Description

Gap and Banana Republic temporarily have negative value within GPS and are masking the value in Old Navy and Athleta. We think that Old Navy and Athleta are undervalued under the Gap conglomerate umbrella and that Gap and Banana Republic have negative equity value to GPS today. We have reason to be optimistic that the Gap and Banana brands are going to stop masking the value in Old Navy and Athleta going forward. New management is making bold and long overdue action the next couple years that could offer a lot of value for GPS shareholders beyond the initial reopening theme that has helped the stock thus far in 2021. The launch of YZY Gap in a month or so is an upside call option and value realization accelerant. 50%-75% upside from here is very possible within the next couple years

Margins are set to expand dramatically from here. Old Navy and Athleta, GPS’s highest margin brands by far, are going from 55% of the company’s revenue to 70% in a few years. These two brands should continue to grow quickly while 1/3 of Gap and Banana stores are shuttered (money-losing stores that are largely mall based). Europe Gap operations, which are also money losing, are either going to be shut or franchised with an announcement likely this Summer. Product margins should expand across the board as Gap over-inventoried in the past and they’re working with their extensive vendor network and supply chain to move quicker and operate with less excess in the system. Offsetting these positive margin drivers (and others) will be spend on digital initiatives and offsetting margin impact from shipping costs from greater ecommerce mix over time. The net effect should be EBIT margins expanding from 6% to 10% over the next few years, with the largest driver being low risk, low hanging fruit (lease exits and rent renegotiation). In addition, the mix shift to Old Navy and Athleta should drive overall company growth to LSD-MSD% from flat in the several years leading up to COVID.

Upside potential remains compelling with YZY Gap potentially accelerating realization. GPS used to trade at 13x forward earnings when it was not growing, half of the company was declining, margins were declining, and there was not a trustworthy game-plan to improve the situation.  We think comp multiples around 15x are conservatively fair for what we think the new GPS will be and on our $3.50/sh of 2023 EPS, GPS would be a $52/sh stock with no buyback or capital return assumed. It’s hard to see why GPS should trade at a discount to prior valuation if the market is more expensive and it’s growing again with margin expansion to boot (13x = $46/sh).

Another way to think about valuation is that you get to a mid-$50/sh stock by valuing Old Navy at an AEO, ANF, CRI-like EBITDA multiple (8x or $34/sh), putting almost no value on Gap/Banana (4x EBITDA or $4/sh), and valuing Athleta like Adidas, Ulta, Fast Retailing, etc (mid-to-high teens EBITDA or $18/sh, 40% discount to LULU). In other words, you’re paying for Old Navy here and getting the rest of the assets for free, including Athleta. 

If we assume that GPS only achieves half of its margin expansion goal (ie 8% EBIT margins), then we estimate $2.65/sh of 2023 earnings assuming no capital return and a stock that would be valued at $35/sh in a bad outcome vs comps (13x).

Beyond the margin expansion and digital initiatives, we think YZY Gap could reinvigorate Gap and accelerate the path to $50/sh and beyond. Kanye is strongly incentivized to generate revenue for Gap above $700m. We include none of this in our Gap valuation, but do note that Yeezy product launches have been insatiable and sometimes sell out in under a minute. If we assume YZY Gap adds $700m revenue (or +21%) to our base case of $3.4b in Gap 2023 revenue and the Gap/Banana brands now receive an AEO, ANF, etc comp-like 0.7x revenue multiple, these brands now have $11/sh of value vs $4/sh above and total equity valuation is pushing north of $60/sh. We are making the general assumption that YZY Gap launches late June / early July.

Material changes being made with urgency – better late than never: GPS is making a major change to the business led by Sonia Syngal, CEO as of March 2020. For the first time in a long time, there’s a “culture of accountability”.

GPS is targeting 300bps of combined company margin expansion from shutting money losing stores and selling or franchising international operations, notably Europe. These are blocking and tackling initiatives that should generate around $500m in profit enhancement. GPS is shutting down 1/3 of money-losing Gap and Banana stores (largely mall locations), which should drive 200bps+ of margin expansion alone. Given that the lease maturity and economics of these stores are known, this should be relatively low risk margin expansion opportunity. Gap has also been losing money internationally. We expect to receive a decision soon on either franchising or getting out of its money losing international operations, providing another 50bps+ of margin expansion from Europe alone.

Selling Intermix, Janie and Jack, announcing Athleta expansion into Canada, speculation on an Asia exit, and a new distribution center in Texas are recent examples (just in the last couple months) of how the company is laser focused on its core brands, margin expansion, and bolstering digital capabilities.

Based on past interviews, Kanye is likely shooting for the moon here. We are including the warrant package to show how incentivized Kanye is to drive 20% sales growth to Gap and help get the stock up:

Quick overview of the company as we see it in a couple years:

Old Navy (59% of revenue, 73% of profit)

·         2nd largest apparel brand in US, $8b in revenue and going to $10b in a few years

·         MSD% grower, with very little growth from new stores - grew 9 of last 10 years

·         Very strong margins – estimated low-teens EBIT margins

·         Value brand that does well following trends (for example, their tech pants are great for all the commuters out there and ¼ the price of LULU)

·         Company is doing well with active, leisure and kids leading the way

·         Providing affordable style continues to resonate

·         Our checks lead us to believe there is no reason for Old Navy to not continue succeeding

Athleta (11% of revenue, 18% of profit)

·         A smaller LULU that solely caters to women and has an all-inclusive image and a strong social connection with their customer

·         Despite being an activewear company, a material portion of their business is actually apparel and they’re expanding constantly into new categories like sleep-wear today

·         20%+ grower with majority from same-store, but by far the most upside in Gap of the four major banners with a goal to double revenue in the next few years

·         Company leading EBIT margins in the mid-to-high teens

·         Very strong R&D team that Old Navy and Gap athletic work with

·         New partnerships with stars like Simone Biles, who recently came over from Nike

·         Our checks have been extremely positive on Athleta – “they are just starting out”, “they have so much runway ahead”, etc

Gap (20% of revenue, 6% of profit)

·         Established as a hip clothing brand revolving around denim that had a hip image – music, optimism, accessible

·         The brand lost its way over the last couple decades and there have been attempts to fix the brand over the last five years, but they haven’t succeeded

·         Current plan is to aggressively close money losing stores and regions (finally)

·         YZY Gap partnership with Kanye has potential to be massive – attract a younger (average Gap customer in their 40s) and more urban customer along with every other high schooler out there - but there’s obviously risk. That being said, Kanye feels it’s his calling given he stole from the store when he worked there and he feels he was “meant” to do this. He wants to bring style to the masses. Plus, he makes a ton of money if it’s successful.

·         Beyond YZY, our checks support the view that the brand is “over-assorted” and that they should lean more heavily into Body and Fit as well as Kids and Baby – Kids and Baby “is the jewel of the Gap brand”

·         Our checks also support the view that the brand is “not broken”

·         We know that GPS is working to lean things up at Gap, but TBD on whether the brand can resonate again like it once did beyond YZY

Banana (9% of revenue, 2% of profit)

·         Not inexpensive clothing to wear to work

·         This is the brand we have the least amount of confidence longer term, but it’s sub-10% of GPS revenue and we expect it to become a smaller and smaller piece of the pie over time

·         It should stage a strong cyclical rebound as workers return to the office

·         This is the one brand that we think the Fisher family could part ways with after it sees through a full post-COVID recovery

Risks

Key risks outside of a recession are that the margin expansion doesn’t pan out as planned. Higher ecommerce logistics costs, labor costs, etc could eat into the 400+bps of planned margin expansion. If we assume that GPS only achieves half of its goal (ie 8% EBIT margins), then we estimate $2.65/sh of 2023 earnings and a stock that would be valued at $35/sh if it traded at its old 13x P/E. YZY Gap could also be a flop and result in Gap and Banana Republic masking the value in Old Navy and Athleta for a longer period of time than we expect.

Catalyst

Catalysts

·         Reopening

·         Upcoming earnings should be robust vs published Street, but this is a multi-year story

·         YZY launch in a month or so (best guess)

·         We are expecting an extremely strong back to school season

·         Europe franchise / disposition decision

·         Continuing to close down money losing stores and regions, hence expanding margins

·         Athleta / Old Navy continuing to become greater % of company