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Gap Inc. (NYSE:GPS)

Q3 2009 Earnings Call

November 19, 2009 5:00 pm ET

Executives

Evan Price – Vice President of Investor Relations

Sabrina L. Simmons – Executive Vice President and Chief Financial Officer

Glenn K. Murphy – Chairman and Chief Executive Officer

Analysts

John Morris - BMO Capital Markets

Jeffrey Klinefelter - Piper Jaffray

Jeff Black - Barclays Capital

Kimberly Greenberger – Citigroup

Paul Lejuez - Credit Suisse

Janet Kloppenburg - JJK Research

Adrienne Tennant - Friedman, Billings, Ramsey & Co.

Brian Tunick - J.P. Morgan

Michelle Tan - Goldman Sachs

Marni Shapiro - The Retail Tracker

Stacy Pak - SP Research

Lorraine Hutchinson - BofA Merrill Lynch

Operator

Good afternoon, ladies and gentlemen. My name is Dixie and I will be your conference operator today. At this time I would like to welcome everyone to the Gap Inc. third quarter 2009 conference call. (Operator Instructions)

I would now like to introduce your host, Evan Price, Vice President of Investor Relations.

Evan Price

Good afternoon everyone. Welcome to Gap Inc.’s third quarter 2009 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 on this webcast and conference call contains forward-looking statements including those identified in today’s earnings press release, which is available on gapinc.com, as well as other statements that express our expectations, anticipations, beliefs, estimates, intentions, plans and forecasts. Because these forward-looking statements involve risks and uncertainties, there are important factors that could cause our actual results to differ materially from those in the forward-looking statements.

Information regarding factors that could cause results to differ can be found in our annual report on Form 10-K for the fiscal year ended January 31, 2009. Investors should also consult our quarterly report on Form 10-Q for the quarter ended August 1, 2009, and today’s press release.

Future economic and industry trends that could potentially impact net sales and profitability are difficult to predict. These forward-looking statements are based on information as of November 19, 2009, and we assume no obligation to publicly update or revise our forward-looking statements, even if experience or future changes make it clear that any projected results expressed or implied therein will not be realized.

This presentation includes the non generally accepted accounting principal measure, free cash flow, which under SEC Regulation G we are required to reconcile with GAAP. The reconciliation of this measure to the GAAP financial measure is included in today’s earnings press release which is available on gapinc.com.

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 Sabrina.

Sabrina L. Simmons

Thank you Evan. Good afternoon everyone. We’re pleased with our third quarter performance. We met our goal of improving our comp store sales trend, and we did it while delivering the highest third quarter gross margin rate in the past ten years.

These two factors drove a 25% increase in net earnings. And now, more highlights for the quarter. Diluted earnings per share were $0.44 versus $0.35 last year. Gross margin improved by 380 basis points to 42.5%. Operating margin was 13.9% versus 11.1% last year, and year-to-date free cash flow was $931 million.

The webcast participants please turn to Slide 4. Third quarter net earnings were $307 million compared to $246 million last year. Third quarter effective tax rate was 38.6% and weighted average diluted shares were 704 million.

Please turn to Slide 5 for sales performance. Third quarter net sales were $3.59 billion, up 1% to last year. Total company comp store sales were flat in the quarter versus down 12% last year. Please refer to our earnings press release located on gapinc.com for total sales and comps by division.

Turning to Slide 6, gross profit, gross profit was up $146 million or 11% to $1.52 billion. Gross margin was 42.5%, up 380 basis points, with 360 basis points from higher merchandise margins and 20 basis points from occupancy leverage. Merchandise margin improvements were driven by more goods sold at [regan] promo and higher regular priced margins.

Please turn to Slide 7 for operating expenses. Operating expenses were $1 billion, up $40 million from last year, driven by increased marketing. Marketing was up $20 million to $141 million, with the increase being driven by Old Navy and Gap. Foreign exchange also drove about $10 million of unfavorability.

Turning to inventory on Slide 8, we ended the third quarter with $2 billion in inventory, down 10% over the third quarter of 2008. Inventory dollars per square foot were down 9% versus the prior year.

Please turn to Slide 9 for capital expenditures and store count. Year-to-date, capital expenditures were $221 million. We opened 36 stores weighted toward international and outlet and closed 42 weighted toward Gap brand. Company wide we ended the quarter with 3,143 stores and net square footage was down 0.3% compared to fiscal year end 2008.

Turning to cash flows on Slide 10, year-to-date free cash flow defined as cash from operations with capital expenditures was an in flow of $931 million, compared with an in flow of $519 million last year. In addition to higher net income, the increase in free cash flow was driven by lower inventory and lower capital expenditures. Please refer to today’s press release which is available on gapinc.com for a Reg G reconciliation of free cash flow.

We repurchased 4.1 million shares in the third quarter for $91 million and we ended the third quarter with $2.4 billion in cash and short term investments.

Turning to Slide 11, our outlook for the fourth quarter, the economy remains challenging for our customers. That said, we are entering this holiday season focused on regaining market share and we’re confident about our holiday plans. We’ve increased our marketing spend, especially at Gap and Old Navy. And we believe our holiday assortments and planned promotions offer great value to our customers.

At Gap, we added a fully integrated marketing campaign which includes holiday TV for the first time since 2006. The TV commercials started on November 12 and run for about five weeks. At Old Navy, we’re continuing with our successful Supermodelquins campaign and added about a week of TV compared to last year. Given these investments, we expect Q4 marketing expenses to be up about $45 million compared to last year. In total, we expect fourth quarter operating expenses to be up about $100 to $120 million versus last year.

For context, operating expenses year-to-date through Q3 are down $85 million. And due to the fact that Q4 operating expenses last year were down $217 million, on a two year basis operating expenses are still expected to be down about $100 million in Q4.

In addition to marketing, the other drivers of the increase in Q4 include higher variable store related costs associated with our objective of improving our sales trends, as well as higher bonus accruals.

Turning to inventory, we expect average unit cost savings to continue in the fourth quarter. Lower AUC’s allow us to provide our customers with the value they’re seeking through the planned and targeted promotions, while still delivering healthy margins. As we enter this holiday season, we believe we have the appropriate inventory levels to achieve our goal of regaining market share. Recall over the last two years we’ve reduced inventory levels significantly. In order to achieve our goals, we’re increasing inventory investments in areas that have demonstrated momentum with our customers such as Old Navy. Therefore we expect the percentage change in inventory dollars per square foot at the end of the fourth quarter to be flat compared to the end of the fourth quarter last year.

Regarding share repurchases, we remain committed to returning excess cash to shareholders and we’re pleased that our board of directors has authorized a new $500 million share repurchase program.

Now turning to Slide 12, guidance for some full year metrics, we now expect depreciation and amortization to be about $575 million. The increase from our previous guidance of $550 million is driven in part by accelerated depreciation associated with our Old Navy remodels. Our guidance remains unchanged for the following metrics, effective tax rate about 39%; capital expenditures about $350 million; new store openings about 50; store closures about 100; net square footage decline about 2%.

In closing, we’re pleased that this quarter we achieved our best third quarter operating margin in ten years, driven by continued gross margin expansion. We’ll closely monitor the returns from the investments we’ve made to drive traffic and sales during this holiday season, and of course we’ll maintain our operational discipline as we focus on our top line.

Thank you and now I’ll turn it over to Glenn.

Glenn K. Murphy

Thank you Sabrina, and good afternoon everybody. Welcome to our third quarter conference call.

I want to reiterate what Sabrina just said. We were pleased with our third quarter results. First and foremost, on earnings per share for us to $0.44 against $0.35 last year was an accomplishment. And the fact that we did it by managing and making good decisions when it comes to the gross margin in the business was the right approach.

Average unit cost is something we’ve been focused on for a couple of years now, but we spent more time in the last couple of quarters working with the merchants, working with the planning community and our field leaders to work the mix inside our business. That performance gave us an operating margin improvement of 280 basis points, 13.9%. Operating margin in the third quarter was also something we feel good about.

And lastly, we improved the trend in our two year comp. Now we still have a lot of work to do. We are very focused on top line, but it’s good to see with the work we’ve done most recently we improved the trend on the two year comp in the third quarter.

Let me talk a little bit more about our financial strategy in the business. You’ve heard from Sabrina and you know that, based on our results, we achieved what we were trying to get done in terms of earnings and margin. But I do want to mention that we’re still very focused on having great cost discipline in the business. So we’re going to save money where it’s appropriate but also make targeted investments where we think we can move the needle, particularly when it comes to growing the business and moving top line sales forward.

Return on invested capital still very critical, making sure we manage that line appropriate and I think we’ve been good custodians of ROIC for the last couple of years, but there’s always more the business can do. We’ve worked over the last six to nine months on traffic generation ideas. How do we get traffic inside the four walls of our stores? Now I think the focus here is how do we turn that traffic into market share. Regardless of the growth that’s available in the marketplace, how do we go out, by brand like you’ve seen from Old Navy in not only this quarter but in previous quarters, go out and gain market share.

The macro environment as we look at it today is still very competitive, still very challenging, and the key for everybody now in retail is how do you cut through. How do you actually make sure your message gets out and is clear and is received by your targeted customer? We’re seeing a competitive environment today. We suspect it will be quite competitive in the fourth quarter and we’re preparing ourselves accordingly.

The unemployment number is still something that’s hanging out there, consumer sentiment doesn’t seem to get much traction from quarter-to-quarter, and ultimately the testament of a company that can do well in these times is how do you manage the volatility. There’s a natural volatility in apparel to begin with, but how do you manage the increased volatility that is being driven by the economic environment in which we’re all operating? That’s something we spend a lot of time here in the business is reading the facts, reacting to them but not over reacting. This is the ultimate challenge for any management team operating during these economic times.

Let me talk about our brands. The first brand I want to speak to you about is Gap brand. The news for them in the third quarter was certainly the re-launch of denim, the 1969 denim. I think the marketing was well done. We took it right down into the store. Feedback from our customers has been very strong and very positive. So the challenge for us is how do we take that re-launch of denim and get that incremental sale? That incremental sale through the right market inside the store, through the merchandising inside the store, through work through our sales associates to get that incremental sale and drive UPT.

And lastly, we have been very pleased with the introduction of the Stella McCartney line in conjunction with GapKids, and we look forward to working with Stella and her team for spring season launch on collaboration with GapKids.

Banana Republic, the work that was done during the third quarter by Jack and his team was actually bringing clarity inside their stores, clarity of assortment, clarity of message. That was very important for them in the third quarter and I think a lot of that work helped us produce the comp performance, a plus 5 comp in October. So I think some of that work behind the scenes helped Jack’s business get repositioned and get a positive result from October and that hopefully bodes well for the holiday season.

Another development in the third quarter for them has been the launch of their new prototype store. We opened first in Las Vegas, then Scottsdale and just last Saturday we opened up in Soho. I think that’s all positive. It’s a new prototype for Banana Republic.

On the Old Navy front, Tom’s business certainly in the last two months of the third quarter, in September and October had very strong comps. And that is when we talk about market share gains, that’s exactly what we’re talking about. And inside of that business, which I don’t think we talk about a lot, has been the performance of kids and baby. Even though the adult business performed well, what’s really been strong inside of Old Navy has been the kids and baby performance and the work that’s gone into re-engineering the product, reposition and becoming aggressive and really going after market share gains.

The other development in this quarter, we opened up 50 of our new store prototypes called Project ONE. It’s nice to know we got those done as quickly as we got them done. And they opened the last day of the third quarter. So we hope to see them contribute to our performance in the fourth quarter.

You’ve seen us make a good investment in marketing and we’ve talked about that. I think Old Navy has a nice twist upon the marketing messaging they started back in March with the Supermodelquins. That’s critical. Gap has come out now with their new marketing message. It started last Thursday. It’s very early to read the reaction right now, but it’s nice to see us coming back with a theme and a fully integrated marketing message for Gap.

And we have a very good marketing position. Not an investment, but a very good marketing position at Banana Republic and I do believe that even our outlet business and our online business are finding ways again to break through and have a good message for this very important fourth quarter.

As I look forward to the holiday season, one thing I can say we’ve done better than we’ve done, and this is my third holiday, my third Christmas with Gap Inc., we are better prepared than we’ve been before. From the back end work with the vendors to the logistics to store presentation to store execution, I think we’re better prepared on what I would call the blocking and tackling of a retail operation.

Equally important to the preparation we did is we’ve now built good contingency plans to make sure that we react to the consumer. We are able to make good, solid decisions and while we have a plan and ideally want to stick to it, in this volatile environment as I spoke about earlier, it’s nice to have contingency and alternatives you can consider over the next six weeks. And we are certainly in a much better place than we’ve been before when it comes to that part of our business.

So we now turn it over to Evan and we’ll take all the questions that you have. Thank you.

Evan Price

Thanks Glenn. That concludes our prepared remarks. We will now open up the call to questions. We’d appreciate limiting your questions to one per person.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from John Morris - BMO Capital Markets.

John Morris - BMO Capital Markets

My question would be regarding the operating expense guidance going forward. We’re seeing no change on the marketing spend in terms of your plan, but can you give us a little bit more color on the higher variable store costs that you’re referring to for Q4? What does that entail?

Sabrina L. Simmons

Yes, John, those are just simply associated with our goal of continuing on this path of improving our comp store sales trend. So if we’re fortunate enough to sell more units, you would expect nominal dollars of SG&A to increase with the store related part of our structure. That said, it’s always our objective to keep those in line with sales. So we wouldn’t want to de-leverage that piece, but from a nominal dollar perspective they would go up.

John Morris - BMO Capital Markets

And then on the gross margin, the IMU benefit, you did give us a little bit of a description about the components to gross margin. Can you give us a feel for how much of a magnitude better IMU contributed? And could we expect to see the same kind of magnitude continue in Q4 and even in Q1?

Sabrina L. Simmons

Yes, I think the structure of our gross margin as a reminder is this year we’ve been benefiting strongly from average unit cost reduction. And those are really meaningful reductions. And the good news is, during this recessionary time where our customers are really looking for value, that has afforded us the opportunity to be out there proactively, with planned promotions and giving our customers planned value, which we did all throughout Q3. That means our AUR was actually down. But despite that, we actually delivered this great margin expansion. And that’s our very plan as we move into Q4.

Operator

Your next question comes from Jeffrey Klinefelter - Piper Jaffray.

Jeffrey Klinefelter - Piper Jaffray

Glenn, I just wonder if you could comment a little bit more about the Gap domestic business, and more specifically adults. You know the launch of denim was a big accomplishment for you this year. I know there’s a lot of enthusiasm about the initial sell throughs of that product. Could you talk about your own expectations for how that evolves and eventually brings back more of the core business to Gap? I don’t think the intent was that it was an immediate overnight success, but that it’s a gradual build and you’re going to drive trial in it. Would you just describe that process a little more and what metrics you’re looking for over a period of time?

Glenn K. Murphy

There’s a lot of metrics we’re looking at in denim. First and foremost, I think the reason it was chosen was that it’s you know a dominant part of our business. We have heritage and credibility in it, don’t feel necessarily good about how maybe we’ve come across to our customers in the last five years. So the reinvention of it by the Gap team was the right decision. And I think all retailers do this. They look at you know what are the categories that will draw people into their store? So you know we’re always trying to define needs versus wants. And if we can be a dominant player again, and at a higher level, we are taking some market share when it comes to we think denim is pretty close to a need component when it comes to apparel and fashion.

And I think the upside for us is getting people in on a regular rotational basis, probably helping us with our frequency. So it has a real category management strategic value. Now ongoing, the real focus, and I’d say the commitment we have on denim was not to re-launch it in August, ride the wave in September and then basically move on to the next big idea. The commitment we made to each other you know, see a little bit of that coming up in our holiday marketing as we turn November into December, is how do we continue with a constant reinforcement? Innovation, good product, differentiated ideas when it comes to denim on a month by month basis as we turn the page and look at 2010.

And again in our holiday you would expect, and I think the natural feeling in apparel is we can’t sell denim in December. And I think maybe it’s not the best month for denim, but if you’re the dominant player and you want to be known for that, we should be finding ways through product development, through messaging and marketing to make sure everybody knows every single month is denim month inside of Gap.

So I think the team has done a nice job. As you said reception has been positive. We feel good about customer feedback. We have been chasing it into inventory in September and October, probably not, Jeff, until this week and maybe the latter part, definitely coming in to Thanksgiving weekend do we actually feel we have the inventory by size, by fit, by wash, that we started out in the first week of August because, you know, we thought we did a very good job of building inventory but we learned a lot. And we’ll be in a much better place in November. Now we’ve got to continue to be innovative and keep pushing it and keep marketing it and keep speaking to customers because it was not a one season wonder. It is a permanent part of our marketing messaging going forward.

Jeffrey Klinefelter - Piper Jaffray

And just one thing out of your sourcing, do you expect sourcing benefits next year in terms of cost of goods? Or more of a neutral environment?

Sabrina L. Simmons

We talked about we’ve been buying our goods now for the first half. It’s a little too early to comment on the second half. We’re definitely focused on getting savings throughout the year. But we feel good about the first half. So we’ll continue to see average unit cost savings. They will moderate, because now we’re going to be lapping two years of really healthy, average unit cost savings. And we don’t anticipate that we’ll get quite the tailwinds we’ve been getting from the you know economic circumstances. But we feel really good about what we’re accomplishing in the first half.

Operator

Your next question comes from Jeff Black - Barclays Capital.

Jeff Black - Barclays Capital

Hey, Glenn, can you, you know it seems like you’ve expanded the focus I mean clearly to gaining market share and I think we understand the marketing elements behind that. But what about the merchandise margin side of the equation? I mean, can we expect a more value focused element at the store level? And just how much merchandise margin are we willing to give up in order to gain share? And is that in fact what we should expect in 4Q versus 3Q? Or you know the mix shift that you talked about that could benefit the margin and cost and they might benefit the margin. Thanks.

Glenn K. Murphy

You know, Jeff, just to turn it as a parallel comparison to SG&A. You know we worked really hard for two years to take out of our business approximately $700 million of SG&A. And the benefit of that is it’s given the company flexibility to make good decisions, whether it’s marketing investments or other investments we want to make in our business. The comparison to average unit cost is identical. You know we back in ’07, ’08, and as Sabrina just said a good chunk of ’09 have really put a big focus on that through changing the processes internally, about who negotiates what, being much more tough minded, introducing reverse options, all the things we’ve done is to make sure that we are getting the best cost, while protecting our quality in the business.

What that’s given us is the flexibility as you suggest to make sure the business now with the margin great we have in the business, and how we’ve built that up over the last couple of years, now it allows us as we talk about market share to make sure that we’re not irresponsible, but we get the business talking about gross margin dollars per foot. So now we can make the right decisions and I think we’ve proven that at Old Navy. As the first brand I think they have gotten a lot of cost benefit, the work they’ve done. But now as you saw their performance in the months of September and October, with those sort of low teen comps, I think Tom and his business have made those tradeoffs between where do you want to be a little more aggressive to get to market share, all part of a larger value proposition that that brand stands for.

Now he’s in a unique circumstance, but the theory also applies to Gap, Banana Republic, our online channel and of course our outlet business which is a dominant player in value, is with the added benefit of the gross margin rate mostly from AUC and strong inventory management, how do we make better decisions now to get market share by focusing the company on gross margin dollars per foot? One last thing I’ll also say to you and I kind of said this in my opening comments, we’ve expanded our thinking quite a bit now when it comes to gross margin. What are the other levers the business needs to pull and be thoughtful about? So I think I might have referred to in the opening comments on mix.

The mix inside our business and I think the best retailers are always thinking with a merchant lens on what they present to their customers. But behind the scenes are our good people, more category management type people, who are spending time going what’s the category trade off that can satisfy the customer, get the incremental sale and conversion, maintain loyalty, stand for what the brand proposition is, but get an added economic benefit by doing the right mix inside the four walls of your business.

So we’re spending a lot of time on that, which I hope as we get skilled at, and we’re not there today, will give us even more gross margin rate benefit, which will allow the company even greater flexibility to make these further decisions we have to make to gain market share.

Operator

Your next question comes from Kimberly Greenberger – Citigroup.

Kimberly Greenberger - Citigroup

I was wondering if you could just talk broadly about how you’re thinking about SG&A dollars in 2010. Should we think about a continuation of the fourth quarter trends here into next year or are there any other opportunities you have to cut expenses?

Sabrina L. Simmons

Yes, Kimberly, at a high level, because I don’t want to go too far into 2010, we’ll of course do more of that on the fourth quarter call, but broadly speaking you know we’ve really done a lot to reset our expense base. So what I’ve talked about is kind of there’s three buckets. So in all the overhead buckets where we’ve taken a lot of headcount out, about 18% over the last couple of years, you know we’re going to remain very disciplined in that area. But about half our expense save is store related and a big piece of that is variable. So if we are successful in continuing to regain market share and improve our sales, those dollars should go up, but again we want to leverage those over time as they move up.

And then our marketing expenses are the third big bucket of our expenses. And those we’ll be just monitoring closely to see how much we want to invest. When you think about 2009 and the investments we’ve made at Old Navy to date, we’re quite pleased with the return we’ve gotten on the marketing investment. So that causes us to want to continue investing to feed that momentum. We’ll be watching. We’re just initiating the marketing investments at Gap in a meaningful way right now, so we’ll be measuring and monitoring those closely. And those will inform how much we want to spend on marketing of that brand in 2010.

Operator

Your next question comes from Paul Lejuez - Credit Suisse.

Paul Lejuez - Credit Suisse

Earnings in the EPS in the fourth quarter is typically higher than 3Q. Is there anything that’s changed structurally that this relationship wouldn’t hold? And then second, just wondering you know Gap traffic, Gap brand traffic has been below the mall for some time and I’m wondering if you’re expecting TV to kind of get you back to a point where you’re in line with the mall, or would you expect TV to take you to better than mall traffic levels? Thanks.

Sabrina L. Simmons

Hi, Paul. I’ll take the first piece. And I think you’re absolutely right if you look over a long period of history, Q4 earnings are often higher than Q3. We obviously saw that reverse last year as we fell into a deep recession, with I think ourselves and most retailers you know having Q4 fall a bit. This year you know we’ll see. We haven’t provided explicit earnings guidance. We’re intending to drive our Q4 just like we did our Q3 which is to say we’re very focused on improving our comp store sales trend, and doing it with very healthy margins. You know how the customer responds to our offers, our value, our product, you know the jury will be out and we’ll read that every month during this important quarter.

Glenn K. Murphy

And on the traffic side, just some information. We were in traffic on Gap and second quarter we’re minus 7, and in August we were minus 3, and in September we were minus 3 on traffic at Gap. I think those kind of data points definitely gave us, even though we’re not proud of the absolute number, we like the direction it was going in and that kind of motivated us. Last time we were on a call we weren’t sure if we were going to be spending money on television, what the actual make up of the marketing campaign of Gap was going to look like. So now we decided to put some incremental money, make sure the campaign could really as I said in my opening comments cut through, resonate with people.

And when you think of the mall traffic, you know it’s something we obviously watch. We get a weekly number, just not on NRTI but we also have different breakdowns and different information that we get from our stores. But to go to your direct question, obviously we are trying to get at the very least equal, but if you’re going to gain market share and that’s an Inc. number, Gap Inc. will be pushing by all our brands, but try to think Inc. level to gain market share. We certainly with the television investment, fully integrated marketing campaign, and other ideas we have going forward, introducing a little bit more call to action to the Gap marketing, we would certainly expect that our traffic would be better than the overall mall traffic.

We’re watching it closely. As I said we have good contingency plans. And we’d like to be pure to the plan we put together four or five months ago, but we’re ready to be competitive and make sure that our value proposition stands out, as in each one of our brands for different reasons based on how we read the market and how customers respond. So you know time will tell. Obviously the holiday season is made up of November and December. We’ll see how the market develops. But that’s certainly one of our going in goals is to try to be better than mall traffic.

Paul Lejuez - Credit Suisse

Are there any signs early days with Gap TV that you’re heading in that direction?

Glenn K. Murphy

You know it’s so early to tell. We were talking around here earlier today saying you know if you had asked me that question in October, after the second week, you know a lot of us not knowing what everybody else was doing probably would have said yes. Then as you know the second two weeks of October given this volatile environment changed the make up of the entire month. So I think what I’ve learned, not only in the specialty apparel business which has a natural volatility to it, but obviously in this economic time and how consumers are feeling differently across the country, is to not overreact on any given day or week. So if we ended up having a great week in the first week of November, this is hypothetical, if we had that, then we’re not going to overreact. We’re going to stick to our plan. We’re going to read it properly.

TV is only and it’s seven full days it’s been running, so that was the set up campaign, what we call internally the anthem campaign. And of a five week campaign, the second week through the fifth week are more about reinforcing, giving a different twist to the message you’ve seen already, and then making sure we end with a call to action. So to me the real watch on the benefit of the television starts with the second week when the call to action gets introduced, and seeing how customers react to that.

Operator

Your next question comes from Janet Kloppenburg - JJK Research.

Janet Kloppenburg - JJK Research

I wanted to ask a strategic question, Glenn. It feels like this call to action, this gaining market share strategy, is something that’s a win for you guys and I’m wondering if the program, the campaign for Gap is successful if we can look for this type of TV ad campaign to be an ongoing part of the brand strategy. And I’m also wondering if the call to action, which is you know pretty strong promotions, also going to be an integral part of the business mix for both Old Navy and for Gap. In other words, you know as we go into the store and we see take 25% off today or the Internet communication that I got this week, 20% off any single purchase, if this is all part of the new strategy for the Gap to be able to offer the customer great value while still maintaining some pretty good looking gross margins.

And secondly, given what sounds to be a good success with the Stella McCartney partnership, I’m wondering if you would look to other partnerships with designers going forward even for the Gap or Old Navy, much the way that Target or a Topshop have used.

Glenn K. Murphy

Thank you. I think part of the question kind of slipped into Old Navy. Certainly on the Old Navy front I’m a big believer, I know Tom and his team are, too, that given the market in which they compete and the people they’ve identified as their direct competitors, and there’s many, people where we have to go get the market share. And this is under the assumption, Janet, that let’s assume this for now, that there would be no growth in apparel spending in all of 2010. Therefore the only way to grow yourself is to make sure you’re taking market share.

So for retailers to win that means somebody has to lose. And I think it’s part of the Old Navy thinking the voice we’re currently using the campaign of the voice that communicates is appropriate Old Navy DNA, but the aggressiveness on the right categories, and as I said earlier to Paul the preplanning of that. Not reacting in season because that’s an inventory state of mind. Our state of mind is how do we preplanning and one get customer traffic into our stores? Inventory should we hope then take care of itself. But this is a bit of a cultural shift inside the business, where more about getting customers across the lease line as opposed to being a mover of inventory.

Old Navy for sure, I’m a big believer that it is part of its overall brand positioning. And the customer target is to have that aggressiveness that Tom and his team have demonstrated in the last six or seven months.

Now when it comes to Gap I do believe that the customer today, and probably a broader customer than used to be, and I think people have had a change of what their expectations are. My view is if I’m going to spend marketing as we’ve done this week, I think there’s a way to set up and speak to the brand and why it’s different, bring that what I would call that courageous optimism message in the holiday, Christmas season that Gap brings. But then as we get into different weeks, I think then repositioning the marketing, still being consistent with the overall theme and the voice, but giving people a reason.

And I think at the end of the day, do I wish the customers psyche was somewhat different? I think every retailer did. But at the end of the day today, the customers psyche is give me a reason. Give me a reason to cross the lease line. Give me a reason to drive to the mall. Give me a reason to get out of my house. What is that reason? We as custodians of the brand have to find the right balance for Gap in particular between what is the overall brand stands for, how do we get people re-engaged and make the brand relevant again, and how much do we want to depend on this call to action.

That’s the balance we have to find. I think this is the new normal that we’re facing right now with customers. And I think we’ve got to stay close to them. You know unbelievable product, and I’m going to turn this to Stella in a second. At the end of the day, just unbelievable great product should motivate people to cross lease line and come into your store and convert. I think we as an organization have certainly learned in the last couple of years we need to find the right balance. And you know this is an art, not a science, and we work every day to find what is that right balance, whether it’s 25% off, whether it’s you know a bigger play like our Give N’ Get promotion, which is the old Friends and Family, finding those tools to make sure we get people across the lease line.

Stella is definitely one of those tools that has nothing to do with the one part of the equation of value which is price, but has everything to do with the other side of the part of the equation to find value which is quality product. So using her globally I should add, because it’s a very global campaign, we were pleased to announce today that Stella and our GapKids team given the success and the relationship that was built in the first round are looking forward to working together and collaborating together in the spring. Hopefully her product will have as much success in the [inaudible] launch as it’s had so far with us in the month of November.

Going forward, we think that we fall into a grouping of retailers that want to bring in celebrity and well known designers. I think you know that’s certainly not part of the strategic view of the company. This was something that she wanted to do. We were excited that she made contact with us. We think it makes sense. But I don’t think it’s a strategic intent that you could watch us every year coming out twice as maybe H&M has done and maybe Target has done. This just seemed like the right fit.

Operator

Your next question comes from Adrienne Tennant - Friedman, Billings, Ramsey & Co.

Adrienne Tennant - Friedman, Billings, Ramsey & Co.

Sabrina, my question is about back to the operating expense guidance, the incremental $100 to $120. Did you say that you would not expect to de-leverage on the incremental sales? And how much of that would be variable to the extent that you may not be seeing the comp impact that you wanted to? How much could you pull back and how quickly?

Sabrina L. Simmons

Sure. No, we didn’t talk about the leverage part. I mean I think the important thing is again, in the short run marketing is probably going to de-leverage. Now we still expect a return, which means its not going to be dilutive to earnings if we’re successful. But it takes a lot for it to actually leverage. So the marketing piece will probably de-leverage. With regard to the variable part of the expense, that’s going to be truly flexible. So you know that’s going to increase if we meet our goal in nominal dollars, and we can increase if we meet our goal of improving our sales trend. Likewise we can pull that back. So there’s flexibility in that lever depending on how we’re marching in terms of our objective of meeting our sales goal.

The last piece of that I think I mentioned in my prepared remarks, there’s another piece which is unusual this year which has to do with our bonus accruals. And that really is playing a factor because last year we had very odd seasonality of our bonus accruals. Typically we ramp up our accruals with normal seasonality of the business, but last year we had a healthy performance in the first half, when the recession hit deeply in the fourth quarter our bonus accruals were very modest in the fourth quarter. And then you compare that to this year, where you have much more normal seasonality in bonus that creates a differential that we’re having to lap in the fourth quarter this year. And that’s actually kind of unique to the circumstances between last year and this year. So those are really the big drivers.

Adrienne Tennant - Friedman, Billings, Ramsey & Co.

So if we were to see de-leverage in the fourth quarter, that’s not something that we should expect to see going into Q1 of next year?

Sabrina L. Simmons

We haven’t commented yet about 2010, so we’ll do more of that on our fourth quarter call.

Operator

Your next question comes from Brian Tunick - J.P. Morgan.

Brian Tunick - J.P. Morgan

I guess one for Sabrina and then one for Glenn. So I guess Sabrina on the rod line, were there any one time items that were impacting that number or you know going forward can you guys get leverage on that line with a flat comp? And then for Glenn, maybe on the buyback announcement and you know potential uses of cash, I mean does this announcement today change your view of maybe the CapEx or remodel opportunities at the brands or other growth initiatives such as acquiring another online tab or something like that? Could you maybe just talk about those two topics?

Sabrina L. Simmons

Sure. We’ll start with rods. I mean the rod movement directionally was as expected, Brian. So I think we’ve been saying for some time that it would be hard to leverage rod unless you got close to a positive comp. So the good news is with a flat comp, we got this 0.2 of a point of leverage, so directionally its doing exactly what we expected. There’s no real big standout unique, one time issue in that formula. It’s really you know our comp store sales base improving. Now within our comp store sales base improving what you do have that’s a little bit unique to all of 2009, not unique to the quarter in particular, but we’ve talked about the fact that we’re getting positive impact from co-tenancy failures moving into alternate rents. So that’s played a role in why we didn’t de-leverage as much as you would expect in Q2, and it’s also playing a role in our leverage a little bit above what you might expect in Q3.

Glenn K. Murphy

And on the announcement today on the new buyback program we’re going to initiate, that doesn’t change anything. We are in such a good position when it comes to the balance sheet and the free cash flow in the company is so solid that we chose to step up the Old Navy models and that’s what that indicated. And our customers are reacting. We had a lot of flexibility to do that in 2010. So anything that comes to remodels or decisions, internationally we’re talking about the recent analyst’s days, the entry into China, making sure we can stay strong in the franchise business, look at other growth opportunities, Banana Republic into the UK, possibly into France, I don’t feel constrained one bit in terms of the capital structure inside the business.

On acquisition, you know when it comes to feeding something beside [athleta] is I guess what’s known internally, we may have talked about this externally also, the six tab, you know we’re not in active discussions with anybody about that. We’re not spending a lot of time. But if we found something that made sense, certainly again with the cash on the balance sheet and the free cash flow this business has lots of options in how to invest its money. It just happens to be that given the strength of the two factors I mentioned earlier, we are easily in a position where Sabrina and myself and the board of directors believe that a $500 million program is appropriate.

Sabrina L. Simmons

Yes, and just to reinforce what Glenn said, you know our first call on capital is always within our business. So to the degree that we have long term growth opportunities or other projects that we feel confident are going to deliver the right value for our shareholders, that’s always going to be our first call of capital. Because our cash flow generation is so powerful in the company, we generally always still derive after all those calls on cash, we still have a healthy amount of excess cash.

Operator

Your next question comes from Michelle Tan - Goldman Sachs.

Michelle Tan - Goldman Sachs

I was wondering if you could expand a little bit on the success you’re seeing at Old Navy with the kids business. How big is that business roughly for Old Navy? Is there anything specific you’re doing that’s driving your relative strength there? And then finally do you see any signs or risks that you’re cannibalizing that business at the Gap brand?

Glenn K. Murphy

Michelle, we don’t give out the size. Here’s what I’ll tell you. When we were I guess clearer and Tom and his team were clearer just over a year ago about what the target customer was for Old Navy it really was as we defined it, you know, a woman who shops for her family and then for herself. So the notion of baby and newborn and the kids business to the Old Navy brand proposition and what our target customer expects of us is a critical part of it, particularly in this environment when mothers are shopping for their family first and then for themselves.

So it’s a key part of getting traffic inhouse. I think Old Navy does it very well recently. Part of the progress I was trying to report is one, we don’t talk about it a lot. I think maybe internally but definitely externally a lot of us seem to be enamored sometimes with the adult business and don’t talk as much about kids and baby. I’d say a couple of years ago we lost our way a little bit. Maybe we were a little too focused on the adult business and the problem coming into the business, a woman named Michelle DeMartini, she used to be at Gap brand, I’ve seen a resurgence in terms of the marketing we’re investing behind it, the value proposition, the loyalty in all the customer service index and research we do. People really like Old Navy for that.

And you know whether it’s on basic items, whether it’s on a little bit of fashion, I think across the range I’ve seen a difference. I really have. I saw a difference in our September business, our October business, and I believe that they will continue to go after market share. And I think there are certain people we compete against, we’ve targeted who we think have market share that we can go after and remove from their business and put into Old Navy.

Cannibalization? That’s a huge category, kids and baby. And a lot of people play in it. All the big value players participate, there are specialty apparel players in it. You know I personally think that GapKids and Baby is a nice complement to the Old Navy business. I think anybody in between that business might find themselves in a bit of a squeeze, where you can have the Gap business coming from above, particularly when you add on ideas like Stella. And then the Old Navy business coming from below, pushing it when it comes to the value proposition for that mother.

I think actually they’re really well positioned and the teams I know, because we asked for that since for about the last 18 months. We expect a much higher level of collaboration between our brands. Yes, they visit a little bit of internal, healthy competition takes place, but certainly a lot more collaboration where they can maybe target competitors and go after them with the one-two punch. So I think it’s a nice complementary business.

Operator

Your next question comes from Marni Shapiro - The Retail Tracker.

Marni Shapiro - The Retail Tracker

My question comes on the heels of Janet’s and you talked a little bit about Stella McCartney and a little bit about Old Navy on the last answer, but if you could talk a little bit about your licensing, you’ve done a really good job with at first it was junk food but then it was superheroes and rock bands and I’ve noticed sports teams and colleges at Old Navy. And if you could talk a little bit about that business, what you’ve learned and if there’s more opportunity there going forward.

Glenn K. Murphy

Thanks, Marni. That is I would say in the last 12 months a shift that Tom and Mark and Michelle and I mentioned earlier has led our efforts. You know they really believe and we’ve been spending a lot of time talking to our customers and stuff like the NFL, whether it’s rock as you mentioned, whether it’s college, I think all of those coming together it’s something that certainly family can do together and participate. And I think it’s nice because even though it’s a seasonal business, it kind of evens itself up over the year.

I think when you add that to something that Tom has done, which I think is a really smart idea, as he’s resurrected the Old Navy brand and something he calls, this is an internal acronym, logo land. I think that in combination with the Old Navy logo product, which you saw us do in the summer and really add that with our Flag T’s and everything else that goes with it, and there’s some nice product for the holiday, that married with graphics which we’ve always had a nice reputation for, typically on the men’s business. Recently they’ve done some nice work on women.

And now in licensing, I certainly have heard that the people we’ve partnered with again at NFL like what we’ve done, think that we’ve done a good job whether it’s been in, you know we don’t just do the traditional T shirt. There’s been some vintage work that’s been done and some different twists on it. And customers have responded positively. I think it’s a nice draw and I think it fits with the Old Navy customer and their expectations.

Operator

Your next question comes from Stacy Pak - SP Research.

Stacy Pak - SP Research

So my question’s on ’10 and if you don’t want to answer 2010, maybe you can just kind of address longer term. But I’m wondering a few things. I mean one is when you’re looking at sales going forward, do you think there’s a lot of room for productivity improvement such that that would outpace any square footage reductions? And I’m talking about kind of the business you have now rather than you know international expansion, etc. On the gross margin side you are, I mean it’s been an incredible year, you’re hitting peak levels, is there room to grow from here? And if so, what is it driven by going forward? SG&A, do you assume leverage going forward if sales are increasing? And then finally, Glenn, I’m wondering do you think Gap division will comp in Q4 given the assortment you see and given the television you see?

Sabrina L. Simmons

Yes, Stacy, I don’t want to go too far into 2010, since it’s only the Q3 call. But I’ll try and answer and be helpful at a high level. The sales productivity definitely is what we’re looking to improve. When we actually, and you guys know this because we report our sales and our square footage publicly, you know we’ve lost a lot of productivity over the years. And we definitely think that’s an opportunity. So even as we contract some of our unproductive square footage, dollars per square foot we definitely have an objective of improving.

So that’s certainly an opportunity. When we look at gross margin going forward, you know Glenn’s hit on some of it, so in 2010 we certainly still are going to get some average unit cost savings, although they’re going to moderate. You know our AUR, we’re going to still offer value to our customer, but with that average unit cost savings again we think we can continue to deliver healthy margins.

We’re also going to be looking at the mix of the goods we sell to make sure we’re getting, you know, a good and nice mix that drives a healthy margin rate. So that’s going to be an important part of our equation in 2010 as we get ever more surgical on our mix and how that drives a nice rate.

Expenses again, I’ll just keep going back to with regard to our store related expenses, certainly we hope to at a minimum keep those in line with sales and over time leverage those as sales really improve in a meaningful way. Marketing investments will depend on the return we’re getting. And then we’re going to try and hold on the divisional overhead piece. So of course you’re going to have a little bit of inflation there.

The other piece we’ll talk more about, we started to talk about in October, we’re going to talk more about in Q4, is our investments for the long term. Because we’re always balancing as a management team our drive to have really healthy, short term results, with making sure we’re seeding our long term growth. And we talked about China. We talked about opening e-commerce in Canada and UK, and that takes expense.

Stacy Pak - SP Research

And Glenn, any comment?

Glenn K. Murphy

Well on the Gap performance, here’s how we’re looking at it. We are trying as much as a lot of people have, I’m listening to forecasts for the holiday season from you know minus 2 ranging up to plus 2. The other day and I’m not sure if it was Brian or Paul who were asking the question earlier, I think we’ve done a lot of work across all our brands. I know there’s a particular interest in Gap with the return to television. You know one of a number of goals we’ve established and one is we’d like to see them gain market share in this holiday season. And the fourth quarter started two weeks ago and will take us right until the end of January. So we’d like to see them gain market share.

The number one criteria we put forward to them, though, is that the expense in marketing we’d like to get that back in gross margin dollars. So we want to make sure that the marketing expense pays for itself so they get the incremental sales that we contract because of the marketing investment they’re making, turn that into gross margin dollars so we do not have any kind of drag on the expense.

Now this is a brand that I keep reminding people, and maybe we’ve asked before can we expect the kind of trajectory from Gap that we saw from Old Navy back in March? And you know without trying to put Gap into a different position than Old Navy, the reality is they are in different positions. The Old Navy business has not had as poor a performance for as many quarters as Gap has. It’s going to take a little more time. I think we’re going to exercise patience, but I think you’ve also heard from Sabrina and myself and the Gap team knows that we have a disciplined process, they’ve been given the money, they had a good idea, we’re supporting them, they’re telling us and we’re going to make sure they execute, and at the end of the day we’re going to weigh and balance whether the investment had a return. But part of the objective here is to change their trajectory.

And as I mentioned earlier, again I’m not sure if it was Paul or Brian, they had a minus 7 traffic in Q2, they had a minus 3 traffic in August, a minus 3 traffic in September and that’s around the time we made the decision. So when we saw a slight improvement from the denim re-launch investment was enough for us to say okay, let’s take that one more step. And I’m hoping we’ll see more signs and we can continue, because it’s such an important brand to us to continue to make further steps with them as time goes forward. But they know we are expectations, they know our deal and our understanding and let’s see what the next six or eight weeks look like.

Evan Price

And operator we have time for one more call.

Operator

Your last question comes from Lorraine Hutchinson - BofA Merrill Lynch.

Lorraine Hutchinson - BofA Merrill Lynch

Just looking back to last year, I think you used some of the traffic over the Black Friday weekend to move through some inventory pretty quickly and I was just curious how we should think about the progression of sales through November, December and January given that your inventory’s much lighter coming into the holiday season. How should we look at sort of a monthly run rate?

Sabrina L. Simmons

I think that the first thing to point out, Lorraine, is remember that inventory per square foot being down 9, a lot of that’s just driven by the average unit cost being down. So our units are definitely not down to the degree the dollars are down. So we’re not that much lighter. We don’t talk about our units per se, but we feel like we’re in a good position in terms of inventory. Last year was really unique because the traffic was falling off pretty precipitously with the deep recession. We were trying to get ahead of that and you’re right, with the traffic we got on Black Friday, through a lot of promo and you know get a lot of movement early in the season so that we weren’t last protect ourself so we weren’t left with a lot of liable goods at the end.

I think this year we feel really good about our position with inventory as we go in, but we also know that it’s going to be a highly promotional season. Even though all retailers out there for the most part have cleaned up their inventories, what we know is the customer’s really looking for value.

So we’re going to play hard and you’re going to see us really competing over Black Friday for those dollars and that market share through really strong promos.

Evan Price

Great. I’d like to thank everyone for joining us on the call today. As always the Investor Relations team will be available after for further questions. Thank you.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Gap Inc. Q3 2009 Earnings Call Transcript
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