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Gap Inc. (NYSE:GPS)

Q3 2007 Earnings Call

November 21, 2007 11:00 am ET

Executives

Glenn Murphy - Chairman and CEO

Sabrina Simmons - EVP of Finance and acting CFO

Evan Price - VP of IR

Analysts

Dana Cohen - Banc of America

Brian Tunick - JP Morgan

Jeff Black - Lehman Brothers

John Morris - Wachovia

Paul Lejuez - Credit Suisse

Janet Kloppenburg - JJK Research

Adrienne Tennant - Friedman Billings

Lorraine Maikis - Merrill Lynch

Kimberly Greenberger - Citigroup

Jennifer Black - Jennifer Black & Associates

Jeff Klinefelter - Piper Jaffray

Todd Slater - Lazard Capital Markets

Michelle Tang - UBS

Lauren Levitan - Cowen & Company

Operator

Good morning, ladies and gentlemen, and welcome to Gap Inc.'s Third 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 downloaded without Gap Inc.'s express 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 may 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 morning everyone. I would like to welcome you to Gap Inc.'s third quarter 2007 Earnings Call.

For those of you participating in the webcast, please turn to slides two and three. 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 our quarterly report on Form 10-Q for the quarter ended August 4, 2007, and today's press release, which is available on gapinc.com.

Future economic and industry trends that could potentially impact net sales and profitability are difficult to predict. These forward-looking statements are based on information as of November 21, 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 principles measures, free cash flow and diluted earnings per share excluding Forth & Towne's net loss and expenses associated with the company's cost reduction initiatives, which under SEC Regulation G we are required to reconcile with GAAP. The reconciliations of these measures to GAAP financial measures are included in today's earnings press release, which is available on gapinc.com.

Joining us on the call today are Chairman and CEO, Glenn Murphy and EVP of Finance and acting CFO, Sabrina Simmons. Now I'd like to turn the call over to Glenn.

Glenn Murphy

Thank you, Evan, and welcome everybody. Thank you for joining us on this Thanksgiving eve. I'd like to make a couple of general comments and then I am going to hand it over to Sabrina, who will take you through the third quarter financial results.

There are a couple of common themes in our financial performance in the third quarter I would like to touch on. First and foremost, we continued with our disciplined inventory management, which we have been quite disciplined around last 12 months. At the end of the third quarter, our inventories were actually down 8% on a per foot basis. Also, we had some cost reductions. The majority of the cost reductions in the quarter came from $75 million reduction of marketing expenses.

Beyond the financial components in the third quarter, I want to just touch on that we continue to push the notion of simplification. And we really are pushing down responsibility and accountability into the brands. We filled a number of key executive positions in the quarter that we feel good about. And lastly, we launched a co-branded visa card across all our brands in September of this year and while it's early days, we actually feel good about the consumer response to-date.

As we look forward to this long weekend selling season, two of our brands really participate at a higher level when it comes to the Thanksgiving, the Black Friday and the selling season that ensues on the Saturday and the Sunday. First and foremost, that's Old Navy, and Old Navy will be opening almost all of their stores, 90% to be exact at 5 o'clock in the morning this year, and that compares to 7 o'clock in the morning last year.

More importantly, Dawn and her team really have a fully integrated marketing campaign going on for the Thanksgiving. We started the Thanksgiving selling season and going right through to the end of the holiday. It's much more fashion-conscious than it was last year, and brand-appropriate. And I think what I like about it, it has a weekly promotional cadence that's unique each and every week, which will bring value to that 20-something consumer on a weekly basis starting again this week and going right through the end of holiday season.

Tom Wyatt and his outlet team will be opening 170 stores at Midnight this year, and that compares to 70 stores last year. And they also have a much more compelling value propositioned and product offering than they did in 2006.

Our Gap and Banana Republic brands have made positive strides on their product offering for the holiday season. The Gap brand is all about color and the theme of that is Crazy Stripes. As a matter of fact, I am wearing a Crazy Stripe sweater as we speak.

Judging by the reaction from our employees, and I was in stores with Marka and her team in Ohio, this past week. We spent a full day in the stores in Columbus and judging by employee reaction, people feel good about the product offering and how they are positioned for the holiday season.

At Banana Republic, the theme is sharing the gift of color and Jack and his team are really focused on bringing better gift ideas that are brand appropriates to what Banana Republic stands for in the marketplace.

As we look forward, there are a number of key areas the business is focused on and we're trying to anchor people's time and effort around some key components for our business to be successful going forward. First and foremost it's about product, being innovative and creative and ran right across our portfolio brands.

We are looking forward to the work that Patrick Robinson and his team are going to bring to the marketplace in the New Year. And I know that Todd Oldham, because I was e-mailing him last night, has been in San Francisco a number of times working with the design team at Old Navy and I think Dawn's reaction so far has been positive with Todd, and we're looking forward to the differences he's going to make on the fashion forward product that Dawn's going to have in 2008.

Return on invested capital is an important theme for the business next year. One of the sub-components of that is going to be the real estate strategies that the brands have just begun to do some work on. There is a lot more work to do, it's a large fleet. It's somewhat complicated but we are committed to getting the real estate strategies in place and that will definitely help us become more disciplined and tightened up our process when it comes to return on invested capital.

Productivity and cost, all great and successful retailers are continuously finding ways to become more productive, more efficient. How do you take real dollar cost out of your business, and in some cases use that leverage of your company to reinvest those dollars into your business, consistent day-in, day-out store execution. We know that's critical in the success of our business. How do we marry up great product development with making that come alive in our stores each and everyday? And our field teams are very focused on their service models for each one of the brands in 2008 and how do we make sure we deliver again on that consistent day-in, day-out store execution.

And lastly people, we want to retain the right people in our business. We want to attract people where appropriate, where we have some opportunities and everybody in our business understands that we are in a financial turnaround and we will execute on our financial turnaround. And they are looking forward to actually accomplishing that and are motivated and focused, and I continue to be impressed by the people I meet each and everyday in our business, whether it's in our product and design area, whether it's inside of the corporate functions, inside the brands, and most importantly when I spend time in the store. So, I think we have very good people in the business today who are committed to the success and our goal is to make sure we retain and attract the best talent for the future.

Before I hand it over to Sabrina, it's worth noting that it has been well written and documented. We also feel this is going to be a tough economic environment in this upcoming holiday selling season. We feel good that we've been disciplined on the inventory front and that we are becoming more and more conscious about our ability to reduce cost, and the consumer will ultimately be the judge. But we feel we're well-positioned for the holiday season. We are also very clearly aware this is going to be a tougher environment than we faced last year.

Having said that, let me hand it over to Sabrina who will take you through the financial results for the third quarter. Sabrina, over to you.

Sabrina Simmons

Great. Thank you, Glenn. Good morning everyone. I'll begin today by reviewing third quarter performance and then I'll take you through guidance for fiscal 2007. First, highlights for the quarter.

For webcast participants please turn to slide 4. Net earnings increased 26% to $238 million, diluted earnings per share increased $0.30 per share from $0.23 per share last year.

Operating expenses decreased by $82 million, driven almost entirely by $75 million reduction in marketing expenses. We repaid $326 million in debt and finally we repurchased 48 million shares during the quarter for $887 million. This resulted in weighted average diluted shares of $791 million for the quarter.

Please turn to slide 5, sales performance. Third quarter total sales were $3.9 billion, flat to last year. Total company comp store sales were down 5% in the quarter versus down 5% last year. An important contributor to the spread between total sales and comp sales was the continued growth of online, which grew 36% to $247 million. Please refer to our earnings press release for total sales and comps by division.

Turning to slide 6, gross profit. Third quarter gross profit was flat to last year's $1.4 billion. Gross margin was 37.5%, up 10 basis points compared to last year. Merchandise margins improved 100 basis points, which was partially offset by 90 basis points of occupancy deleveraging.

Please turn to slide 7 for operating expenses. Third quarter operating expenses were $1.1 billion, down $82 million from last year, driven by a reduction in marketing expenses of about $75 million. As I will discuss in more detail shortly, substantially all of the second half savings we anticipated in marketing, were realized in the third quarter. Marketing expenses for the quarter were $124 million versus $199 million last year. This decrease was primarily driven by reductions at Gap and Old Navy.

Turning to inventory on slide 8. We ended the third quarter with $2.5 billion in inventory, down 5% over the third quarter of 2006. Inventory per square foot was $59, 8% less than last year. As we enter holiday, we are comfortable with our inventory levels at each of our brand.

Please turn to slide 9 for capital expenditures and store count. Year-to-date capital expenditures were $519 million. We opened 187 new stores and closed 127. This includes 19 Forth & Towne closures and 45 Old Navy outlet conversions. Companywide, we ended the quarter with 3,191 stores and square footage increased 2% from fiscal 2006 year end. Our press release contains more information about our store count and square footage.

Regarding cash flows on slide 10. Year-to-date free cash flow, defined as cash from operations less capital expenditures, was an inflow of $484 million compared with an inflow of $214 million last year. The increase was driven primarily by lower inventory level.

Another factor contributing to the increase in cash flow, was a change in our vendor terms implemented in the third quarter. As part of our normal business practices, we periodically benchmark vendor terms within our industry. Based upon this review, we determined that there was an opportunity to modify our terms to be more in line with our competitors. This change became effective on September 1st.

Please refer to our press release for a Reg-G reconciliation of free cash flow. We ended the third quarter with $1.7 billion in cash and short-term investments. We repaid $326 million in debt, leaving $188 million in funded debt on the balance sheet. With regards to cash distribution, we repurchased a total of 48 million shares in the third quarter at an average price of $18.39.

Turning to slide 11, our outlook for 2007. We are updating our guidance for the following metrics. We now expect full year 2007 diluted earnings per share on a GAAP basis to be $0.92 to $0.98 per share versus our previous guidance of $0.83 to $0.88 per share. Our upward revisioning guidance is primarily attributable to the third quarter improvement.

Our outlook remains cautious for the remainder of the year. The rationale for our perspective is as follows: The fourth quarter is our most important selling season of the year. Given that we are still in a turnaround, it is difficult to predict how the product will be accepted and the macroeconomic environment weren't cautioned.

I'd like to now spend a few minutes providing context on the waiting of expected earnings between the third and fourth quarters. Our guidance implies the relationship between the two quarters, that is atypical from past years, and this is largely attributable to the timing of the marketing saving.

We've previously stated that in the second half of 2007, we did not intend to spend the incremental marketing that we incurred in the second half of 2006. That incremental marketing amounted to about $80 million in the second half of 2006. Due to a number of factors within our operating division, substantially all or $75 million of the expected second half savings were realized in the third quarter. As a result, we do not anticipate further significant reductions in marketing expenses in the fourth quarter versus last year.

I'd like to draw your attention back to slide 11. As you'll see in the second of half of 2006, we increased the marketing spend by $48 million in the third quarter and $33 million in the fourth quarter. This equates to about $0.04 and about $0.03 of earnings per share, respectively. Given the timing of when the marketing savings were realized this year that implies about $0.03 of earnings that you may have expected in the fourth quarter have been achieved in the third quarter of 2007. This shift is the primary driver of the unusual waiting between the two quarters.

Turning to slide 12, the balance of our guidance metrics. We still expect expenses related to our cost reduction imitatives to be about $35 million pre-tax for the full year, with approximately $6 million of related expense in the third quarter. This brings our year-to-date total to about $32 million. Excluding about $0.07 per diluted share of expenses associated with the cost reduction initiatives and the closure of Forth & Towne, we've revised our full year 2007 guidance to $0.99 to $1.05 diluted earnings per share from the previous guidance of $0.90 to $0.95.

Please refer to our press release for Reg-G reconciliation of diluted earnings per share excluding Forth & Towne and our cost reduction initiative.

We now expect gross interest expense for the year to be about $28 million down from $35 million due to the reduction of interest accruals resulting from tax audits and other tax resolutions completed during the quarter.

Due to our upward revision in earnings, coupled with a continuation of disciplined inventories and a change in our payment term, we now expect free cash flow for the full year to be about $900 million. Our press release contains a Reg-G reconciliation of free cash flow for your reference.

We are reaffirming our guidance for the following metrics: Full year operating margin in the high single-digits, percent change in inventory per square foot at the end of the fourth quarter down in the mid single-digits on a year-over-year basis.

Stores: We expect to open only 30 stores on a net basis, yielding a full year net square footage increase of about 1%. Store guidance by division is available on gapinc.com. Full year capital expenditures about $700 million, full year depreciation and amortization about $550 million, full year effective tax rate about 39%.

I would like to close by saying that while we were pleased with some of the progress we made in the third quarter, we've recognized there is a lot of work ahead of us. The volatile and uncertain macroeconomic environment reinforces our commitment to return excess cash to shareholders and to maintain disciplined inventory management and expense control. By focusing on what we can control, our intention is to improve our margins as we deliver for our customers.

And now I'll turn it back over to Evan.

Evan Price

Well, that concludes our prepared remarks. We will now open up the call to questions. We'd appreciate limiting your questions to one per person.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question is from Dana Cohen with Banc of America.

Dana Cohen - Banc of America

Hi, good morning, guys. Two things on the SG&A. Can you just talk about with marketing having been up $35 million in Q4 last year, not seem to pay back. Why you would be spending the same amount? And then as well, there is then the 100 million of SG&A cuts coming out of home office, doesn't sound like you got any other benefits in Q3, should we start to see that in Q4? Thanks.

Sabrina Simmons

Yeah. So, on the first piece on Q4 SG&A, we are realizing some savings in some divisions. Obviously, Gap brand isn't running four weeks of television in Q4 that they ran last year. That said, we have seven operating divisions and so we are choosing to make some selective investments that are offsetting some of the savings, for example, in Gap brand. So, one example that I'll take, as Glenn mentioned, we did launch our co-brand credit card in the third quarter, and so we are choosing to make selective investments in that program in the fourth quarter. And then, just remember we have the other operating divisions internationally, as well as outlet, as well as online. So, there is lots of moving part, so we are reducing for example, the television at Gap brand. So, that's the first question.

On your second question, regarding overall savings, as a reminder, we said that given our headcount elimination, we would expect savings of about $100 million on an annualized basis which, using simple math, is about $25 million a quarter. What we are seeing in the third quarter is we were still finishing some of those cost initiative. So, we wouldn't anticipate the full effect. What we've seen in savings in non-marketing areas, is $7 million, but remember in our reported SG&A, we have about $5 million kind of severance one-time cost initiative expenses included. So, what you really have is about $12 million of non-marketing savings in the third quarter. So, there too we are electing to make certain investments that are offsetting some of the savings we are seeing in areas in our online division, for example, that's driving very healthy 36% revenues improvement, we're selectively making decisions to invest there. So, we think the number makes sense. That said, we of course are very focused in continuing, as Glenn has said to manage our expenses on every line item.

Dana Cohen - Banc of America

Great. Thank you.

Operator

The next question is from Brian Tunick with JP Morgan.

Brian Tunick - JP Morgan

Hi, thanks. I guess our question, sort of a bit on Old Navy. We went back and listen to what Dawn had said a couple quarters ago and talked about the strategies and process, so we're just trying to understand. What do you think Glenn, is happening in Old Navy and besides Macro, why don't think that business is getting any better?

Glenn Murphy

Well, what I would say, Brian, is that Dawn is going through quite the evolutionary change in her brand and these things take time, and what you probably witnessed in the third quarter was not across the entire offering within Old Navy. There were some challenges within women's in particular, and not within men's and babies and kids.

She is really trying to institute again. It's an evolutionary change in her business to get it focused on her key core customers going forward and these changes take a little bit of time. As I mentioned in my opening comments, I'm finding from a marketing alignment to what the brand targeted customer is going for an Old Navy.

We are going to see the first of that really hitting this holiday season starting with the Thanksgiving program she has in place of running right through the holiday. That's the first time that she will have everything fully integrated to where the brand positioning needs to be. So, whether if she was talking September-Octoberish and there were some challenges on women's I think, then we'll get a better read on her new marketing position to her key brand customer in this fourth quarter.

Brian Tunick - JP Morgan

Okay thanks and good luck

Operator

The next question is from Jeff Black with Lehman Brothers.

Jeff Black - Lehman Brothers

Yes thanks, good afternoon everybody. Glenn, I know it's early on, but can you tell us at least your thoughts bout the existing remodel program. What might be the fate of that program, as we head into next year? Do we morph into something a little different? Do we table this until we get something better etcetera. Any thoughts on that, much appreciated, thanks.

Glenn Murphy

I'm waiting to get a better read to be honest with you. Some of the, I guess we are not different than many other retailers, some of the remodeled program is backend loaded. I hate to make any harsh decision after a month of sales or even three months of sales. So I'll have much better read for you sometime early next year about the remodel activity we've gone through.

Having said that, to support the fact that there is an aging component to our fleet, there is a certain amount of remodeled capital we have to put into our stores, whether that is wholly defined as maintenance capital in fitting rooms and cash raps and HVAC, some of that has to take place.

We are also spending quite a bit of time with the teams right now defining what different levels of remodels, which I don't think we've really had in the past. And trying to define as we have our real estate strategy set and better understood, by market what kind of capital should we be spending if any, in selected stores that will support our overall market strategy.

So, that work has been put into place right now, but what we're going to end up with is some stores may not be worthy of a remodel, in some cases it may be a minor remodel what people in the industry call it cheap and cheerful. In some cases it might be worthy of a full [gut].

These are all decisions that I think when you really understand what your strategy is by each one of the brands, by market, become much easier decisions to make, so more to come on this. When we speak to you at the end of our fourth quarter, and at which point we'll be talking a little bit forward about 2008.

Jeff Black - Lehman Brothers

Great. Good luck in holiday. Thanks.

Operator

The next question is from John Morris with Wachovia.

John Morris - Wachovia

Thanks, good morning. I guess, first of all, relating to the cost savings as we look out into next year, have you identified further potential for non-marketing cost savings into next year? And Sabrina, assuming that that's kind of a $25 million quarterly that you're talking about, would you continue to reinvest some of that into further investments like you talked about the co-branded Visa Card into next year, and what would those investments be. So really kind of cost savings into '08?

Glenn Murphy

Yes, John. A quick comment just before I hand over to Sabrina to get into some of the detail. One thing we have done in the last number of weeks is, we've broken down SG&A. I think it’s, SG&A is a total pool of cost. We've worked hard with the teams here to get down to 30 to 50 significant cost centers, and ultimately those all add up to an SG&A number.

We've really got focus in the business down to much more detailed information, all the elements that make up SG&A. So that work again has just begun. And we're going to be looking at all of those elements across all of our brands from the corporate entity all the way down to divisional business and finding ways to take out non-value added cost and make sure that we are simplifying the business and working hard to get more productivity and efficiency out of the company.

I'll let Sabrina answer the second part of your question.

Sabrina Simmons

Yeah, John. Overall, as a reminder, we definitely have eliminated the positions that represent about $100 million in annual savings. That said, as we enter every year, just like every retailer, there is momentum for pay raises, for inflationary items etcetera that we have to battle against.

So part of our job, as we enter a new year, is to make sure that we're really capturing the savings and working really hard to offset the natural momentum on expenses that you have as you enter each and every year. So, we are very focused on that.

In addition, we will make choices where, we believe, we will get a return for making the expenditures. So, I used again online business and our investment in marketing for our co-branded credit card as examples. We think those are smart decisions. So, there will be some of those shifts, but overall, as Glenn said, we will be looking on a continuous basis to every line item to look where we can simplify and reduce.

And as a reminder again in '07 not only did we eliminate the headcount, but we also closed the distribution center, and then we've consolidated some of our office space in San Francisco and San Bruno, in particular, and that should bring us about $10 million in annualized savings as well.

John Morris - Wachovia

So, you are saying that you would continue to see further non-marketing cost savings into next year, correct, because of some of those headcount reductions?

Sabrina Simmons

We are absolutely working to reduce our cost base. That said, we have some offsets that are going to go on in terms of momentum entering a new year and investments we choose to make. So, we are capturing savings on an annualized basis from our actions.

John Morris - Wachovia

Okay, thanks. Sorry, go ahead.

Glenn Murphy

Also, we are trying to shift a notion of one time to the concept of perpetual, and this is just the market in which we operate. I know we are against a very highly competitive set of competitors here in North America and around the world. We have to make sure we're perpetually trying to find ways, innovative ways, creative ways to get costs [out] of our business. The business is committed to doing it. These things do take time. Round one is just identifying what we're willing to do and then we choose a time in which we're going to execute on taking those costs out of our business.

John Morris - Wachovia

Very helpful. Good luck for holiday. This of course looks great. Thank you.

Operator

The next question is from Paul Lejuez with Credit Suisse.

Paul Lejuez - Credit Suisse

Hey, thanks guys. Can you just give us a breakdown of how many Gap adults [versus] kids, baby, and body’s there are, maybe talk about what the right numbers are for each of those going forward. Glenn, maybe you have some initial thoughts. And then just a second, you're a few months into monthly flows at Old Navy. Are you are finding that the systems in DCs in place are adequate to handle that or are there pieces missing?

Sabrina Simmons

You know, I'll just start. Just reminding, Paul, sort of where we are at in store count. So, I'll talk more in concept, because many of our boxes contain kids and body and adult. So overall we have about 750 adult concepts, we have about 700 kids and baby concepts and we have about 200 body concepts.

Glenn Murphy

And I would think that that, if Marka was joining us today, I mean, she would admit that her portfolio of stores is a little bit more disaggregated than she would like it to be, and that's why I think the work has begun, led by Eric Bauer within the Gap brand business, to really be crystal clear on what the outcome on the real estate strategy they'd like to have over the next five years. That will drive decisions and will drive priorities. But there is definitely a need to make that portfolio a little more in keeping with how we believe we should be presenting ourselves to the consumer going forward.

On the distribution center front, Don's work at Old Navy, in terms of a month flow there has been some of that taking place in November and December. But the real move to her new flow of products on a monthly basis will begin in February. And yes, our distribution centers have been working in a parallel way with people in Old Navy to make sure they are prepared. We didn't have to make any significant capital adjustments inside the DCs, they are really just process adjustments from the vendor to our DCs out to the stores, and all that work has been going on for the last three to four months.

Paul Lejuez - Credit Suisse

What about the design system in general, I mean is everything smooth flowing on the Old Navy side with the monthly flows?

Glenn Murphy

Again I think it’s early days. We are making quite a change from the way we used to flow goods, the way we flow goods today. And I think there were some categories that were embarking on a monthly flow this fall. But in terms of the entire store, we will see that starting in February, and of course we've made, knowing that we didn't want to do the whole store immediately, we wanted to get a some sort of category by category test at this fall, we will have a much better read. But yeah, whatever adjustments and they were not significant. Again, they're more process adjustments from the vendor to our DCs and into the stores. Those are still being worked on, but I would say are well under control.

Paul Lejuez - Credit Suisse

Thanks. Best of luck.

Operator

The next question is from Janet Kloppenburg with JJK Research.

Janet Kloppenburg - JJK Research

Hi Glenn, hi Sabrina, how are you?

Sabrina Simmons

Okay. Thanks. Good.

Janet Kloppenburg - JJK Research

Glenn, I was wondering if you could talk a little bit about the repositioning of Old Navy? We don't have the advantage of seeing the product for spring in the go forward and I'm wondering if you have confidence in this new positioning of targeting a younger customer and a distinct customer from the old, maybe kids customer. And I'm wondering if we don't see improvement there in the holiday season or in the first quarter, if you would consider cutting the marketing expense for this brand as well. Thanks very much.

Glenn Murphy

No problem. First of all, I want to say that I think when you make the changes that are going on in Old Navy, nothing is set in stone permanently. But I don't mean there is always going to be minor, on emphasized minor adjustments as Dawn and her team learned how customers react to this evolution they are going through at Old Navy.

And the key thing is that we are very focused on the 20-something customer, and I think I believe in that, I think that is the right strategy. Without giving up on the mom which is a critical component to what Old Navy is about. And I think trying to find the right balance is something that the marketing campaign will see a little bit this fall, but definitely in the next spring, is what Dawn and the team are going to strike. I am actually feeling that they are making the right strategic decisions. Now like anything, once the strategy is understood inside that business as how does the execution now in terms of product and marketing, and how does that resonate with customers and how do we make along this journey, the minor adjustments that need to be made as we get good, solid feedback from our customers.

I don't believe personally and I am sure Dawn feels the same way, this is not a massive departure from where we were before and what customers Old Navy have always had and have been loyal to that brand. But yes, it is an adjustment and an evolution from where we have been over the last 12 years. So more to come, we are definitely committed to listen to the customers, hearing what their feedbacks are (inaudible) making necessary adjustments. But overall, at a very high level strategically, I think Dawn is, and her team, are on the right course.

Janet Kloppenburg - JJK Research

And the marketing?

Glenn Murphy

Marketing decisions, I think that, again we are going to get a very early read, as I mentioned in my opening comments, starting this Thanksgiving, her first five-week campaign that is fully integrated to our new customer positioning. We'll see that into the New Year and all of us agree that if for some reason the marketing, whether it's the medium or the overall message is not resonated appropriately, we are more than prepared to make the adjustments necessary. But let’s get a read first and see what customers have to say and see how the stores perform and look at gross margin dollars per foot. And once we have those indicators, obviously, we want to be successful. So we will make the appropriate adjustments.

Janet Kloppenburg - JJK Research

Thanks very much.

Operator

The next question is from Adrienne Tennant with Friedman Billings.

Adrienne Tennant - Friedman Billings

Good morning. My question is on the guidance for the fourth quarter. So, on a similar comp as the third quarter, are you telling us to think that we would not see leverage on the SG&A line. Is that kind of how we should read it?

Sabrina Simmons

You know, Adrienne, we are trying to be helpful by guiding to the operating margin line as well as the EPS line. So just as a reminder, what we've said is a lot of the leverage because we've got over 2 points of leverage on operating expenses in the third quarter and some of that leverage came from the very large marketing expense decrease and the shift out of the fourth quarter into the third. So I'll just leave you with that notion.

Adrienne Tennant - Friedman Billings

Okay. And then I guess, as you are looking at the mall traffics obviously, it's still down it seems. Are you seeing kind of an offset uptick, I mean clearly the direct business is growing, but are you seeing even the more so kind of offsetting some of the weakness that's happening in the malls?

Sabrina Simmons

That can be part of our online increase. It's always hard to say. There has been a decline in overall mall traffic, but our traffic has been negative for quite sometime. So we work all of our other comp levers to try and offset that. Overall in the quarter, in the brands where we were able to overcome and deliver a comp that was better than their traffic comp, we've actually seen those conversion in AUR support the delivery of that.

Adrienne Tennant - Friedman Billings

Okay. Thanks so much and good luck.

Operator

Your next question comes from Lorraine Maikis with Merrill Lynch.

Lorraine Maikis - Merrill Lynch

Thank you, good morning. You’ve been very smart about your inventory buys in this tough macro environment and you were just curious to hear when you will feel confident enough in the product and in your traffic levels to start boosting that buy a little bit to support comps? Thank you.

Sabrina Simmons

Yeah. That's a great question. Our position currently is that we want to continue to buy our inventories at a high level sort of inline with current traffic. We feel that it's really important in driving to our strategy of supporting the probability of getting better regular price selling, and also improving our margins overall, we'd rather add on the side of running out of the few item, than having too much and having to drive back down to markdown and increase the amount of cost sold at markdown. So, I think time will tell, we're watching it closely but in the near term, we are very pleased, especially, given the macro economic climate, in the near term, we don't have an intention of moving off with that.

Lorraine Maikis - Merrill Lynch

Thank you.

Operator

Your next question comes from Kimberly Greenberger with Citigroup.

Kimberly Greenberger - Citigroup

Great, thank you. Glenn, your comments on the Gap real estate strategy were very helpful and I was just wondering if you could, just help us think big picture about what your view is on the Old Navy store base and the future growth there?

Glenn Murphy

Well, I think that my comment about the Gap brand when it came to its real estate position it really applies to all brands, and I think that Dawn and her team and Jack, in Banana Republic and Tom Wyatt in Outlet or at our international businesses, they are all going through the same exercise, and in terms of whether there are new store opportunities for Old Navy, whether there is chances for relocations or expansions or reductions or remodels will all come out of the strategy. It's too soon to predict, we already get there in February. We will have much better indication of what our 2008 capital program looks like. What kind of investments we feel are necessary and needed. And I think sub components of that will be whether it’s new store opportunities.

And I will say to you that, all over North America, there are communities that are growing, that are establishing themselves in different states. And I think it would be inappropriate for us, to not consider opportunities where the average disposable income of that marketplace and the population trends indicate that it's appropriate for one of our brands to enter into that new and developing market.

So, we're going to consider those, we don't want to say there will be no new store opportunities, but as everybody on the phone knows that the focus over the last number of years has been in reducing the fleet and now I think we are going to become a little more disciplined going forward on a return on invested capital, when you marry that up with our real estate strategy I think we will have much better answers for the long-term and I am talking about three to five year internally understood plan of how we're going to invest our capital and ensure we get a return for that capital.

Kimberly Greenberger - Citigroup

Terrific. Thanks, Glenn and good luck for your holiday.

Glenn Murphy

Thank you.

Operator

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

Jennifer Black - Jennifer Black & Associates

Good morning, Glenn and Sabrina. My question really is, what kinds of things if any new things are you doing to drive traffic at Gap. And then, what kind of reaction have you had to the more settled sales line at the Gap brand? Thank you.

Sabrina Simmons

So, what we find Jennifer is that, traffic is typically for us a lagging indicator. So, Marka and his team have been very, very focused obviously in improving the product assortments and improving the store presentation. And what we look to initially is signs of improvement is whether we're actually driving healthy margins, whether we are driving growth margin dollar improvement.

We feel that when those signs appear and we start driving a healthier business in terms of more regular price selling, you naturally start to get back some of your traffic. We saw this half with Banana Republic several years ago. So, traffic again will be more of a lagging indicator. With that said, we are still committed to doing what we can with the marketing dollars that we have committed for the seasons to drive traffic.

So, we've chosen not to do television, but we very much are investing in marketing for the important holiday season. We are continuing to do magazines. I am sure you've seen newspaper, outdoor, so we are committed to keep our brand top of mind and present to the customer, the more improved product assortments and store experience.

Jennifer Black - Jennifer Black & Associates

Great. And the subtle sales signs in Gap, have you had any response?

Sabrina Simmons

Well, we are probably talking about what's going on recently on November sales, Jennifer.

Jennifer Black - Jennifer Black & Associates

Okay, great. Thank you very much and good luck.

Sabrina Simmons

Sure. Thanks.

Operator

The next question is from Jeff Klinefelter with Piper Jaffray.

Jeff Klinefelter - Piper Jaffray

Yes. Just a question on sourcing, hearing more about some sourcing pressures coming out of Asia and specifically China, I'm curious, more on Old Navy where it seems to be impacting the lower cost providers in the apparel industry, as you look forward into '08. Are you anticipating that there would be some of these pressures and are there strategies to sort of diversify your sourcing base to avoid that?

Glenn Murphy

I think there is always going to be pressure, this is the never ending talk between suppliers and retailers. There is no question we are aware of commodity price increases, but I will say that we are a large company, we should be bringing the increasing level of efficiency and leverage, given our size into the marketplace.

Have we seen signs today? The answer is, no. We, as a business, is very prepared and poised to make sure that we can, if there was to be market increases across the board, that we can make sure those are minimal with side of business and we would have offsets against it. The answer is also, yes. But right now, no indication.

Again, we are benefitting from $16.5 billion in sales that we could bring to the marketplace. We have very strong sourcing hubs around the world and they are working with vendors to make sure that we are getting speed, the quality that we ask for when it comes to our relations with these partners and making sure we are getting the cost of goods that we actually deserve given the size of this business. So, we are aware of the macro issues, but we believe we're well positioned to manage accordingly coming into the New Year.

Jeff Klinefelter - Piper Jaffray

Okay. And Glenn, just one other thing, in terms of your Asian expansion through a licensing franchising, would any more aggressive expansion on that front wait until after you see more of a stabilization or recovery of your US business, is that, what is contingent on?

Glenn Murphy

I think it's early days. We definitely dip the toe in the water in Asia with some franchising arrangements we've made. We'll have definitely more to speak about on that front in 2008 because most of those stores didn't open until this late summer and early fall and it's too soon to get a read on them, but we are believers in the initial strategy.

We think there is some long-term potential in our franchise business and as we get a better read, we'll be happy to discuss them in forums such as today, so that people know what the long-term opportunity may be for an expansion, similar to the one we've currently embarked on with franchise businesses in Asia.

Jeff Klinefelter - Piper Jaffray

Thank you

Operator

The next question is from Todd Slater with Lazard Capital Markets.

Todd Slater - Lazard Capital Markets

Thanks and good morning.

Sabrina Simmons

Good morning.

Todd Slater - Lazard Capital Markets

I want to be the first to predict Crazy Farrell's for holiday '09. Well, I was going to ask a little bit more about the international sort of the piggy back conversion on capital, because you've got both owned and franchise stores, obviously depending on the geography. Although most of the newer initiatives have been on the franchising side. So maybe you can just tell sort of how much income that's generating from franchisees and sort of what line item does it hit in the P&L. And maybe you could also just talk about what your outlook is for Piperlime? Thanks

Glenn Murphy

Just on the franchise side we don't break it our right now and have no intention of doing that going forward. What I would say, it's again, it’s early days. It's obviously a business that we would be watching carefully, reading it, understanding it and we've a very talented team under the leadership of Art Peck. Who are doing some work on the franchising side. It's got an attractive return on capital as you would expect, which is good to see. And I think we're going to be looking forward to anniversarying some of those stores early part of 2008 and getting a better understanding of what the potential and long-term growth opportunities and investments will be in franchising.

Todd Slater - Lazard Capital Markets

But on the own side, I mean, do those stores have, I don't think those stores have comped positively since 2000 in its return on capital. Anything to talk about on the, in the UK, Japan, Ireland and France?

Sabrina Simmons

So, Todd we've been working on our fleet internationally. Japan, is actually a very healthy business in terms of return on cash flow, in particular. If you think about their model, we are often within department stores. And so we have a variable rent agreement within those department stores. So that's a pretty solid healthy model, although there is always opportunities to improve it.

In Europe, there have historically been more challenges. Those leases are longer term in nature and the rents can be high. So, we have been working in Europe to improve the state of the fleet. We're looking -- we've been looking at some closures and those are within our closure accounts. We also think there is still great opportunity within Europe. We've opened some concession stores, so in Ireland for example and that's been going very well.

Todd Slater - Lazard Capital Markets

Okay great, that's helpful. And on Piperlime?

Glenn Murphy

Well, Piperlime I think, we just had the anniversary of the Piperlime launch. Toby has a great track record of bringing new brands to market on the online business, so far so good. He is exactly on the plan he'd like to be on. I think he will continue to grow that business. It's a nice -- it's a very nice compliment to our apparel brands.

And I think that, we are -- even though it's not a very large opportunity, I think it's a nice compliment what we have today. And Toby, certainly is putting the right steps in place to get us to the sales that we want to get to and ultimately to the profitability level we believe we can get out of Piperlime.

Todd Slater - Lazard Capital Markets

Thank you.

Operator

Your next question is from Michelle Tang with UBS.

Michelle Tang - UBS

Great thanks. I was wondering if we could get a little more color on the merchandise margin improvement in the quarter. I think you said it was up a 100 basis points. What did it look like on an IMU versus markdown basis? And also the occupancy deleverage was higher than I would have thought given the comps. So, perhaps a little more color that we could get on the occupancy deleverage in the quarter and then how we should think about it for fourth? Thanks.

Sabrina Simmons

Sure. So a couple of things, Michelle, on our merchandise margin side, I would say overall, we were pleased that that improvement was driven by a higher percent of goods sold at regular price. So that is right on with our strategy. The second lever that supported the improvement in merchandise margins was our markdown margins were very healthy. So, those are the two primary drivers, I wouldn't say there is any major change in IMU, certainly from a pricing perspective overall. We're not looking to change that significantly. We're working always to reduce our average unit cost, but I would say overall, it's more regular price selling and better markdown margins.

With regard to the ROD deleveraging, if you're comparing it perhaps to Q2, we did deleverage a little bit more and some of that is simply attributable to higher remodel activity in Q3 of this year, where we accelerate depreciation. So you get a little bit more depreciation going from that activity.

Michelle Tang - UBS

Great, thanks. And I guess just looking at Q4 also, it seems like the gross margin compare is pretty meaningfully easy, I was wondering if there is any major offset either because of the 53rd week or anything else that we should be aware of that make fourth quarter more challenging on the merchandise margin side?

Sabrina Simmons

I don't think there is anything to call out in particular at this time.

Michelle Tang - UBS

Perfect. Thank you.

Operator

The next question is from Lauren Levitan with Cowen & Company.

Lauren Levitan - Cowen & Company

Thanks. I also wanted to follow-up a little bit more on the merchandise margins. Given in Q4, you were up against, I believe, it’s about 450 basis points in decline over the last two years. On the lean inventories, we would hope that you would show again those merchandise margin improvement. I'm just curious if you could give us some sense as to whether or not there is anything in the competitive environment, in the pricing environment that would prevent you from over the next several quarters from getting back to, sort of the average merchandise margins that the businesses have generated? And then related to that with respect to Black Friday, just curious if the stores that opened, in the outlets that opened at midnight last year and the Old Navy's that opened further last year, if the sales in those incremental hours were sufficient to justify being opened? And what kind of offers are going to be out there to compel people to make those kinds of trips versus going to a big box retailer in the [hybrid] side or discounter who might have much higher ticket items discounted during that door-buster kind of timeframe? Thanks.

Sabrina Simmons

Hi Lauren, it's Sabrina. I'll start with the margins question. And I think the best way to answer that is, it is clearly our objective to improve growth margin dollars, primarily also gross margin percent. Part of that strategy is supported by our lower inventory level. So a lot of the result, of course, depends on how the customer will vote and that is uncertain, especially in this environment. So, do we feel like we are taking the correct steps, not only with our inventory levels but also with the teams in the brands working on the assortments and improving the assortments and point of view in the store and how we're presenting that. We absolutely feel like we are moving in the right direction in taking those steps. That said, there is a lot of uncertainty with regards to, A, how the customer will respond and B, we do anticipate that this holiday season as an example will be highly competitive. So, we have to be prepared to take the actions that will be necessary to move through our unit.

Glenn Murphy

And on the store openings, it's a combination of being competitive to what's going on the marketplace and I think we were proactive historically when it came to store hours. The outlet business, for sure, make sense to open at midnight. I mean, that's really the cash A, of what those outlet centers were all about, and I think we were leaders to get 70 outlet malls last year to move up to a 170 this year. And I think that we really believe working together with all the other brands inside those centers, that's our real plus. I am going to be in Florida for the opening at midnight on one of our big stores in Orlando, and I am very impressed what I heard about last year. And we think that's actually going to be a net positive for us on the outlet business.

On Old Navy, the hours just keep sliding on us. We thought 5 o'clock, when the decision was made by Dawn and his team about eight weeks ago was more than appropriate and competitive and now we have some retailers opening at 4 o'clock in the morning.

There is a point and I can't tell you just yet, until we see the results, but I think from an industry point of view, there is a point where you do get a lot diminishing returns. I think right now, we don't believe that's going to be the case, because we are going to manage our labor appropriately over the 5 o'clock opening to the 11 o'clock closing to make sure there is no incremental labor dollars for us. And the customers are going to respond positively. I think we have a great program in place. As I mentioned, it's fully integrated. That brand lends itself. And I think in some of our locations too, we find ourselves, I don't know the exact number, but we can get it fully later on.

The percentage of our 1,000 stores are located right adjacent to a Best Buy, which we think we get the nice [draft in] of the partnering that goes on with some of those locations. So, you feel good about it. But to be fair, given the fact it is two hours earlier than last year, post Black Friday, you compare, there is a number of people in Old Navy who will be carrying through the numbers, doing the right analysis, and making sure that we make good sound economic decisions going forward.

Lauren Levitan - Cowen & Company

That's very helpful. Thank you and good luck for holiday.

Glenn Murphy

Thank you.

Evan Price

Operator, that will be our last call. So, 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

Ladies and gentlemen, thank you for participating in today's Gap Inc.'s third quarter 2007 conference call. You may now disconnect.

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Source: Gap Q3 2007 Earnings Call Transcript
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