蓋璞 (GPS) 2004 Q1 法說會逐字稿

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

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

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The conference call and webcast are being simultaneously recorded on behalf of Gap, Inc. and consist of copyrighted material.

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

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

Investor Relations at 415-427-2175.

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

Good afternoon, everyone.

I would like to welcome you to Gap, Inc.'s 2004 first quarter earnings conference call.

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

I would like to remind that you 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 details on these risks, please refer to the company's annual report on form 10-K and/or other filings with the SEC.

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 non-generally accepted accounting principle measures, cash flow before financing and short-term investing activities and net earnings and net earnings per share before loss on early retirement of debt, which under SEC Reg G we are required to reconcile with GAAP.

A reconciliation of these measures 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, who will discuss our first quarter financial performance.

Then Paul Pressler, our Chief Executive Officer, will provide an update on the company's current areas of focus.

After Paul, Jenny Ming will comment on Old Navy.

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

We expect the call to last about an hour.

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

Thank you, Sabrina.

Good afternoon.

Our teams are executing extremely well against our strategic priorities.

We are effectively balancing our creative strengths with greater operational discipline, and our progress in optimizing the art and science of our business is evident in first-quarter results.

We are capitalizing on near-term opportunities and laying a solid foundation for our longer-term growth.

Our company's operational performance and financial position continue to improve.

We are very pleased that earlier this week Moody's Investor Service upgraded our senior unsecured debt ratings one level to BA-2 with a positive outlook.

As a basis for its decision, Moody's cited our improved performance across key operating and credit metrics as well as our disciplined approach to the business.

Our strong across the board results in the first quarter reflect these themes.

Here are highlights for the quarter.

Net earnings, up 54% over prior year to $312 million or 32 cents per share.

Customer response to spring product and our disciplined inventory management drove significantly higher gross margin and earnings.

Cash flow before financing and short-term investing activities was $118 million for first quarter, up over $190 million over prior year, driven by strong earnings and improved working capital management.

And overall return on investment improved through store fleet optimization and tight inventory management.

Year-over-year return on equity increased 7 percentage points, moving up to 26% for the prior 12 months.

Other key performance drivers included better traffic trends at Gap, Banana Republic, and Old Navy, and higher average unit retail at Gap and Banana Republic.

Here is a closer look at our results.

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

Significant gross profit improvement and higher sales drove record earnings.

Reported first-quarter earnings were $312 million or 32 cents per share, compared to $202 million or 22 cents per share last year.

As a reminder, to support our goal of returning our credit ratings to investment grade, we reduced debt by $170 million during the quarter through early retirement.

Though the bond repurchases are NPV positive, we incurred charges of about $30 million related to premiums paid on these repurchases.

Excluding these charges, first-quarter net earnings before loss on early retirement of debt were $330 million or 34 cents per share.

As a reminder, our convertible note was dilutive in the first quarter.

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

Please turn to Slide 4, sales performance for first quarter.

Total sales were $3.7 billion, up 9% from $3.4 billion last year.

Consolidated comp store sales were up 7% compared with a 12% increase last year.

Sales productivity improved 11% to $97 per square foot compared with $87 per square foot last year.

For first-quarter total net sales and comps by division, please refer to our earnings press release.

Turning now to gross profit performance on Slide 5.

First-quarter gross profits increased 24% to $1.6 billion.

Gross margin was 43%, up almost 5 percentage points from last year.

With three of those points from improved merchandise margins and the remaining two points coming from the leveraging of rent, occupancy, and depreciation expenses.

During the quarter, we sold more at regular price versus last year and realized better year-over-year margins on both markdowns and regular-price sales.

Turning to operating expenses on Slide 6.

First-quarter operating expenses totaled $1 billion, up 16% from last year.

As a percent of sales, operating expenses were 28.0% compared with 26.5% last year.

As stated earlier, first-quarter operating expenses included about $30 million related to early retirement of debt.

This added expense accounted for about 3 percentage points of the 16% year-over-year increase in operating expense dollars.

Marketing expenses in the first quarter were $113 million, up 12% from last year, driven at Old Navy by increased circular frequency and hispanic advertising and at Gap division by additional TV media and production.

Turning to Slide 7, inventory.

Stronger product acceptance, better traffic and refined flow strategies contributed to higher inventory turns, improving overall inventory productivity while maintaining ample in-store merchandise levels to support sales growth.

We ended the first quarter with $1.8 billion in inventory, down $296 million versus last year.

Inventory per square foot was $48 at the end of the first quarter, down 12%.

Please turn to Slide 8 for more detail on capital expenditure and store count.

First-quarter capital expenditures were approximately $44 million, compared with $56 million last year.

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

During the quarter, we opened 14 store locations and closed 20, ending the quarter with 3,016 locations.

Please refer to the press release for end-of-quarter store locations and square footage by division.

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

For the first quarter, cash flow before financing and short-term investing activities was an inflow of $118 million, compared with an outflow of $75 million last year.

This significant improvement was a result of higher earnings and lower working capital uses, driven principally by better inventory receipt timing.

We ended the first quarter with $4.6 billion in cash and short-term investments, of which $1.4 billion is restricted.

As noted earlier, we repurchased $170 million in bonds during the quarter, reducing our funded debt to $2.6 billion.

We ended the quarter with $2 billion more in cash and short-term investments than funded debt.

Turning to Slide 10, I would like to comment on our outlook for the remainder of 2004.

On last quarter's earnings call, we shared our belief that a continued focus on improving product assortments, disciplined inventory management, and store fleet optimization would support gross margin growth and operating margins approaching the mid-teens over the next two years.

We defined mid-teens as 13.5% to 16.4%.

Given our performance in the first quarter, we now believe operating margins, excluding charges related to the early retirement of debt, will reach the low end of the mid-teen range for the full-year 2004.

As we continue to deliver solid results and lay the foundation for growth, we now expect operating expense dollars in 2004 to increase by 9% to 10% for the full year.

With regards to the first half of 2004, we now expect operating expense dollars to increase about 15% over the prior year.

Year-over-year drivers of operating expenses in 2004 fall into three categories: Variable expenses, non-operational drivers, and strategic investments.

Turning first to variable drivers, given our exceptionally strong first-quarter performance, variable expenses are currently running higher than originally anticipated.

In particular, these expenses include store payroll, investments in training, bonuses, and store incentives.

The four non-operational drivers which impact operational expense growth by about 4 percentage points for the full year include the following: First, the reclassification of worker's compensation insurance shifts approximately $35 million from occupancy to operating expenses.

This reclass has no impact on earnings.

Second, our revised asset capitalization policy increases operating expenses by about $35 million.

This new policy raises our asset capitalization threshold and eliminates a significant amount of small-dollar accounting entries.

Third, we expect to see about $30 million of additional expense related to the negative impact of foreign exchange rates given the deterioration of the U.S. dollar against other major currency.

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

And fourth, as previously mentioned, first-quarter operating expenses include $30 million related to premiums paid to retire debt early.

Operating expense dollar growth will also result from our strategic investment in marketing and numerous initiatives to sustain our momentum and enable growth.

Total year marketing expenses are still expected to increase by about $50 million to $560 million, representing over 1 percentage point of year-over-year operating expense growth.

We still expect the entire year-over-year increase to occur in the first half of 2004.

Finally, we are aggressively investing in the infrastructure and systems that form our foundation for future growth.

We are reinvesting in our real estate and store maintenance teams to further support our store fleet and market optimization efforts.

In addition, we are funding the creation of teams and developing the competencies and capabilities to drive our growth initiatives.

Initial investments in areas such as consumer insight and inventory management are already benefiting gross margins and are providing healthy returns.

As such, we have accelerated and increased investments in key areas as our performance strengthens throughout the first quarter.

As mentioned, we will continue to balance inventory productivity with sales, insuring that inventory levels are adequate to support our growth objectives and that our stores are well stocked for our customers.

As a result, we expect inventory per square foot at the end of the second quarter to be down on a percentage basis in the low single digits, compared to a 10% increase in the prior year.

Inventory per square foot at the end of the third quarter is also expected to be down in the low single digits versus a 7% decline last year.

For fiscal 2004, we still expect to open about 125 new store locations and close 135 locations.

Please refer to our first-quarter press release for a summary of first-quarter store activity.

Our 2004 store opening and closure guidance by division is available on-line in the press room at gapinc.com.

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

Overall, net square footage is still expected to remain flat for the full-year 2004.

Moving to interest expense, we expect full-year gross interest expense to be about $200 million, which is below our prior guidance due to reduced interest expenses related to our first-quarter bond repurchases and our recent ratings upgrade.

By quarter, we expect gross interest expense to be about $50 million for each of the remaining quarters. 2004 guidance in the following areas have not changed.

Full-year depreciation and amortization still expected to be $600 to $625 million.

Full-year effective tax rate, 38.5 to 38.5% and full-year capital spending about $500 million.

In summary, we are very pleased with our performance during the first quarter.

We are executing against proven strategies, and we are very excited about the opportunities ahead of us.

Now I would like to turn it over to Paul.

Thank you.

Good afternoon.

Today I would like to share with you where the company is currently focused, talk a bit more about our turnaround, and then Jenny Ming will give an update on Old Navy, including details about an exciting new growth initiative to be launched in July.

Reflecting on the first-quarter results, I am delighted with the progress we are making in the business.

Across brands, we saw a year-over-year comp store sales growth.

Consumers are responding to improved product at Gap, Banana Republic, and Old Navy.

This product acceptance, coupled with disciplined inventory management and improved traffic, has supported significant year-over-year gross margin and operating margin growth.

Our continued solid performance in the quarter confirmed for me that we have the right teams and strategies in place to fuel our growth and set the stage for the future.

I would now like to turn to current business.

People often ask where we are in the turn around.

So I wanted to bring some clarity to how we are defining our turn around and how we are measuring our performance.

For us the turnaround phase has been all about getting the business back on stable ground, improving the base fundamentals of our business, and building the right foundation for growth.

With the goal of returning operating margins to the mid-teens to create significant value for our shareholders, we are measuring our turn around against four key drivers: Optimizing our store fleet, improving our balance sheet, putting new financial metrics in place, and rebalancing our product assortment informed by customer insights work.

Let me talk briefly about where we are on each.

With more than two years' focus on store fleet optimization efforts, our asset base is more productive, resulting in better overall returns.

During the last 24 months, we have closed about 250 stores, and we expect to close about 135 stores this year.

You'll recall the company grew square footage at an aggressive pace through 2001.

Since our leases have initial terms of five years on average, higher-than-normal optimization will continue through 2006; however, we will strategically open stores that meet or exceed our high hurdles.

This year we expect to open about 125 new stores which we believe will create additional value for the company.

Turning to the balance sheet, our progress has been dramatic over the last two years.

At the end of the first quarter of 2002, we had a net debt position of $1 billion.

And we have moved to a net cash position of $2 billion at the end of the first quarter this year.

Our cash flow is extremely strong, and by next spring when we expect to call our $1.4 billion convertible bond, we will be left with less than $1 billion in funded debt.

We remain focused on restoring our credit ratings to investment grade and are certainly pleased with Tuesday's upgrade by Moody's as it represents strong progress in achieving our goal.

The third aspect of our turnaround effort was to focus the entire organization on a more balanced set of metrics to drive shareholder value, including growth in economic profit and growth in free cash flow, in addition to growth in earnings.

A strong focus on these metrics has earned us 7 consecutive quarters of year-over-year earnings growth.

We generated almost double the cash flow in 2003 than the prior year, and return on equity improved about seven percentage points to 26% at the end of the first quarter.

We've also started to imbed economic profit and cash flow in addition to earnings as a performance measurement for management compensation this year.

Rebalancing our product assortments was the fourth aspect of our turnaround.

Over the past year and a half, our consumer insights work has helped us identify core customer segments across the brands and provided us with a deeper understanding of how to better serve these segments.

With a strong commitment to design, we used these insights to develop focused product strategies for each brand.

At Gap, we are delivering enhanced design for our style-conscious men and women customers.

By elevating our design aesthetic at Banana Republic, we are clearly resonating more soundly with our core customer segments looking for affordable luxury.

And we are uncovering many opportunities at Old Navy by focusing on and maximizing the brand's multiple customer segment.

To ensure we stay on track with delivering the right assortments, we have developed product filters against core customer segments.

These guardrails continue to guide our decisions and help to take some of the fashion risk out of our business.

As a result, our margins have improved significantly.

We have gained back much of our markdown margin deterioration and are starting to improve our regular price selling.

We have made good progress, but we still see margin opportunity driven by increasing the percentage of merchandise sold at regular price.

Today we are still below our peak levels of regular-price selling.

So, although we have not fully completed, I am pleased with the substantial progress we have made across all of these areas in our turnaround.

We remain focused on these fundamentals while we now turn our attention more fully to the organic growth opportunities in our existing brands which we began working on some time ago.

We firmly believe there is significant inherent value creation still to be mined within each brand to drive real growth in the business.

Let me share a bit more on the nature of these organic growth opportunities.

Product extensions such as GapBody, maternity at Old Navy, and jewelry, accessories and petites at Banana Republic are driving incremental sales and profit to the bottom line.

We are continuing to understand the depth of opportunity we have in each brand, while studying and testing new product adjacencies such as swimwear at Gap.

In addition to product extensions, consumer insights continue to inform us on a range of other opportunities, from improving and expanding fit offerings to delivering differentiated style aesthetics and addressing a wider range of occasion-based needs, we can organically grow our current businesses and create new revenue streams.

We are also focused on strategic square footage growth, whether it is expanding Old Navy into smaller markets to reach new customers or adding square footage to accommodate new product adjacencies or new store openings for Banana Republic.

Assorting product by size and climate through localization strategies also provides us enormous opportunities to unlock margin potential.

For instance, today we have one national size distribution.

So all U.S. stores receive the same size breakout.

Using statistical techniques to determine size clusters around the U.S., both Gap and Old Navy are beginning to test specific size allocations this fall to better address the needs of our customers.

We expect to roll out localization on a larger scale in 2005 and 2006.

In addition, new product flow strategies at each brand are helping us drive traffic and regular-price selling, which has resulted in improved inventory turns.

Combined, these organic growth and operational strategies roll up to meaningful opportunities for us to drive earnings growth in the business over the next two years.

Looking beyond organic growth in the business, we are actively exploring several new growth opportunities.

Whether we create or acquire a new brand or explore different business models, we will capitalize on our core strength of design, merchandising, and brand building while leveraging our operating expertise and financial strength.

Our focus is on apparel, foot wear, and accessories.

In looking at new growth, we see not one, but multiple opportunities for our company.

For instance, based on continued growth in the value sector, we are exploring the opportunities that exist beyond Old Navy.

In addition, efforts are under way to examine key customer demographics that we don't currently serve today with our existing brands.

And we are studying international expansion.

We are continuing to build our team and talent competencies and are deepening our learnings to understand our total international opportunities.

Near term, we are focused on leveraging our current brands in countries where we are already doing business such as Japan.

We are currently putting resources against these and other prospects to determine the best new growth opportunities for our shareholders.

Our philosophy is to be disciplined about how and when we communicate new growth strategies.

In order to provide the right level of detail, we plan to communicate close to when we launch each initiative.

This is what we are doing today as Jenny will announce the July launch of a new growth initiative for Old Navy focused on women plus sizes.

The large-size market is appropriate for a family brand like Old Navy, and we are excited about this opportunity.

So it has been a great first quarter, and as we said for April, we are off to a great start for summer.

We still have a lot of work to do, but I am very optimistic about the future of Gap, Inc.

The organization is leveraging talent and leadership.

We have a great portfolio of brands still bursting with potential.

And we are putting the right foundation in place to responsibly pursue new growth initiatives.

Thank you.

Now I would like to turn it over to Jenny Ming, President of Old Navy.

Okay.

Good afternoon.

I am very pleased to speak to you today about our performance in the first quarter and tell you about an exciting new extension to our brand.

We are very proud of the financial results we delivered during the first quarter.

Especially as we anniversary strong results from the prior year.

Highlights include strong increases in traffic as we achieved a 9% traffic comp, great response to our knits and graphics for men and women and successful introduction of adjustable waist and extended sizes in kids bottom category.

But one of the biggest highlights of the quarter was the celebration of Old Navy's 10th birthday.

Over the past ten years, Old Navy has made shopping for the whole family fun again.

And this quarter was no exception.

We brought back some of our favorite phases to the Old Navy TV ad campaign, and also we held birthday celebrations throughout our stores in the U.S. by offering our customers tremendous value through giveaways and promotions.

And we had an excellent response.

And I am excited about what the next ten years have in store.

As Paul mentioned, one of our strategies has been to identify strategic growth opportunities within our brand by better understanding our customers.

And over the past year, we have communicated to you opportunities we have pursued in both the maternity and hispanic markets.

And we now offer maternity in 160 stores, and we will be extending that assortment into 64 more stores in the fall.

Regarding the hispanic market, after the testing of our Spanish language TV ad campaign for holiday 2003, we remain focused on building awareness within that market.

In the first quarter, we tested hispanic radio campaign in 17 markets.

And on national summer TV campaign is airing for four weeks, which began May 13.

Now I would like to tell you about the latest new extension to our brand.

And I am very pleased to announce the launch of our women's plus size line.

This is an underserved segment that we identified some time ago.

And we feel there is room for significant growth in this market.

The line will be introduced in July with our fall assortment into 55 stores and on-line.

Through MPD and global insight data, we have learned some important facts about the women's plus-size segment.

Women in their 20s are the fastest-growing age group within this segment.

And about one-third of U.S. women are considered plus-sized.

They represent about $25 billion of the total women's apparel market, and the plus-size segment has the potential to grow about 23% by 2008.

Today, we are already very successful offering a limited number of extended sizes that include size 16 to 20; however, we feel there is still tremendous opportunity for us in the category -- in this category as this customer has an unmet need for fashion clothing and inclusion.

We have already conducted focus groups to better understand the needs of this customer and to test many aspects of the product line.

Specifically we have learned that she's looking for more fashion options and the ability to shop at the same places as her friends and family.

Further, we have a better understanding of what products to offer an how the products fit and how we want to position the assortment.

We will be creating a distinct plus-size shop within our stores, and the assortment will target toward young adults who desire both fashion and value.

With halos to capture moms and teens.

A separate section will ensure that our plus-size customers is able to easily browse the breadth of our assortment.

And over half of the designs will be the same as our regular women's assortment, and the remainder will be exclusive for women's plus size.

We are also improving our fit for this customer.

We are using a plus-size fit model, where as before we used a regular-sized fit model and extended the sizes.

In our product assortment on-line, we will be testing two additional categories, swimwear and underwear.

And we will be using several marketing vehicles to support the launch of this product line.

And in addition to instore signage and PR efforts in July, the assortment will be featured in a September edition of the circular.

The extension of our assortment also provides further support to improved productivity within our stores by optimizing the use of square footage.

So in conclusion, we are very pleased with our first-quarter performance, and I would like to take this opportunity to recognize the commitment and enthusiasm of the entire Old Navy team.

As we continue to identify with our customer and better understand their needs, we will seek further opportunities within our core competency to effectively utilize store space and capture more of the marketplace.

Thank you.

That concludes our prepared remarks.

We will now open up the call to questions.

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

Ladies and gentlemen, if you would like to ask a question at this time, please press star and then the number 1 on your telephone keypad.

Your first question comes from Mark Friedman with Merrill Lynch.

Good afternoon, everybody.

Great job on the quarter.

Paul, Byron, I was wondering if you would care to put any numbers behind the view on growth going forward as you are looking at these initiatives, and how -- how are you prioritizing these various initiatives that you are looking at?

Thank you.

Well, no specific numbers per se, although as we've -- as Jenny described today, we recognize that there are rich markets like the plus-size markets that we think that we can take significant opportunity for us to grow our business and drive our share.

Each of the brands are focused on a set of growth initiatives that are appropriate for each one their businesses.

And our expectation is that we will do testing, whether they be in a limited number of stores or the work that we are doing through focus groups, to really understand the depth of demand and to make sure that we've got the right kind of return models that we expect for the business.

And that we'll continue to share that with the market as we get really fully flushed out and make business plans associated with that.

So as we said, we think there's, you know, great opportunity within our existing businesses and we are continuing to put our resources against opportunities outside the existing businesses.

More to come over the coming months.

So we --

Your next question comes from Kimberly Greenberger with Lehman Brothers.

Great.

Thank you.

Good afternoon.

I was wondering if you could talk about the specifics driving your gross margin here in Q1, and in terms of the sustainability throughout the year, just looking at, you know historical trends, it looks like something higher than the low end of the mid-teens operating margin, you know, could be possible using your SG&A guidance.

I am just wondering if you could talk about sustainability in the gross margin trends.

So first part of your question -- this is Byron.

The first part of your question was what were the drivers in the first quarter.

So, as I talked about in my opening remarks, we had -- we experienced not only a rise in regular-price selling, but we also experienced improved margins for both markdowns and for regular-priced products.

So all three of those were at work.

Question -- second part of your question was going forward, sustainability, how does that position us within the range of mid-teens?

Recognizing -- so the second part first.

Recognizing that we are still a company that is -- that is in turn around, but even more important than that, building capability and competencies to position ourselves for sustainable, profitable, attractive returns-driven growth in the future.

What I would be careful about applying past levels of profitability or margin on a go-forward basis in terms of, you know, what we're achieving quarter by quarter.

Past may not be prologue.

Having said that, we as a management team, given the performance in the first quarter, are comfortable in guiding that we will reach the -- the lower end of the mid-teen range for the coming -- for the coming year 2004.

And in guiding to that range, we believe that the steps we are taking, the competencies and tools, techniques, the blending of science with the art will allow us to sustain performance in that range.

Thanks, Byron.

Your next question comes from Janet Klopenberg with JJK Research.

Good afternoon, Jenny, I wanted to ask a couple of questions about the plus-size launch.

Is this a test in the 55 stores or is this a commitment to the whole chain, and if it is, when do you see that rollout happening, and lastly, if you can discuss any significant margin differences between this business and the rest of your businesses.

Thanks.

Okay.

Well, first of all, a 55 store rollout will really enable us to learn a lot about the business.

You know, we really learned a lot from our maternity, you know, rollout.

Right.

If you think about it, we launched two years ago and by the end of the two years, we will have over 200 stores.

And you are know, with the statistics that we see the growth there, I think it will be a really meaningful business, but I think we have to remember, again, it is really about learning, and then we will go from there.

As for the margin, we see it as very similar to our women's margin.

But, again, this is -- again, 55 stores and we won't be able to leverage until we have more stores.

You about it should be very close.

Thanks.

Thank you.

Your next question comes from Emme Kozloff with Sanford C. Bernstein and Company.

Hi, I have a question on SG&A expense.

Today you upped your guidance from 9 to 10% growth from 5 to 6%.

To clarify, 9 to 10 include cost for early retirement of debt.

Second, since you already mentioned the reclass of worker's comp when you gave the 5 to 6% guidance, the incremental, the $160 million is now for the variable cost of strategic expenses.

So can you tell us how that is split out between the two and are those strategic expenses ongoing?

Thanks.

Byron.

So the 9 to 10 does include the $30 million of debt repurchase premium incurred in the first quarter.

So the 9 to 10 includes that.

It -- I think taking a step back -- because we did talk about when we gave original guidance, we did talk about things like worker's compensation and some of the drivers.

So -- at our last earnings call.

So when we -- when we look going forward, I think it is important to keep in mind that many of the initiatives we are investing in that show up in SG&A have a very direct link to our ability to drive gross margin improvement.

And we have been pacing the investment in those initiatives along with the improvement in our business.

So when we look at things like consumer insights or initiatives against consumer insights, inventory management, pipeline efficiency, training, training at the store level, at the designer level, at the merchant planning level.

Some of these are already -- particularly consumer insights and inventory management -- are already having an impact on our gross margin which you can see, given the 5 percentage point expansion we experienced in the first quarter.

Others are going to pay dividends in the quarters to come.

So I would say, given the -- given the importance that we cement these capabilities, that there will be an ongoing investment in these initiatives in the quarters to come in order to position ourselves to reach and sustain a mid-teen operating margin for the company as a whole.

Your next question comes from Jeff Klinefelter with Piper Jaffray.

Can you comment on inflation-deflation as it has been impacting your total topline sales trend in the past couple of years.

If you could attempt to quantify how far inflation has been the last couple of years.

What sort of lift do you think you're getting from that being minimized here.

Both top-line and in terms of sourcing, we are hearing a lot about the cost of quotas dropping not only for '05 in China but starting to drop already.

Any sense of what just in total savings you will see on the cost line that you will reinvest in product quality over time?

Jeff, let me start maybe backwards, the sourcing side.

Clearly with the lifting of quota, we anticipate that probably a little bit more in the long run than in the short run that there's going to be costing opportunity, you know, in the marketplace.

How that plays out over the next quarters or years is yet to be determined.

As we know some of those quotas are phased over a period of time, but we are well positioned to make sure we are taking advantage of that.

Looking back, a lot of the cost savings that we have been able to achieve as a result of opportunities in the sourcing market, we have invested back into our product.

It is very clearly seen in all the businesses, particularly Banana Republic and Gap brand where we improved our fabrications, improved our quality and needless to say it's driving our averaging in retail as a result.

So we feel like we are getting good return from that.

So overall, we are not anticipating any dramatic or significant change in either our IMUs or in the pricing equation, but clearly, we are keeping a watchful eye in terms of the opportunities for us to drive our costs down and we will be cognizant of what happens in the marketplace as it relates to pricing overall.

Again, a lot of our repositioning of our businesses is giving us opportunities to compete and to drive customers into our stores that are looking for different things, and that's allowing us to, you know, drive our average unit retails in response as well.

Thank you.

Your next question comes from Stacy Pak with Prudential Securities.

Hi, thanks.

I wanted to go back to the operating margin questions.

On the -- on the SG&A, can you break out for us sort of how much of -- of the increase we are looking at from last time, the guidance, is, you know, more bonus/incentive related versus, you know, the sort of strategic investment.

And I heard you say in response to Emme's question that there will be more investment over the next quarters, but maybe how much -- should dollar growth in '05 be similar to this sort of '04 levels and going back to the gross margin question earlier in the call, is there something on the cost side that was done in -- in the first quarter that's going to continue to benefit the company for the rest of the year?

Or -- or was it all about more on the fashion side?

I am just trying to get more to that sustainability question.

Stacy, Byron.

The -- so let me clarify first.

When -- in response to Emme's question, what I intended to convey is that we would expect to continue to invest in a broad range of initiatives, which -- which are intended to drive gross margin improvement as well as top-line growth.

And we will pace the level of those investments against the improvement of the business.

And so when you ask the question, do you expect those to have an ongoing impact on margin, implying, I think, do we believe there is further room for gross margin expansion.

The answer is yes on both accounts.

I guess -- um -- can you still hear me?

Yes.

I guess that is not exactly -- I am just -- should we expect -- I mean you know what your initiatives are.

You have a lot going on that you are doing to, you know, drive productivity in the box, et cetera, which -- which is great.

What I am trying to understand from the outside is, how many more SG&A investments do you need to make to get that growth.

So is it reasonable to assume, you know, 10% SG&A dollar growth in '05 as well, and then on the gross margin side, the fashion has been amazing, and that's great, but have you done something in sourcing, whether it is in factories or countries that led to, you know, an amazing IMU, not just you are able to charge a higher price and not get a deep markdown on fabulous wovens at Banana.

Okay.

First of all, as you know we have given no guidance on '05, so we are not prepared -- toward the end of the year we will be prepared to talk about that, but not today.

I guess I am just trying to get qualitatively.

Yeah.

With regard to have we done anything that -- that is a one-time event on sourcing or anything that is a -- that is driving this on sourcing that may or may not continue, the answer is no, that much of the benefits that we would expect to materialize from our sourcing strategies are pipeline work, quota being lifted.

For us, we view that as opportunity yet to be realized in the -- in the results that we have recorded so far.

And when you look at what is driving average unit retail, this is more -- much more about gross margin improvement and is not being driven by changes in average unit costs.

Okay.

Thank you.

Your next question comes from Lauren Levitan with SG Cowan Securities.

Thank you.

I am wondering if you can update us on the reverse cannibalization or any positive impact you are seeing from the progress you have made so far in the real estate optimization, specifically if you have any measure of the degree of comp growth that is being driven by these optimization programs and if there is any learnings that we should see applied over time to the rest of the fleet with respect to whether some stores should be stand-alone versus being housed inside others.

Thank you.

Yes, Lauren, the answer is we do have models in place that as we open and as we close stores that do project the level of cannibalization and reverse cannibalization.

So, in fact, we use these measures to help validate that we are, in fact, making the right decisions when we open and close a unit.

So internally, we do have an informed perspective, one that so far based on our analytics is statistically valid.

We are not yet at a point where we are prepared to break down our comp and disclose publicly or give guidance publicly with regards to how much of our comp is due to reverse cannibalization.

What we would say is while it helps a comp increase, it is not a primary driver today.

Thank you.

Your next question comes from Brian Tunik with J.P. Morgan.

Thanks.

Good afternoon.

I know you don't traditionally give divisional breakouts on the operating margin side, but since we have Jenny with us on the call maybe she could talk about maybe the one or two opportunities at least from Old Navy's perspective of what they can still be doing to get their operating margins back to, you know, what we estimate were the high teens back in '99.

I think just by, you know, really focusing on productivity in our fleet, in our store within our store, just like we are talking about maternity and large sizes really one of the -- it will help us gain productivity, but I also really think focusing on presentation.

Just like what we did on baby, by segmenting it from newborn, infants and toddler again helped us improve our productivity.

So there are many things we are doing but really focusing on our diverse customer base is what we are -- what we are focusing on today.

Your next question comes from Barbara Wyckoff with Buckingham Research.

Kind of as a follow-up to what you just said, Jenny.

Can you talk about the results of the other first-quarter product initiatives and in kids you talked about baby and newborns but there was an initiative about tween boys and girls, segmenting out from the normal kid business, and then in adult, segmentation by consumer demographic, like the pants initiatives, different fits and tops.

Can you quantify how much these initiatives contributed to the business and et cetera?

First I mentioned the introduction of kids extended sizes and adjustable waist.

We launched that in February, and we are very pleased to hear from parents, especially mom if we could fit their child, they would be a very loyal customer.

I would say 75% of our assortment now has adjustable waist and over one-third of our styles have extended sizes.

So these are just ongoing.

Refining our customer base, and what I just talked about, about baby, we have really been focusing on growing the newborn and infants business because we have a very healthy toddlers business.

For women's, obviously the teen, we continue to see bringing more relevant teen fashions back into our store and we are seeing a better uptick in some of our fashions.

We also introduced, you know, fits beside our pants the last two years, we introduced top fits or T-shirt fits.

If you notice in our store we have three fit, a tiny fit, a perfect fit, and an easy fit.

Of course, the tiny fit is for the teens and she is really responding to that extremely well.

So that she will be able to find what she is looking for in our store.

And on the men's side, we pretty much introduced the same thing in fit.

We did a vintage fit which is slightly slimmer and then, of course, our regular fit.

So continuing to refine our customer segment or the family has really been able to really help us grow the business a little bit more strategically.

Your next question comes from Todd Slater with Lazard.

Thank you.

Jenny, just a quick question on the 55 test stores for plus sizes.

I am wondering what the square footage -- how much you are dedicating to that effort, and what area will see a reduction in funding.

And Byron, on your 2004 operating margin outlook, has that at all changed from three months ago when you, you know, you thought expenses would be 10 cents a share or so lower?

Thank you.

Okay.

So I am going to start first.

On the 55 stores, I said we have a dedicated shop.

So some of them are single shop and some of them are double shop.

Because we really want to learn as much as possible.

And the square footage is really coming from -- really optimizing or really -- in some cases reconfiguring some of the stores so we could put more into it.

So it could be coming from, you know, our markdown shop that we are -- now is going to be our existing shop or in some cases where we have overexcess in men's, we have been able to take a shop from that.

It has been across the board.

I wouldn't say from one place.

With maternity, we found there was very little impact to the existing business, and we really believe the large-size will be the same.

We are going to learn a lot from this summer, this fall, and then we will go from there.

So, Todd, Byron.

The answer is that when we first give guidance at last earnings call, we said mid-teens within two years.

And so the different points of view is we think we are now in a position to get into that range a year earlier, implying that the pace of our improvements has, in our view, picked up.

Your next question comes from Dana Cohen from Bank of America Securities.

Sees like right under the wire.

First, Paul, you do mention from time to time sort of thinking about acquisitions as well as internal growth strategies.

You know, how do you weigh one versus the other?

And then just a question for Jenny.

On the large sizes, can you just talk about the customer, is it the exact same customer that you have got but large sized.

It sounded from what you said it was skewed younger, but I was confused.

On the first piece, I think it's fair to say that the DNA of our company has been about the development internally of brands and ideas to capture both the imaginations of our customers and also market share.

So it's more of the focus that we have today, and when we do mention acquisitions, in a lot of ways, we think if at all, it would be in an effort to enable either accelerated growth, acquiring real estate faster, or maybe finding a brand that is small that we can grow.

But our focus is first and foremost what the opportunity is, what is the opportunity for us to develop it internally, and then what are the best business strategies to maximize the opportunity of which acquisitions could, you know, be a possibility.

You about it really isn't a primary focus of our growth strategy in terms of growing through acquisitions.

As for the large-size customer that we are focusing on, our target, it really is the young adult.

When I say the reason it is the young adult is because it is very much to the Old Navy sensibility, fashion.

And we really feel that it will halo to the mom that is looking for casual clothes and even to some teens.

But I think the main thing is, is it the same customer coming in our store, yes, some of it is.

And some of it we are hoping that she haven't been able to buy in our store -- shop in our store.

So as you know, we do carry size 16 to 20 in our store now, but we use this as a regular fit model and just grade it up.

This now will really be a large-size fit that will be for her.

So I think for -- for me, I think we will satisfy more of our Old Navy customer, and we will then hopefully gain some new customers that are coming in.

We heard from them she haven't been able to shop with her family or shop with her friends and now she will be able to do that.

Thanks.

Your next question comes from Dana Telsey with Bear Stearns.

Good afternoon, everyone, and congratulations.

You have talked a lot about product development cycle and the importance of the product's flow schedule.

Can you give us an update on how the product's development cycle by division is working and what adjustments and improvements you are seeing there and how that is translating into the product flow cycle.

And lastly, on your growth opportunities, does it require new real estate or do you see reallocation of existing real estate.

Thank you.

Thanks, Dana.

Well, first, overall, on the flow strategies, all three brands are focused on what is the best opportunity for us against each of the businesses.

And a lot of this just started from the fundamental understanding about shopping behavior.

Clearly, the difference between men and women.

So, for instance, in Banana Republic, we have reduced the number of product flows from 3 to 2 per season, because we recognize he is not shopping as frequently as women.

And obviously that is going to have positive effects in our overall inventory management and in margins.

On the women's side, it is less about the number of flows as it is the frequency and the depth of the flows.

So what we clearly recognize is that our -- our customers are coming into our stores very frequently, and we want to give them the opportunity to find something new as they come in.

So when you take a look at our summer flow instead of having it all arrive at the same time.

You are seeing portions of it arrive and some of it flowing over the next couple of weeks.

Some of which will just be new items that will flow as well.

That, too, will contribute to better management of our inventory and to our margins overall.

Jenny, I don't know if you want to add anything to that.

No.

Not very much over what you just said.

It really is just -- it is just getting smarter of how we can do it.

We hope to be able to drive traffic as part of our flow strategies because, you know, the more we signal to our customers there is more newness coming into the store.

As you know we've talked in the past about the transitions from seasons to seasons to make them not as abrupt so that we can optimize our selling again.

So we are pleased with the strategies we have deployed and the brands are continuing to roll them out.

You will see more of it in the fall and holiday.

Operator, we have time for one more question.

I think she also asked about --.

Oh, I am sorry.

She asked about the design cycle and I wanted to add that in there.

The biggest difference is now we have a lot more collaboration between merchants and designs.

We added a meeting from -- you know before we just had an unveiling and you just see the line.

But now we actually have an extra meeting in there that there's -- there's more a working session between the merchant and design that they know exactly what is the bodies we are talking about, what are some of the new fabrication.

So it is much more a working session.

And then the third meeting is really adoption, and we seen that.

So there is no surprises.

So there is a lot more preparation in a season that we can be much more planful.

We have seen our adoption rate I think in all three brands really increase dramatically.

So I think that's been a pretty big change in our product development cycle.

Your final question comes from Marsha Jong with Sanders Morris Harris.

Hi, good afternoon.

Congratulations on a great quarter.

Can you talk about marketing strategies for each quarter and talk about the ones incremental.

Thank you.

Thank you.

We have -- we have mentioned that there is incremental spending for summer for Gap brand.

We used television for Gap brand four-week flight that's currently on, which is something we didn't do last year, and as Jenny mentioned for Old Navy, we are adding a flight of hispanic, which also are on air now began May -- May 13th we started for his hispanic television as well.

And Old Navy is also dropping one more circular by comparison to prior year.

So that -- that accounts for the increased in advertising that we spoke to earlier.

Great.

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

As always, the investor relations team will be available after the call for any questions.

Ladies and gentlemen, this concludes Gap, Inc.'s first-quarter conference call.

You may now disconnect.