蓋璞 (GPS) 0 Q0 法說會逐字稿

Good afternoon ladies and gentlemen and welcome to Gap Inc. first quarter 2006 conference call. [OPERATOR INSTRUCTIONS].

The conference call and webcast are being simultaneously recorded on behalf of Gap Inc and consists of copyrighted material that may not be rerecorded, reproduced, retransmitted or rebroadcast or downloaded without 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 of your 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 like to introduce your host, Sabrina Simmons, Senior Vice President of Treasury and Investor Relations.

Sabrina.

Good morning everyone.

I would like to welcome everyone to Gap Inc.'s first quarter 2006 earnings conference call.

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

I would like to remind you that the information made available on this webcast and conference call contain forward-looking statements, including but not limited to forecasts relating to improved business performance, comparable store sales, earnings per share, pretax expenses under 123 R, free cash flow, dividend amounts, operating margin, inventory per square foot, gross interest expense, depreciation and amortization, capital expenditures, effective tax rate, store openings and closings, real estate square footage 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 can cause results to differ can be found in our annual report on Form 10(K) for the fiscal year ended January 28, 2006, investors should also consult today's press release.

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

These forward-looking statements are based on information as of May 18, 2006, and we assume no obligation to publicly update or revise our forward-looking statements even if experience or future change make it clear that any projected results expressed or implied therein there not be realized.

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

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

Joining us on the call today are CEO Paul Pressler, CFO Byron Pollitt, Gap brand President Cynthia Harriss, Old Navy President Jenny Ming and Banana Republic President Marka Hansen.

Now, I would like to turn the call over to Paul.

Thank you, Sabrina, and good afternoon.

On our fourth quarter earnings call we said the first half of the year would be challenging.

Consistent with that view, we delivered first quarter earnings generally in line with our expectations and we still expect that the second quarter will be tough.

In Q2, we will continue to invest in important areas like store payroll and marketing to build traffic going into fall, but we don't expect a financial return on this SG&A spending until the second half.

With that said, I am pleased that we are making progress in each of our brands and we look forward to seeing improvements in our product and store experience reflected in our results.

Banana Republic, as we predicted, is beginning to regain its momentum first, and we still expect that Old Navy and Gap will begin seeing improved customer response this fall.

We remain confident in our turnaround strategies underway in each of our businesses.

Today Cynthia Harriss, Jenny Ming, and Marka Hansen will provide updates on their progress.

First I will turn the call over to Byron for an overview of the financials.

Thank you, Paul.

Good afternoon.

As Paul mentioned, our original full year EPS guidance reflected a challenging first half.

Our view, especially given first quarter results, has not changed.

We expect comparable store sales to remain negative in Q2, while our investments in SG&A continue, and we begin to increase spend in important areas like store experience and marketing.

As we said on our last earnings call, we expect comps to turn modestly positive in the second half of the year.

Here is some highlights from the first quarter: Earnings per share were $0.28 and operating margin was 10.8%.

We generated $225 million in free cash flow and ended the quarter with $2.9 billion in cash and short term investments.

We nearly doubled our dividend in the quarter from $0.045 to $0.08 per share, and we repurchased $21.7 million shares at a cost of $389 million.

Since we began our share repurchase program in 2004, we have spent nearly $3.4 billion repurchasing 168 million shares.

Now please turn to slide three for a review of earnings performance.

First quarter earnings were down 17% to $242 million, or $0.28 per share; including $2 million of expense related to the adoption of 123 R., not incurred last year.

First quarter weighted-average diluted shares were $861 million.

The first quarter effective tax rate was 38.6%, 90 basis points above the prior year rate.

Recall that the prior year first quarter effective tax rate reflected favorable tax settlements primarily from the resolution of state audits.

Please turn to slide four, sales performance.

First quarter total sales were $3.4 billion, down 5% versus last year.

On line sales continued to grow during the quarter, increasing 15% versus prior year.

Total Company comp sales were down 9% in the quarter.

The four percentage point spread between total sales and comp sales was driven almost entirely by new stores with on line sales contributing as well.

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

Turning to slide five, gross profit.

First quarter gross profit decreased by 7% to $1.4 billion.

Gross margin was 40.2%, down 60 basis points compared to last year, 20 basis points of this decline are from lower merchandise margins, the remainder is from the deleveraging of rent, occupancy and depreciation.

Please turn to slide six for operating expenses.

Despite a lack of television advertising at Gap brand during the quarter, overall operating expenses were about equal to last year at $1 billion; as investments in growth strategies and store experience continued.

Marketing expenses in the first quarter were down 22% to $97 million.

Turning to inventory on slide seven, we ended the first quarter with $1.9 billion in inventory, down about 1%.

Inventory per square foot was $48, down 5%.

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

First quarter capital expenditures were 91 million.

We opened 38 new stores and closed 21, ending the quarter with 3,070 stores.

Square footage increased 3%.

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

Regarding cash flow on slide nine.

Free cash flow, defined as cash from operations less capital expenditures, was an inflow of $225 million, up $112 million versus last year, driven primarily by a decrease in working capital.

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

We repurchased a total of 21.7 million shares in the first quarter at an average price of $17.91, including commissions.

And we increased our dividend to $0.08 per share in the first quarter.

Finally, we ended first quarter with $2.9 billion in cash and short term investments.

Turning to slide ten, I would like to comment on our outlook for 2006.

Regarding earnings, we are confident that our product milestones are being met.

It is our belief that with consistently improved product, together with the effect of our improving store experience and cumulative marketing efforts, we will realize a positive momentum shift in top line results in the second half of the year.

For this reason, we are maintaining our annual EPS guidance of $1.23 to $1.27.

Regarding share-based compensation expense from the adoption of 123 R., our current estimate for full year expense is about $25 million.

Given the immaterial size of this amount related to our overall SG&A spend, going forward, we will report actuals only.

Regarding operating margin, we still expect operating margin of 10 to 10.5%.

Regarding inventory, we now expect inventory per square foot at the end of the second quarter to be flat, compared to a 3% decrease last year.

Inventory per square foot at the end of the third quarter is also expected to be flat, versus a 7% decrease last year.

2006 guidance for the following items remain unchanged: Depreciation and amortization, about $535 million; gross interest expense, about $40 million; tax rate, about 39%; capital spending, about $675 million; store activity and square footage; open, about 175 store locations, closed, about 135; full year square footage to increase 1 to 2%; free cash flow, at least $900 million.

Those are the financial highlights for the first quarter.

Now I will turn it over to Cynthia.

Thank you, Byron.

Good afternoon.

On today's call I would like to share with you our progress and key strategies for 2006.

Then I will take you through how we are building momentum for fall with our upcoming product, marketing and store initiatives.

As I've discussed previously, with the objective of becoming more nimble and focused, we made the decision to align our organization and talent around three key business units, Adult, Kids, Baby, Maternity, and Body.

Our new alignment coupled with strong leaders, clear accountability and jobs that are more manageable in scope will allow to us address the unique needs of each business unit and deliver the right product and store experience for our customers.

We've made great progress by hiring strong, decisive leaders with deep merchandising and apparel industry experience to lead each of these teams.

Pam Wallack joined late last year to head up Kids Baby Maternity, and Tom Wyatt joined in March to lead GapBody: we just announced that Denise Johnston will join news June to run our Adult business, has more than 25 years of experience and recently as President and Chief Merchandising Officer for Liz Claiborne.

We also continue to make progress in our merchandising strategy which is anchored and elevated high quality casual clothing and focuses on key categories.

While summer product is still work in progress, visual merchandising for the season is improved, and features clear, compelling visuals to help clients finds what they want.

Our stores are set up as the go a to place for summer essentials like polo, graphic tees, tank tops and soft colorful hoodies to wear home from the beach.

By July 20th, our fall product will be in stores and you will see that we have taken a step forward in terms of product details and fabrication.

You will also see category shops for fall that represent what we believe in and make it easy for customers to shop denim, T-shirts, pretty activewear and our clean look.

We are beginning to ramp up our marketing in advance of fall.

What you are seeing for summer is an integrated campaign, Rock Color, which features printed adds, outdoor, direct mail, on line and radio spots.

In our top four markets, New York, Chicago, San Francisco and Los Angeles, you will see us out there with fun buzz generating promotions including our summer concert series and bus tour.

For those of you in New York we invite to you Rock Color bus as it stops in Union Square on June 5.

These events are designed to continue building momentum as we roll into the next season.

Reflecting our confidence in fall products, and our merchandising strategies, we've built a comprehensive marketing plan to inspire customers.

TV spots begin July 20, to coincide with our fall products.

They will run for a total of eight weeks versus six weeks last year.

The first TV campaign focuses on denim, one of the key categories of our merchandising strategy, with a print campaign running concurrently.

We are making progress with the instore experience and we are pleased that our customer survey results are improving.

I'm sure you've seen our windows and in store images with Rock Color inspired graphics.

They are representative of how we're refreshing windows each month to signal newness, and how we are paying greater attention to visuals and service.

It's been one year since we launched our store redesign in Denver.

We learned that elements like denim bar, larger fitting rooms, shop layouts and dark wood floors create a warmer environment that resonate well with customers.

We firmly believe that the remodel strategy is an important part of rebuilding our brand and although remodeling the entire fleet will take time, we are not standing still.

This year we will refresh our top 200 adult stores in key markets.

Customers will experience store environments with updated paint, selling fixtures, mannequins, and signage by August.

In closing, we remain confident in our long-term strategies to turn around the business and look forward to delivering more tangible proof of our progress in coming seasons.

Thank you.

Now I will turn it over to Jenny.

Thank you, Cynthia.

As I shared with you last quarter, we are focused on repositioning Old Navy in the market, anchor back specialty products at great value.

During the first quarter, we made incremental progress in improving our product, marketing and store experience.

We are offering more product that reflects our specialty repositioning and our [Pure Naturals assortment] performed well during the quarter.

However, versus our expectations, our customers' purchases were weighted toward more of our lower priced value product versus core and better.

This negatively impacted our AUR.

We know it will take time for our customers to recognize our repositioning, and drive even greater demands toward our specialty products.

While we are addressing our traffic and AUR challenges by evolving our marketing to focus more on our specialty flair and less on our commodity promoted items.

And we made some progress in March and April.

We elevated the look of our circular with more lifestyle photography and cleaner layouts, and we had a strong presence on TV with two new spots that highlighted our trend-right products.

Though we had negative traffic during the quarter, we attribute the improvement in April in part to these efforts.

Another important step to winning back our specialty customer is to improve our store experience.

Since holiday of 2005 we've been investing in more store payroll and we are pleased to report that the investment is beginning to pay off.

Our customer experience scores improved each month during the quarter in key areas like the fitting room experience, wait time for check out, and neat, clean and organized store.

We are now achieving the highest customer service ratings that we've had over the last year.

We still have more work to do but we are pleased with the progress we've made and we continue to build momentum in the second quarter.

Looking ahead, we continue to offer product that will reflect our specialty repositioning.

As we are highly confident that the strategy we are pursuing is the right one.

I'm sure many of you have seen our madras products that's in the stores now.

We are pleased with its quality and how it looks, and we are looking forward to our fall flow at the end of July.

We are also continuing with our marketing.

We will be on TV with madras campaign for the next three weeks and, of course, we will run a Memorial Day circular that feature both fashions and value with traffic-driving $5, $10, and $15 deals for the family which we reinforce with radio.

We also added a PR campaign that's incremental to last year.

This campaign is intended to generate awareness and buzz of the brand.

When we first started Old Navy, our TV adds frequently featured our mascot, Magic the Dog.

Now we are doing a special contest in search of a new mascot.

Throughout the month of May, customers enter their dogs on line, and we have already received tens of thousands of entries, and the campaign back to the new line of dog product were launched in our store in July.

So our new mascot will be announced in early August and we will feature it in our holiday TV spot.

Lastly, we will definitely be on TV with our back to school campaign at the end of July.

We are heading in the right direction, and we continue to improve our product, marketing and store experience.

Importantly, our customers are telling us that their experience in our stores has improved.

This is an important foundation to winning their frequency back.

We remain confident that we will make progress each season.

Now, I would like to turn things over to Marka.

Thank you, Jenny.

Good afternoon, everyone.

It's been awhile since I have had a chance to speak to most of you so I am going to go into a little detail.

First, I would like to set some context for my comments today.

Two years ago we experienced great success with fashion in our assortment.

However, in 2005, we pushed our product too far into fashion that was complicated and difficult for customers to shop.

As a result our traffic and sales suffered throughout 2005.

We realized this in the back half of '04, and we were able to correct our assortments starting with spring '06, and are now beginning to see improvements in our results.

While traffic continued to be challenging in the first quarter our other sales levers combined to offset some of our traffic miss, particularly in March and April.

We believed our assortments were better beginning with holiday, supported by feedback from customers and store associates, and we are pleased that these improvements are now resulting in tangible comp improvement.

We are not all the way back yet, we still have work to do, but I can share learnings with you and how those are shaping our future.

Our most important learning is that while our customers love us for fashion, they ultimately want balanced assortments, and they expect a Banana Republic filter on everything we do.

Our aesthetic is accessible luxury.

At our best, we offer elevated products that is versatile, has noticeable quality that is both approachable and sophisticated.

This aesthetic is consistent and evident in our spring line.

One of our biggest changes was to balance the fashion in our line with the more versatile range of wearable item.

Today's collection emphasizes style essentials, and has been better resonating with our customers.

For example, our assortment of versatile white shirts for women.

This collection includes everything from the classic three quarter sleeve poplin shirt, a quintessential work item, to a great tunic that that is just trimmed right.

This demonstrates our response to feedback heard last year that customers were having trouble putting outfits together in our store and they wanted to make it easier for them to build wardrobes.

So let's turn to men's.

Suiting has been great this spring, especially our increased offering of blazers.

Men's sweaters and pants have also been strong.

In particular, our go to work message has worked well.

In contrast, last year we offered a narrow range of choices.

For example, last year's woven shirts were saturated with color and focused on a going out occasion.

Today, men coming into our stores are finding product they can wear for work, casual weekends and going out.

An example of range we found in our chino offering.

We have the perfect dress chino, a boot cut chino and relax fit chino, presenting an assortment wide enough to appeal to both the conservative and fashion forward customer.

We are pleased that customers responded to these better balanced assortments during the quarter and they began to show tangible results.

Also as part of our efforts over the last two years, we have worked to grow and extend our brand.

A few years ago we began offering petites, which helped to us capture a new customer base for Banana Republic.

We now offer petites in 52 stores including five standalone stores, and are looking forward to growth opportunities with both free-standing stores and including petites in the new stores we build.

We expanded into Japan last year with four stores and it has been very successful for us.

We are very excited about this opportunity and will continue to add stores throughout Japan with about ten more planned for 2006.

We see other brand extension opportunities as well.

We have a very successful accessories business with belts, shoes and jewelry all performing well.

A great extension to this business has been handbag.

This spring we introduced a new elevated line of hand bags that extend our life style brands and response has been amazing.

We now offer beautiful day to night bags that are consistent with the marketplace and complements our apparel.

Our average price points have increased from about $65 to $175 for our new bags and we have seen great customer acceptance.

We are very excited about our newest extension, personal care, which launches this fall.

Many of you may have seen last Fridays cover story in Women's Wear Daily introducing our five new fragrances to the editorial community.

We will support the launch with new selling fixtures and a print marketing campaign.

Along with our efforts to improve our product, we have also worked on our in store experience.

We tested a comprehensive store experience in New York this spring including remerchandising our stores, visually to cut through ideas, supported by clear destination signage, fixtures to increase capacity, and elevating our window messages.

We believe the elevated experience in these stores supports the aesthetic of our product and this fall we will roll many of the most impactful ideas to all of our stores.

As we make progress on our products, we are continuing to focus on those things that will drive traffic.

Compelling advertising, PR events that generate buzz and excitement, editorial coverage and elevated store experience and new product extensions like personal care.

Setting a brand like BR, word of mouth is our most powerful traffic driver, and we intends to address that by consistently delivering amazing product each season.

Thank you.

Now I will turn it back over to Paul.

Thank you, Marka.

As you heard from our Brand Presidents today the teams are making progress on their turnaround plans.

Across the business, in addition to focusing on product, we are working to drive our traffic.

We are implementing marketing plans for summer to excite our customers and we are making additional investments for fall including Gap brand television back on television that reflects our growing confidence in our product offering and visual merchandising.

Most important we are confident in the strategic direction of each of our brands.

If Gap were focusing on re-establishing the brands iconic positioning through key categories, improved quality and style.

Cynthia has built a strong, seasoned leadership team that is driving this strategy through design and merchandising, store experience and marketing.

Old Navy's hybrid positioning as a value and specialty player differentiates the brand in the marketplace.

We believe we have the right strategy to win back our trade down customer through more specialty product and an improved store experience while still providing the value they expect from Old Navy.

Banana Republic has maintained its compelling, accessible luxury positioning as the team has rebalanced the assortment with approachable fashion and versatile key items.

We will continue to extends the brand with new product lines as we have with the successful launch of petites and hand bags.

While improving the core business is clearly our top priority, we will also continue to pursue our growth initiatives.

We are opening stores and extending our existing brands for new lines like Banana Republic's Personal Care.

We are expanding internationally, which includes opening new stores in Europe and Japan and executing our franchise agreements.

Finally we are growing our newest brands.

We are encouraged by customer response to Forth & Towne reflected in strong product acceptance, high fitting room usage and feedback that customers appreciate exceptional service.

Confident in our positioning, we are excited about our growth prospects.

The team is focused on building brand awareness as we prepare to open about ten new stores this fall in Atlanta, Houston, Los Angeles, San Francisco, and Seattle markets.

In closing, I want to recognize our teams who have been working with relentless commitment making the necessary changes to turnaround our business results.

Confident in our direction, we will continue driving execution, make progress each season and create value for our shareholders.

Thank you.

That concludes our prepared remarks.

We will now open up the call to questions.

Please limit your questions to one each.

[OPERATOR INSTRUCTIONS].

Your first question comes from Margaret Mager with Goldman Sachs.

Margaret, your line is open.

Okay.

Thank you.

I wanted to ask about your view on inventory per square foot and that you are looking at it to be flat in the next two quarters.

Is that a sign that at this point the inventory is really where it needs to be and you would be at peril to take it much lower because of the negative impact of not having enough inventory in the store?

Just what is the message here with the inventory per square foot outlook?

Thanks.

This is Byron, let me respond.

So the guidance for end of Q2 and end of Q3 are both flat.

Recall that for the same period last year Q2 is up against a minus three.

Q3 is up against a minus seven.

Clearly, we have been very prudent about managing our inventory levels during the past year.

But as we become more confident in our product, the merchants are at liberty to buy deep where they have confidence, and as we move into the second half you should interpret that as very, from our vantage point, a very appropriate level of inventory given how we were postured last year and with our growing confidence in the product outlook for the second half.

Thanks.

Your next question comes from Brian Tunick with JP Morgan.

Thanks, we were hoping maybe the three brands president's could update us on lead times, speed to market and maybe thoughts on some sourcing in the U.S.

And then maybe Paul could comment between Old Navy and Gap, which one do you think is closer to showing evidence of the turn?

Why don't I start, this is Jenny.

We still in some of our key categories like graphics and knits and denim, we are able to go from eight to a twelve-week cycle.

And we are able to, as we stay more experienced in traction we are able to do more and more quantity.

Those are our key categories that we really can chase back into.

And we are keeping them open and a little bit more liquid as we go into every season.

This is Cynthia, I would say for Gap brand, we've been spending this past year really as I said before, getting our team in place, getting our talent in place, getting the aesthetic of the product right.

At the same token knowing that speed is essential for us.

We have examples where we have fast tracked products predominantly in knits, where just as Jenny said, we can cut down the time considerably.

But this work of speed to market will be a big part of our endeavor now that we have our team in place.

This Marka at Banana.

We have done a couple of things.

One is we've been leaving some dollars open for to us trace trends, for us it looks like a big reorder in white shirts this season when they were successful as well doing some things like consolidating our denim base into fewer fabrics and using some local production in Los Angeles to chase into our premium denim and being more smart about cutting off things that aren't working and refocusing those into things that are working.

Brian, for your last question, first I think it's really important to note that all of our teams, production teams or design teams or merchant teams they are out and working with our vendors so they are not only gaining speed and access but visibility to innovation, what's happening, and that's been a fundamental shift for the businesses across the board.

As to which one is turning or the pace of the turn between Gap and Old Navy I think I just want to remind you that both are in a little bit of a different track.

Clearly we had said for Gap that the new teams, the new vision was going to be really first expressed as part of the fall presentation.

Both from an in-store standpoint, the merchandise categories and the product.

Keep in mind that Cynthia's new team and design team, fall is really their first expression so they have a little bit different trajectory in terms of expectations.

Jenny has been working the specialty redirection now as part of the first half in each quarter and we are seeing incremental improvement so we expect it to continue to improve.

Needless to say, most of that is going to hit as we bring all of these elements together for the second half.

So that are they are a little bit on different paths but we certainly expect the second half to be better for both.

Your next question comes from Stacy Pak with Prudential Equity.

Thanks.

My question is for Jenny, surprise, surprise.

Jenny, I guess a couple of things.

One is, what you said about the April improvement in traffic, part of it being due to what you are doing in store in some of the marketing.

Does that suggest that you are seeing a continuation of good traffic in May?

And then the real question I have is on the Neutral or Pure Naturals Collection, what's left of it in the store I'm still not seeing marked down, and I was wondering whether there has been a change in your mark down approach, whether you are seeing the same kind of success on the madras collection with regard to recession on full price purchases?

And if you could kind of just rate or critique Old Navy's execution of summer overall in your opinion on everything, product, advertising, stores, and talk about some of the other comp levers?

I mean we've all seen the traffic.

But what about conversion and UPT and AUR, and where Old Navy is or isn't achieving the progress you would like, that would be helpful.

First of all, you and I could have a fifteen-minute conversation.

You can talk for 15, I've got time.

But the traffic, actually I think we can't forget that April is also Easter shift although I was encouraged to see some improvement.

But I think for us for summer, we have I said earlier we have our madras TV is on now for the next three weeks and we have a strong circular that will drop this weekend for our Memorial period and then of course we have Magic.

So we have some strong marketing effort and I'm hoping that will drive a lot better traffic.

But regarding our Pure Natural and madras, Pure Natural was always meant to stay on to really as a backdrop to madras because they actually look great together.

So what you should see on floor is madras as more as a backdrop, I mean Pure Natural as more in the backdrop and madras sitting in the forefront.

They look great together and it's meant to be that way.

So it's a flow from summer one into summer two and they should live together.

So.

And as I said really for us the levers that's been really challenging is the retracking and AUR, And it's really about that.

So have you seen, I guess two follow-ups, have you seen any improvement in conversion and shouldn't we have seen the Pure Naturals collection marked down by now?

That's the part that sort of surprised me.

Actually conversion has been pretty steady and where we have seen some improvement is the UPT That's the driver from selling a little bit more value than we anticipated.

So our UPT has been strong.

Great.

And that was that was one long question, operator, next question.

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

Good afternoon.

I guess this question is for Byron, one there was change of the inventory time particular from end of Q2 it went from negative to flat, if you could confirm that, is there a reason for that?

And second, I know you don't project SG&A, but can you tell us, think about it as we move into the back half of the year what is going to change sequentially with marketing coming, can you just give us a sense of what will change year over year sequentially, just help to us think about that line?

Sure.

So let's reset first of Q2 inventory.

If I understood your question, the original guidance we had was low negative single digits and we've moved it to flat, for end of Q2.

This was our first guidance for Q3.

SG&A.

So let me elevate and give you all a perspective on how to think about SG&A for Q2 and through the balance of the year.

So, first, we are in the midst of a turnaround and we do feel it is appropriate to spend in some of the critical SG&A categories in order to accelerate our recovery.

Therefore, as we enter Q2, you can expect to see a building investment in store labor, in our existing stores in order to enhance store experience, which is a fundamental lever in our turnaround approach.

We are adding new stores, which boost payroll and store expense through the balance of the year.

In Q2, we will begin to ramp up marketing which will also continue through the balance of the year.

And we will at the same time continue to invest in our growth strategies.

Forth & Towne, the expansion of Banana Republic in Japan, launch of our franchise business, localization of our international management teams and the upgrading of our Internet platforms.

We don't expect that all of these costs will be offset with cuts in other places.

Though this is a deliberate approach.

Your next question comes from Jeff Black with Lehman Brothers.

Thank you very much.

I guess I have a question for Byron as well, on the inventory side, let me continue with that.

Where are the bulk of the increases going by division?

In other words, is Gap getting a little more inventory than Old Navy, et cetera, as you look at moving to flat?

And secondly how do you feel about the clearance inventory as you start making your transition into the next season?

Thanks a lot.

First of all, recall that our guidance was from low, for Q2, is moving from low single digits negative to flat.

In the big scheme of things, that's a pretty small change in inventory.

Consider it across the brands, growing confidence in our position, lapping a negative in the prior year.

So I would just put this in perspective.

It's a small increase.

With regards to clearing.

We are committed to continue to manage inventory levels season by season and to clear liable inventory.

We are entering Q2 with an overall inventory level in line with what we hope to achieve but with a bit more spring still to clear.

So when we said on an earlier sales call we expected to have some margin pressure in the second quarter, this was related to entering into the quarter with a bit more spring than we had planned and we do expect to move decisively to clear it in this quarter.

Okay.

Thanks very much.

Good luck.

Your next question comes from Janet Kloppenburg with JJK Research.

Good afternoon.

I had a question for Jenny and Cynthia.

Jenny, I wonder if you could talk a little bit about, it seems like this change in purchasing pattern that began in April with the customer focusing more on the value, I thought before the customer really liked the fashion, it's just that you didn't have enough investment in the fashion category.

Maybe if you could talk about your analysis of that change.

And Cynthia, I was hoping you could tell us what metrics you are using to gain confidence in the Gap's fall line and perhaps categories that are performing well now that you are feeding back into or some test projects that you run that give you confidence that the business will turn at that time.

Thank you.

Actually our fashion product especially the Pure Natural actually has gone well, and of course as I said the value products are better than our expectations.

Where I think it's really hurting our business is our core product such as categories like denim, that's the piece that is not hitting our plan.

It's not the fashion, the Pure Natural, all of that has been doing well.

So what will you do about that, Jenny?

What actions have you taken?

On denim, obviously it's a very important category for us.

So going into fall it will continue to be an important category so we have actually revamped our entire assortment for fall, especially in our women's denim for spring and summer, it's a little bit trickier, it has embroidery, embellishment, how we look at going forward is better fabric, cleaner wash, a little bit more elevated, more sophisticated.

That's what will you see for fall.

And other core categories that you saw a change in purchasing pattern?

What do you mean by that?

Besides denim?

I mean you emphasized this change in pattern in April.

It's not really a change in pattern.

Actually our value piece has been selling continuously selling.

Where I want to really assure is that our specialty product actually is doing very well.

So for us it really is about marketing more of our specialty so that we can win back our trade down customer from before.

So it's also looking at rebounding our core product.

We make sure that it is elevated a little bit more specialty.

I understand.

Thank you.

Hello, this is Cynthia.

Hi, Cynthia.

Hi.

Your question about why we have that level of confidence in fall really goes back to the overall strategy.

We have been consistently saying that we are focusing on our four key categories.

Those are categories that Gap has historically been known for.

That's where we've had the greatest momentum.

We have put our attention to really ensuring that we have the aesthetics.

This is a good match to what is Gap.

That clean, confident, we are very casual, it's a very casual aesthetic.

But equally important has been adding back in great attention to the quality and detail that really we think are essential to having the full assortment.

And lastly was that we have done surveys and focus groups with customers that give us some early indicators of positive uptick.

Thank you.

Your next question comes from with Paul Lejuez with Credit Suisse First Boston.

Thanks guys.

Can you give more color on merchandise margin by division, perhaps not specifically in basis points but maybe directionally?

And you did say that the first quarter was essentially in line, was just wondering about the different pieces of the puzzle and how they performed relative to your expectation, top line, gross margin?

Thanks.

Byron, so let me just respond at a high level since we don't typically talk to margins quite at the level you're asking for.

But as we look, as we hindsight the first quarter, BR is clearly out of the gates first and so with them performing well, the shortfall in margin is more in the two bigger brands, Gap and Old Navy.

And with the under performing of the AUR,

in Old Navy, we have a bit more of a gap to close with regards to that division.

In connection with the other expenses and with the top line results we said that we expected the first half to be challenging, first quarter was and there are no real cull outs here.

Roughly it performed in line with our expectations.

Thanks, guys, good luck.

Your next question comes from Barbara Wyckoff with Buckingham Research.

Hi, Jenny and everybody.

I have a question I guess for Cynthia.

You've made some changes which you talked about a little bit on the merchandising priorities.

Excluding that Denise Johnston's job doesn't start yet when will we start to see the fruits of the labors in kids and body and when will you start to share with us your learnings?

And have you made any strategic changes in processes in these two businesses outside of the looking at the lead time kinds of things?

Are they doing anything very differently?

Well, first of all, I would say right now we are experiencing a pretty solid business in our Kids Baby Maternity as well as in our Body business which is a nice foundation for to us billed upon.

Our two leaders now being in place, I think what we are seeing is just the fact of their seasoned leadership giving these teams good direction for strong in season management.

Obviously in the product it will take a period of time before you see the influence on the overall product assortment.

But as I've said in previous conversations, is this was more than just getting leadership.

It's really aligning our teams against working categories, philosophy more nimble, more quick, more decisive.

So I would say bottom line with that is we've got the leadership and the team in place.

We've got a solid business to really start to build upon and in the coming months this will really start to take hold.

Okay.

Thank you.

Your next question comes from Gabrielle Kivitz with Deutsche Bank.

Good afternoon.

A question for Cynthia.

Are you changing anything within the organization to make sure that the product offering is trend relevant and that you are capitalizing on the right trends in the right seasons?

How is the organization adapting to ensure this happens?

For instance, how do you make sure that you are not too khaki focused in a year when denim is the dominant bottom, or you have enough dresses in the offering in a season when dresses are on fire in the industry?

And a second question, also for Cynthia could you talk about the mark down strategy at the Gap division and how that changed in the first quarter?

It looked like you think you may have had improved profitability in the first quarter but are you pleased with how the strategy is working and will you continue it going forward?

Thank you.

So a couple of things.

This overall shift in our organizational structure is one of the elements to really accommodate us having the right assortment in our inventory.

First of all it's by having focused leadership against a competitive set.

And against each one of these businesses for the not only the consumer but in a competitive sense allowing us to really be more focused and on target the best.

One is about scope and focus.

The second thing is with the fact that I will use the adult business as a place holder for what we are doing in all the businesses by having the key categories, then setting it up in shops versus having a collection base really is requiring us to be very tuned into what is the emerging trends within those categories as well as you will see in fall when the store set up in the shops it does allow us to keep feeding into new current product as it emerges as opposed to a previous times where we had more dramatic seasonal shift or slip with that.

So I would say there are multiple aspects of it that are set up to accommodate that and then most importantly is really just the attention and shift on the way we work in terms of our processes in working closely between design merchants, production and being speedy in back to market.

On the mark down strategy we really haven't changed anything and we continue to use the tools like profit logic to help make us and be clear with this and overall we are clearing our inventory in an appropriate fashion.

Great.

Thank you.

Your next question comes from Kimberly Greenberger with Citigroup.

Thank you.

I was hoping each of the brands Presidents could talk about the risks that they see, the opportunities for different comps positive in the second half of the year if that happened if you had to take a look at it and say the risks that it is positive is X., what would that be by brand?

Thanks.

This is Paul, I think maybe I'll talk to it because it's needless to say the teams are very confident in our strategies for fall.

And every single day we are focusing on what do we need to do to improve our business today and tomorrow.

So we just, we have the confidence.

We really believe in our strategies.

We are beginning to see from our internal milestones some success associated with that and we just have to believe and be committed and be confident in what we are doing.

We can't control the consumer in terms of the season in which they come back.

All we can do is to make sure that we have the right products, we have compelling markets, we have compelling store experience and as we've said we are going to invest in this second quarter to help ensure that we are telling the consumer why we believe in what we are doing and we are just going to fight it every day and make sure that we are winning back share. but I just think we are confident.

We believe in our product.

We believe in our strategies.

We are going to fight every single day at whatever level it takes to make sure we win back those customers' confidence.

Your next question comes from Jennifer Black with Jennifer Black and Associates.

Hi, good afternoon.

I just wondered if you could refresh us about who the target Gap customer is, if you could describe the demographic that would be very helpful.

Hi, this is Cynthia.

So the target customer, and this is just a reiteration of what we've been saying all along is really that 18 to 35 year old customer with really the sweet spot being in the mid to later 20s with it.

It's a young adult.

We as a broad brand that is focused and especially I think you will see more so in fall on the really key core categories give us the liberty to be able to halo a little younger and a little older along with that.

Operator, we have time for two more questions.

Your next question comes from Dana Telsey with Telsey Advisory Group.

Good afternoon, everyone.

Can you please talk a little bit about if you think about each brand, Old Navy, Gap and Banana, store remodeling and store presentation, how is that changing for the fall given the product changes that's coming back.

What do you expect to see in the in-store environment to accompany the changes?

Thank you.

Maybe I will do it broadly and Cynthia may want to pick up.

Our strategy for in-store experience is unique for each one of the brands.

First and foremost for Gap we are very focused on continuing to roll-out our remodels.

The remodels generally speaking, as you saw from the Denver experience.

We believe strongly that that's a critical element for the overall repositioning of the brand and its success.

And then within Gap as well, Cynthia had mentioned, since that's going to take some time we are making sure that we are communicating our merchandise strategies to our customers by reorienting our merchandising visuals around these key classifications.

So you are going to see a shift in that, and then you are going to see some marketing elements that we think will make it a clear sign to the customer that something has changed.

Jenny has already been putting into work stronger visual presentation both on the standard signs but also making sure that there is compelling a specialty sensibility to it, so new signage that's going up in our stores, the way she's reworking the front and center and the way she's reworking her main streets in terms of accessories.

Of course for Banana Republic you are seeing it already reflected in the stores but you are also seeing it as Marka continues to make sure that each one of the classifications we really believe in whether it's the chinos and white shirting, are very clear and very compelling to our consumer and that we continue to push on Banana Republic's elevation whether we do it through product introduction like hands bags and later this fall through the introduction of personal care.

Thank you.

Your next question comes from Todd Slater with Lazard Capital Markets.

Thanks very much.

Just a quick question on the SG&A side given the investments made there.

If you could just tell us what the leverage point now is on comps or if that's changed at all.

So, it's Byron.

It is, there is no formulaic relationship yet on leveraging SG&A and comps.

As you can appreciate, we are in a turnaround and it's a little painful but we do feel it is absolutely appropriate for us to spend in certain key categories like store labor, like marketing, both of which hit SG&A not only as a critical component of our turnaround but to help accelerate the rate of turnaround and that of course causes the deleverage in a way that's not normalized.

And at the same time, we are now beginning to add stores net of our closures, so that adds to SG&A particularly store payroll.

And then we have the launch of a number of growth strategies for our future which are in a non-normalized state of incubation, including Forth & Towne, BR in Japan, franchising, the movement of management teams to local in-country business teams, and the investments we are making in the Internet.

So in short, we've got a lot of activity occurring in SG&A in a way that's not normalized.

And so it would be very premature at this point to describe any sort of relationship between comp and SG&A leveraging.

Fair enough.

We look forward to the day, though, that we can do that.

So do we.

Thank you.

So I would like to thank everyone for joining us other call today.

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

Thanks everyone.

Ladies and gentlemen, we do appreciate your joining us today for our Gap Inc. conference call.

This call is now concluded and you may now disconnect.