蓋璞 (GPS) 2003 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the Gap Inc.

second-quarter conference call.

At this time, all participants are in a listen-only mode.

If anyone should require assistance during the call, please press the star key, followed by the zero key on your touchtone phone.

The conference call and web cast are being simultaneously recorded on behalf of Gap Inc.

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Your participation represents your consent to these terms and conditions, which are governed under California law.

Your participation on the call also constitute your consent to having any comments or statements you make appear on any transcript or broadcast of this call.

If you have any questions regarding this policy, please contact Gap Inc.

investor relations at 650-874-4670.

I would now like to introduce your host, Sabrina Simmons, Senior Vice President of Treasury and Investor Relations.

Good afternoon, everyone.

I'd like to welcome you to Gap Inc.'s 2003 second-quarter earnings conference call.

For those of you participating in the web cast, please turn to slide 2. I would like to remind you that the information made available on this web cast and conference call contain certain forward-looking statements, which reflect Gap Inc.'s current view of future events and financial performance.

Wherever we use the words "expect", "plan", "anticipate", "believe", "may", and similar expressions, identify forward-looking statements.

Any such statements are subject to risks and uncertainties and the company's future results of operations could differ materially from historical results or current expectations.

For more detail on these risks, please refer to the company's annual report on form 10K and our other filings with the Securities and Exchange Commission.

This presentation includes a non-generally Accepted Accounting Principle measure, cash flows before financing activities, which, under SEC regulation, we are required to reconcile with GAAP, GAAP.

A reconciliation of cash flows before financing activities to GAAP financial measures is included in our earnings press release, which is available on www.gapinc.com.

This afternoon we'll begin with Byron Pollitt, our Chief Financial Officer, discussing second-quarter financial performance.

Then Paul Pressler, our Chief Executive Officer, will provide an update on company-wide priorities and accomplishments.

Paul will also give brief highlights of Gap brand and Banana Republic.

After Paul Jenny Ming will comment on Old Navy.

After Jenny's remarks we'll open the call to questions.

For this call, Jenny Ming is joining us out of our New York offices while the rest of the team is in San Francisco.

We will do our best to make the call go smoothly despite having Jennie in a remote location.

Now I'd like to turn the call over to Byron.

Thank you, Sabrina, good afternoon.

Second-quarter results reflect continued momentum in our business.

Our performance further demonstrates our ability to generate strong earnings in comps when we effectively execute against our strategies.

Gap and Old Navy were the primary drivers of sales and earnings during the quarter, but all divisions improved performance.

Here are the highlights.

More consumers are coming into our stores, some summer marketing helped improve traffic come particularly at Gap and Old Navy.

Old Navy posted three consecutive months of positive comp store traffic in the quarter and Gap's traffic comps strengthened and were in line with the national mall average.

As we build traffic, we're also improving customer service, which drove stronger conversion at Gap and Old Navy.

And customers are spending more at our stores.

Better product assortments and improved inventory management drove higher average unit retail at Gap and Banana Republic.

The result, we sold more units at slightly higher margins.

Overall in second quarter, we delivered a better experience for our customers and greater value for our shareholders.

Margin, cash flow, and returns on capital remain our priority.

We're working to ensure that our top-line successes translate into bottom-line growth.

Let's look at our second-quarter results.

For web cast participants, please turn to slide 3 on earnings performance.

Earnings were $209 million or 22 cents per share, compared with $57 million or 6 cents per share last year.

Our convertible note was diluted.

Sales and gross profit drove this significant earnings growth.

Our earnings also reflect a more normalized tax rate of 39%, compared with 49% for the second quarter last year.

Now, let's review the underlying drivers of our business.

Please turn to slide 4, sales performance for second quarter.

Total sales were $3.7 billion, up 13% from $3.3 billion last year.

Consolidated comp store sales were up 10% compared with a 7% decrease last year.

Sales productivity improved 13% to $97 per square foot, compared with $86 per square foot last year.

Looking at comp store sales by division for the quarter.

Gap U.S., up 9% versus down 13% last year.

Gap International, up 13% versus down 12.

Banana Republic, up 5% versus down 5. And Old Navy, up 11%, versus down 1. For second-quarter total net sales by division, please refer to our earnings press release.

Turning now to gross margin performance on slide 5. Gross profit increased 22% to $1.3 billion as we sold through more units at slightly better merchandise margins.

Gross margin was 36%, up approximately three percentage points from last year.

Here's what drove our gross margin gain.

We gained one point from better merchandise margin, and we achieved two points from the leveraging of rent, occupancy and depreciation expenses.

Turning to operating expenses on slide 6, for the second quarter, operating expenses totaled $930 million, up one per cent from $922 million last year.

This is lower than our prior guidance of a mid-single-digit increase.

As a percent of sales, total operating expenses were 25.2% compared with 28.2% last year.

The improvement was driven by better store payroll efficiency and Gap's shift in TV advertising to spring from summer.

Because of this seasonal shift in advertising expense, it's important to look at operating expenses on a year-to-date basis.

Operating expenses in the first half of the year were $1.8 billion, increasing 8% from last year, slightly lower than our guidance of a 9% to 11% increase.

As a per cent of sales, first half operating expenses were 25.8% versus 27.4% last year, driven primarily by improved store payroll efficiency.

Advertising expenses in the second quarter were $89 million, down 24% or 28 million from the prior year.

This was due to the shift in Gap TV and lower spending at Old Navy.

First half advertising expenses were $190 million, down 3% or $5 million below last year.

Turning to inventory on slide 7. We ended the second quarter with $ 2.3 billion in inventory, up 186 million versus last year.

Inventory per square foot was $59 at the end of the second quarter, up 10%, compared with a 17% decline last year.

This is slightly lower than our previous inventory per square foot guidance of an increase in the low to mid-teens.

We're pleased with our inventory management in second quarter.

Inventories entering the third quarter were clean of liable goods and well positioned.

Please turn to slide 8 for more detail on capital expenditures and store count.

Year-to-date, capital expenditures were approximately $110 million, down 40% from $184 million last year.

This decrease was driven by reduced capital spending for new stores.

Net square footage at the end of the second quarter remained about flat to last year.

Year-to-date, we have opened 17 and closed 39 store locations, ending the quarter with 3,095 locations or 4,230 concepts.

Please refer to the press release for a summary of our end-of-quarter store location and concept counts and square footage by division.

Please turn to slide 9 as we walk through the key components of our cash-flow performance.

During the second quarter, cash flows before financing activities were $317 million, compared with $60 million last year.

This was due to higher earnings, lower working capital uses related to inventory purchases, and reduced capital spending.

For the first half, cash flows before financing activities were $242 million, compared with $43 million last year.

With higher earnings and reduced capital spending driving the significant year-over-year improvement.

We ended the second quarter with 3.1 billion in cash, of which $1.2 billion is restricted and backs our letter of credit agreement.

Our cash balance at the end of the quarter was slightly more than our total outstanding debt of $2.9 billion.

As a reminder, we paid off a $500 million note during the first quarter of the year.

We are pleased that Moody's Investor Services recently raised their outlook on our credit rating to stable from negative.

They also raised our liquidity rating one level to SGL1, their highest.

Turning to slide 10, I'd like to comment on our outlook for the rest of the year.

Second half operating expenses are expected to increase slightly to about $2.3 billion versus $2.2 billion last year.

We expect third-quarter operating expenses to increase to about $1.1 billion versus $1.0 billion last year, driven mostly by increases in advertising and store repairs and maintenance.

For the fourth quarter, we expect operating expenses to be about $1.2 billion, flat the last year.

Given the encouraging returns we've seen from our first-half advertising investment, advertising expenses are expected to increase in the second half to be between $340 to $350 million dollar compared to $301 million last year.

Specifically, third-quarter advertising is expected to increase to about $200 million from $167 million, driven mostly by Old Navy marketing.

And fourth-quarter advertising expenses are expected to be about $150 million versus $134 million last year, due mostly to Gap advertising.

With regard to interest expense, we expect gross interest expense to be approximately $55 to 60 million in each quarter for the rest of the year and $240 to 245 million for the full year compared to$ 249 million last year.

For the year, we still expect depreciation and amortization expenses to be in the mid-to high $600 million range.

Turning to tax rate.

We still expect the effective tax rate for the fiscal 2003 to be 39%.

Our mix of domestic and international earnings and the overall level of earnings may cause this rate to fluctuate higher or lower by about 8%.

So any fluctuation could result in an anticipated effective tax rate of between 38 and 40%.

Regarding inventory, improving the return on our inventory investments is a priority.

We are focused on maximizing inventory productivity and reducing overall inventory levels, while also keeping stores well stocked for our customers.

During the first half, we began implementing initiatives to better manage inventory and improve inventory turn.

These initiatives include: Optimizing receipt timing, re-evaluating optimal in-store and distribution center inventory levels, and re-evaluating replenishment frequency.

As a result of our efforts, we now expect inventory per square foot at the end of the third quarter to be about flat to last year, lower than our prior guidance of a mid-single-digit increase.

By the end of the fourth quarter, we expect a decrease in inventory per square foot in the low-to- mid-single digits.

In terms of capital expenditures, we still expect capital spending to be $300 to 325 million for the year.

And here's how that breaks down: Store capital is expected to be $150 million, with approximately $35 million for new stores and $115 million for remodels.

IT spending is still expected to be about $140 million, and the remaining $35 million will be split between headquarters and distribution centers.

Looking at real estate, we will continue our rigorous work around improving our returns on capital and the productivity of our store fleet.

We still expect net square footage to decrease about 2% for the full year.

Regarding new store openings and closures for fiscal 2003, we still anticipate total new-store openings to be between 30 to 40 locations, which translates to 40 to 60 concepts.

Store closures are expected to be about 125 locations, or about 150 concepts.

Please turn to slide 11 for the calculation to determine the dilutive effect of our convertible note on second-quarter earnings per share.

To determine the dilutive effect of our convertible note on earnings per share, the note must be compared as debt and as equity.

Looking at the slide, the left-hand column treats the note as debt.

Now, let's walk through the right-hand column, which treats the net as equity.

First, $12 million in after-tax interest on the convertible note is added back to second-quarter net earnings of $209 million.

Second, 85.6 million convertible shares are added to our diluted share base of about 902 million shares in the second quarter.

This results in a total diluted share base of about 988 million.

As you can see, earnings per share is less when treating the note as equity than when it is treating the note as debt, so the note has a dilutive effect for the second quarter.

In terms of knowing when our convertible note is diluted, assuming our second-quarter effective tax rate of 39%, the dilutive break point is 14 cents per share in any quarter and 57 cents for the full year.

This completes my review of our financial performance.

In summary, our second-quarter results continue to demonstrate our ability to generate strong earnings in comp when we effectively execute against our strategy.

Sales and margin comparisons become more challenging in the second half of the year, but our strategic priorities will not change.

Improving margins through better regular price selling, strengthening our balance sheet by boosting cash flow, and increasing our returns on capital by improving inventory turns and optimizing the productivity of our store fleet.

As customers continue to respond to our improved product assortment, targeted marketing and enhanced customer service, we'll continue to drive shareholder value and earnings growth the old-fashioned way, through healthy margins, growing cash flow, and strong returns on capital.

Thank you, and now I'd like to turn it over to Paul.

Great.

Good afternoon, thank you, Byron.

We are pleased to have delivered our fourth consecutive quarter of earnings growth.

Our continued performance improvement underscores the tremendous work being accomplished by our teams in executing our strategies.

With each quarter, our product assortments are stronger, our consumer messengers are more targeted, our customer service focus is sharper, and our operations are more disciplined and efficient.

Our division presidents, along with their teams, deserve full credit for the momentum we've achieved over the past 12 months.

They've owned and driven the improvements customers are seeing every day.

At each brand, product design and merchandising teams are working more closely together and they're delivering more edited assortments to more clearly defined customer segments.

Consumer insights, gained from focus groups and other research, are better informing our product and merchandising decisions.

As a result, we're more effectively matching our creative vision with the needs of our customers, and we're more easily identifying product and merchandising opportunities.

Our marketing also is improving, with messages tailored to key customer segments to build brand awareness, promote our products, and drive traffic.

For example, for the first time, Old Navy is simultaneously running separate TV campaigns for its key fall product assortment, reaching families and teen customers with targeted messages that appeal to each segment.

We're very pleased with our back-to-school and fall marketing at Gap.

Madonna and Missy Elliot turned our Cord jeans into a statement of individual style, creating a fresh pop culture moment that is quintessentially Gap.

Media coverage has been phenomenal and special events at our flapship stores in Manhattan, Chicago Miami, Los Angeles and San Francisco, drew thousands of customers wanting their own monogrammed pair of Gap cords.

Though it is still too early to analyze the results of the campaign, traffic was up following the launch and cords are selling above expectations month to date.

Settling to fall.

In September Gap is following the youthful brand-building spirit of the Madonna campaign with separate TV spots for men and women, as well as a print campaign.

Our September marketing targets core customers with a broader focus on fall products and an emphasis on wardrobing.

Efforts at Old Navy and Gap are the furthest along, Banana Republic is making progress as well.

We're seeing performance improvements in key areas and I'm confident in the brand's strategic direction under the new leadership of Marka Hansen.

I'll speak more about the Banana Republic and Gap in a moment, then Jenny will provide an update on Old Navy before we take questions.

In the first half of this year, our strategies have driven strong comp and margin improvements.

Of course, comparisons get tougher in the second half of the year, but we're confident our ability to continue driving bottom-line results.

Conversion and traffic continue to be priorities, which will help drive comp performance.

We're pleased with the trend improvement in traffic at Gap and the positive traffic Old Navy has seen in recent months.

In addition to these comp drivers, tighter inventory management and stronger product assortments enhance our emphasis on improving regular priced selling and maintaining healthy margin performance.

Looking beyond the second half, my priorities continue to be centered on building management bench strength and driving company-wide initiatives with our senior leadership team.

We are working to develop and leverage core competencies across all aspects of our business.

Our focus is on product design and merchandising, consumer insights, operating efficiencies, and talent.

While developing talent across our organization is a priority, we are placing particular emphasis on nurturing our product-design teams.

To that end, we just announced that Patty Jerosa a former Gap executive with 18 years of experience at our company is returning in the new role of Senior Vice-president creative talent development in our New York product design office.

In this human resource role, Patty will help foster a creative design environment, facilitate the growth in the development of creative teams, and build relationships with design schools.

Before turning it over to Jennie, here's a brief update on Banana Republic and Gap.

Banana Republic has three priorities.

First, differentiating product through fit, quality, and elevated fashion.

Second, effectively marketing and creating a strong emotional connection with our customers, and, third, delivering more elevated customer service and a better in-store shopping experience.

Since joining the brand as president in early June, Marka Hansen has moved quickly to ensure her teams remained focused and continued to gain traction on these initiatives.

In second quarter Banana Republic saw strong customer response in areas where the brand has made the most progress.

Overall, women continue to perform the strongest, while men's remained more challenging.

In women's, Banana Republic's wide waist skirts, linen skirt and crop pants be have been best sellers.

Our men's cotton polo fitted Ts in a range of colors and nylon jacket were strong performers as well.

The brand's first ever summer sale in second quarter was a traffic driver, following that event, customer response was strong to B nana republic's fall transitional merchandise flow in mid-July.

This assortment reflects the brand's emphasis on offering customers more wear-now product.

Women's skirts were a standout with a clearly differentiated point of view and more feminine design esthetics.

Bags and wear-now fashion jewelry complimenting product assortments drove strong performance in women's accessories, based on the success of accessories, Banana Republic is expanding its jewelry department.

Banana's Republic fall line begins arriving in stores today with a full assortment in place next week.

Early fall product is much more dressed up with a continued emphasis on color, detail, and quality fabrications.

In our men's business, we have seen some preliminary positive indicators in categories such as woven shirts, where upgraded quality and style are making a stronger statement to customers.

Our new Luxe twill shirts for men, which arrived in stores in mid-July, are performing well.

After successful test in 30 locations, Banana republic's urban sport collection for men is rolling out to all stores.

A women's collection will be introduced for holiday.

Also for women, Banana republic is extending its popular relaxed pants fit to all stores for fall.

Also, in response to customer demand, select items in Banana Republic's petite collection previously offered only on line will be introduced this fall at our flagship stores in New York, Chicago, Santa Monica and San Francisco.

Fall marketing conveys more of a designer sensibility for women as we aim to build a stronger emotional connection with our customers.

For men, targeted direct mail and newspaper ads focus on dress woven shirts and introduce Banana Republic suits which serve to further differentiate and elevate the brand.

Banana Republic's suiting brand features classic and modern styles with separates that make it easy for customers to find their perfect fit with less need for aultdrations.

To enhance service, Banana Republic has doubled the number of training hours from four to eight for all sales associates.

Product training, tools, measurements and incentives are all being redesigned to support Banana Republic's new service culture.

Turning to Gap.

The brand continued to gain traction in second quarter against its priorities, improving product assortments, engaging customers with targeted messages, enhancing the store experience, and gaining consumer insights to further refine brand positioning.

Gap is delivering product assortments that are balanced, iconic items with a strong fashion sensibility and color point of view.

In second quarter, women's summer product performed well, including capris, crop pants, sleeveless tops and bottoms and Gap delivered a strong color message with its popular tunics.

Men's woven shirts also performed well.

The brand continues to elevate product fit and quality, our recently launch of men's denim anyone updated fits and washes which we are supporting with television marketing in September.

Fall assortments offer a variety of styles and fabrications for different customer segments.

Key categories include cords and jeans, including low-rise, boot-cut cords and our new slim-fit jean for women, and broken-in jeans for men with updated fits and washes.

Pants with a wider selection of length and trend--based styles in our popular stretch fabrication for women and cargos and work pants for men.

And accessories with items such as the cargo hobo bag.

Back-to-school, Gap Kids Denim and khakis were re-launched with improved fit, quality and product detail, incorporating feedback from focus groups.

Our new Gap-shield stain resistant and water-repellent coating on key back-to-school things for boys and girls is extremely popular with moms.

To support these and other improvements to our product assortments, Gap Kids returned to TV for the first time since 2001, with a campaign targeted style-conscious mom and kids.

In addition to the evolution of Gap's merchandising and marketing, the brand also has made substantial progress in training store associates to deliver a better shopping experience to customers.

The initiative has helped drive conversion, greater replenishment accuracy, and better-fitting room and cash-wrap experiences for our customers.

Gap also continues to analyze consumer insights and store manager feedback to refine its segmentation efforts on how to develop longer term strategies and how to effectively serve various customer groups.

Across all brands, our Pass-it-on field survey are generating better insights from store managers and sales associates.

More important, the survey tool has opened up communications between merchants, product designers, and store managers to help us all better serve our customers.

We remain confident in Gap's overall direction and are extremely pleased by the excitement generated by the brand's marketing campaign and fall product assortment.

The energy and attention highlight the intrinsic emotional connection Gap enjoys with its diverse customers.

That's the foundation of the tremendous opportunity facing Gap long term, as we better understand Gap's many different customer segments and improve our ability to consistently meet and exceed their expectations.

Now before taking questions, Jenny will update you on Old Navy.

Thank you -- thank you, Paul.

Good afternoon.

I'm very pleased to speak to you today on the heels of our strong second-quarter performance.

As we've outlined before, our primary strategy for 2003: better understand and meet the needs of our target customer segment, strengthen Old Navy's brand positioning as a value player with a specialty flair, and maximize the productivity of our existing store and optimize our realistic strategy.

Today, I'd like to take the opportunity to provide more insight into what we are doing to better meet the needs of our target customer segments.

Beginning last year, we undertook a comprehensive effort to carefully examine our brand positioning within our competitive set, and understand the motivation of our customer base.

We used customer research, including focus groups, store intercepts, e-mail polls and other tools to increase our knowledge of our customers.

Now, with a better grasp on these attributes, we're evolving our merchandising and marketing strategy to better meet our customers' needs and gain market share.

In merchandising, we are looking to leverage the intelligence we have gained through our customer research to become much more innovative in our merchandising strategies.

Our focus is shifting from reactive to proactive, and we are redefining how we look at our business.

For example, we revised our traditional view of July as a markdown month.

Last year, we launched our first-ever early fall stock-up sale.

In doing this, we were able to highlight more transitional and wear-now merchandise instead of focusing solely on summer markdown.

This year, we were able to even more effectively use promotions on fresh, new merchandise, keeping the product much more compelling for the customer, resulting in better July sales.

We have also begun to use our merchandising focus to fill a need for key customer -- key product categories.

For example, we feature socks and underwear during the early fall stock-up sale, highlighting an expanded offering and sending a strong value message to our customers.

We have re-costed and re-priced these items to offer a much more competitive everyday price and an exceptional value during our stock-up sale.

These items are incremental purchases representing a promising opportunity to generate additional sales and gross profit dollars.

Another category we are using to address our customers' needs is uniforms, especially for the back-to-school season.

The number of schools with dress codes has been growing by about 15% per year.

We had a minimal market presence during last year's back-to-school season.

For this fall season, we made improvements to our uniform product offering and increased our investment in that category.

This is a key focus hole, and we are offering a wide range of products at a great value.

A more dominant uniform message on circulars, direct mail, and in-store marketing have supported our expanded dress code offering both in store and on-line at OldNavy.com.

We believe this category represents an excellent opportunity to feel our growth in the kid's business.

We are complimenting our merchandising strategies by using our marketing to more effectively target our customer segments, especially through the use of TV and the circular.

This fall marks the first time that Old Navy has produced completely distinct ads to speak directly to two of our customer target segments, namely teens and families.

The first TV spot, Cargo Train, targets the teen segment and airs on MTV, VH1, Friends, and Gilmore Girls.

Appealing to the teens, these ads showcase younger, trendier cargo products such as cargo mini skirts.

In the second spot, Leave It To Cargo targets family and airs on daytime shows, such as Regis and Kelly, as well as ABC Family Network.

These two television messages each have a unique concept and creative execution, thereby allowing Old Navy to showcase our extensive cargo fall assortment for the whole family, while appealing to teens as a place for them to shop.

Both spots placed within Ad Age Top10 recall ads, and to date, cargo has been meeting our expectations.

Coming up, a new TV campaign will launch at the end of September with which we will continue our segment to marketing approach and use this campaign as an opportunity to talk with another distinct group of customers.

In addition, this holiday we will start to explore marketing directly to Hispanic community with a Spanish language TV campaign.

The Hispanic community is an important customer base for Old Navy.

As we have learned, our brand positioning of fun, family and fashion at a great value really resonates with this customer.

In addition to TV, our circular continues to be one of our most important marketing tools.

We are using this medium as an effective way to talk to moms.

Our circular continues to evolve as we increase our level of sophistication by delivering unique marketing messages to very strategically by region, time of year, and product categories.

So, for example, in October, we will selectively segment circular by geographic region, highlighting different product messages for our hot-climate stores.

Also, we are using different times of year to speak to moms in a way that makes sense.

In August, we use the circulars to feature back-to-school fashions that she can buy for her children.

We will then use the post back-to-school period to entice mom to buy for herself.

We are very pleased with the success of our linen circular in spring and will continue to highlight product categories that resonates with our mom customer for both herself and her family.

Overall, we are very pleased with our first-half performance, and I'd like to take this opportunity to recognize the commitment and enthusiasm of the entire Old Navy team who executes and supports our strategies every day.

Together, we have achieved four consecutive months of store traffic increase, and post a 9% comp in July, on top of a positive comp a year ago.

In closing, I feel that we have strengthened our unique brand positioning, allowing us to draw from a very broad-based customer.

And we have refined our messages and become much more sophisticated at delivering that message to our target customer groups.

I believe that we will continue to drive the business forward and deliver sustainable financial growth.

Thank you.

Thank you.

That concludes our prepared remarks.

We will now open the call up to questions.

We would greatly appreciate it if each caller limits his or her questions to no more than 1.

At this time I would like to remind everyone, in order to ask a question, please press star 1 on your touch-tone keypad.

Your first question comes from Jennifer Black with Wells Fargo.

Good afternoon and congratulations on a great quarter.

This is kind of a tough question.

Some of us have had not such a great experience with Patty Gerosa in the past, and I wanted to know what kinds of checks and balances you have in place as far as changing merchandise assortments?

I realize she's a creative addition, but can you speak to that, please?

Yeah, let me be very clear about what Patty's role is.

Patty is not going to be responsible for choosing product, merchandise assortment, anything to do with the day-to-day business.

That is the role and responsibility of our business unit heads, Jenny, Gary, and so on.

We really felt that we had an opportunity to bring what I call a teacher or professor into the organization, someone who has the kind of experience associated with what it takes to bring creative and product together, and they are really focused on training tools, development tools, going out and working with the outside community, particularly design schools, to be able to nurture new talent into the organization.

So the role is truly a human resource development role, and not involved in the day-to-day decision making as it relates to product.

All right.

Thank you so much and good luck.

Your next question comes from Dana Cohen with bank of America.

Hey, good afternoon, guys.

I was wondering if you'd talk a little bit more on the inventory strategy?

Obviously it's coming down more than you originally anticipated.

Can you just amplify on, you know, the initiatives that are going on, and sort of the reverberations and timing?

Yes.

Byron.

One of the early focuses upon my arrival here was to try and bring a greater focus to metrics important to our business beyond growing store comps.

And inventory turns is one of those metrics that we have been focusing on a lot since the first quarter.

And it has become apparent that we were carrying what I would describe as excess inventories, particularly in our distribution centers and in the store stockrooms.

And so the focus here has been, first and foremost, to get a lot more precise and disciplined around how we time the receipt of our inventory.

And to do it in a way that is paced so that we don't have to carry excess inventory, particularly in the DCs and in the stockrooms.

And so as we begin to launch those initiatives, there's always the question of how quickly will such initiatives be embraced, how quickly will they be implemented.

And so, what we're finding is that we are able to influence receipt timing faster than we anticipated with no impact to the level of inventory that is available on the selling floor.

And we are able to do it with having no impact our planned units sold during the quarter.

So this is pure and simple inventory efficiency gains which we fully expect the resulting inventories to support our planned level of sales.

Thanks so much.

Your next question comes from Jeff Klinefelter with U.S. Bancorp.

Yes.

A question regarding the traffic trends and what that -- you know, should imply, I guess, as we look forward to the number of transactions and the transaction value during the next two quarters.

I know you don't like to comment specifically on margin trends or on comp trends, but considering that you are coming up now against positive comps from last year, should -- is the appropriate way to look at this, considering a stable but still somewhat negative traffic trend nationally, that we should see, sort of on a two-year basis or two- or three-year basis, a similar sort of comp trend that we've been seeing during the first two quarters?

And what would that imply about sort of your gross-margin targets for the year?

This is Byron.

As I think you know, we don't guide to future comp trends, so good question.

I think we will be able to respond to it the historical way, month by month.

Yeah, I just -- I'll just add a bit, is that, you know, clearly we're very pleased with what we've seen in the Old Navy's ability through our marketing efforts to drive traffic as we continue to segment and talk to specific customers.

So the strategies that we've been putting in place as it relates to our marketing efforts, which we believe have had a strong effect in the first half of the year, we certainly hope, will anticipate to grow in the second half of the year as well.

Okay, thank you.

Your next question comes from Stacy Pak with Prudential.

Comment on your thoughts on the real estate portfolio longer term, any rationalization, cannibalization, and what you're learning from Thompson Financial.

Yes.

The story here remains the same.

With four to five hundred lease actions coming due each year, and with really good models, we believe, in helping us understand market-by-market what happens to the value we can create, either by opening new stores, repositioning existing stores, or by selectively closing certain stores within a market, we expect to continue to make lease decisions using those models.

But for the most part, making those decisions at the time that a lease is scheduled to expire.

So, really no change there?

No change.

Then, as a follow-up, since there's no change, can each brand comment on denim?

Well, let me give you kind of a broad piece across the board.

Is you know that we have, particularly at Gap brand, have re-launched our men's denim.

I mentioned in my notes is that we are going to support that with television advertising, so that we're hopefully really driving that.

We're seeing some very good success with regard to the denim fashion wash product, and we're excited about where that's happening.

The new-fits, we've been calling out and getting store feedback has been extremely positive.

So generally speaking we're feeling like we're in a good position related to the products that we've put in place for the fall.

And Banana and Old Navy.

We've been focusing on Cargo on TV.

And on Denim, we've been really using our circular to really focus on that product and we're very pleased with Denim so far.

I mean, as you know, Denim really is about back-to-school.

But we did make a shift from, you know, our basic denim-wash to, as Paul mentioned, the fashion-wash, and we are really seeing an increase in sales in the fashion washes.

So it's really the Fashion Washes and the Fashion Silhouettes.

And just quickly for Banana Republic, I think you know that denim is not a major contributor so we're not seeing anything particularly different there.

Right.

Thank you.

Your next question comes from Todd Slater with Lazard.

Thank you.

Congratulations on your continued progress of building a better Gap.

I have a question about the third quarter.

You generated about $500 million more in the third quarter than in the first quarter, and I see the consensus efforts for the third quarter are still below that of the first quarter.

I notice that in the 13-year period from '87 to '99, the third-quarter earnings were typically double that or roughly 70% of those years, double that of the first quarter.

I'm wondering if there's something in this year's quarter or in your inventory investment that would hinder your ability to leverage that expected incremental volume?

Todd, what I would say, first of all, that we don't -- we're not yet prepared to talk about the third quarter with regards to beyond the guidance we have already given.

And so as we get closer -- well, you know what, until we get through the third quarter, I don't think we can respond to your question directly beyond the guidance we have already given you on the levers that directly relate to third -- to the third quarter.

You know, we've tried to be helpful on the levers that we've communicated, but beyond that, I'm afraid you'll have to wait.

Your next question comes from Ron Phyllis with Bank of America.

Good afternoon -- or good evening, wherever we are here.

It's afternoon but sometimes feels like evening.

Yeah, especially today.

Congratulations on a great quarter.

Thank you.

I guess I'm going to ask a repeated question regarding the use of potential future free cash flow, which looks to be significant, as well as current excess cash on the balance sheet.

You know, what are your plans in terms of using those monies?

Is there anything new on an acquisition front that you can chat about?

Well, first of all, Ron, we are very focused on generating free cash flow, and that is a metric that stands equally with our focus on growth and earnings, and return on capital.

As I said before, during my prepared remarks, we now have about $3.1 billion of cash on the balance sheet.

Because of the new credit facility we put into place in the second quarter, we are now using our own cash to collateralize our letters of credit.

And as a result, of the $3.1 billion, we now have $1.2 billion categorized as restricted cash, and this specifically collateralizes the LCs, and directly relates to almost $10 million of financing charges associated with our use of letters of credit compared to what we were paying last year.

That leaves a balance of a billion nine.

As you know, we are below investment grade at this time, which means our access to the commercial paper market is restricted.

And because we are still in turnaround, we believe it prudent to carry the levels of cash that we currently do that are unrestricted.

What we have we believe is fully ample for our business, and as -- and our primary use beyond supporting the ongoing operations of our business will be directed toward debt retirement in order to strengthen our balance sheet.

Would there be any specific areas of de-leveraging you would consider the most, you know, appropriate as you look at your capital structure.

As it stands now, we are looking to follow our normal maturity schedule.

Thank you very much.

Your next question comes from Amy Halzoff with Sanford Bernstein.

Hi.

I've got a question for Paul.

You guys have talked a lot about consumer segmentation.

Can you rank the brands in terms of which one you believe holds the greater opportunity for penetration going forward?

And just quickly for Byron.

You said payroll was one of the main reasons for the SG&A improvement in the quarter.

Are there additional operating efficiencies in this area or are you pretty much tapped out?

Thanks.

Amy, it's a little challenging to think about this in the context of which has the greatest opportunity.

I mean, clearly, Old Navy, given the breadth of categories and consumers that they are serving by comparison to Banana Republic, you know, arguably has a better opportunity within the breadth of the things that they're doing.

So -- and the size and scale of their stores alone.

So I think maybe one way to think about it is real estate's a driver of that.

But each of the brands have been able to find ways to really focus and drive penetration against these segments by finding the levers, whether it's a design lever, an assortment lever, to really drive the appeal for each one of these pieces.

So we feel very good that they all three have opportunities.

And I guess the best answer to your question is that certainly Old Navy, given the breadth and scope of their products in the marketplace and who they appeal to, should be able to do it in more categories and more classifications.

Amy, on leveraging of expenses, what I would say is -- you know, if you look at it from a historical perspective, we've reached, this year aside, we've been in the -- we've got as low as 26%.

With this quarter, we're down to a little above 25%.

So from a historical level, we are reaching kind of the best we've been able to achieve.

I do believe that further progress against those is possible.

Let me give you one example.

As we continue to rationalize our existing fleet, then we should get better leverage over existing store, labor, and selling expenses.

So -- but the first mission is to sustain -- to get our operation to a point where we can sustain kind of the best we've done so far, and then to start working on achieving greater leverage.

But I do believe there's more room to be gained here.

Great.

Thanks so much.

Your next question comes from Richard Baum with CSFB.

Hi, yes.

Good afternoon, everybody.

Could you talk about where you stand, andit's the smallest category, but with regard to maternity product?

You've got it in Old Navy, you've got it in Gap, and just in terms of the number of stores, you know, where it's being located and what your plans are?

Thank you.

Jennie, why don't you start with Old Navy.

Okay.

As I said, we are very pleased with the result to date, and we just completed another rollout of an additional 30 stores this fall.

So now it's available in over 80 stores and we're right now looking at additional stores for 2004.

How we are looking at it is really by market.

We really believe maternity is in a destination category, and so depending on the market and size will determine how many stores we can have.

I think the main thing is the store has to be big enough to carry another full shop before we can roll it into that store, but it's been a great category for us and we've been very pleased with it.

And then for Gap brand, as you know, that we've been selling our maternity stuff on line.

Today we have about 15 stores within the Gap brand.

And the focus is a little bit different for the Gap brand, where it's really a lot more about wear-to- work maternity versus Old Navy, which is broader.

So we're still going through learning at the Gap brand, but are confident in what we're building so far.

Thank you.

Your next question comes from Barbara Wycoff with Buckingham Research.

I'll add my congratulations.

Jenny, I have a question for you.

Given your very strong performance in first quarter and second quarter -- can you hear me?

Yes.

I saw 16 and 11% comps.

You know, if you're looking back, if you could do it over first quarter and second quarter, what would you do differently.

That's such a great question.

We've been very pleased, again, with our first half of the year.

I think really focusing back on the teen customer, has really started gaining some momentum.

So I think that's one area that I think we could even do a little bit more with the teens.

Not forgetting, again, I think we stabilized that segment, but what we want to do is probably gain even more market shares there.

Again, I want to stress that we don't want to lose -- continue to grow, really, the family and the mom customer along with the teens.

I think we probably could have been stronger for the first half of the year.

Okay.

Great.

Thank you.

Your next question comes from George Nissan with Merrill Lynch.

Yes, thank you very much.

Congratulations on a phenomenal quarter.

Thank you.

I have a quick question for Byron.

Byron, right now I'm very interested in how you and the Gap company are approaching the compliance of Sarbanes-Oxley?

And since the final four ruling was announced, what's your timeline towards utilizing solutions that are enabled and compliant?

Great progress on our front.

And I will say that the requirements associated with 4 of 4, I think that these are good initiatives for all companies to pursue.

So I don't consider this make-work, I don't consider it a trial that we've got to go through.

This is good solid control work.

We are pursuing a schedule that assumes that the original time frame did not change.

And so we are continuing -- we had a plan to meet that time frame, and we are continuing with that schedule, because our teams were already in place, it's good, solid work, and I, frankly, am very pleased with the progress we've made and the focus of the work.

When are you planning to be compliant, and, also, have you worked with the big 4, are you putting in a software solution?

What's your plans to be compliant?

The answer is that we have retained KPMG to work with us, and we are using a KPMG proprietary tool to assist us with both the mapping of our processes and then -- and that tool also not only enables us to go through a very disciplined process for testing the controls, but it does it in a way that teaches the purpose of the control, documents the control, and then builds a process that will allow us to sustain it on an ongoing basis.

And those were our objectives as -- as we said, about complying with this requirement.

Great.

And continued success down the road and congratulations on a wonderful quarter.

Thank you.

Your next question comes from Joe Teklits with Wachovia Securities.

Congratulations.

Byron, I wonder if you can give us some color on the 200 basis point leverage of rent occupancy and depreciation on a 10% comp, and whether that kind of leverage carries forward on a similar comp going forward in the second half of the year?

We have a rule of thumb that says for every percentage point gained in comp year-over-year, you get anywhere from a.1 to.2 % leverage on ROD, and I think that's probably a pretty good rule of thumb.

So that would be very similar in Q2 as to Q1, so the same for the whole year, every quarter for the whole year?

Yes.

And going forward next year as well, that doesn't change?

Well, you know what?

It's a rule of thumb that we've developed looking over a series of years, so I think that's a good multi-year guideline until we start to see a fundamentally different relationship.

Super, thanks so much.

Good luck.

Thank you.

Your next question comes from Dorothy Lakner with CIBC World Markets.

Yes.

And good afternoon, everyone, congratulations on a great quarter.

Thank you.

I wonder if you could comment a little bit more on the segmentation, particularly as regards the type of thing you're doing with Pass-it On field surveys.

You talked in the past, Paul, about doing more work with all the people that you have that work in stores and that touch the customer, talk to the customer every day.

I just wondered if there are other examples of things you're doing you could share with us, and just a little bit more color on what you're doing in those surveys?

Thanks.

Well, there's lots going on.

There is a variety of different ways that we are trying to not only build a broad view of the apparel segment and the segmentations that we compete in today, and those segments that we think we can compete in tomorrow.

So we're doing this with qualitative work, focus groups with our consumers.

We're doing it with significant quantitative work, much of which was led by the Leo Burnett Company and other companies in that process.

But also important in terms of testing our approaches and our hypotheses and hearing directly from our customers, we have a variety of on-line surveys, where we incent our customers to come and talk to us about product as well as customer satisfaction in store level.

And then the Pass It On survey, which we are now in our second quarter, is a survey that goes out to all of our store managers.

We've had tremendous input from all our stores and virtually all of them participating.

And what it's really doing is giving us better ideas about our assortments.

For instance, on a regional basis, that's giving us better indication about how well we're doing in terms of setting up, whether it be sweaters or outer wear and sending it to our market early or late, giving us feedback on product fit.

So there's a variety of information that we're gleaning from a variety of consumer intercepts and programs to be able to build on this.

As it relates to the segmentation work, broadly, each of the brands now have pretty much completed their segmentation work.

What you learn from segmentation work is, it's the beginning of the frame.

And then, ultimately, over time you continue to build more robust insight from these consumers to understand how we can serve their needs.

So we have the frameworks in place today for each of the individual brands, and then of course at the Gap Inc.

level, we continue to look at these segments to understand where the opportunity is for long-term growth.

Thanks.

And then just another comment.

Given the success of the in-store event you had in New York with the monogramming on the cords, are you thinking of doing similar things or more things like that in more stores, perhaps in the fourth quarter.

Well, that particular event was a huge success, and we did roll it out to several other markets.

You know, we think that there's -- when we look at our marketing strategy for Gap, we need to consistently look for opportunities for us to drive traffic, and also create buzz and excitement.

And we think that this event did very much what we intended it to do.

Needless to say, it's almost impossible to find a pair of red cords out there today.

And --

Almost impossible to find them that morning, I can assure you.

Yes, exactly.

So we were thrilled with that.

And an incredible number of people who didn't want their own initials but wanted the M, which I always find a little fascinating, but fantastic.

So, you know, what?

I think the one thing about the Gap brand for us, which is important, is it has always been what I kind of call culturally current, always looking for creative ideas that really are spot-on to cultural phenomena that are happening in the marketplace.

I think the dynamic mix of Madonna and Missy Elliot was, frankly, brilliant.

And it achieved what we hoped it would achieve, and certainly it talked to younger customers.

And as I mentioned in the speech, in a couple weeks we'll be breaking with our second campaign focusing on women.

But for more of our core customers, more of the traditional customers that we expect, that are looking for those iconoclastic products from us, but done in an updated fashion way.

Operator, we have time for just one last question.

Your next question comes from Dana Kelsey with Bear Stearns.

Good afternoon everyone.

Byron, can you talk a little bit about the operational financial metrics that you've had in place, the revenue flow through to earnings, cash flow before financing and economic profit?

Since you've come to the organization, have they changed at all?

What if any adjustments or enhancements and how are they tracking?

And lastly, with the value proposition that you've installed in the clothing, where the clothing actually has become better, whether it's the buttons or the inside lining of the pants, can the pricing be maintained with the enhanced product qualities in the different products across all concepts?

Thank you.

Okay.

I'll take the first one, Dana, and then Paul will take the second.

In terms of financial metrics, what I would say, first of all, is that the three that are the centerpiece are growth in after-tax earnings, growth in free cash flow, and then a use of -- the focus is on Return on Capital, the measure we'd like to use is an economic profit measure.

I would say the two that have lead focus since my arrival -- by the way, all three of these measures are ones that pre-dated my arrival, but it's a matter of bringing focus and balance between the three.

And I think what's important is that all three, in a sense, have an equal representation at the table.

And the two that I think -- not think, the two that are getting much more focus in combination with earnings is the focus on free cash flow and economic profit.

And the first area of focus within free cash flow is on inventory turn, and really putting a focused effort behind rationalizing our store fleet and optimizing it so that we can improve our Return on Capital.

Economic profit is one that requires a bit more architecture in order to implement effectively.

So I look at economic profit more as an '04 measure as opposed to a '03.

The focus on earnings and cash flow very much in place in '03, but probably will have more impact on the cash-flow side in '04, given the lead times in our business.

Flowthrough is- before I turn it over to Paul, flow through is a very important metric for us.

We look at it -- basically how much incremental earnings are we flowing through based on how much incremental sales we produce?

And I think this is -- keeping this front and center, as opposed to simply looking at the absolute increases of our earnings, is an enormously important, because it's a real measure as to the quality of our earnings growth.

And so that is – that is now a very strong focus within our organization, and we talk about it every -- every month in forecast review and then as a part of every debrief of our quarterly financial performance.

And then the answer to your second question, you know, there's two sides of the coin, and I just want to remind everyone of the tremendous sourcing leverage that we have in the marketplace that allows us to continue to gain improvements in products and also be able to gain improvements in our costing throughout the world.

Having said that, we clearly know, based on our feedback from our consumers, that when we put in relative details or fabrication improvements that our customers are responding very favorably, and maybe a couple examples, in the kid's area when we've added Gap Shield to the khaki pants have been very well received from our consumers.

When we look at our denim product and the washes and the complexity of providing that kind of product and detail, we're getting very -- a very good response.

Banana Republic, when we try to work very hard at not only our details but our fabrications, mixing with fashion, our consumers are responding well to that.

So a combination of leverage with our sourcing and putting it where our consumers are recognizing the difference and where it's important to them, we feel that balance is getting us where we need to go.

Thank you.

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.

Good night.

Thank you for participating, you may now disconnect.