蓋璞 (GPS) 2003 Q4 法說會逐字稿

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

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Investor Relations at 415-427-2175.

I would now like to introduce your host, Evan Price, director of investor relations.

Good afternoon, everyone.

I would like to welcome you to Gap Inc. 2003 fourth quarter conference call.

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

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

Wherever used, the words estimate, expect, plan, anticipate, believe, may and 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 with the Securities and Exchange Commission.

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

The company assumes no obligation to publicly update or revise its 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 principles, or GAAP, measure: cash flow before [INAUDIBLE] financing activities, which under SEC regulation G we are required to concile with GAAP.

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

This afternoon, we will begin with Paul Pressler, our chief executive officer, providing an update on company-wide priorities and accomplishments.

Then, Byron Pollitt, our chief financial officer, will discuss fourth quarter financial performance.

After Byron, Gary Muto will comment on Gap brand.

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

We expect the call to last about one hour.

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

Good afternoon.

I'm extremely proud of what our team has accomplished in 2003.

Against increasingly challenging comparisons, our performance significantly improved.

We sustained our turnaround, delivered exceptionally strong results to our shareholders and began to position our company for long-term growth.

I'll share some of the highlights.

First, earnings were more than double the prior year, driven by sales and margin improvements.

Fourth quarter marks our six consecutive quarter of year-over-year earnings growth.

Net sales for 2003 grew 10%, doubling the prior year's growth rate.

Through year-end, we posted 16 consecutive months of positive comparable store sales.

Gross margins were up almost 4 percentage points for the year.

We have generated seven consecutive quarters of year-over-year gross margin improvement.

Cash flow before financing activities was $1.9 billion, almost double the prior year.

We reduced debt by $626 million, lowering our year-end funded debt to $2.8 billion.

We ended the year with a cash balance of $4.7 billion.

In 2003, we delivered substantial down payments on our turn-around strategy.

While improving earnings, we also began strengthening infrastructure and building our strategic capacity to grow.

For example, we implemented mark-down optimization software in each brand, helping to drive better margins.

In January, we went live with our new global financial system, which gives us more robust business insight and analytical capabilities going forward.

And we have incorporated cash flow and economic profit metrics into the 2004 incentive compensation plans for our senior executives, reinforcing a team commitment to driving quality earnings.

Gap, Old Navy, and Banana Republic improved merchandise assortments and embedded customer insights into product development processes.

Our brands established clearly-defined target customer segments and drove product designs and merchandising strategies against each customer group.

For example, Gap began offering more occasion-based assortments.

Old Navy introduced more segmented fits for women and segmented sizing for newborns, infants and toddlers.

And Banana Republic strengthened suiting for women and men.

Importantly, with stronger, more segmented product assortments we achieved higher margins on lower inventory, particularly in the fourth quarter.

We improved our marketing, but there is still much more to do.

We strengthened our talent throughout the company, and we began building competencies and capabilities to drive long-term growth.

These successful strategies fueled our performance in 2003 and will help drive growth in 2004 and beyond.

All of our work is driven by a focus on our four corporate priorities.

These priorities create our framework for growth and drive our decision-making and resource allocation.

And they will continue in 2004.

Our first priority: better understanding our customers.

We are using consumer insights to influence every aspect of our business.

Our efforts have strengthened brand loyalty, deepened customer engagement, sharpened product design and merchandising and opened growth opportunities.

We further refined and separated our brands, creating clear differentiation in the market place.

Banana Republic is more elevated, with a noticeable designer sensibility, targeting a more sophisticated, fashion customer.

Old Navy is more competitive in the value segment.

The brand is delivering more consistent messaging, well balanced assortments and a strong price value proposition to its three core customer segments: moms, families and teens.

Gap is reengaging its core style-conscious customers in the casual specialty market.

Consumer insights have helped us target organic growth opportunities within our existing portfolio.

In 2003, this led to the in-store launch of product categories such as petites for Banana Republic.

We also improved the store experience.

Old Navy, for example, began displaying more merchandise on hangers with sizes easily visible which makes it easier for customers to shop.

Our consumer segmentation research also helped us to better define growth opportunities in segments not served by our brands today.

Our second priority is to deliver compelling balanced product assortments to our customer segments.

Using consumer insights to confirm product focus for each brand, our designers and merchants can appropriately interpret fashion trends to satisfy customer needs.

At Banana Republic, for example, feedback from store associates led to the brand ensuring that more fashion assortments are in every store versus only large format.

In Old Navy focus groups last year, moms made it clear that we could do a better job serving kids of all sizes.

In response, Old Navy added extended sizes and adjustable waists.

Our consumer insight work takes some of the fashion risk and the volatility that comes with it out of our business while improving regular priced selling and marked down margins.

We have an incredibly talented team of designers and merchants in place in each of our brands.

I'm extremely confident in the creative abilities of our teams to support our segmentation efforts.

Our product assortments reflect incredible attention to color, fabrication, quality, detail and individual style, creating compelling value that is a competitive advantage for each of our brands.

Improving our operations to better serve our customer is our third priority.

Markdown optimization tools, tighter inventory management, more strategically timed product flows, and other initiatives helped drive margin improvement in 2003.

We ended the fourth quarter with $344 million less inventory than the prior year.

Our view global sourcing base as a with a strong competitive advantage, delivering flexibility and competitive unit costs.

In 2004, we will focus on enhancing our end-to-end supply chain.

We will be building more strategic relationships with our vendors, including sharing planning and forecasting information to further leverage our sourcing capabilities.

We also are piloting localization initiatives in 2004.

Longer term, these will enable us to better sort product at the store level based on size, weather and other local consumer preferences.

Our fourth priority is developing talent to help us better balance the art and science of retail.

I'm very pleased with the progress we've made in 2003 in developing our talent base and building our core creative and business strength.

We've acquired new skills necessary to move our business forward, and we've strengthened to nurturing talent with a focus on building one of the best career development and training programs.

These efforts will improve our ability to attract, retain, develop and motivate the best talent in all areas critical to our growth.

Talent development never ends, and we still have work to do.

This is the responsibility my entire leadership team shares.

Looking ahead to 2004, we are investing more in product initiatives, marketing and talent to further strengthen and sustain our turnaround and also position the company for growth.

These strategic operational investments, combined with other non-operational factors, will result in somewhat higher operational expense dollars in 2004.

Byron will provide more specific detail.

But I will give you highlights on marketing and talent.

We are strengthening our marketing to drive traffic, support regular priced selling and create brand relationships with new customer segments.

For example, Old Navy, after accepting Hispanic TV advertising in the fourth quarter, is investing more in Hispanic markets.

The brand is also broadening the reach of its successful circular.

Gap is adding a summer TV campaign, which hits in second quarter, supporting the brand's objective to communicate more consistently throughout the year.

This investment is also important to build traffic as we anniversary strong comps.

Throughout the year, we are focusing on delivering more innovative and integrated messaging on a more consistent basis to our targeted customer segments.

We will closely measure the return on investment of each campaign to continually refine our strategies and improve the effectiveness of our marketing dollars.

Our investments in talent are critical to building our company's foundation for growth.

We are developing the talent necessary at the corporate level to drive our growth initiatives.

We have strengthened our corporate strategies and consumer insight capabilities and are developing international competencies.

We also have continued to invest in design, merchandising and supply chain initiatives.

The foundation we are creating will enable us to continue to drive organic growth within our existing portfolio.

And we are also creating the capabilities to grow through brand expansions, new brands, and market extensions.

In summary, we believe these investments will further enable and support our growth.

We are entering an exciting phase for our company.

The success of our efforts in 2003 gives us confidence that our turn-around is sustainable.

We still have work to do in each of our brands to gain more market share.

At the same time, we can now begin making incremental investments in long-term growth opportunities.

In the near-term, we intend to continue delivering high quality earnings by trading products sold at markdown with more merchandise sold at regular price.

Sectional product design supports this objective, with strong assortments driving consumer acceptance and also improving inventory returns and tightly managing inventory levels to limit unnecessary markdowns as we successfully did in the fourth quarter.

Although comps are an important measure, healthier margins will continue to be a key driver of earnings growth in 2004.

We will continue to take a strategic approach to our investments, adjusting accordingly to manage business realities and ensure we consistently deliver value to our shareholders.

All of these efforts will position us for growth in 2004 and beyond.

Now Byron will provide a financial overview of the quarter and our outlook for 2004.

Thank you, Paul.

In 2003, we measured success against three financial metrics: Earnings, cash flow and return on invested capital.

We are pleased to have delivered -- to have delivered our shareholders strong results across the board.

We stabilized our business, improved the health of our balance sheet and began building the capital necessary to fuel longer term growth.

While I will provide more complete details in a moment, let me first give the highlights.

Improved product assortments and tighter inventory management delivered healthier margins and significant earnings growth.

Fourth quarter earnings per share were up 37%.

Full year earnings per share more than doubled to $1.09.

Cash flow before financing activities increased more than $500 million in the fourth quarter and about $1 billion for the full year.

Improved margins, higher inventory turns and strict management of capital expenditures drove strong cash flow.

We improved liquidity and reduced debt, supporting our objective to restore investment grade credit ratings.

Return on invested capital improved as we further optimized our real estate portfolio and reduced our inventory levels.

We ended the fourth quarter with $344 million less inventory than prior year.

The collective ability of our teams to deliver against our brand strategies and corporate priorities drove these exceptional year over year improvements.

In the fourth quarter, key performance drivers included higher average unit retail at Gap and Banana Republic.

Stronger conversion at Gap and Old Navy and better traffic trends at Banana Republic.

Here's a closer look at our results.

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

Strong gross profit and better sales in the fourth quarter drove significant earnings growth.

Fourth quarter earnings were $356 million or 37 cents per share compared to $249 million or 27 cents per share last year.

Our fourth quarter tax rate, 38.4%.

We accrued at a higher tax rate of 39% during the first three quarters of the year.

Our fourth quarter tax rate adjusts the prior year accruals for a full year effective rate of 38.8%.

Full year earnings were $1 billion or $1.09 per share compared with $477 million or 54 cents per share last year.

Our convertible note was diluted in the fourth quarter and for the full year.

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

Please turn to slide four.

Sales performance for fourth quarter.

Total sales were $4.9 billion, up 5%.

Consolidated comp store sales were up 3% compared with an 8% increase in the fourth quarter of 2002.

Sales productivity improved 7% to $128 per square food foot.

And for fourth quarter total net sales and comps by division, please refer to our earnings press release.

Turning now to gross profit performance on slide five.

For the quarter, gross profit increased 13% to $1.8 billion.

Gross margin was 37.6%, up almost 3 percentage points.

About two points came from better merchandise margins and the remaining one point from the leveraging of rent, occupancy and depreciation expense.

Total year gross profit increased 21% to $6 billion.

Gross margin improved approximately 4 percentage points to 37.6%.

Turning to operating expenses on slide six.

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

As a percent of sales, total operating expenses for the quarter were 24.9% compared with 25.9% last year as we leveraged expenses on improved sales.

Total year operating expenses were $4.1 billion compared with $3.9 billion last year.

As a percent to sales, operating expenses were 25.8%, down 1.2 percentage points from last year.

Marketing expenses in the fourth quarter were $146 million, up 9%, due to increased investments in holiday marketing at Old Navy and at Gap.

For the full year, marketing expenses were $509 million, up 3%, driven by increased circulars and the holiday Hispanic campaign at Old Navy.

Now turning to inventory on slide seven.

We ended the fourth quarter with $1.4 billion in inventory, down $344 million versus last year.

Inventory turns increased during the quarter.

Better receipt timing reduced excess inventory in distribution centers and store stock rooms.

This led to inventory per square foot of $45 at the end of the fourth quarter, down 16% and in line with our previous guidance.

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

Total year capital expenditures were approximately $272 million, down 10% due to less capital spending for new stores.

Net square footage at the end of the fourth quarter declined 2%.

For the full year, we opened 35 store locations and closed 130, ending the year with 3,022 locations.

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

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

For the fourth quarter, cash flow before financing activities totaled $1.4 billion, compared with $889 million last year.

For the full year, cash flow before financing activities totalled $1.9 billion compared with $974 million last year.

We ended the fourth quarter with $4.7 billion in cash, of which about $1.4 billion is restricted.

During the quarter, we repurchased about $140 million in domestic bonds, reducing outstanding debt on our balance sheet to $2.8 billion.

Turning the slide to 10.

Our outlook for 2004.

Improved product assortments and better inventory management helped drive a four-point improvement in gross margins for 2003.

We expect further gross margin growth in 2004.

Here's why: first, improved product assortments and marketing, targeted to specific customer segments should continue to support regular priced selling while disciplined inventory management should ease markdown pressure.

Second, markdown optimization tools should continue to improve markdown margins.

And third, stores optimization will help further leverage rent, occupancy and depreciation.

We have closed over 220 underperforming stores since 2002.

Optimization will continue through 2006 as we lap our period of substantial store growth.

As a result of these efforts, we expect operating margin to improve in 2004.

Over the next two years, we believe we can achieve operating margins in the mid teens.

In the second half of 2003, we balanced inventory productivity with sales and customer service.

We will continue this disciplined approach in 2004.

At the end of the first quarter, we are planning inventory per square foot to be down on a percentage basis in the low to mid teens, compared to a 17% increase in the prior year.

At the end of the second quarter, inventory per square foot is expected to be down in the low to mid single digits versus a 10% increase in the prior year.

In 2004, we will further optimize our store fleet, which leads to improved returns on store capital and gross margin growth as we better leverage rent, occupancy and depreciation.

For fiscal 2004, we still expect to open about 125 store locations.

We now expect to close about 135 stores.

This slight increase from prior guidance reflects our decision to exit Germany and close ten locations as we previously announced.

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

Please refer to our fourth quarter press release for the summary of 2004 store openings and closure guidance by division.

Please recognize that our guidance for 2004 store activity is an approximation and can vary based on final lease negotiations.

Overall, we still expect net square footage to remain flat for 2004.

Inventory and store optimization initiatives helped to improve gross margins in 2003.

Now that our turn-around is well underway, we are confident that the timing is appropriate to step up our funding of growth initiatives.

We expect operating expense dollars for 2004 to increase 5 to 6%.

Beyond normal payroll increases related to wages, benefits and higher unit sales, the noteworthy drivers of this increase can be categorized into two areas: non-operational drivers and strategic drivers.

Three non-operational drivers impact operating expenses in 2004.

First, starting in 2004, workers compensation insurance will be accounted for in operating expenses rather than cost of goods sold in occupancy expenses.

This reclassification shifts approximately $35 million but does not impact earnings.

Second, we are implementing a revised asset capitalization policy that will increase operating expenses by about $35 million.

This change raises our asset capitalization threshold.

While our old method met accounting standards, our new method eliminates a significant amount of small dollar accounting entries.

And third, we expect foreign exchange rates to negatively impact operating expenses in 2004 by about $30 million.

This is due to the continued deterioration of the U.S. dollar against other major currencies.

Importantly, this increase will be more than offset by the positive impact of foreign exchange on sales.

Now let's look at the strategic drivers.

As Paul outlined, we are funding strategic areas in 2004 to sustain our momentum and to ensure we are enabling and supporting growth.

These areas include marketing effectiveness and our foundation for growth.

In marketing, we are investing to deliver more consistent messaging, to targeted customer groups to drive traffic, to support regular-priced selling and to strengthen brand relationships.

Total year marketing expenses are expected to be about $560 compared with $509 in 2003.

This increase includes the addition of a summer TV campaign at Gap and increased Hispanic marketing and circular frequency at Old Navy.

The entire year over year increase occurs during the first half of 2004.

To build our foundation for growth, we are funding the creation of teams and infrastructure that will give us the competencies and capabilities to drive growth initiatives.

This includes the strengthening of our corporate strategy, consumer insights and international capabilities as well as investments in supply chain and inventory initiatives.

Please note that while full year operating expense is projected to grow at 5 to 6%, we expect operating expense in the first half of 2004 to increase by about 10%, driven primarily by increases in advertising and our investments in growth initiatives that began during the second half of 2003.

In terms of depreciation and amortization, we expect full year expenses to be 600 to $625 million.

Moving to interest expense, we expect full year gross interest expense to be 210 to $220 million compared with $234 million in 2003.

This year over year decrease is due primarily to the reduction in interest expenses related to the debt that we retired in 2003 and does not factor in any potential ratings upgrades.

Turning to tax rate, we expect the effective tax rate for fiscal 2004 to be between 38.5 to 39.5%.

As a reminder, factors that affect our tax rate include our mix of domestic and international earnings and our overall level of earnings.

We expect capital spending for 2004 to be about $500 million.

Here's how that breaks down.

Store capital, about $320 million with approximately $120 million for new stores and about $200 million for existing stores.

IT spending, about $155 million and approximately $25 million split between headquarters and distribution centers.

Regarding our balance sheet, our goal is to improve our debt ratings, and paying down debt plays an important part.

Given our strong cash position, we will continue to retire debt according to our current maturity schedule and regularly evaluate early debt retirement opportunities, executing purchases that make economic sense.

Now would I like to review changes we are making in how we report store opening and closure activity.

We believe that these changes will provide greater transparency and enhance the usefulness of our external reporting.

First, beginning with our 2003 fourth quarter press release, we are providing full year opening and closure guidance by division.

Starting in the first quarter of 2004, we also will provide quarterly reporting of actual store openings and closures by division.

Second, we will no longer provide store concept recording beyond fiscal 2003.

We feel that the store locations is a more useful and clearly defined measure than concepts, since the definition of concepts is somewhat arbitrary and is based on square footage thresholds that change over time as our businesses change.

In summary, we are very pleased with our performance during the fourth quarter and for the full year.

We have made significant progress, but we have only just begun to capitalize on the opportunities ahead.

In 2004, we will be making critical investments in our business that will sustain our current momentum, address near-term opportunities and build the teams and infrastructure that will drive the future growth of our company.

That completes my remarks.

Before we take questions, Gary will provide an update on Gap brand.

Thank you, Byron.

Good afternoon.

I'm extremely proud of our team's accomplishments in 2003 against our four priorities.

First, delivering more focused product assortments to our style conscious and updated classic customer segment.

In particular, we gained traction with women by designing more feminine styles and offering more occasion-based wardrobe assortments.

Next, improving marketing effectiveness with our core customer.

Sustaining positive traffic remains a challenge but our research shows that we are strengthening the brands relationship with style-conscious women.

Segmenting our marking with more product-focused messages targeted separately to women and men also is working as evidenced by strong sales of featured products.

Third, developing a more clearly defined strategy for Gap Body, Gap Kids and Baby Gap while making progress repositioning Gap adult.

Fourth, continuing to improve our operations.

Our more disciplined approach to managing inventories, combined with the more strategic and less aggressive promotional strategy contributed to stronger margins in 2003.

Conversion rates, average unit retails and average transactions were all up for the year as well.

Let me take you through each priority in more detail.

First, we have evolved our product assortments in response to our customer insight work.

We have clearly defined our core customer segment, style-conscious and updated classics, and we're created product design and merchandising filters for each.

Importantly, we've learned that these customers like to shop for occasion more than key items.

As a result, we have evolved our design and merchandising strategies to address three casual apparel wardrobe occassions: the weekend, going to work and going out.

For women, this meant better merchandising tops to complement our strong bottoms business.

For men, it meant improving our khaki assortment.

Customers' response has been encouraging, and we are just beginning to scratch the surface for this opportunity.

We've also learned that our customers like a sense of discovery while they shop.

So we are now floating product more often, beginning with women's spring product.

The products will be be delivered over a few weeks rather than all at once.

We will still clearly communicate when a season changes.

The customers will discover more new products every few weeks instead of twice each season.

In our second key area, marketing, we continue to use our customer segmentation learning to build more focused integrated marketing campaigns.

For example, we're using more direct mail to compliment TV.

Both men and women have responded to more targeted messaging like our holiday promotion and we saw a grand perception [INAUDIBLE] improved in 2003.

Driving higher quality and more consistent traffic is our priority.

We've learned in 2003 that we need to be more consistent in our messaging.

So we are adding a summer TV campaign in 2004.

We plan to have a TV message each season, and more strategically use print, direct mail, windows and other marketing channels to ensure frequent integrated messaging to our core customer segments throughout the year.

I would like to turn now to our third key area and talk about some of the work we have done to more clearly define our other Gap concepts, Baby Gap, Gap Kids and Gap Body.

At Baby Gap, segmenting our newborn, infant and toddler sizing has improved our business.

Our assortment are more complete in each segment, and customers find the store easier to shop.

We are now capitalizing on an opportunity as a destination for gift-givers, particularly a newborn.

At Gap Kids, we are focused on offering style-conscious moms real fashion for real kids ages 5 to 10.

We are moving the brand away from everyday commodity items and emphasizing quality, fit, fashion and style.

For example, we have seen customer response to our Gap Shield stain-resistant khakis and in denim we have updated [INAUDIBLE] based on customer feedback.

At Gap Body we are exclusively targeting women and positioning the brand as comfortable, sexy and feminine.

We are now emphasizing our full line of bra offerings, from light to full support, extended sizes, training fit specialists and stores and a loyalty [INAUDIBLE] for this spring are all designed to establish our store as the place to shop for foundations.

Improving operations is the fourth area of focus.

We have made progress on a number of fronts, from real estate to operations to customer service.

In real estate we continue to optimize our fleet for productivity.

Through on-going lease actions, we closed 81 underperforming stores in 2003.

This year we will continue our optimization work and looking for more aggressively on how we can allocate square footage to better serve the target customers.

In all stores we made a concerted effort to improve operations and the store experience.

Through tighter inventory management, we have improved margins by reducing the pressure to sell excess inventory at markdown.

We've also improved operational efficiency by allowing associates more time to sell, and we're focused on improving customer engagement with training that emphasizes selling and services.

As a result we saw higher conversion and higher than average transaction.

With our success last year, we are planning a broader more strategic approach to improving our store experience.

This year we are at least doubling the number of in-store hours devoted to training.

We are creating a 12 month curriculum where store staff can refine and hone skills.

And we are telling them where they can get more sales opportunities like gifting at Baby Gap and bra fitting at Gap Body.

Before we close, would I like to add I'm very excited to announce that we named Julie Rosen as Gap's new senior vice president for Gap adult and body merchandising.

Julie is a 12-year Gap veteran, joining from us Banana Republic.

She has a diverse merchandising background and has demonstrated the ability to understand customer segments and translate that into successful product strategies.

Julie will begin her Gap brand duties next week.

In closing, by focusing on four key priorities we made substantial progress in our turnaround efforts in 2003.

The more we do and the more we learn, the more opportunities we see for our brand.

In 2004, we will continue to deepen our efforts in each area and better serve our primary customer segments.

Thank you.

That concludes our prepared remarks, we will now open the calls to questions.

We would appreciate it if each person limits their questions to no more than one.

At this time, if you would like to ask a question, please press star and then number one on your telephone key pad.

The first question comes from Neala Dominga from Piper Jaffray.

Thank you and congratulations to all of you for a fantastic year.

Gary, this question is for you, with respect to the product flow changes in inventory.

You can give us a sense on what you are doing to execute that?

Are you going to be designing the same number of styles but committing to fewer skus?

What's behind the scenes?

Give me an idea of what have you are doing to change the calendar.

What we are doing is we recognize the opportunity to -- there are differences between how men shop and women shop.

So we are really looking at how we flow the product into the store.

We had a one-size fits all approach to how we would flip on a season.

We would flow all of our product into the store over a two to three day period of time.

And we are taking -- you know, smoothing approach to how we are flowing the product.

So, for example, the product will flow into the store over a two-week period of time and in women, we will inject newness into a couple of weeks of selling.

In , men, it's just looking at how men shop.

They shop closer to need.

We will indicate transition out of fall into holiday.

Holiday into spring.

We know that -- you know, they tend to shop later in the season.

So you will see more newness later on as opposed to up front.

How do you have the ads done that would feature a particular outfit that they will not be able to get until two weeks later?

Our advertising, whatever marketing message would be reflected with what is in the store at that time.

So that would be pre-planned.

Your next question from Mark Friedman with Merrill Lynch.

Good afternoon.

Thank you.

Paul, you were talking about the successful research of the brand and starting to invest for growth.

Without giving too much specifics about the key drivers behind this.

What more you can reveal today.

And you can give us any time frame over how we could expect to understand what key growth drivers you're looking at unveiling behind the recovery.

Thanks.

Thank you.

As we described in our talk, there are several initiatives that we see in 2004 that will continue to fuel our growth and that we think have growth potential beyond 2004.

The work around segmentation, the work around product adjacencies that we are continuing to build out such as petite and accessories and jewelry in Banana Republic.

These are new product adjacencies that we think grow the top line within the existing brands.

Not to mention some of the initiatives like localization where we have a real opportunity to get the right size into the right different market demographics and sizes that exist around the countries.

Gary mention we really were a one-side fits all and by size was not part of our product allocation.

So that has a huge impact for us.

At the same time, we clearly have signaled that we are going to make the infrastructure both talent and competencies and to continue to look at opportunities for growth.

And that we are will unveil as we learn and as we grow and as we pilot more and more of those growth initiatives.

Your next question comes from Kimberly Greenberger with Lehman Brothers.

Thank you.

Good afternoon.

I have a question for Byron on the gross margin line.

Just in reference to your mid teens operating margin goals here over the next couple of years.

If you could give us more color on gross margin and do, in fact, you see gross margin going above historical levels?

If so, you can comment on the source of the improvement, specifically in the merchandise margin relative to what it was, for example, back in '98 and '99.

That would be great.

So as perspective, the historical high for our gross margin is 41.8%.

And we have -- in 2002, we were at 34 even.

And in 2003, we moved that up to 37.6.

So when we look at where we finished '03 and where our historical high is, we think that there's a lot of opportunity that remains for us to move north 37.6 and get in the range of our historical high.

And that would be -- that improvement would be the major source of margin gain that would allow our operating margins to move up into the mid teens.

By the way, our definition for mid teens is somewhere between 13.5 and 16.5%.

Recognizing that our historical high operating margin was roughly 15.6%.

So we are in effect saying that we expect to be able to achieve within the next couple of years margins that are in the range of our historical high.

In terms of color, we view -- probably the single most important contributor to that is the opportunity to improve red price selling.

And remembering that a lot of the gains we began to make in red price selling and margins in the second half of the year were associated with a much more disciplined approach to inventory management.

We get to lap that in the first half of this year, and in fact, you know, in '04 we have a full year of much more disciplined inventory management to boost our red price selling.

We have also -- as you've heard from Gary with regards to Gap, and this will also take place in the other brands, we are adjusting how we product-flow our merchandise, which also has a positive impact on red price selling.

And the consumer segmentation and consumer insight work that we have well underway is allowing our product assortments to be much better aligned with our customers, which, again, should support red price selling.

Another element that boosts our margin is the opportunity in all three brands to have a full 12-month use in '04 of the markdown optimization tools were implemented in '03.

Because we have several years left of continued opportunity to optimize our store fleet, this allows us to further leverage our profit margin over rent, occupancy and depreciation.

So, from our standpoint, we have a lot of opportunity ahead across a number of measures that should allow us to improve gross margin and thereby improve our operating margins.

Byron, that's enormously helpful.

Can I just ask one follow-up.

On the regular priced selling, does the mid teens' guidance for operating margin assume that your regular price selling returns to the '98, '99 level, or actually, is there a possibility they could exceed it.

I can't answer that question specifically.

What I would say is that in the fourth quarter, we experienced improvement in both red priced margins and marked down margins.

And we would say going forward that the bigger margin opportunity is centered around more red price selling and that that's the principal lever as opposed to the expectation that will have much higher margins on red price sales themselves.

Great.

Thanks.

Your next question comes from Janet Klopenberg with JJK Research.

Good afternoon.

Byron, just a clarification.

You're looking for operating margins to grow to to 16.5% by the end of '05; is that correct?

Yes, that's correct.

Within the next two years, we expect to be delivering operating margins in the in mid teens which we are defining at 15.5 to 16.4%.

For those of you who don't know, we have on our Gap Inc. web page a table that demystifies the code that we use when we say high single digits and mid teens and that sort of thing, so I encourage you all when we use that kind of guidance to look at the ranges that are on that Gap web page.

Is that a bit higher than you've been saying in late '03?

I think it was more like 11 to 13%.

What you said, the answer is yes.

We are moving up in increment in that.

So what we said up to this point was low teens which the upper boundary of which, I guess, is 13.4%, and we are now saying mid teens which moves up to 13.5 to 16.4.

A primary vehicle would be, then, through the gross margin improvement.

That would be the single largest contributor.

Paul, you talked about growth initiatives and you included in that the idea of new brands, does that mean you would be thinking about internally creating new brands or could there be an acquisition strategy at hand?

Well, the benefit of consumer segmentation work that we have been doing this past year clearly allows to us better define where our current brands fit within the overall consumer nature.

And also tells us that those markets we do not serve or underserve with our existing brands.

That could lead to opportunities to expand within the current brands, as we are doing today.

It could lead to new brands over time.

And then certainly, acquisition is always possibility.

So it's really the foundations that we have built that are allowing to us understand where are those customer opportunity that we could serve in the future.

Where would we learn about those --

I think we have to move on.

Those are about four questions.

Your next question from Lauren Levitan with S.G. Cowen.

I watched to get more information on the SG&A drivers.

Byron, you gave us detail on what the Delta was between' 03 and '04.

But you mentioned some of them began in the second half of '03.

When should we see the revenues to offset those investments?

Are those longer term investments or should we expect some of those could be producing revenues over the next couple of years, and then maybe give us a sense of how much of that investment spending was already affecting the '03 level so we can get a sense of what the Delta is on those strategic investment pieces of the SG&A.

Thank you.

Lauren, the biggest piece of the increase, is in fact, marketing.

We said that would be roughly a $50 million increase year over year.

And frankly, the returns associated with that investment we would expect to start seeing results in the current year, frankly.

The other investments -- let me give a flavor for the range that this covers.

It is everything from investments in building up -- not only a consumer insights capability but actually conducting the research itself, which requires a lot of studies and third party involvement.

Is the building up of our corporate strategy, resources, capability, and market research, because as we begin to look for new growth opportunities, this requires a lot more dedicated resource support in order to quantify it and first time out how best strategically for us to figure out those opportunities.

We have already indicated with the arrival of Andrew Rolph who headed up our international group.

We will be evaluating opportunities to expand abroad.

So spending in this area has begun.

We are on a relentless focus to increase our supply chain capabilities and performance which is another area of investment here.

Training and invest in development across the company in many key disciplines and at the store level and inventory management where we are introducing a lot more science into the way that we manage our inventory, the way we take markdowns.

I think I've indicated earlier that we have established an inventory center of excellence where we now have a chief algorithm officer, where we didn't have one before.

Don't ask me to define this.

So it is a broad range of initiatives, many of which are supported by IT expense.

And so, while I haven't broken out a specific increment, it is infrastructural foundational in nature.

And the payoffs will be in the short and longer term in terms of expectation.

Your next question comes from John Morris with Harris Nesbitt.

Good afternoon.

Quotas coming off from '05.

I'm wondering on your thoughts in terms of the impact of the business, benefit or impact.

In particular, how are your thoughts about that factored into your assumption in getting back to the mid teen operating margin that you're talking about.

What kind of assumptions do you make in terms of those gross margin projections.

Thanks.

I guess starting backwards.

We have not built into '04 any major assumptions in change in business practices.

We know, based on the incredible supply chain capabilities we have today -- we know, given the flexibility of that supply chain, we know because of the relationship with our vendors, that we have both the adequate capacity and ability to flex as market conditions change.

We also recognize that in '05, as you know, many of the quotas are actually going to phase out over a period of time.

So we're not anticipating any dramatic changes in '05.

And we do have the capabilities and flexibilities to have the strength to be able to position ourselves well in the market place.

Clearly, over time, we will have to wait and see how it all plays out as it relates to unit costs and so on and so forth.

But I think it's very clear that we have demonstrated over the years that given our size and our clout in the market place and our relationships that we certainly can take advantage of the opportunities that may be generated as a result of quota going away.

Your next question comes from Barbara Wyckoff with Buckingham Research.

What was the merchandise margin increase in the fourth quarter?

We said that the merchandise margins increased roughly 2 percentage points.

Okay.

That's close to what I have.

And then the second thing is, the openings, will they be offsite or in the mall and will you be closing any mall sites over the year?

I will answer that one broadly.

In the sense that our strategy for Old Navy continues to be a focus on off-mall, in the strip centers.

And that we will -- so our perpensity to open new stores will be in off-mall locations.

But as lease renewals come up, we look at opportunities in some cases we may be changing out a mall location for a strip mall location within the same geographic area.

In other cases with where we have highly productive stores within malls we won't make a change unless we think there's a better opportunity.

Philosophically, it's moving more to the off-mall locations which have demonstrated better economics for us.

But it will be a case by case basis as we look at location.

Okay.

Thank you.

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

Thanks.

Byron, you gave us great detail on the operating expense.

I had one follow-up there, and I wanted to ask questions on the margin.

The effects -- currency impact of 30 million.

How does that differ from what the impact was this year, with a year over year change, is what I'm looking for.

And then, is there any -- you know, I understand the opportunity is regular priced selling.

But beyond that, is there anything basis point change we could expect from an improvement in freight, from sourcing, mix, and you can share with us what the margin impact from the optimization of the store fleet was this year.

So in terms of the FX impact year over year, that's something that we could try and get close to.

But we will have to take that one off line and get back to you.

In terms of freight, there have been significant increases, particularly in ocean freight, which I assume is the focus of your question this year.

And we have been able to -- so have we experienced it?

To a certain extent, yes.

But we've been able to take measures to mitigate it.

So there has been no material impact this mast past year on ocean freight.

We still have tactics in the year to come and contract protection in the year to come to mitigate that.

Would I say in sum, we are not experiencing material margin deterioration on freight.

Having said that, and given the increases that we are experiencing in ocean freight, it is unlikely -- certainly in 2004, that we would have much margin improvement looking at that sort.

In terms of sourcing, we are generally speaking -- certainly over the past year, very chosen to reinvest our sourcing savings in quality, and thereby hold price.

And so, from that standpoint, I don't see a material change from that approach in the coming year.

With regards to mix its too early to call, I think that's something we can only tell you from hindsight.

In the way we are planning, we don't think we have any significant plan shift that's worth a callout.

And with regards to the specific returns associated with the store fleet, what I would say is great leverage over rod further this year, we would expect to even leverage rod further next year.

We haven't guided to specific increases in terms of margin improvement related to that item.

Just one follow-up.

A lot of companies have been commenting on comps since its the very end of the month.

Would you care to update us on business for February?

No.

Unfortunately, you will have to wait a week.

We did say during our January call that we were pleased with what we saw going on at Old Navy and for Banana Republic, and because of the little later flow of Gap brand that we weren't able to give you a read during the January call.

Having said that broadly, we are still confident in our products.

You next question comes from the line Dorothy Lakner with CIBC World Markets.

Thanks.

Good afternoon, everyone.

I wondered if you could talk about your international strategy.

You did announce a change in Germany recently and you do have a new head of that business.

I wonder if you could share anything else about how your thinking might have changed since you last updated us or at least where you are in the process and when we might expect to hear more on the international strategy in the company?

Thanks.

Sure.

Well since we last spoke the most significance change obviously was our decision to exit Germany.

And the reason behind it was two-fold.

First, while we have learned quite a bit this last year, both in business performance and more importantly in the research in customer segmentation that we had been doing overseas as well, that there are certain countries where the cultural biases for fashion are greater than in other countries.

We felt in Germany particularly if we were going to be successful long term that we would have to allocate a fair amount of resources to think about both design and product assortment in the marketplace.

So we felt that it was smarter for us to think about taking our resources and focusing them on Japan, the U.K. and France as well as focusing our resources on the development and study of what other markets or what other brands we should introduce over seas.

So it gives you a little bit of color about recognizing that we do have to develop assortments market specific.

We want to take those markets that we think we can have a higher degree of success, both top line and bottom line, and we will be spending this year, certainly the next six months, on doing just that work to understand those markets where we think we have opportunities to grow and create shareholder value.

Your next question comes from Dana Telsey with Bear Stearns

Good afternoon, everyone.

Can you -- you talked a lot about merchandising and your improvements are clearly evident.

In each division, can you tell us about how you want to balance now that you've made initial improvement in merchandise between basics, trend, emerging trend and special occasion?

How does that play out?

Thank you.

Well, I'll start and Gary can finish.

It's a large question that goes between each of our brands.

Needless to say, what you've identified is exactly what the planning process is for each of our businesses.

We recognize that first, and something we are proud of and have success is that each of the brands first started to understand its customers so Banana is clearly elevated.

You see that.

As a result of that, some of the product categories they go into has changed and broadened.

Particularly in the areas of suiting as it relates to men's and women's.

Some dresses and so on and so forth.

Having said, that each of the brands focuses on who is the customer and then what percentage of trend, emerging trend and basics.

So each one of the businesses have a bit of a different point of view.

And then even, for example, within Old Navy, for instance, you know, when you take a look at our knit T-shirt program, even within that segment, we look at the opportunity to say, what percentage should be basic.

What percentage should be on-trend, whether it be graphic trend or silhouette.

So its a pretty good matrix that we have against each of the businesses going forward.

I think the most important thing out of all of this is understanding who we are targeting and understanding their wants and needs, I think is the first filter we go through.

I think the other opportunities we have developed filters and Gap around essential style and trend.

It varies by men and women.

I think that's very, very important to remember.

You know, our concentration in Gap brand, specifically in women's is really around essentials and styles.

We identify those as items core to a women's look.

It could be the perfect white shirt or the perfect black pant.

That she is on the hunt for.

And the style is how she projects herself.

And that's our opportunity to bring that style out for her and offer a variety of looks that she can express herself in.

That's really the key.

And making sure that looking at our tops and bottoms.

Having tops to go with the bottoms and making it much more about wardrobing and less about items.

For that we are going through our research.

As I mentioned, as related to the Banana Republic.

We clearly had a callout from our stores ha that the more fashion- oriented items from the Banana Republic were in our basic core stores.

So we have moved some of our fashion items to be a higher percentage of the mix in the core stores.

But at the same time, as Gary mentioned, we are not walking away.

So we view this as an opportunity.

We have time for one more question.

Your last question comes from Todd Slater with Lazard.

Thank you.

Some of the banking analysts might want to pick up the coverage soon.

Just a quick question on the priority of the consumer.

One thing you said earlier on was you would build a consumer research department and you would do surveys on a more regimented basis.

I'm just wondering if you talked about where you are on this and some lessons that might have been learned in the recent past.

Well, the department is built.

And we will continue to build it out this year.

We have connections with our corporate center of research and consumer insights with each one of the brands, so that's well underway.

We have been mining all kinds of information and data from our consumers that are constantly informing what we are doing.

You know, one of the pieces that I mentioned was around store excellence within Old Navy where we talked to our consumers and learned a lot about their ability to find their size.

So we moved to a hanger program where you can see some of the tags.

We lowered our sets because our customers told us it was hard to reach and grab our products.

Just a tremendous amount of learning in every aspect in our business.

We have been doing qualitative work and quantitative work, and we are continuing to work on new tools, whether they be survey tools at the cash register.

As when someone gets home, or other intercept tools that we hope to introduce later this year to continue to understand the shopping behaviors of our consumers and what motivated them to come to our store.

So a huge work in progress and lots of fruit has been mined and the team is well in place today, and we expect to add more members in '04 to strengthen those capabilities.

Have you done the exit polling you talked about doing, I think at Disney.

Not in a quantitative fashion.

We have done that on the qualitative side.

A random number of our customers at the end of a receipt tape asked to call a 1-800 number.

We get rich dialogue with customers there.

We have that in place.

And we are anticipating we will develop tools and pilot in '04 the ability to enhance that and make it more robust.

Great.

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

As always, we will be available after the call for further questions.