蓋璞 (GPS) 2005 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to Gap, Incorporated's second 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, Incorporated and consists of copyrighted materials.

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

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

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

If you have any questions regarding this policy, please contact Gap, Incorporated investor relations at 415-427-2175.

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

Good afternoon, everyone.

I'd like to welcome you to Gap, Inc.'s second quarter 2005 earnings conference call.

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

I'd like to remind you that the information made available on this webcast and conference call contain forward-looking statements including, but not limited to, forecast relating to earnings per share, free cash flow, operating margins, effective tax rate, capital expenditures, store openings and closings, net store footage, inventory per square foot, earnings per share, gross interest expense, depreciation and amortization, creating and delivering long-term value for share holders 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 10K for the fiscal year ended January 29th, 2005.

Investors should also consult our quarterly report on Form 10Q for the quarter ended April 30th, 2005 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 August 18th, 2005, and we assume no obligation to publicly update or revise our forward-looking statement, even if experience or future changes make it clear that any projected results expressed or implied there in will not be realized.

This presentation includes a non-generally 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 include in our earnings press release which is available on gapinc.com.

On today's call, Paul Pressler, our CEO, will summarize second quarter performance and discuss second half product strategies at all brands.

Byron Pollitt, our CFO, will follow with a recap of financial performance.

After Byron's financial review, Paul will make some additional closing remarks.

We will then open up the call to questions.

We expect the call to last about one hour.

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

Thank you, Sabrina.

Good afternoon.

Today, Byron and I will discuss our second quarter results and our outlook for the remainder of the year, including actions we are taking to improve business performance.

And then I'll share some of the progress we're making on our growth strategies.

In the second quarter, we delivered respectable financial results, but summer performance continued to be challenging from a product perspective.

Although we are executing our strategies to improve second half performance, each brand's August results to date are trending significantly below our expectations, driven primarily by decreases in traffic.

Our previous annual EPS and operating margin guidance was predicated, in part, on the belief that our efforts to improve performance would begin to gain momentum by fall.

In light of our disappointing month to date August results, combined with concerns about the macroeconomic environment, we are now lowering our 2005 guidance.

With that said, we remain confident in our long-term strategic initiatives and are focused on strong execution.

I'll share some of the actions we are implementing today and throughout the second half to improve our performance.

At Gap, as we expected, women's second quarter performance was disappointing, as summer product did not reflect our fresh casual American style aesthetic.

And while we're not satisfied with overall fall women's assortment, I'll share an example that illustrates the direction we're headed.

The brand's renewed focus on denim is quintessential Gap.

Iconic looks that are clean, casual, current, and versatile across occasion.

And our store windows, visual merchandising and marketing all support this focus.

Reinforcing Gap's culture relevance, we are featuring musicians in our ads and sponsoring the MTV video music awards this year, and to encourage customers to try our new denim fits we're offering free iTune downloads in stores.

In addition, as you know, we've launched Gap's new store experience in the Denver market in May, and we're expanding to it the Hartford, New Haven and San Diego markets this fall.

Although we are pleased with early results, we need to continue to monitor long-term performance to understand which elements are yielding the highest returns.

Banana Republic results were mixed for the second quarter.

Although some women's product did very well, we pushed a bit too far in the overall balance and didn't provide enough essential items.

The fall assortments, which hit stores this week and next week, still have key emerging trend pieces, but there's a greater emphasis on versatile essentials grounded in neutral colors.

We have also increased our men's and women's denim presentations with more elevated styles and higher price points.

Finally, Banana Republic has launched higher quality handbags in all stores now, which are a perfect extension of the brand.

In contrast to previous handbag offerings, which were usually designed to complete outfits for going out, these versatile bags can be used from day to night.

They're priced from $78 to $300, and so far we're encouraged by a positive initial response from customers.

Turning to Old Navy, although we were pleased with the initial response to fall fashion in July, we haven't been able to sustain the momentum in early August.

Overall, we are disappointed in second quarter performance, particularly in the men's and kid's businesses.

We believe this is partially due to continued pricing pressure in the sector.

To refine our pricing architecture, we reviewed the competitive set for each of our customer segments, and as we previously communicated, we are evolving old Navy's pricing strategy around three assortment categories: Trend, core and value.

Trend items, such as special edition denim are offered at regular price.

Core items like cords, will have planned promotions, and basics, like socks and t-shirts are offered at everyday low prices.

We just began rolling out this strategy in all stores, and will take time to communicate the changes to our customers.

Although we are still confident that this is the right strategy, we have not yet seen immediate improvement.

In addition to sharp pricing and promotions, we will continue to focus on offering trend right product with a specialty flair that distinguishes Old Navy in the marketplace.

The team is improving the way they work to ensure that we are innovative, fast and flexible in our execution.

As of this week, Old Navy's design and product development team has officially relocated from New York to San Francisco, and the transition is going very well.

Across all of our brands, we are taking actions to improve our top line performance.

Before I discuss our growth initiatives, I'll turn the call over to Byron, to provide an overview of our second quarter results and specifics on a revised financial guidance.

Thank you, Paul.

Good afternoon.

As Paul just mentioned, business during the second quarter continued to be challenging at all three brands.

While customer response to product was disappointing, financial results were supported in part by financial strategies and operational discipline.

I will take you through our results for the quarter and then walk you through our guidance revisions.

Results for the quarter can be summed up as follows: Net earnings improved 39% to $272 million, or $0.30 per share.

Gross margins declined 120 basis points.

We ended the quarter with 2.6 billion in total cash and investments.

We doubled our Q2 dividend to $0.045 and finally, we repurchased 45 million shares of stock during the quarter for $944 million, reducing our end of quarter shares outstanding to 881 million.

Since October of 2004, we have utilized $2.5 billion to repurchase 119 million shares.

So far this quarter, we have not made any repurchases against our latest $500 million authorization.

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

Second quarter earnings were 272 million, or $0.30 per share, compared to 195 million, or $0.21 per share last year.

As previously announced, we reversed a sublease loss reserve during the quarter, related to a building in the Mission Bay area of San Francisco that we now plan to occupy.

The amount of the reserve reversal was 58 million pre-tax, or $0.04 per share and is included in the second quarter earnings.

First half earnings were 563 million, or $0.61 per share compared to 507 million or $0.53 per share last year.

Please turn to slide four for sales performance.

Second quarter total sales were flat to last year at 3.7 billion.

Consolidated comp store sales were down 3%, versus flat last year.

Second quarter total sales per square foot declined 2% to $97.

Versus last year, year to date total sales were down 1% to 7.3 billion, consolidated comp store sales decreased 4% versus a 3% increase last year.

Year to date sales per square foot declined 2% to $192.

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

Turning now to gross profit performance on slide five.

During the quarter, we experienced pressure on merchandise margins as customer response to summer product was below expectation.

As a result, second quarter gross profit decreased 3% to 1.4 billion.

Gross margin was 37.3%, down 120 basis points from last year.

With merchandise margins down 180 basis points.

Partially offsetting the decline in merchandise margins was favorable rod leverage of 60 basis points which was entirely the result of a nonrecurring final adjustment related to our change in lease accounting.

In the first half, gross profit decreased 5% to 2.9 billion.

Gross margin was 39%, down 180 basis points from last year, driven by a 200 basis point decline in merchandise margins partially offset by rod leverage.

Turning to operating expenses on slide six.

Second quarter operating expenses were 957 million.

Please note that reported expenses include a $58 million benefit from a one time reversal of a sublease loss reserve.

Marketing expenses in second quarter were $110 million, up 3% driven by increased in store marketing at Old Navy, as well as marketing in support of our Banana Republic Japan launch.

First half operating expenses totalled 2 billion of which marketing expenses were 235 million.

Regarding interest: Due to the successful deleveraging of the balance sheet, net interest income for the quarter was 15 million versus interest expense last year of 31 million.

Turning to inventory on slide seven.

Despite the challenges of the second quarter, we remain disciplined in our inventory management.

We ended the second quarter with 2.1 billion in inventory, down 10 million versus prior year.

Inventory per square foot was $54 at the end of the second quarter, down 3% in line with our guidance provided at the beginning of the year.

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

Year to date capital expenditures were 259 million, compared with 147 million last year due to a higher number of new stores and remodels during the quarter.

Year to date we have opened 81 store locations and closed 46.

We ended the quarter with 3029 stores and a 2% increase in square footage versus second quarter last year.

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

Please turn to slide nine for more detail on free cash flow.

Year to date free cash flow defined as Cash From Operations Less Capital Expenditures with an in flow of 21 million compared to an in flow of 88 million last year.

The decrease was driven by higher capital expenditures.

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

We ended second quarter with 2.6 billion in total cash and investment, of which 97 million is restricted.

We ended the second quarter with 2.1 billion more in total cash and investments than funded debt.

Turning to slide ten, I would like to comment on our outlook for the remainder of 2005.

As Paul stated earlier, our previous annual EPS and operating margin guidance was predicated in part on the belief that our efforts to improve performance would begin to gain momentum by fall.

That improvement has not yet materialized.

Given the continuation of these disappointing trends and concerns about the macroeconomic climate, we feel it prudent to lower our guidance.

Regarding earnings per share, we now expect annual earnings per share for fiscal 2005 to be in the range of $1.30 to $1.34, down from the previously provided range of $1.44 to $1.48.

Regarding operating margins, we now expect operating margins to be about 11.5% below our previous guidance of about 13%.

Regarding store activity and square footage, we now expect to open about 190 store locations versus prior guidance of about 170 with the additional stores weighted to Old Navy.

We expect to close about 140 store locations, up from the prior guidance of 135, driven by additional closures at Gap division.

Given the additional new stores we now expect full year square footage to increase about 3%.

Regarding depreciation and amortization, we expect depreciation and amortization expense for fiscal 2005 to be about $550 million.

We have not changed our 2005 guidance in the following areas: Capital spending, we still expect full year capital expenditures of about $625 million.

Tax rate, we expect our full year effective tax rate to be 38 to 39%.

Inventory, we expect inventory per square foot at the end of third quarter to be down on a percentage basis in the low single digits compared to a 1% increase in the prior year.

Inventory per square foot at the end of the fourth quarter is expected to be flat versus a 6% increase last year.

Gross interest expense, still expected to be 55 million and cash flow we still expect to generate free cash flow of at least $1 billion.

In summary, while we are not satisfied with our operating results, when combined with our debt reduction and share repurchase strategies, we are pleased to have delivered an increase in reported EPS for the quarter.

Having said that, we are acutely aware that to generate significant value, we need to strengthen our top line performance.

Now I'll turn it back over to Paul.

Thank you.

Thank you, Byron.

At all levels of the company, we are laser focused on improving our performance.

At the same time, we are making progress on the growth strategies that we began seeding more than a year ago including brand extensions, international expansion and our fourth brand.

I'll provide a quick update on each.

First, personal care represents a significant opportunity to extend our lifestyle brands and drive incremental sales.

We are building these businesses by leveraging the deep expertise of external partners.

Last month, we signed an exclusive agreement with [interpopunes] to develop and manufacture personal care products for Banana Republic and Gap, launching in 2006 and 2007 respectively.

And Old Navy is partnering with Kiss My Face to create a new co-branded product line that will be in our stores this October.

Next month we will launch Banana Republic in Japan, opening stores in four of the most prominent shopping areas in Tokyo and Yokohama.

Given Japanese customers' strong affinity for American brand icons and luxury products, this represents a strong opportunity to position Banana Republic in the fast growing premium segment.

Finally, we will open our first Fourth In Town store at Palisades Center in Niyak, New York on Wednesday, followed by four stores in the Chicago area on August 31st.

We look forward to sharing more details at our Fourth In Town investor event at Palisades Center next week.

In closing, none of us is satisfied with our current performance.

We know what needs to be done for our Company to be successful, and we're committed to the flawless execution required to get us there.

My management team is focused on today as well as the future to drive long-term share holder value.

Now I would be happy to answer your questions.

Operator, that concludes our prepared remarks so we'll take questions now.

[OPERATOR INSTRUCTIONS] Your first question comes from Lauren Levitan with SG Cowan.

Good afternoon.

I was wondering if you could share with us any insights that you're gaining from the customer research that you're conducting across the multiple brand.

If you could share any of the learning there and findings that might suggest how you might be able to stimulate traffic both in season for the current fall season and longer term going forward, in terms of either marketing initiatives or how they're responding to store experience, or if it really all does come down to the exact product assortment each season?

Thanks very much.

Well, needless to say, product is king and number one.

Our consumer insights are really not going define the trends in the marketplace for us.

So, we - - our designers and our merchants are responsible for that piece.

We have been using our insights for giving us strategy and for allowing us to measure our execution of our strategy.

So on the strategy side, as a few examples, what you've seen deployed at Gap brand with regard to our new fit came directly from the insights from our customers and gave us the opportunity to create another fit.

Our pricing strategy at Old Navy came from the insights that we gleaned both in the marketplace and from our consumer segments.

Insights that we got with regard to Banana Republic, that we weren't meeting the needs of our customers as it related to core essentials, allowing us to adjust our assortment at the same time.

So, on the one hand we're using it as a effective tool for us to learn how to deploy strategies or create strategies, not to mention opportunities, adjacencies.

We spoke to customers about the opportunity to bring handbags into Banana Republic and what were the needs and what were the price points?

So, that's informing everything that we're doing.

At the same time, we're able to measure and monitor how well we are executing at the store level and the store experience.

One of the things that we did learn was several things.

One, that informed the way we thought about redesigning our Denver stores for Gap, but also with regard to Old Navy, that we had an opportunity for our stores to be neater, both in terms of our visual presentation, and at our fitting rooms, were critically important to the overall experience for us.

So, we see it as an on going opportunity for us to continue to learn, drive in our strategies and then making sure that we're executing against those strategies well.

Have you learned anything related to the competitive set or if you're viewed differently competitively than in the past?

Any thoughts on that would be helpful.

Thanks very much.

I'll do that one quickly.

Yes.

I think one of the things that we have been doing through our customer segmentation, particularly at Old Navy, is understanding where these customer segments are shopping in addition to ourselves.

What we do recognize for instance, is that our younger customers, our teen customers, frankly, are more shopping specialty retail as the competitive set and we recognize that kids shopping a lot more in the value sector than previous.

So it is helping us as we go through our pricing strategy to understand that we're not dealing with aggregate basket demands, but that individual core segments have the opportunity for us to understand where the competitive set is and then setting our strategies accordingly.

Thank you.

Your next question comes from M.E.

Kafsa with Sanford Bernstein.

Hi.

Can you give us more color on the problems with the Gap division product strategy?

With negative comps in nine of the past twelve months, this isn't a short-term issue.

So are you willing to consider a more dramatic change to your design or product development process given the chronic weakness?

And then secondly, given a lot of lead times in apparel can you really meaningfully change the assortment any earlier than late spring of '06?

Thanks.

Thanks, M.E.

Clearly as we've articulated, we do think that we need to make a pretty large change in our design aesthetic for Gap and what customer we're serving and how we're serving that customer.

If you remember, we really focused on diagnosting - - diagnosing the issues back in the fourth quarter.

We set our strategies up in the first quarter.

We spoke to our investor community about what are the things that we needed to do.

What emerged from that was our fresh casual American style aesthetic which we think is critical for us and who we are to be successful.

Also, keep in mind that we had deployed a very strong occasion strategy in the first half that we think that was miscued primarily because we missed the design aesthetic.

At that time, we had already started to course correct our product.

We did realize that fall was going to be very challenging for us to be able to improve upon that aesthetic.

Although there are a few things that we did do and did some chasing into a couple key products that we think need it.

But overall on women's, it has been a challenge for us.

On men's and the other business, particularly baby, I think the aesthetic is a lot closer to what we want it to be.

Having said that, we recognize that it really isn't until holiday and spring that we believe that we have affected the design and the assortments to better reflect the aesthetic that we believed is true to our Gap customers.

So, didn't expect a lot of improverment in fall.

Expect some improvement in holiday and then for spring, against that design aesthetic.

Can we assume that the denim may be challenging given the commentary on August comps?

So for Gap specifically, we're actually pleased with our women's denim performance.

The fits have resonated with our customers, particularly the curvey fit.

Frankly, it's outperforming our test markets with regard to curvey.

So we are back chasing, taking our fabrics and cutting them into the silhouette that is more appropriate.

Maybe we'll leaving a little bit on the upside of the table right now because we're not as deep in our curvey fit as we would like to.

But at the end of the day we have been pleased with the women's side.

Thanks.

Your next question comes from Jeff Klinefelter with Piper Jaffray.

Hi.

Yes, I was wondering if we could get just get a little bit of an update on maybe the thoughts or plans for the Gap core franchise in terms of square footage adjustments going forward?

And also the - - your observations today in this environment to maybe considering the last year, the optimal size for a Gap store.

Does it continue to be a rationalization sort of by market and by volume and getting any sense for what the right size is for that fleet?

Okay, well let me - - I'll start and then I'll turn it over to Byron.

I think as you saw or had the opportunity to hear about our work in Denver, there was several things that we were doing.

Particularly optimizing what we felt was the right square footage against the business.

So on average, we think that we're somewhere in the 7,000 to 9,000 square foot range.

But one of the things we did in Denver and that we're rolling across the fleet is increasing the square footage that we are allocating for women and a little bit less for men.

And even on a market by market basis, we're evaluating our baby square footage versus our kid's square footage based on demographics and where we think the opportunities are.

So seven to nine is about the average, but we are juggling the optimization of what we think the right levels of inventories and presentations should be by classification.

And with regards to optimizing the fleet size for Gap, clearly the economics that emerge from the revised business model for Gap will dictate how large the ultimate chain will be.

But we have guided to the - - on a full-year basis that we expect to open about 40 units this year in Gap division, but close about 100, for a net reduction of 60.

We would - - we've not yet revised our projections for next year, but we would continue to have an optimization strategy in '06 that is more likely to reduce the fleet size further.

But we'll guide to that more specifically at the end of the year.

Okay.

Just one quick follow up on M.E.'s question on the denim.

There's a lot of concern about inventory levels.

Sounds like your inventory seems to be in good shape and your plan is for it to be in good shape despite the sales shortfall.

Can you give us a sense for what kind of a build you actually had in that category and where you're sitting currently?

Well, let me just answer that within the overall context ; so we ended the quarter, as I mentioned, with inventory per square foot down 3%.

That is exactly the guidance we gave at the end of the year.

We've said overall our inventory at the end of Q3.

We expect to be down low single digits and then flat year over year at the end of the year, at the end of fourth quarter.

So, the denim position specifically is running up a bit at Old Navy, but very manageable and at Gap, year over year, we're about flat.

The other thing I want to add quickly is the notion that, from a supply chain standpoint, we're in a better position today than we've been in the past that we've reduced the amount of base cloth fabrics that we are using across our brands and it gives us much greater flexibility to be able to cut and sew the silhouettes and styles and trends that are working and to get back into the business.

So, for instance, in Old Navy men's, as we speak, we know that our carpenter and worker jean hasn't been as strong as we'd like.

We're taking those fabrics and cutting them into five pocket, which is tending stronger for us in Old Navy men.

We have more flexibility than we have in the past on our supply chain as well.

Thank you.

Your next question comes from Mark Friedman with Merrill Lynch.

Thank you.

Good afternoon, everybody.

Paul, I was wondering if you could talk a little more about traffic and marketing.

Specifically on traffic, where is it - - where is it among the divisions as far as, is one unusually weaker than the other to address that going forward, or how are you thinking about the marketing?

Is there plans to step up the marketing spend to drive it or will this be more driven off of promotional activity to get the inventory in the right position?

Okay.

Thanks, Mark.

Let me give you perspective on what we think is driving some of the traffic challenges and then I'll give you a little bit of details of some initiatives that we're taking and deploying as we speak to improve our traffic.

First you should know that it's pretty much down across the board from July.

So it isn't a specific division.

We're feeling it across all of the divisions.

I attribute the root cause for each one a little bit different.

Of course our teams are diagnosing as we speak and deploying to be able to improve it.

So, I'll give you my broad feeling.

First with regard to Gap, I think we're all recognizing that we've had disappointing traffic and weakness throughout all of '05, largely driven by disappointing in our women's product.

I think that the continued evolution of our product and getting our momentum and, frankly, word of mouth against women is going to be an important traffic driver for us as we continue to improve in that area.

Frankly, I'm generally pleased with our marketing for Gap.

I think we've actually executed stronger than we have in awhile.

I think if you look at our stores, you look at consistency of the message about fit, the windows, driving traffic drivers with the iPod - - iTunes free download, I feel pretty good about that.

Having said that, we are looking at some ways, as we speak, to try to amp it up a little bit.

You may be familiar that we have something called a hit squad, where we have people in local markets that we're actually more deployed towards college markets to get people to try on our jeans.

We're going to redeploy it this weekend to our top malls.

So that we have people that are really focused on building the traffic.

At Old Navy, frankly, I assign more of it to our marketing effectiveness for back to school.

Our commercial which we broke with, which was intended for moms shopping for kids, we don't believe was as effective as it could have been and should have been.

And we are - - although our overall gross rating points have been similar to last year, we don't think the message is as effective.

So there again, we're taking immediate action.

The first thing we've done is already replaced that commercial in rotation with our teen cord message, which we feel much better about and we feel pretty good about how we're doing with our cord product in the marketplace today.

At the same time, we're looking at selectively deploying email to our primary customers.

We're adding selective radio as best we can next week to improve that traffic performance.

We had always planned for an additional circular in August, but that will deploy on Sunday as well.

That should be another traffic builder for us.

And I think you're also familiar that we're having a double denim promotion that we have actually accelerated and moved up for this weekend.

And that will be another traffic driver.

So, there I think it's a bit of our marketing message and effectiveness.

We are deploying initiatives and going with the strength that we have against cords and our denim offering which I think will be compelling as well.

And Banana Republic, real quickly, since our fall product really isn't hitting until this week into next week and the marketing isn't significant, there isn't any real change in plan there.

All right.

Thank you.

Sure, Mark.

Your next question comes from Stacy Pak with Prudential Equity.

Hi.

Just one quickie and that is, can you share comps by division for August?

And then, what are you doing, Paul, to attract new design talent to the organization or to make it a more attractive place to be if anything?

And then, Byron, can you give us SG&A dollar growth for Q3 and Q4?

That would be great.

Okay.

So I'll dodge the comp because we're not going to give it by individual piece.

You'll have to wait until our monthly call.

But we did want to clearly indicate that we're, at this point, disappointed with our performance.

As it relates to design field, I actually feel pretty good.

As I said in the speech, we now have our New York design team moved out to San Francisco.

We have been able to hire pretty much everyone that we need to be able to get the help that we need in San Francisco for Old Navy.

So that team is up and running.

They're in the building.

They're working together.

We've seen the benefits of having these teams work together with our Fourth In Town organization.

Not only the quickness but also our ability to be able to make decisions and be more trend right.

So I feel really good about that.

Our Banana Republic team has been rock solid and continues to be solid.

We have not had an issue at all in terms of attracting new talent.

I think as we have described before, we have now a very strong filter about what is the aesthetic that we want to deliver to Gap brand and we're making sure we've got the talent in place to deliver on that.

We feel very good about it.

It hasn't been an issue for us.

With regards to SG&A, Stacy, as you know, we now focus our forward guidance on EPS and operating margin and don't guide specifically to SG&A.

But having said that, I think it's important to share with you all that, as it relates to our day to day business, we are clearly tightening down on SG&A reflecting the current trends in the business.

But as it relates to the SG&A spend against our major strategic initiatives Fourth In Town, the launch of BR in Japan, the work we're doing on developing a franchising business, these are important growth initiatives for us and we are maintaining the SG&A investment spend against those initiatives.

I would say as a callout, Stacy, no major shifts in SG&A for balance of year.

Okay.

Thanks.

Your next question comes from Janet Kloppenburg with JJK Research.

Good afternoon.

Paul, on the last earnings call, you had told us that you didn't expect the Gap brand to really improve until holiday or spring of '06.

I'm wondering now, as you're seeing the merchandise issues unfold for the fall, if you feel you have correctly addressed the merchandising issues that you need to, in order to make that turn around happen.

And also, you had talked about the fact that you thought Old Navy and Banana Republic's businesses would improve this fall.

Beyond traffic levels, can you talk about some of the trends that are different from your expectations in those brands?

Thank you.

Sure, Janet.

I'll start backwards.

Banana Republic, as I said, Fall doesn't really hit in our stores until women's this week and men's next week.

And our primary objective there was to balance our assortments.

So we'll have a better indication at the end of the month as to how we're meeting those expectations.

Still, from a product standpoint at Old Navy, we are trend right in a lot of the areas we are.

We have our [inaudible] jackets which are trending in the marketplace.

Our embellished knits are working well in the marketplace.

Our fashion denim.

So I feel really good about that.

Again, I think it is our marketing effectiveness that we haven't delivered on and we will correct that and we will make it a lot better.

With regard to Gap, nothing has changed.

As we said and you correctly called out, that we were not as confident.

We knew we wouldn't be able to course correct for the fall assortments, but we have course corrected for the holiday assortments and the spring assortments, so nothing has really changed in our perspective there.

Do you still feel confident in the ability of the plan to make some progress next spring?

Yes.

As I sit here today, knowing the strength that we want to have in our fresh American casual style and that that's our design direction, that we will deliver on it, yes.

Great.

Good luck.

Your next question comes from Joe Checklich with Wachovia Securities.

Hi.

Thanks.

Paul, can you just share what concerns you exactly about the macroenvironment which both you and Byron mentioned and maybe anything brand specific, any brand specific exposure?

Well, I think it's - - look I think we're all looking out over the second half and wondering how the consumer is going to respond.

Needless to say it's difficult to know whether we can peg directly to gas prices, but particularly for our Old Navy business, you know, we are concerned about consumer spending and patterns out there.

We also recognize that if there is a overall downturn in the business, that it's going to potentially get more challenging from a competitive standpoint.

So, we're just keeping a watchful eye out for it.

I think we just feel a little bit less bullish on just general macroeconomics, given what we're seeing in the marketplace today.

But it's, again a little early to tell how sustainable this will be over the half.

Your next question comes from Barbara Wyckoff with Buckingham Research.

Hi, everyone.

I have a couple questions.

Can you talk about the selling results of the Old Navy special edition jeans, both in men's and women's versus the more basic styling?

And then I have a follow-up question about Gap.

Okay.

So, I'll start on Old Navy, which is, we've been very pleased throughout the first half and as we move into the second half with our special edition.

We have more product flowing in, particularly in women later next week, so we'll feet better when we can get back into our inventory positions that we think are healthier with regard to that product.

Overall we're feeling pretty good about that.

Throughout denim in Old Navy, we've got some pluses and we've got some challenges.

Five pocket for women hasn't been as strong as fashioned.

We're five pocket for men has been stronger by comparison to our carpenter and worker pant.

So, we're adjusting our assortments, balancing assortments, recutting fabric where we can, with a great sense of urgency to be able to balance the assortments where our customers want to be.

Great.

Thank you.

The question that I have about Gap is, can you talk about sort of the spraying in early fall performance in Gap body, which we never really seem to talk about as well as kids and baby?

The results, the competition, any changes in strategy there?

Yes.

Actually, we're very pleased with our body performance.

We've made a lot of good traction, particularly in our foundations business, our lounge business, really across the board.

So we've been really happy with it.

You may have seen that we've been doing these broad - - bar tours across the country which is we really get people in to understand our product and our - - the fit.

Getting people to try it.

We've seen some very nice lifts in our business when these come to town and into the malls.

So we're feeling very good about body today.

We'll continue to build on that business.

Kids have been okay.

We've held our ground from where we were.

Again, we've got some highlights.

The long and lean product for girls has been strong in denim.

We've got some knit product that's working.

We've got some outer wear that's not as strong.

So overall I'd say it's about neutral for kids and baby.

We're feeling pretty good about that.

Body has been more successful for us.

How many body stores are there, Paul?

Well, we have - -

Roughly.

Yes, we have - - there's freestanding and then there's ones that are connected.

I guess there's about 200 points of destination, you know, maybe a little bit less than that, 180.

But, we can get back to you on that.

That's ballpark.

We'll get back to you, Barbara.

Okay.

Thanks.

Your next question comes from Brian Tunick with JP Morgan.

I guess, Byron, if you could maybe give us maybe some more color on the marketing for the third quarter.

Either the timing and length of the TV campaigns at Old Navy and Gap versus last year, you know, marketing spending as percent for the quarter, and then just, Paul, I would just be curious what the thinking was on offering shoes in the Gap stores and how that's been working so far.

Thanks so much.

Sure.

Let me - - I'll start with the marketing piece, specifically it relates to what we're doing for the early part of fall.

For the most part, I think it would be fair to say that our marketing strategies in terms of the flights, our gross rating point, our weights with regard to radio or other mixes that we've been doing is generally the same as last year with the - - probably the biggest exception being the extra circular at Old Navy.

We've done a good job, I think in doing segmentation, particularly with Old Navy, so that these circulars are focused on mom, focused on teens and focused on back to school.

So that really hasn't changed.

We have deployed what I call some more guerrilla tactics that are more viral that we've been doing.

Things on websites.

Things like the hit squad.

Things like the bra bar.

They're a little bit more viral and a little more just getting really closer to our consumers than some of the broader marketing mix that we would typically deploy.

As it relates to shoes, do you know what?

It's not a - - first of all, we've been doing shoes for awhile.

It's not a big deal.

Yes, we took a little bit of a fashion step with some of our patent leathers.

But it's - - in the scheme of things, it's not terribly material.

Your next question comes from Paul Lejuez with Credit Suisse.

I was wondering based on August trend if you're seeing any differences across regions of the - - different regions of the country.

Also wondering if anything that you're seeing now, is there anything so extreme that makes you question next year's guidance or long-term plans?

Thanks.

Yes.

I'll just do the first piece.

We'll be able to share more on the sales call with regard to overall traffic.

Clearly, weather has played a part into some of the trends.

We're seeing that, for instance, some of our long sleeve product in women's knits is a little bit more challenging.

But we'll share more with you at the end of the sales call.

With regards to guidance for the out years, given that we have made a substantive revision to our guidance for this year, you all should no longer rely on the original guidance we gave for both 2006 and 2007.

Once we've got the holiday season behind us, we will re-evaluate and readdress guidance for those two years.

Thanks.

Your next question comes from Jeff Black with Lehman brothers.

Thanks.

Good afternoon.

Wondering if we could get some color on how to allocate the impact between 3Q and 4Q.

Are we going to see most of the downside for the remainder of the year in the third quarter?

And given that sales aren't materializing as planned, how flexible are your inventory commitments for Q4 and ending on that flat number what level of comp is that plant against and do we have the chance to adjust that prior to the fourth quarter?

Thanks.

Let me respond to that.

So first, we, as I think you know, we don't guide to that level of detail quarter by quarter, but I can say that the operational disciplines we have put into place around inventory which you have already seen the evidence of with the quarter just ended, given that our business experience headwinds and yet we were able to deliver the guidance is completely a function of us taking action much sooner when we see different levels of sales velocity than what we had anticipated.

So, the inventory is bought for the second half.

As Paul said, we can repurpose and recut and rewash some of that inventory.

But it is basically bought.

So it's much more about getting it allocated to where the sales velocities are greatest within our fleets and taking action on promotions and pricing to make sure it's cleared at an attractive margin within the desired timeframe.

That's very helpful.

Thanks.

Your next question comes from Randall Conic with Goldman Sachs.

It's actually Margaret Mager.

Let's see.

With regard to the outlook and your view of the economy being a factor, can you give me a sense of how much you think the economy is impairing your business versus execution?

I'm just curious what you're seeing in the economy that concerns you.

That would be great.

Thanks.

Margaret, Byron.

We don't want to overweight the impact of the macroeconomic environment.

The truth of the matter is, when we prepared our original guidance for the year, it - - all along we were looking for an uptick in our business in the second half beginning with the fall season.

And the first couple of weeks of August is a very important leading indicator for fall and not only did we not see the uptick, but we actually saw a downturn in traffic.

And when we combine those two, recognizing that there is enormous operating leverage in the second half of the year to be won or lost, we felt that it was a prudent time to reassess halfway into the year.

Early signs, early reads on fall and reguide accordingly.

And you should read into our guidance.

These were the principal reasons.

The macroeconomic environment was a context that we also applied.

But it was primarily performance driven revisions that drove our guidance.

Okay.

I guess one of the things that I find kind of hard to read is when you say that your August date results are significantly below expectations.

Because we don't really know what your expectations were going into the month.

Can you gauge that perhaps against the actual results in the second quarter?

In other words, same-store sales down 3%.

July down 4%.

Is it - - are we talking something that looks meaningfully different than that, or - - can you just help me gauge that a little bit?

I think the best way to put that into context is we had a certain set of expectations which were consistent with the guidance we had given for the full year.

When those expectations were not realized, and, in fact, not only - - as I said before, not only did we not see an uptick, but we saw traffic fall off, then we retumbled our forecast and revised accordingly.

I think that's the best perspective I can give you.

Any update on the share repurchase authorization, that extra 500 million?

Yes.

As I said in my remarks, as of this telephone call, we have not yet spent any of the additional $500 million authorization that we announced previously.

Go to the next caller.

Thank you very much.

Your next question comes from Kimberly Greenberger with Citigroup.

Great.

Thank you.

Good afternoon.

I wanted to ask a follow-up to Stacy's question, sort of the corollary to her question, which is, it sounds like you're not having any problem attracting talent to the business in terms of design and buying, but has there been an increase in your turnover rate of existing talent within the business, and could that be causing some level of disruption?

You know, we're deep and rich company.

Given our size and needless to say that we have and will always have some level of turnover.

I feel very good about where we are today.

Across the board.

Not just in the design side, but across the board.

We've got teams that are well seasoned and have been in place and have been working together for a long time.

Particularly at our senior levels.

The Julie Roses, the Karen Helmens, the Cheryl Clarks of the world, not to mention our senior leaders that are in place.

Ivy Ross has now been in place.

So I feel very good about our teams and who is in place.

I also feel more confident now that Cynthia is in place and we've got a leader at Gap brand, which is critical for making people feel inspired and excited about the direction we're going.

I think now that we've rolled out where we want to go at Gap brand specifically, people are energized.

They see it and they see where we want to got, and we all kind of feel in our bones that this is the right way for us to take the product and the product thesis.

So I feel pretty good about where we are.

Needless to say we're a large Company and there's going to be some ins and outs all the time.

Your next question comes from Richard Jaffe with Legg Mason.

Thanks very much.

Paul, if we were going have a report card for the divisions, should we look for merchandising initiatives at Gap to be evident in spring '06, specifically first quarter?

And should we look for the marketing initiatives that impact in the fourth quarter this year?

And similarly for Banana Republic merchandising initiatives to improve in the fourth quarter as well?

Is that a reasonable timeframe?

Richard, it is.

Let me just go back and give you my expectations.

For Gap brand, it is an evolution to the new style aesthetic, as you know.

Soon you'll be able to see some of our fall - - our holiday products out there.

So, I do believe that we have and you will see for holiday, that we've impacted our assortments to a degree with regard to the design aesthetic.

And then, absolutely, for spring, we will be a lot closer to having the majority of our product along that aesthetic.

Keep in mind that I really see this as the women's side of it.

We feel very good about our aesthetic in the other sides of the business.

The marketing at Gap, you know, really is fairly solid in our opinion.

We definitely think we can look at ways to improve our direct relationships with our consumers but it really is about product.

We've got to get that right, and then we can optimize it with some better marketing.

So, that would be fair.

With regard to the Banana Republic, we have rebalanced our assortments for Fall.

That will show up in our store right now in our deliveries for women and men.

I'm expecting that that strategy should begin to pay off for Fall at Banana Republic now.

You know, their marketing is pretty consistent, unchanged.

I think we've elevated the brand quite nicely.

We get tremendous feedback.

Our lux card has been supportive there.

No real changes there.

But expectations are is that we've moved the needle on the assortment mix and that we should be getting some traction once we deliver those assortments.

Operator, we have time for two more calls.

Okay.

Your next question comes from Dana Cohen with Banc of America.

Two things.

First of all, Byron, should we be thinking in the back half of the year that the change in operating margin is largely deleveraging or do you continue to see margin pressure?

And, Paul, I - - we're hearing what you're saying that you're currently comfortable with your team.

But I guess if time goes on and business does not improve, or how long would the current business trends have to continue before you would change that view?

Dana, Byron first.

With regards to the second half of the year, we are - - our guidance reflects that we believe that there will be continuing pressure on both top line and margin.

And then Dana, from my standpoint, needless to say, we are all taking accountability for where our business is today.

And it starts at the top.

So, we are focused a lot of the folks that are in place are seasoned and know what to do to course correct.

We have new folks in place that are getting their traction going.

Particularly in some of the design areas at the same time.

Teams like Banana Republic, who have been in good shape.

I think it's more of an assortment issue and how we're buying it [inaudible].

Needless to say, we're all holding hands and we're all accountable and we need to deliver as a team.

Great.

Thank you.

Your final question comes from Dana Telsey with Bear Stearns.

Good afternoon.

Can you talk about on the expense fund how are you managing expenses in light of this changing environment?

Is anything being adjusted by division?

Is it any particular category?

And do you feel that your traffic is different than the overall mall traffic and what you're hearing out there?

And lastly, if the traffic picks up, could your estimates be conservative?

Thank you.

Do you want to start with traffic?

Thanks, Dana.

Do you know what?

We do follow the mall traffic.

We are below mall traffic.

So we do recognize that we are missing by comparison to the aggregate demand out there.

And that's what we need to address pretty quickly.

With regard to SG&A, I think you know this management team and needless to say, gave based on our new outlook we are certainly scrubbing every opportunity for us to improve upon those SG&A areas and be very, very diligent about every dollar that we're spending.

Having said that, we are not going to back off the SG&A investment that we're making in key initiatives for our future growth.

Like franchising in international.

Like Banana Republic in Japan.

Like our accessories areas and hand bags in Banana Republic.

We are, needless to say, being very diligent about the day to day dollars that go out the door, but making sure that we are not waffling or moving off of the investments that we are going to make to improve our long term performance.

So with that 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.

That concludes today's Gap, Incorporated second quarter 2005 earnings release conference call.

You may now disconnect.