other retailers have been slow to do. Old Navy has rebounded with a 6% same-store sales increase in FY17 (ending January of this year). The balance sheet is reasonably clean, with net cash on the books as of the end of Q1. Despite a disappointing Q1, Gap looks better (to my eye, anyway) than it did several quarters ago.

In fact, it looks like a pretty solid buy at the moment - despite consolidated numbers that appear to be going in the wrong direction. At a conference last year, Gap disclosed for the first time brand-level operating margin information. Those figures suggest that Old Navy is driving as much as three-quarters of profit for the business. That in turn implies that with GPS at rather low multiples (6.1x EV/EBITDA on a TTM basis, 11x+ the midpoint of FY18 EPS guidance), Old Navy alone could support the entire enterprise value of Gap Inc. at the moment. In essence, that would give investors at the current price Gap brand, Banana Republic, and athleisure concept Athleta for free.

It's not a perfect case, to be sure. Investors don't trust Old Navy to the extent of off-price peers - and possibly with good reason. Gap brand and Banana Republic may not be that valuable at this point. Athleta still is reasonably small, and a clear second to Lululemon (LULU) in the athleisure space.

But there's enough here to suggest that GPS' fair value is much closer to $40 than to $30. That in turn makes it (again, to my eye) at worst one of the more intriguing stories in retail. With a 3.2% dividend yield helping the case, I like GPS at these levels.

The SOTP Argument

Jefferies analyst Randall Konik made a similar sum of the parts-based case for GPS last September, per reports, assigning a target to GPS of $39. A week earlier, at a Goldman Sachs (GS) conference, Gap for the first time gave some detail on its brand-level operating margins:

Source: Gap presentation

Five quarters later (note the margins are from FY16), we can build a reasonable model based on those numbers to try and generate segment-level valuations (note figures are trailing twelve months through Q1):

Brand	Revenue ($M)	% Total	Adjusted EBIT ($M)	% Total	Adj. Margin
Gap	5,364	33.1%	107M	7.7%	2.0%
Old Navy	7,421	45.8%	1,034	74.4%	13.9%
Banana Republic	2,427	15.0%	170M	12.2%	7.0%
Other*	986	6.1%	79M	5.7%	8.0%
Total	16,198	100%	1,390M	100%	8.6%

Click to enlarge

Source: Author Estimates (* - includes Athleta, Intermix, and Weddington Way)

Admittedly, there's a bit of guesswork here, but directionally, the numbers appear to be in line with commentary at the conference (and elsewhere) and the slide above. Intermix, which has struggled (Gap took a big goodwill impairment charge on the business in Q4 FY16) likely brings down Athleta's double-digit margins, moving the segment as a whole into the high-single-digit range. Old Navy margins most likely were stable at worst last year, given strong comp performance. Gap and Banana Republic very well may have weakened given negative same-store sales. For those brands combined, the company is closing over 10% of locations over the next three years - stores which are basically unsalvageable and no doubt negative in terms of EBIT margins. (For what it's worth, Konik appears to have reached a similar conclusion through his efforts, at least relative to Old Navy's share of profits.)

What jumps out is that there's a credible case that Old Navy alone supports a current enterprise value for GPS just below $12 billion. Assigning company-wide D&A to each segment based on store count (at the end of Q1), TTM EBITDA for Old Navy is about $1.23 billion in this model. (That probably understates the case a bit, since Old Navy stores are larger: the chain accounts for 34% of locations but over 50% of square footage.)

If Old Navy is worth 10x EBITDA, then it is worth the $12 billion at which Gap as a whole is being valued right now. That doesn't seem particularly onerous. TJX (TJX) and Ross (ROST) trade at ~14x and ~13.6x FY18 EBITDA, respectively, based on my calculations (reverse-engineered from respective guidance). P/E gets to a similar place: at a 26% tax rate (per post-Q1 guidance), a standalone Old Navy would generate nearly $2 in earnings per GPS share, suggesting a sub-16x P/E and a noted discount to TJX (20x the high end of its FY18 EPS guidance) and ROST (21x the top end).

Neither off-price retailer is a perfect peer, admittedly. The business models are different, most notably, in terms of sourcing. 'Fast fashion' peers might seem more similar from a qualitative standpoint - but there, too, peer valuations seem to support a double-digit EBITDA multiple for Old Navy. Inditex (OTCPK:IDEXY) trades at 16x TTM EBITDA. H&M (OTCPK:HNNMY) admittedly is trading at ~8x FY17 EBITDA.

But H&M is struggling with comps and margins and has $4 billion in inventory to move, raising legitimate risks about the long-term health of the brand. Qualitatively, it seems close to self-evident that Old Navy deserves a premium to that retailer. Meanwhile, Old Navy's ~13-14% margins are better than not just H&M but TJX's 11% and not far behind ROST's ~15%. (They are behind Inditex's ~20% - but a multi-turn discount to that stock still validates the case here.)

All told, there's a reasonable argument that Old Navy, on its own, supports the entire value of GPS at the moment. To be sure, 10x EBITDA and ~16x earnings aren't notably cheap for a U.S. apparel retailer in this environment. But Old Navy doesn't have the same mall exposure as many other publicly traded peers; it has a differentiated brand and a growing online business (with the ability to compete with other outlets on price; that's what it has done from the start). It's a better business than most of those other retailers at the moment. I'll happily accept the argument that it merits a discount to TJX/ROST, particularly after a couple of weak years (flat comps in FY15, +1% in FY16) unnerved investors. But I'll argue just as strenuously that Old Navy deserves a sharp premium to challenged retailers, particularly those with mall exposure. (Most of Old Navy's locations are off-mall.)

Meanwhile, Athleta may be an underappreciated part of the story here. The company's specific revenue hasn't been broken out, but given weakness at Intermix and a sharply higher store count (147 vs 38), Athleta probably is doing at least $700 million in revenue. (It has 80%+ of the stores in the segment which is nearing $1 billion in revenue on the whole.) Assuming 10%+ operating margins, its EBIT should be in the $80 million range (conservatively), with EBITDA over $100 million.

LULU trades at 5.5x FY18 revenue (based on guidance, and backing out cash) and 22x EBITDA. By no means should Athleta receive those multiples, to be sure. It's a clear second place in athleisure, and Lululemon is guiding for ~20% operating margins this year, which are probably close to double those of Athleta.

Still, does a low double-digit EBITDA multiple sound unreasonable here? That would suggest a valuation in the range of $1.3-1.5 billion and something like 1.8x sales. It's still a growing business, one which Peck has said should hit $1 billion in revenue over the next few years. Duluth Holdings (DLTH), which itself has a combination of expansion and organic growth ahead, trades at about 15.6x the midpoint of EBITDA guidance and nearly 1.5x revenue with lower margins. (Admittedly, that's a weird comp from a fashion standpoint, particularly in terms of demographics, but there aren't many growing, public retailers that work as a comparison at all these days.)

As for Gap and Banana Republic, I'm not sure there's much value - but there's some. Gap brand still does $5 billion-plus in revenue, with over 40% of that overseas (including 20%+ in Asia, a market with much more in the way of growth potential). Banana Republic has shown some signs of life, with comp declines narrowing from -10% to -2% over the past two years, and a +3% print in Q1.

Both brands have real challenges in the U.S., as I still believe they are essentially the polar opposite of where consumer tastes are heading. But I still think an investor easily can value each brand at $1 billion-plus. My numbers estimate Gap brand EBITDA at $333M (though that might be a bit high depending on actual D&A, for the same reasons Old Navy's might be a bit low). Banana Republic's figure should be in the $260-270 million range. 4-5x EBITDA - as low as mall retailers are getting these days - puts Gap at $1.3-1.6 billion and still suggests a reasonable ~0.3x revenue multiple. That would be down toward Express (EXPR) and below even Abercrombie & Fitch (ANF), though A&F has shown some signs of life lately. The same EBITDA multiple values Banana Republic at ~$1 billion, which suggests 0.4x revenue - again, toward the low end of the entire category.

Valuation, Risks, and Challenges

So, if you add it up, there's some nice potential upside here:

Brand	Low End Valuation	High End Valuation	Notes
Old Navy	$9,840M	$12,300M	8x EBITDA/13x P/E on low end, 10x/16x P/E on high end
Athleta	$1,000M	$1,700	9x EBITDA/1.4x revenue on low end, 15x EBITDA/2x+ sales on high
Gap	$1,250M	$1,780M	4x EBITDA/0.23x rev on low end, 5.5x EBITDA/0.33x rev on high end
Banana Republic	$1,000M	$1,300M	4x EBITDA/0.4x rev on low end, 5x EBITDA/0.5x rev on high end
Total	$13,090	$17,080
Net Cash	$125M	$125M
Shares Outstanding	393M	393M	share count at end of Q1
Price Per Share	$33.63	$43.78
Upside	10.4%	43.7%	from Thursday price of $30.46

Click to enlarge

There are some points to make here. First, as fancy as the table looks, this clearly comes down to an argument about Old Navy. If an investor doesn't trust Old Navy - or if Old Navy stumbles - the theoretical SOTP here pretty much falls apart, barring a huge acceleration in Athleta or a surprising turnaround at the weaker brands. Secondly, there's no accounting for operating lease commitments (which are material, but not onerous: $1.39 billion in years 3-5 and $1.792 billion more than five years out, per the 10-K.)

Most importantly, there's not necessarily a path to unlocking this value. A split into Old Navy Inc. (Old Navy and Athleta) and Gap Inc. (Gap and Banana Republic) might highlight the value of the good brands, but it would also create a pretty challenged spin-off with declining comps, EBITDA margins in the 7%+ range and EBIT margins closer to 3% (admittedly on almost $8 billion in sales). I can't imagine Gap could find a buyer for Gap brand or Banana Republic, even if it were interested in selling.

That said, the relative importance of Old Navy does suggest that at some point, its growth will shine through - simply because the effect of Gap and BR is going to fade. 270 new Athleta and Old Navy stores are being built, a 20%+ increase in count, while the number of Gap and BR locations is going to drop double digits. Management at least has recognized that Gap and Banana Republic need to be managed appropriately. That probably leads to a further shrinking of those businesses over time and a focus on profitability rather than a quixotic attempt to make Gap and Banana Republic sell more merchandise every year with challenged brands and mid-single-digit annual declines in mall traffic. And as poorly positioned as those brands are at the moment (and I'll be the first to point out their flaws), unless their combined value is negative, current valuation at worst holds up pretty well as long as Old Navy does.

And in fact, the SOTP-based argument is that the opportunity exists only because Gap and Banana Republic are mucking up the numbers. On a consolidated basis, Gap really doesn't look all that impressive, with Q1 operating margins of just 6.1% and a steady compression on that front over time. But the long-term targets for Old Navy - $10 billion in revenue, up from a TTM $7.4 billion - and Athleta - again, $1 billion-plus - alone suggest the stock should rise, even with zero from those brands. 14% margins at Old Navy (about where they appear to be at the moment) and 12% at Athleta suggest combined EBIT would be at least $1.52 billion. That's about $2.86 per Gap share, and a reasonable 15x P/E multiple (and 9x+ EV/EBITDA) gets the stock to $43. Considering store count growth, those targets probably can be hit in three years - and discounted back even at 10%, those businesses alone are worth $32 if they barely reach Peck's goals.

This isn't a riskless trade by any means. Retail is a risky sector at the moment, for reasons ranging from e-commerce competition to the sometimes-forgotten fact that we're heading into year ten of an economic expansion. But in that sector, Old Navy is one of the better businesses. (Going from zero to $7 billion-plus in revenue in 24 years is no small accomplishment.) Athleta is a good business. And by even reasonably conservative valuation metrics, the market isn't pricing in those positives. It's treating Gap as if it were A&F or Express - when only two brands are. And even if those brands are worth nothing, I still think there's double-digit upside in GPS from $30+.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in GPS over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.