蓋璞 (GPS) 2004 Q2 法說會逐字稿

Welcome to Gap, Incorporated's second quarter conference call.

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

If anyone should require assistance during the call please press the star key followed by the 0 key on your touch-tone phone.

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

They may not be rerecorded, reproduced, retransmitted, rebroadcast or downloaded without Gap, Incorporated's express written permission.

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

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, Incorporated, Investor Relations, at 415-427-2175.

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

Ma'am, you may begin.

Good afternoon, everyone.

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

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

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

Wherever used, the words estimate, expects, plans, anticipate, believes, 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 operation could differ materially from historical results or current expectations.

For more detail on that's risks, please refer to the Company's annual report on Form 10-K and our 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 debt retirement of debt which under SEC Regulation G we are required to reconcile with GAAP.

A reconciliation of these measures to GAAP financial measures is included is 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 second quarter financial performance.

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

After Paul, Marka Hansen will comment on Banana Republic.

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

We expect the call to last about an hour.

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

Thank you Sabrina.

Good afternoon.

Our second quarter and first half performance underscores our ability to deliver solid year-over-year margin and earnings growth as we execute against our strategic priorities and manage the volatility inherent in apparel retailing.

Following a strong start in May, business in June and July was challenging with traffic trends softening and monthly results disappointing.

Our strategic decision to reduce overall promotional and mark-down activity partially contributed to the deterioration of traffic during the quarter.

However, our operational focus sustained healthy bottom line performance for second quarter, and we continued to strengthen our balance sheet through early debt repurchase.

While our learnings from second quarter will inform future tactical decisions, we remain confident in our long-term strategies.

Here are highlights for the quarter.

Net earnings before loss on early retirement of debt improved 12% to $234 million, or 25 cents per share.

Disciplined inventory management supported year-over-year merchandise margin improvement of two percentage points.

We ended the quarter with 4.3 billion in cash and short-term investments after retiring 303 million in debt during the quarter.

Our credit outlook improved.

Earlier in the quarter Moody's upgraded our credit rating and Standard & Poor's recently raised their outlook on our credit rating from stable to positive.

And overall return on investment improved, as year-over-year return on equity increased two percentage points, moving up to 24% for the prior 12 months.

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

Reported second quarter earnings after debt repurchases were 194 million or 21 cents per share compared to 209 million or 22 cents per share last year.

We continued to de-lever our balance sheet by reducing 303 million in debt during the quarter through early retirement.

As a result, we incurred pretax charges of 65 million related to premiums paid on these repurchases.

Excluding these charges, second quarter net earnings before loss on early retirement of debt were up 12% to 234 million, or 25 cents per share.

Reported first-half earnings were 506 million, or 53 cents per share, compared to 412 million, or 44 cents per share last year.

First-half earnings before loss on early retirement of debt were up 37% to 564 million or 59 cents per share.

As a reminder, year to date we have repurchased 473 million in debt through early retirement.

Now please turn to slide 4 for our sales performance.

Second quarter total sales were 3.7 billion up 1%.

Consolidated comp store sales were flat versus a 10% increase last year.

Second quarter total sales per square foot improved 2% to $99.

Year to date total sales were up 5% to 7.4 billion versus 7 billion last year.

Consolidated comp store sales increased 3% versus an 11% increase last year, and year to date sales per square foot improved 7% to $196.

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

Turning now to gross profit performance on slide 5.

Second quarter gross profit increased 8% to 1.4 billion.

Gross margin was 38.5%, up 3 points from last year with 2 points from improved merchandise margins and 1 point coming from leveraging of rent, occupancy, and depreciation expenses.

During the quarter we realized better year-over-year margins on regular price and mark-down sales.

We also sold more at regular price versus last year.

First-half gross profit increased 16% to 3 billion.

Gross margin was 40.7%, up 4 percentage points from last year, driven primarily by a 3-point improvement in merchandise margins.

Turning to operating expenses on slide 6.

Second quarter operating expenses, including 65 million of expenses related to early retirement of debt, were 1.1 billion.

Second quarter operating expenses excluding loss on early retirement of debt were 1 billion, up 9% from last year.

Marketing expenses in second quarter were 107 million, up 20%, or 18 million, driven by an incremental summer TV campaign at Gap Division.

This investment occurred early in the quarter and supported improved traffic and better regular priced selling during the month of May.

First-half operating expenses including $95 million of expenses related to early retirement of debt totaled 2.1 billion.

First-half operating expenses excluding loss on early retirement of debt were 2 billion, up 11% versus last year.

Marketing expenses in the first half were 219 million or up 30 million or 16% over last year.

Turning to inventory, slide 7, we ended the quarter with 2.1 billion in inventory, down 187 million versus last year.

Inventory per square foot was $55 at the end of second quarter, down 7%.

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

Year to date capital expenditures were 156 million compared with 110 million last year.

Year to date we opened 41 store locations and closed 64, including the planned closures of all 10 of our stores in Germany during second quarter.

We ended the quarter with 2,999 stores and a 2% reduction in square footage versus second quarter last year.

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

Year to date cash flow before financing and short-term investing activities was an inflow of 79 million.

We ended second quarter with 4.3 billion in cash and short-term investments of which 1.4 billion is restricted.

As noted earlier, we repurchased $303 million in debt during second quarter, reducing our end-of-quarter debt to 2.3 billion and decreasing gross interest expense for the balance of 2004 by 20 million.

Since May of 2003, we have retired over 1.1 billion in debt.

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

Turning to slide 9, I would like to comment on our outlook for the remainder of 2004.

We continue to focus on driving gross margin growth by evolving our product assortments, managing inventory tightly and continuing to optimize our store fleet.

Given our progress in these areas, we still expect operating margins excluding charges related to early retirement of debt to reach the low end of the mid teens range for the full year 2004.

As a reminder we define the mid-teens range as 13.5 to 16.4%.

We remain committed to managing operating expenses in a disciplined and responsible manner.

Including all losses on early retirement of debt incurred during the first half, we now expect full year operating expense dollars to increase by about 11% with expense dollars up about 11% in third quarter and up about 3% in fourth quarter.

Our prior guidance of an expected 9 to 10% increase in total year operating expense dollars did not contemplate early debt retirement during the second quarter.

Marketing expenses are still expected to be about 560 million for full year, reflecting a shift of $20 million from first-half to second half.

As mentioned, we'll continue to balance inventory productivity with sales, ensuring that inventory levels adequately support our growth objectives and that our stores are well stocked for customers.

We now expect inventory per square foot at the end third quarter to be flat on a percentage basis versus a 7% decline last year.

Inventory per square foot at end of fourth quarter is expected to be up in the low single digits versus a 16% decline last year.

For fiscal 2004, we still expect to open 125 new stores, but now expect to close 150 stores, 15 more stores than prior guidance, all from Gap U.S.

Please recognize that our 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.

Please refer to our second quarter press release for a summary of store activity and our on-line press room at gapinc.com, for our 2004 store activity guidance by division.

Moving to interest expense we now expect full year gross interest expense to be about 180 million, below prior guidance of 200 million due to reduced interest expense related to second quarter bond repurchases.

Gross interest expense is expected to be about 43 million for third quarter and about 41 million for fourth quarter.

Our lower gross interest in fourth quarter reflects the expected interest savings from paying off our Euro bond that matures this September. 2004 guidance in the following areas has not changed.

Full-year capital spending, about 500 million with no change in the breakdown of our spend.

Full-year depreciation and amortization, 600 to 625 million.

And full-year effective tax rate, 38.5 to 39.5%.

In summary, we delivered a solid bottom line performance in second quarter that included healthy margin improvement, double-digit earnings growth before loss on early retirement of debt, a 303 million reduction in debt, and an ending balance of cash and short-term investments of 4.3 billion.

As we work to increase traffic and strengthen top-line performance in the second half, our strong design and operational discipline will continue to provide a solid foundation for our overall performance.

We remain confident in our brand strategies and our ability to drive long-term growth.

Now I would like to turn it over to Paul.

Thank you.

Thank you, Byron.

Good afternoon.

Today I'd like to talk about the second quarter, the first half of the year, and our priorities moving forward.

And I'll share details about an exciting new cross-brand initiative we are launching in late fall.

Finally, I'll discuss Gap and Old Navy's fall marketing strategies, and then Marka Hansen will provide an update on Banana Republic.

Coming off the second quarter, although we delivered solid earnings growth, we were disappointed with our performance.

Our strong May results signaled customers are responding very positively to Gap, Banana Republic and Old Navy's product assortments.

However, June and July proved difficult as we managed summer clearance against weaker traffic trends.

Importantly, we are evaluating and learning from the traffic trends we saw in summer and looking especially at marketing and the competitive environment.

We are building these lessons learned into our strategies moving forward.

For example, at Old Navy our summer circulars were timed too close together and we also feel we have an opportunity to better differentiate our marketing messages.

As I've been reminding our team, our business is not run one month at a time.

We're taking a long-term view, and while comp is an important metric, we're also focused on balancing top-line growth with healthy margins.

I talked a lot about how our operational discipline and consumer insights work is helping us strike a balance between the art and science in our business.

This work has been paying off and is giving us the flexibility we need to manage through bumps in the road.

For example, despite the challenges we experienced in the quarter we were able to move through inventories and still deliver solid gains in merchandise margins over prior year.

Reflecting on the first half I'm pleased with the progress we continue to making against our priorities.

Before early debt retirement we continued to drive year-over-year double-digit earnings growth with a 12% increase for the quarter and a 37% increase for the first half of the year, and we're making substantial progress reducing our debt and returning to investment-grade standing.

Our priorities remain the same as we strengthen our core competencies and leverage the talent and leadership in the organization.

One, continue mining the significant growth opportunities that exist within each brand.

Two, actively explore and pursue new growth initiatives that we determine are most optimal for our shareholders, and continue to apply rigorous operational discipline to how we run our business while working to improve our financial flexibility.

Now I'm excited to announce a cross-brand initiative that represents the first of its kind in specialty retail.

Leveraging the strength of our portfolio we are launching a brand-new credit card program this October giving Gap, Banana Republic and Old Navy customers greater incentive to shop our brands.

The consumer proposition is simple.

One credit card to shop, earn points, and redeem rewards across all three of our brands including on-line and outlet stores.

A combined reward program allows us to maximize the strength we have in our existing credit card business by adding a great value proposition to our customers and rewarding them for shopping across our brands.

Our current cardholders are our most loyal customers, spending and visiting about twice as much as our other customers.

These customers also actively shop across brands.

In fact, about 65% of Gap cardholders tell us they shop our sister brands, and 75% of Banana Republic cardholders shop at Gap and/or Old Navy.

We see a significant opportunity to drive sales by encouraging cardholders to purchase within Gap Inc.'s family of brands.

For instance, our new program is a great vehicle to influence our Banana Republic deluxe customer to shop at Gap and/or Old Navy for her family's wardrobing needs.

The new program gives us ample marketing opportunity to drive traffic and conversion.

It also provides a valuable platform to strengthen our customer relationship management capabilities and leverage future cross-brand initiatives both on-line and in our stores.

Each brand is launching a newly designed card maintaining the brand identity of Gap, Banana Republic and Old Navy.

We're sending welcome kits to our cardholders, another opportunity to increase penetration.

The launch will also offer cardholders and each new applicant three 10% coupons redeemable at each of our brands when they use their card to purchase.

Additionally there is an added 10% discount for customers who use their card poor the first on-line purchase.

We see this as a significant opportunity and one our stores will rally around in October.

The credit card launch represents just one element of an exciting fall as we debut our marketing campaign this month.

At Gap we spent the past year establishing our core customer segment and evolving our marketing and product strategies to meet the needs of our style-conscious men and women customers.

We've seen strong response to our enhanced product design as we continue our focus on serving more of their occasion-based needs.

This fall we're communicating more specifically to Gap's core customers both from a timing and message standpoint.

The fall, How Do You Wear It campaign, featuring style icon Sarah Jessica Parker, began this month and runs through September.

Supported by key item focus, our messages highlight how the brand serves a range of occasions and will be sustained through both the fall and holiday season.

This year new elements were integrated into the campaign to give customers reasons to get excited about the brand beyond the launch of television advertising.

Special in-store customization events will help deepen Gap brand's loyalty with customers, and an integrated marketing website will augment our commerce site by providing style ideas to help customers outfit for various occasions.

The campaign reinforces Gap's cultural connection.

We're also sponsoring the MTV Video Music Awards at the end of this month.

Old Navy's back to school and fall marketing campaign is focused on strong value and fashion messages for mom, teens, and families.

We continue to reach our core customers through TV, print, circular and in store promotions.

Denim, including our new special edition denim in washes and finishes, is the focus of our back to school circular highlighting great prices for fashion denim for the whole family.

We're also reaching new customers through new store growth.

Old Navy kicked off the back-to-school season with a grand opening of seven new stores in Montreal which was met with great fanfare, and we expect to open about 50 more stores in the U.S. by the end of the year.

We continue looking for expansion opportunities in smaller markets in addition to primary and secondary markets.

So it's been a solid quarter and a strong first half.

We continue to focus on organic growth initiatives while putting the right foundation in place to support new growth opportunities.

We're excited for the many opportunities we see in the business.

The latest of which is the launch of our new credit card.

We're a month into our plus size launch at Old Navy.

Gap continues its focus on occasion-based wardrobing, and Marka Hansen will fill you in on Banana Republic's priorities and some of the ways we're mining additional growth in the business.

I'm confident we have the right teams and strategies in place to fuel our growth today and for the long term.

Thank you.

Now Marka will give you an update on Banana Republic.

Thank you, Paul, and good afternoon.

I am very pleased to be here today to share our second quarter results and provide an update on some of our priorities entering fall.

We ended the second quarter and the first half with positive results, and I am pleased with our top-line performance and especially with the quality of our results.

This year we solidified our positioning as an innovative and accessible luxury brand, and we're resonating with our core customers.

During the second quarter we delivered a positive 4 comp and saw comp store traffic increase by 5%.

Importantly, we drove these results with significant less promotional activity than last year.

As you probably saw in June, we had our semiannual sale, which was a success.

In July results reflected the conscious decision to maintain our full price position rather than anniversary last year's longer markdowns.

While this is consistent with our strategy to drive regular price selling, we are reviewing these results to ensure we're driving optimal balance between sales and margins at a highly promotional time of year for our competitors.

Now, we're working to build a stronger relationship with our customers and are becoming more relevant for serving their occasion-based needs.

We're really excited about the tri-brand card we're launching as it will serve to reinforce this relationship.

Along with relationship building we continue to elevate our brand through evolved product assortments, emotionally appealing marketing and a superior shopping experience.

Staying close to our customers through various consumer insight vehicles such as fit clinics and pass-it-on surveys, we have a better understanding of what they're looking for.

As a result we are creating compelling and differentiated product assortments and serving our customer, from the right thing to wear to work, to going out, to casual weekend.

And we are also making it easy to put the whole outfit together with a particular focus on accessorizing.

Let me give you a few examples.

In women's we are deepening our relevance for the work occasion by offering fashion and basic suits, both made of exclusive Italian fabric and designed with detail such as special pattern linings.

In addition, we are offering the quintessential items for the foundation of the wardrobe such as stretch merino sweaters and our big-button wovens.

We are also filling women's weekend needs by offering a collection of fashion denim and casual feminine tops.

Additionally, we've become a destination for fashion-right outerwear.

We are taking similar approach in men's.

In spring we helped show men how to wear woven shirts for multiple occasions and we've seen explosive growth in this category.

Our woven collection includes a casual offering at our opening price point of $54.50, a great selection of shirts for work, and we are now adding a $98 premium woven with great attention to detail including contrasting linings in the cuffs and collars and beautiful elevated buttons.

Now that men know how to wear the woven shirt, we'll be showing them how to wear a blazer across occasions, from dressed up with a suit to casual with jeans.

We are also focused on making it easier to put together an entire outfit for each occasion.

One example is the use of accessories to help build the wardrobe.

By offering a wider breadth of assortments such as seasonal scarves and wraps, as well as a more complete range of styles and colors in our shoes, hand bags and jewelry. we help them to complete the total look.

During the second quarter, these product and merchandising initiatives have supported our committment to regular priced selling, and contributed to solidifying our overall brand positioning.

This fall we continue to reinforce our brand positioning through tailored marketing messages that speak to our core consumer segment.

Our print and outdoor media will highlight elevated apparel and accessories and we'll use direct mail to educate our core customer on how to put the whole look together.

Our two fashion shows have proved to be a tremendous success and our editorial coverage has increased by over 60%.

I'm most excited about the recent full-page spreads we received in Vogue, Glamour, and Women's Wear Daily.

We are also looking forward to our sponsorship of Project Runway , a new fashion-focused reality television show airing on Bravo this fall.

This sponsorship provides us with a great opportunity to directly connect with our consumer and show-case our design talent.

Another key strategy that is continuing into the back half of the year is our commitment to elevating the in-store experience.

We've had great success in retaining our top store management through targeted development program, and we're deepening our service-based training programs for all of our store employees after great results in the first half of this year.

Visually we're rejuvenating our stores to further elevate and reinforce our brand message.

For example, we are implementing a signage package that enhances the elegance of the brand and more effectively communicates our wardrobing message.

We will have completed our POS system rollout to all U.S. stores in time for holiday this year, allowing our associates to spend more time servicing the customer.

So let's turn to growth.

Our accessories business continues to provide an excellent opportunity for growth.

We'll continue to design and merchandise accessories that clearly tie back to and apparel selections, building on the successes we've seen with our handbags and shoes.

In the past two years, jewelry has become a successful addition to our brand.

Having jewelry in all our stores, we will continue to analyze opportunities to expand the collection.

We are also expanding our petites business.

We've taken petites from online and 4 flagship stores last spring to 23 stores this fall.

We're pleased with our second quarter and first half results, especially around the quality of the business we have built this year.

I have a fantastic team in place.

We continue to deliver against our strategic priorities and our customers are responding.

We will look forward to the opportunities that lie ahead.

Thank you.

That concludes our prepared remarks.

We will now open up the call to questions.

We would appreciate if the 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 press star then the number 1 on your telephone keypad.

We'll pause for just a moment to compile the Q and A roster.

Your first question comes from Todd Slater with Lazard Freres.

Thank you, everyone, and good job in the first half.

I just have a -- we saw a few events going on at Gap and Old Navy stores and I was hoping you might comment on them.

At Old Navy we saw a $10 off $50 purchase promotion which we don't remember from last year so I was just wondering if that was an incremental event.

At Gap we saw average 47% markdowns on a product that came in a couple of weeks ago.

And lastly we noted that at Gap they seem to be cutting some store payroll hours, and I'm just wondering if that might be related to the current sales trend.

Thanks.

Todd, let me answer your last question first.

Regarding store payroll at Gap seasonal always tend to bring payroll hours down before we launch fall so there's just a seasonal cadence that happens every year.

When we look year-over-year, in fact, payroll hours are not down at Gap brand.

Regarding the promos we might take that off-line with you.

It doesn't look like there's a big difference at Old Navy with regard to the promos but the team would be happy to take you through each and every one after the call.

Next question comes from John Trendesman with Pendulum Capital.

Hi guys, good first half.

My question is more balance sheet oriented, and I'm wondering if you had revisited your credit agreement with your bankers yet for your sort of untapped working capital line to get released from some of the negative covenants that prevent you from buying back common stock or increasing your very modest dividend as opposed to buying back bonds in the market which are trading at, you know, very high premiums.

Thank you.

I'll take that question.

You know, we are always looking at the bank market to see how it's changing and evolving and if there's an opportunity out there to get a better deal.

We certainly would pursue it, so there are discussions certainly going on with regard to our credit facility.

I will say the current credit facility does have the restrictions around share repurchase and increases in dividends.

I believe, you know, if we had a very strong case for that for our shareholders, and we maintained the responsible outlook that we intend to, with regard to managing our balance sheet with prudence and conservatism, that that wouldn't be an issue to get an amendment.

But, again, it's also probable that we'll be relooking at the credit facility since there have been improvements in the bank market.

Thank you.

Your next question comes from Margaret Mager with Goldman Sachs.

Okay.

Actually, I wanted to ask about the Old Navy coupon as well.

Can you just put that in the context of your marketing strategies?

You know, I understand circulars and TV, that's pretty straightforward, but these things that come across on-line, how do they work?

Are they planned?

Or are they opportunistic?

Can you just speak to that a little bit?

Thanks.

Let me give you -- this is Paul.

Let me give you a little bit of a sense.

Clearly Old Navy is -- a lot of their intended go forward plan is looking at both our planned promotions which we plan out in advance, then we absolutely leave ourselves flexibility to adjust to the marketplace, adjust to sell, adjust to competition.

So that's an ongoing phenomena that we've been doing for the last year at least.

When you take a look at any specific item today you shouldn't read too much into it as much as it's just reacting.

In the broader context it's planned it's just not every single drop is planned with the exception of our television which is certainly, you know, on a quarterly basis is planned and our circulars are well planned but the on-line drops the promotional things we do in store, what we maintain flexibility for us to be able to react to the business.

Your next question comes from Dana Telsey with Bear Stearns.

Good afternoon, everyone.

Can you talk a little bit about this new marketing initiative on the credit card?

What happens to the old card?

What's the marketing plan for this new card, and third, is it third-party ownership, and can you give us update on product expansions, whether is is Body at Gap, jewelry at Banana or teen and large sizes and how that plays into gross margin going forward?

Thank you.

I'll start and maybe my colleagues will chime in.

We're very excited about this opportunity.

We've gone out and talked to, with the hypothesis that we had that our customers would want to have both the utility being able to use their credit card because we clearly saw the behavior was such that they were using it across brands but the idea of being able to reward them across all three brands in the portfolio as well as on line seemed like an opportunity to get more of our customers to stay within our portfolio as opposed to going to our competition.

So we validated that through talking to our customers.

And what will happen is our existing customers will get a new piece of plastic, it will stay with the home brand, so the front of the face will remain, if I'm a Gap card holder, I'll still have a Gap, will give our customers a choice, should they want to choose, to have the face of another brand.

It's basically a new piece of plastic.

On the back will be clearly identifying the opportunity to use all three of our brands and the logos will exist.

Then we will comingle the rewards so that the rewards they earn at any one of the brands will be good to redeem at any one of the brands.

We're not planning any television or print around this but we're going to do it all through in-store using our sales associates, in-store point of sale, and by giving extra special promotional offers for people that are signing up and for the first time that they engage and use their card.

So we think we've got a pretty strong compelling in-store opportunity.

We hope that it's going to drive penetration which we think is an opportunity by comparison to the marketplace.

We think it can drive traffic, we think we can get, you know, our customers who are current looking at competitors or using competitors as part of their wardrobing in their closet as an opportunity to stay within our portfolio.

So third part -- you want to talk about that?

The current program we have with each of the three brands is third-party administered, so the actual processing of the card as well as the carrying of the receivables is all done by the third party, and it is that relationship we will be leveraging to use to support the tri-brand.

Lastly, we continue to focus on the new initiatives.

Marka had mentioned a few, particularly in jewelry and accessory and BR, the rollout of more petite stores that we are excited about, plus sizes, we're in about 50 stores, we anticipate adding another 20 stores.

So we're pleased with the results so far.

Thank you.

Your next question comes from Barbara Wyckoff with Buckingham Research.

I have a question for Marka.

Can you talk about where you stand in the pant initiative?

Are you still committed to three fits and the balance between the three fits?

And then as a follow-up are you doing anything to streamline your sourcing operations for better response time?

With regard to fits we're still committed to three essential pant fits, Martin, Harrison, and the Camden.

We continue, although on fashion fits to offer what we call other.

And that's been very successful as well.

We're very pleased with what we've built and continue to stay focused on that.

Sourcing piece, we are well down the road in building our strategic vision for sourcing of the future.

The elimination of quota is clearly giving us the ability to kind of reinvent how we think about our relationship with our vendors, and those relationships will become broader and deeper, our sourcing will be more concentrate.

This is going to give us the opportunity to not only look at opportunities to streamline our efficiencies through speed to market but also quality and costs.

So all that is work in progress clearly until the quotas come off at the end of the year.

This is work that will go on with our vendors over the next two years but we're way into it in terms of the opportunity that we think exists to be able to move the lever on all three.

Cost, quality, and speed.

Great.

Thank you.

Your next question comes from Lauren Levitan with SG Cowen.

Thanks.

Good afternoon.

I had a question on marketing.

In the first half with marketing spend up 16%, throughout that first half you would comment on the monthly calls that often times you saw the sales increase you thought related to those marketing increases.

With a smaller marketing increase forecast for the back half, can you give us some sense as to, you know, how you think those marketing -- do you think that the reach will be as significant on lower marketing dollars, or lower increase in the back half, and in addition to that, Byron, you had commented that you thought that some of the weaker traffic in June and July could be attributed to things that you may have done internally in June and July.

When do you think you'll have the learnings assessed on that.

When should we expect to see some of changed strategies either in marketing or otherwise rolled out?

Thank you.

First, let's talk about the -- what was the source of the incremental marketing in the first half?

It was almost exclusively related to restoring a Gap summer TV campaign which we omitted in 2003 and we put into place in -- back into place in 2004, and that was a campaign that launched early in the quarter, and we think had a direct impact on the traffic that was -- the attractive traffic at Gap during the month of May.

This is a campaign that during this particular season, we don't believe has legs much beyond the early -- the early May period.

So when we look -- when you reference that the increase is less in the second half, it's compared to 2003.

We had a full compliment of marketing in the second half, and so there were no openings in the marketing schedule to fill.

We are also very confident with regards to our campaign lineup in the second half, of which be happy to let Paul talk to you a little bit more about.

But we feel like we're in very good shape.

The timing, of course, is a bit different, and I'll let Paul talk about that.

Particularly I think the biggest shift is in Gap brands where last year our two campaigns, if you remember, we did the Madonna, Missy Elliott, which was late July, beginning of August, then our second campaign which was in September, frankly looking at from the last year, although we moved some, you know, decent business on cords, we didn't move traffic as much as we would have liked last year against the campaign.

So strategically this year we decided to focus more on the fall selling season, particularly as it related to September, and our campaign -- we didn't do the beginning of August but we're starting the teasers now, then the full-blown campaign will begin on August 30, or 31st, so we feel very good.

Needless to say the Sarah Jessica Parker piece we think combines both the cultural relevancy that the Madonna gave us along with impact that we did see from the wardrobe selling commercial that came later on so we think we've got a better communication message.

We're also integrating a lot more exciting promotionals, there's a styles van going around to key markets, Sarah Jessica is going to be in one of our stores.

A tremendous amount of publicity, editorial pickup as a result of it.

Our on-line focus is going to give our customers opportunities on how to style it.

Hopefully you've seen our print ads which are overwhelmingly compelling.

The other brands are fairly consistent in terms of weight and expectation.

And we certainly hope that our advertising messages are even more compelling.

I might mention that for the first time we're starting to do pre and post research on our advertising for Old Navy, so that we can really see whether our messages are clearly communicating as we expect against those customer segments.

Of course, as a result of that we'll take those learnings into holiday and into next year as well.

Thank you.

We saw the van San Francisco.

It's a lot of fun.

It's way cool.

Your next question comes from Kimberly Greenberger with Smith Barney.

Thank you.

Good afternoon.

Paul, I just wanted to ask about your comment in the press release, you're actively exploring new growth opportunities and I assume specifically you're talking about outside of your existing brands, and I'm wondering if you could provide, you know, any insight or an update as to how you're thinking about that over the longer term.

And then, Byron, if I could just get a clarification on the second quarter SG&A it looks like in total if you include the debt retirement it's up about 390 basis points, or 4 percentage points.

I can account for close to half of that with the debt retirement increase, and another 50 basis points with advertising expense.

Can you just talk about what was driving the other components of the increase in SG&A in the second quarter?

Thanks.

Well, just -- the press release isn't signaling anything new that I haven't mentioned earlier about our growth, other than to say that we clearly have a team, a variety of our folks, really focused on opportunities for growth, the buckets that we have talked about are organic growth, and you're hearing more about those.

New growth opportunities looking at under exploited opportunities as well as international growth.

So we haven't given any new specific information about what those growth pieces are but as we communicate in the past, as we're ready to roll them out we will communicate them to the market and to our investors.

With regards to second quarter SG&A, if you pull out the costs associated with the early retirement of debt, the kind of the pure year-over-year increase is 9%, and additional impact associated with the -- with second quarter, and they really impact the entire year, recall that we have reclassified our Workers' Comp costs so that they are no longer in ROD, which they were in 2003, they are today in 2004 in SG&A.

We also went through a capitalization change that caused us to capitalize -- stop capitalizing smaller short-lived assets.

The combination of those two changes from 2003 to 2004 added approximately 70 million of SG&A to the year which you can apply ratably to each of the quarters.

For a more detailed breakdown we could take that off-line.

Great.

Thank you.

Your next question comes from Emme Kozloff of Sanford Bernstein.

What do you need leverage your R&D expense and are we to assume the expenses for new credit card expense are embedded in guidance?

Second for Paul along the lines of Kimberly's question we've heard you talk about doing a strategic review so a lot of us are curious, are you saying basically you're going to release growth initiative information just on a piecemeal basis that we shouldn't expect anything in the spring that maybe a comprehensive conclusion sort of conclusion about growth strategies and balance activity?

Thanks.

Okay, so let me talk first about the -- answer your question about tri-brand.

The answer is yes.

All the costs that are associated with the launch of the tri-brand credit card are embodied in our expenses for SG&A.

With regards to leveraging of rod, let me -- so if past is prologue, one point of comp yields about a tenth or so of leveraging at the rod level.

But let me put a little more color on to that.

With regard to the rod leveraging we've got three factors this year that are impacting it in a way that I would say is nonnormalized.

The first is we are continuing to optimize our store base particularly in Gap brand which means we're pulling out the lower productive -- the less productive stores which inherently have less leverage on rod and some of those sales are releveraging on to existing stores.

Also, during this period where we have an above average number of closures, we are reducing our depreciation associated with our store base faster than we're adding to it, and so we have some benefit there that we actually expect to continue for a bit longer, but that's nonnormalized.

And then third, in connection with the prior question about SG&A, just recall that in 2003 Workers' Comp was embedded in our rod, and in 2004 it's not.

So -- and that's the difference year to year, is that we reclassified about 35 million.

And then on the growth, you should expect as we had articulated, that for -- certainly for the second half you can expect us to share new growth initiatives as we bring them on line or as we get close to the launch.

As we've done now with plus sizes, maternity at Gap and Old Navy petite, Body, Old Navy new store, Gap occasion, we've got a lot coming on and we hope to be able to share more over the coming months but they will be close to the time when we're ready to go announce.

We haven't really thought through our communication strategy completely for the first quarter of next year.

However, we have said that we are reviewing our balance sheet and clearly reviewing what our policies might be or change as it relates to dividend and share repurchase and that's something that we would share in the beginning of next year.

Great.

Thanks.

Your next question comes from Janet Kloppenberg of JJK Research.

I recently read an article where they talked about shifting the focus of the Gap plan target market to 20 to 30-year-olds.

Wondering if you could talk about the research that you discovered and base that decision on and if you think your 1400 or so domestic store base of Gap can gain enough business from that, and from that population, and I'm wondering about the 30 and older population, if you will address that population or if that's just something for Old Navy now.

And lastly I'd like to understand more your decision to trim your advertising in the Gap brand in the month of August and the shift that seems to be going into September.

Thank you.

Well, let me give you the first one.

I think Gary was clearly talking about the work that we've done in our segmentation.

As we look at our customers we do think about our customer segments in their style preferences, obviously there's age skewing associated with that but clearly our style conscious consumer who tends to be the 20 to 30-year-old is our core focus, and I think if you look at our product assortments, particularly as we move into fall and our advertising communications we're really looking for that customer and continuing to focus.

That's if customers who have been in our stores and been participating in this brand for many, many years need to focus more specifically on them as opposed to trying to be all things to all people becomes really the difference.

Having said that, we recognized there's other customer segments like our updated classics and teens that shap at our Gap brand and the brand clearly halos to those customer segments.

But particularly as it relate to the new occasions and our marketing messages.

With regard to the fall advertising and the shift, simply we felt it was more appropriate or better opportunities for us if we didn't repeat the early advertising game pain that we had done last year and instead focus on a campaign that breaks as we speak and a little bit later and give it a little bit more strength and a single consistent message as opposed to breaking our advertising into two different messages and then spreading it over the time period.

So that was the thinking behind the shift.

Thank you.

Your next question comes from Mark Friedman with Merrill Lynch.

Thank you.

Good afternoon, everybody.

Paul, Byron, I was wondering if you could talk although bit more in detail about the 11 and 3% spending, what was driving that.

I didn't fully understand that in your prepared comment as to the impact.

And I just wanted to clarify, there was a little shift in marketing from the first to the second half.

I thought did you say that also.

Yes.

Mark, I'd be happy to take that.

First, let me make clear that our basic guidance for SG&A that we gave during the first quarter hasn't changed for the full year except we have added to our SG&A guidance this spend for early debt retirement that was incurred in the second quarter.

The original guidance of 9 to 10% for the year included the cost of early retirement for the first quarter because we had -- by the time we gave the guidance we knew that to be the case.

So the basic guidance hasn't changed.

And maybe I could just walk through cadence.

If we were to -- so the full-year guidance is about 11%, and that's all in, including all debt retirement costs for both first quarter and second quarter.

If we were to strip that out, then for the first half, we would be at about 11% SG&A increase year-over-year, third quarter would be 11%, fourth quarter 3%, that blends to about a 7% increase in the second half, and then if you look at that on a full-year basis, it would be about 8.5% SG&A increase.

Once again, that's 8.5% without any of the debt retirement charges.

If you were then to pull out 35 million for the full year estimate of Workers' Compensation which is now in SG&A which was not in the '03 base, and if you were also to adjust for the capitalization policy change, which was not in place in '03 but is in '04, that would be another 35 million.

Then the -- kind of the year-over-year increase, that guidance would be about 7%.

Now, with regards to why the third quarter is up 11, in terms of our guidance, we -- the principal components would be the increase in Workers' Compensation, the capitalization change, the annualization of strategic growth investments that we began making in fourth quarter of last year, and we shifted some of the marketing that we had expected to spend in the first half to the second half.

The specific nature of the marketing, two buckets.

One, we were able to execute in the first half a little bit less expensively than we had budgeted had but rather than remove that from guidance for the full area we are reguiding for that to be spent in the second half to support traffic.

The other marketing bucket is commercial production cost, as I think you know as we produce commercials we have to expense them as incurred.

We had expected some of the fall campaign to be completed in the first half.

More of that is going to be completed in Q3, hence we shifted that to the second half.

With regards to Q4 and why it's only 3%, you may recall that we had a number of one-time charges in fourth quarter of last year, including a reserve for Germany, including some debt repurchase costs, and including some charges we took for sublease reserves.

Great.

Thank you very much.

Your next question comes from Jeff Klinefelter with Piper Jaffray.

Yes, quick follow-up question on sourcing.

Understand with the big changes coming at the end of this year in China, is there any increase at all in your cost of goods or your sourcing to prepare for that, in terms of contingency planning?

We have heard that some of the costs have gone up as companies have gone to backup source elsewhere.

And is anything happening in terms of the lead times in getting product through customs right now?

We understand that's becoming more of a focus and has stretched out some of the processing times.

The short answer on all of that is no.

Given our strength in the marketplace, our relationship with vendors, our diversified sourcing base, we have moved some things around, but similar to things we've done in the past so it's not affecting our price, it's not affecting our ability to get goods, it's not affecting our ability to get goods into market or lead times at all.

It's having no effect for us.

Having said that we clearly had strategies in place to make sure it didn't have any effect and we're confident that we have no problem going into the fourth quarter.

And then one quick other question would be on the clearance inventory.

Like going into June of this year versus going into June of the prior year, could you just recap again what your clearance inventory change this year was versus last year?

Let me answer that this way.

As we completed the second quarter, which would be July, we are -- we believe we're in very good shape in terms of entering the third quarter, and that our cost inventory at mark-down is about what it was last year.

So we're very satisfied with what we've been able to move through in the quarter, and are looking forward to the fall season.

Thank you.

Operator, we have time for about two more questions.

Okay.

Your next question comes from Stacy Pak with Prudential Securities.

Hi.

Two questions.

One is just a follow-up on that SG&A that you were answering for Mark.

How much shifted out of Q2 SG&A because that marketing that you didn't spend?

That's one question.

Then, Paul, I'd just like your perspective on what happened in July and whether you guys still feel as confident on the full price selling, how easy it's going to be, or whether, you know, fashion is, you know, tougher and maybe the 13.5 to 16.4% operating margin goal is not so easy.

And if you would care to comment about the August month to date trends, that would certainly be interesting.

Stacy, I'll take the first one.

As opposed to how much shifted out of second quarter out of first half into second half.

Second quarter.

Specifically relate to marketing, it was 20, 20 million.

So that's the piece, Byron, that just -- that you were going to spend in Q2 that you didn't spend?

That's what I'm asking about.

No.

When we originally gave guidance --.

No, I have that.

-- we had planned to spend 20 million more in the first half, and we have shifted that to the second half, and ace said, throughout the first half we were able to execute a number of our marketing initiatives at less costs than what we had budgeted.

Those savings, so to speak, occurred in both first and second quarter.

The commercial production piece that we expected to spend in the second quarter, that's a specific second quarter piece that will now shift into third quarter.

You want to give that you say dollar amount?

No.

It's 20 million in total.

And then, Stacy, with regard to, you know, I guess my first broad answer is, we don't think that anything has occurred that's going to change our strategy going forward.

We still are very focused on our reg price selling, we've had good experience in elevating our brands, getting our customers to be paying full price and getting our product right.

So although we were disappointed with July we're not seeing any change.

What clearly was driving July was lower traffic, which was disappointing and unexpected.

As we go back and look at the timing of our advertising, the timing of the drop of our circulars, and other activities that we could have done or should have done, those are things that we'll focus on on a July over July basis, but they are not systemic or implications as to what we believe our strategies need to be going forward.

We're still very commit to our focus and we feel very good about where we're taking these plans.

But overall we remain confident in our approach and the quality of the earnings that we'll continue to deliver, and, no, we're not prepared to talk about August.

That will be in a couple of weeks.

This will be our last question.

Your final question comes from Don Trott with Jefferies & Company.

You've done a lot of constructive things, modifying the assortment meant, targeting particular social demographic economic groups and so on.

Yet the traffic response doesn't seem to have been as robust as one would have hoped for.

Why do you think you're not generating a greater traffic other than at Banana?

Don, there's a couple of things.

Clearly we had some tremendous traffic gains that we saw, very good traffic gains we saw early in the year and in May, and then our traffic slowed down.

A big part of the contributing factor clearly is less markdowns, and that we didn't last year, if you remember, particularly at Gap brand, we were closing out, marking down men's bottoms and boys bottoms in preparation for the launch in fall for the relaunch of both of those product classifications.

We spun a lot of product, and we drove traffic as a result of spinning that product.

So we didn't anniversary that.

So we attributed some of the traffic clearly to less mark-down activity, particularly on those things that we were trying to clear through merchandise.

And we're looking at our marking.

The timing of our circulars you Lars.

I think in retrospect we probably put our two Old Navy circulars a week apart probably should have been two weeks we're looking at some of our messaging but we clearly see this as what did we do in that particular month, what could we have done better, and not necessarily something that needs a strategic change in our overall approach.

Could you give us some guidance, as big a range as you feel comfortable with, as to what kind of ongoing traffic gains you would feel, you know, is targeted?

Yeah, Don, it's not something that we go forward that we're prepared to talk about.

We continue to focus on driving quality earnings, and driving our comps, and we really want our comps particularly to be driven off of a lot of the new initiatives.

Certainly as it relates to maternity and plus, taking market share in classifications so we drive the top line through that we want to drive our bottom line to make sure we've got the right inventory levels to drive through, and compelling marketing.

We're looking at the adjustments we make this fall by comparison to last year and we think they're going to pay off.

But time will tell.

Thank you.

Okay.

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

As always the Investor Relations team will be available after the call for further questions.

Thank you.

Ladies and gentlemen, this does conclude today's conference.

You may disconnect at this time.