蓋璞 (GPS) 2006 Q3 法說會逐字稿

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

At this time, all participants are on a listen-only mode. [OPERATOR INSTRUCTIONS]

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

Investor Relations at 415-427-2175.

I would now like to introduce your host, Sabrina Simmons, Senior Vice President Corporate Finance.

Please go ahead, ma'am.

Good afternoon, everyone.

I'd like to welcome you to Gap Inc.'s third quarter 2006 earnings conference call.

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

I'd like to remind you that the information made available on this webcast and conference call contains certain forward-looking statements including but not limited to forecasts relating to earnings per share, free cash flow, operating margin, inventory per square foot, interest expense, depreciation and amortization, capital expenditures, effective tax rate, store openings and closings, real estate square footage, market and product category growth, and excess cash usage, as well as other statements that express our expectations, anticipations, beliefs, estimates, intentions, plans and forecasts.

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

Information regarding factors that could cause results to differ can be found in our Annual Report on Form 10-K for the fiscal year ended January 28, 2006.

Investors should also consultant our quarterly report on Form 10-Q for the quarter ended July 29, 2006 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 November 16, 2006 and we assume no obligation to publicly update or revise our forward-looking statements, even if experience or future changes make it clear that any projected results expressed or implied therein will not be realized.

This presentation includes non-Generally Accepted Accounting Principal 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, Banana Republic President, Marka Hansen and Gap Brand President, Cynthia Harriss

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

Good afternoon.

Our third quarter results reflect that each brand is at a different stage in its turnaround.

We were pleased with the solid performance at Banana Republic and continued progress at Gap, but Old Navy's third quarter results were disappointing.

Although we believe we've made improvements in Old Navy's product and store experience over the past several months, traffic trends unexpectedly deteriorated in October, making it difficult to clear fall product.

I'll share further details on Old Navy later in the call.

At Gap, we continue to make progress during the third quarter, although we'd like to see top line results improve faster.

Each month this quarter our comp trend has moved in the right direction.

We're creating great buzz in the market with our Audrey and Red campaigns, but we know it will take several seasons of compelling messaging and product to rebuild our traffic.

Most importantly, Cynthia has laid the groundwork for Gap's long-term success, setting solid strategies and hiring strong talent to lead the execution.

At Banana Republic, I'm pleased that we reported three months of positive comps while continuing to achieve healthy improvements in margins.

Customers have responded positively to our assortments which the team has balanced with both elevated fashion and versatile essentials.

Building on Banana Republic's unique, accessible luxury positioning, we will continue to expand the brand into new product categories.

As we look at our third quarter performance and November results so far, Old Navy's business continues to be challenging month-to-date and momentum at Gap Brand is slower than we expected.

Accordingly, we are lowering our earnings guidance for the year.

I'll turn the call over to Byron to provide more details on this and to review our financials.

Thank you, Paul, and good afternoon.

As Paul said, though we were pleased with performance at Banana Republic and progress at Gap Brand during the third quarter, business at Old Navy remained challenging.

Today I will review third quarter results and then walk you through guidance for fiscal 2006.

First, Q3 results Net earnings were $189 million, or $0.23 per share.

Gross margin increased 210 basis points to 37.4%.

We ended the quarter with $2.4 billion in total cash and investments.

We increased our quarterly dividend to $0.08 per share.

And finally, as of November 15th, we have utilized a total of $344 million of our $750 million share repurchase authorization and have repurchased 20 million shares of which 16 million shares were repurchased during the third quarter.

For webcast participants, please turn to Slide 3.

Third quarter earnings were $189 million, or $0.23 per share compared to $212 million, or $0.24 per share last year.

As stated in our October sales release, the tax rate benefited from an adjustment related to a tax treaty resolution that was originally booked in January of fiscal 2005.

Therefore, our third quarter effective tax rate was 35.4%, 410 basis points below the prior year.

Third quarter weighted average diluted shares were 832 million.

Please turn to Slide 4, sales performance.

Total Gap Inc. sales in the third quarter were $3.9 billion, flat to last year.

Gap Inc. comp store sales decreased 5% in the third quarter, compared to a negative 7 in the third quarter last year.

The 5 percentage point positive spread between total sales and comp sales was driven primarily by new stores and online.

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

Turning now to gross profit on Slide 5.

Gross margin was 37.4%, up 210 basis points from last year, with 20 basis points from leverage on rent, occupancy and depreciation, and 190 basis points from higher merchandise margins, of which 60 basis points were related to the impact of our reclassification of sourcing costs from operating expenses to cost of goods sold last year.

A word of further explanation: Last year during the third quarter, we made a $30 million entry to reclassify certain sourcing costs from operating expenses to cost of goods sold.

$20 million of that year-to-date catch-up entry was related to costs incurred in the first and second quarter.

As a result of this catch-up, last year's cost of goods sold were higher and operating expenses were lower by about $20 million.

Turning now to operating expenses on Slide 6.

Third quarter operating expenses were $1.2 billion, up 15% over prior year.

When considering this year-over-year increase, keep in mind that expenses last year were lowered by $20 million as I just discussed.

In addition, third quarter operating expenses increased over prior year due to the following investment: Incremental payroll associated with a net increase of 40 new stores, an additional $50 million of marketing in the quarter related to incremental campaigns across all the divisions, particularly Old Navy and Gap.

Total marketing expenses in third quarter were $202 million, up 33% from last year.

These investments are critical to driving our turnaround.

We expect them on a cumulative basis over time to help communicate the relevancy of our brands and drive quality traffic to our stores.

And we continue to invest in our growth initiatives, Forth and Towne, international, franchise, and Piperlime.

Turning to inventory on Slide 7.

Inventory per square foot at the end of the third quarter was $64, flat to prior year.

We ended third quarter with $2.6 billion in inventory.

Turning to Slide 8 for detail on capital expenditures and store count.

Year-to-date, capital expenditures were $406 million compared to $448 million last year.

Year-to-date we have opened 160 stores and closed 56.

Square footage is up 2% over third quarter last year.

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

Turning to Slide 9 for detail on free cash flow.

Year-to-date free cash flow, defined as cash from operations less capital expenditures, was an inflow of $214 million compared to an outflow of $120 million last year, driven by reductions in working capital.

A Reg G reconciliation of free cash flow can be found in our press release.

At the end of the third quarter, we had total cash and investments of $2.4 billion.

Please turn to Slide 10 for guidance covering the remainder of the year.

Given the deceleration of momentum at Old Navy in October, which has continued into November, coupled with a slower turnaround pace at Gap Brand than was assumed in previous guidance, we are revising our outlook for the remainder of the year.

Earnings per share We now expect annual EPS for fiscal 2006 to be $1.01 to $1.06.

Operating margin: We now expect operating margins to be about 8%.

Capital expenditures: We now expect capital expenditures for the year of $625 million, $50 million less than prior guidance.

Regarding inventory, we still expect inventory per square foot at the end of the fourth quarter to be up in the low single digits versus an 11% decrease last year.

We expect inventory per square foot at the end of the first quarter 2007 to be flat versus a 5% decrease in the first quarter of 2006.

Guidance for the following areas has not changed: depreciation and amortization, about $535 million; interest expense, about $40 million; tax rate, about 39%; free cash flow, at least $800 million; store count and square footage, we expect to open about 190 store locations and close about 125 stores; square footage is expected to increase 2 to 3%.

And finally, a word on cash balances.

To support the normal operating requirements of our business and adequately withstand a prolonged downturn like that experienced in 2001 and 2002, we originally established a minimum cash target of $2 billion with an expectation that this amount would come down as we demonstrated greater discipline in managing our cash flows.

Despite several quarters of challenging top line results, we have delivered healthy free cash flow.

Because of this, we are now comfortable reducing our minimum cash target to $1.5 billion and we will continue to revisit this target periodically.

We plan to deploy excess cash according to the same three priorities we have previously outlined.

First, investments in the business; second, increasing our dividend; and third, share repurchases.

Thank you.

Now I'll turn it over to Marka.

Thank you, Byron, and good afternoon, everyone.

When I last spoke to you on the first quarter earning's call, I shared an important lesson our team had learned the past year.

That customers love us for our fashion point of view, but they expect to find versatile wardrobe builders in addition to the latest fashion trends.

We have been sure to reflect this balance in everything we do from our product assortments and in-store shopping experience to our windows, direct mail, and print marketing campaign.

Of course, it all begins with product.

In 2005 we worked hard on rebalancing our assortments to include great elevated fashion along with high-quality style essentials that could be worn to work, out at night, or on weekends.

By holiday of 2005, we all believe that the assortments had achieved the balance that was right for the brand.

At the time of the Q1 call, we were beginning to see signs that customers were responding.

This progress has not only continued but has resulted in positive sales comps and healthy margins for the past three months in a row.

This fall, women responded very well to knit dressing, classic and feminine woven shirts and suitings.

She also completed her wardrobe with our accessories, such as elevated handbags, the perfect belt and trend right jewelry.

For holiday we've positioned Banana Republic as the destination to meet all of her holiday occasions.

We are all about affordable luxury.

Great items that you can wear to work, to an office party, or out at night.

We are also offering a wide range of covetable gifts, both for yourself and for others.

From leather accessories to cozy sweaters featuring cashmere, alpaca, and [inaudible] as well as our essential sweaters like merino.

Our men's business continues to gain momentum.

Both the traditional and fashion forward customer have returned to Banana Republic to update their wardrobe with product ranging from our new chinos to sweaters to suiting and tailored blazers.

Similar to our women's holiday assortment, we have versatile product to help our guy transition smoothly from what to wear on the weekend, whether denim or chino to casual go-to-work and our already-established suiting business.

This holiday in addition to these style essentials, we're really excited about sweaters from our foundational merino and silk cashmere blends all the way to ultra luxe cashmere.

In addition to rebalancing our assortments, we also focused on improving the in-store experience and marketing.

After testing a wide range of visual elements in New York this spring, we rolled out the best of these ideas to the rest of our stores, including clear destination signage such as denim or chino, updated fixtures that allowed for more capacity, technical displays, and new propping and window enhancements to elevate the shopping experience.

We also updated our marketing imagery to clearly communicate the brand position with Banana-appropriate fashion items like the pencil skirt, which you should have seen featured in our fall campaign.

For holiday, we'll be featuring our sweaters, accessories, and holiday dressing.

Importantly, while our focus has been on the base business, we continue to develop and execute on our growth initiatives.

For example, we continue to expand petites and now carry petites in 85 stores, including five standalones.

In fall of 2005, we opened our first Banana Republic store in Japan and by year-end 2006, we'll have 14 stores.

We launched our elevated handbag line in the fall of 2005 and continue to expand our accessories offering with small leather goods, hair accessories and out-of-case jewelry.

As I'm sure many of you have seen, we launched personal care in September with five fragrances, elevated packaging, full in-store fixtures, and a dedicated ad campaign.

All of these initiatives are performing very well for us.

We continue to extend our brands through our latest venture, eyewear, which we just announced yesterday.

We have established a licensing partnership with Safilo, a leader in the eyewear industry, to sell Banana Republic sunglasses in our stores as well as in Safilo's wholly owned solstice sunglass stores beginning at the back half of 2007.

Additionally, Banana Republic eyewear will be sold through independent opticians.

This partnership is very exciting for us because it enables us to extend our brands through a new channel and engage in the $7 billion eyewear, frame and sunglass market.

I'm very pleased with the progress our team has made by staying committed to our strategies.

We are now seeing tangible results in our efforts.

We know that in order to win we must remain relentlessly focused on creating amazing product offered in a compelling store environment.

Thank you.

And now I'll turn it over to Cynthia.

Thank you, Marka, and good afternoon.

On today's call, I'll review the progress Gap Brand has made turning around the business and highlight specific accomplishments across each of the business units.

I will close with a key focus for holidays.

As you know, this year we've been working hard to turnaround the business, adopting a long-term plan with clear strategies to improve product, store environment, and marketing.

Today, we are executing against the plan with the right talent leading each of the business units and as a result, we're seeing good traction, especially at Body and Baby.

While progress remains slow in adult, we have strategies in place to strengthen the business.

We remain confident in our ability to win back customers over time.

In the third quarter, we saw positive indicators across the brand that validate our long-term strategy and encourage us to stay the course while making appropriate corrections along the way.

First, comp sales improved each month this quarter.

Second, customer experience scores are up significantly from last year with customers reporting they feel more welcome in our stores, attended to by helpful employees and they appreciate the neat and organized store environment.

And third, we have generated strong buzz and exposure with our marketing campaign.

I'd like to share some specific accomplishments in each of the business units.

Under the leadership of Tom Wyatt, we are seeing solid performance in creating strong momentum in our Body business.

As a reminder, Tom joined us nine months ago to head up Gap Body.

A veteran leader with more than 30 years experience, including 25 in the intimate apparel industry, Tom's expertise has been instrumental in creating a long-term strategy that positions the business for growth.

The combined foundation, lounge, and swimwear business is a $20 billion market, which we believe represents a tremendous growth opportunity for Gap Body.

While we plan to share more details in coming months, here's some highlights of Tom's strategy to capture the growth potential.

First, we are positioning the brand to embody a playful, emotionally essential aesthetic that will empower our customer to celebrate her unique and individual style.

Second, in addition to continued focus on key items of bras, panties, sleep, loungewear, swim, and sport, we will refocus our efforts around the category of personal care next year.

Equally important, we will distinguish Gap Body in the marketplace by creating a compelling new store experience.

Two weeks ago we unveiled the new store design in Mission Viejo, California and the Old Orchard Center near Chicago.

Because shopping for intimates is inherently different and more personal than shopping for apparel, these stores are transformed to create an intimate boutique-like experience with distinct rooms, soft colors, unique fixtures and decor.

We're very pleased with the early positive feedback and will share more about our strategy in the coming year.

Pam Wallace joined the team 11 months ago to lead our Kids, Baby, and Maternity business.

Pam is a proven merchant and seasoned leader with more than 25 years experience in these categories.

Our positive momentum, especially in Baby, is a reflection of Pam's dedicated leadership and strategic influence to position the business as mom's favorite place to shop in the mall.

We continue to offer exquisite product in Baby Gap and Gap Kids in a compelling range of comfortable, everyday clothes, as well as enhanced options in the premium assortment.

New categories that are resonating well with customers include our everyday playwear for toddler girls and layette collection in newborn.

In addition, we are enhancing our in-store experience with innovative fixtures that provide more efficient access to our broader assortment.

Denise Johnston joined the team in June of this year as the President of Gap adult.

She's a seasoned merchant [inaudible] leader with more than 25 years experience with major retail and wholesale companies.

In her five months with the Company, Denise has been working closely with the teams to bring our new product categories to life, while developing tactical strategies for upcoming seasons.

Our shop-in-stop concept, focused on key categories, was first presented in-store in late July and while we're anxious for stronger traction, we are encouraged by indicators of positive progress.

In women's, we're especially pleased with the momentum in the Clean Shop, which was fueled by the skinny blank pant, Audrey three-quarter sleeve knit turtleneck, and the V-neck boyfriend cut in cashmere sweater.

We've also success in shoes, particularly the assortment in ballet flats, and we're encouraged by recent Gallup Poll results indicating our efforts to reconnect with core target customer segment, women age 18 to 34, are showing positive results.

Our men's business continues to be challenging.

We are working to add more newness across the board and to make deeper investment in the Clean Shop, which is performing well.

Denim also continues to be a difficult category.

We're in the midst of a two-month test to help us explore the right fit, fabric, and wash of our five-pocket denim moving forward.

As we continue to position our business units for success and execute on individual strategies, we also remain steadfast in our commitment to provide exceptional in-store environments and inspiring marketing.

Our dedication to an up to date and compelling in-store environment continues with fleet remodel.

We will have approximately 100 stores in the new design by the end of the year and will ramp-up that effort in 2007 remodeling 75 to 100 additional stores.

In addition, our stores will be continually refreshed with dynamic in-store marketing and windows, seasonal enhancements, and dedicated visual specialists.

In marketing, we are focused on inspiring campaigns which invite customers back into our stores with fresh messages each month.

We know it takes time and consistent cumulative messaging to shift consumer behavior.

Our objective is to steadily build brand awareness by focusing on key iconic products in a culturally relevant and entertaining manner.

In September, we celebrated Gap's iconic skinny blank pant with the "Keep It Simple" marketing campaign, the innovative TV spot featuring timeless style icon, Audrey Hepburn, generated great PR buzz.

As a result, our skinny black pant performed well while we also saw an encouraging halo effect in other areas of our women's business.

In mid-October, we launched Gap Product Red in North America, as an inaugural partner in the global initiative founded by Bob and Bobby Shriver to help eliminate AIDS in Africa.

We're excited about how Product Red is connecting with our customers on a deeply personal level.

We've heard from customers and employees across the country how proud they are to support this meaningful cause by purchasing Gap Product Red.

Throughout our five-year commitment we'll carry a collection in our stores each season and evaluate the opportunities to feature Product Red in our marketing and PR campaign.

Overall, we're encouraged with the progress in the third quarter and are confident in our strategies moving forward.

Gap brand will continue to focus on delivering exquisite product, creating a compelling store environment and inviting customers back into our stores in innovative and unique ways.

Our Q4 holiday campaign launched today with the tag line, "Pease, Love, Gap" and celebrates the unspoken emotion of the season with compelling images of warmth and family presented in a very culturally relevant manner with the TV spot bringing our holiday message to life with the iconic music and dance which is the spirit of Gap.

A variety of products for gifts and self-purchase make up the holiday collection, including hoodies for the whole family, sweaters, and a wide range of accessories.

In closing, we remain confident in our long-term strategies.

We are seeing signs of traction across the business and we have confidence in our ability to stay consistently top of mind with our customers while delivering exquisite product and creating warm and inviting store experiences.

Thank you.

Thank you, Cynthia.

As I said, Old Navy's third quarter results were disappointing.

Although we believe we've improved our offering of trend-right product and began seeing traction in women's fashion early in the quarter, results declined as traffic deteriorated in October.

Because challenging business trends have continued month-to-date, we are cautious about our fourth quarter outlook.

I strongly believe that we have hired the right leader for Old Navy.

Dawn Robertson is on board working with her team to regain momentum in the short-term and to look at the brand's competitive positioning for the long-term.

I hired Dawn based on her deep merchandising and marketing expertise and her nearly 30 years of retail experience.

She's held leadership roles at Federated, the May Company, and Saks and most recently Dawn lead Myer, the largest department store chain in Australia, where she successfully repositioned the brand and significantly improved their financial results.

Needless to say, Dawn has been immediately focused on quickly diagnosing the needs of the business.

The Old Navy team is continuing to execute their plans to get trend-right product into stores faster, to maximize store productivity, and to develop compelling marketing.

Holiday television advertising is primarily focused on the family.

Our first spot featuring winter fashion began last Thursday and runs through November 21st.

This will be followed by a spot supporting our Black Friday promotional event, then two additional spots focused on gifts for the family run through December 22nd.

Aligned with Old Navy's emphasis on trend-right specialty product, we've doubled the number of fashion magazines we're advertising in this holiday.

Finally, on Black Friday, we'll be holding a "Steal Deal Unreal" promotional event, including $10, $20, and $30 gifts and in every store, we'll be giving away a $250 shopping spree as well as other discounts.

We'll be holding similar promotional events every weekend until Christmas.

Across all businesses, we are continuing to hold ourselves accountable for delivering great product supported by compelling store experiences and effective marketing.

And I'm confident in Dawn, Cynthia, and Marka's ability to lead this work.

While improving each brand's performance is our top priority, we continue to believe in leveraging the strength of our brands to achieve our growth objectives.

Our strategy is to build and expand our brands through new product categories and through international, online, and real estate growth.

I'm pleased with the progress the teams are making delivering on these plans.

First, we believe there are many opportunities to extend our lifestyle brands into categories beyond what we offer today.

For example, as you heard from Marka, the team is building on the success of Banana Republic petites, high-quality handbags and personal care by licensing Banana Republic eyewear.

Second, in terms of international expansion, we believe that brings our brands to new markets represents a significant growth opportunity and we can do this faster and with less risk through franchising.

In the third quarter, our first franchised GAAP stores opened in Singapore and Malaysia and are exceeding expectations.

One of the top-selling products has been our GAAP logo tee reinforcing the connection that people have with our brand across the globe.

Next, Banana Republic franchised stores will open in these markets and we also plan to enter Indonesia and the Middle East and are evaluating new markets as well.

In addition to using our franchise business model, we'll continue to expand vertically where we can generate the appropriate returns.

For example, last year Banana Republic entered the Japanese market where customers are responding very positively to the brands' elevated positioning.

We will have 14 Banana Republic stores in Japan at the end of the year and we'll continue to open new locations in 2007.

Third, we've built a world-class online business.

Our Gap Inc. direct division continues to report strong sales growth.

The new systems that Toby Lank and the team put in place one year ago not only improved our efficiencies and online customer experience, they also created a platform for launching new businesses.

An example of this is Piperlime.

The team successfully launched this online shoe business last month and the initial response is encouraging.

The site currently offers more than 100 brands, which we're continuing to expand.

Online footwear represents a $2.8 billion market that's expected to double by 2010 so we're excited to go after this opportunity.

Finally, Gary Muto and his team opened ten new Forth and Towne stores in the third quarter.

By the end of the year we'll have 19 new stores in nine markets.

Customers continue to respond positively to the product, exceptional service and the unique fitting room experience.

We have an opportunity to improve store productivity, so this fall the team has been testing smaller boxes and we've learned that we can retain the core store experience in less square footage than originally planned.

We're also focused on building brand awareness.

The team launched a marketing campaign for fall and holiday, targeting older women who have a strong fashion sensibility.

Overall, we continued to be encouraged by customer response and believe in the concept's potential for expansion.

In closing, each of our brands is in a different place today.

At Banana Republic, we're gaining solid momentum.

At Gap, we remain committed to executing the strategies that we believe are gaining traction.

And at Old Navy, while we've made improvements, we have more work to do to win back our customers.

I want to recognize our teams who have been working incredibly hard to achieve our plans.

Heading into the holiday season, we will continue to focus on driving strong execution.

By focusing our turnaround on our business and through continued cash distributions, we remain committed to delivering shareholder value.

Thank you.

That concludes our prepared remarks.

We will now open up the call to questions.

We'd appreciate limiting your questions to one per caller.

Your first question comes from the line of Brian Tunick with JPMorgan.

Hi.

Thanks, guys.

I guess my question is, I was just trying to keep track of all the different projects and initiatives you talked about on the call between Piperlime and the Banana Republic sunglasses.

Just maybe talk about the philosophy of trying maybe not to just to focus on just maybe three things and doing them well.

Why are there so many projects that you guys continue to pursue when, obviously, the opportunity in the core businesses are still ahead of us?

Hi, it's Paul.

Let me answer that one.

I think it's a good question.

First, we are all unbelievably focused and committed to our turnaround and we are not going to let anything get in our way or distract us from making sure that the teams are focused on executing that.

As we've said, there's a couple of things.

First of all, we want to continue to invest in our future growth and we set up a while ago and said that growth was going to come through a couple of different avenues.

First and foremost was the natural extension of these brands, because we think they're covetable lifestyle brands.

And when we look at what Marka's doing in Banana Republic, it's clear that that brand is not only is covetable, but she and her team have the bandwidth to be able to expand and offer those products to our consumers that we think is relevant to the business.

We also think that these brands are relevant internationally and growth is going to be an important part of our growth, which is why we set up the franchise business.

Our franchise business and our vertically integrated businesses are being led by separate and distinct teams that are not part of the U.S. team so it's not a distraction, and they're able to take the assets and now particularly since we have our teams in place in markets in Europe and in Japan, they are truly operating independently.

On online, not only have we built the systems, but Toby and his team have the capacity to be able to grow that business, hence the reason for Piperlime and for the new systems that we've put if place.

And again, it doesn't distract from the major brands and those teams and what they need to do.

The principal that we continue to follow is that the turnaround is our most important focused.

We will not do anything that we believe in any way distracts the talent and place to accomplish that turnaround.

At the same time, we want to continue to invest in our opportunities for growth, which will be the product extensions, our international growth, and our online business.

Okay.

Thanks.

That's very helpful.

Your next question comes from the line of Randall Connick with Bear Stearns.

A quick question.

Just on the, if you look at the product quality at Banana, it seems to be getting a lot better and a lot elevated, you talk a lot about cashmere in your assortment, and then the Gap Red products seem to be the higher quality but in the Gap stores, the rest of the assortment seem to be just a bit of a lower quality.

Can you discuss some of the learnings from the Red assortment in terms of how you may elevate the rest of the product assortment going forward in coming quarters and what categories you may be focused on?

Hi.

This is Cynthia.

We're very proud of Product Red and it's provided not only great buzz for the brand, but great learnings of all of us.

We were able as a team to go from concept to delivery in pretty short order with that.

Along with that, part of our intention was that Red was intended to be the premium of expression of the brand.

And from that, we've actually learned a lot about the customer's response and I think that you'll see many of the fabrications and attitudes of that showing up in future seasons in the rest of the assortment.

Hello?

Yes.

And just a quick one for Byron.

Byron, if I may, if you look at the cash flow statement, the accounts payable and accrued expenses have been very significant drivers of cash flow.

Could you just explain those drivers and are they sustainable sources of cash in '07?

The primary driver on the working capital increase, which did have a pretty significant impact on our cash flow this quarter, can be traced back to a strategy we implemented some time ago in connection with shifting most of our product purchases from letter of credit to open account.

And this was made possible by the significant improvement in our credit rating.

And although the original intent was to reduce financing fees associated with letter of credit, an additional consequence of this strategy was to increase the amount of payables outstanding and, therefore, we received a pretty significant working capital impact.

And to the extent that that differential continues, then it would be sustainable.

With regards to the increase in accrued expenses, without getting into the details of what caused it in the third quarter, the heart of your question was whether it's sustainable and I would say there are natural fluctuations on this account and I wouldn't view that component as being sustainable.

Thank you.

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

My question is regarding the store remodel program.

When you think about how your allocating between marketing dollars, advertising dollars and then towards store remodels, is there any consideration, given what you've learned so far with the productivity improvements, to direct even more of the marketing dollars, the national marketing dollars towards store remodels, given what it seems with your, particularly Gap and mall-based locations, mall traffic having sort of stabilized nationally from what we understand, that that would be an even more effective way of driving the conversion.

And then just as a follow to that is, what is the current age of the leases across your three divisions?

This is Byron, let me start with that one.

With regards to remodels, we don't view the remodel campaign at Gap to be in conflict with the allocation of dollars to marketing.

In order to maintain a brand standard, what it means to the brand as it relates to the store shopping experience and the experience of the customer inside the store, the moment you say you have a brand standard, you sign up for a certain amount of remodel over time.

That's been seriously neglected at Gap brand.

We are in catch-up mode and, frankly, we would remodel our stores as quickly as the length -- as we can negotiate leases that would allow an adequate time to amortize those improvements.

So to be clear, there is no cash constraint associated with our remodels.

The decisions to do specific marketing campaigns and the productivity of those campaigns are a completely separate decision and they have to stand on their own merits and in no way detract from our ability to remodel as fast as we can the Gap fleet.

And what is the current age of each fleet?

We haven't guided -- we haven't really talked about that.

Your question began with Gap, and because Gap is the oldest brand and has the highest percentage of older leases, what happens when a lease runs out of options, you no longer have a guaranteed option to extend the lease and, therefore, what's slowing the program down a bit is that we -- or what's governing its pacing is we have to go in and negotiate renewals and extensions to those older leases.

And that's why we've been calling this out as a pacing factor for our remodel program.

Okay.

Thank you.

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

Oh, hi, guys.

I just wanted to come back on the issues that -- or the business momentum at Gap division.

I can understand you pointing to things like customer satisfaction scores, but at what point do you feel you would need comps and other objective measures for the business -- or to start to put up those types of numbers in order to have incremental confirmation that you're moving in the right direction?

Hi, Dana, this is Cynthia.

Certainly I understand your question and during the Q3, we would have liked to even had stronger performance, but what we know is that it's a long-term strategy, the fact that we've disappointed customers over many seasons and it will take a period of time.

But what I would say in Q3 there were positive indicators, some of which I mentioned in my remarks, but with the specific product in women's, we're getting strong indicators in those areas, specifically in the Clean Shop, Body, Baby, as well as each month during the quarter we did make improvements, even though not to the level that we wanted against comp and against traffic.

So we're just viewing this as indicators.

That being said, we know we've got to work it hard every single day because there's more ahead.

Great.

Thank you.

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

Hi.

A couple things.

Byron, I was wondering if you could address how you were thinking about SG&A expense dollars for '07 given the lack of momentum in the business?

I guess what I think I'm hearing is that you're going to continue to spend on marketing and so we should probably look at those dollars being up that same amount.

Also for you, why should inventories be up low-single digits?

Why is that the right number if comps are down mid to [high]?

And then Cynthia and Paul, I guess I'm just trying to understand the strategy to reinvigorate Gap and Old Navy.

Not Gap Body, not Baby, not international and extensions, but what are you going to do to get the brands reinvigorated?

Is there anything about adding third party brands?

What do you do?

I mean you had Oprah and Bono and it didn't seem to do much.

I'm not understanding.

Thanks.

Stacy, Byron.

I'll begin with the SG&A.

So the same approach we have used to support our turnaround strategies in marketing, in store labor, investments, and in supporting our growth initiatives, Forth and Towne, international, franchise, Piperlime, we will follow that same expense investment approach in Q4 and clearly all -- we expect all our expenses to have a return.

So as we approach '07, the budgets for which we are currently in the midst of, we will evaluate each of the seasons accordingly, beginning with the first one in '07 and make whatever adjustments we feel appropriate.

But to be clear, the guidance that we have given you reflects in Q4 of '06 the same approach we adopted in Q3.

With regards to your inventory question, we guided to low single digits at the end of this fiscal year.

Just keep in mind that we're comping against a prior year's fourth quarter of minus 11, and so when you put that -- when you just look at the two-year comp, you're in negative territory.

Stacy, I'll just -- it's Paul, I'll just mention quickly on Old Navy.

As I had mentioned, clearly, we were pleased with how the teams had refocused our product positioning against our specialty flair, and although we think we did a good job on that, of course, there's always opportunity for us to get better.

After seeing some momentum, particularly in September, we were disappointed and unexpected the deterioration of the business in October.

Having said that, we do feel like we've got the holiday advertising campaign to be able to drive our business and get our customers excited, not just about our product, but also about the excitement and fun that Old Navy has always been and reflected on.

So we feel good that we've got the marketing plans in place.

But needless to say, that now that Dawn's here, it's going to give her an opportunity and for all of us to have a new fresh pair of eyes on the business to see how we can look for other opportunities for us to drive excitement with our customers, whether it be advertising campaigns, product campaigns, repositioning of the merchandise within the store.

So we're clearly looking and open to ideas, but we feel pretty good about our holiday plans in place and are hopeful that it can drive the traffic we need.

Hi, this is Cynthia.

The strategy overall is really focusing on the product, the in-store experience, service and marketing.

The Q3 performance, where it's not to the level we wanted, was some indicators of progress.

It's the first season where we delivered the new product assortment and we are learning a lot with it.

Several of the things that you mentioned, certainly are things that we're exploring and whereas it's not a big part of our business, things like we did introduce Converse into our stores, in 25 stores, and it's been a success.

It will be in 75 by this next week, but that's just one indicator, an indicator that we are open to exploring a variety of things.

You've heard the buzz about the Roland Mouret dresses in Europe and those will be in seven of our Manhattan stores next week.

But the big focus is really on the product of the core product.

Thank you.

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

Thank you.

I wanted to ask a question on marketing, specifically for Gap Brand.

I think you mentioned that the Audrey campaign haloed to the rest of the store, but if you could just go through your third quarter campaigns, the denim, the Audrey, and the Red, what campaigns did successfully not only sell the items featured but haloed the rest of the store?

And then just if Byron could give us an update on Cap Ex for '07 given the 75 to 100 '07 remodels, that would be helpful.

Thanks.

We went back on air in July for the first time with a television commercial.

I would say the Audrey commercial with the skinny black pants, "Keep It Simple" really was a breakout for us.

That's where we had strong performance in the categories not only in the ad, but had a nice halo affect within what we call the whole Clean Shop.

Red, on the other hand, the product assortment was really always intended to be premier and is a small proportion of the inventory rate buzz on that and we've had great response to the product and, in fact, pleased that the fact that the team was able to scurry and chase into additional products so that will be as it's delivering into the stores now for the rest of the holiday season.

Kimberly, it's our custom to give all '07 guidance on the fourth quarter earnings call, so look forward to answering that question then.

Thanks, Byron.

Is there any way you might be willing to comment on what an average store remodel might cost, or a ballpark range?

We haven't talked about that yet and we'll talk about capital expenditure by category on the fourth quarter earnings call to give you a better flavor of how many -- how much money we are investing in remodels and existing stores.

Great.

Thanks.

Your next question comes from the line of Jennifer Black with Jennifer Black and Associates.

Good afternoon.

Have you seen a response to your ads in the front of magazines, oldnavy.com?

And then I also wondered if you could comment on how you feel about the depth of the assortment at both Gap and Old Navy?

Thank you.

Hi, Jennifer, it's Paul.

Hi, Paul.

I'm not quite sure I got that first question, but we continued to look at lots of different mediums for Old Navy.

As I mentioned on the call, we think that print, particularly as it relates to our fashion sensibility, is new for us and we're going to continue to do that.

The teams are always looking at new mediums, whether they be online through our own sites or even through other sites as a way for us to get attention about what's important overall to our product.

Well, what I asked was if you're measuring the response?

Because you can't miss the ads in the front of all the magazines.

The teams have a pretty robust measurement tools that we use for all our mediums where we can get it.

Clearly, when it comes to direct mail and there's a response, it's a lot easier to get an exact science on measuring the effectiveness of that.

A print campaign in a magazine book is a lot more difficult if there isn't a response.

But we have pretty good programs in place to be able to understand the value creation from some of these vehicles.

Okay.

And then I also asked the question about how you feel about the depth of the assortment at both Gap and Old Navy.

Jennifer, this is Cynthia.

Hi, Cynthia.

Hi.

As you know, we've made significant shifts in the presentation of our stores compared to last year and I'd say overall the inventory levels are appropriate for where we are with the business.

But just to the fact that there has been such a shift in the look, the feel, the quality of it, we're learning a lot and finding areas where, frankly, we're chasing some business.

As I mentioned earlier, probably the greatest strengths that we're having in the adult business is coming in the Clean Shop in both men and women.

There's certainly some categories where we wish we had a little more depth in that but I think that's part of the learning journey that we're on.

And then, Jennifer, as it relates to Old Navy, I'll answer it in depth in two ways, both inventory and classification.

So we feel really good going into holiday on the classifications, particularly in sweaters, in some of the great product that I think Old Navy's done with sherpa and faux fur.

So we feel really good about the general depth of the classifications that we're covering, hoodies and men's and so on.

As it relates to inventory, clearly, in hindsight for October, for fall, we were deeper than we would have liked to have been given the deterioration in our traffic.

However, we did buy holiday lighter, so even given our softer business today, we think we're in pretty good shape.

Okay.

Thank you very much and good luck.

Thank you.

Thank you.

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

Hi, everyone.

I guess a couple of questions.

One for Marka and one for Cynthia.

Cynthia, I guess, and Paul, given the success of the plans of the Body business, we really haven't heard any plans to accelerate Body openings, it would seem that that might be a good idea.

And then Banana, Marka, on Banana, just if you could talk generally about Banana domestic versus international, meaning Japan.

Realize Japan doesn't have much scale, but how many stores do you think you could open there and where do you think the margins could get to relative to domestic Banana?

Are they the same kind of levels, do they have that potential or could you talk a little more about that?

Hi, this is Cynthia.

We're really encouraged about the big opportunity we think that there is in Gap Body.

And as I mentioned, is just two weeks ago we introduced a new look and feel of our store and are really enthused about it and I hope you have an opportunity to go visit at one of the locations.

There's more to come on this and, frankly, this is the work that Tom and the team have been working toward on putting together a strategy, but we really view this as a big opportunity.

With regard to Banana Republic, I think we are learning a lot from our Japan counterparts.

As you know, we know we opened five stores last year, eight more this year and we're just going to continue to grow the market as it is appropriate, but we've learned a lot with smaller stores, some new fixturing that we've actually brought back to the states.

So it's been a really great learning experience on both sides and we are looking at Banana as a global brand where the product assortment is actually pretty much the same globally, which is working, really, really well.

The proposition of affordable luxury has worked there as well as our women's business has been very strong in Japan.

Okay.

Thank you.

Your next question comes from the line of Ee Lin See with Credit Suisse.

Hi.

What is your stance on selling or spinning off any of your brands and on acquisitions?

And would that stance change based on the pace of the turnaround or the stock price?

Thank you.

Thanks, Eileen.

I think it's obviously responsible of our management team to continue to evaluate the strategic options that really determine the best way for our shareholders to increase their value in the Company.

We believe that we can create significant value to our shareholders by staying just maniacally focused on our turnaround in the short run.

And that's really the focus of the team today.

Operator, we have time for about one more question.

Your final question comes from the line of Lorraine Maikis with Merrill Lynch.

Thank you.

Good afternoon.

Just back to Old Navy, can you just talk briefly about what you think the biggest problem was with the product?

What changes you've made and will this be in time to impact holiday?

I think, as I said, we do feel like we did a nice job getting our product filter to be more special in our stores and to be more trend-right.

So having said that, we feel good but, obviously, the results aren't there.

We recognize that it is a fiercely competitive market set that Old Navy plays in and that it becomes really important for us to continue to make sure that our differentiation, which is not just product and price but a fun and compelling experience, is critically important.

We did see some good traction in our women's business that made us feel like we were on the right track.

That's contrasted against our men's business, which has been really tough.

So I think all in all, the product has gotten better, we need to continue to make sure that our marketing is compelling on all three dimensions, and needless to say, we know it's a competitive marketplace, we need to do what we need to do to be effective against our competition and win share.

So 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.

This concludes the Gap Inc.'s third quarter conference call.

You may now disconnect.