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Gap, Inc. (NYSE:GPS)

Q2 2008 Earnings Call Transcript

August 21, 2008 5:00 pm ET

Executives

Evan Price – VP of IR

Sabrina Simmons – EVP and CFO

Glenn Murphy – Chairman and CEO

Analysts

Lorraine Maikis – Merrill Lynch

Jennifer Black – Jennifer Black & Associates

Barbara Wyckoff – Buckingham Research

Michelle Tan – Goldman Sachs

Jeff Klinefelter – Piper Jaffray

Kimberly Greenberger – Citigroup

John Morris – Wachovia

Marni Shapiro – The Retail Tracker

Jeff Black – Lehman Brothers

Dana Cohen – Banc of America Securities

Brian Tunick – JPMorgan

Richard Jaffe – Stifel Nicolaus

Janet Kloppenburg – JJK Research

Dana Telsey – Telsey Advisory Group

Operator

Good afternoon, ladies and gentlemen. My name is Kara and I will be your conference operator today. At this time, I would like to welcome everyone to the Gap, Inc. second quarter 2008 conference call. At this time, all participants are in a listen-only mode. (Operator instructions) I would now like to introduce your host, Evan Price, Vice President of Investor Relations.

Evan Price

Good afternoon everyone. Welcome to Gap, Inc. second quarter 2008 earnings conference 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 2, 2008. Investors should also consult our quarterly report on Form 10-Q for the quarter ended May 3, 2008, and today's press release. Future economic and industry trends that could potentially impact net sales and profitability are difficult to predict.

These forward-looking statements are based on information as of August 21, 2008, and we assume no obligation to publicly update or revise our forward-looking statements even if experience or future changes make it clear that any projected results expressed or implied therein will not be realized. This presentation includes the non-Generally Accepted Accounting Principle measures, free cash flow and diluted earnings per share excluding expenses related to the company's cost reduction initiative, which under SEC Regulation G we are required to reconcile with GAAP. The reconciliation of this measure to the GAAP financial measure is included in today's earnings press release which is available on gapinc.com.

Joining us on the call today are Chairman and CEO, Glenn Murphy and Executive Vice President and CFO, Sabrina Simmons.

Now I would like to turn the call over to Sabrina.

Sabrina Simmons

Thanks, Evan. Good afternoon everyone. We are pleased that in the second quarter we again delivered on our strategy of achieving bottom line earnings growth driven by strong merchandise margins and cost management.

I'll begin today by reviewing the quarter’s results followed by an update on our full-year guidance.

First, highlights for the quarter. Earnings per share were $0.32 versus last year’s $0.19. Excluding last year’s $0.02 per share of expenses associated with the company’s cost reduction initiative, last year’s EPS was $0.21 versus this year’s $0.32. Please refer to our press release for a Reg G reconciliation of EPS. Driving our earnings, gross margin increased 390 basis points to 38.2% versus 34.3% last year. Operating expenses decreased by $74 million to $965 million and we repurchased 16 million shares for $284 million.

For webcast participants, please turn to slide 4. Second quarter net earnings were $229 million. The effective tax rate was 39% and weighted average diluted shares were 719 million.

Turning to slide 5, sales performance. Second quarter total sales were $3.5 billion, down 5% versus last year. Total company comp store sales were down 10% in the quarter versus down 5% last year. Please refer to our press release for total sales and comp by division.

Turning to slide 6, gross profit. Second quarter gross margin was 38.2%, up 390 basis points compared to last year. Merchandise margin improved by 560 basis points versus prior year, driven by improvements in both regular price and markdown margins. Although occupancy cost deleveraged by 170 basis points, second quarter gross margin dollars increased by 6% to $1.3 billion.

Please turn to slide 7 for operating expenses. Second quarter operating expenses were $965 million, down $74 million versus the prior year, largely driven by reduced expenses related to our stores, some of which are driven by the decline in sales. Please note that last year’s reported expenses included $20 million in pre-tax dollars related to our cost reduction initiative. Second quarter marketing expenses were roughly the same as last year, $82 million this year versus $88 million last year.

Turning to inventory on slide 8. We ended the second quarter with $1.7 billion in inventory, down 14% versus the prior year. Inventory per square foot was $39, down 17% versus down 6% in 2007. Entering August, we remain comfortable with our overall inventory level. As we had shared previously, we’ve adopted the principle of buying inventory broadly in line with current traffic trends. That discipline continues to serve us well in the current macroeconomic environment.

Please turn to slide 9 for capital expenditures and store count. Year-to-date capital expenditures were $208 million. We’ve opened 55 stores and closed 52 stores this year and ended the quarter with 3,170 stores. Total square footage is flat to prior yearend. Please refer to our press release for end-of-quarter store count and square footage by division. Regarding cash flow on slide 10, year-to-date free cash flow defined as cash from operation less capital expenditures was an inflow of $354 million compared with an inflow of $347 million last year. Please refer to our press release for a Reg G reconciliation of free cash flow.

With regard to share repurchases, we repurchased a total of 16 million shares in the second quarter for $284 million at an average price of $17.45. We ended the second quarter with about $1.7 billion in cash and short-term investments.

Turning to slide 11, our outlook for 2008, although we are pleased with our first half performance and the progress we are making, there is still much work to do, especially at Old Navy. Our second half financial strategy for the company remains anchored in delivering healthy margin and managing cost tightly.

Given the volatile macro environment and recent economic indicators like housing and unemployment, which don’t seem to point to any improvement in the second half, we believe our short-term strategy is prudent.

We took both these internal and external factors into account in developing our full-year EPS guidance, which as previously stated on our July sales call is $1.30 to $1.35, up from a $1.20 to $1.27.

We are also updating full-year guidance for the following metrics: Operating margin, increased to about 10%; full year capital expenditures down to about $450 million from $500 million, driven by fewer new stores and remodels. Our guidance by category is about $110 million for new stores, $190 million for existing stores, $100 million for IT, and $50 million for headquarters and distribution centers. Free cash flow: About $1 billion, up from $900 million. Please refer to our press release for a Reg G reconciliation of expected free cash flow.

The number of new stores we expect to open in 2008 has decreased by 15 stores to about 100 for the year, driven primarily by Banana Republic. The number of closures has not changed from last quarter’s guidance and remains at about 115. These figures include about 15 store repositions which are reflected as both an opening and a closing. Please refer to our press release for a summary of store activity in gapinc.com for 2008 store guidance by division.

There are no changes to our guidance for the following full-year metrics. Interest expense remains at about $5 million. Effective tax rate remains at about 39%. Net square footage remains about flat, and depreciation and amortization remain at about $550 million. We are providing our initial inventory guidance for the third quarter and expect the percentage change in inventory per square foot at the end of the quarter to be down in the mid-teens compared to last year, driven primarily by reductions at Old Navy.

In summary, we are pleased with our second quarter earnings result. As we move forward into the second half, we remain focused on successfully executing against factors that we can control such as costs and inventory management and returning excess cash to shareholders.

Now, I would like to turn it over to Glenn who will provide an update on our brands and our business. Thank you.

Glenn Murphy

Thanks, Ms. Sabrina, and good afternoon everybody. Now I have a few comments I want to make before we get to the Q&A session of the call. I want to build, first off, on a few comments that Sabrina made, particularly when we look at the macro environment. There is nothing new from our perspective looking to the second half as we were living through the first – looking at second half as we lived through the first half of 2008 and certainly nothing new from what you have heard from other retailers over the past number of months. The environment is still challenging. We don’t see any reason for any optimism in the back half of the year. We’re managing our business accordingly.

As you can see from our results, we have been very focused on the three key financial pillars that have produced the results you have seen over the last four plus quarters, namely, driving on trying to improve and grow margin dollars in our business, certainly been the number one pillar of our financial strategy. Secondly, reducing real dollar cost; and as we have mentioned before in another calls, we believe the base inside the business was too high and we have done some work on the last 12 months and there has continued to be a runway and more work to be done on reducing real dollar cost inside the company, and lastly, improving our return on invested capital.

That current financial strategy is one that has carried us well so far. We believe we’re going to continue on that front as we look forward to the back half of 2008. The one thing beyond that, we want to make sure everybody is clear about, we recognize the fact that the trajectory of our traffic in our business is unacceptable and while there are definitely consumer sentiment issues and macroeconomic issues, as we look at the traffic in the business and look at the market share leader that we are, it’s unacceptable we have been on this trajectory for a number of years. So, we always want to reassure people, we are doing work behind the scenes and we are getting ourselves ready to play more offensively minded when it comes to getting traffic through the front doors and across the lease line [ph] at the malls in which we’re in.

As I said at the last call, the decision as to when to do that by brand or by month is really premised on, when is the product right, and all the work we have done on brand positioning, target consumer and product aesthetic; when are the stores is right, in order to make sure that the product that gets developed by our talented teams gets presented right to the consumer; when is the marketing message correct and are consumers really willing to respond and be attentive to the messages we are going to have. On those four components, we feel comfortable and confident on. You will see us having to add a fourth component to our three key pillars, which is reversing the trajectory of traffic that we have been on for the last number of years.

Now, let me shift gears and talk about the brand updates. This morning, we put out a press release that announced that Tom Wyatt has become and was announced the President of Old Navy. Tom has done an amazing job in the last six months. He went in clearly, as you all know, as the interim President of Old Navy. Has done a great job getting the team focused on their target consumer, their brand positioning, rallying them around a vision that we think is appropriate for Old Navy.

It’s important for everybody to know, we in the last six months had a full slate of candidates which we met with. We’ve actually been pretty impressed with the candidates that came forward and a number of people actually wanted to run Old Navy. It was an impressive list, therefore, made it a tough decision for us to get to what we got this morning. But the one thing I do know was nice to have choices and nice to be in the position where we could choose the best candidate for the brand who would give us the best chance of being successful going forward.

Tom has exhibited that; he has been tested the last six months. He has done an incredible amount of positive work and the first day he went in there, I told him to run it like he owns it. He has demonstrated to me that he gets that premise in the work he has done to position the brand for future success.

Now, also in the release, we were very clear that we are actively looking for a senior season merchant to work alongside of Tom and to pick up that critical part of the business. In the last six months, through the search we have done, we have met a lot of great candidates. There has been a lot of people who may not have been particularly appropriate to step in to the ultimate role, but have great experience and will be considered as part of this active search we have going on to bring in the senior season merchant to work alongside of Tom in the future.

Let me shift gears and now and talk about Gap. At Gap, the business consumer acceptance was still very positive for the product in July. And I think that’s evidenced by us, but not only the time we are on the stores and talking to customers and talking to our employees, but also by the metrics we look at, like cost sales at Reg [ph] and the healthy margins that business has been running.

I was in New York recently and talked to the teams who do the work for us in product design and in merchandising, and I really believe the work Mark has done to get them so focused on their customer and what Gap is all about, you can really feel it inside that building. Hopefully, July consumer acceptance is the beginning of Gap returning to being very consistent in how they approach and how they design into what their ultimate target consumer is and the brand positioning of Gap brand.

Looking forward, there is some work done over the last year and what we call the influencer campaign. The examples of that are the collect work that is coming up in September, the Pierre Hardy bags that we have done, the artist Ts. A lot of those influencer ideas received a lot of positive PR and in the markets in which they were in, are well received by consumers. But in fairness, they were limited in their scope. So, I think the marketing team are looking forward in the fall and into holiday season of continuing along that relationship that Gap has always had with culture and building on that and finding how well that resonates with its core customer and looking to do that in the fall and going forth in a much more macro way, but not as selective as it has been done over the last six to nine months.

Speaking if I could about Banana Republic, traffic continues to be the issue of at Banana Republic. We’ve spoken about that for the last number of months and we’ve been very focused on the external impact to our traffic, people who are in our competitive setting, specialty apparel, some department stores that we consider to be direct competitors of Banana Republic have been much more promotional that we have seen in the past. There is no question that has put pressure on the traffic in Banana Republic. Having said that, because we are talking about traffic declines going on to a number of months now, we have an equal amount of work going on inside the business, looking at ourselves internally, as we have been looking at the business externally over the last three to four months. As recently as last Friday, I was in some stores with our leading merchants talking about the business, looking at it hind sighted [ph] and talking to Jack Calhoun, our president, like I guarantee on the fall, and there is a lot of effort going on being aware how we manage our business, and how Banana Republic shows up against these external forces, but also not being delusional that there is always – as a business, we should always be looking internally to what the missed opportunities may be for us.

Lastly, I felt it was appropriate to speak a little bit about real estate. The last couple of quarters, we talked about the real estate strategy work we have had going on. That work is now completed, got done at the end of July. I had meetings over the last two weeks with all the brand leaders and the real estate representatives. I want to just refresh everybody that we’ve never had a clear real estate strategy for 3,100 plus stores in our 40 million square feet. That was one of the first observations that were made when new management came in and that work is now completed. It was very much done to what is the role of every single store from its simplest form, rolling that up. What is the role of every store in every market? What is the right size for every single store? How do we take a more consistent approach by market, by store? And now that we have that clearly articulated that fits with the overall brand position of each brand, the real estate strategy is aggregative [ph] of what the brand position is. We now have that information and that’s going to make our lives so much easier and provide clarity inside the business, allow us to make the quicker decisions, and ultimately become the kind of company we should be, which is one that is more agile and nimble and a simpler structure than we’ve had historically.

One element of the real estate strategy I can report on, but clearly not to reason why we did it, was one of the outcomes was what’s going to happen with our square footage. And as we’ve foreshadowed in the past, we believe our points of distribution are fairly appropriate. There’s always going to be some culling of stores that’s going to take place over the next number of months and years of underperformance. That’s always to going happen for any retail company. Our conclusion was we have more square footage per point of distribution than we needed.

It looks to us like we will have the potential to reduce somewhere between 10% and 15% of our square footage over the next three to five years. So the work now is really how are we going to execute on this strategy we have in place and what’s the sequencing of getting that done. But one of the outcomes, and I want to make sure I’m clear on this, this is not the reason to the real estate strategy. Real estate strategies are critical to any business like ours. We need to have a clear understanding of how your portfolio is going to be managed looking forward. But from our perspective, at 40 million square feet, looking at potential opportunity between 10% and 15% square footage reduction over the next three to five years.

So those are my opening comments. Again, thank you for your time. There are questions coming – before we do that, I want to hand it back over to Evan. Evan?

Evan Price

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

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Lorraine Maikis with Merrill Lynch.

Lorraine Maikis – Merrill Lynch

Thank you, good afternoon. I just wanted to ask a question about the SG&A opportunities going forward. You’ve managed to hold the dollars pretty flat in a tough environment, and I was just curious to see what other areas you’re looking at for the back half and into ’09 and if there are other opportunities for cutting there.

Sabrina Simmons

Yes. I think with regards to the back half, as a reminder, I want to be helpful because we don’t explicitly guide to SG&A dollars. But as a reminder, in the back half, we are anniversarying our companywide cost reduction initiatives from last year. So, the comparisons do get more difficult. As we’ve said before, Lorraine, we are looking at kind of across the board every line item, but with some of the bigger buckets being focused around driving continued efficiency in our store payroll, our logistics spend, we think we have opportunities there and then on our cost sales line, really our average unit costing and continuing to keep a strong, strong focus on that. I do want to also mention that it is important to remember that in Q3 of 2007, we actually brought down our marketing expenses significantly. So in that area of marketing, you shouldn’t expect any great or significant reductions in Q3 of 2008 given that we have already brought those down quite a bit.

Lorraine Maikis – Merrill Lynch

Thank you.

Operator

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

Jennifer Black – Jennifer Black & Associates

Good afternoon. I wondered if you could talk about the kind of reception you have had at your Shopping Made Simple web redesign campaign and if what learnings you have had from that? Thank you.

Glenn Murphy

If you are referring to what we call internally as universality, then I think the response is – it is difficulty to measure after five or six weeks, but initial response certainly the buzz that’s going around from people who are heavy users of e-commerce and that is very positive.

For some people on the phone who may not know what Jennifer was asking about is right now you have the ability which no – we didn’t have the ability before, no other e-commerce business with multiple brands like we do have developed an ability to go into the Gap and Banana Republic and Old Navy and Piperlime and buy something from each one of them and check out once in that one shipping fee.

So that is really from our perspective in a world where you are always trying to be innovative and the word we use internally, transformational, which we don’t have as many transformational ideas and concepts as we'd like to have going forward, that’s really something to Toby Lenk and his team worked very hard in the last year to develop.

Initial feedback from customers is very positive. I think it is a little early to get a really good read but you can trust us that we have every metric possible looking at in terms of the baskets in the cross shop between brands and every metric you would imagine we’re looking at intently. But I will say is, I’m pleased we did it. It makes absolutely sense.

I think what the universality allows us more anything else is the ability to consider down the road if there was another tab that we want to develop beyond Piperlime. Those are things that give the flexibility to look at that. Right now, we are very content with the four brands we have but the actual platform gives us those flexibilities that we can consider down the road.

Jennifer Black – Jennifer Black & Associates

Thank you very much. That’s very helpful and good luck.

Operator

Your next question comes from Barbara Wyckoff with Buckingham Research.

Barbara Wyckoff – Buckingham Research

Hi everyone. Historically, Gap and Old Navy operating margins were kind of close together and I’m sure they are far apart now. But how should we be thinking about margins by division, Banana at the top and then Gap going down the line like that or is the potential – can Gap and Old Navy get back together at one point? Is there anything standing in the way of that right now?

Sabrina Simmons

Yes. I don’t want to get too far in to that because, as you know Barbara, we don’t segment report. But I think it is fair to say, as you have noted, that directionally, given where Banana Republic is positioned in terms of affordable luxury, that from a merchandise margin perspective they have tended to have the highest merchandise margin, then it moves on down as you would expect sort of Banana to Gap to Old Navy.

Now, from an operating margin profile, those – that merchandise margin profile doesn’t necessarily hold because, of course, the operating expense profile for each of the divisions is different as well.

What I will tell you is, most recently, we have been very pleased with the progress both on merchandise margin as well as operating margins that the division, with the exception of Old Navy, had been making. So with the improvements that we are working on, we certainly hope that the profile improved not only on the merchandise margin line but also on the operating margin line for Old Navy.

Barbara Wyckoff – Buckingham Research

Thank you.

Operator

Your next question comes from Michelle Tan with Goldman Sachs.

Michelle Tan – Goldman Sachs

Thanks. Sorry for the voice. I’m a little under the weather. I guess my couple of questions would be – what does the inventory look like if you look at it on a unit basis? And then how does the inventory look by division? And if you look at the Gap brand specifically, is the fact that the comps are so significantly negative continuing to be the lack of clearance in the stores or what needs to happen? I knew you mentioned going more on offense. What needs to happen to drive traffic beyond the fact that we have already seen the product improvements?

Sabrina Simmons

Yes. So let me start with just a reminder on our principle. So we have adapted the principle and it’s broad; it is not a policy it’s a principle. But broadly, we begin our inventory conversation by looking at our unit buys being in line with traffic.

Now, our inventory per square foot, given that we have been very focused on our average unit costing, our inventory per square foot that we report can actually be down further than our units are down as we gain traction on the average unit costing. With that said, we feel comfortable that in this macro environment we want to stay broadly aligned with that principle. What we will be doing as we gain confidence in the product acceptance, for example, at Gap brand is we do take in to account many other metrics and levers, conversions, UPT, percent sales at Reg [ph], markdown margin, and when we see consistency in those levers, other levers improving, then of course that would give us confidence to begin potentially buying more units into the system. And the driver again to the inventory being down both in Q2 and in Q3 is, of course, Old Navy. Since we have lots of work to do there to improve the assortment and we’ve been talking about that in the first half, we think it is an important risk mitigator to actually hold their inventories especially tight and even below traffic.

Michelle Tan – Goldman Sachs

Okay great, that is helpful. And then any color on where the inventory division – I know you mentioned most of the reduction came from Old Navy.

Sabrina Simmons

We report traffic. So again, I think it’s broadly speaking, it's fair since we report traffic to be broadly in line with that with the exception of Old Navy where we’ve made a conscious decision to bring the units much further down.

Michelle Tan – Goldman Sachs

Okay, perfect. That’s helpful, thank you.

Operator

Your next question comes from Jeff Klinefelter with Piper Jaffray.

Jeff Klinefelter – Piper Jaffray

Yes, thank you. I just wanted to follow up a little bit more on the margins, on the merch margins. Clearly very impressive results despite this negative traffic environment and I was just curious if you could share just a little bit more detail on – or perhaps a few examples, success stories, on is it system-enabled, process-enabled? Are you going back and working on your lead times? It just seems very, very strong merch gains and wondering what you have changed in the process to drive that in this environment.

Sabrina Simmons

I would say that although, of course, we continue to work on bringing tools onboard that will help us in the future, and as you know we are in the midst of rolling out a new planning and allocation tool that will help us drive greater localization in our stores and better distribution. I would say that to date, I mean certainly in the quarter, the margin improvement we’ve seen is the result of progress we are making at divisions especially like Gap on actual product acceptance. So we’ve seen strong AURs across the board and that actually is driven of course by much stronger markdown margins and we’ve seen very healthy regular margins as well as we’ve worked hard on our AUCs. So less about technology this quarter and more about better products.

Jeff Klinefelter – Piper Jaffray

Okay and just make a following up on that. There is certainly a lot of discussion and some evidence already of these costs increasing, sourcing cost increasing. So, what is the strategy now to continue driving down those AUCs in the face of that inflation?

Glenn Murphy

I think that we were achieving some success over the last nine months what I would consider to be a more rudimentary traditional approach to getting our cost down with some evidence that a little bit of our own making by not having the structure in place and the people in place. And I think I may have mentioned a while ago, just too many cooks in the kitchen in terms of one voice to the vendor. Some of that work is now in place. That has produced some of the results you've seen in Q2.

Going forward, we have talked a little bit about e-sourcing. We have talked about the consolidation of some vendors. We have talked about how we are going to go to the market and I personally have spent time with our global sourcing team, trying to help them along on what is the best way for us to achieve the kind of cost by product that we believe we deserve given the size of our business.

So we’ve always been a very flexible – more flexible today as an organization, how we can move from country to country, that’s appropriate. But I think we’re approaching it much more strategically. I spent some time the last six months working with that team on how we come to market, so some early wins, absolutely.

On a traditional approach, we are trying to make sure we can maintain AUCs. There are some further benefits to come but having said all that, we've recognized that it’s a tough market out there. There is certainly pressure on our vendors and they have to find some relief. But given our size, there is a lot of other relationships where they can find relief before they come presenting cost increases to us. So we continue to work aggressively at it, in an accretive way. And there’s going to be a law of diminishing returns at some point, but we’re just not faced with that just yet.

Jeff Klinefelter – Piper Jaffray

Great. Thank you very much.

Operator

Your next question comes from Kimberly Greenberger with Citigroup.

Kimberly Greenberger – Citigroup

Thank you. Good evening. Glenn, you talked about driving traffic into the stores at some point in the future. Obviously, the first thing that comes to mind would be an increase in marketing dollars, and I think you've contemplated potentially Gap brand is the division that you might do that first. Is there anything else that you think you can do beyond marketing that would help improve those traffic numbers? And secondarily, when do you think Gap might be in a position for you to go back to that marketing budget?

Glenn Murphy

I think there is lots we can do besides marketing. Marketing is definitely a significant tool in the chest for us to pull out and absolutely use to drive traffic. But there is a store rule [ph] in driving traffic. In the past, our conventional wisdom has been that stores are really focused on UPTs and conversion and service.

At Old Navy, we have spent some time with Tom in the seat over the last three to six months going to stores and speaking to our stores what their role they have to play on traffic. And there are some things we’ve done that have not been positive to us, having what I would consider to be repeat purchases, to getting traffic back in the business. One of the big issues on that has been we have been out of stock at an unnecessary level in some basic categories. And that is, even though if you had great marketing programs that drove in traffic, you may be eroding some of your loyal customer’s belief in your brand if you don’t have the products available when they come in. And we have suffered from that, I’ll be honest with you, definitely at Old Navy and to a smaller degree in the other two brands.

So we have a multi-dimensional approach that’s why I've been saying that the product is right and the store is right and one component store, it is not only the presentation of the store and the store – caliber of the individuals who are there to receive customers but also availability of product from across. Sometimes we have product that’s in the stores that's not on the shelf which is unfortunate but true inside our business. So as we work our way down, how are we actually going to get the traffic there, all the brands have been told until product and until store conditions and until the appropriate marketing message of the identified, there’s going to be no release of funds to drive marketing.

Gap brand as you suggested is one that I suggest is getting a little closer to being prepared for that and marketing will certainly be a tool. We have been very dogmatic and tenacious on cost across the entire business. One of the reasons to do that is when the time is right, if we were to use marketing as a step-up investment, we have been able to reduce the overall cost base in the organization or an investment will not be as significant a hit to the company when it comes to our SG&A as may have in the past because we’ve done such a good job so far and being honest with you, we have way more work to do on getting non-marketing costs still out of our business. And that will just give us more flexibility that we have had in the past.

So working our through that sequential order or cutting cost to make sure when the time is right, we can afford it and I think Gap is a brand that they are pretty close. They are much closer in a way of the journey of product, store, what’s the message, and then if there is a return for that marketing, there is no question we’ll spend it.

Kimberly Greenberger – Citigroup

Great. Thanks and good luck.

Operator

Your next question comes from John Morris of Wachovia.

John Morris – Wachovia

Thanks. Congratulations on a tough environment. Sort of a follow-up on the marketing unless I missed it in the prepared remarks that and may be if you can give the marketing spend and timing comparison to last year for Q3 but really also your thoughts at this point into Q4 as well?

Sabrina Simmons

So what I said about Q3, because we don’t guide to explicit dollars from marketing, but what I did say was in Q3 of last year, we reduced our marketing expenses significantly. So last year in Q3, we spent $124 million and so you shouldn’t expect significant savings below that in marketing in Q3 this year given that we brought it down so much last year.

John Morris – Wachovia

And the timing? In terms of some of the campaigns, the prints?

Barbara Simmons

So I’ll begin with Old Navy. So we’re on television for about three weeks this year versus four weeks last year. So we’re losing a week that we were on TV last year in September and so most of our TVs in August. And then we have three circulars this year in the fall versus four circulars last year. Direct mail and all that is about the same, and in the Gap brand we are actually doing quite a bit of print, more print this year than we’re doing last year. And at Banana Republic, most of the fall advertising campaign is similar.

John Morris – Wachovia

Great, thank you.

Sabrina Simmons

Sure.

Operator

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

Marni Shapiro – The Retail Tracker

Hey guys. Can you talk a little bit more on the directives? I was curious just about the expense structure and the operations behind it, as you have linked your web sites, is it impacting your shipping revenue at all? Are you looking to consolidate your DC to ship out of one place for all of the brands? I guess I’m looking forward a bit, because I’m actually one of those shoppers that thinks this was a brilliant move on your part and I’m curious how it’s impacting you on the profit side and what the thoughts are (inaudible) on the operational side.

Glenn Murphy

Actually, we already shipped out in one DC in Colombus, all three brands. And Piperlime is also in Colombus. What we have been able to do in order to join all four together under this, again, internal acronym of universality is all four do ship together having been like a test of it, I have been a loyal weekly buyer to make sure it was working properly. I do know that all four come together, it is beautifully packaged, and that works extremely well for us.

The issue on the shipping revenue is simple for us. We look at it and we look at the combination and you can imagine when you’re talking about the people who are doing this work in the analytic side of our online business clearly understand the benefit of gross margin dollars to the expense of shipping.

And if you can get the UPTs and therefore the overall basket size at the certain level, it pays for us to have one shipping fee. So the incentive is for people to go in and accumulate across the brands and have the one shipping fee. I think it is a nice incentive for people.

I think your comment, which is the reason I would do it, shipping fee aside because I still go for the 24 hours which costs $17 instead of $7. What I like about it is the convenience of it, the convenience is phenomenal; it is well packaged. The product comes in, it is in my case delivered in one day, which you have one day, two day or traditional four day delivery. And I think the idea, while early; we have not overly marketed it. We have taken a prudent approach to make sure that all the logistics work effectively. And then I think Toby and his team really have a marketing opportunity, back to the previous question on marketing. A real opportunity to little bit we have down now, to really get people excited about the potential of this investment and this transformational initiative that Toby has put together.

Marni Shapiro – The Retail Tracker

Can I just follow up a question with that? I actually had an experience – I had different packages come, but I still felt it was excellent. Other question is I love the cross-shopping functionality. Does it put more pressure on Gap and Old Navy down the line to really make sure that their product is differentiated because I find once you’re on this cross-shopping site and you look at say, I’ll use the men’s as an example because there’s less fashion there, but you look a men’s cargo short and you are on that site, it’s much easier now to click over to Old Navy and see if they have a cargo short and it is less expensive.

Glenn Murphy

I think that the reality is that it makes it easier, which we actually think is a good thing. The value expression of each one of the brands is obviously in the quality of the garment, so we’re looking at more as the incremental sale as opposed to people buying down inside the business. That is what they choose to do which we’re still keeping it inside of Gap Inc’s. We think that a positive. But your point is a good one. Now, we’ve had this conversion internally as now that you can toggle so easily between all of the screens, we got to make sure that the brand as we’ve defined it, comes across very well. Banana right now and Piperlime stand out clearly. You can go on that site, you know exactly what site you’re on. I think actually your point is a good one. We’ve had the conversion internally, by making it easier, you kind of make sure that individual personality of each brand now comes across very well and that’s probably some work that Toby and his team would acknowledge they have to get done.

Marni Shapiro – The Retail Tracker

And just one more follow up on it. Does that mean, go forward, can you link marketing campaigns, as you’ve done friends and family in the past, I noticed this year you did the 25% off, not as successful but are there campaigns going forward in the future that could now link all your brands together with one discount because you have it online like this?

Glenn Murphy

I think that you’re spot on; I think that gives us a lot a flexibility to get people. We have the information now on what brands people are buying, why they are not purchasing one brand, and one brand or not the other, or maybe they are in one category not the other. It really takes our CRM efforts to a whole new level and allows us to get diagnostic information we never had before.

Marni Shapiro – The Retail Tracker

Great. Thanks guys, good luck with the rest of season.

Glenn Murphy

Thank you.

Marni Shapiro – The Retail Tracker

Thanks.

Operator

Your next question comes from Jeff Black with Lehman Brothers.

Jeff Black – Lehman Brothers

I want to say, Mr. Murphy, that's one heck of a performance with this level at top line. I guess my question relates to guidance, I’m just trying to square up over the second half the gross margin part of it. When you talk about taking Old Navy inventory down, has that been down through cancellations already or are we to assume that you’re planning for a higher level of markdown than we saw in the 2Q? And as another question, on the 560 basis points of merchandise margin improvement, can you give us a sense of how much of that is regular price and how much is markdown? I get that there’s less markdown there, but I’m less certain and I'd love some comments on how are we to understand that the product has really improved? Thanks.

Sabrina Simmons

I'll start with the Old Navy inventory. So as you know, we have been successful in shortening the pipeline for Old Navy. So, the good news is when we started hitting really tough headwinds for Old Navy even in Q1, we were still able to effect and incorporate decisions with regard to our Q3 inventory buys. So, we were able to make decisions to buy less inventory. We’re not doing a lot of last minute canceling. The bringing of the inventory down has been planned for and has been enabled because of our shortened pipeline. So that’s Old Navy.

And then with regard to how we have delivered our margins in the quarter, we have gotten a little bit more regular priced selling in the quarter across the board which is good. But the increase is really driven by the expansion in our regular margin and much healthier markdown margin. And as I said before, part of that is that the customer is willing to come in and purchase at regular price. Some of that expansion of regular margin is simply that we have been successful in negotiating our average unit costing more favorably.

Jeff Black – Lehman Brothers

Okay. Fair enough. Thank you very much.

Operator

Your next question comes from Dana Cohen with Banc of America Securities.

Dana Cohen – Banc of America Securities

Hi guys. It sounds from your comments that the margin improvement in the second quarter was entirely Banana and Gap division. Can you give us a sense as you move into the back half of the year, given the improvements those two divisions have already seen, where are you in the continuum of where you’d like those businesses to be? And then secondarily for Old Navy, is it reasonable to assume that there would be improvement there in the back half or are you pushing the turnout?

Sabrina Simmons

I would say, Dana, without going into too much detail, I would say that actually our merchandise margins have been strong across the board. So, we have been managing our inventory tightly at all of our divisions and even with the headwinds that we’ve been experiencing, even at Old Navy, I would say across the board on a merchandise margin level, we have been pleased with what we were able to achieve in the second quarter. Now, what we’re facing again in the third quarter is more difficult comparison. But we do feel that there is still opportunity in our margins given the fact that we are continuing to buy inventory very tightly that we do believe that our product assortments are improving and that we are starting to implement, as we roll out some of these tools, we are starting to implement that our allocation and planning of the inventory that goes into our stores.

Dana Cohen – Banc of America Securities

Okay. Thank you.

Operator

Your next question comes from the Brian Tunick with JPMorgan.

Brian Tunick – JPMorgan

Yes, thanks. I guess first for Glenn, maybe just talk about the timeline for Tom, may be to fully affect the merchandise at Old Navy. When does the balance shift away from, I guess what you guys have been saying too much fashion in the stores to what makes you think you need for the offering? And may be just for Sabrina, can the operating margins be up next year if these current sales trends continue? Thank you very much.

Glenn Murphy

To answer the first question, the balance for the first month this month was an improvement of fashion which we will call in four-week buys to seasonal basics to basics. First month we have seen improvement. It’s not where we want it but it’s off of the historical highs of four-week fashion product in our stores. We will get better again in September and then in October, we get a combination of that still improved balance of the mix between those three different product types inside our store but also the beginning of, I want to make sure I’m clear on this issue, just the beginning of the product that Todd Oldham and Doug Howe and Tom worked on to get to the new, which was our historical, but the current new target consumer brand positioning.

So improvement in the mix going forward but October is you get the first shot of Todd’s involvement and it's early days but its first impact on the business from a product perspective and a continued improve balance right to the end of the year.

Sabrina Simmons

And with regards to the operating margin, Brian, it’s pretty early to start talking about 2009 but clearly it’s our objective to keep improving our operating margin. And our two big levers will continue to be gross margin dollars and cost. Over the longer term, clearly it has to be about gross margin dollars. So the way forward is we need to maintain these very nice healthy margin rates that we have been achieving and then we need too in time, as we drive more traffic into our stores, buy more units and drive greater velocity that would drive greater gross margin dollars.

Brian Tunick – JPMorgan

All right. Thanks and good luck.

Sabrina Simmons

Thanks.

Operator

Your next question comes from Richard Jaffe with Stifel Nicolaus

Richard Jaffe – Stifel Nicolaus

Hi guys. Just a follow on with Old Navy, clearly there’s a large transition going on. Could you spend a minute and just talk about the repositioning of the brand, how you envision Old Navy should look perhaps by fourth quarter, certainly in ’09, the focus on the customer, the balance in the merchandise, and some of the initiatives we should expect from Tom to get there?

Glenn Murphy

I just mentioned to Brian that I think that the balance in the fall, as defined by October for us, will be an improvement. The balance will definitely start to see improvement. I think the product will be the beginning of going after the target consumer we’ve defined which is a young woman between the ages of 25 and 35, who is on a budget, who shops for family and shops for herself. On top of that, there is a fun component. There is all these other attributes to Old Navy’s personality, but just from a pure simple demographic, that’s the one we’re going after. Product will be in keeping with that, not forgetting about the fashion component of Old Navy, you get this family and this fashion part of its personality. So that will be more visible in October.

The next step for us back to what I spoke early is, how are the stores going to present themselves. I think some changes we made recently at Old Navy and the team I’ve spoken to of district managers, regional directors, zone VPs, and Jeff Kerwin [ph], who is our head of field operations, I really believe they understand they have a huge role to play going forward in how the store gets presented, how it comes across, and the kind of people and service expectation that the customer is going to have.

And then the marketing message which has been changed slightly coming in to the marketing of this weekend and until Labor Day and will continue to evolve. I’d say back in the holiday season, that would be the last piece you’ll notice, is the marketing will shift, be more appropriate to not only that demographic but to the brand personality that Old Navy has, which is one of its strongest attributes. We have kind of abandoned that a little bit over the last number of years but it’s going to return and it would be appropriately presented and what is that unique energy that Old Navy has. You’re going to see that in our media. You’re going to see that inside the store.

In 2009, to complement all of the work that Tom is leading for us, is how the store is going to look because we basically have been building the same store since 1994. Now, that store model and that merchandising presentation served us well for the better part of the decade. But I was just in the store nine months ago and the last ones we’re going to open that’s new and looks exactly like the store we opened in 1994 except for the odd refresh. Reality is that store because of how important the physical volume of space is to the Old Navy brand, I think you’ll see that in 2009, as we start a manageable remodel program that will have to hit our return thresholds in order for us to put the capital forward. I think that’s another missing component that will make I think Old Navy more exciting. That’s for 2009.

Richard Jaffe – Stifel Nicolaus

I’ll look forward to it. Thank you.

Operator

Your next question comes from the line of Janet Kloppenburg with JJK Research.

Janet Kloppenburg – JJK Research

Good afternoon. I had a couple of questions. First, in terms of Gap and completing its turnaround, I wonder what variables or criteria you’re using to determine if you should build inventory. Right now, the inventory levels are down and traffic is down. I am wondering if some of that traffic being down and comping down is associated with the lean inventory levels. And secondly, is it correct to assume on Old Navy that there is a lot room for margin improvement and expense savings that could help you leverage operating margins for that brand and for the company in fiscal '09? Thanks.

Sabrina Simmons

I’ll start with Gap brand, Janet.

And so we look at many metrics, so the buying of inventory is one of the most important decisions we can make obviously in the company, so we take it seriously and we look at lots of metrics. We begin our discussions with this principle of what is traffic because traffic we see is a proxy for demand. So we begin our discussions around looking at units in line with traffic. But as I said, we look at many other metrics including inventory turns which is really important obviously because if we saw our turns speeding up a lot that would be cause for us to pause and consider whether we need to start buying more inventory units and if we saw conversion consistently improving or a combination of conversion with UPT consistently improving, that would be another cause for us to consider buying more inventory. So we are watching, as we speak, all of those metrics and the teams are hard at work at looking how they can move those comp levers today to give us confidence around our buys in 2009 to begin to move the needle on that.

So that is Gap and then with regards to Old Navy, I think we have opportunity in both the areas you’ve called out. So both the areas of improving our margins as we improve our product assortments, and hopefully the product resonates more with our customers. We should be able to do better on our merchandise margin but as well we think there is opportunity on cost and I think you saw Tom Wyatt take some important steps today in terms of looking at his organizational structure and in some cases taking action to simplify and take out layers that we felt very comfortable we could operate just as well or better without those layers of management.

Janet Kloppenburg – JJK Research

And then Sabrina or Glenn, as we look into fiscal ‘09 and your goal of increasing operating margins further, I’m wondering how important the comp variable is. I mean can you increase operating margins in ‘09 if comps remain negative? Is it something that is more necessary for fiscal '10 to keep margins moving higher? Perhaps you could give us some idea about how important comp improvement, positive comps would be in fiscal 09 to help deliver improved results. Thanks.

Sabrina Simmons

Yes, again, I’ll talk directionally Janet because again it’s a little early to be talking about 09. We are just kicking off our budget process internally but what I think is worth stating is, although we have fully embraced this notion that we are going perpetually be good cost managers and be very disciplined about cost, that is not a strategy upon which to build market share and top line. We know that we need to get that back.

And part of what I’ve stated before as part of our objective is to, of course, not lose ground on the great progress we’ve made of achieving healthy margin rates. We want to keep that margin rate and see these other levers coming through for us as far as traffic and conversion to give us the confidence to buy units where we can move them at this healthy margin rate. And that actually obviously drives comp and we want to be driving comp in our future. We don’t know how much of that will come and we’ll be working on that and talking to you more about it as the quarters follow.

Janet Kloppenburg – JJK Research

Thanks very much and good luck.

Sabrina Simmons

Thank you.

Operator

Your next question comes from Dana Telsey with Telsey Advisory Group.

Dana Telsey – Telsey Advisory Group

Good afternoon everyone. As you right-size the real estate, how is the reception from the real estate development community and is it different for mall versus the off-mall formats, and the timeframe in terms that it takes for you to dispose of the square footage that you like. And I think also you had mentioned in one of your recent meetings besides the average unit cost as a driver to margin, price optimization mix is also important, do you look at one more important than another? Thank you.

Glenn Murphy

Definitely the real estate’s square footage, it all comes down to the quality of the mall and the quality of the real estate. Landlords are going through their own version of the headwinds which we are all facing that is why we defined today this is going to be a three to five-year process for us to do this. We have engaged some people preliminarily. I was in a meeting recently, just had some discussions, tried to explain on a very high level what our strategic thinking is. I think they appreciate that. They love the clarity, like the transparency, and I mentioned in previous calls and having been to – the over 500 stores I’ve been to, it is clear to me, we just have a good quality of real estate. I think the landlords are the first place we go to because they know other tenants who may want to relocate, they know about the people who are looking to maybe expand their businesses and go from a model that’s small to a model that is mid-sized. They are well connected. At the same time, in order to hedge our bet because we have flexibility in most of our leases, is who else could we want to bring in, who else would we want to bring in beside a strip in the strip centers you referred to of Old Navy that could be a national player, that could be complementary to some excess space that we don’t need at Old Navy.

First step is at the landlords. Second step is we do have the ability and have already had some positive signs, who may be willing to have conversations with us about that.

It’s going to take some time to get done. The good thing is the work has been done. It might get tweaked, but for the most part it is established now and we’re going to be able to have those meetings ongoing with landlords to find out what’s the best way for us to offload that operating space, which is good for us not only from a rent perspective but the variable costs that are associated with that. It is also an easier business to run. It is easier to run 10,000 square foot store than a 17,000 square foot store. So that work is on the way.

Price optimization is, I would say, AUC is a known, so therefore is more important in the equation of margin because if you get something that is 5% less in cost, that’s an absolute known that goes right to the P&L. Price optimization which we have adopted recently, which started off with localized markdown. That has been very helpful for us and Old Navy is going to go [ph] through that in the fall. I know those equations [ph] just came up. One of the benefits to Old navy’s gross margin, because all other brands adopted it this year is going through the price optimization on localized markdowns this fall.

Eventually, you get to localized promotion, and then beyond that we know there’s a lot of pricing opportunities for us. It is not one of – being a great cost retailer may not be one of our core competencies. Pricing, because we price so far out, is as also compared to other retail segments that either I’ve been in or who I observe and admire, it is also not one of our strengths. So we’re going to start with markdowns and promotions and we’re going to go from there from an optimization perspective.

Evan Price

Operator, that will be our last call for today.

Operator

Yes, sir.

Evan Price

I would 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

That concludes this evening’s teleconference. You may now disconnect.

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Source: Gap, Inc. Q2 2008 Earnings Call Transcript
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