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Executives

Mark Webb – Vice President, Investor Relations

Glenn Murphy – Chairman and CEO

Sabrina Simmons – Executive Vice President and CFO

Analysts

Janet Kloppenburg – JJK Research

Connie Wong – Wedbush Securities

Edward Yruma – KeyBanc Capital Markets

Michelle Tan – Goldman Sachs

Lorraine Hutchinson – Banc of America

Evren Kopelman – Wells Fargo Securities

Jennifer Black – Jennifer Black & Associates

Stacy Pak – SP Research

Brian Tunick – JP Morgan

Dorothy Lakner – Caris & Company

Marni Shapiro – The Retail Tracker

Roxanne Meyer – UBS

Gap Inc. (GPS) Q2 2010 Earnings Call August 19, 2010 5:00 PM ET

Operator

Good afternoon, ladies and gentlemen. My name is Bryan, and I will be your conference operator today. At this time, I would like to welcome everyone to the Gap Inc. Second Quarter 2010 Conference Call. At this time, all participants are in a listen-only mode. (Operator Instructions)

I would now like to introduce your host, Mark Webb, Vice President of Investor Relations.

Mark Webb

Good afternoon, everyone. Welcome to Gap Inc.’s second quarter 2010 earnings conference call. For those of you participating in the webcast, please turn to slides two and three.

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, anticipation, 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 30, 2010. Investors should also consult our quarterly report on Form 10-Q for the quarter ended May 1, 2010, 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 August 19, 2010, 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 principle measure of 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’ll turn the call over to Glenn.

Glenn Murphy

Thank you, Mark, and good afternoon, everybody. Before I hand it over Sabrina, let me give you some of my thoughts on Q2. Overall, I would characterize the second quarter for Gap Inc. as a decent quarter. We were able to achieve $0.36 in EPS, which was $0.03 above last year. We were able to leverage the operating margin line in the business by 40 basis points over last year and we did all of that against the challenging backdrop.

Now, with that said, I need to say, that I was disappointed in our inability to generate the sales that we had expected to generate in the second quarter. Because of that, we’ve certainly spent a lot of time over the last four to six weeks meeting with the brand Presidents and their teams to make sure where necessary, we took course corrective action coming into the back half of the year.

There was a heightened level of intensity on those meetings and we spent a lot of time talking about traffic and traffic generating ideas. Our marketing initiatives in the back half, inventory management in the back half, how do we continue to innovate and differentiate ourselves.

And most importantly we talked about the key product initiatives we have coming up and that’s where, I left a lot of those meetings, to be quite honest invigorated. I really liked what I’m seeing from those teams, from the merchant teams, the design teams, what they’re doing on product in the back half, how we’re actually taking our brand proposition to an improved level. So there’s two tangibles in the back half of the year.

First intangibles is what will the macro climate be exactly in the second half, which is out of our control. What is in our control is our ability to execute. This team has executed at a very high level over the last 12 quarters. Now it’s up to us to take these corrective measures from Q2, put them into place and execute into the second half.

Let me now give you my thoughts on each one of the brands. Banana Republic had a three comp in Q2 and that’s the second quarter in a row we’ve seen nice positive comps from that team. As I look what transpired in Q2, one of the big changes that we’ve been talking about for the last year, is they’ve really changed their wearing occasions and I’m seeing a much more appealing offering when it comes to going out and to casual dress attire which is important to Banana Republic.

Big improvement in accessories, which we feel good about as we look towards the back half, really like the marketing that came out this week, hopefully people saw it, life at work, very appropriate for Banana Republic, showing the versatility of the products and the key categories in which they’re pushing towards. So all in all, good performance on Banana Republic, look forward to even more improvements in the second half of the year.

Let me now turn to Old Navy. The good thing about Old Navy is they finished strong in the second quarter. They had a plus 6 comp in July which is good news. A number of things going on at Old Navy, all of their remodeled stores were complete at the end of July. So that will now gives that team about 260 new prototype stores in the marketplace.

I like where the new marketing is going. The new team has really taken the creative platform to a whole new level, I’m excited about that. I like what the type line is doing for product. You’ll see definitely some improvement in fashion in the back half of the year.

The uniform business which is one of these key categories we identified about nine months ago has been a very big success for Old Navy. Back-to-school, be much more aggressive on uniforms, going after the market share with television, with product, it’s been definitely big success.

The team is working behind the scenes, new category development which we should see in 2011. Now like the testing that’s gone on in that front and there’s been some good real estate success in the second quarter, a lot more stores to be relocated or being reduced in size to meet the new prototype size for Old Navy.

So all in all, I think, Tom and his team had a good plus 6 comp in July. I like what I’m seeing from that team and now Tom’s job is to anniversary that performance we saw last year and to gain market share.

Gap brand, let’s talk about some of the accomplishments at Gap brand in the second quarter. They also in a much lower scale than Old Navy completed 200 remodels towards their denim, shop-in-shop 1969 look, every one of those stores is going to open this Saturday.

They introduced the anniversary of the 1969 denim re-launch two weeks ago. We put the new black pants into the store two weeks ago. The marketing for it is going to come out August 25th. What I like about the black pant re-launch, it plays off the success of denim.

So it’s a different wearing occasion but very clearly it goes to the strength and the core of what made denim successful which is fit. So we see that in the black pants with seven unique fits and just a foreshadow in September we’re going to be launching a new sport pant and it’s going to be called GapBody fit, so we’re tying that nicely together.

The kids business came out with its 1969 launch in the month of June and two weeks ago our LA office opened for denim merchandising and design team. We announced that about two months ago and we are very excited with that team, and what they’re going to do for us as we look forward.

However, Q2 was a minus 4 comp. I know Mark and his team were disappointed and we’ve just spending a lot of time with them, not only taking some of the elements I just spoke about but what else do we need to do at Gap brand.

One of the missed opportunities, with the heart of challenges in Q2, there just were not enough tops in the business and I want to say not enough great tops in the business, take advantage of the marketing push we’re having on bottoms. Now, that’s going to get course correct through Q3 marginally and definitely much better in Q4 and I’ve seen some early indication of spring and we definitely at a much better place there.

Let me give you an update now on our growth initiatives with a real focus on international. Our online site opened up in Europe this week, which is very exciting for our European customers and a great win for our stores. That’s going to be followed up this coming Monday with our Canadian site which is going to open up. Canadian team is very excited about that as well.

Also by the end of the month, we’re going to open up our first store in Australia. So our franchise team will now have 150 stores and growing very quickly.

Everything is on target for China. We’re going to open up at the end of October in Shanghai and we’re going to have four stores by the end of the year in Shanghai and Beijing, and very pleased with the team, how they’ve come together, their marketing strategies and how they’re putting together plan to win in China.

And Italy, which was the other big country we announced a few months ago, we’re going to be opening up in late November in Milan with both Banana Republic and Gap stores.

So in closing, before I hand it over to Sabrina, I want to just take a few minutes and talk about our economic model. We’ve been speaking now for the better part of a year that we have a new strengthened economic model at Gap Inc. What Q2 proved to me is also that economic model is flexible.

In the early part of the quarter, when we realized we didn’t have momentum we needed and planned for in the sales and gross margin line, we were able to flex down our economic model and take cost out of the business to deliver the healthy earnings we delivered in the second quarter. That’s positive news.

As we come into the third quarter, now we’re all very confident in the strategy of the company. We need to grow topline and we have to push even harder to get market share gains in North America. Our global business, led by franchise, online, global outlet, two new countries in China and Italy, are really developing and coming together and becoming an even bigger part of our company strategy.

The economic model produces great cash flow and we will continue to give it back to shareholders as evidenced by the $800 million of shares we bought back in Q2. So all in all, we’re looking forward to the second half. The business is very focused, very committed, the management team is going to execute at even higher level.

And with all that said, I want to now hand it over Sabrina to take you through the financial results for the second quarter.

Sabrina Simmons

Thank you, Glenn. Good afternoon, everyone. For those of you participating via webcast please turn to slides four and five. While we encountered a few more challenges than we anticipated when the quarter began, we’re pleased that we met our goals of growing topline sales and increasing earnings per share. Here are some highlights for the quarter.

Earnings per share up 9%, total sales up 2% with comp store sales up 1, online sales which are not part of our comp base up 15%, operating margins up 40 basis points to 12% and we returned nearly $900 million to shareholders, $800 million in share repurchases alone.

I’ll now provide some additional detail on our Q2 financial performance. Please turn to slide six. We grew net income to $234 million and delivered EPS of $0.36 versus $0.33 last year. Our effective tax rate for the second quarter was 41.2% and our year-to-date effective tax rate is 39.3%.

Turning now to gross margin on slide seven, gross profit for the quarter grew 2% to $1.3 billion. Gross margin for Q2 was nearly flat to last year, down 8 basis points to 39.6% as rent and occupancy leverage of 40 basis points almost entirely offset some merchandise margin decline of 50 basis points. Year-to-date, gross margin of 40.9% is up 120 basis points over last year.

Looking at inventory on slide eight, after four years of inventory reductions, we decided earlier this year to increase investments in key categories for fall, aiming to improve the customer experience with better in-stock levels in categories like uniform at Old Navy, denim at both Old Navy and Gap, and the launch of premium black pants at Gap.

As a result, inventory dollars at the end of Q2 were up 11% to $1.6 billion and as expected, inventory dollars per square foot at the end of Q2 were up 12%. This compares to down 14% in 2009 and down 17% in 2008.

Turning to slide nine, operating expenses. In Q2, while making continued investments in growth, including the Old Navy remodel, the launch of our online businesses in Canada and Europe, and the opening of our first stores in China and Italy, we leveraged operating expenses by 50 basis points, demonstrating our commitment to cost discipline.

Expenses grew by $4 million to $917. Included in total operating expenses is $101 million of marketing, which is up $7 million to last year, driven by our online brands Athleta and Piperlime.

Please turn to slide 10 for capital expenditures and store count. We ended the quarter with 3,076 stores and net square footage was down 2% compared to Q2 2009. In the first half, we opened 19 stores, weighted towards international, closed 38, weighted towards Gap brand and spent $248 million in capital.

Regarding cash flow, on slide 11, year-to-date, free cash flow was an inflow of $292 million. We repurchased 52 million shares in the first half for $1.1 billion. Even after these share repurchases, we ended the second quarter with about $1.7 billion in cash and short-term investments.

At the end of Q2, we had about $150 million remaining on our current $1 billion share repurchase authorization and as evidence of our continued commitment to return excess cash to shareholders we announced today a new $750 million authorization.

And now, please turn to slide 12 for our outlook for the rest of the year. Today, we are reaffirming our full year EPS guidance of $1.77 to $1.82 per share, which represents a 12% to 15% growth in EPS versus last year.

Let me walk you through our assumptions for the back half. As Glenn mentioned, we remain focused on driving sales growth. A key driver of sales growth is increased unit sales and I stated earlier, that we made calculated inventory investments for fall, which were just starting to sale through. It has always been our intention that following these initial fall inventory buys, inventory levels would come down overtime. In line with this, we expect inventory per square foot at the end of Q3 to be up in the high single digits.

As a reminder, we remain focused on reducing square footage through closures and down sizes, as we drive topline sales growth on this declining square footage base, it’s reasonable to expect some increase in inventory per square foot.

Moving to operating expenses, similar to the first half, we feel confident that costs in the base business will leverage as sales grow. That said, our investments in growth initiatives increased quarter-over-quarter in the fiscal year and this could put some pressure on our ability to leverage total operating expenses in Q3.

The following full year guidance metrics remain unchanged, depreciation and amortization about $550 million, effective tax rate about 39%, operating margin about 13%, capital expenditures about $575 million, new store openings about 65, store closures about 110 and net square footage decline about 3%.

In closing, we remain focused on our goals of topline sales and EPS growth and we’re very pleased that at the same time we continue to generate and distribute significant amounts of cash, which we believe are an important component in meeting our overall objective of driving shareholder value.

Thank you. And now, I’ll turn it over to Mark.

Mark Webb

Thank you, Sabrina and Glenn. Operator, that concludes our prepared remarks. We’ll now open up the call to questions and everyone we’d appreciate limiting your questions to one per person.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Janet Kloppenburg with JJK Research.

Janet Kloppenburg – JJK Research

Good afternoon, everyone. Glenn, I’d like to ask you to focus on the Gap assortments right now and I’m wondering why there’s such an underinvestment in tops and given your lead times, I’m wondering when you expect that we should see a meaningful improvement there, so much so that you can have a multiplier effect with the bottom sales. Thanks so much.

Glenn Murphy

I think it’s a combination of the investment we made in denim, combined with the incremental investment we’ve made in black pants. And those two in combination put us in a position from a total inventory perspective that inventory is one pool. And when those investments got made, I’d say from our perspective that’s a missed opportunity that while we made the strategic investment in bottoms, we did not leave ourselves enough room on tops.

Now, that’s one component. The bigger issue I could say to you Janet was that even the tops we had in, given this imbalance, even with that, we just didn’t have the right tops. And I think that the team in New York recognizes that, the team in San Francisco recognizes that. If you go in our store actually this weekend, I think you’re seeing the beginning and I want to make sure I’m clear, just the beginning of some top that’s have come in through a faster pipeline.

We’ve been working on for a year. That compliment the black pants and I think that to the question you ask about time lines, because we’ve been able to shorten the pipeline initially, I think you should notice and I’ve seen all the product over the next six months, you should notice a difference on October 1st.

I think when that product comes in, I think it’s September 28th to about the second week of October, there’s a bunch of new product come in that compliments a strategy we have on black denim. I think there should be something noticeable there for sure from my perspective, hopefully yours as well. I think you’ll also see a step up from there in holiday and one more step up probably in spring and then really I think the balance we’re looking for will be established. Now, it’s up to the design and merchandising team to keep that balance and then just continue to design into what the aesthetic and what the target customer is.

There’s a number of reasons why we didn’t get there and it’s too long an answer to give on this call. Let’s just say that it’s -- that more than a few months ago it was clearly stated that that had to change. We’re seeing slight improvement now because of this new pipeline we have. And I’d be surprised this fall if not only people on the phone but more importantly our customers don’t notice the appropriate shift that arguably should have happened a number of seasons ago is going to take place starting October 1.

Operator

Your next question comes from Betty Chen with Wedbush Securities.

Glenn Murphy

Hello?

Operator

Betty’s line is live.

Connie Wong – Wedbush Securities

Hi. This is Connie, actually calling in for Betty. I was wondering if you guys could talk about the current pricing environment, how does it make you guys feel about the marketing campaign?

Glenn Murphy

Are you talking about pricing to the consumer or costing to us?

Connie Wong – Wedbush Securities

Pricing to the consumer.

Glenn Murphy

The pricing environment from our perspective is no -- certainly no better and not any worse. This is the environment in which we operate. There’s going to be moments where there’s some deeper aggressiveness, whether that’s driven by the beginning of a sales season or because some competitors are deciding to club proactively and be more aggressive.

But I think all in all, when you add it up, this is a business that week by week if you measure an index on aggressiveness, it could be slightly better one week, like the week in which we’re in and it could change in any given moment.

So I think we’re used to the fact that we need to make sure, one, we’re on top of what’s going on in the marketplace. Secondly, we stick to the plans we put into place. We react when necessary. We know clearly what is meaningful to us in terms of our value proposition to consumers. When do we have to make an adjustment by brands. Every brand stands for something differently, different customer, different value proposition.

I definitely would characterize, I’m very close to it, I would say that the overall market when you average it out is still promotional, definitely still more aggressive than it was a number of years ago, but Q2 aggressiveness was no deeper and certainly no better than it was in Q1.

Connie Wong – Wedbush Securities

Okay. That’s helpful. Thank you.

Operator

Next question comes from Edward Yruma with KeyBanc Capital Markets.

Edward Yruma – KeyBanc Capital Markets

Thanks very much. You mentioned that once sales look like they’re going to come in a little bit lighter than you expected that you pulled back on expenses during the quarter. Can you talk about specifically where you cut expenses and how sustainable that is, should sales remain pressured? Thanks.

Sabrina Simmons

Sure. Our biggest pool of expenses is store related. So that’s over 50% of our expense and a large piece of that is variable and that’s actually the one we can impact the most in the short run. The other large bucket of expense that we can impact is marketing but of course, marketing, we view as driving importantly traffic for us so we’re very careful about changes we make to our marketing plans. So in Q2, where we were able to do better than we initially expected once we saw a little bit of softness in our sales, was primarily coming out of the store related buckets.

Edward Yruma – KeyBanc Capital Markets

Got you. Thank you.

Operator

Your next question comes from Michelle Tan with Goldman Sachs.

Michelle Tan – Goldman Sachs

I was wondering if you guys could talk about what kind of average unit cost declines you had in second quarter and I know you talked about some opportunities still as you go through the back half of the year. What kind of declines we could expect for the second half? Thanks.

Sabrina Simmons

I’ll start with that, Michelle. So we talked about for some time coming into the year that we felt really good about the first half costing and in fact through the second quarter, we didn’t experience any cost increases. When we look to the back half, indeed the pressure started mounting so we had to work really hard on the back half. But I’m happy to say that on like for like items, we actually achieved our goal and on like for like items, we’re not really experiencing any cost pressure either.

Now, what we have done in the back half as you know, because we talked about it quite a bit. And it’s also impacting our inventory dollars per square foot, that is we made mix decisions, more into bottoms, as an example, that have increased our average unit cost when just taken at face value actual, because of course the bottom costs more than a knit. So that’s indeed happening in the second half.

Michelle Tan – Goldman Sachs

Right. That makes sense. Any kind of color on magnitude of the decrease in Q2?

Sabrina Simmons

We’ve talked about coming into the year, Michelle, that they were greatly moderating from what we experienced in eight and nine. So I’ll tell you very modest.

Michelle Tan – Goldman Sachs

Thank you very much.

Operator

Your next question comes from Lorraine Hutchinson with Banc of America.

Lorraine Hutchinson – Banc of America

Thank you. Good afternoon. Just wanted to talk a little about the sales outlook, with disappointment in Gap and very tough comparisons at Old Navy, I guess, how are you thinking about top line and if it doesn’t accelerate from the second quarter are there still some levers that you can pull?

Glenn Murphy

Lorraine, it’s Glenn. I would say that we are definitely thinking about the Gap performance, as you saw in Q4 of last year, they had a minus one comp and they got to a plus two comp in Q1 of this year.

And then I look at Q2 more as I mentioned in my opening comments that all brands, but we’re speaking about Gap right now, definitely have corrective measures they can take to get the business positioned the way we expect it to be to deliver the growth that we planned for with them. And so I look at their business and say that we may have mentioned a while ago that it’s going to be a little lumpy when it comes to Gap brand given the seven-year history we’ve been dealing with.

And maybe for now a two step forward, one step back quarters is something that from a patience perspective I’m willing to live with right now. At the end of the day, we expect a lot more from that brand. They’re not anniversarying the kind of comps you referenced at Old Navy. I see some definite improvement coming but just on continuing with the theme of patience, my patience is not indefinite.

With the Old Navy business, Tom and his team are definitely up against as you referenced some very good comps in the back half last year but here’s what we’ve been saying to that team. They also have been giving up market share over about a three to four year period and regardless of the comps, positive comps which we were pleased about in the back half in 2009. We still expect that team to go out and grow their business and continue to get the market share because one year did not take them back to where they were. One year only set the business on the right course, on the right trajectory.

So we can’t give numbers out as you know, but I think they are two different businesses that are both expected from us to grow their top line as we look at the second half of the year. Now, always the intangible for us is the macro environment as I talked about in some of my opening comments. But what is in our control is execution and people in both those businesses know that we set their expectations for them and we expect them to deliver on them.

Operator

Your next question comes from Stacy Pak with SP research. Stacy’s line is live.

Mark Webb

Operator, we’re not hearing Stacy’s question.

Operator

Would you like me to move on to the next one?

Mark Webb

Yeah, please.

Operator

Okay. Your next question comes from Evren Kopelman with Wells Fargo Securities.

Evren Kopelman – Wells Fargo Securities

Good afternoon. Thank you. I had a question on the international eCommerce. When you think about how quickly that business can grow, if we think about kind of in the U.S. eCommerce is 10% of sales, how quickly do you think you can reach that point and do you think actually you get there more quickly because you have fewer stores internationally? Can you talk about that? We’re trying to figure out how quickly it’s going to impact the overall bottom line. Thanks.

Glenn Murphy

It’s tough to sit here today and say we’ll get here more quickly. Here’s what I can tell you with the two recent investments we’ve made. So Europe first, which we opened up our site on Monday, the growth of eCommerce in Europe today is significantly higher than it is in U.S. today, just pure market. And so for that reason, I think they’re going to catch a nice wave, probably similar to the wave we caught 10 years ago when we launched our first site here, Gap.com.

So I think we feel good about the fact that they’re hitting at the right time. I guess it’s very news-worthy and where it may be an advantage for us to at least get to the 10% and this is as we think about it, can we get to 10%, I think the answer is yeah. And we’re going to hold them accountable for that. Could it get higher is really how we’re looking at strategically saying that should actually be higher than that because our penetration of stores, particularly in the U.K. and France, when you think of the fact it’s going to be in nine other countries by the end of October and then spreading from there to a lot of countries where we have no store presence or limited store presence as we go to a city strategy in Western Europe as opposed to a strategy we have here in the U.S.

I think the opportunity is to at a minimum get to that level and possibly more, down the road. In Canada what we like about our opportunity is the Canadian site is a lot of American companies ship over the border but do not have specific sites in the country and their own distribution center and therefore, you cannot return product to stores. I think that gives us a real advantage in the Canadian marketplace.

So even though our penetration is not as broad as it is here in the United States, it’s still pretty established in Canada. So I think there’s a slight opportunity there but the bigger opportunity being we are one of the few American companies or global companies, I should say, who establish a site specific in the country. So again, from that perspective, that should give us an advantage to at a minimum get to the 10% penetration.

Operator

Your next question comes from Brian Tunick with JP Morgan. Brian is live.

Mark Webb

Operator, perhaps we should remind folks to unmute their phones.

Operator

Okay.

Mark Webb

We’re having trouble hearing the questions on our end.

Operator

(Operator Instructions)

Mark Webb

We’ll try Brian again.

Operator

Your next question comes from Jennifer Black with Jennifer Black & Associates.

Jennifer Black – Jennifer Black & Associates

Good afternoon. I was -- I wanted to know about the kind of results you’re seeing with regard to social media, specifically foursquare/Twitter, and the recent Groupon offer. Was the Groupon offer planned and do you intend to use it again? Thank you so much.

Glenn Murphy

All these offers are planned, I think in particular foursquare and Groupon which came out today. Those are definitely all offers that our team here and I’d say, I think Gap team in particular, leading some of those efforts, working with our CRM team here in the office that do work across all of our brands. We’ve been pushing that quite a bit. We’ve been working with different companies that have been helping us to unlock social media.

Social media reminds me a little bit of when I was in a different business over a decade ago and CRM came out and loyalty programs came out and the only way they could be successful if you really just don’t follow what the pack does but find innovative ways of doing things. So I’m actually a bit encouraged and recognize the customers that we are trying to build deeper loyalty with, I would say the younger end of our scale of demographics are people who are -- this is obviously motherhood statement, get information differently, behave differently and don’t actually react to traditional ways of marketing as much as some of the customers we have.

So we’ve been working hard for the better part of the last six or nine months to make sure we understand what are the right tools, how do we make sure it fits appropriately for the brand. And Jennifer, this is the beginning, I believe, of more and more of our time marketing investment, communication and customer loyalty build happening at different mediums than we’ve used in the past, whether we use Groupon again that’s to be determined.

The one thing I also know about communication is you can’t go to the well too often. We have to make sure. We made that mistake a few times in the last three years. So when we have a new communication vehicle that we think is successful and it’s fresh, we’ve got to make sure that you do it and you learn from it but you don’t overuse it, which case I think some of these customers do not want to have excessive communication. They want the right communication and I think in this case, on the two that you referenced for sure, I think both of them so far have proven to be well received by the customers we’re going after.

Jennifer Black – Jennifer Black & Associates

Great. Thanks so much.

Glenn Murphy

Thank you.

Operator

Your next question comes from Stacy Pak with SP Research.

Stacy Pak – SP Research

Don’t tell me that you still can’t hear me. Can you hear me?

Sabrina Simmons

We can hear you now.

Stacy Pak – SP Research

Oh, god. It was beginning to bug me. Okay. So I just want to know, what’s the read on black pants? I know the advertising doesn’t kick in yet but it’s been in store for a little while now. So I wanted to know the read on black pants and also how well does Old Navy’s assortment compete beyond uniforms? It seems like you had a great uniform promotion in July. What about the rest of the assortment there? And is that the kind of thing that we should expect from Old Navy in the back half? Do they have more of those up their sleeve or how should we be looking at Old Navy? Thanks.

Glenn Murphy

On the Old Navy front, let me answer that first, Stacy. I would say that we were -- what we like about the uniform piece, we’ve been saying this for a few quarters now, I think that it was based on strategically what that customer wants and kind of customer shops Old Navy, but also some customers we wanted to get deeper relationships with, it was planned well ahead of time. The marketing was fully integrated with online inside the store, television marketing and we bought inventory. And I think we hit the right price point. We gave the right space to the store and your question about whether to expect more of that, I think the answer to that is yeah.

I think we definitely expect that that kind of coming out strong, clear market share gain initiatives, playing to our strength, using the space we have in the store, buying the inventory right and going right to the heart of the customer we really want to have is something that Tom and his team, as I look at their marketing programs over the next six to 12 months, not identical to what you saw in the uniform event that started about 10 to 14 days ago.

But in the spirit of that you’ll see more of that going forward. I think the television that comes out tonight is about hoodies for the family. And I think that also has a similar play that you’ve seen take place last two weeks when it comes to uniforms. So not every week we’ll have that feel, that kind of commitment but definitely within a quarter, there will be more programs like the uniform.

Sabrina Simmons

And then really quickly on the black pant, we’re obviously going to say a lot more when we report August sales, Stacy, but they just started falling in July and we talked about the fact that we were really pleased with early, early reads. August is an important month. September will be another really important month for black pants because it’s true fall for that target adult customer but so far, so good as we saw in July.

Stacy Pak – SP Research

Yeah. Thanks.

Operator

Your next question comes from Brian Tunick with JP Morgan.

Brian Tunick – JP Morgan

Thanks. Good afternoon. Wanted to sort of dive a little into the gross margins for a second and also your 13% operating margin, I guess targetish for the year. I guess Sabrina, this looks like it’s the first quarter that you’ve had down gross margins and merch margins in quite a long time.

So I guess the first question is, trying to understand -- it looks like you did get rod leverage, which we didn’t think was possible on a one comp this quarter and all the Old Navy remodels. So we were curious what was happening there. And then on Glenn’s comments about taking market share, should we be thinking that merchandise margins are now going to start being down for the back half of the year?

Sabrina Simmons

Yeah. Great question, Brian. So I think -- I just want to start with a little bit of context on the merch margins. Because, I think as you guys know, since 2006 we have actually expanded our merchandise margins by over 700 basis points. And we hit all-time highs for this company in 2009.

So we began to signal as we entered 2010 that especially in this kind of fragile customer environment, we didn’t want to keep overworking that one lever. And that where we really saw our opportunity going forward as sales grew was to leverage rods. So we felt comfortable for some time that on any positive comp, we can leverage rod, which is what we were able to achieve in the second quarter.

The amount of leverage we get is kind of hard to predict. It’s not like straight math because we have factors like foreign exchange, net book value, write-offs, amount of co-tenancy failures and remedies, all kind of moving parts in different divisions but we always felt comfortable that that would leverage. So as we go forward in time, I think what’s fair to say, again, is that we’re going to try and deliver healthy merchandise margins.

But even with a small deterioration in Q2, the absolute merchandise margin is very, very healthy and the fact that we drove positive gross margin dollar growth is really kind of where we want to focus on in driving earnings growth and shareholder value.

Brian Tunick – JP Morgan

Terrific. Thanks and good luck.

Sabrina Simmons

Thanks.

Operator

Your next question comes from Dorothy Lakner with Caris & Company.

Dorothy Lakner – Caris & Company

Thanks and congratulations on the quarter. Going back to the denim category, you’ve obviously had lots of success since the launch of denim, premium denim at Gap and you talked about better funding the denim after you moved out of the launch period last year in this quarter when there were quite a few out-of-stocks.

So as you talked about inventory and the increases that you’ve been seeing in inventory starting to taper off, I’m just wondering how you feel about denim inventories? It seemed like with the last promotion that there were some out-of-stocks in the stores that I checked, I’m just wondering if you feel comfortable with the level of denim you have going into the back half of the year, given its success?

Sabrina Simmons

Yeah. We do feel comfortable. I mean, I think with a fleet as big as ours, Dorothy, so there’s about close to 1100 Gap stores in North America.

Dorothy Lakner – Caris & Company

And I didn’t go to all of them.

Sabrina Simmons

It is really hard to go for perfection in terms of every store being in stock of every single size, but we think our investments are really appropriate and we stood behind those in a big way. So we’re comfortable with the inventory investments in that. We actually over time, right, want to make sure that with these big fall investments we’ve made, as I said in my prepared remarks, we do want to make sure that we’re bringing that relationship of inventory back more and closely in line with sales. So we’re good so far.

Dorothy Lakner – Caris & Company

Okay.

Glenn Murphy

I can add to that, Dorothy. There’s clearly areas that as you hindsight everything, if you look at Gap stores right now with the launch of the legging business that they put in that segment, they came out about four weeks ago, I think that they tried to buy it appropriately.

They do all the algorithmic work you could ever imagine. But at the end of the day that’s one we sit back and go, I wish we would have bought more of that because that went very quick in our stores.

Dorothy Lakner – Caris & Company

Yeah. It did.

Glenn Murphy

And we really -- we have, no different than the five pocket launch a year ago, we have the fabric, we’re ready to go. It’s on the water. It’s coming in. I was in Old Navy stores last Friday in Seattle and no different than them. They put out kids denim for the program they have going on right now and the promotion they have going on, boys skinny was completely sold out in a couple stores.

Dorothy Lakner – Caris & Company

Yeah.

Glenn Murphy

I guess they never thought it was going to turn out to be 42% of their business. Again, they’re ready to replenishment. It’s coming in this week. So I think that -- I always look at these things and go bottom line, it’s unacceptable. It’s easy for me to fall for the fact these things happen.

I think the teams are more and more focused on managing in-stocks. One of the reasons the inventory level is at 12%, as we’ve been pushing the teams to try to get to a better in-stock level so our customers satisfaction scores, which were not great a year ago which are now really getting stronger when it comes to in-stock and a key category of that is denim for us.

So, any time we hear stories like yours it doesn’t make us feel good because we certainly put a lot of time to make sure we understand it. Move inventory around, allocate it properly, so it’s unfortunate it still happens but I know that every time we get out to the stores and we see it, the stores here react to it and adjust their levels to make sure it doesn’t happen again.

Dorothy Lakner – Caris & Company

Okay. Good to hear. Good luck.

Glenn Murphy

Thank you.

Operator

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

Marni Shapiro – The Retail Tracker

Hey, everybody. Good afternoon and congratulations. I was curious if you can give us an update on the direct business in aggregate including Piperlime and Athleta and if you’re seeing very different trends online than what you’re seeing in stores? Because, clearly this business has been healthy across the board at most retailers and you guys have a unique platform that involves some businesses that have stores and some that don’t and I was curious if you could talk a little bit about it.

Glenn Murphy

We had a good quarter online. We were up 15%, so we were pleased with that number. And our online business have been perennial market share gainers except for one month last year in 2009, Toby and the team have pretty much had a six year run. So I think the universality platform has certainly helped. We already know Piperlime and Athleta certainly help to make the total offering more holistic. But I can’t say is, we’ve been really, really pleased with Piperlime and Athleta.

I’m really pleased with the teams there in Piperlime, as you know when it was launched four years ago was strictly in one category segment which was shoes. Then we added handbags and we added accessories, which was mostly jewelry then we added apparel and we’re really likening the momentum we’re seeing out of Piper.

As I mentioned in my opening comments, we’ll be doing a pop-up store for fashion night out in New York and I think in that 10 day, 15 day period they’re going to have that store and I think Rachel is also going to be there a couple nights. I think you’ll see the next wave of where Piper is going. We are not resting when we are saying, there’s a lot more that that site can become and turn into. We’re very excited about the strategic direction.

Athleta too, very strong response to the catalogs, a bit of a shift towards more performance products, so I think Athleta is the perfect marriage of strength and beauty, a little bit more on the strength side. Not at the expense of beauty, necessarily but we’re putting more of our product, our marketing and our focus on the strength side of its assortment.

And that’s really resonated and it’s doing very well. Both of those new brands which are young brands for us, but as we said at recent meeting with investors and we’ll definitely speak about in October when Toby addresses everybody at the Analyst Day, really have high hopes for those brands, not just today but where they’re going the next three to five years.

So overall I think we’re pleased. I think that’s a well-run business. The investments we made in software for universality have paid off and these two new brands are certainly part of our future.

Marni Shapiro – The Retail Tracker

Very exciting. Congratulations and good luck.

Mark Webb

Thank you. Operator, we have time for just one more question.

Operator

Final question comes from Roxanne Meyer with UBS.

Roxanne Meyer – UBS

Thank you. You were up against pretty strong denim performance last year at Gap. So I guess I’m wondering if performance of denim and black pants, if they do well, will that be enough for you to generate positive comps if tops do stay soft and then when you think about the tops gradually improving throughout the fall and into spring, what is it about that aha moment that makes you think that you like the direction of where they are going? Was it is about them that -- how are they positioned differently or how have you change the silhouette or the looks of the tops where you think you’ve got the right balance now.

Sabrina Simmons

Hi, Roxanne. I’ll start. With regard to the tops, we talked about sometime that we realized that we needed to put kind of more femininity and more emotion into the tops. So they got probably a little too androgynous and a little bit too commodity, like and basic like.

And I think it’s a marketplace where people’s dollars and their wallet are precious and they really need that emotional aspect of the product to throw them over to the POS line. So that’s really was we’ve been working on and that’s what Glenn’s talking about when he says that he’s seeing that improvement come through, marginally at first.

It’s always a work in progress. I think the team did a much deeper dive on improving that full line of tops when you look at the spring tops that come out in January, but you should see some marginal improvement as we go along. With regard to camping ourselves, I think as Glenn said, everybody knows that the name of the game in Q3 is about execution.

We’ve had these plans in place for some time and even though we’re going up against better numbers, we know that we lost a lot of productivity over the years and we absolutely need to stay on a path of getting that back. So we are focused on using all of these opportunities with regard to our assortments, our marketing plans, our promotional plans to try and drive that. That is the goal.

Glenn Murphy

And just one thing I can add. We made a change late last year and made Patrick Robinson in charge of total global Gap design and I think the benefit of that is going to show up not only to our stores in Europe and in Japan and soon to be our stores in China, but really North America is going to benefit from that because the global team we now have in New York and again, that’s why -- that was an announcement we made without explaining some of the reasons we did it.

It wasn’t just done for synergy reasons and for continuity of the brand around the world. Patrick’s team in New York have five people who work in the team in New York who are Japanese designers.

Patrick’s team in New York have five people who work in our European designers and the injection, the knowledge of what’s going on around the world because they have trend managers on the ground who deal with the design team in New York who then help assemble the global line, this fall and this holiday will be just the first step of Patrick’s team and really it’s their collection, they’re accountable for it, the merchants buy off and support it.

At the end of the day we hold the designers accountable for the Gap collection. The new team that’s come together that’s really starting to work very well, I think part of that is their influence and their injection from what they’re seeing in their own countries where the North American merchants are now being exposed to that.

That’s why I say you’ll see a slight improvement in October, a little better coming into holiday and definitely better in spring and it’s not from our lack of recognition. We need to get to as Sabrina talked to femininity. I think we have a team now that has given us great information and that’s long-term, assuming we execute and we will execute.

It’s one of our advantages just to have a global design team with people representing the world, injecting one line that our merchants around the world can buy from. And I think that’s one of the changes that was made late last year, but the benefit is only just now going to be seen in October.

Roxanne Meyer – UBS

Great. Thanks so much for the insight. Best of luck.

Glenn Murphy

Okay. We would 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 the full recap of our Q2 results as well as the forward-looking guidance included in Sabrina’s remarks today. And as always, the Investor Relations team is available after the call for any further questions. Thank you.

Operator

This does conclude the Gap Inc. second quarter 2010 conference call. You may now disconnect.

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