The Print
To say this GPS print was interesting is the mother of all understatements. The quarter was terrible. Comp miss, including 350bps miss at Old Navy. GM miss, down 260bps (ex rev accounting change) from higher promos at GPS and Old Navy (which still didn’t comp). EPS met expectations from pulled SG&A, which included slashing bonuses Y/Y, a headwind for 2019 SG&A. GPS guided 2019 below the street by ~6%, that was likely expected – at least we expected it. Separately Old Navy looks to have pulled forward its “Thank You” sales event to now from May, which includes 30% off purchases, or 40% with a GPS credit card. That means margin pressure likely continues, and growth compare in 2Q is harder. Finally downsizing Gap…but taking $250mm in charges for 150 stores at lease expiration? I have never seen anything that financially puzzling in my career. In sum, there was nothing financially redeeming about this quarter for GPS. It fully earned its status as one of the pre-eminent junk-tailers.
The Separation
It’s clear that the 16.2% move is all about the separation of Old Navy into its own company, while the rest of the brands stay together as “NewCo” (the name for now - can GPS top Tapestry, Capri and Kontoor for worst new company name?). This announcement is somewhat ridiculous as the company gives no info on profitability of Old Navy vs NewCo. How can we objectively analyze the value of the separate entities without detail on the separate businesses? That certainly puts a bearish buy-sider in a pickle. One other thing to consider is that Old Navy is likely to get stuck with far more debt than Sonia Syngal (ON CEO) thinks. Most of the debt historically belonged to Gap given its earnings volatility, but the reality is that to saddle the junkier NewCo with all the debt could easily make it worthless. The best way to de-lever the combined entities is to put as much debt on ON as it can handle (if not more) and then use the excess cash flow to de-lever. The problem is that I think GPS is overstating the current margin structure of Old Navy. Props to the sell side for asking the obvious yet necessary questions of Profits? Cross brand selling impact? Supply chain, sourcing separation? General dis-synergy impact? One that was missed is how does it affect their Synchrony credit partnership? That is ~40% of EBIT after all – across concepts. This is not an easy separation folks…in fact, could be one of the ugliest we’ll have seen in many years.
Will This Really Create Value?
Looking at the separation though, let's focus on cash flow for a moment. Free cash flow this year was $676mm. Or $1.74 per share. That puts the LTM FCF yield now at 5.9%. FCF in 2019 is probably going down meaningfully, but let’s just say that’s the number for now for (conservative) argument’s sake.
The purpose/timing of the separation (despite what management says) is to get a better overall multiple on this business, mainly on the Old Navy piece. We hear all the time about Old Navy as being “off price” like TJX implying they should get similar multiples. That is completely FALSE. Different value prop, different model, different customer. One is a cyclical brand (ON) the other (still arguably a short) is a multibrand treasure hunt retailer.
But even if ALL of GPS’s FCF is Old Navy we could argue a FCF yield somewhere between TJX (4.4%) and KSS (12%). Let’s be generous and say even better than a long term survivor of TGT at 7.8%, so 7% yield? That’s a $25 stock, again not contemplating any NewCo cash generation would prob come in at 12%+.
Big Near Term Cash Generation Change
FCF in 2019 could be down 50%-80%, with $250-$300mm in GPS restructuring costs, capex stepping up $50mm, and a net cash outflow of about $100 to $150 million related to real estate transactions. Because of this, share repo has been guided down, losing one of the value return levers to shareholders. After the separation, the resulting end run rate is unlikely to be better than 2018 given ‘18 was a consumer peak, synergies/economies of scale are going to be lost in separation, and the company slashed bonuses this year.
Let the Profit/Price Speculation Begin
We’re already seeing some of the estimates for Old Navy. The chart below of 2016 margins has people excited. It implies ON has a mid teens margin. That leads the easy math to say something in the area of 12-13% operating margins for the new company.
For the life of me, I don’t buy it. First, 2 years ago (when the chart was dated) was a long time, retailer margins have fallen, and Old Navy has 20% of its business now online, with low price points. There is likely some deleverage there. Also GPS was likely recently been ramping spend in online search/marketing to help drive ON growth both via store and online. We’re not sure that marketing spend is properly allocated across the banners.
Let’s look at operating margins for some comparable (and some better) companies…
TJX – 10.8%
URBN – 9.7%
AEO – 8.3%
KSS – 7.4%
H&M – 7.4%
I don’t think Old Navy can be out earning that group by ~300bps. If it is, it’ll prob be a great short as a standalone – as that rate is thoroughly unsustainable. It’s challenging to make a convincing short case on any business when you can’t line up and quantify the precise quarterly catalysts. But these numbers simply don’t add up. Until we have detail we can analyze to see if the potential value of these businesses the market is implying might be correct, we’re definitely biased short side, like seriously.
Source: GPS Presentation
