蓋璞 (GPS) 2003 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to Gap, Inc.'s third quarter conference call.

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Investor Relations at 415-417-2175.

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

Thank you, ma'am, you may begin.

Good afternoon, everyone.

I would like to welcome you to Gap, Inc., 2003, third quarter earnings conference call.

For those of you participating in the webcast, please turn to slide 2.

I would like to remind you that the information made available on this webcast and conference call contains certain forward-looking statements which reflect Gap, Inc.'s current view of future events and financial performance.

Wherever used, the words "expect, plan, anticipate, believe, may have similar expressions" identify forward-looking statements.

Any such forward-looking 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 10-K and/or other filings of the Securities and Exchange Commission.

Future economic and industry trends that could potentially impact revenues and profitability are difficult to predict.

The company is under no obligation to publicly update or revise 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 a non-generally accepted accounting principle measure, cashflow before financing activities, which under SEC reg G we are required to reconcile with GAAP.

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

This afternoon, we'll begin with Byron Pollitt, our Chief Financial Officer, discussing our third 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 Old Navy.

After Paul, Marka Hansen will comment on Banana Republic.

After Marka's remarks, we will open the call up to questions.

We expect the call to last an hour.

Now I'd lime to turn it over to Byron.

Thank you, Sabrina.

Good afternoon.

A recurring theme of our earnings calls has been our focus on driving ongoing fundamental improvement in the health of our business and in the quality of our earnings.

This third quarter strongly reinforces that theme.

Our teams produce solid results against the toughest comparisons we've faced since our turnaround began over a year ago.

We are pleased that total sales and comps were up in each division.

We better satisfied our customers, and we delivered more value to our shareholders.

Strong performance always begins with great product.

At Gap, Banana Republic, and Old Navy we are clearly driving stronger product acceptance with our customers as evidenced by third quarter improvements in regular price selling and overall merchandise margins.

More disciplined, fiscal, and operational management insured that we translated those gains for the quarter into higher quality earnings, key to these gains, with tighter inventory management.

At lower inventory levels than prior year, we supported positive comp store sales growth and margin improvement while meeting customer expectations.

Here are other highlights for the quarter.

Traffic trends improved, especially at Banana Republic and Old Navy.

Conversion and units per transaction increased at Old Navy and average unit retail was higher at both Gap and Banana Republic.

Overall for the third quarter we executed well against our strategic priorities, driving quality earnings by improving margins, flowing our earnings through to strong cash flow, and increasing our returns on capital by improving inventory turns and optimizing the productivity of our store fleet through selective closures and repositioning.

Now let's take a closer look at third quarter results.

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

Third quarter earnings were $263 million or 28 cents per share compared with 135 million or 15 cents per share last year.

Our convertible note was dilutive.

Sales and gross profit drove this significant earnings growth.

Our earnings also reflect a more normalized tax rate of 39% compared with 45.5% for third quarter last year.

Year-to-date earnings were 674 million or 72 cents per share, compared with 229 million or 26 cents per share last year.

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

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

Total sales were 3.9 billion, up 8% from 3.6 billion last year.

Consolidated comp store sales were up 6% compared with a 2% increase in the third quarter of 2002.

Sales productivity improved 8% to $103 per square foot compared with $95 per square foot last year.

Looking at comp store sales by division for the quarter: Gap U.S, positive 5% versus negative 2%;

Gap international, positive 4 versus positive 2;

Banana Republic, positive 11 versus positive 1; and Old Navy, positive 6 versus a positive 6.

For third quarter total net sales by division, please refer to our earnings press release.

Turning now to gross profit performance on slide 5.

For the quarter, gross profit increased 16% to 1.5 billion.

Gross margin was 38.9%, up approximately 3 percentage points from last year.

We gained approximately 2 points from better merchandise margins.

The remaining 1 point came from the leveraging of rent, occupancy, and depreciation expenses.

Year-to-date gross profit increased 26% to 4.1 billion.

Gross margin improved approximately 4 percentage points to 37.7%.

Turning to operating expenses on slide 6.

For the third quarter, operating expenses totaled 1.1 billion up 4% from 1.0 billion last year, due mostly to higher store payroll to support increased sales and to increase to store repairs and maintenance.

As a percent of sales, total operating expenses for the quarter were 26.8% compared with 27.7% last year due to leveraging of expenses on improved sales.

Advertising expenses in the third quarter were 174 million up 4% or 7 million from the prior year.

This is below our prior guidance of about 200 million, due mostly to lower-than-expected costs at Old Navy and Gap.

Year-to-date operating expenses were 2.9 billion compared with 2.7 billion last year.

As a percent to sales, operating expenses were 26.2%, down 1.3 percentage points from the prior year.

Turning to inventory on slide 7.

We ended the third quarter with 2.6 billion in inventory, down 227 million versus last year.

During the quarter, we continued to execute against our strategies to optimize inventory productivity.

Specifically, we more effectively managed slow returning inventory and optimized overall receipt timing.

This allowed us to reduce overall inventory while maintaining appropriate in-store merchandise levels to support sales growth.

As a result, inventory per square foot was $67 at the end of the third quarter, down 7% and below our previous guidance of remaining about flat to last year.

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

Year-to-date capital expenditures were approximately 181 million down, 16% from 217 million last year.

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

Net square footage at the end of the third quarter declined about 2% from the prior year.

Year-to-date, we have opened 33 store locations and closed 75, ending the quarter with 3075 locations.

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

Now, please turn to slide 9 as we walk through the key components of our cash flow performance.

During the third quarter, cash flow before financing activity was 278 million compared with 42 million last year, driven by higher earnings and lower working capital uses related to inventory purchases.

Year-to-date, cash flow before financing activities was 519 million, compared with 85 million last year.

Similar to the quarter, stronger earnings and better inventory management drove this significant year over year improvement.

We ended the third quarter with 3.4 billion in cash, of which 1.4 billion was restricted.

Our restricted cash primarily supports our new letter of credit program which has enabled us to lower interest expense this year.

Our total outstanding debt was 2.9 billion, leaving us with 500 million more in cash than we had debt on our balance sheet.

As we have said for some time, it is our goal to bring down debt leverage.

In addition to paying down debt per our maturity schedule, we are regularly evaluating early bond retirement opportunities.

To that end, you will note in our third quarter financials, we repurchased $27 million of Euro bonds in the open market.

We have also made some repurchases in the U.S. in the fourth quarter, but these amounts are not material.

Turning to slide 10, I would like to comment on our outlook for the rest of 2003 and provide some initial guidance for 2004.

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

Fourth quarter advertising expenses are still expected to be about 150 million versus 134 million last year.

The increase is due mostly to Gap brand investments in holiday window displays and TV advertising.

With regard to interest expense, we expect gross interest expense to be about 55 million in the fourth quarter and about 235 million for the full year, compared with 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 2003 to be 39%.

Factors that could cause this rate to fluctuate include our mix of domestic and international earnings and our overall level of earnings.

We estimate that fluctuations could result in an anticipated effective tax rate in the range of 38 to 40%.

Regarding inventory, we remained focused on maximizing inventory productivity.

Going forward, we will continue our efforts to: one, manage slower turning inventory effectively; two, optimize receipt timing; three, reevaluate optimal in-store and distribution center inventory levels; and, four, reassess replenishment frequency to optimize inventory turns.

Importantly, we are always working to properly balance inventory productivity with sales, insuring that our stores are well stocked for our customers.

As a result of our efforts, we are now planning inventory per square foot at the end of the fourth quarter to be down on a percentage basis in the mid to high teens compared with a 13% increase last year.

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

By the end of the first quarter of 2004, we are planning a decrease in inventory per square foot in the high single-digits compared with a 17% increase in the prior year.

As we experienced in the third quarter, we believe that these lower inventory levels are appropriate to support our growth objectives and to meet customer expectations in our stores.

In terms of capital expenditures for 2003, we expect capital spending to be about 275 million for the year, below our prior guidance.

Here's how that breaks down.

Store capital is expected to be about 105 million, with approximately 30 million for new stores and up to 75 million for existing stores.

IT spending is still expected to be about 140 million, and the remaining 30 million will be split between headquarters and distribution centers.

We expect the capital expenditures for 2004 will be about $500 million.

We will provide more specific capital spending guidance next quarter, once our budgets are finalized.

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

For the full year, 2003, we anticipate about 35 new store locations and about 135 store location closures.

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

For fiscal 2004, we expect to open about 125 new store locations and expect a comparable number of store location closures.

New store locations will be weighted towards Old Navy, while Gap domestic stores will account for the majority of locations closed.

As a result, we expect net square footage to remain flat for the full year, 2004.

This completes my review of our financial performance.

In summary, we are pleased with our performance this quarter.

We are executing against our strategic priorities, and we're seeing the results in higher quality earnings, strong cash flow, and increasing returns on capital.

Now, I would like to turn it over to Paul.

Thank you.

Good afternoon.

Today I will talk about our third quarter accomplishments, speak to my focus on developing our management talent, and provide a brief update on Gap and Old Navy.

Marka Hansen will give an overview of Banana Republic.

I am proud of what our teams achieved in the third quarter and how we are balancing short-term objectives with long-term priorities.

Factors, such as the blackout and unseasonably warm weather, added unexpected volatility to the quarter, but we delivered a solid overall performance.

Third quarter reflected more disciplined execution of our brands' growth strategies, as well as the benefit of our evolving customer insight and segmentation efforts.

Compared to a year ago, when our turnaround was just getting under way, our product assortments this fall were more sharply edited and more clearly merchandised to our key customer groups.

Our marketing was better executed, as well.

We continued to learn how to effectively segment and target customers communications to drive traffic and support sales in featured products and categories.

Stronger merchandise and marketing helped improve regular priceselling and markdown marginsm.

And our focus on inventory management drove higher store productivity with lower inventory per square foot in the quarter.

Customers are clearly responding to Banana Republic's more elevated product design and emphasis on affordable luxury.

Gap continues to build momentum with more fashion-right product, particularly in its women's business.

Old Navy is driving growth by consistently delivering compelling value in distinctive fashion to moms, families, and teens.

With our corporate emphasis on operating discipline and tighter fiscal management, we flowed our top line accomplishments for customers into strong bottom-line earnings growth for our shareholders.

Although we are entering a holiday season with more difficult fourth quarter comparisons, I am confident in our strategies.

Before providing more detail on Gap and Old Navy, I would like to touch on talent and the progress we made during the third quarter in strengthening our senior management team and our Board of Directors.

A priority for me has been developing our management team in attracting top talent to lead our growth strategies.

To that end, we announce during the quarter, three additionals to our senior team.

Andrew Roth will lead our International Division as President.

His leadership experience in managing a variety of business models across diverse international markets will allow us to begin in earnest our analysis of growth opportunities.

Nick Cohen joins us as our new Chief Supply Chain Officer to help us more fully leverage the competitiveness of our global infrastructure, and Michael [Desougy] joins us as our new Chief Information Officer to lead the implementation in alignment of technology to support our business strategies.

At the board level, we announce two new directors: Meg Whitman, President and CEO of eBay, and Jim Schneider, CFO and Senior Vice President of Dell.

The Board also named former Wal-Mart executive, Bobby Martin, as its lead Independent Director.

I am looking forward to the insights and contributions of Meg and Jim, as well as the continued support and expertise of other board members.

The diversity of business experience represented in our board is a tremendous asset to our management team and to our shareholders.

Now, here is a brief update on Gap and Old Navy.

Gap is continuing to build momentum by staying focused on its key priorities: improving design, using customer insights to inform and sharpen product assortments, and engage customers through more targeted communications and enhanced service.

In addition to more regular price selling, ongoing sales training focused on helping customers put together complete outfits, supported gains in average unit retail for the quarter.

Product assortments in the third quarter were more targeted to Gap's adult's two primary customer segments: style conscious and updated classics.

For example, Gap introduced a new slim fit jean and a wider variety of pant length and styles in popular stretch fabrics for women.

Gap continued the segmented marketing efforts launched in the spring following our popular-back to-school advertising in August, featuring Madonna [inaudible].

Gap launched separate TV ads for men and women in September featuring key products for fall.

Strong sales of the women's stretch bottoms and men's relaxed boot-fit jeans featuring these spots underscored the effectiveness of these efforts.

For holiday, Gap is focusing on its strength in color and gift giving.

Crazy Fair Isle sweaters and accessories in a strong holiday color pallet are the key products of the season, building on the success of last year's Crazy Stripe sweaters and scarves.

Gap's holiday message is carried across adults, kids, baby, and body.

Holiday marketing features separate TV ads for men and women, two additional ads, one featuring accessories and one dedicated to the family, reinforce the warmth and emotion of the season with Gap's perfect gift holiday message.

Turning to Old Navy, the brand continues to better understand and meet the needs of mom, families and teens and communicate compelling value with specialty flair messages to customers.

Product and marketing segmentation have been key drivers.

For example, Old Navy's September circular focused on the popular essential pant for moms offering in pre-fits.

Knits also performed well, supported in part by T-shirt offered in three fits: tiny, perfect, and easy.

These fits have broad appeal to teens, moms, and young adults.

Old Navy's maternity line also continued to be a success.

Maternity was expanded to 30 more stores in the quarter, bringing the total to 83.

Also in fall, Old Navy launched a TV campaign promoting Cargo, with separate spots for teens and families.

The Cargo campaign was well received, allowing the brand to showcase it's extensive Cargo assortment for the family while appealing to teens as a shopping destination.

For holidays, Old Navy also targets teens and families with separate TV ads.

Key products featured this are split-neck sweaters, performance fleece half zips, hoodies, and an assortment of great giftable accessories.

This holiday, Old Navy also is testing its first campaign targeted to Hispanic consumers.

The ads, which will feature Erik Estrada and Walter Macado will air in Spanish on major Hispanic TV networks, welcoming Hispanics consumers into Old Navy stores with a message to moms and a focus on fleece.

Circulars also continued to be powerful part of Old Navy's marketing mix.

The brand has learned a lot this year about how to use circulars to drive traffic and communicate a strong value message.

As with last year, two of Old Navy's fourth quarter circulars will be nationally distributed, serving both as an effective brand communication vehicle and a holiday gift guide.

As I look back on my first year, I am extremely proud of the work achieved by our teams, and as we enter the fourth quarter and look to the next year, our brand priorities remain the same: continue evolving our product design and merchandising, deepen our customer insights to inform our product, marketing and customer service strategies, and enhance our marketing communications.

Corporate ride will remain focused on improving our operations and balance sheet and building a strong foundation for longer term growth.

Now, before we take questions, Marka will update you on Banana Republic.

Thank you, Paul, and good afternoon.

I am very excited to be heading up this great brand at this time.

We are pleased with the path we are on, which is reflected in the Q3 results.

Some of you may not be aware that I began my Gap, Inc. career here at Banana Republic, 16 years ago as a merchandise manager.

So it's a special reward to be back.

Today I would like to update you on the priorities of the brand, how we are executing against those, and touch on our preparations for holiday.

First, however, I would like to spend a few minutes on our third quarter performance.

We have been pleased with the performance of fall products as positive customer response helped drive average unit retail and conversions up in the quarter.

Importantly, our traffic trends turned positive in September and October, coinciding with fall product flows.

This success reflects the impact of our efforts to elevate and differentiate the brand, as well as the impact of tighter execution from our design, merchandising, and store operations team.

During the quarter, our success in women's continues to be driven by a focus on dressing for different occasions, offering the right clothes for work and the right clothes for the weekend.

We showed strength specifically in sweaters, skirts, and accessories.

Our accessories line allows us to complete the outfit by offering the perfect scarf, the perfect clutch, or the perfect earrings.

We have seen positive response to our jewelry, and we've added additional cases in about half our stores during the quarter.

In the men's business, we saw strength at both ends of the spectrum with elevated style items and casual items.

The relaunch of suiting rolled out in stores in August was very well received.

Our Better Luck's twill and novelty shirts continue to perform well.

On a more casual end, the relaunch of denim also [inaudible] for the brand.

I would like to turn now to our three primary priorities: differentiation in the brand through the product, elevate an in-store experience for our customers, and more effectively segmenting our marketing and communicating the brand message.

On product: You're seeing the impact in stores of more focused assortments around coveted items and fewer basics.

We use this focus to create more excitement and more demand, which is even creating waiting lists for a few of our more special items, the playsuit, for example.

We continue to increase our focus on offering irresistible, affordable luxuries in all stores, and we're able to deliver a very high quality fabric at great price points.

Also this fall, we've expanded our B Republic line of sports-inspired casual and weekend apparel.

This collection represents fashionable weekend wear that is consistent with the style aesthetic offered in the rest of our collection.

Rolled out to all stores for -- in fall for men, a women's B Republic line will be introduced in all stores for this holiday.

Another initiative we're pursuing that we've previously only offered online is the Banana Republic Teeth collection that we rolled out to our four flagship stores this fall.

Women who buy petites are some of our most valuable online customers in terms of strong brand loyalty, high average order size, and increased purchasing frequency.

We're pleased with the early success and plan to add another 11 stores for spring.

Another of our top three priorities is to elevate and improve the in-store experience.

We have taken a comprehensive approach to this, looking at how we measure and manage the stores from a large scale perspective down to how the stores are staffed and how they look and feel.

For example, from a visual perspective, you will notice the use of more props in the stores.

We're also making more subtle changes like altering wall colors to match seasonal pallets.

This fall, for example, we painted an accent wall pink in the women's store to complement the collection but also painting a wall silver in the men's store to accent the B Republic line.

For store employees we doubled the amount of time devoted to training.

In addition, we've completely redesigned all of our product training, tools, measurements and in Spanish to support our enhanced service culture.

We are also piloting a program to bring back clientele specialists in select stores.

These specialists keep a book of customers for whom they provide personalized service.

They are also compensated in a way that recognizes their superior contribution to sales.

We also got an early start on holiday hiring this year, providing a couple of benefits.

We get to be a bit more selective in our hiring and we get more time to train and emphasize our commitment to service.

I would like to turn now to our brand communication where our focus is continuing to communicate our elevated styling, upgraded quality, marketing to men and women separately, and increasing our reach in more publications.

Wish for color is the theme of our holiday campaign and will be an integrated campaign across all the brands marketing channels.

Emphasizing gifting, the campaign features which colors and luxury fabrics to make a clear and bold brand statement.

It is inspirational, sophisticated, and colorful enough to grab attention.

We will continue to expand our reach to both our men and women target customers with print tailored to each.

In addition to newspaper magazines, you will also see our campaign executed online, in stores, outdoors bus sides and taxi tops, and other iterations.

Also the holiday display windows went up this week and are especially compelling.

We have also begun communicating about our upcoming spring line by conducting Banana Republic's first ever fashion preview for editors earlier this month.

This type of event drives editorial coverage in fashion magazines and helps us communicate to the more sophisticated shopper.

Early feedback from the show was overwhelmingly positive with an early write-up on the cover of last Tuesday's Women's Wear Daily.

It's been a strong quarter.

Our team is in place and energized, and our customers, both men and women, are responding to our elevated styling and improved in-store experience.

It's great to be a part of the Banana Republic Team.

Thank you very much.

That concludes our prepared remarks.

We will now open up the call for questions.

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

At this time, if you would like to ask a question, simply press star, then the number 1 on your telephone key pad.

We will pause for just a moment to compile the Q&Ar roster.

Your first question comes from Mark Friedman.

Thank you, good afternoon, everybody.

Paul, I was wondering as you look beyond Christmas, what are you thinking about as far as some of the continued research do as to where you see opportunities.

Is there anything new that you have uncovered especially in product extensions within the current brands where you see focusing the businesses in 2004?

Well, as you know, we are continuing to learn a tremendous amount by the efforts we put in place in the third and fourth quarter.

We continue to look at maternity, expand that product and category.

We are looking at GapBody as an opportunity, petites in Banana Republic.

Marka will be rolling out some more stores.

We are measured in our approach in making sure that we can achieve success as we grow it out.

We think that there is great product in category extensions.

We also know from our segmentation work, it gives us the opportunity to better serve the customers that we have today.

Moms in Old Navy and teens, I think that we can be more aggressive there, as well.

I think across all the brands there are lots of different areas that each of them are pursuing.

Thank you.

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

Bancorp Piper Jaffray.

Yes, question for you, Paul, as well.

Considering your recent series of ads that you had on TV, the two women's and one men's ad are very targeted in terms of what networks and what programming they were on.

Have you seen any response to that?

Any light you can shed?

I know you don't break down category performance during the quarters, but any light you can shed on how those two categories are performing relative to that ad campaign?

Yes.

Generally speaking, we were very pleased with the performance in fall and specifically those ads.

We wanted to do two things.

We wanted to follow up what we think is our more more culturally hip commercial with one that was very focused on wardrobing.

Not only did it feature the strength of our bottoms, and we had some very good strength in cords, both for men's and women's, but we definitely felt it gave a woman a better opportunity to see the overall presentation that she can do with tops and bottoms.

So stretch pants for women was clearly a call out and as a result of the ad campaign.

We feel really good on how effective it was.

For men's as well.

Some of the fashion washes were clearly a call out for us at Gap, Inc.

Thank you.

Thanks.

Your next question comes from Emme Kozloff with Sanford Bernstein.

Hi, I've got a question for Byron.

When you talk about inventory optimization, can you tell us out of the factors that you named, like better receipt timing and overall stock levels, things like that. which of the levers has the greatest opportunity going forward, and is this a systems-driven process or more a shift in management strategy?

Thanks.

I would still say with regard to the first part of your question, that the combination of receipt timing, the bringing more science with regards to our replenishment algorithms, what we keep in the DCs, how much we should be keeping in the back stockrooms of the stores, that is really a system solution, and the math works from the supplier all the way through to the time of goods arrive in the store.

I would say the optimization of that inventory flow is the biggest opportunity for us going forward.

And with regard to whether that is a system solution, there is much we can do to optimize that flow by bringing algorithmic math much more into how we make decisions on inventory levels, and that is more about applying math.

At some point, we will need systems enablers that will allow us to take that to another level.

But I think over the next six to twelve months, there is a lot of progress we can make.

You are already seeing some of the returns of that progress.

That is not systems dependent.

It is much more decision role and about introducing more science into how we set our inventory levels.

Great, thanks.

Your next question comes from Janet Poppenberg with JJK Research.

Hi, Byron, hi, Paul.

I wanted to ask a question about the opportunity for gross margin growth in the fourth quarter.

You had a very strong increase in gross margin last year.

I know you're seeing full price selling improve, and I am wondering if there is substantially more opportunity for that or if you are reaching your goal levels?

I would say that, well, we as a management team believe that there is further room in the gross margin.

And I would categorize it into two buckets.

Uh-huh.

The first is, we believe there is still an opportunity for us to move up the mix of our reg price selling, which would move gross margin up, and, in addition, for the next several years, we have an opportunity to continue to optimize our store fleet, closing stores that are our lower performers, replacing them with stores that have higher returns.

So part of gross margin is your ability to leverage on your rod, related expenses, and we believe over the next several years there is still an opportunity for us to move the gross margin with further leverage on rod.

Great, thanks very much.

Your next question comes from Kim Greenberger with Lehman Brothers.

Great, thank you, good afternoon.

Byron, this question is for you.

As you look at the SG&A expenses for GAAP, just over the longer term, where do you think the best opportunity for cost savings might exist, and what do you think the optimal level of SG&A expense is, just, you know, maybe not next year but just as you look at over time?

Kim, this is a very good question.

To be perfectly frank, we don't have a clear picture of that yet.

We've--you know, naturally, SG&A should leverage as you ramp up your sales.

But we have a number of factors that are impacting SG&A that we are still studying pretty hard, the first one of which is just a phenomena.

We went through several pretty tough years, and coming out of that, we had deferred some repairs and maintenance at the store level.

We have a bit of catch-up to do.

So, certainly over the next two years, I would say we will be in catch-up mode on store repairs and maintenance.

That hits your SG&A line.

In addition, as many companies have experienced both medical and workers' compensation expenses have been growing pretty significantly, and we have not yet -- we are still very much in study mode with regards to what longer term implications we have both to control it and what that implies about our cost structure.

Marketing for us is a critical driver of traffic.

The role of marketing differs within each of our three major brands.

We have not yet settled on what we would describe as a more normalized rate of marketing spend, and that has a big impact on the degree to which we will leverage.

Finally, fourth, we are now getting to a point where we are beginning to spend on opportunities for future growth.

Those expenses also appear in our SG&A line, and we have not yet sized the opportunities that we have before us and what kind of spend that would imply with regards to evaluation and then, in fact, launching those initiatives.

Until we have a clearer picture of that, we are reluctant to be much more specific on SG&A going forward.

That was very helpful.

Thank you.

Your next question comes from Stacy Pak with Prudential Equity Group.

Hi.

I guess on the 500 in Cap Ex, can you share with us how much of that is -- I know you haven't defined it perfectly, but how much of that is, you know, new stores versus remodeling and IT.

Given where you are in the turn, which obviously has been very impressive, what are your thoughts for growth beyond next year in terms of a concept for or an acquisition, and when will you be prepared to talk about?

Why don't I take the first part, which is the Cap Ex, and then I will turn it over to my colleague here for growth.

First of all, traditionally at the third quarter point, we try and give some guidance for next year's capital expenditure level which we have in the $500 million range.

During our fourth quarter call, we will provide the buckets that we are projecting those capital expenditures to fall in.

So, Stacy, you will have to wait a quarter to get a more detailed answer.

But having said that, we have indicated that we thought we would be -- we are projecting to open 125 new stores, so that will be clearly an important bucket for that capital spending.

Just as we have a bit of catch-up to do in repairs and maintenance, we have a bit of catch-up to do in remodels.

We'll talk about that more at the fourth quarter call, but we would expect to increase our remodel budget.

Finally, on the IT front, I think this is important to call out, that the primary expense associated with the implementation of our new POS system and the hardware deployment is going to occur in fiscal year 2004, so that will be an important component of our IT spend.

Beyond that, Stacy, I will ask you to wait till the next call.

Just on those stores, Byron, is there anything unusual, i.e. a lot of flags, or is this just sort of normal stores?

Normal.

Paul?

Yes, just real quickly on growth.

I would say it's too premature for us to talk about anything significantly different, vis-a-via a acquisition or fourth brand.

We still are -- feel very compelled by the amount of growth that exists within our existing brands, through the strategies that we continue to deploy.

And then, of course, as a management team, we continue to look at the overall opportunities for us long term, but a little too early for us to talk about it right now.

Thank you.

Your next question comes from John Morris with Harris Nesbitt.

Hi.

Good afternoon.

My question would relate to do the Old Navy opening slating -- slated for next year, and the fact that the bulk of them would be -- bulk of your new openings would be for Old Navy.

Is there any change we should anticipate or that you're working on with respect to your real estate strategy, to your location approach for those stores in terms of demographics, etc?

I would say -- this is Byron.

I would say, no, we are staying on strategy.

You will -- with Old Navy, you will see a weighting more towards strip locations than mall locations, but we are primarily looking for opportunities that offer attractive rates of return on our capital spending.

So, and these generally, you're gonna find those in market voice.

I would say you will probably see most of those opportunities occurring in both Canada and the U.S.

So both of those countries.

But basically, we are staying on strategy for all the brands in terms of store openings.

Thanks, very much.

Good luck for holiday.

Thank you.

Your next question comes from Barbara Wyckoff with Buckingham Research.

Hi, everybody.

Hi.

I have a question about merchandise margins, 200 basis point improvement.

How much really of that was related to lower markdowns and how much was from the initial markup.

And then what is the opportunity to keep growing IMU going forward?

And then lastly, three part question, if you could comment on the expected impact on the reinstatement of quotas from China?

Well, with regards to the improvement in merchandise margins, what you saw was the result of an improvement in our reg price mix versus markdown.

And then also within our reg price selling, we had an improvement in our reg price margin.

That improvement was largely due to two factors: the first, if you recall, when we have planned promotions, we include that in our reg price margin.

We had a little less planned promotion sales in our reg price mix.

That helped margin.

And in addition, we experienced some favorability in cost, which gave us a little bit higher margin at reg price.

Okay, and then opportunity growth forward?

I think from a merchandise margin standpoint, I think we pretty much covered that with an earlier question.

Then I think you asked something about--

Well, just in terms of China and quotas.

You know what, there's two things.

One, as you know, we have got a very broad sourcing base.

And as you also know that in 2005, quotas doesn't really get lifted across the board.

It is a slow transition all the way through 2008.

So we've got about 14% of our goods that are sourced out of China today.

We have a tremendous amount of flexibility to either chase or make to sure that we have got enough sourcing around the world to accomplish our goals.

So don't see any material effect in the change of quota status in '04 -- '05.

Okay.

Thank you.

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

Thanks.

Good afternoon, everyone.

I wondered if you could talk a little bit more about what you're thinking about international now that you've been here for a year, Paul, and you have just hired a new president for international.

Are you thinking about international in any different ways than you were before, and I wonder if you might just share that with us.

Thanks.

In fairness I'd say that I'm not thinking about it any differently other than to say that, one, we still think that it is a tremendous opportunity for us.

Two, we also know that it's probably a lot easier to figure out how to get a top line than a bottom line, so we want to be incredibly prudent in our approach internationally.

Now that Andrew's on board, I do have a leader who can help really focus on the opportunities for us next year.

So I think '04 is pretty much a steady year.

Look at the markets, look at the brands, look at the nature of how we would do business, the different economic models.

So it's pretty consistent with what I've said in the past.

We're a lot smarter today having been in the market that much longer, and some of the effective strategies we have put in place.

We expect to certainly accelerate our learning curve on strategy for '04.

All right, thank you.

Your next question comes from Don Trott with Jefferies and Company.

Good afternoon.

With respect to the ramp-up of expansion of Old Navy, could you share with us your rate of return on investment hurdle involved in that and how long a payout you expect to recover your investment?

Yes.

We don't discuss publicly specific rates of return.

Okay.

Thank you.

Your next question comes from Dana Kelsey with Bear Stearns.

Good afternoon.

With inventory levels coming in leaner than expected, is this part of the beginning of your transition to adjusting the products load, the number of products load in each division?

And how does the systems investments that you have been making accommodating this, where do you stand with that?

Thank you.

Byron.

Dana, the inventory -- since, really, over the last nine months, we have been working on initiatives to optimize the level of inventory, recognizing that in both the fourth quarter of last year and in the first quarter of this year -- we had -- the context was we had had pretty sizable increases in our inventory.

So over the past nine months we have been working on initiatives to have a much more effective optimum balance between our sales and inventory.

We are beginning to see the results of that, really, in the third quarter.

Those results should build as we go through.

And in terms of the flow strategies, I think you are going to see the beginning impact of the flow more in the spring and less of what you have seen so far in the third and in the expectations for the first quarter.

That is less about flow.

The ability for systems investments to help us, that is an opportunity for us down the road.

The improvements that we have been able to make so far have not been systems dependent.

Thank you.

Your next question comes from Margaret Major with Goldman Sachs.

Hi, it's Margaret Major.

I have a question for Paul.

At this stage, if this were a nine-inning game, where do you think you stand in terms of the turnaround for Gap, Inc.

I know each of the three divisions are at different points along that spectrum, but if you aggregate it up to the Gap, Inc. level, where do you think you stand on the turnaround, number 1?

And, number 2, what is it that you are waiting for or looking for before you will be ready to say, you know, what is the next step for this organization, you know, looking out beyond a turnaround phase?

Thanks, Margaret.

I guess it depends on if it's a five-game series or a seven-game series.

I might have a different point of view.

But we still think that we're -- using your analogy -- in the early early innings.

We believe that because we know that we have so much to learn and do with our existing brands, with our customers and understanding them better, and segmenting our product, getting our fits consistently better, flowing our inventory better, finding extensions in product categories that allow us to build on the success that we've had, improvement of margins, so we still think that there's -- we have made a tremendous stride over the last year, but we still think that there is still a tremendous amount of opportunity as we go forward.

So I would put it in the early innings.

As for growth, my expectation is that we are going to continue to evolve this business and demonstrate that we can provide the kind of returns our shareholders expect on a consistent basis, and that we will look for growth strategies, first, organically or internally, before we think about some kind of necessity to rush into a growth strategy, you know, for the long term.

So early innings, opportunities to still focus on our business and grow it, certainly are looking at growth opportunities, international being one of those that we'll focus on next year.

But we will be evolving our strategy and continue to communicate as it develops.

Okay.

Thank you.

Your next question comes from Jennifer Black with Jennifer Black.

Hi, this is Jennifer Black.

Congratulations.

I wondered if you could speak to, Byron, your goals of productivity on a per square foot basis, if you had goals, you know, two to three-years out?

It would be -- typically we don't talk about that, but I would say at this point that I personally, and I don't think the management team yet has a -- has a view of where we will be targeting three years, but we do believe that we have opportunity in all three brands to first get back to peak productivity levels, which we are still below, and as we bring more science and system enablers into the business, we ought to have an ability to hopefully meet or exceed those peak levels.

Okay, thank you very much.

Your next question comes from Todd Slater with Lezard.

Thank you.

You talked about Gap brand with fall success is somewhat related to better designs coming from consumer insights you had gleaned.

I was wondering if you could discuss a little bit how you're communicating with your customer, how you were able to translate that into, you know, quickly into getting product into the stores, and, where you are with your -- I think you talked about creating a department of information that you could tap into on a regular basis.

If you could just sort of talk about those issues I would appreciate it.

Yes, sure, Todd, just quickly on the last one, it was a group of consumer insights.

We have hired an executive to lead that group.

They will help facilitate and coordinate our efforts across the entire company so that we're gleaning all of the learnings and leveraging across the business.

When you think about the customer insights, it comes in lots of different buckets -- buckets as it relates to fit, things that we heard from our customers about the length of pant that they wanted, it translated into the product that you saw going into the stores in fall.

Part of it looks -- is focused on our edited assortments so that our various customer segments who come in can find themself in the store, clearly and articulated with good merchandising assortment and visual displays.

As we look at these customer segments, and we know that there's groups that are more style conscious, we focus on the right kind of balance between on-trend, emerging trend products within the overall assortments, and that's being reflected in the store.

We are looking at occasion, particularly as it relates to work wear or going out, certainly in Banana Republic.

You can see that expressed in Gap, as well.

All the things that we are learning from our customers, both in terms of what their style aesthetic need is or what their occasion need is or what their fit need is, is being translated into our product.

Clearly, the most important thing we continue to do, is to look at trends in the marketplace and develop and edit those trends in a Gap style that we think is most appropriate for our customers.

I think all of that, is, you know, is a result of our third quarter performance.

We have time, Operator, for just one more question.

Okay.

Your final question will come from Ron Filese with Banc of America Securities.

Hi, guys, this is Brian Park for Ron Filese.

I just have one quick question.

You guys have a lot of cash again this quarter.

Can you tell us, do you plan on using the cash to make changes in your capital structure at all in the near future?

In effect, we already have.

We, as you know, at the end of the third quarter, we have roughly 3.4 billion in cash.

In June of this past year, we restructured our credit facility, took 1.2 billion of that cash and dedicated it in a restricted format to sell fund our letter of credit program which had a meaningful savings with regard to our interest interest expense.

I also wanted, just to remind you all, that we are still below investment grade, and so our access to the capital markets is restricted, and, therefore, we believe, since we are still, as Paul said, in the early innings of our turnaround, that it is prudent for us to keep higher levels of liquidity.

So we are very comfortable with the cash balances that we are maintaining, net of what we have dedicated as restricted.

So you don't see any changes until you go to investment grade; is that correct?

Not necessarily, but I think that until we have -- until we have a better -- until we are further along in our turnaround and more comfortable with the macro economic environment ahead of us, that it is prudent for us to be keeping our cash balances, net of which is restricted, in the neighborhood of what we have.

One final question.

Do you guys see any acquisitions in your future?

Way too premature to think about that.

As we think about our growth strategies going forward, we will certainly put that into consideration.

Thank you very much.

Thank you.

I would like to thank everyone for joining us on the call today.

As always, the investor relations team will be available for the cal l-- after the call for further questions.

Thank you.

This concludes today's conference call.

You may now disconnect