Can Gap Prosper Without Old Navy?

The Motley Fool Industry Focus: Consumer Goods podcast team continues a discussion on the impending breakup of Gap (NYSE: GPS) into two separate companies: one that will operate as Old Navy and the other that will comprise the Gap, Athleta, Banana Republic, Intermix, and Hill City brands. Our hosts respond to a question posed from a listener on Twitter: How will isolating the slower-growth Gap brand help it increase its fortunes? Click below to understand why this strategy may actually yield results for struggling Gap stores.

A full transcript follows the video.

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This video was recorded on March 5, 2019.

Asit Sharma: To get to our question on Twitter, which I want to really dive into here, if you're taking all the older assets -- the Gap and Banana Republic assets with a few growth brands -- and spinning that off into a new company, how can that particular bucket grow?

One thing I wanted to point out is, it's going to start with a lower baseline of expectations and it's going to be a slower-growth company. The good side of that coin is that if they can figure out how to jigger some growth, the multiple that the market assigns to them is probably going to increase. While it's still this whole ball of wax for the next year, Gap is cutting down the number of specialty stores it has. It started with 725 at the beginning of 2018 and cut that down to maybe 650. It's going to cut that number in half again by closing underperforming stores. The company says that will ding it for about $625 million in revenue, but it'll add $90 million pre-tax to Gap's bottom line.

Now, by the time Gap sees that money, it will be in a separate holding company, and that will have a much greater effect on its P&L than if it was still in this big company, which has almost $17 billion in sales. So that's one really smart way that a company can actually show some growth in the part that's being spun off, and that's simply by making some really smart cuts.

Other strategies they have are to pour more money into brands like Athleta. I was surprised, Jason. Since Gap hasn't performed well, I haven't followed it closely for a number of years. I was surprised that Athleta has grown at a 30% two-year comparable-sales clip as of this last quarter. That's pretty good.

One other thing to note about these newer brands is Athleta -- I think you pronounce it differently?

Jason Moser: Yeah. I'm not sure which one it is. I would imagine both are acceptable at this point.

Sharma: Maybe I'll flip between them to be fair. Athleta is a certified B corp. If you know anything about B corps, basically they're a sustainable type of corporation. You have to have a sustainable bent, be more than just about the bottom line. That's a cache for millennial purchasers.

Moser: Absolutely!

Sharma: I think that the Gap company, Gap brands, with these newer brands, is going to push that, especially their online sales. So there is some earnings potential here for what looks like a drag on earnings.

Moser: I guess we'll see. One of the things I always look at with the retail space in general -- obviously, when we say "retail," that's very wide reaching -- when it comes to fashion in particular, as an investor, you look at this market and you think, what are the competitive advantages? Are there any? I don't know that there really are. Maybe the brand is the biggest competitive advantage a fashion retailer can actually possess. And then, obviously, they have to maintain that brand.

I think Gap and Banana Republic have held their own through the years. I'm not sure that they're brands that warrant a whole heck of a lot of pricing power going forward, but I think that the Athleta brand could be that. There's something with that athleisure wear, we're seeing that market growing, we're seeing Nike pursuing it a little bit more, the success that lululemon has had. I know that Under Armour is trying to test those waters as well. So, I think there's the opportunity there, and that would probably be the brand that I would be most excited about at this point.

Old Navy is always going to be a value offering. That's not to say that's a bad thing, but you have to remember how that plays out on the bottom line. They're probably not going to be growing their top lines, either company, at extraordinary rates. But I do think that splitting them up gives them a chance to focus on what they do well, right-size their cost structure, streamline the businesses.

As we always say with retail, these to me, at least, are not buy-to-hold investments. You need to buy these retailers when the pessimism is high, the stocks are cheap, and you need to have a clear path toward why that changes. If you can have a thesis that really tells why you think that narrative changes, then you can potentially realize a value investment there, where you buy in at a good price and you sell out at a good price.

Definitely a difficult market to get. I certainly don't profess to be a market timer by any stretch, and I don't think you do, either.

Sharma: No, not at all. Last point I want to throw in about Old Navy. Let's look at that possible scenario of the stocks splitting up. Maybe we get a market downturn. Pessimism is running high, as you say. If you're looking to pick up Old Navy, what would be your reason to buy into this stock? If you look at Gap's current financials, it has the greatest comparable sales growth of any brand in the company. But that's pretty meager. It's usually 3% or 5% in a quarter. However, when you put these companies in different buckets, they each have a fairly decent balance sheet that's not that encumbered.

The potential for Old Navy really is in some unit growth, some smaller stores. They've looked at this in the past and have had decent expansion. But being part of this multibrand animal, the resources haven't really been there for Old Navy to expand in any significant way. So one lever they could pull is a little bit faster unit expansion. They still profess to feel under-penetrated in the value sector. That might be some reasoning investors can employ if you do see -- as Jason's pointing out, as we see all the time with retail stocks -- if it happens to get to a point where it looks attractive to you, that might be a rationale to pick up a few shares.

Moser: One last question and we'll wrap this up. This is a bit of a hypothetical, but I'd be interested in your answer here. You, Asit Sharma, will be the CEO of one of these two businesses. You get to choose. Which one are you choosing and why?

Sharma: Interesting question because the CEO of the current company made a point in the last earnings call just last week to say, "I'm going with the old assets. I'm going to run Gap and these other brands. But, oh, I love Old Navy just as much! This was a hard decision for me!" [laughs] He went out of his way.

Moser: [laughs] I don't know if it was.

Sharma: He's a very diplomatic guy, but you and I don't have to be so diplomatic. I'm going to give a contrarian answer to maybe what you'd expect. I'm actually going to go with the Old Navy brand. It's got limited potential in terms of ever growing at that fast a clip. Actually, the potential, as you point out, might be in the Gap brands with Athleta and Hill City. At least those can grow with online sales. But I like this idea that Old Navy isn't as well-represented. I would go out, cut some more costs, I'd do another bond offering. I might have a secondary stock offering in a year. I would plow into as much as I think the market could bear. Then I would trumpet that to shareholders every quarter. I'd focus on unit growth, not on those comps that are still 3% to 5%.

That would be my strategy. It's not a very risky strategy. There's some obvious value there to unlock. I don't have the chops as a CEO to go in and grow the fashionable brands and explore those online strategies that are so necessary to compete today.

Let me flip the question back to you, my friend! Jason Moser, investor extraordinaire, consummate dad, really smart guy, you have a choice and you have to choose. Which door is it?

Moser: Either from an investing perspective or from a CEO perspective, I think I'm going Old Navy either way. I agree with you. I think there is a consistency there that would be a lot easier to continue with moving forward. I think that Old Navy through the years has done a very good job of marrying a good brand recognition -- I think there is some brand equity there -- with the value offering that it proposes. We see these commercials constantly. They've done a great job of marketing that name through the years. I think that would be a fun one to keep that ball rolling.

We'll see. We're talking about 2021, this actually plays out. You still have some time. I'm sure there will be an arbitrage play or two out there being proposed, as well.

Asit Sharma has no position in any of the stocks mentioned. Jason Moser owns shares of Nike, Twitter, Under Armour (A Shares), and Under Armour (C Shares). The Motley Fool owns shares of and recommends Twitter, Under Armour (A Shares), and Under Armour (C Shares). The Motley Fool recommends Lululemon Athletica and Nike. The Motley Fool has a disclosure policy.