The Gap's (GPS) CEO Glenn Murphy on Q2 2014 Results - Earnings Call Transcript

Aug.21.14 | About: The Gap, (GPS)

The Gap Inc. (NYSE:GPS)

Q2 2014 Earnings Conference Call

August 21, 2014 5:00 PM ET

Executives

Katrina O’Connell – Vice President-Corporate Finance and Investor Relations

Glenn Murphy – Chairman and Chief Executive Officer

Sabrina Simmons – Executive Vice President and Chief Financial Officer

Analysts

Oliver Chen – Citigroup Global Markets Inc.

Matthew J. McClintock – Barclays Capital, Inc.

Simeon Siegel – Nomura Securities

Amber Leigh Turley – Morgan Stanley & Co. LLC

Lorraine Maikis-Hutchinson – Bank of America Merrill Lynch

Jennifer M. Davis – Buckingham Research Group

Susan K. Anderson – FBR Capital Markets & Co.

Paul L. Lejuez – Wells Fargo Securities LLC

Barbara Wyckoff – CLSA Americas LLC

Brian J. Tunick – J.P. Morgan Securities LLC

Operator

Good afternoon, ladies and gentlemen. My name is Kevin, and I will be your conference operator today. At this time, I would like to welcome everyone to the Gap Incorporated Second Quarter 2014 Conference Call. At this time, all participants are in a listen-only mode. (Operator Instructions)

I would now like to introduce your host, Katrina O’Connell, Vice President of Investor Relations.

Katrina O’Connell

Good afternoon, everyone. Welcome to Gap Inc.’s second quarter 2014 earnings conference call. I’d like to remind you that the information made available on this webcast and conference call contains forward-looking statements.

For information on factors that could cause our actual results to differ materially from the forward-looking statements, as well as reconciliations or descriptions of measures we’re required to reconcile to GAAP financial measures, please refer to today’s press release, as well as our most recent annual report on Form 10-K and our subsequent filings with the SEC, all of which are available on gapinc.com. These forward-looking statements are based on information as of August 21, 2014, and we assume no obligation to publicly update or revise our forward-looking statements.

Before we begin, I also want to mention that Sabrina will be using slides to supplement her remarks, which you can view by going to the Investor Relations section at 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 Glenn.

Glenn Murphy

Thank you, Katrina, and good afternoon, everybody. Before I hand the call over to Sabrina, who will take you through the Q2 financial highlights with Gap, Inc. I thought I’d just give you my customary take in the quarter and also give you a few highlights of the upcoming quarter in Q3.

So, Q2 internally, we even think about the quarter as a quarter in which we made some progress, some progress on the first quarter, which we needed to make on a number of different areas, but it’s progress nevertheless and we are committed to making further progress as we look towards the back half.

First, Sabrina will talk about progress on margin rate, obviously, an improvement from Q1, which we needed to make. So I think that that’s a sign of some of the changes we’re making the business to improve that very important line item in our P&L. We definitely made progress at Old Navy, and that was a really as very strong second quarter with a four comp on top of last year’s six comp, that is market share gaining in really the most important sector that we compete in the value center, with the most competitors where ingenuity and innovation matters the most, I’m very impressed with the Old Navy team.

We opened up three stores in China for Old Navy. so now, we have four stores. we have at least one more to go this year, maybe a second one, but that’s a big milestone move for us, as we look at the China market, as everybody knows critical to the future growth for Gap Inc. We’ll end this year with 110 Gap stores still on planned; up to six Old Navy stores, I think that combination of the two of them in the China markets can be very strong for us.

Our omni-channel initiatives continued to grow. we really saw some step-up in our reservations on a daily basis of Banana Republic and Gap stores. so I feel good about what that means for the second half, people are time pressed and this reserve in store is unique as a competitive advantage. so I think that that’s really going to shine for us in the second half.

more importantly, we tested order in store, and as everybody on the phone knows about the ability for something to come into our store, we have the device us that’s connected to WiFi, we can actually complete orders when something is not available in the stores, some things in a flagship store, which is on the flagship city, we get to that product. So that’s been in Banana Republic, Gap and Old Navy being tested, we’re going to roll that out to our 1,000 stores in the month of October.

And we’ve been testing a loyalty program and what we’ve been doing at Gap, Inc. for a number of years now was continually trying to find different ways and voices, something creative when it comes to talking about our value proposition. Let’s say, so there’s a bit of a promotional merry-go-round in marketplace until the companies are willing to be bulled, to be different to try something that’s different in terms of offering value to people, but not in the way that’s predictable, those are the companies that could win, and I believe this test we are doing in only 25 Banana Republic stores could become the basis of something we can use down the road to present a different twist on our value proposition.

And lastly, we have spent an incredible amount of time the last three months, getting ready for the second half and getting our prefatory work ready not only on product, but on merchandising, on marketing; on digital communication, on innovation, on customer messaging you name it. There’s a lot of lessons of business learned in 2013. We’ve addressed those as we come into the second half of 2014.

Some quick thoughts about the third quarter, which were two weeks into before I hand the phone call over to Sabrina, last week, at Banana Republic, we launched a new marketing campaign called the New Look, it’s the beginning of enhancements in product and marketing digital content from now right to the end of the year and beyond. And I think it was a nice start for the team. I think they really made a change in terms of this past, the Banana Republic has been on from two conservative to more of a contemporary product appeal that I’m speaking mostly about women’s products.

I think our men’s business has been strong. This is most of the women’s product and what you’re going to see going forward is a step-up in that messaging in the months of September, October into the holiday season. In the month of September, you’re going to see a similar change go on at Gap brand, which is much needed, it’s going to be a combination of push product put together by our merchant and design team of Michelle Demartini, Rebekka Bay, brand-new marketing campaign from Wieden & Kennedy, a big change in our online site to match up. so it’s a fully integrated communication plan.

I just want to be clear that the store business in North America has not been as strong as Stephen wants and I wanted so far this year. And while we’re both pleased with what consumers are going to see in the month of September is just a beginning, release that positions us in a much better way as we look forward to September going into the fall, going into holiday season.

Some other updates for Q3, the team feels a lot better about our inventory position on a per foot basis across all of our markets, which will bode well, in terms of the health of the business for the back half, in second half of this year, you’re going to see the company push much harder into personalization.

And this is on our mobile devices, on our desktops, on iPads and we believe there’s a huge opportunity here to personalize home pages, personalize content more than we ever have before, we’ve been tested on the first half. and this is the ultimate definition of the use of big data.

This week, we’ve relaunched Piperlime; we don’t talk about Piperlime much. It only has one physical store, it’s an online business. While it’s easy to look at Piperlime as a small part of the Gap Inc. portfolio. what I will tell you is we use it continuously as a site where we test a lot of ideas. Ideas that can work for that business, because that’s what matters first, but then can be taken to our other brands, and I believe the relaunch of their site provides for a lot of innovative ways to present our online business to customers.

Just a quick update on our franchise business, because the company operates in about 50 countries. It’s been a unique year with some franchise markets, clearly showing some declines like in Russia, Ukraine and Israel. We have been very pleased with some long-term future markets like Brazil, Mexico, UAE with the strong growth midway through this year.

And as a matter of fact, as I’m speaking to you, we’re putting out the release sales, that’s going to be opened up stores in India. In 2015, we believe the Gap brand has very strong brand awareness and looking forward to adding it to our franchise portfolio.

So in closing, I just have one comment to make. Today is the 45th anniversary of Gap Inc. and this was the in 1969 that Doris and Don Fisher, both spend $21,000 each of their own money to start this incredible company.

What I’d like to say is on behalf of the 140,000 employees and millions of people who have worked in this company a big, big thank you to the Fishers. This incredible couple who founded this business, who make us proud every single day and I think that it’s a testimony to the strength of our brands, of our people, of our creativity, our commitment to the customer that this business has been around for 45 years and continues to move forward and to blaze trails and be a formidable force in the apparel business.

We have one goal and one goal only. And I think Don Fisher passed away five years ago on September, would appreciate this to become the number one global apparel company in the world. And if we keep not being afraid to take risk, push forward the business we will achieve that goal.

With that said, let me hand it over to our CFO, Sabrina Simmons.

Sabrina Simmons

Thank you, Glenn. Good afternoon everyone. As we begin the second half of the year, I’d like to take a moment to reiterate the priorities we set at the beginning of the year. We continue to focus on a balanced approach to driving long-term value. As a reminder, our financial priorities for the year are growing sales with healthy merchandise margins, managing our expenses, delivering earnings per share growth and returning excess cash to shareholder. As I described, the financial results for the quarter it’s worth noting that all reported numbers include a $39 million gain on asset sale that we reported with our July sale.

In Q2, we made progress, again, several of our financial priorities. Specifically we grew net sales by 3%. Expenses were managed very tightly with operating expenses down $44 million including the gain. We delivered earnings of $332 million and earnings per share of $0.75 versus $0.64 last year. Year-to-date we’ve generated free cash flow of $668 million and we distributed $802 million through share repurchases and dividends.

Regarding sales for the second quarter, total net sales were $4 billion and comp sales were flat for the quarter following last year’s five comp. Total sales and comp by division are listed in our press release.

Moving to gross margin. The second quarter gross margin was down 110 basis points to 39.4%. This is an improvement in our trends from Q1. Merchandised margins were down 90 basis points for the quarter driven by elevated promotional levels at Gap brand. Rent and occupancy deleveraged 20 basis points. As a remainder, we need positive comps to leverage rent and occupancy and the threshold for ROD leverage is higher this year given our mix shift for international markets like China that have higher ROD cost.

Regarding SG&A, second quarter total operating expenses were $1 billion, down $44 million from the prior year. Operating expenses versus last year benefitted $39 million from the gain on sales. Marketing expenses were down $6 million to last year at $142 million. As a percentage of sales total, operating expenses leveraged 180 basis points versus last year to 25.2%.

Regarding the balance sheet we’re pleased that we’re meeting our goal of better aligning inventory with sales in each period. Inventory dollars per store were up 2% at the end of the second quarter. We ended the quarter with about $1.5 billion in cash and used $364 million to repurchase 9 million shares, resulting in a quarter-end share count of 434 million.

Regarding capital expenditures and store count, year-to-date capital expenditures were $328 million. Year-to-date we opened 36 company-operated stores on a net basis and ended the quarter with 3,200 stores. Square footage was up 1.6% compared with Q2 2013. Store count and square footage details are listed in our press release.

And now I’d like to share our outlook for the rest of the year. Our full year operating outlook remains unchanged. However, we are updating our full year guidance to reflect the gain on sale worth $0.05. Therefore, our full year guidance range has increased from $2.90 to $2.95 to $2.95 to $3. At its midpoint, including the gain, this represents growth of approximately 9%.

On a constant currency basis, the growth rate is estimated to be 5 percentage points higher or solid double-digit growth rate over last year’s 18% growth rate. Underlying this guidance is the expectation that we maintained tighter inventory levels that are more in line with sales. At the end of the third quarter, we expect year-over-year inventory dollars per store to be up in the low-single digits.

Regarding expenses, it’s important to note that there is no change to our full year goal of achieving leverage. However, as we mentioned last quarter, we expect full year leverage to be very modest, given the shift of about $160 million of income out of expense into merchandise margins as we discussed in depth on the Q1 call.

We achieved one point of leverage in the first half of the year in the phase of more challenging sales and traffic trends. In the second half of the year, assuming we meet our sales goals this dynamic will likely change as we had difficult comparisons from expense savings last year, and as we invest to support marketing, especially a Gap brand.

We expect marketing expenses in the third quarter to be up about $25 million versus last year. For the full year, the following guidance metrics remain substantially unchanged. We expect operating margins to remain flattish on a reported basis. We continue to expect square footage to be up about 2.5%.

We still plan to open about 185 company-operated stores and close about 70 net of repositions. Store closures are weighted towards Gap North America and store openings are weighted towards China, Old Navy in Japan, Athleta and global outlets.

We expect capital expenditures to be about $750 million and depreciation and amortization to be about $520 million and our full year effective tax rate to be about 38.5%.

In closing, as we commenced the second half of the year, we’ll continue to focus on the levers that we control while we work to deliver compelling product and marketing. Thank you.

And now I’ll turn it back over to Katrina.

Katrina O'Connell

That concludes our prepared remarks. We’ll now open up the call to questions and we’d appreciate limiting your questions to one per person please.

Question-and-Answer Session

Operator

Thank you. We’ll take our first question from Oliver Chen with Citi. Please go ahead.

Oliver Chen – Citigroup Global Markets Inc.

Hi, thank you. We had a question related to the Gap division. What do you think the next major hurdles are there to what we should watch for as you look to further move along with merchandise execution, and just as a quick follow-up could you talk briefly about supply chain and how you are feeling about fabric platforming and test read and react? Thank you.

Glenn Murphy

That’s two questions. Kidding aside, the Gap business as I talked about in my opening comments, I think that we can – if we wanted to, we could rationalize a way the first quarter which was a difficult quarter for business that has a strong U.S. based division. And that’s been the division that clearly has been underperforming the most for Gap brand of all its global presents the U.S. has been the business that we’re most disappointed. And second quarter was a bit of a carryover from the first quarter combination of product, and other issues in the second quarter. I think they’ve made a lot of changes and people on the call and mostly our customers were going to be shopping that business on their device or in one of our stores around the world. They are going to see a better face of the brand from a product perspective starting in the first week of September much better communication.

So I don’t want to get into the full integrated plan you’re really focused on merchandise and I think you see some changes in the product and you start to see now what the benefit is of teamwork between a very strong and talented designer and a commercial merchant, not a product merchant, or a commercial merchant and Michelle Demartini who partners with Rebekka Bay. We see how that works over at Old Navy and its producing the results we’re seeing now as we redefined the role of the merchant and make a much more commercial to drives the business and doesn't necessarily just pick product and we are seeing that in the early days of the relationship between our Banana Republic consumer of Julie Rosen and Marissa Webb.

So I think you’ll see a change in the merchandising, but as I said in my opening comment it’s the beginning, Gap had a very nice run in 2012 and 2013. First two quarters I said that you could explain and I’m not happy with them, you could explain them. And now I think you’ll see the beginning of the change in the first week of September take us all way through holiday, and not actually in spring and I think they continue to do what any good brand should do has deliver a better and better assortment every single season. I think this will be just the beginning in this fall launch.

On supply chain fabric platforming I’m really impressed with how much progress we’ve made. It’s taken us a while to get there as we shifted our relationship from vendor-based relationships to mill-based relationships, but we’ll have a significant amount for us of our assortment on fabric platforming in the second half and that’s going to help us a little bit with cost of goods, Compare to the first half as the whole intention behind it’s not only, finally the platform to run or respond to supply chain tools off of we can’t run the tools without a significant amount of your assortment on fabric platform, but also as you consolidate your fabrics and create a much more tight library of fabrics and negotiate directly with mills that allows you to get the benefit of cost of goods.

Oliver Chen – Citigroup Global Markets Inc.

Thanks a lot. Best regards for the holiday season.

Operator

Our next question will come from Matt McClintock with Barclays. Please go ahead.

Matthew J. McClintock – Barclays Capital, Inc.

Hi, guys, good afternoon, everyone. Glenn, I was just wondering, you outlined a lot of very strong digital initiatives, you talked about the reserve in store, order in store, and you also talk about personalization. Overall the digital growth rate for revenues is actually decelerated meaningfully from the run rate last year. And I was just wondering could you maybe speak to that a little bit, I’m not trying to poke holes in a double-digit growth rate because clearly that’s very strong, but the deceleration itself, what are you seeing in that business that’s driving that in and when can we potentially expect a reacceleration? Thank you.

Glenn Murphy

Well, a couple of comments on that, Matt. One, I would say, that inside of that double-digit growth rate, in the second quarter was poor performance at Gap brand, and then some of the reasons I’ve just explained all of them earlier, I think they’re just a matter of record now, where one is happy with our assortment in North America in particular or the U.S. in particular. But it was 11 on top of 27. So was it two-year 36. So that’s 18% per year. Definitely market share gaining over two years, but I won’t disagree with you. I thought we should do better than 11%.

Now, order in store drives business in the store and it’s only being tested in 30 stores right now. Reserve in store stepped up in the second quarter, drives business in the stores. So even though those tools – I know you get the eyeballs from online, but the sale goes to the store. And I think personalization, what I’m trying to say in opening comments, possibly wasn’t clear. We’re just testing that. It’s been about six months we’ve been in beta test, but we now believe that personalized content and personalized promotions eventually on our homepage, in our emails, in our messaging will definitely help online business going forward.

But I don’t know. I think it was a good performance online over two years. I said if the market is growing between 10% and 12%, maybe I’m being generous when it comes to apparel. Two years of back to back 18% is good, but I’d have my eye on 11%. I won’t deny that. That was a number we circled at the end of our P&L because we know every part of our business has to fire in cylinders for us to reach our goal. And our online business did a decent job in the second quarter, but we are always looking for strength, especially given your point, the investments we are making.

Matthew J. McClintock – Barclays Capital, Inc.

Thank you very much, Glenn.

Operator

We go next to Simeon Siegel with Nomura. Please go ahead.

Simeon Siegel – Nomura Securities

Great, thanks. Can you provide any color on the trend of the outlets, I mean for broader challenges across that channel?

Glenn Murphy

I think that it’s a business that when the core brands are strong, they do very well. I mean, there’s just this incredible relationship between the specialty business and our outlet business. And our outlet business did very well in 2012 and 2013 because our core business was stronger at that time. So, if certain malls around the country, mostly B malls, maybe the odd C malls start to act promotionally like an outlet mall that’s 10 miles away, it’s more difficult to drive traffic to the outlet mall.

I think over time, especially in our business, this is maybe a macro comment about the specialty mall business in general, as it becomes and needs to become more innovative, as it puts production separation between its outlet business and its specialty business, which is critical, as it speaks and engages customers in a way that’s not so dependent on just pure discounting, I think the outlet business is in its right form and within our portfolio, was a critical part, a very important channel inside our business. I’d say for that reason Jack Calhoun and Steve Sunnucks are really focused in the back half to make sure the specialty business gets to the right position on the continual mobile portfolio from Old Navy on the left hand side of the portfolio value based to intermix on the right hand side of the portfolio, which is luxury.

And for our outlet business, even though traffic ebbs and flows for it to be really successful, we need strong specialty business, brand recognition is there, but strong acceptance and a value proposition that is less baked in a percentage of as a tool to express their value, which is really the tool of the outlet business. I’d say the last comment is there’s been some new real estate lately. The only place that we’re seeing real estate growing and square footage increasing as in lifestyle centers after being converted to the power centers, or being converted to outlet centers.

We participate in those we think is right, but for the most part our investment for last couple of years have been in urban locations, street locations and power centers as we try to make sure we stay in only the best outlet malls. But looking where the customer is going and where traffic is, there’s a lot of street locations we’ve gone into inner urban locations, where there is no crossover from a specialty store. We’ve dropped in one of our factory store businesses having done very well. So, we’re being careful not to just react that we did years ago to new square footage, but be thoughtful and strategic on how we spread our outlet stores across the country.

Operator

We go next to Kimberly Greenberger with Morgan Stanley. Please go ahead.

Amber Leigh Turley – Morgan Stanley & Co. LLC

Hi, this is Amber Turley on for Kimberly Greenberger. So as you think about moving into fall and its promotional merry-go-round you talk about, what kind of steps are you thinking about in terms of easing up the promotions, but still maintaining a shopper, or are you thinking in terms more of developing the a better platform such as the cost of good decreases and maintaining the promotions to keep the shopper interested. What sort of lessons did you learn from last year that you’d like to implement this year?

Glenn Murphy

While, lots of lessons from last year, I think, have already been implemented and these are no word of importance, but I think that ourselves and my opinion is, a significant amount of the rest of the apparel market is in a much better leaner inventory position than they were 12 months ago, coming into the back half. I think that drove a lot of the – from that promotions what we saw in 2013, but I think the consumers feeling slightly better, which now we think it’s good for the overall industry.

But whether the consumer feels slightly better about apparel comes up to how well all of us, but I’ll speak for Gap, Inc., how well we bring product that they love, because that’s what it needs these days, which have the incredible marketing that reaches out to them to them through all the different tools we have to speak about our brands. We as I talked about earlier, I think, was Matt’s question, are going to talk quite a bit about the convenience in the back half, using our tools of reserving store, omni-channel – sorry reserving store, order-in store, other tools we have.

So we can talk about much more than the set of more traditional definition of a value proposition. I think the market we are investing and it’s because we do believe we made some really good decision to the back half, I think, our marketing is much better. So, look at it as a step between product, channel execution led by online, supported by stores, integrate marketing into unique innovative ideas like our omni-channel tools, which are unique that be able to marketplace. And better inventory, work your way up and we’re trying to avoid and only when necessary, how to play a more traditional game of communication customers as it was more predominant last year.

At the end of the day we are ready for whatever outcome develops in the marketplace that’s what we have Old Navy to go out on behalf of the portfolio, gain shares it did in Q2, with a four comp over six, be aggressive and that’s – it’s rolled in the portfolio. That’s to a previous question why outlet is important to us. We have those three businesses, Old Navy, Gap Outlet, Banana Republic Factory Stores, those are the businesses that grow on behalf of the Gap, Inc. portfolio and become more aggressive and play more of a promotional game and the other brands are to be positioned differently and that’s the work on the work that Gap and Banana Republic need to execute on their specialty business in the back half.

Amber Leigh Turley – Morgan Stanley & Co. LLC

Right thanks.

Operator

The next question will come from Lorraine Hutchinson of Bank of America Merrill Lynch.

Lorraine Maikis-Hutchinson – Bank of America Merrill Lynch

Thank you. Good afternoon. Glenn now that Old Navy has rolled out in China, can you take a step back and just talk about where you think you have the greatest opportunity there, whether it’s full price Gap stores, the outlets, or the Old Navy concept?

Glenn Murphy

That’s a good question Lorraine. It’s so early, I was there three weeks ago when the fourth Old Navy opens I'm probably just a little bit painted just because that was a big to do it was our fourth store second one in Shanghai, the first one off to a tremendous start and this one so far so good after just a few weeks. I would say that my instinct sitting here today was Old Navy will have a chance to go deeper into the country than Gap will.

The number of stores to be determined, obviously here in U.S. we have 50% more Old Navy stores than we have Gap store specialty. I don’t see any reason why that couldn’t play itself out in China overtime. Say may have a different view what matters I guess right now sitting here my view and I’d say I could see that playing out in China. But definitely will be at for a GAP right now is in some let’s call in for argument sake tier 4 and tier 5 cities doing well. Everything in China we’ve uncovered so far is customers love fashion. It is big family play which obviously fits Old Navy and for Gap value proposition, but not discounting just being money not overpaying for quality, which is you know good definition of value which is important to the Chinese.

And as I think, as we look at that and add it all together, I think, we’re super happy that both brands in our outlet business and the strong online business in China. I think overall, I look over the next five years, I can see where we would have more Old Navy’s going deeper into the country as we planned on our real estate strategy.

Lorraine Maikis-Hutchinson – Bank of America Merrill Lynch

Thank you.

Operator

Our next question will come from Jennifer Davis with Buckingham Research Group Please go ahead.

Jennifer M. Davis – Buckingham Research Group

Hi, guys good afternoon. I was wondering if you can talk a little bit about Athleta give us some color on how that’s doing and maybe an incentive metrics that you’re willing to share around the stores. And then Glen it’s good to hear you talk about starting to may be utilized some of that big data. Thanks.

Glenn Murphy

You guys also bring Sabrina here too right.

Jennifer M. Davis – Buckingham Research Group

Yeah. Hi, Sabrina.

Glenn Murphy

She is firing at me. Anyways what we feel good about Athleta nothing has changed, I think, that the team has done a really good job, taking a business that was very solid. Now will get to we were joking other day, it’s amazing how quickly we got a 100 store. So we’ll get the 100 stores by the end of this year. What I like about it is, it fits in types of real estate, which is very important for brand, you thinking can you work in mall, can you work in a street, can you work in a strip center and we’ve proven all that.

So online business is doing really well, we have all the metrics that say we go into a trade area, we don’t have a store, when we drop a physical store in the multiplier on the pool of online business we do is very attractive. I think that it’s in multiple activities, we continue to push that. So it’s not a one-dimensional business. I’ve also said many time our key competitor is Nike all those other competitors who get a lot more air time at the end of day Nike is the big player here and the person we look at the most. And where the share is going to come from Athleta, but its metrics and store productivity sell through it right, which is something we continue to push inside of other businesses.

Store productivity; sell through it like service scores in terms of the people and the quality of people we have. The relationship is it’s our only business as we move to a seamless inventory model during the next couple of years has led over the years of seamless inventory business, one team overseas all of its inventory between an online, catalog and a store business. So we really get a lot of benefit under that. I said in the April Analyst Meeting and still believe that I think it’s going to be our fourth global brand. I think it’s earned the right to be considered for that, we haven’t decided yet, but it’s earned the right to be given consideration.

And lastly, what every business launch, but especially a business in the period of apparel is the trend – is their trend, right of the business they are going after performance as their trend, the new way of dressing is their trend, street wear everything that’s happening right now. The women who are coming for the Millennial, so many things are going in their direction. So we are very happy with that, loved the team there and their leadership. So we’re going to continue to speed and I got a very nice return on capital, which always make the two of us happy. So we are going to continue to invest behind them.

Jennifer M. Davis – Buckingham Research Group

All right. Great, thanks. Best of Luck.

Operator

We go next to John Morris with BMO Capital Markets. Please go ahead.

Unidentified Analyst

Hi, it’s actually [Julianne Victor] (ph) on for John. I was wondering if you could talk a little bit about your product testing and your rapid responsiveness. I know you had some pretty big win there maybe earlier this year. So just wondering if you could give us kind of what percent of the assortment of each brand is being tested right now and what are the learnings and how you see it rolling out going forward? Thank you.

Glenn Murphy

We talked in April, the Analyst Meeting I think at the end of meeting I had Q&A, I think John was there that really was hoping that testing at a minimum, but also another important tool for us, rapid response would be a little more developed for the back half. Most of the benefit from the testing will come in the first quarter. That’s same with rapid response; we have a little bit of benefit come in the second half. That was in the original plan, but the fabric platform work we’ve done should help us on the gross margin in the back half of 2014.

I’d say I’ve seen every week I get a report in all the tests we do. So we just finish doing a number of tests across all the businesses for the first quarter. But it tends to point two; it helps us with the range bound of inventory, how big a buy. this is not a test of what the designers know what they’re doing. We trust our designers. This is what there’s something 300,000 units by 350,000 or 400,000. Then within that, it helps us with the CC component, and most times what it tells us is to give a style, or program at NCCs. You don’t need the NCCs.

So we got to keep working on that. Sometimes, multiple colors have advantaged nicely for Gap, but it is helping us very much understand the size of the power of the buy of that style. And within that style, it could be unique actually within each style, but mostly, it could be color of printed pattern and all the results I’ve seen are very helpful for the team. And we always got to apply commercial judgment and how do we gain market share to drive it, but the tests are certainly validating some of that and getting that a big opportunity Gap Inc.’s P&L, which is what I just told you was that led us towering strength, which is units sold at regular price. I think this has helped quite a bit in 2015 on that metric.

Unidentified Analyst

Okay. Thank you.

Operator

We go next to Susan Anderson with FBR Capital Markets. Please go ahead.

Susan K. Anderson – FBR Capital Markets & Co.

Good evening. Thanks for taking my question. I was wondering if you could give us an update on how Athleta is performing and maybe there’s any updates on growth trajectory. And then if you could also maybe talk about the landscape a little bit, that seems like a lot of players are trying to enter it and keep seeing any increase there at all? Thanks.

Glenn Murphy

Look, whenever there is, I was just saying to a previous question, whatever you have I think I described that the trend is your friend, a lot of people tried to jump in on this business. Now in fairness, Old Navy has been added for with their active line for about three plus years. Gap have Gap fit, they’ve had that over three years also. So we look at it that Athleta is a standalone business that focuses on women’s performance product and that’s the first attribute, but as performance, but also as a fashion component to it.

So we look at it from a Gap Inc. portfolio, we’re dominating for sure with Athleta, which is a standalone business. There are a lot of people get into the category, but that doesn’t mean they’re going to be successful. We really like how Athleta is performing like very much decisions that teams have made recently, whether that’s on marketing, or whether that’s in the assortment strategy, whether that’s on real estate. And I think it’s the – it’s kind of a beautiful split in its business between online and stores.

And that’s as for those of you who have been following, Sabrina and I, for the last seven plus years, we untangled some of the store decisions of the past. so we definitely promised to ourselves when we go into China, when Old Navy goes international, if we buy something like Athleta, we’re going to take those lessons with us and make sure that out of the gate, we see how customers want to shop to find a better split between our digital business, and our physical business, and Athleta certainly, has a beautiful split in this business.

Susan K. Anderson – FBR Capital Markets & Co.

Okay, thank you.

Operator

We go next to Paul Lejuez with Wells Fargo.

Paul L. Lejuez – Wells Fargo Securities LLC

Hey, guys. just wondering if you could talk a little bit about cotton prices, are you staring to see benefit there, if so, when might you expect that to become a tailwind in the P&L? Thanks.

Katrina O’Connell

Yes. There’s always a little bit of a lag, because we place orders some months before, obviously they show up in stores, Paul. So it’s great news to see cotton coming down, because of the lag effect, we would expect some small benefits, probably in spring. But assuming that the prices stay down as they have been, you see a much more pronounced effect in summer, which is obviously good news as we look forward to 2015.

Paul L. Lejuez – Wells Fargo Securities LLC

Thanks, guys. good luck.

Operator

And we go next to Barbara Wyckoff with CLSA. Please go ahead.

Barbara Wyckoff – CLSA Americas LLC

Hi, everybody. Could you talk about the potential for store closures end of this year? how many leases are coming due this year and next? I think last quarter, you talked, Glenn, about gap may be being a place you might be looking at versus the others? Thanks.

Glenn Murphy

We’re fortunate in some ways; I think the best math to apply is we have 2,500 odd stores in the U.S., so about 500 leases come up every single year. So that phenomenon plus the recession is what allowed us to do the work we did in the last four or five years. Going forward Barbara, I think, we’re a little less focused on closures, although are mid too, there’s always opportunity to look at stores that could be less about untangling this web that we inhered in 2007 and more about strategically looking at every single market and doesn’t make sense on a physical presence. With our omni-channel tools, once I talked earlier about especially, with reserve in store and order in store, we’re much more now focused about a physical presence does matter, although we’re challenging as the size of the store.

We definitely decide about Old Navy and took it a lot of square footage in the last five years. But now we are turning to Gap and to Banana Republic, and won’t talk about on this call, but in the February call we can definitely talk about some of the ideas we have for testing a different kind of physical space, we’re working with our team here and bring the digital physical teams together working on our store going forward. It allow us to have a high touch store, lower square footage, and applying the current plus many more omni-channel tools to that store. I’m hoping that will be a success for us is something we can deploy as we look at our real estate going forward, but great thing about the way our real estate team operates, we have a lots of flexibility.

Barbara Wyckoff – CLSA Americas LLC

Great. Thank you.

Operator

And our final question today will come from Brian Tunick with J.P. Morgan. Please go ahead.

Brian J. Tunick – J.P. Morgan Securities LLC

Thanks, good afternoon guys. Hoping to get I guess an update on denim trends and how you are planning inventory there? I guess what is denim as a percentage of sales in the two big brands and how does that impact you are thinking on the timing of seeing positive comps. I guess that’s the Gap brand in the second half? Thanks very much.

Glenn Murphy

Here's how I look at it Brian. I would say that denim when you run the business in a portfolio for the American brands and I think you’re referencing obviously well maybe in Gap. Those are heritage foundational categories for both of those businesses. To me this is where commercial merchants earn their keep, obviously understanding trends, understanding their brands, understanding customers and competition, let me just highlight one example.

So we’ve had a team together of Joe Stenson and Joni Berger at Old Navy now working together, one a creative Director of Commercial Executive, and one a commercial leader on behalf of the business, and Old Navy did a four comp in Q2 on top of the six last year with denim across the marketplace negative comp and let’s say where denim negative comp is that across the marketplace, what they do? They (indiscernible) denim was under delivering the marketplace they played a different color game, they introduced really worked hard on their fit pant, which is their active pant, really invested in that, got behind it, double expose that gave a lot of space online and digital content introduce the pixie pant, introduce the redesigned fabrication on the chenille pant and now where the first of our brands to embrace soft dressing.

And, when a commercial merchant works with their partner and design and figures out exactly that those trends like we’ve lived through skirts versus dresses, we lived through knits versus woven is going to happen they have indigo denim and there is a little too much in the marketplace. If you can’t understand the market, understand your customer, take advantage of the gain share then we probably don’t have the right commercial merchants.

In the Gap business, in fairness to them, Rebekka Bay, who is our creative director have a lot of confidence and didn’t have a partner for the first half of this year. And first part of the relationship between Rebekka and Michelle has going to be introduced on our September product comes in, that’s our mistake by the way, that’s not Rebecca’s fault, that’s my mistake, that’s Steve’s mistake, we should make sure day one she had a solid partner with her, because she runs six months with people, she worked with a lot partner to the caliber of Michelle.

So, let’s see how they have figured it out and navigate, but this is what they do for living, whether it’s sweaters, and holiday or – always understanding where they are going to gain share, is that where the customers at, how do they beat the competition ultimately how do we win. So, I think that we’ve demonstrated that in one business and the other one not as well, that’s why we’re disappointed in our performance so far, but it’s explainable, but I think you’ll see hopefully an improvement in the back half as our tandem comes together. Thank you.

Katrina O’Connell

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

Operator

Ladies and gentlemen, this does conclude today’s conference. We thank you for your participation.

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