Gap's Old Navy spin-off was met with praise - but risks still surround both brands

Business Insider/Jessica Tyler

• Gap's announcement that its Old Navy brand would be spun off into a separate public company was met with praise on Wall Street and excitement from investors who drove the stock up nearly 20%.
• Analysts praised the decision, citing Old Navy's impressive strength relative to Gap's namesake brand - but still couldn't ignore the challenges facing both brands.
• Old Navy's comparable sales came in flat during the holiday quarter, and its full-year sales fell.
• Watch Gap trade in real-time.

It wasn't difficult to see how much the stock market loved Gap's decision to spin off Old Navy into a standalone, public company.

Shares of Gap spiked nearly 20% Friday as the planned split garnered praise among analysts, who cited Old Navy's strength relative to Gap's struggling namesake brand.

Still, a handful of hesitant analysts noted weakness in both brands' growth, and said they wouldn't buy in just yet.

"While we view the transaction favorably, we believe it comes at a time when the company is undergoing significant changes (which present execution risk) and remain on the sidelines, especially given the stock's reaction to the news (up ~25% in the after-market)," Deutsche Bank analyst Paul Trussell, who maintained his "hold" rating on Gap shares, wrote in a client note.

The company's fourth-quarter results showed both brands are facing challenges - particularly the Gap brand, Trussell said. He pointed to pain in both brands; Gap will close 130 namesake stores in 2019 and a total of 230 stores over the next two years, while Old Navy posted quarterly earnings results that fell short of Wall Street's estimates.

Read more: Gap will shutter 230 stores as sales plunge

Old Navy recorded flat quarterly comparable sales after a 9% rise in the same period a year earlier. For the full year, the retailer saw 3% comparable sales growth, down from 6% growth the prior year.

Both measures were still stronger than Gap's results, which showed comparable sales fell 5% for both the fourth-quarter and for the full-year.

Old Navy's performance, though a solid driver of growth for Gap, has proved inconsistent on a longer-term basis. It's seen unchanged or negative comparable performance in nine of the past 20 years, according to Morgan Stanley analyst Kimberly Greenberger.

"So while we view Old Navy's market position more favorably than that of Gap and Banana Republic, the business exhibits the same kind of volatility as other fashion apparel retailers," Greenberger wrote.

Read more: We visited Old Navy and saw why it became Gap's biggest asset before it was announced it was spinning off as its own company

She recommended investors stay "underweight" the stock in their portfolios, and said the spin-off news "offsets Old Navy blues." Morgan Stanley is advising Gap on its Old Navy spin off, which is expected to be completed in 2020.

While additional details for the spin-off will come in the quarters ahead, "the decision to spin out the GPS profit engine was clearly a move the market was not anticipating," wrote Kate Fitzsimons, an analyst at RBC Capital Markets.

It's no secret that the retail space has undergone spectacular change in recent years, as e-commerce has grabbed market share away from legacy brick-and-mortar brands in every corner of retail. The market has rewarded brands seen as successfully incorporating e-commerce into their business model, - like Walmart with Jet.com - and punished those who have not, like a myriad of department stores.

Other retailers will undoubtedly take note of the spin-off, said Simeon Siegel, an analyst at Instinet.

"It is near impossible to determine what other decisions this may trigger," Siegel wrote in an email to Markets Insider on Friday. "That said, it is definitely fair to assume that board rooms across the retail ecosystem are having a discussion today that they may not have had yesterday."

He continued: "And it is also fair to wonder if this is the acknowledgement that the turn in the Gap brand wasn't going to play out how they wanted."

Read more: Gap's decision to spin off Old Navy could cause a wave of retailers to follow suit

Once the two brands split, shareholders are expected to receive a pro-rata stock distribution, and as a result own shares in both the new company and Old Navy equally, the company said.

The new, yet-to-be-named company will include Gap, Banana Republic, Athleta, Intermix and Hill City, and will be led by current Gap CEO Arthur Peck. Meanwhile, Old Navy will be headed by its current chief executive, Sonia Syngal.

"In addition to separation efforts, fundamental issues remain at the Gap brand as it works through achieving the right product balance and increasing customer traction," Oliver Chen, an analyst at Cowen, wrote to clients following Gap's earnings last Thursday. "Old Navy is also working through some fashion misses that led to softer sales during the holiday season."

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We visited Old Navy and saw why it became Gap's biggest asset before it was announced it was spinning off as its own company