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Gap: Wall Street Frowns On Old Navy Spin-Off

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About: The Gap, Inc. (GPS)
by: Shock Exchange
Shock Exchange
Long/short equity, long only, short only, special situations
Summary

Gap is experiencing falling same-store sales and deteriorating margins.

Jefferies frowned on chatter that Gap could spin off Old Navy.

Management likely needs to better reposition Old Navy so that it can compete on price.

Old Navy appears to be betwixt and between. This could be an odd time to spin off the brand.

Gap is down over 25% Y/Y and remains a Sell.

Source: Barron

Source: Barron's

Several traditional retailers have had a difficult time growing revenue through physical locations and have had to cull underperforming stores. To energize shareholders and potentially help their share prices, some have floated the idea of spinning off high-growth segments. Jefferies was critical of Gap's (GPS) plans to spin off Old Navy:

Gap is down 1.5% postmarket after Jefferies cut the stock to Hold from Buy.

The firm points to mixed results from each division of the company as well as an Old Navy spinoff that might not still make strategic sense.

The company also still needs a permanent CEO, Jefferies says, prompting a cautious approach.

It's cut its price target to $17 from $24, implying 7% downside from today's close.

The idea of an Old Navy spin-off sounded rather odd when I first heard about it. Companies usually spin off operations into separate entities when certain operations (1) are in different lines of business than the parent company or (2) have a much different growth trajectory than the rest of the company. I am not sure Old Navy fits either of these descriptions.

Gap has struggled to grow revenues, and its stock has suffered. A spin-off could change the narrative and spike GPS in the short term. Management needs to find ways to spur the stock price, and declining revenue and earnings likely will not do it. In its most recent quarter, Gap reported total revenue of $4.0 billion, down 2% Y/Y. The decline was mainly driven by Gap Global, whose revenue fell by double digits.

Old Navy reported revenue of $1.9 billion, demonstrating flat growth. At 49% of total revenue, Old Navy was Gap's largest segment. Revenue from Gap Global fell in the double-digit percentage range, while Banana Republic Global's revenue rose 3%.

Headwinds to the top line and an aggressive promotional environment also wreaked havoc on margins. Gap's gross margin fell 70 basis points versus the year-earlier period, while gross profit declined 4% Y/Y. Operating expenses grew, which caused EBITDA to fall by double digits.

Old Navy Appears Betwixt And Between

Old Navy was unable to generate top line growth last quarter. Comparable sales for the Old Navy, Gap and Banana Republic brands were down 4%, 7% and 3%, respectively. It is difficult to recommend a stock when the company cannot generate consistent revenue growth. It begs the question, "What does Old Navy have to offer that investors cannot get by buying GPS?"

In my opinion, the Old Navy brand is betwixt and between. I consider it more fashion forward than clothes from Target (TGT), Walmart (WMT) or J.C. Penney (JCP), yet not as fashionable as Urban Outfitters (URBN) or Abercrombie & Fitch's (ANF) Hollister brand. Old Navy also appeals to cost-conscious buyers, yet it may not be as cheap as merchandise sold through off-price retailers like Burlington (NYSE:BURL) or TJ Maxx (TJX). By competing solely on price, Old Navy could lose some of its fashion sense. However, the off-price retailers are delivering solid same-store sales growth at the expense of other retailers.

In trying to reposition the brand or tinkering with optimal price points, Old Navy could experience more growing pains over the next few quarters. Repositioning a brand is not easy. L Brands (LB) is dealing with this issue with its Victoria's Secret brand, and Bed Bath & Beyond (BBBY) is struggling with most of its product line. There could be more pain ahead until Old Navy figures out whether it wants to compete on fashion or on price.

Old Navy Could Be A Beneficiary Of Geography

The other phenomenon at Gap was that performance in the U.S. was much better than international. Revenue from the U.S. was $3.3 billion, flat Y/Y. Revenue from Canada, Europe and Asia all declined. Total non-U.S. revenue was $734 million, down 10% Y/Y.

Gap revenue by region. Source: Shock Exchange

The U.S. economy has been stymied by the trade war with China. However, there have been knock-on effects; the trade war has hurt global trading in Europe. Industrial activity in Europe is extremely low, and it could be hampering retail activity. Asia is likely feeling headwinds from the trade war as well; Asia is Gap's third-largest segment at 6% of total revenue.

Old Navy may have benefited from its lack of exposure to international markets. Of Gap's total U.S. revenue, over half came from Old Navy and another 21% from Gap Global. Old Navy's revenue breakdown is even more telling. About 91% of its revenue was derived in the U.S. and 8% in Canada. Old Navy received very little of its revenue from Europe or Asia, areas that may have been most affected by the trade war.

Again, Old Navy's performance relative to Gap Global and Banana Republic could primarily be due to the fact that it receives over 90% of its revenue in the U.S. The relative performance of the brands could be due to timing. At some point, Europe or Asia could outperform the U.S. From a geographical standpoint, Gap appears to have a solid portfolio of businesses. Spinning off Old Navy would hive off over half the company's U.S. revenue, the region that may be performing better than other markets.

Conclusion

Spinning off Old Navy could come at an odd time, as management needs to better position the brand, and Old Navy's top line is stagnant. GPS is down over 25% Y/Y and will likely fall further amid declining same-store sales. Sell GPS.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.