蓋璞 (GPS) 2005 Q1 法說會逐字稿

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

At this time, all participants are in a listen-only mode. [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 express written permission.

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

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

If you have any questions regarding this policy, please contact Gap 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 first quarter 2005 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 contain certain forward-looking statements, including but not limited to: forecasts relating to operating margin, effective tax rate, capital expenditures, store openings and closings, net square footage, inventory per square foot, earnings per share, gross interest expense, 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 29, 2005.

Investors should also consult 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 May 19, 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, express 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 GAAP.

The reconciliation of this measure to GAAP financial measures is included in our earnings press release which is available on Gap Inc.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 first-quarter performance and discuss product strategies for Gap and Banana Republic.

Following Paul, Jenny Ming will discuss Old Navy.

Following Jenny, we will then open the call up to questions.

We expect the call to last about an hour.

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

Thank you, Sabrina.

Good afternoon.

Business in the first quarter was challenging as headwinds experienced in the second half of last year persisted.

As you will hear from Paul, the brand teams have diagnosed the issues with product and are working to correct them.

Here is an overview of results for the quarter.

Net earnings, down 7% versus prior year to $291 million, or $0.31 per share.

Free cash flow of $113 million for the first quarter, down $17 million versus prior year.

Our tax rate for the quarter was 37.7%, reflecting favorable tax settlements.

Regarding the continued progress with our balance sheet.

We completed the conversion of our convertible bond into 86 million shares, leaving just 513 million of debt on the balance sheet.

We repurchased 26 million shares in the quarter at an average price of $21.53, resulting in an end of quarter diluted outstanding share count of 932 million.

On April 5th, Moody's upgraded our credit to investment grade with a B double A 3 rating.

And just after the quarter closed on May 6th, we released all $900 million of restricted cash that collateralized the committed bank lines supporting our letter of credit facilities.

Finally, we doubled our Q1 dividend per share from $0.022 to $0.045.

Here's a closer look at our results.

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

Up against last year's record earnings for the quarter, reported first-quarter earnings were $291 million, or $0.31 per share, compared to $312 million, or $0.33 per share, last year.

Let's review the underlying drivers of our business.

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

Total sales were $3.6 billion, down 1% from 3.7 billion last year.

Consolidated comp store sales were down 4% compared with a 7% increase last year.

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

Turning now to gross profit performance on slide 5.

First-quarter gross profit decreased 6% to $1.5 billion.

Gross margin was 40.8%, down 2.3 percentage points from last year.

Entirely the result of lower merchandise margins.

This margin decline was due to lower regular-priced margins driven by higher promotional selling.

Rent, occupancy and depreciation expenses were flat as a percentage of sales for the quarter.

Turning to operating expenses on slide 6.

We continued to invest in initiatives intended to drive long-term value.

First-quarter operating expenses totaled 1 billion, up 2% from last year.

As a percent of sales, operating expenses were 28% compared with 27.2% last year.

Marketing expenses in the first quarter were $125 million, up 11% from last year, driven by incremental marketing in our international division.

Turning to inventory on slide 7.

We ended the first quarter with $1.9 billion in inventory, up 101 million versus last year.

Inventory per square foot was $51 at the end of first quarter, up 5%.

This increase was primarily driven by timing associated with the early receipt of summer merchandise.

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

First-quarter capital expenditures were approximately $112 million compared with $35 million last year, due to a higher number of new stores and remodels during the quarter.

Net square footage at the end of the first quarter increased 1% from the prior year.

During the quarter, we opened 41 store locations and closed 25, ending the quarter with 3,010 locations.

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

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

For the first quarter, free cash flow, defined as cash from operations less capital expenditures, was an inflow of $113 million compared with an inflow of $130 million last year.

The decrease was driven by lower earnings and higher capital expenditures, partially offset by reductions in working capital.

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

We ended the first quarter with $3.7 billion in total cash and investments, of which $1 billion was restricted.

As stated earlier, just after the first quarter ended, we released all restricted cash that collateralized our bank line supporting our letter of credit facilities.

Our restricted cash is now down to approximately $100 million.

We ended the quarter with $3.2 billion more in total cash and investments than funded debt.

Turning to slide 10.

I would like to comment on our outlook for the remainder of 2005.

As you may recall, in the past we have booked reserves against office space for which we are obligated to pay rent but are not occupying.

Based on emerging business requirements, including the move of Old Navy's product development team to San Francisco, management made the decision in mid-May to occupy one of the properties located in San Francisco against which such a reserve had been taken.

As a result of this decision, we will reverse the reserve related to the property we will now occupy and begin expensing rent.

The amount of the reserve reversal is 58 million pre-tax and is a Q2 event.

The pre-tax impact to full-year 2005 earnings will be approximately 51 million in income, which reflects the amount of the reserve reversal less additional rent expense and related items, including interest.

Partly due to this decision, we are revising guidance for full-year gross interest expense to 55 million for 2005 and 45 million for full-year 2006.

Including the impact of this reversal, we are still expecting operating margins for full-year 2005 to be about 13%.

Solely as a result of these real estate decisions, we are revising annual EPS guidance for 2005 and 2006.

Our 2005 EPS guidance is a range of $1.44 to $1.48 and our 2006 EPS guidance is a range of $1.58 to $1.62. 2005 guidance in the following areas has not changed: Tax rate, we expect our full year effective tax rate to be 38 to 39%.

Capital spending, we still expect full-year capital expenditures of about $625 million.

Store activity and square footage, we still expect to open about 170 store locations and close about 135.

We still expect full year square footage to increase about 2%.

Inventory, we expect inventory per square foot at the end of the second quarter to be down on a percentage basis in the low single-digits compared to a 7% decrease in the prior year.

Inventory per square foot at the end of the third quarter is also expected to be down in the low single-digits versus a 1% increase last year.

In summary, we are focused on improving our product and believe that our strong operational discipline will continue to provide a solid foundation for healthy earnings.

We are confident in our brand strategies and our ability to drive long-term shareholder value.

Now I would like to turn it over to Paul.

Thank you.

Good afternoon.

Today I'll address our first-quarter performance, then I'll share GAAP and Banana Republic's product strategies and Jenny Ming will provide an update on Old Navy.

We were disappointed with our first-quarter results.

However, we were up against record earnings from last year and, in spite of our fashion misses, we delivered a solid 12.8% operating margin.

As we shared at our investor update last month, we understand the issues in each of our businesses and our teams are making the necessary changes to improve.

At Gap, we are pleased with the progress we've made in the men's business but are not yet satisfied with our women's product.

In our efforts to serve more occasions for women, we broadened our merchandise and design perspective going a bit outside Gap's iconic style aesthetic.

So our teams have worked to develop a strong brand architecture, including an aesthetic filter that we call Fresh Casual American Style.

This sensibility represents what our customers expect from Gap, clean, pure color, cotton-based fabrications that are easy to wear, trend-right looks, as well as iconic items rooted in denim.

Our customers still want versatility.

So we will continue to provide outfits she can wear for the weekend, work, and going out, but we'll accomplish this more through styling, such as dressing up jeans with a great jacket and accessories rather than using separate filters to design for each occasion.

Our teams are working as quickly as possible to incorporate this work into their development processes, but we are not expecting significant women's product improvements in the short term.

The aesthetic will be more fully expressed in the holiday and spring assortments.

In the meantime, the Gap team is focused on three areas: First, using our new filter, we have adjusted our fall and holiday buys where possible to improve our color and fabrications.

Second, we are visually merchandising those products that best represent the brand.

For example, our white jeans, bright colored layering tanks and metallic accessories are trends interpreted in a Gap way: clean, current, casual and versatile across occasions.

And we've just moved our women's denim forward in the store to give it more visibility.

And, third, we feel good about Gap's new customer experience that we launched in seven Denver stores last month.

We are rigorously studying the results and applying what we learned as we expand our rollout to 10 stores in the Hartford-Newhaven market and five San Diego area stores this fall.

Anecdotally we're hearing positive feedback from Denver customers who tell us that the stores look and feel fantastic.

They've been especially excited about denim, which is showcased in the new-store design.

We're encouraged by strong average-unit retail transactions, fitting room usage is up considerably, and customers are spending more time in the stores on each visit.

And finally I'm very pleased to have Cynthia Harris in place as Gap's new President.

Cynthia is quickly getting up to speed so she can help accelerate the team's progress.

Turning to Banana Republic.

On the runways we are seeing a shift towards simpler, cleaner, more neutral-based fashion.

Aligned with this trend, Banana Republic essentials in key categories, such as suiting, blazers, denim and knits performed well for both men and women in Q1.

We learned from some female customers that while they were inspired by our novelty fashion product, they weren't confident putting outfits together.

So we have incorporated more styling suggestions in our summer visual merchandising and marketing.

Beginning in fall, we're adjusting Banana Republic's assortments to include more versatile items.

There's a little less focus on emerging trend pieces and more emphasis on essentials and approachable fashion; grounded in neutral colors with great layering pieces.

Now I'd like to turn it over to Jenny Ming to provide an update on Old Navy.

Good afternoon.

I'm very pleased to speak to you today about our performance in the first quarter and to share with you some of our key learnings and details about our upcoming summer season.

We faced some challenges recently, including our mix performance during the first quarter.

We spent time learning and we're applying our findings to our product and marketing strategies.

And one of the areas that we are improving is having a better balance of inventory invested in uptrending items and reducing inventory in downtrending items.

We've done a good job offering trend-right items such as tunics and polos.

And we've seen a good customer response.

At the same time, we have focused on right-sizing our inventory investment in downtrending items such as graphic t-shirts and cargo.

As you heard at our analyst meeting, denim continues to be an important category for us and our special edition fashion denim has been well received.

We'll continue to explore other opportunities in denim for our customers.

Overall, we are responding and managing our businesses better and looking forward, in response to customer feedback, we made some changes for the summer season.

First we're offering different shade assortments with each product flow this year.

Last year, our final summer flow was very small and not very different from the other flows.

This year, we're offering three distinct summer flows that are more clearly different shaded.

We wanted to give our customers new products to be excited about throughout the summer season.

So in our third summer flow in May, women's clothing moved from bright colors to a richer offering in earth tones with more ethnic flair, beading and embellishments, which we believe is really trend right.

Second, we have improved our swimwear collection this summer.

We learned from our female customers last year that we had an opportunity to improve the fit and fabric in our swimsuits.

This year, we've incorporated a new two-way stretch fabric for comfort and fit.

In addition, we expanded our offerings, we're giving customers more choices for style and coverage with an assortment of tankinis and mix and match bikini tops and bottoms.

Third, this year we're striking a better balance between family and young adult customers with -- and experimenting with new approaches in marketing.

We are moving towards having more targeted and segmented marketing campaigns to reach our family and young adult markets.

And here are a few examples: In the second quarter, we began with a TV swim campaign aimed at the whole family and we will move into a gypsy skirt TV campaign aimed at the young adult market.

This compares to one broad summer family campaign message last year.

A Memorial Day circular will be distributed and will appeal to the family with a fun in-store promotion that we are running over Memorial Day weekend.

Families shopping over the weekend can scratch tickets for a chance to win a $10,000 family vacation of their dreams.

I am also pleased to tell you about a new venture for us in marketing.

Old Navy is known for its fun fashion for the family.

This quarter, we're teaming up with Dimension Films and cross-promoting the summer family movie, The Adventures of Shark Boy and Lava Girl, in 3-D.

And among the tie-ins that we will do are exclusive 3-D t-shirts with 3-D glasses featuring key characters from the film.

The t-shirts will be available on-line and in all of our stores with a special point of purchase display.

And we'll hand out Shark Boy and Lava Girl stickers in our stores.

This is a good example of how we are evolving our marketing campaigns to create buzz around our brand.

In addition to the marketing and product initiatives that we've undertaken, we're also proactively changing the way we work at Old Navy; so that we can be more dynamic in our approach to innovation and in responding to our changing competitive environment.

So many of you may recall that we mentioned at our investor update meeting last month that we are moving our product development function under one roof.

We communicated the news just a few weeks ago and we're in the process of working through the moves with our team.

Overall, the move is going well.

As of today, the design leadership team that we will need to lead the process here will be moving to San Francisco.

We feel very comfortable with our ability to manage through this transition.

As Byron mentioned, we have leased office space in the Mission Bay area of San Francisco and I'm pleased to tell you that the entire Old Navy team will be moving into this space in the summer of 2006.

We are creating a new collaborative environment where our whole team can work together.

In conclusion, this is an exciting time for Old Navy.

Innovation continues to be our top priority.

Being innovative is what truly set us apart from our competitors.

It's what allows us to really deliver something special and unexpected that is a great value to our customers.

So I'd like to take this opportunity to recognize the commitment and enthusiasm of the entire Old Navy team.

They have worked hard applying our key learnings and we're well-positioned for future growth.

Thank you.

That concludes our prepared remarks.

We will now open up the call to questions.

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

[Operator Instructions].

Emme Kozloff, Sanford Bernstein.

A question for Byron.

Using the midpoint of your '05 and '06 guidance, I get to 12% year-over-year EPS growth.

Can you help us understand how much of that growth comes from reduced share count, given we don't have anything explicit on the timing of the share repurchase?

I'm just trying to determine what the net earnings growth guidance is for the business.

And then just quickly quickly Paul, many retailers are using well-known designers for special addition assortments, would you ever consider that for the Gap brand?

So Emme let me go first.

So with regards to the 12% growth guidance we gave.

What we said was that over half -- over half of that increase in EPS growth would be coming from financial strategies which, not only include share repurchase, but if you'll remember, we had-- in last year -- we had significant -- roughly $105 million worth of debt premium that we paid to retire debt early, which will -- which we assume will not repeat this year.

We also are carrying considerably less debt, so we expect lower interest this year and next.

And then we have the ongoing share repurchases that began last year, are continuing this year, and we-- we would expect to continue the year after.

So in short, over half of the growth would come from a combination of those three financial strategies, Paul.

And then Emme, real quickly.

It is something that we've batted around internally.

We do not have any plans at this time.

At best, we see it, as a promotional opportunity -- you know, just something that's quick; but no plans at this time and not sure that we'd actually executed against it.

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

Thanks, good afternoon.

My question is for Byron as well.

I was hoping you could give us some thoughts on expense structure, your commentary on the gross margin was that all of the deterioration was associated with merchandise margin, which says to me that ROD was flat on a minus 4 comp.

How much of this is associated with store closures and how sustainable is that kind of of relationship?

And then related to that, the marketing increase that you saw in Q1 for incremental spend in international, is that something that strategically will roll forward?

How should we think about how the marketing spend will be applied both in quantity and in terms of direction over the next several quarters?

Okay.

So on the merch margin piece.

That's largely -- as I said in my -- in my opening remarks, that's primarily due to reduced regular price margins.

Recall that within the regular-price category, we include planned promotion.

And the -- the primary driver of the margin decrease at the reg level was a higher level of promotion -- planned promotion during the quarter.

The reason ROD was flat is -- is exactly what you surmised.

It is a combination of optimizing the fleet by retire -- continuing to retire the lower performing Gap stores, which tend to carry a much higher ROD percentage; and, in effect, replacing them with Old Navy new stores, which tend to leverage ROD much, much better.

With regards to the marketing, marketing went up 12 million.

And of that, it is almost entirely attributable to international and the international campaigns were really twofold.

The-- the marketing that went behind less weaves, both in Japan and in Europe, and then the Sarah Jessica Parker spring campaign in the UK commanded additional marketing support.

So on an ongoing basis, too early to tell whether that's a -- whether that's a permanent increase to the marketing.

This was -- in this particular quarter, opportunistic support of specific programs .

Your next question comes from the line of Mark Friedman, with Merrill Lynch.

Thank you, good afternoon everybody.

Jenny, could you provide a little bit more detail on how you're accomplishing this better inventory balance between uptrending, downtrending items without increasing the risk?

Are you buying the goods later?

What are you doing exactly?

And how does this translate in the bigger seasons, like fall and holiday?

As we talked about in the investor meeting, in the fashion -- some of the fashion trends we are holding back inventory dollars, so closer to the season that we can even better predict the fashion trend and buying closer to season.

So gypsy skirt was one of those that we didn't place, really, until February.

And it is in the store as we speak.

So we are doing that.

And we have plans to continue doing that for fall and holiday.

Your next question comes from the line of Dana Cohen, with Banc of America Securities.

Hi guys.

Just quickly.

You didn't talk at all in terms of back-to-school -- you know, your back-to-school strategies, particularly denim, which, you know, was not a focal point starting in back-to-school last year.

And then second, Byron, When you said that the operating margin target was 13, did that include the new 51?

So let me start.

We haven't called out specifically our plans at this point, it's a little bit premature to do that.

Having said that, we're well aware of the opportunity for us to increase our focus on denim.

And you'll be seeing all three brands having a greater, tighter focus on denim for back-to-school.

With regards to margin.

So we had said, Dana, that on an operating margin for the year we guided to about 13.

So with the additional 51, it's not enough to really move that guidance.

And I want to be very clear that when we say about 13% operating margins, you should interpret that as it can be plus or minus a modest amount, but-- but not to the level that it would rise to mid-teens, which operating margins -- which for us begin at 13.5.

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

Yes, a question on sourcing.

A lot of speculation now that we may go into some kind of an embargo situation coming out of China partway through the year.

I know you guys have a lot of contingency plans on that.

But any thoughts in terms of if that does happen, do you have to make changes for the second half of your year?

How would that change kind of your flow strategy for fall and holiday?

Yes, no.

Actually, we rather anticipated this coming and the potential for some kind of safeguards to come in.

And our plan for the entire year anticipated and made adjustments according.

So we see this as not having an affect on us at all.

We're very well diversified which, as what you know, we have done through the years; so no affect either today or do we anticipate even with additional safeguards put in place.

Your next question comes from the line of Stacy Pak, with Prudential Equities.

Hi.

I was hoping someone can address why Gap division had so much trouble executing the white denim campaign.

You know, the commercial launched on the 28th and it seemed like the division was still struggling to get the presentation in store by mid-May.

And sort of what can be done about store execution there?

And, secondarily, Jenny, what can you say about the production move to San Francisco?

I mean, people might not be telling you now that they're not going.

How -- what sort of preparation do you have in place in case key people don't make the move?

So Stacy, let me address the first piece.

And, I think as you know, we're constantly balancing the workload of our stores.

And given the timing of our summer flows, the TV campaign, we actually gave our stores a little bit more time to be able to set up associated with the campaign.

Keep in mind that when we first go on television, it takes a little bit -- a week or two for us to start to build awareness.

In hindsight, we could have been a little bit cleaner on doing that, but we're really trying to manage a variety of executional issues that we're trying to pull off in the store.

As for the move, we have key people, as I said, all the key leadership that we need to lead the design team have already designed -- have decided to sign up and they will be moving to San Francisco.

So this is a very important piece for us.

And we do expect some attrition.

I mean, there's no way that we wouldn't.

We feel we can handle all the recruiting here in San Francisco and we really feel that there is talent in the West Coast besides the East Coast.

So we feel really comfortable with our transition plan at this point.

Your next question comes from the line of Dorothy Lakner, with CIBC World Markets.

Thanks, good afternoon everyone.

My question is for Paul on Gap.

And I was wondering if you could give us more color on how you made adjustments to the fall assortments at Gap given the new filter that you've put in place?

And then just again on the denim component of that, you've moved denim to the front, what -- what have you done in terms of the actual commitment in inventory to denim?

Sure.

As I shared in -- in my little talk, we clearly recognized that as we focused on different occasions and serving those occasions, that we went a little skewed in our design aesthetic across the board.

So the work that the team did really is to get us regrounded on those principles, on the design aesthetic that we think is really strong.

And I just want to also be clear that it really has been a women's issue for us and not the other products in the store.

So as a result of that, we went back and looked at our fall mix.

Some of it was just simply in the cases of where we wanted to make our commitments on buys, on products we felt better about.

In other areas, it was adding a color or two or rebalancing our color.

So that was really the primary strategies for fall.

Also as I mentioned we will be focusing significantly on denim in the fall, back-to-school period; as well as fit, which is going to be an important component of what we're going to communicate to our customers.

When you mentioned Banana Republic, you were talking about a move back to neutrals.

Is that something that you're doing only at Banana, or is that filtering down to the Gap as well.

No.

It's across the board.

It's a trend that we're clearly seeing out there.

Not just a cleaned-up look, but the focus on the neutral colors, particularly in our essentials products, where it's going to be important.

So you'll see it show up in all of our brands.

Your next question comes from the line of Brian Tunick, with JP Morgan.

My question I guess for Byron.

The composition of the inventory as you end Q1, what do the carry-over levels look like?

Should we expect AURs to continue to pressure second-quarter comps?

And then I guess on that note, the Retech inventory management, what's the timing of that rollout?

So inventory first.

We ended inventory end of Q1 up five, all -- virtually all of that is early receipting.

So other than getting our timing of receipt a little better, no issue there.

And then if you recall in my remarks, we have guided to end of Q2 and end of Q3, we expect to be down low single-digits.

And so that should signal that we feel we have our inventory levels well managed through the next two quarters.

With regards to Retech, the first business unit that will go live on our Retech inventory system is Banana.

And we expect that to occur this summer.

The other business units would then follow.

Barbara Wyckoff, Buckingham Research.

Can you comment, Jenny, on the progress of the development of maternity in plus sizes in -- in Old Navy.

And then do you -- the second kind of adjunct question to the plus sizes.

Do you adjust the missy size range in 16, 18 and 20s in those stores that have the plus sizes?

So let's start with maternity because it's been a business a little longer.

We are -- keep rolling out maternity especially in our new stores.

It's a business that we feel that we have a really good handle on.

And this is really balancing our fashion in our core in the maternity.

And also really adjusting the new fit.

What I mean by new fit, we see that the traditional fit of over your belly is really trending down, it's really more under the belly.

And we're adjusting our inventory to that.

Right now it's about-- in about 350 stores in our maternity.

Plus sizes, as we talked about that, is we still are improving the fit.

Because in plus sizes it's all about the fit.

And we have made adjustments to our summer and our fall line from what we learned from our customers.

Again, we haven't had it in -- in the store more than a year.

It will be a year by fall.

We are in about 170 stores right now.

And we are going to probably hold until we learn more.

But we think the -- we know the potential of this is really, really great in our plus sizes.

Joe Teklits, Wachovia Securities.

A question for you and then maybe -- maybe Paul, Byron -- maybe Paul can answer the second part.

I was wondering if you can give us some information on store payroll as a percentage of expenses in the quarter.

And then as a follow-up to that, Paul, maybe just your view on balancing cost savings in a quarter or in a period where comps are slowing with -- with the stores looking presentable; especially given that that's probably the number one, call it, marketing tool for the customer to see every time they hit the mall.

So with regards to payroll.

We've -- let me just say, we've experienced no major shift in payroll as a percent of sales during the quarter.

And I guess it's easier to add on to that is, we're very focused, both on the customer expectations and the brand expectations for our business.

And as much as we are always looking for cost productivity opportunities, we recognize that our face to our customers is critical.

Cost savings as a way to drive our business is more -- is going to come more from our opportunities in sourcing than it's going to come from trying to diminish any of the values that we present forward facing to our customers.

Dana Telsey, Bear Stearns.

Given the changes in merchandising that are coming up, are there pricing adjustments that we should expect , differing by brand, that are any different than what we've seen in the past?

And what are you seeing in terms of product costs, IMU benefits and the environment out there?

Maybe I'll start Dana, thanks on the first one.

You know, needless to say, as I think we talked about in our investor things; we believe there's tremendous opportunities for us to gain value from our new sourcing strategies.

As we think about deploying the savings, we think about it in several different areas.

One -- and it really is brand by brand, classification by classification, competitive set against each one of those classifications.

So a little hard to aggregate them all together.

Having said that, clearly we know that there are some classifications where quality and where we can bring in higher mix of products, like we're doing in denim; whether it be a special edition that Jenny's doing at her 1969 Gap, where we can add quality and has, in some cases, increasing prices.

In other areas, we think that there's going to be increased pricing pressure.

I think particularly in Old Navy as it goes into some of the commodity pricing that Jenny's talked about in the past and furnishings and some of that cost is going to come hopefully to our bottom line.

So every class is a little bit different.

We're recognizing there continues to be pricing pressure in the marketplace.

But as we've described in the past we think, not only do we have to in some cases expand our pricing architecture to be competitive, but it also gives us opportunities as we're presenting better product.

Jeff Black, Lehman Brothers.

You know, we've seen some of the competitors, particularly in denim start to take what appears to be a more aggressive posture regarding inventory in the third quarter.

Now, given what you just said about your inventory being down, low single digits at the end of Q2, is there a risk here that we're being too defensive on inventory, or should we understand the business in terms of what you're going to distort by business?

Yes.

No.

Overall, keep in mind that we're remaining very consistent with our strategy that we've talked about over the last year.

We are very focused on building our business but doing it at a profitable way.

We're also very focused on our turns, so that we're speeding up our deliveries, our receipting, so that we're carrying less inventory.

So that's all the back of house, so to speak, strategies that are going to continue to drive our inventory down.

As we look across classifications, needless to say, we are making the investments in those areas that we are most confident and bullish about in the areas of opportunities for us to continue to grow the business .

Margaret Mager, Goldman Sachs.

I know you're doing a lot of good things that your shareholders like, so I hate to focus on the issues; but I'm curious about your description of what to expect from the Gap business as we progress through 2005.

It sounds to me like you're telling us to keep our expectations low for the Gap until holiday '05, spring '06.

And I know you don't want to give same-store sales guidance, but I don't know -- if we're supposed to interpret this as down comps or what.

And I -- and then I-- I'd like to reconcile that with maintaining your guidance for the full year.

If your Gap division isn't quite performing the way we might have expected going into the year, how do you maintain the same outlook?

Thanks for the kudos upfront, I'll take that.

Margaret, I guess we are, as I said, we are disappointed in the direction for our women's business.

Bear in mind that, as a result of the input coming from our store managers, the input coming from our customers, we recognized back in holiday that we were not doing our best job presenting what our customers expected.

So we put in place what I talked about in terms of our design aesthetic, we have been working with the design and merchandising teams over the last couple of months to really solidify what we feel is the aesthetic that's going to be important moving forward.

We've done that.

Our team is totally aligned.

We are very focused on executing against that.

And, as a result, we recognize that the biggest impact that we were able to make towards this aesthetic that we think is more on target, a little less focused on the occasion, is really going to come to life in holiday, and then its best expression in spring.

We've done the best we think we can do to focus on our ability to improve holiday.

And again it's a women -- fall I mean but it's, again, an issue associated with the women's side of the business.

So we're doing the best we can, but you'd be fairly accurate in signaling that we're not as confident in our women's early on but more confident as we move into holiday and then into spring.

So also, Margaret.

Remember, we're a portfolio of a number of brands and with regards to Old Navy and Banana, we are confident in the strategies that we have for both of those divisions, both for fall and holiday.

Both of those periods, the comps aren't quite as difficult as they were in the first half.

We've got a significant -- in our view, we have a significant opportunity to leverage margin in the second half, fourth quarter in particular.

And we're managing our inventories tightly to optimize the earnings yield associated with the investments we've made to support our second half.

Todd Slater, Lazard Capital Markets.

I just wonder if I could get some clarification on the denim back-to-school question.

You said you'd be tighter, and I'm assuming you don't mean tighter fit; but I'm sure-- I'm just wondering if that means fewer SKUs, maybe more narrow and deep, or maybe more assorted.

What is your, sort of, your overarching strategy for back-to-school?

No tighter was really in reference to overall inventory, not denim.

So we're very bullish on the opportunities for us in denim.

You're going to see, for all the divisions, Jenny continues to work on her special edition, as well as our basic product at great-- at great prices.

You're going to see more styles flowing to Banana Republic as early as July.

And then Gap brand also will be very focused on denim, particularly in the opportunity not only to do different washes and styles, but also to better exploit what we believe is an opportunity in fit.

So the inventory comment was broadly speaking, not with specific to denim.

So does that mean that you plan to have more inventory dollar commitment in denim and back-to-school than last year across the board?

Right.

We're not going to quite go through that level of detail other than to say that it's going to be an important focus for us and we believe -- and we recognize the trend in the marketplace and know that we have a better opportunity to do a better job with our customers.

Richard Jaffe, Legg Mason.

Could you talk about your marketing strategy and ad spend for the next three quarters?

A little bit of a ramp up this quarter, but international, can you more directly focus on the domestic efforts in the next three quarters?

Well, Richard, we're not going to lay out all the plans for each of the brands, and everyone is a little bit different.

You know, as we mentioned, the international one was opportunistic against left weave and we're pleased-- our early reads of certainly the product performance.

We constantly are evolving.

Needless to say we've got our annual plans.

And then as business -- as we read our business and as we read the competition, we're always making adjustments and course corrections.

We're also, as Jenny pointed out in her speech, looking at new innovative ways to test new ways of us communicating with our consumers.

So we'll be doing that.

It's going to be fairly consistent with what you'd expect from us as we did last year, a bit of our mix of media might change a bit, some of our communication message.

But nothing radical that would throw you off in terms of the consistency of what we've done last year.

Operator, we have time for two more questions.

Jennifer Black, Jennifer Black & Associates.

I wondered if you could talk a little bit about your sellthroughs of basics versus novelty and where you see the mix going over the next nine months at both Gap and Old Navy?

And I also wondered if you could talk about your sizing?

Do you feel that you have the right amount of each size?

Smalls seem to be sparse at both Gap and Old Navy and I assume that everything is under a microscope.

You know, Jennifer, we tend not to talk about those baskets because the definition in people's minds and our internal definitions about what we call basics versus fashion is often defined differently and, therefore, subject to misinterpretation.

Paul talked about the fact that we still are very focused on our guardrails and at balancing our investments by brand to make sure we're invested appropriately in basics, essentials, and more on-trend, emerging trend items.

So I think that we feel comfortable that even though we have course corrections to make on the margins, that we're getting that balance back where it should be.

Okay.

And the sizing?

So, Byron.

So with regards to sizing, in the fourth quarter for our holiday fashion adult in both Old Navy and Gap, a substantial portion of those collections will be size enabled for the first time using the localization tools that we have been -- that we have had in development over the past year and a half.

So instead of distributing or allocating on an average store basis, we expect to get a very good read on what kind of lift is possible when the sizes distributed much more closely reflect what the demand patterns are for the stores that receive them.

Paul Lejuez, CSFB.

Byron, just wondering if you can maybe frame for us what kind of leverage you guys can get if you hit a low single-digit positive comp in terms of ROD expenses?

And also looks like the pace on the share repurchase might put you a little bit ahead of the 1.5 billion that you have authorized, any updates on those plans?

So with regards to comp leverage.

I think what we've witnessed this year is that, despite efforts to architect, optimize the fleet; our ability to leverage on the margin is determined first and foremost by how well the product's received and sells through at reg price.

And so, given the volatility we've experienced over the past several quarters on that front, I think that the -- the greatest source of leverage, going forward in the near term, will be having the product strategies click to a better degree than they have over the last several quarters.

With regards to the repurchase of shares, as-- as you all know, we have been authorized to repurchase $1.5 billion worth of our common equity.

At the end of Q1, we had repurchased -- we spent a little over 550 million; so we have quite a bit a ways to go.

And so we are very focused on opportunistically, at prices we deem attractive, retiring stock.

And when we approach the end of the current program, we will have ample opportunity to go back to the Board and seek additional authorizations.

As you all might recall at analyst day, we said that the calls on our cash were first reinvestment in the base business, second dividends, and third, with whatever excess cash we have, share repurchase.

And we expect to have excess cash beyond dividend requirements to continue to support an active share repurchase program.

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

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

Thank you.

Ladies and gentlemen, this does conclude today's Gap Inc. first quarter conference call.

You may now disconnect