Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  
TRANSCRIPT SPONSOR
MF logo

Gap Inc. (NYSE:GPS)

Q1 2007 Earnings Call

May 24, 2007 5:00 pm ET

Executives

Evan Price - VP of IR

Bob Fisher - Interim CEO

Dawn Robertson - President Old Navy

Byron Pollitt - CFO

Analysts

Gabrielle Kivitz - Deutsche Bank

Jennifer Black - Jennifer Black and Associates

Margaret Mager - Goldman Sachs

Paul Lejuez - Credit Suisse

Jeff Black - Lehman Brothers

Richard Jaffe - Stifel Nicolaus

Lorraine Maikis - Merrill Lynch

John Morris - Wachovia Securities

Randal Konik - Bear Stearns

Marni Shapiro - The Retail Tracker

Presentation

Operator

Good afternoon, ladies and gentlemen, and welcome to The Gap Inc. First Quarter 2007 Conference Call. At this time, all participants are in a listen-only mode. (Operator Instructions).

The conference call and webcast are being simultaneously recorded on behalf of Gap Inc. and consist of copyrighted material. They may not be rerecorded, reproduced, retransmitted, rebroadcast, or download without Gap Inc.'s expressed or written permission. Your participation represents your consent to these terms and conditions, which are governed under California Law. Your participation on the call also constitutes your consent to having any comments or statements you make appear on any transcript or broadcast of this call. If you have any questions regarding this policy, please contact Gap Inc. Investor Relations at 415-427-2175.

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

Evan Price

Good afternoon, everyone. I would like to welcome you to Gap Inc.'s first quarter 2007 Earnings Call. For those of you participating in the webcast, please turn to slides 2 and 3.

I would like to remind you that the information made available on this webcast and conference call contains forward-looking statements, including those identified in today's earnings press release which is available on gapinc.com as well as other statements that express our expectations, anticipations, beliefs, estimates, intentions, plans, and forecasts.

Because these forward-looking statements involve risks and uncertainties, there are important factors that could cause our actual results to differ materially from those in the forward-looking statements.

Information regarding factors that could cause results to differ can be found in our Annual Report on Form 10-K for the fiscal year ended February 3, 2007. Investors should also consult 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 May 24, 2007, 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 non-generally accepted accounting principal measures, free cash flow and expected diluted earnings per share excluding Forth & Towne's net loss, which under SEC Regulation G, we are required to reconcile with GAAP. The reconciliation of these measures to GAAP financial measures are included in today's earnings press release.

Joining us on the call today are interim CEO, Bob Fisher; CFO, Byron Pollitt, Old Navy President, Dawn Robertson, and SVP of Corporate Finance, Sabrina Simmons.

Now, I would like to turn the call over to Byron.

TRANSCRIPT SPONSOR

MF logo

Did the analysts get it right?

Wall Street hires some smart cookies. But it’s not always in their best interest to put the hard questions to management. Are YOU even their top priority?

Motley Fool co-founder Tom Gardner is still bullish on Gap. Since April 2002, The Motley Fool's Stock Advisor picks are up 69.18% vs. just 32.02% for the S&P 500. Now, discover the companies David and his brother Tom recommend in their free research report “The Motley Fool's 2 Top Picks - Plus Wall Street's Dirtiest Secret.”

Read the complete report courtesy of Seeking Alpha FREE.

* Returns as of 6/12/2007

To sponsor a Seeking Alpha transcript click here.

Byron Pollitt

Good afternoon. As anticipated, business in the first quarter remains challenging. And while we were pleased with the success of several trend driven categories such as dresses and shorts, overall response to spring product was mixed.

Today, I will review first quarter performance and then update our guidance for fiscal 2007. For webcast participants, please turn to slide 4.

First quarter earnings were $178 million or $0.22 per share. Please note, included in our first quarter earnings were the following two items: A 37% effective tax rate which benefited from favorable tax adjustments and approximately $45 million of losses related to the planned closure of Forth & Towne. First quarter weighted average diluted shares were 819 million.

Please turn to slide 5, sales performance. First quarter total sales were $3.6 billion, up 3% versus last year. Total company comp sales were down 4% in the quarter versus down 9% last year. This 7 percentage point spread between sales growth and comp was driven primarily by new stores and a 23% increase in online sales versus prior year. Please refer to our earnings press release for total sales and comps by division.

Turning to slide 6, gross profit. First quarter gross profit decreased 2% to $1.4 billion. Gross margin was 38.1%, down 210 basis points compared to last year with 30 basis points from the deleveraging of occupancy expenses and 180 basis points from lower merchandise margins, the latter driven by the markdown activity at Gap Brand. As we mentioned on our fourth quarter call, Gap Brand entered the year with excess inventory creating markdown pressure. We expect Gap Brand inventories to be back in line by fall.

Please turn to slide 7 for operating expenses. As we discussed last quarter, we are committed to simplifying our organization with the objective of creating a more nimble, cost-effective operating structure. This is an endeavor that is underway across all parts of the enterprise today. And all brands are in varying states of progress.

Each quarter we intend to provide an update on actions taken and related cost impacts to help you better understand how these decisions are affecting our performance and our cost structure. With the first quarter operating expenses of $1.1 billion, up $85 million over prior year, we recognized that cost must be brought into better alignment with our top line results. Please note, operating expenses include charges of $44 million related to Forth & Towne. Marketing expenses for the quarter were $116 million versus $97 million last year. The increase was driven by an incremental TV campaign at Gap.

Turning to inventory on slide 8. We ended the first quarter with $1.8 billion in inventory, down 5% over the first quarter of 2006. Inventory per square foot was $44, 8% less than last year. Despite beginning the year with excess inventory at Gap Brand our overall inventories are in good shape given disciplined inventory management at Old Navy and Banana Republic.

Please turn to slide 9 for capital expenditures and store count. First quarter capital expenditures were $122 million. We opened 41 new stores and closed 20 in the first quarter. Companywide, we ended the quarter with 3,152 stores and square footage increased 1%. Please refer to our press release for end of quarter store count and square footage by division.

Regarding cash flows on slide 10. Free cash flow defined as cash from operations less capital expenditures was an inflow of $159 million. Please refer to our press release for our Reg-G reconciliation of free cash flow. We ended the first quarter with $2.8 billion in cash and short-term investments. Given where we are in our turnaround, we did not purchase any shares in the quarter. Please remember that in fiscal year 2007, we expect to distribute about $260 million in dividends and repay about $325 million in debt. That said, our philosophy has not changed. This management team remains committed to returning excess cash to shareholders. Recall that since we began our share repurchase program in October 2004, we have repurchased over $4 billion in shares and paid out over $0.5 billion in dividends.

Turning to slide 11, our outlook for 2007. We are updating our guidance for the following metrics. We expect the percent change in inventory per square foot at the end of the second and third quarters to be down in the low single-digits on a year-over-year basis. We are reaffirming our guidance, for the following metrics. Full year 2007 diluted earnings per share excluding Forth & Towne is expected to be $0.80 to $0.90 per share. Please see today's press release for our Reg G reconciliation of earnings per share excluding Forth & Towne.

Pre-tax net loss of Forth & Towne is still expected to be about $60 million, $45 million of which has been realized in the first quarter. We expect all Forth & Towne stores to be closed by the end of June. Diluted earnings per share on a generally accepted accounting principals basis, including Forth & Towne, is expected to be $0.76 to $0.86. Full year operating margin in the high single-digits. Interest expense for the year about $35 million. Full year depreciation and amortization, about $550 million. Full year effective tax rate, about 39%. Free cash flow, about $500 million. Please refer to our press release for our Reg-G reconciliation of free cash flow.

Full year capital expenditures, about $700 million. This includes about $235 million for new stores, about $310 million for existing stores, about $110 million for IT, and about $45 million for headquarters and distribution centers.

At this point, let me step back to review our philosophy around store related capital investment decisions. Despite top line results that have not yet turned around, we believe that Select opportunities remain, for store investments that are lined with our return on investment expectations.

All store decisions, whether opening, closing or remodeling, are based on a robust financial model that measures each store against internal rate of return and net present value hurdles, incorporates the impact of sales cannibalization to nearby stores, and appropriately includes all marginal costs associated with operations at store.

As evidence of our commitment to right sizing our fleet, over the past five years we have closed over 600 stores including 400 Gap stores. We are however opening stores, which we believe provide a healthy return.

Regarding remodel expenditure, we believe regular remodeling is an essential element of maintaining brand health. At Gap, and Old Navy in particular, we are behind in remodeling, and as a result have stepped up our remodel spending.

We are committed to upgrading the physical presentation of our fleet and placing our stores on a regular remodel cadence, in the range of five to seven years. At the same time, we continue to pursue ways to decrease store related construction and maintenance costs.

Turning now to store growth, on a net basis, we expect to open only 30 stores, with about 230 openings and 200 closures, yielding a full year net square footage increase of about 1%. You can refer to our first quarter press release for a summary of store activity, and gapinc.com for 2007 store guidance by division.

In summary, we are focused on making our organization more nimble and cost effective. We are managing our fleet size based on return on investment. We are committed to returning excess cash to shareholders. We are tracking to the earnings expectations set forth at the beginning of the year.

Thank you. Now I will turn it over to Bob.

Bob Fisher

Thank you, Byron. Good afternoon everyone. It's good to be back with you today. During the fourth quarter call three months ago, I laid out Gap Inc's priorities. These have not changed. One, improve the top line by getting the product and store environments right at Gap and Old Navy. Two, retain, develop and recruit the best talent in the industry, and three, simplify our organization and processes, so that we can become more nimble and efficient.

As a leadership team, we are taking important steps towards these priorities during the quarter.

Marka and Dawn are making progress in setting the products and operational strategies necessary to stabilize Gap and Old Navy. We expect all of our Forth & Towne stores to close next month, allowing us to sharpen our focus on our core brands. And we are undergoing a thorough analysis of our organizational structure, and are taking actions to simplify how we operate. This work should also help reduce our expenses. There is more work to be done, but I feel good about the progress we are making.

Today, I will discuss this progress in more detail, including an update on Banana Republic and Gap Brands. Then you will hear from Dawn Robertson, who is eager to share her observations and priorities after the first six months as President of Old Navy.

First, I would like to bring up to date on our CEO search. Our Board of Directors search committee is actively working with recruiting (inaudible) to find the CEO who has the qualities necessary to drive vision and strategy for a global retail business like Gap Inc.

This means focusing on candidates with deep retailing experience, coupled with financial acumen. We are looking at candidates who also understand how to build and develop strong creative senior talent. We know this type of search can take time and it remains a top priority to the Board.

In the mean time, I remain fully engaged in my role and I am working with the executive team in executing our priorities.

Before we discuss each brand, I would like to talk about the ongoing work taking place to simplify our organization. As we mentioned, we are working hard to put the right organizational structure in place. We need less bureaucracy and more creativity, if we are to stay focused on our brands and customers. So we are taking a systematic look at each part of the business and structuring our teams according to the company's goals and priority.

During the first quarter, the senior leadership team devoted themselves to the planning work necessary, so that we could begin to execute, and that work is now underway.

Here is what it entails; One, giving the brands more autonomy, by moving critical functions of corporate back into the brands, so they can more quickly make the decisions that are appropriate for their business.

Two, continuing to find ways to reduce expenses, which will result in a small percentage of layoff's. As an example, we recently restructured our human resources organization and moved a majority of our recruiting and learning and development staff into each brand. By decentralizing this work, we are putting responsibility and expertise in the brands to better recruit and develop creative teams, which is a critical priority for us. This will also allow our teams to focus on building the capabilities necessary to succeed.

As a result, we reduced the department by nearly 100 positions, which is the combination of eliminated jobs and open positions we chose not to fill. The loss of jobs is never easy, but we are realistic in the steps we must take to create meaningful change in our business.

As we move through this process, each brand and division is addressing their organization in a manner and pace that supports their brand goals. We intend to keep you apprised of our progress each quarter.

Now let's turn to the brand reviews. I'll provide an update for Gap and Banana Republic, then Dawn will take you through Old Navy.

Just three months into her role as Gap Brand President, Marka has strengthened her leadership team and has begun to make progress across several fronts. First, we are all pleased with Gary Muto, former Forth & Towne President, has joined Gap as President of Adult and GapBody. Gary had served majority of his 19 year career with Gap Brand and is a talented merchant and well respected leader. Gary knows what it takes to lead a team around a single vision and understands the importance remaining agile and innovative, while staying focused on the customer.

And further supporting our goal to bring strong, creative talent to our brands, we announced yesterday that Patrick Robinson is joining Gap as Head of Design, for Adult and Body. The 20 years experience in the fashion industry at brands such as Armani and Paco Rabanne, Patrick bring both design leadership and a fresh perspective to Gap brand. Most recently he designed a limited edition collection for Target's Go International initiative. We are thrilled to have him on board.

I realize Gap is a large scale brand, Patrick will have two of our best Gap veterans, Marka and Gary, to support his success and development.

Now I'd like to talk about the Gap Adult target customer. You remember during the fourth quarter call that we acknowledged Gap's target range of 18 to 34 was too broad, especially given the dynamics of today's marketplace. We are still refining our new target, but we believe the appropriate demographic for Gap Adult is between the ages of 24 and 34. But the late 20's being our sweet spot. Of equal importance however, is the psychographic or mindset of this customer. They are looking for fresh interpretations of casual American style. They want to find clean, classic looks that reflect today's style and they want casual options for work as well as weekend.

These customers expect quality and they look to Gap for iconic items such denim and khaki and knits in great colors.

Although products, already bought through the remainder of the year, this is the customer filter, market and the Gap team will use it to influence product moving forward. As a result, more of our assortment will reflect the aesthetic that exists today in our clean shop. We are also focused on driving a stronger point of view in our stores through disciplined inventory management and are decreasing our overall customer choices.

One great example of how Gap can emotionally connect with its customer was the recent launch of our limited edition classic white shirts. The shirts did view on the cover of Vogue magazine, which is credible testament to Gap's iconic stature and relevance in the fashion marketplace. As you can imagine, the product generated a great deal of buzz and received terrific customer response and sales in major urban markets, including Los Angeles, New York and San Francisco.

While these kinds of results indicate progress, we realize it will take time for Gap to regain strong momentum. I feel good about the path we're on and confident in market's strong leadership team.

Turning to Banana Republic; we continue to focus on our core customers by offering accessible luxury and versatile essentials. Overall, we are pleased with the performance of our men's business where we have received strong customer response in pants, suiting and knits, such as our solid pocket polo. Broadly, we are pleased with women's business, which remains on track in offering elevated collections for weekend and work. That said, we did experience some challenges in our women's pant category during the quarter. Overall, customers did not respond well to our casual pant assortment. We know that our cotton stretch pants in skinny and slim styles did not perform as well as we would have liked.

Moving forward, the team is very focused on this area of the business. We are working to rebalance our fallen holiday assortments towards our popular elevated style such as trousers, (inaudible) and wool blend fabrication. This summer we are delivering the on-trend items that customers have been looking for and which have been performing well including dresses and shorts. Banana jewelry will also be a key focus Banana Republic this summer.

Before I hand the floor over to Dawn to discuss Old Navy, I would like to close with the conformation of our commitment to the priorities I outlined earlier. Although our search for a new CEO is underway, there is no room for complacency. We are in the process of making improvements and remain focused on turning this business around.

Now, I am pleased to introduce Dawn Robertson. Dawn brings to Old Navy nearly 30 years of retail experience. She has a strong track record of repositioning apparel retail companies, most recently as the Managing Director of Australia's largest department store Myer. As the helm of Old Navy she has been working with the team to assess the brand's challenges and is already driving change across all fronts. Here is Dawn to share some more details.

Dawn Robertson

Thanks Bob. It's been about six months since I joined Old Navy. I came here because I believe this brand has great business opportunities in front of us. It's true we have work to do, but we also have a lot of potential. Today I want to talk about our top priority for 2007, which is stabilizing the business. I will also give you an early look at some of the longer term strategic shifts I believe are necessary to succeed against.

Old Navy began as a powerful brand with great products at great prices delivered in an exciting store environment. But over the years, we are seeing competitors evolve their business models and gain traction. During that time the brand strategy and focus hasn't always been cleared to our customers.

Old Navy initially focused on offering products found at specialty stores but at lower prices then repositioned itself to better compete with value players. In each case, the merchandize mix was tweaked and new strategies were discussed, but we didn't have a strong focus on execution. As a result, we've seen a decrease in traffic and decreased comp store sales culminating in a disappointing year in 2006 and coupled with 2005 showed we needed to change.

Over the past six months, we started to execute tangible steps to make improvements. We have five key strategies in 2007. Specifically, we are stabilizing sales, improving gross margins, building the team, improving our processes, starting with the way we bring product to market, and ensuring alignment and discipline across our functions at Old Navy, which is key to business performance.

So, let me tell you a little more about how we are accomplishing each of these. I think we all agree that the most important thing we will do this year at Old Navy is to stabilize sales. Specific steps we are taking to do this are identifying big trends and big events to stand for during the season or standing for big ideas.

In March, we saw successful execution of our dresses campaign, but this was not the direction we were originally heading in for spring. We plan to carry dresses but spread them out over the first five months of the year. It was clear to me that dresses were our most compelling offer. So, as a team, we made the decision to take more of an authoritative position than we had in some time.

Across the brand, we've brought together the product, in-store experience and marketing and a coordinated customer campaign. Following dresses, we executed a similar campaign on short shorts. Both are a great example of how we can be a leader once again, and in both cases, the customer responded and these categories performed well. You can expect to see more of these focused coordinated product campaigns from Old Navy going forward, like the swimwear which launched on television last Tuesday.

We have also improved our key item focus. For example, item of the week, which is at the front of our stores, has historically performed well. But as we have seen in other areas, we didn't always executed well. In the past, we set item of the week on Sunday to prepare for the week ahead. Now, we are setting it on Friday to improve our weekend traffic and we saw improved results in Q1.

Starting in the back half of the year and going forward, we will deliberately design into item of the week. Each week it will represent a new face of the store and constantly stand for fashion and newness, with the efficient depth of inventory to create a clear statement to our customers and drive weekend traffic.

Another example of the shift we are making to key items is focusing on space productivity. For example, how we merchandise the best space in our stores like the in cap at the end of the each [trial]. In the past, we might have featured several different products in this space. Now we are starting to get clear and more focused presentations that feature just one key item, and we have large signs that clearly tell the customer about the products and the price.

If you go into our stores today, you will see this with the items like the trapeze knit top in women's, the short sleeve woven shirts in men's. As a result, we drove unit velocity and increased productivity.

We are focusing on our marketing and making sure our creative is more consistent across all of our marketing vehicle. Again our dresses campaign is a great example of how we did this. Our circular store front and online presence all reinforce the message on TV. In marketing, we are also working to strike the right balance between value and fashion. We would have a much clear delineation for our customers between fashion, promotional and clearance messaging so that when we are on sales our marketing clearly communicate that we are on sale. And when we are talking about fashion our marketing will showcase our latest fashion products.

The other area I want to mention is our stores. Overall, we are still updating stores as a part of our regular maintenance approach, which really isn't much more than [fresh pain in new life]. In markets where we see opportunities, we will continue to invest in new stores. So, we will approach this conservatively. This year, we plan to open approximately 50 new stores on a net basis and believe this will drive a healthy return for our shareholders.

Ultimately I recognize that we will need to more dramatically update stores going forward, many of them are aging and haven't been refreshed in sometime. So, we are testing new ideas in the back half of this year to create a unique and exciting environment for our customers and we'll have more to share on that as we move forward.

At the end of the day, I know that the most important thing we do to drive traffic in sales is deliver great products. To accomplish this, our teams are focused on three specific product categories. The first is fashion.

Now when I say fashion, I don't mean what you see on the runway. To many people and to many women, fashion simply means something new, something more up-to-date. This category will make up the largest percent of our total assortments. We are developing and executing a stronger fashion point of view to drive purchases, and we are delivering fashion to our stores more often to increase frequency of visits.

Next is fashion key items. Old Navy has been about key items, but they haven't always been fashionable. So, we are making key items more modern. Plus, as I mentioned earlier, we are positioning key items in some of the most productive bait in our stores.

The third category is basics, and they will be an important part of our business, although not the largest in percentage total. In basics, we are focusing on quality, value and being in stock, which we believe will drive frequency of visit and improve gross margins. When I say basics, I mean everything, from intimate apparel to basic yoga pants and basic tees, as well as things like socks and underwear.

With the right assortment, we can compete with specialty and value players. We can win against value players by offering sharper on-trend product, delivering new knits more frequently and pricing our assortment competitively. And we'll win against specialty players with our breadth of assortments, which serves more occasions with lower prices, and with the convenience of all of our real estate.

Second, for 2007 and beyond, we need to improve our gross margins. Our goal is to sell more at regular price, by making our product more modern, by [living it more] frequently and making thoughtful investments. In all three product categories, fashion, key items and basics, we are focusing on making our product more modern and on selling more at regular price.

We are also working to reduce the cost of our goods. With better timelier process, strategic vendor alliances and clear roles, responsibilities, and decision rights by function and by level.

Third, we are building the team. One of the most compelling reasons for me to join Old Navy, was a dedicated and passionate team of leaders and employees. We all recognize that it's going to take a lot of hard work to turn around our results. And that's why I'm focused on building a strong team with clear accountability.

We have some great talent here, with a long history in the brand. The leaders in merchandising stores, IT, visual, just to name a few. We are balancing these internal leaders with new talent to provide a real fresh perspective to our team. For example, when I arrived on November 1st, we had heavy inventories in fall and holiday product and needed to get our stock under control. So I created a new position to lead our inventory management work and a Gap Inc veteran, with deep experience in inventory management to be the head of this group.

We've also gone outside the Gap Inc. As Bob mentioned last quarter, Michael Cape, recently joined us from J.C. Penney as our Executive Vice President of Marketing. He is already making contributions that will focus our marketing going forward.

We do have a search underway for a Head of Design. We are looking for a leader of designers, someone who can actually interpret and execute fashion trends for the Old Navy customers.

We also have a search underway for a Trend Director to identify new trends, who will work closely with the Head of Design. And we think together this team will be a winning combination for Old Navy. Having the right team in place is critical to our success. But so is having the right process, starting with the way we bring product to market. The bottom line is our process today, to design product takes too long and it's not competitive.

I know this is something Old Navy has focused on and talked about before, but it wasn't executed. It wasn't executed because, while we address, what we needed to change, we didn't identify the details of how we were going to do it, who was going to do it, and when it would be done. I am personally accountable for making sure that we deliver what we set out to achieve.

We are building two new processes, a seasonal process and fast process. Products we develop on our seasonal product development process will represent approximately 85% of our line. But, we will develop them in a far less time than we do today. Of course the big question is how will we do that? By defining clear roles and accountabilities for each of our teams, and by empowering our teams to make decisions faster. We will remove the rework and iterations that happen today.

With our fast process, we will get our newest ideas to our customers by reacting to trends in the business and to reorders. Not the majority of our line, we think it will represent approximately 15%.

In the beginning of June, our teams will learn how to execute in this new process, and we will begin to implement for products that arrive in stores in February next year. We will update you on how this goes in the future.

Finally, ensuring that alignment across all functions and proper business discipline is in place is critical to achieving these results. So, we are working on this from free seasonal alignment on events, product flow, marketing and financial. Through in-season management, through monthly performance and alignment with financial objectives, with clear communication of all the decisions. The early results of this alignment have reduced store labor costs during Q1, because we minimize unnecessary changes.

In short, 2007 is about doing many other things we do today, just much, much better.

The changes we have made over the last few months have helped us to make progress in the first quarter. While our overall comp results for Q1 were better than Q4 and delivered with healthier margins, we have a long way to go. We expect to show continuous improvement throughout the year.

But I recognize, that stabilizing the business is not enough for the long-term. For Old Navy to effectively compete and grow, we must develop a sharp focus on who our customers are and how we can differentiate ourselves from the other apparel options that they have available. And looking at the marketplace and our competition, we found that mass and national players were most consistently able to drive share across eight segments, but they levered significant advantage like multiple categories and brands that we do not have.

The opposite is true for most specialty stores, who are highly focused. But this does not necessarily allow them to reach across different segments. As we go forward, we see significant opportunity in having both the target customer for our adult customer and a separate target customer for our kids division. Both are meaningfully sized markets, both offer growth opportunities and both have been instrumental in driving Old Navy's volume.

We have done significant research and begun to form our view around our adult and children customers. Our adult customer target is a 20 some adult, modern, fashionable with broad interest entering into new stages of their lives and with high apparel spend, but inherently value conscious. Our children's customer target is a modern adult who makes all decisions for their children's clothing and wives for gift. They purchase for fashion and emotion, but require consistent quality and a cruciate value. We will use these customer filters for everything we do from product and marketing to the store experience.

I am not prepared to share any more with you today, but will update you as we move forward.

In summary I believe we are heading in the right direction. As we get better and better at execution our performance will improve. But I know, that we have to prove that to you and that only our results will speak to that. We have only just started, in just a few short months things have gotten better. While we have a lot of work ahead, the Old Navy team and I are energized about the potential we have with the brands.

Now, I will turn things over to Evan.

Evan Price

That concludes our prepared remarks. We will now open the call to questions. We would appreciate limiting your questions to one per person.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question is from Gabrielle Kivitz with Deutsche Bank.

Gabrielle Kivitz - Deutsche Bank

Good afternoon. This question is for Byron. Byron, sales per square foot productivity if you look at it for the Gap North America stores, has not eroded as much as one might think after a couple of years of negative comps. I am assuming that the end of productive store closures have helped to maintain a healthier productivity average. But I know that over the last year or at least a couple of years ago, you also had initiatives to reallocate square footage between men's, women's body, etcetera, within the stores to be more efficient. My question is how much did that reallocation actually help productivity, if at all? And if you can restore a better full price selling level and recapture lost customers, can you surpass your past sales per square foot productivity levels with a smaller store base and more efficient use of square footage space?

Byron Pollitt

So the name of the game here is you so rightly observed, it is all about sales productivity. And I would say for Gap Brand, because there has not been a product recovery yet. We don't have a true read on what the inherent sales productivity capacity is for within adult male, female, certain categories and then kids' baby. And so you are absolutely right, the major driver of maintaining the sales per square foot has been a relentless closing of unproductive stores. That's been the primary driver.

Once we have a much better read on the capacity of the different product lines to produce, once we are generating positive comps again. I think, Marka on the team will be in a much better position to reallocate space and that will be a key driver of determining just how much productivity we can gain relative to what we have achieved historically.

Gabrielle Kivitz - Deutsche Bank

Okay. Thanks very much.

Operator

Your next question is from Jennifer Black with Jennifer Black and Associates.

Jennifer Black - Jennifer Black and Associates

Good afternoon. I wondered if you could talk a little bit about your sourcing and IMU potential, and can you speak to the inventories, just at the Gap Brands? Thank you.

Byron Pollitt

Let me start with the inventories at Gap Brand. So spring and summer, were originally bought with a more optimistic view of a product turnaround for holiday and a more bullish view on what that would drive in traffic. And what has happened is history, the turnaround did not occur as anticipated to holiday traffic. Underperformed expectations but the product was bought. And so, we entered fiscal year '07 heavy in inventory. The team has been hard at work through additional promotional and markdown activity to rectify the over-inventory situation. As I mentioned in the speech, we fully expect that situation to be completely rectified by fall. The current team today is buying inventory very much in line with current traffic trend. So, we expect to enter the second half with a significantly strengthened inventory position relative to the run rate of the business.

So, with regards to sourcing an IMU, there is considerable work underway to fix our pipeline. Dawn mentioned that was a very high priority in her opening remarks. And as we streamline our pipeline, we fully expect to be able to move the needle on average unit cost. And with that, we expect to have some lightening, at least the potential, for improvement in gross margin.

Jennifer Black - Jennifer Black and Associates

Byron, did you say what the inventories, the actual percent, up or down at the Gap Brand?

Byron Pollitt

No, we didn't. What I did guide to, however, was that we expect at the end of second and third quarter to be down low single-digits for Gap Inc. inventory per square foot as a whole. We are very focused on driving growth in gross margin dollars, and we think one of the most powerful levers we have to do that is to continue to pull units from the inventories that we're buying, and that's really what's driving those down.

Jennifer Black - Jennifer Black and Associates

Thank you.

Operator

Your next question is from Margaret Mager with Goldman Sachs.

Margaret Mager - Goldman Sachs

Hi. I just wanted to talk about the Gap a little bit and the target customer they are trying to narrow it to more of a 24 to 34-year-old customer. Can you talk about what is it going to take to drive traffic back into your store, specifically with that customer? What is your intelligence suggest at this point, where that customer is currently shopping and how do you regain their interest and get them back into the stores, because it seems like you have a customer target challenge, you have a product challenge, but you also have a competitive challenge that we didn’t hear much about as anything on this conference call? So, can you speak to the total picture of your traffic issues and how you get the traffic back from competition that has picked it up over the past few years?

Bob Fisher

Yeah, Margaret, hi, it's Bob. First of all, I think the key with the focus on the target customer is really the statement that we are not trying to capture the 18 to 23-year-old customer. So, we believe that there is a great deal of competition in that sector in the mall. Narrowing the target customer is going to allow us to deliver a much more focused product assortment. And I think that is really key. When you are trying to design and merchandise for a broad customer, you end up serving nobody.

So, the focus on the late 20s customer is going to allow us much more focused product assortment, much stronger marketing messages, a clear store point of view and the key is that we are focused on clean, classic, American style and casual options specifically for the work and for the weekend. I think one way where you can see that we were off target is if you look at our holiday advertising campaign and in-store merchandizing. When we put on wrappers and when we market and target goodies, I think you are not going to see anymore. Speaking about the competitors, it's really a broad set of competitors, specialty stores and department stores. But by moving away from the 18 to 23-year-old, what we're saying is that we're not taking on ANF and [American Ego] directly.

Margaret Mager - Goldman Sachs

Okay. As I saw the floor, I will ask about online, it's obviously doing very well for you. Is it profitable or is it a drag on your business at this time?

Byron Pollitt

Online, as I mentioned in my remarks, grew 23% for the quarter. It has had strong double-digit growth over the past several years. It is solidly profitable across all the brands, Banana, Old Navy, Gap, that with a very attractive return on investment.

Margaret Mager - Goldman Sachs

Okay, thanks. Good luck going forward.

Operator

The next question is from Paul Lejuez with Credit Suisse.

Paul Lejuez - Credit Suisse

Hey, thanks. Byron, just going back to Gabrielle's question, when you closed Gap stores have you seen a pick up in nearby Gap store comps? And second, Dawn, thank you for the run down by the way. That was very helpful. But can you maybe share with us, given your departments or background as you walk into an Old Navy store, do you feel like there is something missing that perhaps something from the department store background kind of helps you figure out where the missing pieces are?

Byron Pollitt

So, Paul, let me start with the questions you've asked of me. As I said in my opening remarks, when we evaluate any sort lease action, when we open a brand new store where other stores are nearby or when we consider closing a store that is in an existing marketplace with several other stores, one or more stores, we actually model cannibalization or in the situation you are asking, I guess we'd call it reverse cannibalization, and so we model it. It's hard to know precisely, but the model predicts that there should be some reverse cannibalization. We believe we do see a lift in the surrounding stores that are suppose to be affected by the closer of a store. Naturally there is a degree of error associated with any of those projections, but we believe if you can model it and we do, and we base decisions on the results that we see when we both open and close stores and measure the resulting cannibalization or reverse cannibalization. Dawn?

Dawn Robertson

On the Old Navy piece, it did begin as a really powerful brand, and it did have great product, great prices, there is an exciting store environment. But as time has gone on, competitors have evolved. So, if you look at what we compete on today and you walk in, it's not as exciting of product and it's not as exciting a store environment. So, as we look at what we need to really focus on and take steps to change to stabilize our business, we believe it's very much for standing for something and a real sharp focus on who the customer is. I mean our strategy as over the years has evolved in not being terribly clear of who the customer is. And we haven't had a strong focus on products or a strong focus on execution. And if you think about what's happened so far just in Q1, as I talked about, by executing dresses well, which is a big idea of exciting product at a great price and big idea that the customer responded. So it's very clear to me that as we bring those big ideas together with great product, in-store experience, marketing in a coordinated way, and we are consistent about those fashion ideas, and we have that consistency back, we will get the business back.

Paul Lejuez - Credit Suisse

Okay, thanks. Good luck guys.

Operator

The next question is from Jeff Black with Lehman Brothers.

Jeff Black - Lehman Brothers

Thanks. I guess the question for Byron as well. When you look at the expense reduction, what ultimately are we targeting here over what timeframe? And could you just give us a sense either in dollar or in magnitude of margin basis point contribution on the SG&A line? Thanks.

Byron Pollitt

You bet. So, Jeff, we are not communicating a specific target at this point. If I were to step back and say from an operating margin perspective what are we salving for, we are absolutely committed as a team that with positive comps and SG&A and [raw] that is appropriately leveraging, we should be yielding as an enterprise mid-teen operating margins. We fully acknowledge that our cost structure today is at a line with our sales results. We are very serious about tackling expenses. We are taking a measured amount of time to do it thoughtfully, to help ensure that these costs once taken out don't so easily creep back into the structure.

All divisions and departments are participating in this cost review. Each of them is in various stages of planning and execution. And while we have no aggregate impact to communicate yet, we do expect additional actions this year and expense associated with those actions. And with each coming quarter, we will update you all on what those actions are and what the onetime material financial impacts are associated with those initiatives.

Jeff Black - Lehman Brothers

But we would expect some of those to hit this year and then look at it and say the bucketing in '08, '09 or what's the best way to look at it better?

Byron Pollitt

Well, I think the way to think about that is we are very serious about taking action this year to the extent that we implement this year. We are able to create a more attractive expense run-rate going in to the next year.

Jeff Black - Lehman Brothers

Fair enough, good luck, thanks.

Operator

Your next question is from Richard Jaffe with Stifel Nicolaus.

Richard Jaffe - Stifel Nicolaus

Thanks very much guys. Quick question, I guess go back to Bob and his comments about the Gap Brands and its efforts to focus it more on pure choices. And I guess, I would like to better understand the focus. I understand that the shift in demographics or target demographics. I am curious how you would narrow the assortment or I guess limit the customer choices and how that would be effective in recapturing sales?

Bob Fisher

Richard, hi. As I mentioned I think it's about a clear point of view in the stores. When I go into the stores today and Marka and I have had numerous conversations on this. The style proliferation is real problem, and so when that problem comes up, the customer doesn't know what it is that we are selling. And that's the result frankly of lack of confidence by the merchants. Lack of confidence in how they are seeing the customer respond; and lack of confidence in the design of the product that they are receiving. So for fall, we are going to reduce the number of CCs or customer choices as I said, by about 30%. That's going to provide a much clear point of view in the stores around what I talked about clean, classic, American style. That's what Gap has been about. We don't want to go backwards. So we've got to deliver fresh assortments and fashion within that context, within the context of casual. But again, by delivering a much more directed point of view, I think you're going to see the stores cleanup and I think the customers are going to respond.

Richard Jaffe - Stifel Nicolaus

That's helpful, thank you very much. A quick question on the hurdle rates for new stores remodels, particularly with sales per square foot having slid a bit. What is the hurdle rate or can you discuss that a little bit more in terms of remodels? What kind of improvement are you seeing when you do the new box of full remodel?

Byron Pollitt

So, let me address that in two ways Richard. With regards to hurdle rates, we naturally target our hurdle rate, that is, an increment above our cost of capital, when it's a new store, new territory. The revenue stream, not well understood, that hurdle rate is going to be a bit higher when we're doing the renewal, where the revenue stream is well understood, hurdle rate is a bit lower.

With regards to remodeling, remember, at our core we have a large profitable fleet of stores, that just naturally require some degree of investment to preserve its appeal, their appeal and brand health. Most of those are low scope. Today, unfortunately many are in catch-up mode. And we are generally successful at preserving or modestly enhancing the returns that we are already generating in those successful stores. When we invest incrementally to expand square footage at new departments, like BR, we generally seek returns that meet and/or exceed our financial hurdles. Remembering again, that our hurdles are lingering above the cost-to-capital it’s only where we have invested to alter the selling space with no new revenue drivers that our results are mixed and I will just tell you we will be very, very selective about approaching those types of remodels in the future.

Richard Jaffe - Stifel Nicolaus

Thank you.

Operator

Your next question is from Lorraine Maikis with Merrill Lynch.

Lorraine Maikis - Merrill Lynch

Thank you, good afternoon. Could you just talk a little bit about why you did not buyback any stock this quarter and what your plans are for the rest of the year?

Byron Pollitt

Yes, so and thank you for asking that; first let me just repeat again, as I said in my remarks, there is no change in philosophy, we are fully committed to returning excess cash to shareholders. As you might appreciate and recognize, we are in the midst of a turnaround. We've had a lot of management transition and frankly we've just decided to pause until we see business stabilize and gain more traction.

I think our records speaks for itself over the past four years, we have repurchased over 4 billion in stock, paid out over 600 million in dividends. And then I think its also important to keep in mind that in 2007, we have already committed in effect, 600 million of our free cash-flow in the form of dividends, representing about 260 million and in terms of bond repayment about 325 million when we retire some debt in September. So in sum, think of these simply as a pause until the business is more stable.

Operator

Your next question is from John Morris with Wachovia.

John Morris - Wachovia Securities

Thanks. Good afternoon. To clarify Byron, the inventory I guess BR, on a per store basis, as you map t up for the quarters is tracking to be better than expected in terms of being lower? Is that correct, you were actually targeting the first quarter to be flat and you are actually negative eight in the second quarter flat and you are actually now talking negative low single digits. So, I want to confirm that, because I think that's important.

Byron Pollitt

So, let me confirm with just a bit more color. The guidance for the second and third quarter is to be down on an inventory per square foot basis, companywide low single digits. In Q1 we actually did do better than anticipated. To be honest we sold more units during the quarter than we had originally anticipated. BR and Old Navy have been very disciplined during this period and in the quest of growing gross margin dollars. We are convinced that one of the levers that we should absolutely be relentless on is continuing to pull out markdown units from buys.

John Morris - Wachovia Securities

And you said you saw the improvement at Old Navy and Banana. Did you see the same directionally at Gap relative to your initial plan?

Byron Pollitt

The Gap came into the quarter with more inventory than was ideal. They also were able to move modestly more costs, than was originally projected. However, that created the gross margin pressure that contributed significantly to the margin deterioration that we described, heard in the first quarter.

John Morris - Wachovia Securities

Okay. Very helpful and a quick clarification, on the way that you are mapping out or discussing the plan to take concerted action on managing the cost structure and communicate to us the impact. Any benefits so from those initiatives in Q1 or is it all go forward from here.

Byron Pollitt

No benefit in Q1. Remember virtually every one of these initiatives is going to have some onetime costs. The closing of Forth & Towne generated significant onetime costs, but the benefit, all the stores will be closed and by the end of June, we expect all the costs related to the closing of Forth & Towne to be recorded by the end of the second quarter. From Q3 forward, we would expect to see the benefit of that in our SG&A run rates, as an example.

John Morris - Wachovia Securities

Thanks. And Dawn, also I just wanted to say thank you for that very clear math for your strategy and your plans. Goodbye.

Operator

Your next question is from Randal Konik with Bear Stearns.

Randal Konik - Bear Stearns

Can you hear me?

Bob Fisher

Perfectly.

Randal Konik - Bear Stearns

Great. Thank you. So Byron, this question is for you. I just want to go back again on the philosophy here on the buyback and cash flow. It's because I just viewed the numbers off the quarter, almost 3 billion in cash paying down 300 in debt, 2.6. 260 in dividend. I am left with over or nearly $2.3 billion of cash and when you talk about the pause, how long was that pause? And can you talk about free cash flow and your outlook on free cash flow as it has gone down to free cash flow of 500 million? Do you think we have reached the bottom or trough in the free cash flow? Or how do you kind of think about that since we gone from the free cash flow of 1.9 billion in '03 down to 500 million and given that you are not buying back stock?

Byron Pollitt

Okay.

Randal Konik - Bear Stearns

Thank you.

Byron Pollitt

Let me see if I can respond to those seven questions. So first of all as I am sure you can appreciate what is happening this year, just to speak plainly, is that we have guided earnings per share 80% to 90%.

So we are guiding earnings a bit under from an EPS standpoint what we achieved last year, which will put pressure on free cash flow. We have also been very clear that we have stepped up our remodel investment in existing stores. In fact, we have approximately doubled the capital expenditure associated with our existing stores to begin to catch up from the failure to keep many of our stores current and brining new stores current is fundamental to our turnaround strategies.

Those two reasons alone explain the difference in free cash flow from '06 to what we are guiding about $500 million in '07. We consider the level of capital spending this year to be above normal, because we are in catch up on existing stores. We also expect with the turnaround to return at some point to positive comps, which should then allow the business to leverage significantly on free cash flow, on top of the initiatives that we are taking today within the SG&A arena, to bring our operating leverage much closer to the ultimate objective of mid-teen operating margins.

So I would say, yes, much work to do, but we are very, very focused on driving increased free cash flow out of all of our business in the years to come.

With regards to the actual balances, you noticed we ended the quarter with roughly $2.8 billion in cash balances. When we guide to approximately $500 million in free cash flow, recognize that not much of that occurs in the first three quarter. It mostly occurs in the fourth quarter. So as we plan out and think about when to go back into the market for share repurchase. We are mindful of the timing of our cash flow; we are retiring a little over $300 million in debt in September, at a point where we are building inventories to our highest level through end of the year, and preparation for holiday selling. We will have paid out at least three quarters of dividend at that point, three quarters of $260 million. And so, we are just being mindful that the business hasn't quite turned yet, that we've already pledged roughly $600 million of that $500 million of free cash flow and given the end of year timing of most of our cash receipts. We think that this is prudent. Having said that, this is May, we have plenty of opportunity to revisit share repurchase as the year unfolds.

Randal Konik - Bear Stearns

To just to clarify with the CapEx requirement seeming to you be down as a percent of sales and in future years, given you said this is above normalized level. Are you then confident and that in the future years that your free cash flow can rise from the '07 projected levels?

Byron Pollitt

Yeah, let me clarify, first of all we only charge capital expenditures one year at a time. What I said was that the amount we are spending this year is about normal because we are in catch up mode with regards to our existing stores. We do not expect to have fully caught up after one year. And we will guide capital expenditures one year at a time.

Randal Konik - Bear Stearns

Much appreciated.

Byron Pollitt

You better.

Bob Fisher

Operator, we have time for one more question.

Operator

Okay. Your final question is from Marni Shapiro with Retail Tracker

Marni Shapiro - Retail Tracker

Hey guys. Thanks for getting me in under the wire. If you guys can talk a little bit about conversion of the stores. We know traffic has been down, but obviously it moves through a lot of units, a lot of that at markdown, but if you could talk a little bit about conversion at Gap, Old Navy and Banana? And if you could also talk about it relative to the marketing that you've put forth whether it's direct mail or television or circulars?

Dawn Robertson

I'll start and take it for Old Navy. The conversion in store and I think you heard Byron talk a little bit about honestly selling through some more units in the first quarter. Some of that was accomplished by better marketing and by marketing by big ideas. If you think about what you've seen us do in the first quarter and primarily from a media point of view in television, our television has worked more effectively for us in the first quarter than it has in the past, and very focused. It has been very focused in the big ideas which has helped drive traffic to the store but has helped conversion in the store.

So, for example, dresses drove a lot of people in the stores. They were converted once they got there. Short shorts drove a lot of people in the stores. They converted and bought other shorts when they are there. And now swimwear is really driving people in, but that conversion of being in stock when they get in, having exciting presentations when they get in and having that alignment of marketing between circulars, television and outer media is beginning to work, which is helping our conversions. That has helped us, also, by using our space productivity better. You heard me talk about in-camp, getting that stage productivity, that has helped convert customers once they are there. So, all of those things working together have helped us in Q1.

And Marni, with regard to the other two brands really briefly, I would say that really the issue has been more pressure on AUR with Gap and Banana in the first quarter because we talked about the challenge with women's pants and with some of the mark downs. So, if you think about the overall comp we've reported, we've done pretty nicely at both brands against their traffic comp, which means in general their other comp levers are fairly neutral taken together. But I would say conversion hasn't changed dramatically at either brand. We are somewhat offsetting the pressure we've seen on AUR at those Banana and Gap in the first quarter.

Marni Shapiro - Retail Tracker

Great, that's very helpful. Thanks and good luck with the fall season in summer.

Dawn Robertson

Thank you.

Evan Price

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

Operator

This concludes today's conference. You may now disconnect.

TRANSCRIPT SPONSOR

MF logo

Did the analysts get it right?

Wall Street hires some smart cookies. But it’s not always in their best interest to put the hard questions to management. Are YOU even their top priority?

Motley Fool co-founder Tom Gardner is still bullish on Gap. Since April 2002, The Motley Fool's Stock Advisor picks are up 69.18% vs. just 32.02% for the S&P 500. Now, discover the companies David and his brother Tom recommend in their free research report “The Motley Fool's 2 Top Picks - Plus Wall Street's Dirtiest Secret.”

Read the complete report courtesy of Seeking Alpha FREE.

* Returns as of 6/12/2007

To sponsor a Seeking Alpha transcript click here.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: The Gap Q1 2007 Earnings Call Transcript
This Transcript
All Transcripts