蓋璞 (GPS) 2004 Q3 法說會逐字稿

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

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

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If you have any questions regarding this policy, please contact Gap, Incorporated's 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 third quarter earnings conference call.

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

I would like to remind you that the information made available on this webcast and conference call 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 operation could differ materially from historical results or current expectations.

For more detail on these risks, please refer to the Company's annual report on Form 10-K and 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, 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 will begin with Byron Pollitt, our Chief Financial Officer, who will discuss our third quarter financial performance.

Then Paul Pressler, our Chief Executive Officer, will review the third quarter, holiday marketing strategies, and provide an update on our growth initiatives.

After Paul, Nick Cullen, our Chief Supply Chain Officer will speak to some of our supply chain strategies around the upcoming quarter removals.

After Nick'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 strong year-to-date performance demonstrates our ability to drive shareholder value as we position ourselves for longer-term growth.

Throughout the year we've made solid progress against our objectives, delivering strong operating results, and strengthening our financial position.

Earnings year-to-date are up 14%, and the third -- and in the third quarter, our debt has been reduced by an additional 397 million, our credit rating has improved, and we began returning excess cash to shareholders through a $750 million share repurchase program, our first since 2000.

Though third quarter was challenging, our continued operational focus drove solid earnings, margins and cash flow, allowing us to maintain strong cash balances, even after significant share repurchases, and nearly 400 million in additional debt retirement.

Now, let's review our operating results.

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

Reported third quarter earnings after debt repurchases were up 1% to 265 million or 28 cents per share.

We paid off 397 million in debt during the quarter, with 122 million reduced through early retirement.

We incurred pre-tax charges of $10 million to retire this debt early.

Reported year-to-date earnings were up 14% to 771 million, or 81 cents per share, versus 72 cents last year.

As a reminder, our reported year-to-date earnings reflect about 105 million in costs, related to early debt retirement, offset by about 20 million in interest savings related to those repurchases.

Please turn to slide 4 for our sales performance.

Third quarter total sales were 4 billion, up 1%.

Consolidated comp store sales were negative 1 versus positive 6% last year.

Year-to-date total sales up 4%, to 11.4 billion.

Consolidated comp store sales positive 2%, versus positive 9 last year.

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

Turning now to gross profit performance on slide 5.

Third quarter gross profit increased 3% to 1.6 billion.

Gross margin was 39.4%, up 50 basis points from last year.

With 10 basis points from improved merchandise margins, and 40 basis points due to the leveraging of rent, occupancy, and depreciation expenses.

Disciplined inventory management supported slightly improved merchandise margins, while continued store fleet optimization contributed to the leveraging of rent, occupancy, and depreciation.

Year-to-date, gross profit increased 11% to 4.6 billion, gross margin was 40.3%, up 260 basis points from last year.

Turning to operating expenses, on slide 6.

Third quarter operating expenses, which include 10 million of expenses related to early debt retirement, were 1.1 billion, up 5% from last year.

Below our prior guidance of an 11% increase, primarily due to lower bonus accruals, marketing spend, and store expenses.

Marketing expenses in third quarter were 166 million, down 5%, driven by lower-than-expected production costs.

Year-to-date operating expenses, including 105 million of costs related to early retirement of debt, totaled 3.2 billion.

Turning to inventory, on slide 7.

We ended third quarter with 2.6 billion in inventory, up 1%.

Inventory per square foot, $68 at the end of third quarter, up 1%.

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

Year-to-date capital expenditures were 305 million, up from 181 million last year.

Year-to-date, we opened 102 store locations, and closed 73.

We ended the quarter with 3,051 stores, with end-of-quarter square footage flat to 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 159 million.

We ended third quarter with 3.7 billion in cash and short-term investments, of which only 1 billion is restricted.

During the quarter, we amended our letter of credit agreements and reduced restricted cash by 336 million.

As a reminder, this restricted cash collateralizes our letters of credit, and we've reduced this amount to more closely reflect ongoing letter of credit usage.

As noted earlier, our Board of Directors has authorized $750 million in stock repurchases.

Within the quarter, we repurchased 17.1 million shares for $338 million including commissions.

We also retired $397 million in debt, reducing our end-of-quarter debt to 1.9 billion.

Since May of 2003, we have retired over 1.5 billion in debt, and we ended third quarter with 1.9 billion more in cash and short-term investments than debt.

Importantly, earlier in the quarter, Moody's upgraded our credit rating to BA-1, leaving us just 1 notch below investment grade, with both agencies.

Please turn to slide 9 for our outlook for the remainder of 2004.

Despite a challenging third quarter, we still expect operating margins, excluding all charges related to early debt retirement, to reach the low end of the mid-teens range for the full-year 2004.

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

Including all expenses related to early retirement of debt incurred this year, we now expect full-year operating expense dollars to increase by about 10%, slightly below our prior guidance, driven principally by lower bonus accruals, and marketing expenses.

Fourth quarter operating expense dollars are still expected to be up about 3%.

Marketing expenses are expected to be about 540 million for the full year, 20 million below our prior guidance, due to the continuation of lower-than-expected production costs seen during the first half of 2004.

We continue to manage inventory in a disciplined manner, balancing inventory productivity with sales.

As a result, we still expect inventory per square foot at end of fourth quarter to be up in the low-single digits on a percentage basis, versus a 16% decline last year.

Inventory per square foot at end of first quarter 2005 is expected to be flat, versus a 12% decline in the prior year.

For fiscal 2004, we still expect to open 125 new stores, and now expect to close 160. 10 more stores than prior guidance, all from Gap North America.

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

Please refer to our third quarter press release for a summary of store activity and our online pressroom at gapinc.com for our 2004 store activity guidance by division.

We now expect full-year capital expenditures to be 450 million lower than our prior guidance.

Driven primarily by the shifting of remodel timing, to 2005, and lower-than-expected remodeling costs.

Here is the break down.

Store capital, 270 million, with 120 million for new stores, and 150 million for existing stores.

IT, 155 million, headquarters and distribution centers, 25 million.

Moving to interest expense, we now expect full-year gross interest to be about 170 million, below prior guidance due to reduced interest related to third quarter bond repurchases, our renegotiated credit facility, and our recent rating upgrade.

Gross interest is expected to be about 36 million for fourth quarter.

Full-year depreciation and amortization is expected to be about 600 million, and full-year effective tax rate, 38.5 to 39.5%.

Regarding our outlook for 2005 store count, square footage, and capital expenditures, we will now provide guidance for these items on our fourth quarter earnings call, when we provide a more complete set of guidance for 2005.

This change will allow us to better align our guidance discussion with our 2005 budgeting process, which is finalized during the fourth quarter.

In summary, our third quarter highlights included solid earnings and margins, strong operating cash flow, repurchases of over 17 million shares, a $397 million reduction in debt, and ending balance of cash and short term investments of 3.7 billion, and an improved credit rating.

Overall, we remain confident in our brand strategies, and our ability to drive long-term growth and shareholder value despite the volatility inherent to apparel retailing.

We're focused on driving improved operating performance, and have now taken initial steps to create additional shareholder returns by distributing excess cash to shareholders.

This focus will provide a solid foundation to drive shareholder returns over the long term.

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

Thank you, Byron.

Good afternoon.

Today, I would like to talk about our third quarter performance.

Then I will share details on our holiday marketing strategies.

Finally, I will give an update on a new international growth initiative.

And then hand off to Nick Cullen, Executive Vice President and Chief Supply Chain Officer who will discuss supply chain strategy and the impact of trade quota elimination.

Coming off a strong first half, business softened early in the quarter, as traffic slowed and we faced an increasingly promotional environment.

As with other retailers, we also face many external factors.

From record high gas prices, and a waning consumer confidence index to the Presidential campaign.

However, we're always susceptible to seasonal fluctuations and our approach is to focus on the things that we can control and mitigate risks inherent in this business.

So we met these challenges head on, with in-season adjustments to our promotions, marketing and in-store selling strategies to offset the softer trends.

This allowed each brand to better manage their business through the quarter.

Given the tough environment we delivered a slight improvement in margins, which supported solid earnings.

Importantly, in the third quarter, we further reduced our debt by about 400 million.

Our net interest expense decreased by 47% year-over-year.

We repurchased about 17 million shares.

And earlier this month, announced an additional 250 million to our share repurchase program.

This progress is evidence of our commitment to use our balance sheet to drive shareholder value.

These efforts also decreased our leverage and we still ended the quarter with a strong cash balance of $3.7 billion.

We entered into the fourth quarter well positioned for holiday.

Stores are fully set for the season.

And we're pleased with the early reads that we got in October on holiday assortments across all 3 brands.

Gap is featuring trend-right product such as the velvet blazer, as well as a wide selection of gift items.

The holiday assortment offers a range of color and fabrications with clear points of view for work, going out, and weekend occasions.

At Old Navy, design details bring a dressier perspective for holiday, a wider product assortment for kids and babies, help establish Old Navy as a holiday gift headquarters.

And Banana Republic's winter and holiday collections include luxurious fabrics like cashmere and faux fur, reinforcing the brand's elevated design.

Across the brands, our holiday marketing campaigns are phased according to how our customers shop, representing a strategic shift from our traditional approach of sending a single message in November that lasts throughout the season.

Marketing messages, as well as media plans and in-store programs are tailored to leverage our customer's behaviors through the shopping season, from self purchases to last-minute gift shoppers.

Gap, Old Navy and Banana Republic are interpreting these findings appropriately for their brand.

Last holiday at Gap our marketing campaign delivered a narrow message with a focus on feralt [ph] sweaters.

This year, we are highlighting the depth and range of gift items featuring Sarah Jessica Parker, who our customers feel is a perfect fit for Gap.

We're supporting TV with in-store marketing, such as gift card promotions, and incentive programs, to help drive sales and conversion.

At Old Navy, we're communicating newness throughout the season with a series of 6 TV ads, each bringing a fresh product message to our core customer segments.

Messages are strategically timed, correlating to how our customers' shopping habits change through the season.

We've added an incremental national circular, which will reinforce our holiday product and price message to moms.

And we're speaking directly to teens with a print campaign launching this month in 4 major magazines.

Banana Republic's holiday marketing campaign leverages the brand as a destination for covetable gifts, reminding customers that a gift from Banana Republic is about fashion and affordable luxury.

Our most loyal customers will also receive a shop-along gift guide, providing extra incentive to purchase.

And we're also excited about Banana Republic's starring role in Project Runway, a new reality series premiering on Bravo, the first week of December, which will help showcase the designer aspect of the brand.

Turning to growth initiatives, I am pleased with the organic growth we continue to drive in the business.

These initiatives continue to be the foundation of our growth strategy, such as plus sizes at Old Navy, petites at Banana Republic, maternity at Gap and Old Navy and accessories across all divisions.

In addition, just 1 month after launch, our cross-brand credit card is resonating strongly with new and existing cardholders.

Our private label credit card sales are up 16% since the October 15th launch.

Along with driving organic growth in our brands, we continue to make progress on new growth initiatives.

As announced in September, we will be serving women over 35 with a new brand concept in the fall of 2005.

President Gary Muto is making great progress building his new team to debut the brand in next year's pilot.

Finally, I'm excited to announce that based on extensive market study, we are launching Banana Republic in Japan in the fall of 2005.

We are opening 3 stores within the leading shopping areas in Tokyo, to pilot the concept.

Japan is the largest apparel market outside the U.S. and represents a significant long-term growth opportunity for us.

The Japanese consumer has a high affinity for American sensibility, as well as for luxury products.

Although we are disappointed with recent comps in our international division, we've seen strong growth over the long term since Gap entered Europe in 1987 and Japan in 1995.

Our strategy to continue building local merchant expertise in market, not only supports Gap's business, it also gives us added confidence in expanding Banana Republic into Japan.

So we ended the quarter feeling good about our progress.

We continue to mine the significant growth opportunities that exist today at Gap, Banana Republic, and Old Navy.

We're pursuing new initiatives that will fuel our growth over the long term.

And we are maintaining sharp operational discipline on our day-to-day business.

Today, we remain focused on driving shareholder value by improving our operational performance, strengthening our financial position, and returning excess cash to our shareholders.

With that, I would like to turn it over to Nick Cullen, our Chief Supply Chain Officer who will speak to some of our near-term my chain strategies as we prepare for trade quotas coming off in 2005.

Thank you, Paul.

And good afternoon, everybody.

I'm very pleased to speak to you today about Gap, Inc.'s global supply chain operations.

As Paul mentioned, I am going to talk about the upcoming removal of quota.

But since this is my first time speaking to this group, I thought I would start by introducing myself and our supply chain.

And then I will talk about holiday shipments, and quota replications for 2005.

A year ago, I joined Gap, Inc. as the Chief Supply Chain Officer.

I have 25 years of experience in managing large integrated supply operations for global companies such as Mars, HJ Heinz and Biagio.

This was great preparation for the complex supply chain that we run at Gap, Inc.

We define within Gap, Inc. the scope of our end-to-end supply chain as the processes that take the sketches from our designers and turn them into the 1.2 billion garments that you see in our stores.

So it is designer's sketch through samples, to procuring and delivering finished garments to our retail stores.

Our team works closely with each of the brand presidents and their teams to make sure that supply chain strategies are aligned with business strategies.

So some associated supply chain statistics, every day Gap, Inc. ships 45,000 tons of goods.

These shipments we saw from 700 vendors in 50 countries and go to 15 distribution centers, across 4 countries.

Last year, we made 370,000 deliveries to 3,000 stores in 5 countries, in order to retail our 1.2 billion garments.

During the past year, we have been working to strengthen our capabilities as a supply chain.

We've added bench strength to our leadership team, drawing people with international experience from other industries to enhance the already strong talent that we have at Gap.

We've also been improving our end-to-end supply chain network and systems.

For example, we're currently updating our warehouse management systems with the latest in productivity management software, and also building our state of the art transportation management system.

We're taking steps which leverage our scale and drive speed and also efficiency improvements.

So on to the topic of holiday shipments.

We've been working our way through some short-term operational issues.

We move most of our goods via ocean shipping from around the world into our retail markets.

To ensure adequate supply throughout the year, we developed long-term strategic relationships with a small number of global ocean carriers.

These arrangements provide an incentive to the carriers to protect us both on capacity and costs, in return for our long-term support to the carriers.

We've also built capabilities to ensure we have the agility to respond to changes in the transportation environment.

And a good example is the recent congestion of the Long Beach and Los Angeles ports.

I'm pleased to tell you that the port situation won't have a material impact on delivering our holiday goods to the stores.

Like other retailers, we experienced delays of 1 to 3 days on products entering via these ports, due to dock labor and rail car shortages.

We offset these days, because earlier in the year, we had eliminated 3 days from our entire pipeline.

We also reduced our lines on Long Beach and Los Angeles significantly, by redirecting some shipments to Seattle and Oakland, and by moving some products through the Panama Canal to the East Coast.

So moving on to quota in 2005, there is a lot of speculation regarding the impact of quota removals.

Realistically, major impacts won't happen right away.

First of all, there are potential safeguards to contend with in China.

Secondly, the major savings won't come from quota removal itself, but from the lowering of costs that will occur due to the shift of production to lower-cost countries.

It will take resources and investments to affect the capacity and capability in those countries, and this won't happen overnight.

Third and lastly, quota impacts different categories of goods in different countries, in different ways.

Specifically, not all quota caps are exceeded in all countries.

We have to manage the interaction of these several moving parts as we manage our lines post-quota.

So accurately forecasting the '05 impact today is unrealistic.

We currently work with about 700 vendors in nearly 50 countries.

Under the current quota system, we've had to spread our purchasing dollars and haven't been able to leverage our scale and relationships as much as we would have liked.

We have spent the past 2 years getting ready and we're now well positioned for the change.

The lifting of quotas give Gap, Inc. the opportunity to take advantage of our scale and our strategic relationships with vendors in a way that is not artificially constrained.

With the removal of quota, we can re-examine those relationships and consolidate vendors.

In the future, we will work with fewer vendors, but we will have even closer relationships with each one.

The ability to select and develop long-term strategic relationships with a smaller base of vendors who share our commitment and values also gives us more leverage to enforce labor standards in these facilities.

As we're able to provide increased volumes, our vendors will be able to make investments that improve labor standards, innovation, quality, and also to decrease costs.

We recognize the removal of quota is a new era.

We're reaching out to our vendors to work with them through the change, and in January, 2005, we're holding our first global summit with our vendors to address the challenges and opportunities we're going to face together.

Where appropriate, we will also work with other stake holders, such as governments, other retailers, and non-government organizations, to address the long-term impact of consolidation on workers and communities.

So quota removal is just one area we're addressing the Gap, Inc.

We've also put a lot of time over the past 12 months building capabilities in our teams, processes, and systems.

We're now set to build and sustain our leading-edge supply chain capabilities, as the constraints of quota are removed.

We have a strong team in place, and I look forward to updating you on our results over the long term.

Thank you, Nick.

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 1.

(Operator Instructions).

And we will first go to the line of Emme Kozloff with Sanford Bernstein.

Hi, my question is for Byron.

I wanted to talk about SG&A.

The variance from your forecast only 12 weeks ago is material.

It is almost $60 million or about 4 cents in EPS, so my first question is, do you really have that little visibility on this line item?

It also makes me confused as to your thesis on the business model, which I thought was that operating margin expansion will be driven by gross margins primarily, but merchandise margins are flattish and so are comps and SG&A seems highly volatile.

And while R&D leverage is nice to have, it is certainly not something we can bet on in perpetuity.

So can you give us some type of clarity on what the consistent drivers of the operating margin should be going forward?

Thanks.

You bet.

So on SG&A, what we saw in June was our first negative comp month.

The negative comps continued through the summer months.

And so sales unfolded over the last several months somewhat below our expectations.

Along with that sales case, we accrue bonuses accordingly, so as we came to the end of the quarter, and we had a better understanding as to where our sales were coming out, we began to release bonus accruals, and that was an important piece of the SG&A adjustment.

Second, on marketing, we had savings in our marketing budget that began early in 2004, largely related to production costs, and those are not so predictable.

But they did continue.

We had additional savings as it related to the launch of our tri-brand credit card which occurred in October, and so at the end of the quarter, when we saw that the savings that we were accumulating in marketing were less, I mean were continuing, we went ahead and made an SG&A adjustment.

The numbers are large, I agree, but when you consider that the marketing budget is -- began at 560 million, the reduction -- 1/3 of that change is marketing, it is 20 million, it is 3.5% of the total marketing budget, savings of that sort are reasonably happen.

The other thing, Emme, is that once we began to see that the trend in slower sales was continuing beyond June, we began to make adjustments to control SG&A and so we were able to bring down expenses in the store expense category, everything from packaging to fixtures, et cetera, so this was something that came to a head at the end of the quarter.

So I guess what's key is understanding what your sales forecast is embedded in the Q4 SG&A guidance?

That's right.

And when we are in the fashion business, what we had over the summer was a few bumps in the road.

And so that's how we're looking at it, as a bump in the road over the summer, keeping in mind that for the 3e quarters year-to-date, earnings are up 14%, we've had the -- we've got the largest absolute level of gross margin we've had since 1999.

And so I would say the story for the year is consistent with what we've said, we're not going to deliver that story consistently every quarter, because it is not the nature of our business.

Okay.

Thanks.

Your next question comes from the line of Mark Mantagna with Wells Fargo.

Hi.

I was hoping you could give an update on the store counts for where you have Banana Republic petites, Old Navy plus, Old Navy maternity and Gap maternity?

You know, we have Banana petites in about 23 stores now and we're still looking at potential rollouts in the future because it has been quite a success.

Old Navy maternity is in over 200 stores.

I think we're up to about 220.

And Gap maternity is in about 63 stores.

How about Old Navy plus?

Old Navy plus started at 15, it's moving quickly I think to about 60 or 70.

Okay.

Thank you.

Sure.

Your next question comes from the line of Jeff Klinefelter with Piper Jaffray.

My question is for Paul.

In terms of your marketing strategy, you've had several different approaches to marketing since you've been at the helm of Gap, and I was just curious at this point as you look forward, what do you think is the most effective combination of driving trial, or driving or expanding your brand, or how are you thinking about using the television medium at this point to continue to further your brand messages?

The -- well, first, I wouldn't necessarily characterize it as a changing strategy, as much as it is evolving the strategies as we continue to learn more and more both in the context of what are the right kind of levels of communication, or the appropriate communication, and messaging, balance with the right types of media mix, for each one of the businesses.

So for instance, coming off of the -- you know, just the hindsighting from last holiday, compared to this holiday, one of the things that we recognized in the business, both by looking at our metrics and by talking to consumers, is that we had a very, kind of single focus to our message, we also recognized clearly that our competition was far more focused on delivering multiple messages appropriately through the season.

So that's a tactic that we've changed this year and it includes both the way we are flighting our television, the number of commercials and the communication and other things.

So it is a work in progress and it is an evolution, but it is all coming from deeper insights and knowledge that we get by talking to our customers.

Great.

Thank you.

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

Thanks.

I was wondering if you could tell us, Byron, the cash balance that you're comfortable with having on the balance sheet, you know, after you've funded any growth initiatives?

And on the store scene or on the quota question, is it that you can't forecast anything for '05?

Or you don't see any cost savings for '05?

And if you could comment on beyond '05, what you think the longer-term savings will or won't be, or do you expect that will be invested in better product quality?

So Stacy, with regards to the liquidity, I will respond to that.

And then let Nick respond to the question on quota and impacts.

With regards to what we believe we should be maintaining, at least for the time being, consistent with what will be required for an investment grade credit, the answer is 2 billion.

Over to you, Nick.

Thanks, Byron.

The issue around quota is the number of moving parts.

And the ability to see how that is going to flow through.

So if we think about what is happening, there are a number of changes expected on free trade agreements, whether that is Castor or the implications on Nagoa.

It is the risks around safeguards and how they will be implied and when they they will be applied and if you think about life through a vendor's eye, they are saying where are we going to invest in capacity and when are we safe in order to be able to do that?

So it is a combination of both of those factors.

So yes, we would anticipate seeing savings coming through.

It is more of the fact of how do the variables play in and when do they play in.

I think to your question around '05 and '06, the savings that will come through will be back-end loaded within '05.

Because if you think about how the industry operates, a lot of the business is actually locked in for the first half of '05.

Negotiations have started to take place for the second half of '05 at this point in time.

So although quota changes in January, the pricing impact is the back end of the year and I think what we are going to see is a gradual increase, '05, '06, '07 and '08 when we know we are going to be clear of safeguards, so they are going to grow over the next 3 years.

And just as a follow-up, on the '08, do you expect 15 points or what sort of number ultimately?

I think if you reflect back on what I said on the number of moving parts and the decisions by our vendors as to where they invest their capital and where they put their capability, it is far too early to take a view on what is going to happen 3 years or 5 years out.

Okay.

Thanks.

Your next question comes from the line of Jeff Black with Lehman Brothers.

Good afternoon.

The question is for Byron.

Now, turning to the cash again, I would like to know just what are the priorities for cash post the bond prepayment next year?

And when might we see a more significant buyback program given that we're about halfway through the existing 750 you've got out there right now?

Thanks.

When you refer to the bond payment, we have -- we can call our bond in March of next year, the 1.4 billion dollar convertible.

Which we would intend to do, the strike price is 16.12.

So what we have said is that at that point, translate spring of '05, we would be prepared to discuss in much more detail what the calls on our capital would be for the growth initiatives that we would be prepared to outline at that time, and to the extent that we have excess cash beyond that, we would then be prepared to talk about how we would treat that from a financial architecture standpoint, addressing issues not only of stock buybacks, but also what we would propose to do with regards to dividend policy.

So the all-in response, spring of '05.

And, you know, not willing to take a stand and at least outline what your thoughts are, and where buybacks fit in the priority schedule yet?

Well, the answer to that is we want to present what we would do with excess cash once we've had a fuller disclosure of what we would use the cash for in the operating business.

The First Call on our cash flow is growing value in the base business and then in growth initiatives.

Only then will we turn to the use of cash for financial architecture purposes.

So it would be premature.

Okay.

Thank you very much.

Your next question comes from the line of Lauren Levitan with SG Cowen.

Thank you.

Paul, I was hoping you could give us a postmortem or a Monday morning quarterback for us some of the moves that you made in terms of the fall and back to school strategy in terms of some of the timing shifts, and some of the strategy changes, and how you might capitalize on some opportunities for next year?

And similar to that, I'm wondering if you could comment on progress you're making or how you think the customer is responding to some of the product segmentation that has been underway at all the brands, but at the Gap brand in particular?

Thank you.

Yeah, let me -- first, what I want to do is kind of disaggregate a little bit, recognizing that each brand had varying performance throughout the quarter, and keep in mind that, you know, Banana Republic, for instance, you know, certainly had a very solid quarter, our average unit retails were up, traffic increase was up, we delivered a 3 comp against an 11 positive comp last year.

So not -- you know, there is always hindsighting to be done and we look at it but, you know, really solid.

Even in Gap brand, even though we were challenged in traffic early on in the quarter, we did end up in positive traffic trends in October later in the quarter, and a positive 2 against a positive 5 last year.

Having said that, I think probably one of the pieces of hindsighting for Gap brand was around August, and some of the promotional timing for back to school and what we did do or didn't do or made choices about, so we will go back and take a look at that for next year and try and strengthen what we did.

Old Navy was the one that in spite of very positive traffic through the quarter, that we had a tough time with our summer and fall fashion, and particularly our ability to move through those goods, as new deliveries came in.

The other piece I think in Old Navy is we -- as we really studied and looked at some of the later flows in the fall assortments, we felt that there wasn't enough newness and that we probably could have added, instead of just another color, a few other items that we could have brought some more special things in, so that was probably the biggest lesson learned there.

But I will say that I think the teams did an extraordinary job given the softness of really moving through our merchandise and yield managing our margins in a way that delivered solid earnings.

And the Old Navy front, do you have any reason to believe that higher energy costs or other inflationary pressures might be hurting that customer more than some of the other customers shopping at Gap or Banana Republic?

And is there any customer research you're doing to get a sense of their optimism versus your other customers?

No, if there is any, it would be somewhat conflicting because we had pretty positive traffic trends and just didn't have it, so you know, we take responsibility and feel that it is really, did we deliver the right product in the right fashion.

You know, and we did say that we -- the early reads in October on our holiday were strong, and that we felt that we really were clean going into the holiday market time.

Thank you.

Your next question comes from the line of Janet Kloppenberg with JJK Research.

Thank you.

For Byron, I was wondering if you could discuss the flexibility you have in your SG&A spend for the fourth quarter?

Do you have the same flexibility as you had in the third quarter?

And if you could also discuss the lower production costs?

Does that mean that the advertising, the costs of the advertising you did actually was lower than expected or does that mean that you actually advertised less than you had expected?

And for Paul, I was wondering if you could comment on your view of the relative success and return on investment of your celebrity-focused advertising campaign for the back to school season.

Thank you.

I will start.

So let me make one thing clear.

The prior guidance for SG&A spending for the fourth quarter was 3% growth year-over-year.

We're maintaining that guidance.

When you talked about flexibility for SG&A, I would say that the -- that basically, that the same 3 variables are in play for the fourth quarter, so we do have some flexibility.

But remember, with regards to bonus accruals, that's purely a function of how well we do.

Right so if the sales are on track, then you will make that -- then you will make those bonus accruals?

Right.

Right and if they're not, you can cut back?

Right.

On the marketing side, what we had said earlier in the year was that the incremental part of our marketing budget was going to take place in the first half.

All of that increment did in fact take place as we projected.

What we're seeing are expense savings resulting from the actual production of commercials. 2 examples.

Without commenting on what we pay for celebrities, the cost of celebrities in our commercials were less and we ended up doing more on-set locations as opposed to on-location shoots.

So it is not the amount of advertising we're doing, it is the actual production costs of the advertising itself.

And you will work hard to keep those production costs moving down then?

Is that a strategy?

Is that something you're looking to do?

Or is that something that occurred?

I mean the efficiency of our, you know, production capabilities comes with our leverage and our strength and you know, of course we're going to want to leverage it as best we can.

On the other point, with regard to how we think about the campaign, I will say we are very pleased with what we were able to drive with the fall campaign, particularly around Gap brand.

Our customers have told us very clearly that Sarah Jessica Parker was a perfect fit for the brand.

And our awareness levels for the brand were very strong.

So we're very pleased.

I think the lesson or the hindsight in that we looked at is we really featured very specific product, and we didn't communicate the occasion-based product as much as we intended to.

And that was a bit of a lesson learned.

So the products that she featured did sell through extremely well and that's why, you will see when we debut our commercials today, the holiday ad campaigns really get across the broader assortment, by having 3 very distinctive commercials with distinctive looks.

But we're very pleased with what Sarah Jessica did for us and the overall awareness of the campaign.

That will be on prime time tonight?

That's right.

Thanks so much.

Your next question comes from the line of Kimberly Greenberger with Smith Barney.

Great.

Thank you.

I was wondering if I could get some color on your cross branded credit card?

I think, Paul, you indicated that the usage of your private label credit card has gone up 16% in October.

Do you think that's generating incremental sales?

Or are your customers just changing their tender?

And if it is not yet generating incremental sales, do you think there is any way to leverage your database or expand your loyalty program so that can in fact generate some incremental revenue?

Thanks.

Sure.

Thanks.

Well, I will caveat my answer by telling you that it really is very early for me to give you true statistical understanding of what is happening with the card.

We have seen, you know, the increase in the overall sales using the card.

One would like to think that it is coming from a lot of the promotional activity early on that we're doing with it.

Overall, our strategy has been that we feel very strongly that giving our customers the opportunity to shop within the portfolio is going to generate incremental opportunity for us.

We also know that we will be able to grow our loyalty by better understanding each one of these customers throughout the -- as we get smarter and refine these programs as well.

Anecdotally, I can tell you by hearing from our stores, they're excited about it, the rewards and benefits that it gives to our customers, in addition to the utility, has been a big plus and we will know more over the coming months as we dig deeper into the analytics, but initially, we're very pleased with what we're seeing.

Any talks about increasing the benefits associated with using that card or expanding them in any way?

You know, none right now because it is so early, but that's the beauty of the program is that it gives us the opportunities to flex, change, do in-season opportunities with these customers, and we will continue to look at that.

But rewarding our best customers not just at a brand level, but across Gap, Inc. continues to be a focus for us.

Great.

Thanks.

And your next question comes from the line of Dorothy Lakner with CIBC World Markets.

Thanks, good afternoon, everyone.

My question relates to international.

You've announced that you will be taking Banana Republic to Japan.

I wondered if you could talk a little bit more about the progress you're making on the efforts to tailor international assortments a bit more than in the past?

And also, if you have any additional thoughts on the European base of store, and the changes you might make there.

Thank you.

Sure.

The -- well, as we had mentioned in the past, one of our long-term strategies for our international business is for us to be able to tailor our assortments more specific to those customers in those countries.

To do that, we have really a 2-pronged approach that we're beginning to build our capacity.

One is by having merchants closer to our customers in market.

We've moved and have hired a few merchants, both in Japan as well as Europe, and we will continue to build that capacity over the coming months.

Keep in mind that, you know, we are working 9 months out, so the effect on the new merchants on the assortments will be in the latter half of 2005.

At the same time, we are building a design capability within our New York group that will allow us to add in merchandise specific to those countries on an as-need basis.

And some of the work that we've already done, although it's been somewhat limited, we've seen the success of being able to do that.

Whether it is a particular wash, whether it is a silhouette, a style, that's going to be an important part.

So we are building that capacity.

It will take several months for us to do that.

And as we build that capacity, we have more confidence that we will be able to tailor those assortments to meet the needs.

And this gives us additional, you know, support for why we think as we bring Banana Republic to Japan, we will have that capacity in place in order to make sure that we're maximizing the opportunity.

Is that sort of a fast-tracking kind of approach?

Not necessarily, no.

It is really about having the merchants who are in market better understand the trend, better understand, you know, the balance of the assortments of where we should be making our investments.

That's first and foremost.

The second piece is their product trends.

You know, if the blazer is trending here, is it the same trends over there.

The signature and the style esthetic will remain consistent.

But we will look for opportunities for particular product trends in these marketplaces that are specific and then design into them.

And Europe?

Europe, what we've done is, you know, we're doing a little bit of what we're doing in the U.S.

There are some stores that we've closed in Europe that we're optimizing, but and doing a lot of the same kind of understanding of our real estate over there, as we've been doing here.

But, you know, we're confident that we've got a strong business over there and that we will continue to grow it as we get better with our assortments.

And have you -- have you thought about changing your approach to growing the business there in terms of opening stores or other alternatives?

No, there really hasn't been much -- I mean, in the U.K. which is where we have the vast majority of our stores, for the most part we're fully built out.

There might be a few incremental opportunities, but we think we've got the fleet and now it is just about right-sizing.

And your next question comes from the line of Joe Teklits with Wachovia Securities.

Hi, thanks.

A question for Paul.

I'm curious if you've learned anything about your Gap customer this year.

I think earlier in the year you said it was kind of focused on a 20-something or 30-something, whether that, you found is too narrow.

And also, in terms of layering in merchandise for the holiday season, how do you go about doing that?

Are there more floor sets?

Are there more flows?

And also in regard to the customer, does that customer broaden out during the holidays versus the rest of the year?

Thanks.

Yeah, I think the first part of the question, we've learned a ton this year, you know, our pass-it-on surveys, the focus groups, we've continued to learn and understand.

More than anything else, you know, we talk about an age of 20 to 30, as kind of the sweet spot, but the truth of the matter is we halo and we significantly halo on both sides of that.

And people are really buying into our fresh American casual style, as a -- both a lifestyle as well as a style esthetic.

And that's really what we focus on and we learn more and more about that.

What we've learned from our customer is that she wants, the female customer wants more feminine product and I think we've addressed it in fall and addressed it even more in holiday.

The separation between our gender and how a guy shops and how a woman shops and how our floor sets and how we flow our merchandise, I think you're beginning to see in our setups today.

So I think that there is a lot of learning about that.

The customer really hasn't changed.

Our ability to better serve that customer by having the right product is important.

We're also learning a lot about the assortments associated with the different occasions.

You know, in cases we're learning more and getting good traction, particularly on the men's business at Gap where we've seen the little dressier, smarter woven shirts and pants have been the kind of go-to-work piece, has been -- has been a new strength for us.

So we continue just to kind of build on the customer set, but occasion is very important for us, and then looking at our flows, for instance, on women and making sure that we are flowing newness within the season, which is less important for a guy during the season.

How about for the holiday flows, are there more flows to go from self purchasing to gift purchasing?

No, it is relatively the same.

What we're doing is, it is the communication message that's changing.

And you're seeing this in all the brands.

We recognized in the early part of the holiday, consumers are really shopping for themselves for gifts.

And then they're off shopping for others, and then we know there is kind of a last-minute shopping.

And whether it be the messaging or whether it be the promotioning at Old Navy, you will see throughout the season that we're trying to better pulse our messaging.

Not only to bring newness in messaging, but also more appropriate messaging, you know, in the gifting behavior that is going on.

So no real change in the flows in any of the brands.

Other than making sure that we've got newness and new messages throughout the season.

Does gifting mean more key items?

Because there doesn't really seem to be any key items in the stores today.

No, it is not so much as a key item piece, as it is a focus for destination for gifts and that is true for all 3 of the brands.

And it will show up in the way we're presenting ourselves visually.

I just want to remind in order to try and hear as many callers as possible, please keep your questions down to 1 if possible.

Your next question comes from the line of John Morris with Harris Nesbitt.

Thanks, congratulations on a good quarter.

I wanted to, you know, just get a quick clarification on the bonus accrual.

Are you doing that, did you do that on a -- did you do that on a quarter-by-quarter basis?

Or are we talking about a reversal of a bonus accrual year-to-date?

And I guess since that's kind of a quick question, I just wanted to see if you could elaborate a little bit more on your holiday strategy at Gap and Old Navy in terms of merchandising this year versus last year, we're very intrigued by it and I think if you could give us a little bit more color there, that would be great.

Thanks.

I will take the first one, which is the bonus accruals.

We are on an annual bonus program, so we -- what we do is take a position with -- throughout the year, at the end of each quarter, we take a look and decide what would be an appropriate accrual at that time.

And so it does involve a degree of forecasting.

But I think that's kind of the normal approach that any company should take with regards to bonuses and because performance is uncertain, the -- there is going to be a degree of variability in your bonus accruals.

Over to you.

And then on the marking side, I will give you a few examples to kind of bring it to life.

Last year if you remember in Gap brand, we produced a commercial around the feralt [ph] sweaters and it was a very singular point of view about that product.

And we ran it for the entire season.

This year, at Gap brand, we have produced 3 distinctive commercials that show the 3 distinctive ranges of product that you see in the store today, and that we are flighting and pulsing them in ways that gives our consumers a better sense that there is a broader breadth of product.

The other thing in Gap brand is you will see in the commercials and in our print and in the way we're positioning it visually in the store, it is a much stronger gifting message.

That we are a destination for gifts.

By making sure that you -- and you will see did in our advertising, being pretty explicit, as opposed to being a little bit softer than we were last year.

In the case of Old Navy, it is pretty much the same notion that last year, we had generally a single notion of what the holiday was about.

This year, we're produced 6 commercials, they're distinctive, they talk to different target groups and that depending on where we are in the season, the item of the week and the nature of the promotion, will talk specifically to that purchase behavior intent.

You also can go into our stores today and you will see what I think is a greater gifting perspective in Old Navy where we've actually will give our customers the opportunity to purchase bags and gift wrap and other things, begins to bring that holiday gifting headquarters to life in a more special way.

And then for Banana Republic, it is all -- it is again a very strong gift message by using our boxes, and color, and a whole messaging strategy between the giving and getting and receiving of gifts, is an important part of the story we tell on top of the covetable merchandise.

So I think it is a lot more straightforward and being aggressive on making it a gifting headquarters at all 3 and then pulsing our advertising and promotions in a way that I think is far more compelling than we did last year.

Great.

And operator we will take 2 more questions.

Thank you, ma'am.

Again, ladies and gentlemen, I would like to remind you this is a large-volume call, in consideration of the other participants, please limit yourself to just 1 question.

Our next question comes from the line of Barbara Wyckoff with Buckingham Research.

Wow, in under the wire.

Good quarter, everyone.

Can you talk about the potential store, size of the store fleet over time by brand, Old Navy, Gap and Banana Republic?

And most of the closings have been concentrated in Gap, can you talk about the opportunity within the Gap fleet, baby, kids, body, the new accessory thing?

What we can say is that first of all, we will be much more explicit about store openings and closings on the fourth quarter call.

We're moving it from this call to the fourth quarter in order to better align completion of our budgets so that when we talk about that, it will be in a bigger context of what we will be doing for 2005.

With regards to closures, historically, they have been biased towards Gap.

And that has certainly been the case this year.

You can anticipate that that will be the case next year.

And the openings have been biased towards Old Navy.

We have had -- that was certainly the case this year.

You can anticipate that that will be the case next year.

A lot of the work that's going on that we will be talking about next quarter is the optimization that is going on within the boxes, and so when you ask about the sub-brands within Gap, this is something that we will begin talking about further in the quarters to come.

But most of the work with regards to optimizing inside the box is -- will be biased towards Gap brand.

And your final question this evening, sir, comes from the line of Marni Shapiro with Merrill Lynch.

Good afternoon, guys, it is Mark Friedman.

Paul, I was just wondering, wardrobing was a big focus for fall.

A little bit of insight as to how you thought that played out, and what the focus would be as far as using that going forward?

And ward [ph] is well positioned for holiday, are you specifically referring to inventory or the initial response to the holiday line in October?

Is there anything else that we should read into that from the press release?

Yeah, first, on the first part, it is the -- we do think that the wardrobing message that we began to tell in fall for Gap specifically was something that I think we did a good job on building our product.

I think we're learning and building more.

But having said that, I don't think we did as good of a job as communicating to our customers the breadth of the wardrobing options at something, because some of it's, you know, a little bit new for our customers.

So, again, I think when you go and walk into a Gap store today, the one thing, among many things I hope you are seeing that is different, is one, there is real le a different perspective in each one of the sections.

They're clearer about the occasion, as well as the choices in color pallet and look and trend and style.

And it is a little bit of a broader than kind of the very more narrow focus, particularly this time of year, which tends to in the past have been narrowly focused on a few items.

So we're doing that.

As to with regard to being well positioned, I just feel very good about our marketing, our promotions, everything that we planned for the quarter.

And of course, we shall see.

But at the end of the day, I think going into it, we took a lot of the learnings from last year, and the learnings from fall and tried to apply our best efforts as a team and I feel good about at least the plan that we put in place.

Good.

Well with that 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 further questions.

Thank you.

Ladies and gentlemen, we appreciate your participation in joining us today.

This concludes our Gap, Incorporated conference call.

You may now disconnect.