蓋璞 (GPS) 2004 Q4 法說會逐字稿

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

At this time all participants are in a listen-only mode. [Operator Instructions] The conference call and webcast are being simultaneously recorded on behalf of Gap Inc. and consist of copyrighted material.

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

Your participation requires -- 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 comment or statement you make appear in any transcript or broadcast of this call.

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

Investor Relations at 415-427-2175.

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

Good afternoon, everyone.

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

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

I'd like to remind you that the information made available on this webcast and conference call contains forward-looking statements, including, but not limited to, forecasts relating-- relating to earnings per share, revenue, impact of lease accounting adjustments, our convertible bonds, total debt to market cap, cash balances, dividend amounts and timing, share repurchases, gross interest expense, operating margin, inventory per square foot, capital expenditures, store openings and closings, net square footage, effective tax rate and free cash flow; as well as other statements that express our expectations, anticipations, beliefs, estimates intentions, plans and forecasts.

Because these forward-looking statements involve risks and uncertainties, there are important factors that could cause our actual results to differ materially from those in the forward-looking statements.

Information regarding factors that could cause results to differ can be found in our annual report on form 10-K for the fiscal year ended January 31, 2004.

Investors should also consult our quarterly report for the quarter ended October 30, 2004 and today's press release.

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

These forward-looking statements are based on information as of February 24, 2005, and we assume no obligation to publicly update or revise our forward-looking statements; even if experience or future changes make it clear that any projected results expressed or implied therein will not be realized.

This presentation includes a non-Generally Accepted Accounting Principle measure, free cash flow, which under SEC Reg G we are required to reconcile with GAAP.

The reconciliation of this measure to GAAP financial measures is included in our earnings press release, which is available on GapInc.com.

On today's call Byron Pollitt, our CFO, will begin with a recap of financial performance.

After Byron's financial review, Paul Pressler, our CEO, will summarize 2004 highlights and learnings and address some of our near-term priorities and growth strategies.

Byron will follow Paul with a discussion on Gap Inc.'s financial strategies, ending with our 2005 guidance.

We will then open the call up to questions.

We expect the call to last about one hour.

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

Thank you, Sabrina.

Good afternoon. 2004 was an eventful year.

We made solid progress to increase shareholder value and continued to position ourselves for sustainable long-term growth.

Here are the highlights: First, we drove improved operating results.

Second, we reduced debt by 871 million, and our credit ratings improved.

S&P raised our rating to investment grade earlier this month and Moody's is currently reviewing us for upgrade.

Third, we returned excess cash to our shareholders through a $1 billion share repurchase program.

Importantly, we delivered these results while continuing to invest in our infrastructure, near-term growth initiatives, and future growth platforms.

Though fourth quarter was somewhat disappointing, our operational focus produced solid earnings, margins, and cash flow.

Before reviewing our performance, I'd like to discuss important changes to our accounting treatment of leases.

In light of recent SEC clarification and consultation with our auditors, we have re-evaluated our lease-related accounting practices.

Like many other public companies that are correcting commonly-accepted lease accounting practices, we are changing how we account for leases; including how we account for rent holidays and tenant allowances.

As a result, we expect to record non-cash adjustments related to these changes once our internal review is complete.

These adjustments will have no impact on cash, revenues, and comp store sales.

We are working to determine whether these matters will require a restatement of prior-period financials or whether we will reflect all adjustments in our fiscal 2004 financial statements.

While we currently believe that re-statement of prior periods is likely, our overall viewpoint and assessment of the impact are subject to change as we complete our internal review.

We currently believe the cumulative effect of these adjustments will result in a reduction of pre-tax net income for the fiscal years prior to and including 2004 by an aggregate amount of $170 to $200 million with the vast majority of adjustments related to periods before fiscal 2002.

It's important to note that today's review of 2004 performance does not include the impact of these accounting changes.

Now, please turn to Slide 4 for a review of earnings performance.

Fourth quarter earnings, up 4 percent to $370 million, or $0.40 per share.

Fourth quarter EPS was above our guidance of $0.36 to $0.38 due to favorable year-end shrink results, better-than-expected operating expense savings, and a more favorable tax rate.

Fourth quarter effective tax rate was 37.6 percent, reflecting an entry to adjust our full-year effective tax rate to 38.6 percent.

Our full-year tax rate was at the lower end of our guidance due to a favorable mix of earnings among domestic and international operations, and our overall earnings levels.

Full year earnings, up 11 percent to 1.1 billion, or $1.20 per share, versus $1.09 per share last year.

Please recall full-year earnings reflect 105 million in pre-tax costs related to early debt retirement, offset by about 36 million in pre-tax interest savings related to those purchases.

Fourth quarter weighted average shares were 968 million.

Full-year weighted average shares were 991 million.

Please refer to GapInc.com for our full year weighted average share calculation.

Please turn to Slide 5, Sales Performance.

Fourth quarter total sales, 4.9 billion, flat to last year.

Fourth quarter comp sales, down 3, versus up 3 last year.

Full year total sales, up 3 percent to 16.3 billion.

Full year comp sales, flat versus up 7 percent last year.

Please refer to our earnings press release for total sales in comps by division.

Turning to Slide 6, Gross Profit.

Fourth quarter gross profit decreased 3 percent to 1.8 billion.

Gross margin was 36.6 percent, down 100 basis points versus last year; with 50 basis points of merchandise margin decline and 50 basis points due to the deleveraging of rent, occupancy and depreciation expense.

Full year gross profit, up 7 percent to 6.4 billion.

Gross margin was 39.1 percent, up 150 basis points from last year, with 110 basis points from better merchandise margins and 40 basis points from the leveraging of rent, occupancy, and depreciation.

Please turn to Slide 7 for Operating Expenses.

Fourth quarter operating expenses were down 3 percent to 1.2 billion, below our guidance of up 3 percent, primarily due to lower store expenses including payroll, lower bonus expense and lower marketing spend.

Excluding loss on early retirement of debt, fourth quarter operating expenses were down 1 percent.

Full year operating expenses, including loss on early retirement of debt were 4.4 billion, up 8 percent.

Please recall expenses related to the early retirement of debt in 2004 totalled $105 million.

Excluding loss on early retirement of debt, full-year operating expenses were up 6 percent.

Marketing expenses in fourth quarter were 143 million.

Full year marketing expenses were 528 million, below our guidance of about 540 million, as cost to implement planned marketing programs were lower than expected across four divisions.

Turning to inventory on Slide 8, we ended fourth quarter with 1.8 billion in inventory, up 6 percent.

Inventory per square foot was $48, up 6 percent, in line with our guidance.

Please turn to Slide 9 for Capital Expenditures and Store Count.

Full year capital expenditures were 441 million.

Full year, we opened 130 new stores and closed 158, ending the year with 2,994 stores and square footage flat to the last year.

Please refer to the press release for end of year store count and square footage by division.

Regarding cash flow on Slide 10, full year free cash flow, defined as cash from operations less capital expenditures, was an inflow of 1.2 billion.

Please refer to our fourth quarter press release for our Reg G reconciliation of free cash flow.

As noted earlier, our $1 billion stock repurchase program is complete.

We repurchased a total of 48 million shares at an average price just under $21.

We ended fourth quarter with 4.1 billion in cash and short-term investments, of which 1 billion is restricted.

In 2004 we retired 871 million in debt.

As a result, end-of-year balance sheet debt totalled $1.9 billion and we finished the year with $2.2 billion more in cash and short-term investments than debt.

This concludes our financial review of 2004.

Now I'd like to turn it over to Paul.

Thank you, Byron.

First, I'm pleased with our overall progress in 2004.

We delivered solid earnings, we mined the growth opportunities in our brands, significantly strengthened our balance sheet and completed a $1 billion share repurchase program.

With that said, we were disappointed in our fourth quarter performance.

We understand the missed opportunities in each brand and I'm confident that we're making the necessary changes to improve.

I'll share a few insights with you: At Gap Brand, fourth quarter traffic was challenging, but our disciplined inventory management produced higher average unit retail prices that resulted in a flat comp store sales.

Although our occasion-based assortments gained traction early in the year, we missed an opportunity to better balance the holiday assortment with more traditional gift-giving products; such as updated classic sweaters.

We have addressed this issue in our holiday 2005 assortments.

Disappointing performance in our international business reinforced our commitment that more merchandise decisions must happen locally.

We are now building merchant teams in country as well as a dedicated international design team in New York to ensure that products are appropriately tailored for customers in Japan and Europe.

Banana Republic's performance was solid for the fourth quarter and the full year, and we feel great about the brand's elevated positioning.

In the fourth quarter, traffic improved, as did average unit retail prices.

In hindsight, our holiday assortments were a little too wardrobe focused and we could have made it easier for our customers to find covetable gifts.

As planned, a successful winter sale drove increased traffic and enabled us to effectively clear holiday product in time for our spring merchandise flows.

Old Navy experienced solid traffic improvement in the fourth quarter, but this was offset by average unit retail challenges.

In hindsight, we overbought inventory in key categories based on the momentum of our first half performance.

And although we planned for downward trends in categories like performance fleece and down outerwear, customer demand was weaker than expected.

Going forward, our inventory buys will better reflect our historical sales patterns and our teams will continue to focus on providing trend-right product at a surprising value.

2004 was an important milestone year for us as the Company celebrated its 35th anniversary.

Looking back, we're reminded of Gap Inc.'s long history of delivering strong returns to our shareholders.

Historically, as a smaller company, we delivered value primarily through revenue growth fueled by rapid store expansion.

However, as a $16 billion company, delivering value requires a more balanced approach.

Going forward, we expect to create value through consistent revenue and earnings growth as well as cash distributions.

I'm confident that we will achieve this by focusing on the follow five priorities in 2005:

First, we never lose sight of the fact that product is the lifeblood of this company.

We will remain focused on offering products that's inspirational, trend-right and appropriate for our customers; and we will deliver it through engaging, easy-to-shop environments.

Second, we will continue to evolve our supply chain to drive cost savings and efficiencies.

This requires consolidating vendors, building stronger vendor partnerships, aggregating category buys and improving our technology and internal work processes.

Third, based on the success of our size localization pilot, which gets the right size assortments into the right stores based on selling history, we will expand the rollout in Gap and Old Navy this year.

We feel pretty good about the potential margin improvement that can be realized from this initiative, and we will also continue to build broader localization capabilities so we can better assort product based on local market needs.

Fourth, we will grow our existing brands where appropriate and launch two new growth initiatives.

In 2005 we expect to open about 175 new stores, the most significant part of which will come from square footage expansion at Old Navy, where we're planning 75 openings on our base of 889 stores.

We'll also continue to build on the success of our product extensions.

By the end of the first quarter, Old Navy Maternity will be in 331 stores, Old Navy Plus Sizes will be in 177 stores, Gap Maternity will be in 70 stores, and Banana Republic Petites will be in 26 locations.

This fall we're excited to launch our fourth brand in two U.S. markets and to introduce Banana Republic in Japan.

We look forward to sharing more details with you about our short and long-term growth plans at our analyst event in April.

Fifth, we currently generate cash significantly beyond what we need to invest in our businesses and near-term growth initiatives.

So in addition to delivering healthy revenue and margins and improved return on assets, we are also committed to returning excess cash to our shareholders through dividends and share repurchases.

Now I'd like to turn it over to Byron to give you more detail about how we intend to use our cash in 2005 and to provide 2005 guidance.

Thank you, Paul.

I'm pleased to share our new financial strategies today.

We spent this past year working to evolve our capital structure to one that maximizes our operational and financial strength to deliver strong shareholder returns.

In that context, let's review our plans for balance sheet debt and cash deployment.

Regarding balance sheet debt, we plan to call our $1.37 billion convertible debt in late March, 2005.

With a strike price of $16.12, we expect nearly all our convertible bonds to convert to equity with minimal cash required to retire these bonds.

Less our convertible debt, we will only have about $500 million of debt remaining on the balance sheet.

As a reminder, converted shares will have no impact on total diluted shares as we have included these shares in our diluted share count calculations throughout 2004.

Next, I'd like to review our cash balances.

After extensive analysis, we plan to keep $2 billion in unrestricted cash on the balance sheet to support the normal operating requirements of our business and adequately withstand unanticipated volatility.

We also plan to carry voluntary restricted cash balances in the near-term to minimize the expenses related to committed bank lines that back our letters of credit.

As our credit profile improves and we expand payment on open account with vendors, we expect to decrease and eventually eliminate restricted cash balances.

Over time, our view of cash should evolve as the requirements of our businesses change.

As Paul mentioned, cash deployment is important to delivering shareholder returns, now and in the longer-term.

We will always reinvest excess cash in our businesses first in ways that drive strong returns.

After addressing all investment opportunities, we plan to return cash to shareholders through cash distributions.

Please turn to Slide 12 for Dividends.

Starting with 2005, first quarter dividend, we intend to double our annual dividend to $0.18 per share from $0.09 cents.

In 2005 we expect the timing of our dividend payouts to occur in late April, July, October and January.

While we plan to increase dividends over time, we will balance future increases with the corresponding cash requirements of growing our business.

Regarding ongoing share repurchases, we plan to use excess cash to opportunistically repurchase shares at prices we deem attractive.

Today we announced the authorization of a new $1.5 billion repurchase program.

Though the authorization is for 24 months, we expect the majority of repurchases to occur in 2005.

With this new program, we have now authorized 2.5 billion in share repurchases within the past three quarters, representing about 12 percent of our market cap as of the last day of fourth quarter.

Now, let's review our 2005 guidance on Slide 13.

Given our improved financial performance these past two years and our commitment to return cash to shareholders, we are now providing guidance on the following metrics: annual EPS growth, annual minimum free cash flow, expected share repurchases and intended dividend increases.

These metrics are intended to provide greater insight into our earnings potential and plans to distribute excess cash.

We will continue to guide quarterly EPS in our sales release for the third month of each quarter.

Except for operating expense guidance, all other guidance metrics will be unchanged.

For full year 2005, we expect to report earnings per share of $1.41 to $1.45 per share, more than half of this growth will come from the absence of early debt retirement costs, lower share count due to share repurchases, and interest savings.

Our 2005 full-year EPS guidance includes the impact of lease accounting changes outlined earlier, but does not reflect any impact of stock option expensing planned to begin in third quarter of 2005.

To put our EPS guidance in perspective, please consider the following: First, we incurred 105 million in pre-tax charges related to early debt retirement in 2004.

Our 2005 guidance does not contemplate any debt retirement.

Second, though 2005 full-year gross interest expense is expected to decrease by 100 million to about 65 million, interest savings from retiring our convertible debt should have no material impact on year-over-year EPS growth.

Recall that our 2004 diluted EPS calculation includes an add-back for convertible debt interests.

A slide summarizing this calculation is available at GapInc.com.

Third, we're approaching 2005 conservatively and expect operating margins to improve to about 13 percent for full year 2005, as we maintain and modestly build upon our solid improvement in 2004.

Full-year EPS is calculated using the daily weighted average share count for the full year.

As a reminder, our total outstanding diluted share count at the end of 2004 was 956 million.

Now I'd like to comment on cash flow and two of its key components: inventory and capital expenditures.

We expect to generate at least 1 billion in free cash flow in fiscal 2005.

Regarding inventory, we remain focused on driving higher inventory turns and productivity and expect inventory per square foot at end of first quarter to be flat to last year.

At end of second quarter we expect a low single-digit decrease, versus a 6 percent decline last year.

Full year capital expenditures expected to be about 625 million.

Here's the breakdown: stores, 435 million, with 225 million for new and 210 million for existing stores;

IT, 135 million; headquarters and distribution centers 55 million.

Regarding store activity for fiscal 2005, we expect to open 175 new stores and to close 135; with most closures coming from Gap North America.

Our overall full year net square footage is expected to be up 2 percent.

Please refer to our fourth quarter press release for a summary of store activity, and GapInc.com for 2005 store guidance by division.

Finally, we expect our full year effective tax rate to be 38 to 39 percent.

Regarding guidance for full year depreciation and amortization, we will provide guidance once our review of current lease-related accounting is complete.

In summary, we made meaningful progress in 2004, but have only just begun to capitalize on the opportunities ahead.

In 2005 we will remain focused on driving strong operating performance and returning cash through shareholder distributions.

And we look forward to reporting our progress in the up-coming year.

Thank you, and now I'd like to turn it back to Sabrina.

That concludes our prepared remarks.

We will now open up the call to questions.

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

[Operator Instructions] Mark Friedman, Merrill Lynch.

I was just wondering, Paul, if you could talk about marketing?

One, fourth quarter, what decisions were made where the numbers came in better?

And if you could give us an outlook about plans for marketing in 2005, especially in the first half?

Well, let me just broadly talk about fourth quarter.

We-- we tried a lot of new things this-- in the fourth quarter, particularly on our messaging and how we're talking to our consumers.

We are a little bit more, particularly Gap Brand, occasion-focused, although we still had a strong gifting strategy.

So, as I said, we're disappointed that our traffic numbers, particularly at Gap, weren't better than we thought; but, by all other measures, in terms of awareness, likability of our commercials with Sarah Jessica Parker it was very, very strong for us.

At Gap-- or at Old Navy, we didn't have a traffic challenge.

In fact, we improved our traffic, so we feel good about the effectiveness of the marketing.

Going forward, you know, we'll continue to refine our strategies.

We're looking at continuing to do gender-based advertising for Gap Brand and to look at other elements within the marketing mix, particularly as it relates to direct mail as another way for us to effectively communicate to our customers.

Emme Kozloff, Sanford Bernstein.

This is actually Robert Higgenbotham (ph) on behalf of Emme.

Given your 2005 target operating margin is 13 percent, and that's lower than the 13.5 to 16.4 range expected at end of last year, what is your expectation beyond 2005 and you know, just what your long-term target is there?

So, management strongly believes that from an operating margin standpoint we can reach and sustain a margin in the mid-teens.

We had initially anticipated earlier in 2004 that we might reach mid-teens-- the lower end of the mid-teens by 2005.

We came in at 12.7, and our guidance for '05 is about 13.

We're approaching the year with caution, given recent trends.

Whether we can reach higher than that, it's too early to call in the year.

So our guidance is 13 percent, about 13 for the year with an expectation we will reach mid-teens.

Okay.

Quick follow-up, on the marketing cost impact in Q4.

Given that that came in below plan again, can we assume the same kind of swing factor in that line item going forward, just due to the pattern over the past couple of months?

I wouldn't assume any trends.

The marketing programs that were slated for Q4 were all implemented.

What we found in Q4 that it was somewhat less costly to implement.

These savings are spread across four divisions and, therefore, I wouldn't assume any trends from the results of Q4.

Right, but just because we saw that last quarter as well, I was just wondering if you're better able to forecast that now?

Robert, we're going to keep this to one question per caller, thanks.

Mark Montagna, Wells Fargo Securities.

Just had a question about the buying process.

In the past you'd successfully implemented things like guardrails and filters, at least that was the term you had used.

And it seems as though that took you to a certain level and it seems like right now you've kind of leveled off.

And looking at, say guardrails and filters, it seems to perhaps restrict the buyers to some degree.

Wondering if you have done anything to perhaps loosen the reins on the buyers if, in fact, that is something that has happened?

No, I would actually -- I think there's kind of two ideas in there.

The guardrails are really intended for us to get our assortments right based on our customer segmentation work.

That doesn't constrain our merchants to buy what is appropriate for the classifications they need.

It just simply is the weighting of the assortments that we need to be able to put into the marketplace.

Having said that, we recognize, and particularly in Old Navy, which was really the-- the more of the challenge in our fourth quarter, is that there were some trending in a couple key categories, performance fleece, especially; that was trending down and unfortunately trended further down than we anticipated.

So a guardrail wasn't really something that would have prevented that.

It's really the guardrails are intended for us to make sure that we've got the right assortment base.

The inventory buying levels are what we think are appropriate for our sell-throughs.

And, in fact, we do feel that in Old Navy, unfortunately, we're a little overbought, based on the trends that we-- materialized in the fourth quarter.

Barbara Wyckoff, Buckingham Research.

Could you give us a sense of how the operating margins sell by division in 2004, perhaps ranking them highest to lowest and comment on where the most opportunity is going forward?

Is it in the merchandise margin line?

Is there a potential to save on rod or expenses?

Let me respond to the second question, which is where do we believe the operating -- where do we believe operating margin growth and expansion will come from.

And the answer is, we believe that it will come from both gross margin expansion, as well as further -- as well as leveraging of SG&A.

Having said that, the gross margin expansion really represents the focus of most of the investments we are making today in localization, in more disciplined inventory management, in our attempt to understand the customer better, do better assortments to drive more regular-priced selling.

In addition, given the optimization efforts underway with our fleet, the continued removal of the lower-performing Gap stores and a higher mix of stores from both Old Navy and Outlet should both-- both of those together should contribute to rod leverage over time.

With regards to SG&A, we are investing significantly in our capabilities, in international expansion with BR in Japan, with a fourth brand.

All of these types of investments appear in the SG&A, and while management is highly confident that we will leverage SG&A over time, we will be challenged to do that significantly in the near-term, given this investment level.

Melissa Mullikin, Piper Jaffray.

I had a question about pricing trends in your key categories, particularly denim.

You talked a little bit about how AUR had improved in-- at Gap and Banana Republic.

I was wondering if that is a-- if you can talk about the pricing trends and then also talk a little bit if whether mix shift had anything to do with that AUR going up.

If you can just give us a little more color on that.

Yes, particularly at Banana Republic, it's more of a shift towards-- and has been through the year this past year, more of a shift towards our regular-priced selling.

It's really driven more from that than any significant changes in overall price, per se.

I think we had described earlier that, particularly as you mentioned denim and Old Navy, that we've introduced vintage denim, which has allowed us to have a better mix, price points.

So that we've got great opening price points, particularly on promo and, at the same time, the customer that's willing to spend, in the case of Old Navy, some $34 for a better style product, better quality, better washes, better finishes; that we're able to achieve higher price points in those.

But it's really a mix and more reg-priced selling that's driving it.

Kimberly Greenberger, Smith Barney.

My question pertains to Old Navy, and one of the things that--that seemed to happen during 2004 is that some of the key franchise items that had historically driven that business were no longer the drivers, or weren't as successful as they had been historically.

What-- what plans do you have in terms of refreshing the merchandise at Old Navy in order to address some of those challenges and, as you indicated on the call, to make sure that that business is really trend-right?

Kimberly, as you can imagine, our design teams, merchant teams are incredibly focused on where the opportunities for us to be even more timely with our fresh-- with our trend rights.

We anticipated that some of these categories like performance fleece, would be downtrending, and we did replace -- we had, you know, different sweaters, we had some more fashionable fleece items in the store.

Unfortunately, that didn't make up the total volume, but the teams are always scouring and looking for new opportunities.

We are testing new products and feel confident that our overall mix of assortments that we will have products that are very compelling, special, and unique in Old Navy, as they've demonstrated through the years.

So we'll-- we'll course, correct.

Stacy Pak, Prudential.

I guess I was just trying to understand from the-- from the sort of the top line focus, what's being done to remedy what looks like not the best sort of clicking on the fashion across the brands?

It seems to me that Gap has done a tremendous job on all the operational inventory management, et cetera side.

Hence, we're seeing this lovely 12 percent margin.

But to really get up to the mid-teens, you need more on the top line and on the comp full-priced selling.

And I was wondering, Paul, do you think you have enough merchandise and design talent within the existing organization to remedy that top line?

Is there anything being done there to build that depth?

And what gives you guys the confidence that January is sort of not the new comp run rate that we should be using?

Well, I'll start, Stacy.

You know, we have -- I've got great confidence in our design teams and our merchant teams.

You know, they are talented folks and they're recognizing, particularly as we get more insights from our customers, what are the opportunities for us to just continue and improve on the product.

You know, it's -- it was a little disappointing in the fourth quarter.

We think that we know a lot of it.

It was-- a little bit less about some of the styling as it is the way we weighted our assortments and some of our focus, and I think that was the lesson learned for us in the fourth quarter.

It was a traditional gift-giving and, as much as we know that, we had so much success in some of our assortment wardrobe-based approach, particularly at Banana Republic and Gap; that we think some of the weighting of our assortments on some of the giftable items were more of the challenge than pure styling as an overall issue.

So the teams are focused and continue to drive on that, and Byron, do you want to add something?

Yeah, clearly we want the impact of better reg-priced selling on the top line to boost margins, but I don't want to lose sight that we have two other levers that are working-- where we have momentum working in our favor as we move into the mid-teen range.

The first and very important of which is, as quota comes off, we're going to have an extraordinary ability to bring to bear purchasing economies that we simply cannot do today; and this will be a margin booster over the next several years for us.

And in addition, for the reasons I outlined earlier, on a question, we should expect to improve rod leverage as we optimize the fleet mix with fewer Gaps, more Old Navys, more Outlets and then as the expansion initiatives come into play, which today are only delivering costs, shortly will also start delivering revenue and then earnings.

Jeff Black, Lehman Brothers.

Speaking of leverage, it looks like the store closures, at first blush, didn't offset the merchandise margins to the degree we've seen in the past couple of quarters.

Does this suggest that the bulk of the impact on gross margin from the Gap store closures is in the rear-view mirror, or do you think there's a lot to go in the next couple of years with that?

Well, what-- what-- I think what you're referring to here is the leverage that we're getting over rod, our rent, occupancy and depreciation.

And so what you saw in the fourth quarter was that -- which is, remember, fourth quarter is our single largest revenue quarter, and so we had a minus3 comp in that quarter.

And that more than offset several other positive factors that are improving rod leverage and, in fact, contributed to rod leverage earlier in the year.

So, in addition to the closing of the lower-performing Gap stores, our mix in our store fleet is changing.

We're getting more Old Navys, which have a much stronger rod leverage, more Outlet stores, much stronger rod leverage; and it is important to note, that our on-line direct business is continuing to grow.

This adds to revenue in spread, but also enables our rod to leverage.

John Morris, Harris Nesbitt Gerard.

I wanted to just get a little bit more color, if you would, on the merchandising for spring-- for the spring season at Old Navy and Gap Adult, if you can address each of those, giving us a feel for how you're approaching the season in terms of category?

You know, we've heard a lot about denim being very strong, pretty much across the board.

Where are you putting emphasis and where is the opportunity when you're looking specifically at the merchandising categories, pricing, et cetera?

There's a couple of things.

First, as you probably have noticed and will notice when we start our advertising in a couple of days, Gap Brand is very focused on khaki.

It's a core iconic product fabric for us, and we think we've done it in-- with great colors and in a very feminine way to meet with the trends that are working in the marketplace.

So we feel really good about how-- how we've at least approached our spring merchandise with Gap, and we think it's more iconic and approachable than what we've done in the past.

For Old Navy for instance, we know that Bermuda shorts are a big focus in the marketplace right now, and of course, we will do it in our own Old Navy way; which will also be featured in our advertising which starts the first week in March.

So we think we're really trend-right with Bermudas and the kind of fun spring.

Spring is always a good time for us and our brands.

We think we've got a way to connect the iconography of what people expect from Gap with current trends of being more feminine, flirty and pretty; and I think you'll see that throughout our stores as we execute.

And Banana Republic is, you know, I'd just call it luscious.

I mean, it's really still pretty covetable.

Our customers love it, and we're trend-right there.

But we know in the spring season there are just real covetable tops or twin sets, some of the classic items that become really important for her.

Dorothy Lakner, CIBC World Markets.

My question was related to the international business, and if you could just give us a little bit more color on the local product development and how long these efforts are expected to take now that you've established a design team dedicated to that in New York?

We are-- one, just to be clear, we are in the process of building those teams.

And we looked at our business this year and obviously, we're disappointed.

But for the few items that we did make specifically for those markets, we did see success.

Unfortunately, not enough success to overshadow some of the other products.

So we know it's the right approach.

In fact, right now in our European stores, we introduced a product that we call left weave denim only in Europe.

It's a softer hand.

It's a little bit more finished, it's a little bit more fashion-forward, and doing extremely well.

So, we know that when we can find those items and approaches that work, we'll be successful.

As to how long it's going to take, clearly, we're not going to see any significant impact until at least the second half of 2005, and that will be dependent on how fast we can ramp up our merchants and our designers.

We've made a good downpayment.

We've got a couple of key merchants already on the ground in Japan and Europe and we'll continue to build.

That's a number one priority and we think it's the best way for us to improve that business and then give us the capacity to be able to grow it over time.

Todd Slater, Lazard LLC.

Heard there were some store-level and distribution center layoffs.

I'm just wondering if you could weight for us the cost reductions a little bit by bucket: the payroll, the marketing and the bonus.

I know you gave us some of that.

And what your expectations are for those areas in 2005?

And I'm just curious if you answered the operating margin performance by division question that Barbara Wyckoff asked?

So, let me focus -- let me step back, Todd, with regards to, what I'll more broadly describe as, productivity initiatives.

Over the last year or two we have been very focused on investing in areas that will build capability.

And now we're starting to look harder within the SG&A buckets at opportunities to start driving productivity improvement.

In addition, as you recall, at the beginning of this year we modified our incentive system so that our bonus is not just focused on growth in earnings; it's focused on growth in earnings, achieving a certain return on capital, and driving free cash flow.

And what that's caused is, each of our businesses is now looking at their balance sheet and looking at opportunities to take assets off the balance sheet and improve capital efficiency, not just grow earnings.

So, in connection with the distribution center, that situation that you mentioned, with the closing of Gap stores in combination with higher inventory turn, Gap Brand management realized that it could do with one less distribution center.

And so, we identified the one in Baltimore as the one that would be removed from the network and so we made that announcement in January.

That will be retired from the network later this year.

The benefit to SG&A will occur more in 2006 because we have to cover the cost of removing that from the network.

With regards to other reductions, the only other one that would have made the press, so to speak, is the reduction in force we're experiencing in information technology, IT.

And in this situation, we've made significant investments to upgrade and replace our legacy systems.

We're beginning to yield some of the benefits related to that and, as a result, we went in and right-sized the IT organization from this point forward and incurred a reduction in force this month; the costs of which are borne in this fiscal year.

So it's another callout in SG&A as we begin to initiate and implement right-sizing of our organizations.

When you first implement, it comes with cost and so that all shows up in SG&A and starts laying the ground work for some leveraging in 2006.

With regards to the question on divisional margins, we guide at the-- at the Company level, not at the divisional margin level.

Dana Telsey, Bear Stearns.

Can you talk a little bit about the systems investment that you've talked about over the past year?

It's expected to benefit the supply chain and also inventory planning.

How's it progressing, whether it's retech (ph), profit logic, the warehouse management system; and how does it play into IMU and margin?

And just lastly, the new concept, Paul, how's that developing and how's the team forming?

That's about seven questions in one.

A little bit.

Let me -- I'll maybe attack part of it, Byron can attack the other part of it.

You know, we are-- we really have a very strong vision of our supply chain and where we want to take our opportunities.

And, as I mentioned briefly in the speech, we recognize that with the removal of quota, we do have opportunities to rethink, reconfigure the way we manage our business.

A lot of that is starting as we speak in building better foundations and partnerships with our vendors.

That's going to enable the ability to have more robust capabilities, particularly associated with forecasting our businesses and then flowing our businesses and production schedules in a more robust way.

We're clearly recognizing and beginning to see the impact from category management.

This is something where we are really aggregating our buys across all the brands.

For instance, within denim and not something that we had historically done.

It's still keeping the differentiation by product, but it's giving us more leverage in the marketplace.

So partnerships, category buys, all of that is beginning to happen and will become much more robust as we move forward with the overall business.

With regards to system investments, the first ones that have gone operational are the replacement of our financial systems with an integrated financial suite.

Domestic went up February of '04.

International went up February of '05.

Both have gone up very smoothly.

We've replaced our lease management system, which was no small feat, by the way, and all of our -- and we've replaced all our POS systems and upgraded those so that we have the capacity to scale considerably beyond where we are today.

Those are all in, operating, and went up well.

With regards specifically to inventory, the retech inventory system that we're putting into place, the first of our businesses will go live this year.

That will be Banana.

We expect that to happen in Q2.

With regards to-- and that, by the way, that inventory system is really the platform off of which we will be able to do much more sophisticated distribution and allocation of inventory; which means that you should expect to see no benefits from that in '05, with-- with benefits starting to occur in '06, '07, '08.

With regards to the systems investments to support localization, for us the first downpayment is size.

This is now-- our pilots are complete.

It's now being rolled out in adult fashion in both Gap and Old Navy.

It should-- we should start seeing impacts with holiday '05.

And then no new major updates on fourth brand or Banana Republic, other than to say it's on target for the second half of '05.

Richard Jaffe, Legg Mason.

I guess a follow-up on one of your comments that your number one priority is product and also you're seeking to be a more balanced and consistent performing company.

I'm wondering how you're-- how you're managing the design and merchandising team to achieve those two very diverse ends?

That is an inspiring product on one hand and consistent performance on the other?

Well, I guess I don't see them as mutually exclusive in some ways.

I mean, clearly, our teams in New York with our merchants are in the marketplace, around the world every day looking for innovative product ideas that fit within our signature for each one of these brands.

And you know, let's keep in mind that we had a very strong first half.

We were hitting on all cylinders, our creativity, our product was trend-right.

The market slowed.

We didn't perform as well as we'd like, but we have a team that I think is very focused on what it's going to take to be successful and continue to look for those innovative products.

And I think if you go into our stores right now, you continue to see a product that is new and fresh, color-right, trend-right.

And this in this business, as we you know, is just a constant, you know, holy grail for us; and every six weeks we have the opportunity to improve upon it.

So I think that becomes really important.

Separate from that is, you know, delivering value.

This business is going to generate the cash and we're going to be able to use that cash to create shareholder value by deploying it through our dividends and share repurchase.

Those two things are not at odds with each other.

In fact, the more we improve one, the more we'll have the opportunity to do the other.

Operator, we have time for two more questions.

Margaret Mager, Goldman Sachs.

My question, actually, is about Old Navy.

Can you talk about the fact that the traffic trends there have been, you know, a bit soft?

And help us understand, you know, what you think the issue is with traffic.

Is it just related to product or is there something else about Old Navy, for example pricing?

Is pricing as sharp as it needs to be at Old Navy, given who your competitive set is?

And while I have the floor here, I just would like to publicly encourage you to give more disclosure on your profitability by division.

I think that would be very, very helpful for us to understand where the opportunities are for operating margin improvement at your company.

Let me -- I'll start.

First, on Old Navy, traffic, other than the month of January, has been very strong for the brand.

Obviously, much stronger in the first half, but even strong in the second half.

We had positive comps in October, November, December; all the way through.

So traffic's not an issue.

We feel very good about our connection with our customers, the loyalty of our customers, our marketing to be able to engage them and drive them into the store.

So, we feel very positive about the able-- our ability to drive the traffic.

The challenge for us in Old Navy was our average unit retail.

And, as we described, for us as much as we had tremendous ability for us to look at new initiatives and grow the business, when we didn't have some of the trend rights and some of our inventory balancing was not in the right place on some of those categories, it has a bit of a tidal wave effect on the overall averaging of retails which forced us to mark down goods and clear it through.

So our-- you know, look, the overall Old Navy business model is fantastic.

And we continue to drive our traffic.

We continue to do it.

We had a bump in the road in the holiday.

We'll, of course, correct; we'll get our product right.

But we don't see any concerns or erosion in our consumer satisfaction and engagement with this brand.

So we know that we've got some work to do and we need to get our product right, but as I said, we have the opportunity to fix that every month.

Operator, last question.

Rob Wilson, Tiburon Research.

Given your merchandise margins were down in Q4, how are you planning your merchandise margins specifically in the first half of this year?

We-- the merchandise margin decline in the fourth quarter was primarily a reflection of having more difficulty moving through our units at reg price than anticipated.

So more went to promotion and mark-down and-- and, given the environment of the fourth quarter, mark-down margins came in lower than anticipated.

So, this is -- the fourth quarter is much more a function of moving through the units.

We would intend to plan merchandise margins going forward.

Frankly, just as we did going into the fourth quarter, but with tighter control over our unit buys.

I thank you--I'd like to thank you all for joining the call, as always.

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

Thank you.

This does conclude today's conference call.

You may now disconnect.