Gap Going Ahead With Old Navy Spin Despite Problems

No-moat Gap GPS confirmed the poor 2019 third-quarter sales and earnings that it had pre-announced (along with firing Art Peck as CEO) on Nov. 7. On its earnings call, interim CEO Robert Fisher (of the controlling Fisher family) insisted the Old Navy separation is still the best course of action and the split is expected to close in mid-2020. Gap argues Old Navy and its other chains are too different to stay together. We think, however, Gap has still not provided a strong rationale for the deal, which is expected to result in direct costs, capital expenditures, and gross dissynergies of $1 billion or more. Moreover, the Old Navy spin is a huge distraction at a time when Gap is simultaneously searching for a permanent CEO and trying to reverse terrible sales trends. Same-store sales were negative at Old Navy (down 4%), Gap Global (down 7%), and Banana Republic (down 3%) in the third quarter, and Gap provided no confidence they would improve in the fourth quarter, guiding to total company same-store sales down in the midsingle digits for 2019.

Further, Gap disclosed that Old Navy, which we believe generates about 80% of Gap's operating income, has experienced “meaningful” margin degradation in 2019. Based on the limited data provided by Gap, we estimate Old Navy's operating margins have dropped from the midteens to about 10% this year. Gap's adjusted operating margin of 7.5% in the quarter represented a 140 basis point decline and missed our forecast by 20 basis points. We expect to reduce our 2019 EPS forecast of $2.09 by approximately 18% due to the quarter's earnings miss (adjusted EPS of $0.53 versus our $0.58 forecast) and weak sales trends heading into the holiday season. As previously disclosed, we expect to reduce our fair value estimate for Gap of $27 per share by a mid-single-digit percentage. We think Gap, although troubled, is undervalued, as Old Navy remains solidly profitable and Athleta has growth prospects.

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