蓋璞 (GPS) 2006 Q4 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to Gap Inc.'s fourth quarter 2006 conference call. At this time, all participants are in a listen-only mode. [OPERATOR INSTRUCTIONS]. The conference call and webcast are being simultaneously recorded on behalf of Gap Inc. and consist of copyrighted material. They may not be rerecorded, reproduced, retransmitted, rebroadcast, or downloaded without Gap Inc.'s express written permission. Your participation represents your consent to these terms and conditions, which are governed under California law. Your participation on the call also constitutes your consent to having any comments or statements you make appear on any transcript or broadcast of the call. If you have any questions regarding this policy, please contact Gap Inc. Investor Relations at 415-427-2175. I would now like to introduce your host, Evan Price, Vice President Investor Relations.

Good afternoon, everyone. I'd like to welcome you to Gap Inc.'s fourth quarter 2006 earnings conference call. For those of you who are participating in the webcast, please turn to slides 2 and 3. I'd like to remind you that the information made available on this webcast and conference call contain forward-looking statements including but not limited to forecasts relating to the timing of the Forth & Towne closure and the conversion of Old Navy Outlet stores into to Old Navy stores. Diluted earnings per share, excluding Forth & Towne's net loss and on a GAAP basis, free cash flow, anticipated annual dividend, operating margin, year-over-year change in inventory per square foot, gross interest expense, depreciation and amortization, capital expenditures, effective tax rate, store openings and closings, and weightings by brand, real estate square footage, expenses and associated savings associated with the conversion of Old Navy stores and the closing of the northern Kentucky distribution center, plans to repay debt, and use of cash to repurchase shares 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 consult our quarterly report on form 10-Q for the quarter ended October 28, 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 March 1, 2007, 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 measures, free cash flow, and expected diluted earnings per share, excluding Forth & Towne's net loss, which under SEC regulation G we are required to reconcile with GAAP. The reconciliations of these measures to GAAP financial measures are included in our earnings press release, which is available on gapinc.com. Joining us on the call today are interim CEO, Bob Fisher, CFO Byron Pollitt, Gap Brand President Marka Hansen, and SVP of Corporate Finance, Sabrina Simmons. Now I'd like to turn the call over to Bob.

Good morning, thank you for joining us. I'm pleased to be addressing you as interim CEO for Gap Inc. Though it's not my intention to be a candidate, I'm fully engaged in moving this business forward until we name a permanent CEO. I'm excited to be in this role because I'm well aware of what this company is capable of. With more than 30 years of history here, I have a deep appreciation for our creative culture and the exceptional talent we have. Today, I'd like to talk about my priorities and share my early insights on what I believe is necessary to get our business back on track, then we will review 2006 performance. Along with me, Byron will discuss the financials in more detail, and Marka Hansen will share her initial impressions on Gap brand.

I spent the last six weeks getting closer to our strategies and operations and meeting with employees at all levels of the organization. It's clear we have a lot of hard work ahead, but I believe that this company still has tremendous potential. For the coming year, in 2007, our teams are focused on improving the fundamentals and stabilizing the business. Although we'll make progress along the way, it will take time to restore our financial performance to competitive levels. There is no quick fix. We've recently put new leaders in place who are just now ramping up. But let me leave no doubt. I am confident we can and will regain our momentum.

My first priority is to fix our core business. This means putting the right product and store environments back at our Gap and Old Navy stores and reconnecting with our customers by having a clear customer target. We need to rebuild our brands to once again be the premier stores in the marketplace. We have tremendous leverage and upside to our business when we get the product right. We saw this in 2003. That's when Gap and Old Navy's performance helped drive a 4 point improvement in gross margins and earnings more than doubled.

My second priority is to retain, development, and recruit the best talent in the industry. That includes supporting our search for a permanent CEO, and the Board is in the final stages of selecting a search firm. And my third priority is to put the right organizational structure and resources in place. We must find ways to simplify our work and empower the brands so they can make decisions and create change more quickly. And that will create excitement for our customers, too. As we announced in early January, we began the process of re-examining Gap and Old Navy strategies and tactics. Through this process we're assessing what went wrong with the business so we can take the right actions. Here's what we've learned so far.

Bottom line, we were not clear about who we were. Our product and execution suffered and our financial results were unacceptable. We believe three factors are the root cause of this poor performance. One, we did not have the right leaders in the right positions, and we lost too much talent. We've already made some key management changes, as you know, and we're also redeploying key members of our management team against the most critical priorities. We're also focused on recruiting and retaining creative talent.

Two, over the past four years, we tried to gain efficiencies by moving to greater centralization, and it didn't work in many cases. Our effort to leverage operations and save costs did not materialize as planned. In fact, it created bureaucracy and distractions. An example of this is what happened within our supply chain organizations. We tried to aggregate buys across each brand. Ultimately, this slowed us down. The brands were not able to make independent decisions based upon their own distinct product and merchandising strategies. That said, we do benefit from considerable efficiencies by consolidating some functional areas such as IT and finance. Overall, we're looking at ways to take complexity out of our systems and give the brands more autonomy.

And finally, we increased expenses with the expectation that our top line would grow. This clearly didn't happen. So now we're looking for ways to make disciplined decisions to bring our expenses back in line. As a start, earlier this week, we announced our decision to close our Forth & Towne stores after an 18-month test. We implemented a pilot of a concept we felt had great potential, but we haven't seen the kind of momentum required to support the meaningful value creation our shareholders deserve. Second, we decided to convert our Old Navy outlet stores to Old Navy stores to drive better returns. The competitive landscape for the outlet market has changed. From a business model and pricing standpoint, there was no longer enough differentiation between the Old Navy outlet and the Old Navy stores.

Many outlet centers already contain a mix of full price and outlet stores, so we'll still be able to leverage this important real estate channel with our Old Navy brand. And in part due to this decision, and as part of our ongoing assessment of network capacity, we will close one of our distribution facilities in Kentucky. Byron will take you through more details and the financial implications of these initiatives in a few minutes. I'm pleased that we've been able to move quickly on these decisions so we can begin to stabilize the business. We are just at the outset of our efforts and there's more work to be done. We'll continue to provide with updates in the months ahead.

Now let's turn our attention to reviewing 2006. In the fourth quarter, net earnings were $219 million or $0.27 per share. And gross margins decreased 150 basis points to 32.5%. While we had some successes such as Banana Republic's continued progress, the launch of Piperlime and international franchising, these were overshadowed by Gap and Old Navy's performance. Overall, customers did not respond well to product, and our merchandise margins ended significantly below last year. For more detail, let's take a look at each brand.

I will talk about Old Navy and Banana Republic, and then Marka will discuss Gap. Dawn is not joining us today on this call. She is new to the company and just four months into her role, and we think it's reasonable to give her some time, at least six months, to have a good read on things before asking her to speak. Dawn is very excited about the prospects and opportunities at Old Navy. As her broader assessment continues, she and the Old Navy team are focused on opportunities that will deliver incremental results as we work to stabilize Old Navy's business in 2007.

So here's what I can tell you about Old Navy. The team is focused on improving execution. And the key to this is clear, decisive leadership. Dawn is a very strong and experienced leader who's grounded in retail, and she's giving the team firm direction. Looking back at the holiday season, we found that there were three fundamental issues. One, product acceptance continued to be a challenge. Most notably in men's and kids. Two, our TV marketing campaigns were not effective. And three, our promotions and markdowns were not well coordinated.

Moving forward to address product, we'll be investing more in big ideas by identifying relevant trends each season. We will back those ideas with the right inventory investments, visual merchandising, and all element of marketing. We will also improve our popular item of the week so that it stands for fashion and newness each week of the year. With the proper depth of inventory, we will create a compelling statement to our customers from the moment they walk in the door. And to improve Old Navy's marketing effectiveness, our creative will be more consistent and communicate a strong message across all marketing channels. So if we're on sale it will look like we're on sale.

We're also reducing our marketing spend at Old Navy by focusing our dollars on traffic-driving campaigns and decreasing print and special event marketing. As we announced last week, we're excited to welcome Michael Cape to lead Old Navy marketing. He joins us from JC Penney where he was part of a leadership team that helped reinvent that business and drive a fashion-forward message to its customers.

Another opportunity for Old Navy is to better coordinate promotions and markdowns. We were too reactive and ended up confusing our customers. We are developing a proactive promotion with a markdown strategy and have reorganized our teams to ensure alignment. These are just a few examples of how Old Navy is making changes to stabilize the business. Dawn and her team are underway with plans to strengthen Old Navy's foundation and will update you as we have more.

Looking at Banana Republic, we are pleased with our continued progress. In 2006, we really focused on our core customer and improved our product offering to bring customers the right mix of elevated fashion and versatile essentials. To capitalize on our accessible luxury positioning, we also expanded the Banana Republic brand into new product categories, such as elevated handbags and fragrance. Customers responded and helped us deliver improved comp results with healthy merchandise margins. Marka has built a strong team at BR. We feel strong about the leaders in place that will help us continue the positive momentum we have established in 2006.

With that, I'd like to turn it over to Marka, who will discuss Gap.

Thank you, and it's great to be back at Gap brand. In my 20 years at Gap Inc., I've had the opportunity to experience many facets of the business from merchandising to human resources to taking Gap brand international. Having already spent nearly a decade with Gap, I truly have a passion for the brand and I am energized with the challenge of turning around this business. Given my tenure with the company and many experiences in both up and down cycles, I'm very clear on the scope of the issues we face and I understand the complexities of navigating such a large effort. Today I want to share with you my initial thoughts on the business and provide some insights into our immediate priorities.

First, I believe the kids, baby, maternity, and body business strategies are on track, and there are opportunities for growth in both divisions. Clearly our biggest challenge is the Gap adult business. Because we have strong relationship with Pam Wallack in kids and baby and Tom Wyatt in body, I will be able to focus on the turnaround for Gap adult. In the adult business, we have disappointed our customers for too long and my immediate focus is on getting the product right. Improving the customer experience, and smart inventory management.

Let me start with what I consider our number one priority, and that's product. I know that in order to deliver amazing products with great fit and quality, we are going to need the right creative talent on board. We need a distinct point of view and we must lead with creativity and innovations. Fortunately, we have a strong operational team in place, so I will be focused on acquiring, nurturing, and developing our creative talent. In order to produce amazing product, we need to support a culture of creativity, innovation, and risk taking, something that Bob and I are completely committed to.

We have not had all the right people in the right positions for important creative areas. That said, we are fortunate to have a deep bench of creative talent across Gap Inc., and it's our intent to leverage this talent. We took a step in the right direction when we brought Karyn Hillman to lead Gap adult merchandising two months ago. Karen has a proven track record with over 15 years experience at Gap Inc., eight of which were at Gap brand. We are also looking to bring in new talent from outside Gap and are aggressively recruiting new people to lead our critical creative areas.

Another central foundation to product success will be to clearly understand who our customer is and what we stand for. It is crucial that we get all the creative teams, design, merchandising, and marketing focused on working toward the same customer. Previously, we stated that our customer is between 18 to 35 years old. And though this target may have been appropriate historically, I believe that in today's highly competitive and more niche-specialty environment a target of 18 to 35 is too broad. And as a result, we lost a strong -- we lost a strong point of view. For example, we confused our customers with our marketing campaigns, which appeal to an older target with the Audrey campaign, and then swung very young with our holiday campaign. In addition, the latter did not resonate.

While we haven't landed on a specific target customer today, you can expect this to narrow within the 18 to 35-year-old range, and it clearly will not be the 18-year-old. Even with this refinement of our primary target, the aesthetic and appeal of the brand is one that we fully expect to halo both younger and older. In addition to a more defined customer target, our products should be grounded in the brand's heritage. Great knits, clean bottoms, denim and khakis, and be highly relevant and fashion right for today. In fact, the closest to this filter we have in the stores currently is our clean shop. Our teams are already working against this filter, but to be clear, our assortments through Fall are done. That said, we will be making marginal shifts that will begin to align and support our new direction. Ultimately, we need to deliver the style and quality that people expect from us.

I've been in this business a long time, and I recognize the importance of the customer experience. That means that once we create great product, we need to present it in a compelling, fresh environment. I am committed to ensuring that our store environments be as relevant as our products. We have been pleased with the remodels of 2006, and at this point we are moving forward with the 75 to 100 remodels we have scheduled for 2007. In addition, we will continue to refine our fleet, updating our best stores and closing underperforming stores where necessary.

In order to create and deliver amazing product and support a healthy business, we need to also focus on smart inventory management. In the first quarter we probably have a little more inventory than we should, but we are committed to bringing our inventory more in line with our traffic trends as we move throughout the year. At Banana Republic, we've been disappointed with inventory management, which paid off with healthy margins. I am bringing these practices to Gap brand immediately to improve our inventory productivity.

Before I close, I would like to touch briefly on marketing. We spent a significant amount on our 2006 marketing which was -- which has actually extended into a spring khaki TV campaign that we'll start airing next week. As you know, we didn't see the lift in traffic we needed to justify the investment. So moving forward, you can expect this investment to be reduced in 2007 and will most likely come from TV. That said, I am deeply committed to marketing and believe that it can be a strong traffic driver when in concert with fantastic product and strong word-of-mouth buzz.

In closing, let me reiterate that I believe there's significant opportunity here, and I am personally excited and energized to be here. Gap is an iconic brand recognized around the world. We have fantastic real estate. And though we have a few key positions to fill, we have plenty of smart people who are deeply committed to restoring the brand to its leadership position. Being clear on our vision for Gap brand is a top priority. And although it will take some time to be fully realized by the customer, I have absolute confidence we can get there. We will have a distinct point of view and we will lead with creativity, innovation, and risk taking. I look forward to keeping you posted.

And now I will turn it over to Byron who will give you an update on our financials, thank you.

Thank you, Marka. Good afternoon. I will begin today by reviewing fourth quarter results and then provide an update on our outlook for 2007, which will include the financial impact of the initiatives which Bob has described. First, fourth-quarter results. Net earnings were $219 million, or $0.27 per share. Gross margin decreased 150 basis points to 32.5%. We generated $678 million in free cash flow this year. As a result, we ended the year with over $2.6 billion in cash and short-term investments. We increased our quarterly dividend to $0.08 per share, and finally we have utilized about $550 million of our $750 million share buy-back authorization, by repurchasing 31 million shares of which 14 million shares were acquired during the fourth quarter.

For webcast participants, please turn to slide 4. Fourth-quarter earnings were $219 million or $0.27 per share. Please note the fourth quarter effective tax rate was 41.1%. This compares to a full-year effective tax rate of 38.4%. Full-year earnings were $778 million, or $0.93 per diluted share, versus $1.24 last year. Fourth-quarter weighted average diluted shares were 818 million, and full-year weighted average diluted shares were 836 million.

Please turn to slide 5, sales performance. Fourth quarter total sales were $4.9 billion, up 2% versus last year. Total company comp sales were down 7% in the quarter, versus down 6% last year. Full-year comp sales decreased 7, and total sales were flat at $15.9 billion. This 7 percentage point spread was driven primarily by net new store openings and a 23% increase in online sales. Please refer to our earnings press release for total sales and comps by division.

Turning to slide 6, gross profit. Fourth-quarter gross profit decreased 2.3% to $1.6 billion. Gross margin was 32.5%, down 150 basis points compared to last year. 290 basis points of this decline was from lower merchandise margins, driven by the markdown and promotional activity at Gap brand and Old Navy; however, this was offset by 140 basis points from the leveraging of occupancy expenses.

The leveraging of occupancy expenses was driven by the 53rd week of sales against a [rod] expense that is largely based on 52 weeks. And last year's $50 million expense as a result of a change in the way we recorded payments made in France to secure the right to lease stores. Full-year gross profit was $5.6 billion. Gross margin was 35.4%, down 120 basis points from last year, driven primarily by lower merchandise margins by both Gap and Old Navy.

Please turn to slide 7 for operating expenses. Fourth-quarter operating expenses were $1.3 billion, up $123 million over prior year, due primarily to investments in marketing and store payroll. Marketing expenses for the quarter were $161 million, versus $126 million last year, as a result of incremental marketing at both Gap and Old Navy. Full-year operating expenses were $4.5 billion versus $4.1 billion last year. Marketing expenses were $581 million, versus $513 million last year. Management recognizes that our costs have risen since 2003 while our efforts to grow the top line have not been successful. We are committed to bringing expenses more in line and remain focused on ensuring our investments deliver a healthy return. More on this topic in a moment.

Turning to inventory on slide 8. We ended fourth quarter with $1.8 billion in inventory, up 6%. Inventory per square foot was $44, up 2%, versus down 11% in 2005. Please turn to slide 9 for capital expenditures and store count. Full-year capital expenditure were $572 million. We opened 194 new stores, and closed 116. 79 of which were Gap stores. Companywide, we ended the year with 3,131 stores and square footage increased 3%. Please refer to our press release for end-of-year store count and square footage by division.

Regarding cash flow on slide 10, despite a decline in earnings, we continued to generate healthy free cash flow. For the year, free cash flow, defined as cash from operations, less capital expenditures, was an in-flow of $678 million. Please refer to our press release for a Reg G reconciliation of free cash flow. With regards to cash distribution, we repurchased a total of 14 million shares in the fourth quarter at an average price of $19.32, including commissions. Also in 2006, we increased our dividend per share to $0.32 from $0.18 last year. We ended fourth quarter with over $2.6 billion in cash and short-term investments.

Now I'd like to give you an update on several of the initiatives that Bob discussed earlier, which are reflective of both our commitment to delivering returns to shareholders and reducing costs. First, we announced that we will be closing Forth & Towne. Given the sales productivity levels and the traffic momentum we have seen to date we felt the probability that we could achieve an acceptable return on investment from a full rollout of the brand was too low. As a result, we plan to close 19 Forth & Towne stores by the end of June, 2007.

The pretax expense net loss associated with Forth and Towne is expected to be approximately $60 million, of which about $40 million is expected to be from closure costs and about $20 million is expected from operating losses. This will represent about $0.04 per diluted share and will be recognized primarily over the first and second quarters of fiscal year 2007.

Second, we are converting Old Navy outlet stores to Old Navy stores. As Bob stated, given the changing competitive environment, there is no longer a clear distinction between the two businesses. We expect to convert the 45 outlet stores by October of this year. This decision has no impact on our Gap outlet and Banana Republic factory stores. In addition to gaining cost efficiencies in our management structure, this decision also allows us to close one of our northern Kentucky distribution centers. The expenses associated with converting the Old Navy outlet stores and closing the distribution center will be about $6 million in 2007. However, annual savings from these measures are estimated to be $12 million.

Turning to slide 11. I would now like to review our outlook for 2007. As Bob mentioned earlier, 2007 will largely be a transition period at Gap and Old Navy. The new leaders in place at our largest divisions are in the early stages of resetting the strategies and tactics in order to improve performance. As a result, we are broadening our guidance to better reflect the state of our current brand strategies. Now let's review our 2007 guidance.

We expect diluted earnings per share, excluding Forth & Towne's net loss, to be $0.80 to $0.90 per share in 2007. We expect diluted earnings per share on a GAAP accounting basis to be $0.76 to $0.86. Please see today's press release for a Reg G reconciliation. We expect operating margin to be in the high single digits. Inventory per square foot at the end of both the first and second quarters is expected to be flat compared to last year.

I'd like to spend a moment on the Company's real estate strategy for 2007. At this time, we expect to open about 230 new stores and to close about 200. The openings are weighted towards Old Navy as we continue to believe there is additional real estate opportunity and the returns remain attractive, and the closures are weighted to Gap and include the impact of the 19 Forth & Towne store closures. Please also note the 45 Old Navy outlet conversions will be recorded as both a closure and opening to reflect the reassignment. Full-year net square footage is expected to be up about 1%. We remain committed to regularly evaluating our fleet performance to ensure that stores are meeting appropriate financial returns.

During the year as part of their analysis, our new leaders will be evaluating their respective brand store economics as it relates to their go-forward strategies which could influence store openings and closures. As their strategies become finalized, we will provide you with an update. So, more insight to come. You can refer to our fourth-quarter press release for a summary of store activity, and Gapinc.com for 2007 store guidance by division.

Full-year capital expenditures are expected to be $700 million. Here's the breakdown. Stores, $545 million with $235 million for new stores and $310 million for existing stores. IT, about $110 million. Headquarters and distribution centers, about $45 million. We expect full-year depreciation and amortization to be about $550 million. Interest expense for the year is expected to be about $35 million. And for the full year, we expect the effective tax rate will be about 39%.

Now for cash distribution. We continue to deliver healthy free cash flow and expect 2007 free cash flow to be about $500 million. We remain comfortable with a minimum cash target of $1.5 billion. Please refer to the Reg G reconciliation of expected free cash flow. In September 2007, we plan to repay $325 million in debt, leaving $188 million in long-term debt. As a reminder, we consider our off balance sheet lease obligations to be debt. And with over 3,100 stores, this amount is substantial. As we have stated, it is our intent to increase dividends at a rate greater than or equal to the growth in annual net income. As net income in 2006 has declined, we will maintain our quarterly dividend at $0.08 per share, which represents a payout of about 35% of 2006 net income. Regarding our share repurchases, we plan to continue to use excess cash to opportunistically repurchase shares. At the end of the fourth quarter, we still had $200 million available under our current authorization.

In summary, we are committed to generating shareholder value by delivering a product-driven top line, turning inventories more profitably, improving margin through tighter expense control, and returning cash to shareholders through dividends and share repurchases. You will be hearing from us updates on each of these initiatives over the next few quarters. Thank you. Now I'll turn it back to Bob.

Thanks, Byron. Looking forward, I'm committed to the priorities that I outlined earlier. At the end of the day, our success will require extreme focus against the things that matter most. To me, it's tapping into the passion of our employees and reinstilling creativity and innovation in everything we do. And it's about simplifying our work at every turn. Every day, we are uncovering new ways to get back to the product-focused and customer-focused company that made us an American icon. But as we reinvigorate creativity into our business, we will never lose sight of the importance of financial and operational discipline. These things can and will stay in healthy balance.

At the beginning of my remarks, I said I was excited to be leading the company at this time. Let me tell you why. We have powerful brands and passionate people. Every day I'm energized by the amazing talent and resolve that I see in the people who work here. This gives me confidence that we will get back to where we need to be. We've been tested before, and we demonstrated our ability to overcome adversity. Working alongside the management team and the Board of Directors, you have my commitment that we will chart a new course to reinvigorate our brands and deliver strong returns to shareholders. Now, we'd like to address your questions.

That concludes our prepared remarks. We will now open up the call to questions. We would appreciate limiting your questions to one per person.

[OPERATOR INSTRUCTIONS]. Our first question comes from Gabrielle Kivitz from Deutsche Bank.

My question is on the Gap division, so I guess it's a question for Marka. I hear what you're saying about returning the brand to its heritage. But I'm just curious if you could elaborate a little bit more. The marketplace is obviously different than it was when the company was achieving peak metrics. I think key items -- some of the key items that you had previously focused on and become much more commodity like, the environment's become much more competitive. We're seeing a lot more pricing pressure, just wonder if you can just talk about your thoughts on the differences in the environment, talk about how similar or different you think the brands will be or specifically the Gap brand will be when you're kind of through some of this repositioning. How different it will be from the brand we remember.

I absolutely know that we're not the brand of 10 years ago. Nor the brand that -- when I was here in 2002. But I know this -- we do need a narrower target focus, and it doesn't mean we can't halo older or younger. But we need to aim at a more narrow focus. And that being said, I think the categories that we -- our heritage, those being things like denim, like clean bottoms, like being there for people who are either casual work or casual weekend, that we can reclaim an authority position, and that's my intention.

Okay. Thank you and good luck. Look forward to monitoring the progress.

Thanks.

Our next question comes from Dana Cohen of Banc of America Securities.

Hey, guys. Just two quick things. First of all, Bob, maybe you can just help us on the search process sort of a timetable here. Just the month has already passed. Still have not hired a search firm. I mean, obviously, I've never done this. But can you just help us understand, is this the normal time frame? Just particularly since it doesn't seem that the number of people to go after is that large. And then second, on the store growth at Old Navy, just help us to understand, why keep growing it now given the trends in the business?

Okay. Dana, on the search firm, we are literally in the final stages of selecting a firm. The committee has not been sitting idly. Conducting a thorough decision on the right search firm takes time. And the Board is committed to selecting the right CEO. So again, we haven't been sitting idly, and we're just about to finish this process up.

Yes.

So Dana with regards to the Old Navy openings, let me first clarify of the 115 openings that we have listed, 45 of those are conversions from Old Navy outlet to Old -- regular Old Navy stores. So it's not quite as many as it might first appear. And -- and on a net basis because we are closing some Old Navy stores, it's only 50 net new openings. And each one of those store openings have been individually pro forma, pro formaed, reflecting the current trends in the business. It's good real estate with attractive returns, and that's why we're adding them to the fleet.

Great. Thank you.

Our next question is from Margaret Mager of Goldman Sachs.

Hi. Good afternoon. Question on the marketing expense outlook. I think both Old Navy and Gap stores both said that you'll be cutting back on the marketing. Just wondering how much you expect the 581 to drop in '07, and what's factored into the $0.80 to $0.90 EPS guidance. I'm not clear from the presentation what is it that's driving a down year in earnings in '07 from your perspective. Thanks.

Margaret, let me talk about the marketing spend reduction. We made significant incremental investments in 2006. And when we took a look at that, it just didn't pay off. And so we're pulling back from where we -- from where we thought we were the prior year. I think it's a smart business decision. In Gap, it's principally TV advertising. At Old Navy it's around print and promo events. We're still committed to marketing.

I was hoping for a sense of magnitude in terms of where you go from 581?

So Margaret, you know we don't guide to specific marketing numbers. But you should, just as Bob said, we made incremental investments in '06, did not deliver the return we were looking for. We've decided to cut that back from where we were, as it relates to the incremental investment. With regards to why guide down, our attempt here is just to be very realistic with regards to our earnings prospects. We've got Marka and Dawn in the early stages of resetting the direction of two major brands. It's no quick fix. This is -- '07 for us is about stabilizing the businesses. And we frankly just thought it prudent to limit expectations for 2007 and provide a wider earnings range in our outlook.

With all due respect, you're talking about cutting expenses. You're cutting marketing, you're focusing on your inventory. Is it sales -- you expect sales to be your primary issue again in '07?

Yes. I would say that -- yes. That we would expect -- what we're attempting to signal is that '07 is a transitional year in terms of trying to stabilize our sales trends. With regards to expenses, we are very serious about tackling our expense position. When you look back to 2003, we have added a meaningful increment to our expense base with the anticipation that we would have significant growth on the top line. That growth hasn't materialized.

The seriousness with which we're taking a hard look at expenses, I think, is indicated by the type of initiatives that we have already discussed. And as I'm sure you can appreciate in order to take expenses out of a cost structure in a way that will not allow them to so easily creep back in, this takes time to thoughtfully do, and it often is accompanied by one-time expenses, which we also have to factor into our guidance.

Okay. All right. Thank you.

The next question is from Jennifer Black of Jennifer Black & Associates.

Good afternoon. I wondered if you could comment about Piperlime. Could you give us some color on Piperlime?

Yes. So we -- we're very encouraged with the start of Piperlime. Recognize that we only started it three months ago from a standing start. We're -- the satisfaction and intent to recommend customer reactions are off the charts in our post-fulfillment surveys. Operationally we've had no hitches. We've got a healthy customer mix between shoppers that are sourced from our existing customer files and from brand-new customers. So at this point, we're three months into it. We have successfully leveraged an existing platform. And we are successfully leveraging our -- our existing customer file and marketing data base. So we're very encouraged, but we're just -- it's three months into it.

Is it profitable or close to profitable?

Well, we don't talk about that just yet. But we look forward to the point where -- where we'll be more specific about the financial results. We're just getting started with this. So it would be premature to talk about economics.

Thank you.

The next question is from Barbara Wyckoff of Buckingham Research Group.

Hi, everyone, can you hear me?

Yes.

A couple questions. Can you talk about the side of your online business overall and by brand, you said it grew 23%. And if you could give us some insight on projected margins by division. Where would you think they should go, say, two, three years down the road from now? By brand?

So we will -- the size of the online business is $730 million for the year. And the -- and that -- consider that virtually all base business. The base brands of Gap, Old Navy, Banana Republic, PiPiperlime, immaterial contribution to that as this particular point in time. We will be finishing the brand, be it direct sales for each of our brands in our 10-K so that you will see, but we do not, at this point, our margin below the aggregate. We just don't disclose margins for the internet. What I will tell you is that the internet is very healthy, strong returns to capital, very profitable, full cost P&L.

Great. Thank you.

The next question is from Brian Tunick from JPMorgan.

First for Byron, just on the underperforming stores, it felt like a couple of years we've cleansed the store base. Just curious how much those stores are returning, whether or not it's return on sales or on a sales basis. And then maybe someone could comment about the media speculation that you guys have hired Goldman Sachs to explore strategic alternatives. If you hire somebody, does that change perhaps the -- the outlook, and would you still consider splitting up the company as, again, has been reported in the media? Thank you.

So let me start first with the -- with the store closures. So you're absolutely right in the sense that we've done quite a bit of cleansing. Virtually the vast majority of that cleansing has been with Gap brands. Since 2002 we've closed over 400 Gap stores. We're planning to close another 80 in 2007. As -- as we look to the future here, I think what's important to recognize is that it's important to give Marka and the team some time to lock down their customer target and to get the product right. Because when both of those are settled, we'll be in a much better position to right size the fleet for Gap. I do want to add to that that when we go through an individual store analysis, we don't simply assume today's performance and sales productivity levels. We do a full return on investment calculation for a store that does assume some improvement in productivity.

Brian, let me answer the second piece of your question or the first piece of your question. This is Bob. We don't comment on market rumors. We never have. My efforts and the team's efforts are focused around turning around the Gap and the Old Navy business. We're making the necessary changes. I think if we do that, it brings tremendous value to the shareholders. Like any responsible management team we periodically evaluate alternatives that drive shareholder value. But let's not -- let's not forget what's happened in the last six weeks here. We have a new CEO, we have a new Gap President. We've announced the closing of Forth & Towne. We've converted the Old Navy outlets to the Old Navy stores. There are no quick fixes in this business. We're taking a serious in-depth look, and we've got to allow appropriate time for the leaders to assess their businesses.

Okay. Best of luck.

Our next question is from Paul Lejuez of Credit Suisse First Boston.

Thanks. Marka, can you talk about your role in the Gap brand turnaround back in '02, '03. What do you see as the similarities today and then what are the big differences?

In '02, '03, I was focused primarily on adult and all around merchandising, visual and planning. I don't see anything any different than there. There are ton of great, talented people here with lots of great ideas. I think it's just about focusing the team, focusing on just compelling product assortments and a great store experience. It's not that difficult. It's just about getting everybody pointed in the same direction and being absolutely relentlessly focused on great products and great creativity. And -- and there's plenty of talent in the team to make it happen. I do realize it's not the Gap of when I was there. So I'm being very careful to make sure I don't just go back and say what worked for us in 2002 because the landscape is different. But in terms of how you fix businesses, I've done it a bunch of times, and I really like to do it, and I'm going to do it again.

Thanks, good luck.

The next question is from Richard Jaffe of Stifel Nicolaus.

Thank you very much. We say Stifel. Stifel Nicolaus. A question on CapEx given the expense cutting and the store count that is on an absolute basis very similar to last year's level. Why the increase in CapEx is about $125 million?

Yes. Richard, Byron. The -- all of the increase is concentrated in remodels. The amount on new stores is very close to what it was last year, and as I'm sure you're aware, we have said for some time that we are behind the curve in terms of refreshing the fleet. And so, both Old Navy and Gap are receiving an incremental increase in the amount of remodels budget for the coming year. And we feel this will play an important role in our turnaround.

Could you just remind us the number of remodels last year and the plan for this year by division.

What I'll do is give you Gap. So last year, we did about 25 remodels for Gap. We are planning 75 to 100 remodels for Gap. I don't have Old Navy's remodels for last year handy. But what I can tell is that the remodels for Old Navy are approximate to the number of remodels for Gap this year.

Got it. And just a question for Bob. Given the -- the process that has to occur with selecting a headhunter or head-hunting firm and then proceeding with a search and given the time that it took last time the firm did a CEO search, it could be quite some time -- I was wondering, Bob, are you committed to staying the course for what could be six months or longer until a new CEO is found?

Absolutely. I am fully engaged in driving the business forward, and I will do that until a permanent CEO is found. I've committed that to the Board and will do whatever it takes.

And could you be convinced to participate in the search yourself or be a target of the search?

You know, it's not my intention to be a candidate. The Board asked me to take on the role as interim CEO.

Thank you very much.

[OPERATOR INSTRUCTIONS]. The next question is from Jeff Black of Lehman Brothers.

Yes, thanks, good afternoon. I guess a couple of questions. First for Mr. Fisher. I was surprised to hear the supply -- the benefits from purchasing power from the three divisions really don't redound to the supply chain. And given that and given the complexity we face with multiple divisions and a Europe division, what are the thoughts for keeping everything together here at Gap as you look out to hire a new CEO? I mean, why not cut off Europe, sell Banana, do something that would really refocus this chain on Gap and Old Navy as it sounds like you're trying to do?

And then for Byron, what's an optimal expense rate, what's the low hanging fruit, and really how long does it take us to get there? Thanks.

Well, let me talk about centralization. The keys here for us is that we empower our brands. One of the things that happened when we went to more of -- more of a centralized structure as it related to sourcing was that we lost the distinctiveness in the brands, we lost the nimbleness in the brands. And each of our businesses, if you start with Banana Republic, the smallest of the three businesses at $2.5 billion, there's not that much more of an advantage to scale. In terms of -- in terms of our sourcing opportunity, and Old Navy with the size that it's at, the same thing.

Centralization is appropriate, however, in certain areas. And those are areas that aren't related to distinctiveness in the brands, areas like IT and finance. Then there are certain functions like online and CRM where we get incredible power in being centralized.

What I would say, Jeff, we're -- as opposed to talking about an optimal expense rate at this point, what I would say is that we have talked quite a bit over the past year about the importance of determining whether incremental investments in store payroll and in marketing could make a difference, and we made those investments. You've also heard that we're going to be dialing those back because we haven't got the return we were looking for.

The truth of the matter is, though, as you look back at our cost structure from 2003, our costs have risen across a broad range of categories. So we are seriously addressing through a complete look at our cost structure significant and serious opportunities to bring down our costs. And so as I related with an earlier question, to get these -- to design out these costs so that they don't creep back in will take time during this year, but we do intend to take serious action this year as indicated by the three initiatives we were prepared to talk about during this call.

Got it. Thanks. Good luck, guys.

The next question is from Lorraine Maikis from Merrill Lynch.

Good afternoon. Just wanted to talk a little bit about the Gap remodels and if you could just share with us some of the metrics you found on the 25 that you did in '06 in terms of return on capital and sales growth that you generated from these remodels, thanks.

What we find is that when we do the Gap remodels, we got a modest lift in retail comp. We got a modest lift in margin versus our store control group. However, it is absolutely clear that in order to get the returns we're looking for, we've got to get the product right in combination with the remodel. And that we did not do. And so as we approach the coming year, we will be looking hard at -- Marka and the team will be working hard at getting the product more targeted so that when we do the remodels, the stores have been remodeled in a way that reflect the target customer segment -- best reflect the customer-targeted segment that the team will narrow it down to. And then we will look at the returns of those stores with better product remodeled to determine the ongoing business model economics that are proper for Gap.

The next question is from Dorothy Lakner of CIBC.

Thanks. I wanted to ask Marka if she could share with us how much tweaking you think you can do to the Fall product, and what should we expect for holidays? Is holiday a line that you'll be able to completely effect or 50% effect? If you could give us some color there.

And then a question I think for Byron. You've given us very detailed guidance for '07 as a whole. I wonder if you could give us a little bit more color on what we should expect in the first half of the year and particularly in the first quarter. And speaking to that, how we should look at the charges for closing Forth & Towne, how that should be divided, if it should just be divided equally between the first quarter and the second quarter. Thanks.

So I'll answer first. I think what I'm trying to do is make incremental improvements every day on everything, product being the most important thing. And I don't want to make any promises of curtains up on a certain day that you'll see a new, reinvented Gap. I think that was something we did in the past and it doesn't pay off. The customer has to tell us when we have it right. So that being said, we're working on Spring development, holiday development, and fall development, or fall placement, all at the same time, and doing what we can to make sure we believe it's brand right, and that's all I'm prepared to say at this point.

So, with regards to Forth & Towne, as I've said, given the total charges of about $60 million that -- the vast majority of which would be -- would occur over the first and second quarter, it's a little premature to break it apart between quarters. What we do intend to do later in the year, once we have closed the last store and revenue production has stopped at Forth & Towne, it is our intent to reclassify this as a discontinued operation. And then we will be able to more specifically describe the costs that in effect should not repeat the following year.

In connection with guidance, our practice has been to give full-year guidance. We're not prepared at least at this point to depart from that practice. So your updates on the first quarter and the first half we will -- we will give them with every sales call. That will give you insight as to how we're progressing through the quarter. And then end of the first quarter we'll give you a look back on what occurred, what we think was ongoing expense and if there are any special callouts on one time.

Operator, we have time for two more calls.

Your next question is from Marni Shapiro of the Retail Tracker.

Hi, guys. Congratulations on the move forward on the product. I'm very happy to hear that. Could you talk a little bit about the marketing. You talked about cutting it back and refocusing it. But are you considering maintaining the levels of marketing where the product is healthy so maybe kids, baby, body, and have you thought about possibly even increasing it in some of those areas or at Banana Republic?

Hi, Marty, it's Sabrina. I'll start just by saying that as you know, a lot of our plans are still in the making. So we tend to give you a season and a time with regard to our definitive marketing plans. So with regard to Old Navy, we are of course launching television tonight. So we'll be on for five weeks versus six weeks last year. And you'll see that our presence for Spring is largely about the same., so three circulars for Spring versus three circulars last year and then as Marka alluded to in her remarks, Gap for spring still has quite a bit of marketing. So last year we had no television. This year we actually will be on for four weeks. And that will start next week. So -- so the rest of the seasons are really still in the making. And we'll be describing that more to come.

Okay.

Your final question is from Dana Telsey of Telsey Advisory Group.

Good afternoon, everyone. Wanted to follow up on just markdown rate this year versus last year. How are you looking at the markdown rates by brand or for the overall company? And given your abilities to efficiently source, is there any improvement that you can see there on the cost structure side? And lastly, have you adjusted your hurdle rates for new stores and for lease renewals as for what you're expecting? Thank you.

Let me start. So as we look to last year, the much higher degree of promotional and markdown activity actually caused a decline in both our regular and markdown margins versus the prior year, so we actually got hit on both. As we work hard to get our inventory levels more closely in line with our actual traffic trends, we would expect in the coming year to sell less at markdown. With regard to hurdle rates, our hurdle rates are -- remain constant. Our cost of capital has not changed materially, and the so -- so the hurdle rates remain the same. What is different is our projections. So it's not the model. It's not the business model. It is the assumptions you make about what kind of sales level growth and margins you can look forward to in the future.

Thank you.

Great. 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.

Thank you for your participation in today's call. You may now disconnect.