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Gap (NYSE:GPS)

Q3 2012 Earnings Call

November 15, 2012 5:00 pm ET

Executives

Katrina O'Connell

Glenn K. Murphy - Chairman and Chief Executive Officer

Sabrina L. Simmons - Chief Financial Officer, Executive Vice President of Finance and Principal Accounting Officer

Analysts

Betty Y. Chen - Wedbush Securities Inc., Research Division

Dorothy S. Lakner - Caris & Company, Inc., Research Division

Erika K. Maschmeyer - Robert W. Baird & Co. Incorporated, Research Division

Kimberly C. Greenberger - Morgan Stanley, Research Division

Adrienne Tennant - Janney Montgomery Scott LLC, Research Division

Janet Kloppenburg

John D. Morris - BMO Capital Markets U.S.

Evren Dogan Kopelman - Wells Fargo Securities, LLC, Research Division

Edward J. Yruma - KeyBanc Capital Markets Inc., Research Division

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

Randal J. Konik - Jefferies & Company, Inc., Research Division

Brian J. Tunick - JP Morgan Chase & Co, Research Division

Oliver Chen - Citigroup Inc, Research Division

Operator

Good afternoon, ladies and gentlemen. My name is Jemariah, and I will be your conference operator today. At this time, I would like to welcome everyone to the Gap Inc. Third Quarter 2012 Conference Call. [Operator Instructions] I would now like to introduce your host, Katrina O'Connell, Vice President of Investor Relations.

Katrina O'Connell

Good afternoon, everyone. Welcome to Gap Inc.'s Third Quarter 2012 Earnings Conference Call. For those of you participating in the webcast, please turn to Slides 2 and 3.

I'd like to remind you that the information made available in this webcast and conference call contains forward-looking statements. For information on factors that could cause our actual results to differ materially from the forward-looking statements, as well as reconciliations of measures we're required to reconcile to GAAP financial measures, please refer to today's press release, as well as our most recent annual report on Form 10-K, and our most recent quarterly report on Form 10-Q, all of which are available on gapinc.com. These forward-looking statements are based on information as of November 15, 2012, and we assume no obligation to publicly update or revise our forward-looking statements.

Joining us on the call today are Chairman and CEO, Glenn Murphy; and Executive Vice President and CFO, Sabrina Simmons.

Now I'd like to turn the call over to Glenn.

Glenn K. Murphy

Thank you, Katrina, and good afternoon, everybody. Before I hand the call over to Sabrina, I do want to talk about the quarter and the performance of Gap Inc. in Q3. I want to talk about the announcement from a month ago of the move of Gap Inc. to global brands. So let me start with that.

A month ago, we announced that our business made a structural change that will be effective in February 2013. In 2008, Gap Inc. was an American-centric channel led business. That was completely the appropriate structure for that time. But we've been on a journey. We have been moving the company at a pace that we're comfortable with, you could never go from an American-centric organization to global brands without having stores in China, without having online that was launched globally, without having outlet stores internationally. As those proof points came together, it made sense, this was the right time to move to a global brand structure.

This was driven by the customer. Customers clearly are becoming more and more global. As we go around the world and all of us travel, there's more in common than I've ever seen between a customer in New York, in London, in Tokyo and Toronto and Istanbul. So from our perspective, looking at our business globally is very important, to have one lens, one management team looking at the brand across all different channels in all different international countries. What we're expecting to get out of this change is speed, for sure, with one team deciding across every touch point we have to the customer. We're going to get more efficiency, which is critical. This change definitely puts the brand ahead of channels. Channels are important. And the corporate strategy has been clearly identified as multiple channels. But this is putting the brand first. And secondarily, it's about global over local. Local is important. We need to understand the local needs of our customers, in Gap brand in particular that operates in over 40 countries. But this is the global approach to the business first. And this structure from my perspective has definitely been put in place to fuel long-term growth. We've had a good year so far on growth. We want to have strong growth every single year looking forward, and this structure is going to be an enabler to that kind of performance.

Now let me talk about the quarter, and I'll look at it a couple of ways, one domestically, internationally, and also give you a little bit of commentary on our growth initiatives.

Domestically, the business had an 8% comp, that was a very good performance for our domestic brands. Now what is encouraging as I talk to you about in the second quarter, this was product-led. Our product teams delivered the product to our online business, to our stores that allowed us to get to this kind of comp, and it's key categories. Everyone of our brands has been strategically saying, what's the category? This comp is an outcome. You have to have a plan across the categories where you want to differentiate yourself, how can you get a competitive advantage? Where do you want to put your inventory, your marketing? Drive those categories to get to a comp, and that's what we saw in this quarter. The other thing I want to talk to you about is we've been working on more of a wear now approach. There's been a couple of transition seasons between summer and fall, and winter and spring. I think as a business, we've lost market share. So this quarter more than anyone I've seen in our past was much better executed in that transition of product. And that's why our comps were strong in August and September.

And lastly, we had very good reg price selling. Selling more products online and in our stores at regular price is a metric we're watching closely and does talk about long-term health of the brand. On the International business, we had a minus 3% comp. Now our total sales were on par with our domestic business, and that speaks to Old Navy Japan, our China business, our franchise business, but our comp of minus 3% is something the team is focused on. We would like to see the International business improve that trajectory through the corrective measures they are taking. Let me give an update on the company's growth plans.

Our franchise team has opened in 8 countries already, with 1 more to go. So a very big year for that team in terms of number of new countries. We opened up in Japan online. So now Gap Inc. has an online presence that we control. In Europe, in Canada, in the U.S., in China and now finally, in Japan. And if our strategy, which we are so committed to multiple channels and to multiple geographies continues to produce the results we hope, this was a critical step in that direction. In China, we're very comfortable with the performance of our business. We're on track to open the number of stores we've committed ourselves to. The milestone in the third quarter was we opened 4 outlet stores in China. So in November 2010, we opened up 4 specialty stores with our online business day 1, and here we are, less than 2 years later, opening up our outlet centers in China, which we believe will be a nice opportunity in that country.

And lastly, Athleta continues to perform very well. And most encouraging in this quarter is now we've opened up stores in all different kinds of real estate. We have street stores, we have mall stores, we have lifestyle stores, we have strip centers. And what's been impressive is how well Athleta performs in everyone of them. That opens up lots of opportunities for that brand if it can perform at this level going forward in all different types of real estate, that makes the brand very flexible.

Let me close by mentioning we know it's been a very difficult time for people on the East Coast, dealing with the aftermath of Hurricane Sandy. Gap Inc. has 28,000 employees that were in the path of the hurricane, and what was primary to us was the safety of our employees, nothing is more important to us than that, and we're so happy that by all accounts, our employees are safe and sound. They've been impacted like so many other people. That's why I want to encourage you on the phone, if you haven't given, please give money to any cause, give to the Red Cross, give to the Salvation Army. People are in need even 3 weeks after this horrible event. We're in the fourth quarter. We've been preparing for this for many, many weeks. We know how important this quarter is. We're 2 weeks in, but this quarter now is all about execution. How we're going to execute in the stores? How we're going to execute online? How we're going to execute in our outlet channels versus our specialty channels? This is what it comes down to. I think our team has shown to continue to be even better at execution, committed to it. And this is a quarter where you want to go out, you want to have the right product, the right marketing, you want to gain share, and you want to win. And that's our goal.

So with that said, let me turn it over to Sabrina to take you through the financial performance of the third quarter.

Sabrina L. Simmons

Thank you, Glenn. Good afternoon, everyone. We're very pleased with our third quarter performance as we continue to make meaningful progress against our stated 2012 priorities including: driving increased sales with healthy merchandise margins, prudently investing in our business and growing earnings per share.

Here are some highlights for the quarter. Net sales were up 8% and comparable sales were up 6%, with all North American divisions continuing to post positive comps. Operating margin expanded by 380 basis points to 13.5%, and earnings per share grew 66% to $0.63.

Please turn to Slide 4 for our earnings recap. In the third quarter, operating income was $520 million, up $174 million and net income was $308 million, up $115 million.

Turning to Slide 5, sales performance. As customers continue to respond favorably to our product, third quarter total sales were $3.9 billion, up 8%, with comp sales up 6%. Total sales and comps by division are listed in our press release.

Turning to Slide 6, gross profit. Gross profit dollars grew by 21% to $1.6 billion. Third quarter gross margin was up 450 basis points to 41.2%. Our merchandise margins were up 330 basis points, driven primarily by decreases in average unit costs. Rent and occupancy leveraged 120 basis points.

Turning to inventory on Slide 7. With the benefit of average unit cost coming down during Q3, we were able to sell more units while managing our total inventory dollars tightly. As a result, inventory per store in terms of dollars was down 4% at the end of the third quarter.

Please turn to Slide 8 for operating expenses. We've noted throughout the year that we plan to invest more in our businesses during 2012, and highlighted that it's likely we will de-leverage operating expenses. In line with that framework, third quarter total operating expenses were $1.1 billion, up $105 million from the prior year, with an ongoing focus on the areas of marketing and store payroll. As a percent of sales, total operating expenses de-leveraged by 80 basis points. Marketing expenses grew $29 million to $178 million, driven primarily by ongoing investments in Gap brand marketing and CRM.

Please turn to Slide 9 for capital expenditures and store count. Year-to-date, capital expenditures were $449 million. With regards to company-operated stores, we've opened 32 stores on a net basis year-to-date and ended the quarter with 3,068 stores. Square footage was down 2% compared to Q3 2011. Store count and square footage by division are listed in our press release.

Regarding cash and share count on Slide 10. Year-to-date free cash flow was an inflow of $776 million, and we ended the third quarter with about $1.8 billion in cash and short-term investments. Year-to-date, we spent $463 million on share repurchases, including $96 million to repurchase 2.7 million shares in the third quarter. We ended the quarter with 480 million shares outstanding.

And now I'd like to discuss our outlook for the remainder of the year. Please turn to Slide 11. Given our progress year-to-date, we are raising our estimate for full year earnings per share, which includes the 53rd week to $2.20 to $2.25. In addition, we are increasing our full year operating margin guidance from about 11% to about 12%. As a reminder, it's our objective to continue to drive consistent top line growth while delivering healthy merchandise margins.

As we lapped last year's average unit cost increases, we expect fourth quarter merchandise margins to expand.

In terms of inventory, inventory dollars per store at the end of Q4 are expected to be up in the low single-digits versus last year.

Regarding operating expenses, we plan to continue to invest in areas like marketing and store payroll. Therefore, we expect the increase over last year in operating expenses in Q4 to be at least as large as the 11% increase in Q3. And as a result, we also expect to de-leverage operating expenses in the fourth quarter.

Moving on to cash. We plan to continue repurchasing shares opportunistically, though it's important to note we consistently stated we expect the level of share repurchase to be more modest in 2012. As a reminder, our third quarter weighted average diluted shares were 488 million.

Regarding our effective tax rate, we now expect our full year rate to be about 39%, down from our previous guidance of about 39.5%, driven primarily by tax credits.

The following full year guidance metrics remain substantially unchanged: Square footage down by about 1%; company-operated stores about 15 net openings; capital expenditures about $675 million; depreciation and amortization about $475 million.

In closing, we're very pleased with how we executed against our strategies in the first 3 quarters. As we enter our most important selling season of the year, we remain committed to executing on our financial goals while continuing to make improvements and investments in our business. Thank you.

And now I'll turn it over to Katrina.

Katrina O'Connell

That concludes our prepared remarks. We'll now open up the call to questions. [Operator Instructions]

Question-and-Answer Session

Operator

Our first question will come from the line of Betty Chen with Wedbush Morgan Securities.

Betty Y. Chen - Wedbush Securities Inc., Research Division

I was wondering, Glenn, if you can speak a little bit more in terms of the commentary about each brand successfully pursuing key items or key categories, how -- were there any learnings in terms of how those strategies played out? And what can we expect in terms of Q4?

Glenn K. Murphy

Well, the categories that we've been focused on, that's really been for at least the last 15 or 18 months. I think you have a combination of 2 things going on. We talked about this back in the call in February, our sort of refocused design, merchandise and inventory teams, about what are the key businesses that we clearly see us gaining market share on, that are right for the brand, define the customer, can be marketed properly. And as I said in my commentary, really provide either a competitive advantage because you have a product asset and a point of differentiation against our competition. So I think the teams have been very much focused on that. I think there may have been a moment in time where I think we were probably just spreading our focus a little too broadly. Now I've always been a believer that if you have a set of categories that hit all the criteria mentioned earlier, Betty, and then you can bring in new businesses and new categories, because the only way we're going to be at a comp consistently is to focus as I've said on -- about those key categories and product assets that each brand believes in while looking at new business opportunities that one day could become possibly, a product asset. So I think that it's that marriage of those 2 that allows the business to get an outcome of positive comps. Now on Gap, no big surprise. You've got the denim business, which our LA office, working with the New York office and all those teams, I really think that they've delivered since spring, a denim offering that has not only driven and lifted the overall business, but I think has been bringing in the right customer, which is critical to Gap's marketing strategy. And on top of that, another, of course, are the product asset for Gap brand is it's Baby business. I think those 2 just as examples have really helped propel the kind of comps you've seen at Gap brand and domestically. In BR, again no big surprise, suiting has been a very strong business for us. Men's and women's for the last 3 quarters, and we've complemented that with woven tops, which was stronger in men's for a long, long time, but it's nice to see this year a little bit of our investment in products has gone to women's woven tops. And that's also been a very strong business for us. At Old Navy, it's been denim, but really a focus on the Rockstar jean, which is a little bit of a higher AIR. Hopefully, through that you materialize to a higher AUR. But the fit, the colors, the marketing have all come together. That and the Kids business at Old Navy, especially in Q3, where the team I think did an exceptional job on back-to-school. So execution of the plan for the last 15 months has been good, but I think it's that combination, I spoke about earlier, that's important to me being right strategically, right on the execution, looking at new business opportunities and therefore, the goal here is to have momentum on the comp performance in our global business. But in this quarter particularly, our domestic business was very strong.

Operator

Our next question is from Dorothy Lakner with Caris & Company.

Dorothy S. Lakner - Caris & Company, Inc., Research Division

I wondered, Glenn, if you could talk about regular price selling. Clearly, you're driving more of that business with regular prices. But I just wonder where you are now relative to history and where you think the levels of regular price selling can go from here? What opportunities do you have over the next quarter and the next year?

Glenn K. Murphy

Well, Dorothy, I have to say we're just coming off 2008 and 2009, I think that the business probably lost perspective of what a healthy brand, which we have 3 brands, what that looks like and therefore, what one of the measurements of success of a healthy brand, which is how much -- what percent of your units go through at reg price. This has been the best year we've had in a long time. So I've been pleased with the step up. Now that's a -- obviously, it starts with the right decisions being made on product, I was saying to Betty earlier, that all holds true towards reg price selling. I think inventory management had a tough a tough year last year. It was difficult for them with the huge increases in AUC to buy right. That probably didn't help in our goal last year even to try to get to better reg sell price. There's been some really good decisions being made. I think a little bit of that is process changes, some investment in systems, I think that has certainly helped that team. Then you have the marketing investment we're making. And then lastly, I would say that our store team have been much more focused. And I think we've been flowing the product to them that allows them to capture a better opportunity on reg price selling. So we have really been pushing new arrivals. I'm not going to give you the number, but the percentage of weeks now that Old Navy flows new product, it has -- I don't know this for a fact, but my supposition is, it has to be the highest it's ever been. The number of weeks that Old Navy receives fresh, new product. So you put that all in combination, and we've had a good year on that front. Now what I will say to you that we have a long way to go to get to the numbers I think that all 3 brands should be at. I think that's going to -- it's really going to happen through consistent performance on the product side and consistent execution and marketing. But the team's commitment, and I think our customers' response so far -- a big thing I've always believed in that we've done a decent job of, but not as well as I thought we could have, our actual initial pricing is very sharp across the different brands, different customer groups. If you look at the initial pricing at Old Navy, at Gap, at Banana Republic, it's very good. So our goal midterm and long term is to reduce our dependency on having to get off those prices because they are very good. And this is really a global strategy that you're seeing being applied much more focused now in Europe, in Japan and in China. So I think the teams are pleased with the performance so far. But to answer your question, I think this is really early days for how high the bar can be for these 3 brands on reg price selling. Now it helps having Athleta in the business because we realize how high is high, because their reg price selling is very attractive. It's been helpful too that Stefan joined the company because I think he has also been giving us a feeling from his perspective of what healthy looks like when it comes to reg price selling. So I think those are just 2 other sort of data points that have reinvigorated the team to be committed to this metric over the next number of years.

Operator

Our next question is from Erika Maschmeyer with Robert W. Baird & Co.

Erika K. Maschmeyer - Robert W. Baird & Co. Incorporated, Research Division

Could you talk a bit about the traffic that you've seen? I know in the past you've mentioned that the traffic that you've gotten for your value businesses had exceeded Gap and Banana is -- is that still the case and can you talk a bit about the contribution from AUR as well?

Glenn K. Murphy

I will start with the traffic and then Sabrina can give you some insights on AUR. That trend still holds true. Our value businesses being made up of Banana Republic Factory Stores, Gap Outlet and Old Navy, their traffic is still noticeably stronger than it is at Banana Republic and Gap specialty stores. So I think -- if I just give you one sort of approach we're taking. Gap brand, we've been putting more marketing behind the brand since spring. And I think we've all been clear here that as we try to get more new customers, some lapsed customers into the business and ultimately move that traffic metric, it's going to take a little bit of time. There's a lag effect that's going to take in Gap brand. We're committed to the marketing. We're committed to our messaging. We're committed to the new mediums, in the areas we're investing, but we -- the team knows that there's an expectation, that as we keep giving them more funds in marketing that at some point, we're going to -- at some point, we've explained to them there's a date we want to see the traffic be much -- on a much better trajectory than it's been so far in specialty. It's not a disaster. It's just not what we believe it should be long term. And that's again the health of the business. As I was answering some of the questions earlier, I think when you're talking about better product and you're talking about better inventory management, focused on key categories, that again being consistently done, is the ultimate driver of better traffic. But marketing is something that we've taken very seriously this year, and we've been again, we've been pleased. There's always improvement in our value business. We've been pleased. The third quarter was I think another -- another better performance by our 3 value businesses in terms of traffic. But we'd like to see Banana Republic specialty and Gap specialty start to change the trajectory they've been on, on traffic. And so we'll watch that in Q4, and we'll see how we do.

Sabrina L. Simmons

Yes, and Erika, regarding AUR, the quarter actually played out very similar to how we've framed it up on the Q2 call, which was, we stated that when -- with AUCs coming down overall, we were going to be introducing more units into the system to get Old Navy, especially back to a normalized level of units per store after last year. And with that reintroduction of units, we expected that the growth rate in AUR would not be as high as it was in the first half. So in fact, in Q3, overall, AURs were up just very slightly. And that phenomenon was really driven by Old Navy. So that implies that, of course, Gap and Banana did better on AUR. But overall for the company, up modestly.

Operator

[Operator Instructions] Our next question is from Kimberly Greenberger with Morgan Stanley.

Kimberly C. Greenberger - Morgan Stanley, Research Division

I'm wondering if you can look out to 2013 and beyond and just talk about where you see the opportunities to drive your business to the next level. And what are the strategic priorities internally to drive both sales and margins higher over time?

Glenn K. Murphy

Well, I think we'll probably have a lot more to say on that front in February in terms of what those levers are. But suffice to say, look, we -- one big one that we've talked about publicly, but it's also part of some of the performance improvement we've seen this year, and something we believe in long term will continue to add value to the business on the operating margin side, is this shift in our mix of our business towards where the customer is. And it just happens to be where we think we have a competitive advantage against our global competitors. So the customer is certainly moving more and more online. That's not a new story. But we have invested properly in that business. We will talk more in February about what our version, which I'd like to think is a little unique to the omni-channel approach that's going to be across our 3 brands, and how we've set ourselves up. And that even though we're making the change to our global structure and making online and outlet and specialty and franchise all part of one leadership team, what I said in my opening comments, I think one of the benefits of making that change is the speed of decision-making and the move on that strategic front at a faster pace than we're going to see. So we put one person in charge of all earnings across the brand, one amount of capital that, that global brand president is going to be. One thing I know about capital, it tends to go to where the biggest opportunity is. So I think the online business will grow -- continue to grow much stronger than our specialty business. But I think that even at that delta can even grow over time as we get to this new structure and start putting the infrastructure in place to execute our version of omni-channel long term. Our value business, defined as Banana Republic Factory Store and the Gap Outlet business, I think again globally, still has a long, long way to go and huge opportunity. So you may have heard us say this before, Kimberly, but I think our strategy against our global competitor is right. I think we have a competitive advantage. I think the customers are moving both aggressively and accepting more and more people going to either power centers, value centers as lifestyle centers get transitioned. Globally, again, power centers, value centers, and we have a channel that appeals to that customer to where that growth is, same with online, and we've obviously been pretty clear about this. The best return on sales and the best return on capital the company has is on those 2 channels. So I think that the new global brand presence, looking at the brand holistically will move much quicker, even though I think we've moved at a decent pace over the last 3 to 4 years. That's to execute on that strategy. I think that's going to give the company -- execute it properly, will give us nice earnings growth going forward as we change the mix of the business.

Operator

Our next question is from Adrienne Tennant with Janney Capital Markets.

Adrienne Tennant - Janney Montgomery Scott LLC, Research Division

My question is on the inventory units, particularly at Old Navy. It sounds like the build is weighted toward Old Navy. So I just wanted to know whether there was going to be unit build at Gap and Banana as well? Should we expect the AURs to be down and should we expect a comp acceleration? So are you kind of hitting the AUR so that we would see increased market share gains?

Sabrina L. Simmons

Yes, I think overall, Adrienne, we're trying to ground on trying to get Old Navy and the value channels, but especially Old Navy back to a normalized -- so we're not really changing our model from history. It's really that we're comping a year that was unusual in '11. With that very high average unit cost, we pulled out a lot of units because from a total cost inventory perspective, we didn't want that ballooning too much. So this year, with that coming down, we're actually trying to just reintroduce units to a level which are more comfortable from any historical velocity level that we would see at Old Navy. Now of course, our hope in all of that is to continue as our overall goal is for the company, is to continue to positive comp in a manner that has us gaining some market share. So that is our overall goal. But we want to do that with healthy margins. And we think with this average unit costing providing us some nice tailwind, we don't need a very large increase in AUR to still give us obviously, nice margin expansion. So that's sort of the formula. Delivering a nice, positive comp is the goal that gives us some market share in a way that also provides very healthy merchandise margins.

Adrienne Tennant - Janney Montgomery Scott LLC, Research Division

And AUR should be up, is that what you're implying slightly?

Sabrina L. Simmons

No, no -- I would -- we're not guiding to AUR, but I would say reminders are -- I just said in Q3 that it was only up very slightly, and we're entering probably our most promotional season of the year. So we'll see how it turns out.

Operator

Our next question is from Janet Kloppenburg with JJK Research.

Janet Kloppenburg

Sabrina, I was wondering if you could talk -- you just mentioned your AUC tailwind. As I recall, the fourth quarter of last year had the steepest level of input price increases. So I'm wondering if we could look for incrementally higher sourcing reductions here in the fourth quarter, and therefore, some additional opportunity for gross margin gains. And Glenn, I was -- I'm curious about the timing that you might consider for incremental marketing dollars at Old Navy. You spent a lot at Gap. Old Navy has had a nice turnaround, and I'm wondering when we might see the marketing start to pick up for that brand.

Sabrina L. Simmons

Yes, so I'll start with your gross margin question, Janet. So to be helpful, because we don't give explicit guidance on that line, but to be helpful, definitely, it's true that our peak costing last year was at holiday. The differential between fall and holiday though was that not that enormous. So I don't want you to think that, that's some big differential that we're moving into. But for sure, holiday was the peak. In -- across Q4, we'll of course complete selling fall, mostly holiday, and we'll start selling spring. So there's a mix of seasons there. All of that said, it's true that holiday should have nicer tailwinds on the AUC. I think what we'll see how it works out is on the AUR, because again, it's a promotional season. We have great plans, we feel really confident about. We're going to be in there with our -- especially at Old Navy with a great lineup of promotions. But we're selling a lot more units. So that might be a bit of an offset. So yes, on the AUC, and we'll see how the AUR turns out. But margins should be healthy.

Glenn K. Murphy

And on the marketing front, we're actually fairly pleased with the amount of marketing that Old Navy has, and we don't see ourselves making any kind of move above where they are right now on a relative basis until when Stefan gets more settled in his job, because he's been -- this is month one for him. And him and Michael Francis and myself, spend a little more time together probably early in the new year discussing Old Navy and its creative platform that supports its brand positioning. And I think more than anything, as I've talked to Michael quite a bit over the last 45 days, I think Michael what he sees is an opportunity to change the mix of our marketing and maybe get a little more bang for our buck like some other brands out there. Maybe we're a little too married to our television exposure. Television and Old Navy go hand and glove. There's something about that brand, about its customers, about the audience, and how it really resonates. Hopefully, we'll see that as the television kicks in next week for Black Friday, and the weekend after Black Friday. But the creative I think, the work that Michael has done since he's been here, which is really looking not only about the creative positioning of Old Navy and all the tools and mediums available for us, but how do we get more for the money we have. So still to be determined. I think the 2 of them are spending lots of time together. Michael's adding some great value already. I think early in the new year, we'll sit down and figure that out. Obviously, I'm always a big believer that if there's a justification, and we're going to get something from it that in this case, could be whether it's traffic driving or whether we introduce a new category or there's some other reason, I'm sure we're open to it. What I also will say to you is, don't forget Old Navy in 2013 steps up a little bit more globally, and we're going to have to start looking at some marketing in the Japan market to make sure that brand gets off to a strong start. So I'd be more focused on putting some incremental money there than do anything domestically. Because again, worth repeating, I'm pretty comfortable with the amount of money they have right now.

Operator

Our next question is from John Morris with BMO Capital Markets.

John D. Morris - BMO Capital Markets U.S.

Okay. So my one question is on International, Glenn, and a little bit relating to the global restructuring that you've talked about. You talked in your prepared remarks about taking some corrective measures for next year. So if you can elaborate a little bit more on what those are and the goals that you're hoping to achieve? What are the yardsticks you'll be measuring and how does that fit in with the global restructuring repositioning? Obviously, that would have some impact on that.

Glenn K. Murphy

I would say that some of corrective measures I referenced -- I'm hoping that some of them will be helpful sooner than 2013. A big area that's changed. The first step we took towards global brands was in the spring summer of 2011, with a number of changes we've made in the company structure. One that gets to the corrective measure comment you just made was to bring one International leader, Stephen Sunnucks, who is now going to be our Global President for Gap brand, and he brought all the International merchant teams together, hired an amazing lead, who's now going to run the global merchandising for him named Liz Meltzer, who has a history at J.Crew and Uniqlo. And what Liz did, and you'll start to see some of that work show up in the market just now, in our franchise business, in Europe, in Japan and in China, was really bringing all of that -- all of those teams together under one strong view on assortment architecture and pricing architecture. Now we weren't so divergent that you wouldn't know it was Gap brand. I actually in my comments at the beginning what I said was, possibly up until this year, we are a little more local at the expense of global. And that's fine. I was -- I was trying with the other executives in the business, we were all sitting back and trying to find out what is that right balance? Clearly, with some of the work we've done, some of the research, some of the customer work we've done around the world, the decision through the new structure was put global first and local second. In keeping with that, the work that Liz under Stephen's leadership have put forward is that, you will see now a much more consistent approach in our assortment around the world, not identical because we are such believers in local opportunities. What I believe is going to happen now is, they will now be able to go, instead of an inch deep and a mile long, they will be able to go an inch wide and a mile deep on what really differentiates Japan from China, from Europe, from some of our key franchise markets. That work is already beginning. Now we're not going to get a huge benefit in the fourth quarter, but I am expecting that some of the changes they've made will be the beginning of some of the course correction action. That, coupled with our pricing, I was talking earlier that we've actually pretty good with our initial pricing. I actually feel in North America, we're highly competitive for the customers we're going after against the competitive sets of each one of our brands. I probably couldn't say that with as much confidence internationally until now. And I do think that again, under the leadership of Stephen and Liz, our International business is much more competitive in this fourth quarter, and therefore, going forward with its pricing architecture. So those 2 of many actions that have been taken while Stephen led the International business, hopefully will start to change the trajectory we've seen in that business for the last, I don't know, 5 or 6 quarters now.

Operator

Our next question is from Evren Kopelman with Wells Fargo Securities.

Evren Dogan Kopelman - Wells Fargo Securities, LLC, Research Division

Can you talk a little bit about the profitability in China in that greater region? And maybe the timeline around how we should expect that profitability to improve?

Sabrina L. Simmons

Yes, we don't segment report that, Evren, but what I will tell you is that, it's a long-term investment. It has been dilutive, but its profile has been improving. And we expect a nice, big step in that improvement for fiscal '12 as we will probably for '13 as well, and as they keep adding stores that are doing nicely. We talked about the fact that doing business in China has its complications and requires more infrastructure than doing business in more developed markets. But we think it has great potential for our long term. So we're definitely invested there for the long term, and we're making good progress against that dilution.

Operator

Our next question comes from Edward Yruma with KeyBanc Capital Markets.

Edward J. Yruma - KeyBanc Capital Markets Inc., Research Division

My question, as it relates to your global realignment, are there other functional pieces of the business that needed to be changed now that you've kind of reorganized at the top of the house, and how do we think about expense build as it relates to this infrastructure longer term?

Glenn K. Murphy

Yes, no, I think that clearly, nobody should be making the assumption that the restructuring we made and the repositioning of the brands to a global view is going to add cost to the business. That's not what the intention behind it was. As I said earlier, we're going to get speed. One of the big benefits we're going to get is that and a more common approach as we shift to, as I said earlier to the global local approach to our business, the Gap brand in particular across over 40 countries. We've actually, since 2007, I'd say let's call it to the service functions in the business between finance and HR and real estate and supply chain and IT. I think the business under Sabrina's leadership have done a great job making a very efficient service model to the brands in place. And those services were already global. So the infrastructure on which the brand sits were already global, and we're leveraged, and we've been doing a great job on that front. This was a change related to brand level only. It will sit on the exact same infrastructure we had before of shared services, where we've continued to actually get great benefit and efficiency from that. So this is really a change that I think is customer facing, that will get the benefits I talked about earlier. Now you have 3 significant leaders who run all of our big iconic brands, and I think that it's early days. Those teams don't officially start working together until the new fiscal year, but we're confident that we're going to get the outcomes I talked about earlier.

Operator

Our next question is from Jennifer Davis with Lazard Capital Markets.

Jennifer M. Davis - Lazard Capital Markets LLC, Research Division

I guess I'll stick with the International theme here and I was just wondering if you could maybe give a little more color, Glenn, around trends in Europe and Japan by brand. I think the Old Navy store is doing very well in Japan. I know it's very early still. I believe that Gap Outlet and Banana Republic are doing better than full price Gap. So I guess could you maybe just give a little more color around, like I said, Europe and Japan and the brands?

Glenn K. Murphy

I think that your assessment is actually pretty much spot on. Both in Europe and in Japan, I'd say our Banana Republic business, our online business, and our factory store value business is doing quite well. And not in that order. Well, obviously, online businesses which are young in both the 27 countries we serve in Europe. And as I said earlier, Japan just opened a month ago. But earlier indications of Japan are very positive. The online business in Europe is very strong. And look, we've been making the same sort of approach that we've had here in the U.S. Making sure the stores are right. Focusing on key cities in Europe. Making sure we're investing and remodeling the stores that make sense, and we're going to hold on to long term. And as the customer starts to return, and I would not say in Europe we're seeing any signs of that just yet. There's some numbers just came out in the U.K. And once again, the customer apparel numbers were soft in the U.K. for October. So there's no -- there's no great sign right now in Europe. You saw H&M's numbers that came out today. So we don't have a large business there. We have an important business. We're keeping it tight. We're investing in our value sector and online, and that's it for now until we see signs of real improvement inside of Europe. In Japan, where the consumer is slightly better, our Old Navy business, as you said, is 1 store only. We'll comment in February about how many stores we're going to open for Old Navy in 2013. But we feel very good about the first store. Online I think will be an amazing add-on to the bricks business we have right now. And there, again, it's Gap specialty. The team is on it. I was answering John's question earlier, I think some of the work that Liz Meltzer has brought to the business, early indications will be in 2013, about how that change -- those corrective measures are going to take place. A little bit in the fourth quarter, but I think we've taken a lot of steps to get our International business performing at a higher level for Gap specialty. That's certainly not been an area we've been pleased about. But I think the team we have confidence in, and they're going to take some of those ideas now. They're going to go into the brands, and I believe the brands will execute that strategy and find even more ways to make sure that our International business performs better in 2013 on a top line basis than we've experienced so far in 2012. But more to come on that front.

Operator

Our next question is from Randy Konik with Jefferies & Company.

Randal J. Konik - Jefferies & Company, Inc., Research Division

Glenn, could you just talk about -- you mentioned some of the process changes and systems changes, can you expand upon that a little bit for long-term sustainability of improvement in the business? And then if you could, you said something with regards to Stefan talking about how to be best-in-class or what have you. So can you just, if you could, give us your thoughts on what he said were opportunities in the Old Navy business for us?

Glenn K. Murphy

Look, I think that what I was saying on the inventory management, one, you've got a few new people particularly at Old Navy who've come into the business, and I think they've been instrumental in making some process changes that we wish we probably would've undertaken some of those in 2011. But again, in fairness, 2011 was a very difficult year for our inventory management team with this change in -- of this paradigm shift of average unit cost to inventory units that they bought. Having said that, I really think that the process changes I'm seeing driven at Old Navy, but some of this applies to Gap specialty and Gap Outlet, Banana Republic Factory Store and Banana Republic specialty business, that the inventory teams I think are doing a much better job in 2012, and I'm actually feeling that any system investments -- and look, everybody is always putting some kind of money to their inventory management system. I think that we're just making sure those teams have all the right tools. But as we look, and we'll talk more about this in the new year, as we look at our business because right now, we've been talking about how inventory can be viewed more seamless from a customer perspective between channels. So we've been doing a little bit of that work right now on our ship-from-store strategy, which allows us to take product that is in demand online and ship it from one of our stores. So we've done a lot of work on that front. We'll talk more about that in the new year. But I think one of the next moves even though there's been some small investments that have been helpful in 2012. The big shift for us is how do start treating our inventory that's seamless to a customer across channels of online and specialty, and across geographies most importantly. I think that's going to be critical looking forward for a business like ours. And there's a lot of value to be created by doing that. And Stefan, look, it's 30 days. I just think that, we didn't hire him to come in and just oversee the status quo. We brought him into the business because we believe his experience, which is phenomenal, and his view of retailing, whose knowledge of specialty retail and of fashion in particular. His work he has done on processes and making sure that company's like ours learn to move faster because that's really going to be important going forward. The customer is moving fast, therefore we have to respond by moving equally as fast. I think that early days, but I'm just impressed with some of the observations that he's making, and I'm sure as shareholders and investors on the phone turn to 2013, there'll be an opportunity for everybody to meet him. And I'm sure he'll be happy to share some of his observations, what he thinks is great about Old Navy, which obviously, that includes a lot about the brand and its positioning. But what are some of the opportunities that he thinks he's going to put into place and what speed to create incremental value for shareholders.

Operator

Our next question is from Brian Tunick with JPMorgan.

Brian J. Tunick - JP Morgan Chase & Co, Research Division

Glenn, just curious about your view where we are, I guess, in the real estate portfolio side of the business? Sort of, where are we regarding sort of remodels, store closings, footage reduction and sort of which brand or 2, do you still think has the best opportunity for productivity, recapture as you start -- try to think about getting beyond last year or 2's, operating margins?

Glenn K. Murphy

I just -- with David Zoba today, who runs our global real estate, and he's been pretty consistent about this. We're thinking we'll end this year on our domestic real estate strategy. I'll come back to Europe in a second. But our domestic real estate strategy will end this year in the 7 or 8 inning of the plan we outlined to investors in 2008, so I think -- hats off to our real estate team who have done a phenomenal job. So by the end of '13, I think when you look at square footage reductions at Old Navy, I think we'll pretty much be there. We look at Gap closures, pure closures and then consolidations, I think we'll pretty much be there. Banana Republic was never a big change, but there's some changes that were necessary in Jack Calhoun's fleet. Those are for the most part done. And I think that the move now domestically is to look at these missed opportunities for the Gap Outlet business and the factory store business. We just opened up a store in Fulton Street in New York City, where the specialty business would not get the kind of customer traffic it needs given its value proposition. We put in a Gap Factory Store there, and it's doing phenomenally well. So I think that as we've tightened up the real estate for all the right reasons, there's a few opportunities still available for us domestically. And when Katrina was giving out or maybe when Sabrina was giving out the net number of stores in the quarter, I always think about, this is a year where we're going to open close to 200 stores. But we have a lot of closures this year because this was a very big year for us for closures. We have one more year to go of repositioning in 2013 and meaningful number of closures, probably not as high as '12, but we'll give you that information in February in 2013. And then we'll be able to be in a place where we're not operating like we had the last 4 years, with quite a few closures per year that dragged down the company's total sales. So I think that good performance by the real estate team -- I'll deal with 2 issues that you brought up at the end. Remodels, we're still very happy with the remodel work at Old Navy. I'm sure Stefan will have a point of view on that, but we've been very happy at the work that's been done. We've been very happy with the Gap global model. We just opened on 34 Street in New York, just reopened beautiful store doing very well. So very happy with how that store looks and how it's coming across. I think Jack Calhoun has continued to tweak the remodel prototype for Banana Republic. So I think that it's good, but I think he is tweaking it. So I think we feel good about our models. Athleta, obviously, is very strong. And lastly, if I was to say there was one area where productivity is the hugest -- sorry, is the most significant opportunity for us on productivity, that would be at Gap brand specialty. All our brands have an opportunity on productivity, but Gap brand specialty, with a repositioned fleet now in terms of number of stores and square footage, I got to believe Mark Breitbard is looking at that and going, that's the biggest opportunity for him is to get better productivity in his new fleet.

Operator

Our final question for today will come from the line of Oliver Chen with Citigroup.

Oliver Chen - Citigroup Inc, Research Division

Regarding the average unit cost dynamic, fourth quarter sounds like that's the optimal peaking event. How should we think about the evolution of that? And how do you prioritize what's going to be the biggest positives for gross margin after you kind of wind down the average unit cost benefit?

Sabrina L. Simmons

We're going to talk more about '13 on the Q4 call, Oliver. But obviously, we'll start to lap sometime in '13 really good costing. So we still have lots of great sourcing strategies ahead of us. So we're never done looking for opportunities to get optimal costing using fabric platforming, our new category management. So we have lots of tools within sourcing to keep optimizing costing. But certainly, we're not going to have the magnitude of tailwind that we've been experiencing this year. We obviously, are focused on great assortments. So part of the sustainability of moving forward with our positive comps, which is our objective, is going to be to keep making investments in those smart areas, where we think we can get the average unit retail for it. So we keep those healthy margins. But mostly, it's going to be a continuation of healthy product acceptance and modestly introducing more unit sales once we've achieved that healthy merchandise margin, so we're growing our gross margin. So that's going to be the recipe going forward into '13, and we'll give more details as we enter that year.

Oliver Chen - Citigroup Inc, Research Division

Okay. And if I may as a follow-up, what is your thoughts around your parameters for making a decision for investment in the future versus harvesting returns on the fixed cost side?

Sabrina L. Simmons

What exactly -- you want to restate that, maybe I'm not sure...

Oliver Chen - Citigroup Inc, Research Division

Just how are you thinking about going forward, this year, you're deleveraging in terms of the infrastructure investments...

Sabrina L. Simmons

Yes, got it, I think. Absolutely next year, I mean, this year was an important year for us to take some steps in reinvesting, and I think we we're prudent about where we took those measures, especially with regard to the pockets of product we reinvested in and the marketing investments. Now that we'll be anniversary-ing those, and we're definitely looking for return on those investments, we will be looking in '13 to go back to a more traditional economic model where we should be leveraging our expenses. So that doesn't mean that nominally, the expenses would go down as we grow our sales. You might expect us to go up obviously, but we would look to return to a more balanced economic model, where the expenses are leveraging.

Katrina O'Connell

I'd like to thank everyone for joining us on the call today. As a reminder, our earnings press release, which is available on gapinc.com contains a full recap of our third quarter results, as well as the forward-looking guidance included in Sabrina's remarks. And as always, the Investor Relations team will be available after the call for further questions. Thank you.

Operator

Ladies and gentlemen, thank you for your participation in today's Gap Inc. Third Quarter 2012 Conference Call. You may now disconnect.

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