蓋璞 (GPS) 2007 Q3 法說會逐字稿

Good morning, ladies and gentlemen.

Welcome to The Gap Inc.'s third quarter 2007 conference call.

At this time all participants are in a listen-only mode.

(OPERATOR INSTRUCTIONS) The conference call and webcast are being simultaneously record odd behalf of Gap Inc.

and consist of copy righted material.

They might 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 may appear on any transcript or broadcast of this call.

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

Investor Relations at 415-427-2175.

I would now like to introduce your host, Evan Price, Vice President of Investor Relations.

Good morning, everyone.

I would like to welcome to you Gap Inc.'s third quarter 2007 earnings conference call.

For those of you participating in the webcast, please turn to slides two and three.

I would like to remind you that the information made available on this webcast and conference call contains forward-looking statements including those identified in today's earnings press release which is available on GapInc.com as well as other statements that express our expectations, anticipations, beliefs, estimates, intentions, plans and forecast.

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 February 3, 2007.

Investors should also consult our quarterly report on Form 10-Q for the quarter ended August 4, 2007, and today's press release which is available on GapInc.com.

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 21, 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 principle measures, free cash flow and diluted earnings per share excluding Forth & Towne's net loss and expenses associated with the Company's cost reduction initiative which under SEC Regulation G we're required to reconcile with GAAP.

The reconciliation of these measures to GAAP financial measures are included in today's earnings press release which is available on GAAPInc.com.

Joining us on the call today are Chairman and CEO, Glenn Murphy; and EVP of Finance and acting CFO, Sabrina Simmons.

Now I would like to turn the call over to Glenn.

Thank you, Evan, and welcome, everybody.

Thank you for joining us on this Thanksgiving eve.

I would like to make a couple of general comments, and I am going to hand it over to Sabrina who will take you through the third quarter financial results.

There are a couple common themes in our financial performance in the third quarter I would like to touch on.

First and for most, we continued with our disciplined inventory management which we have been quite disciplined out over the last twelve months.

At the end of the third quarter our inventories were actually down 8% on a per foot basis.

Also we had some cost reductions, the majority of the cost reductions in the quarter came from a $75 million reduction in marketing expenses.

Beyond the financial components in the third quarter, I want to just touch on the we continue to push the notion of simplification, and we really are pushing down responsibility and accountability into the brands.

We filled a number of key executive positions in the quarter that we feel good about, and lastly, we launched a co-branded Visa card across all our brands in September of this year, and while it's early days, we actually feel good about the consumer response to date.

As we look forward to this long weekend selling season, two of our brands really participated a higher level when it comes to the Thanksgiving, Black Friday and the selling season that ensues on the Saturday and the Sunday.

First and foremost, that's Old Navy, and Old Navy will be opening almost all their stores, 90% to be exact at 5:00 in the morning this year, and that compares to 7:00 in the morning last year.

More importantly, Dawn and her team really have a fully integrated marketing campaign going on for the Thanksgiving -- starting the Thanksgiving selling season and going right through to the end of the holiday.

It is much more fashion conscious than it was last year, and brand appropriate, and I think what I like about it, it has a weekly promotional cadence that's unique each and every week which will bring value to that 20 something consumer on a weekly basis starting again this week and going to the end of the holiday season.

Tom Wyatt and his outlet team will be opening 170 stores at midnight this year, and that compares to 70 stores last year, and they also have a much more compelling value proposition and product offering than they did in 2006.

Our Gap and Banana Republic brands made positive strides in their product offering for the holiday season.

The Gap brand is all about color, and the theme of that is crazy stripes.

As a matter of fact, I am wearing a crazy stripes sweater as we speak.

And they are, judging by the reaction from our employees, and I was in stores with Marka and her team in Ohio this past week, we spent a full day in the stores in Columbus, and judging by employee reaction, people feel good about the product offering and how they're positioned for the holiday season.

At Banana Republic the theme is sharing the gift of color, and Jack and his team are really focused on bringing better gift ideas that are brand appropriate to what Banana Republic stands for in the marketplace.

As we look forward, there are a number of key areas the business is focused on, and we're trying to anchor people's time and effort around some key components for our business to be successful going forward.

First and foremost, it is about product, being innovative, being creative, being innovative and creative and being brand right across our portfolio brands.

We're looking forward to the work that Patrick Robbins and his team are going to bring to the the marketplace in the new year, and I know that Todd Oldham, because I was e-mailing him last night has been in San Francisco a number of times working with the design team at Old Navy, and I think Dawn's reaction so far has been positive about Todd, and we're looking forward to the differences he is going to make on the fashion forward product Dawn is going to have in 2008.

Return on invested capital is an important theme for the business next year.

One of the subcomponents of that is going to be the real estate strategies, the brands have just begun to do some work on.

There is a lot more work to do.

It is a large fleet.

It is somewhat complicated, but we are committed to getting the real estate strategies in place, and that will definitely help us become more disciplined and tighten up our process when it comes to return on invested capital.

Productivity and cost, all great and successful retailers are continuously finding ways to become more productive, more efficient, how do you take real dollar costs out of your business, and in some cases use that leverage of your Company to reinvest those dollars into your business.

Consistent day in, day out store execution.

We know that's critical in the success of our business.

How do we marry up great product development with making that come alive in our stores each and every day.

Our field teams are very focused on their service models for each one of the brands in 2008, and how do we make sure we deliver again on that consistent day in, day out store execution.

Lastly, people.

We want to retain the right people in our business.

We want to be able to attract people where appropriate, where we have some opportunities, and everybody in our business understands that we are in a financial turn around.

We will execute on our financial turn around, and they're looking forward to actually accomplishing that and are motivated and focused, and I continue to be impressed by the people I meet each and every day in our business whether it is in our product and design area, whether it's inside of the Corporate functions inside the brands, and most importantly, when I spend time in the stores, so I think we have very good people in the business today who are committed to the success, and our goal is to make sure we retain and attract the best talent for the future.

Before I hand it over to Sabrina, it is worth noting that, it has been well written and documented, we also feel this is going to be a tough economic environment in this upcoming holiday selling season.

We feel good that we've been disciplined on the inventory front and that we are becoming more and more conscious about our ability to reduce costs.

The consumer will ultimately be the judge, but we feel we're well-positioned for the holiday season, and we're also very clearly aware this is going to be a tougher environment than we faced last year.

Having said that, let me hand it over to Sabrina who will take you through the financial results for the third quarter.

Sabrina, over to you.

Thank you, Glenn.

Good morning, everyone.

I will begin today by reviewing third quarter performance and then I'll take you through guidance for fiscal 2007.

First, highlight its for the quarter.

For webcast participants, please turn to slide four.

Net earnings increased 26% to $238 million.

Diluted earnings per share increased $0.30 per share from $0.23 per share last year.

Operating expenses decreased by $82 million driven almost entirely by a $75 million reduction in marketing expenses.

We repaid $326 million in debt, and finally, we repurchased 48 million shares during the quarter for $887 million.

This resulted in weighted average diluted shares of 791 million for the quarter.

Please turn to slide five, sales performance.

Third quarter total sales were $3.9 billion, flat to last year.

Total Company comp store sales were down 5% in the quarter versus down 5% last year.

An important contributor to the spread between total sales and comp sales was the continued growth of online which grew 36% $247 million.

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

Turning to slide six, gross profit.

Third quarter gross profit was flat to last year's $1.4 billion.

Gross margin was 37.5%, up 10 basis points compared to last year.

Merchandise margins improved 100 basis points which was partially offset by 90 basis points of occupancy deleveraging.

Please turn to slide seven for operating expenses.

Third quarter operating expenses were $1.1 billion, down $82 million from last year driven by a reduction in marketing expenses of about $75 million.

As I will discuss in more detail shortly, substantially all of the second half savings we anticipated in marketing were realized in the third quarter.

Marketing expenses for the quarter were $124 million versus $199 million last year.

This decrease was primarily driven by reductions at Gap and Old Navy.

Turning to inventory on slide eight.

We ended the third quarter with $2.5 billion in inventory, down 5% over the third quarter of 2006.

Inventory per square foot was $59, 8% less than last year.

As we enter holiday, we are comfortable with our inventory levels at each of our brands.

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

Year-to-date capital expenditures were $519 million.

We opened 187 new stores and closed 127.

This includes 19 Forth & Towne closures and 45 Old Navy outlet conversions.

Companywide we ended the quarter with 3,191 stores and square footage increased 2% from fiscal 2006 year end.

Our press release contains more information about our store count and square footage.

Regarding cash flows on slide 10, year-to-date free cash flow defined as cash from operations less capital expenditures was an in-flow of $484 million, compared with an in-flow of $214 million last year.

The increase was driven primarily by lower inventory levels.

Another factor contributing to the increase in cash flow was a change in our vendor terms implemented in the third quarter.

As part of our normal business practices, we periodically benchmark vendor terms within our industry.

Based upon this review, we determine that there was an opportunity to modify our terms to be more in line with our competitors.

This change became effective on September 1.

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

We ended the third quarter with $1.7 billion in cash and short-term investments.

We repaid $326 million in debt, leaving $188 million in funded debt on the balance sheet.

With regards to cash distribution, we repurchased a total of 48 million shares in the third quarter at an average price of $18.39.

Turning to slide 11, our outlook for 2007.

We are updating our guidance for the following metrics.

We now expect full year 2007 diluted earnings per share on a GAAP basis to be $0.92 to $0.98 per share versus our previous guidance of $0.83 to $0.88 per share.

Our upward revision in guidance is primarily attributable to the third quarter improvement.

Our outlook remains cautious for the remainder of the year.

The rationale for our perspective is as follows.

The fourth quarter is our most important selling season of the year.

Given that we're still in a turn around, it is difficult to predict how product will be accepted, and the macroeconomic environment warrants caution.

I would like to now spend a few minutes providing context on the weighting of expected earnings between the third and fourth quarters.

Our guidance implies a relationship between the two quarters that is atypical from past years and this is largely attributable to the timing of the marketing savings.

We've previously stated that in the second half of 2007 we did not intend to spend the incremental marketing that we incurred in the second half of 2006.

That incremental marketing amounted to about $80 million in the second half of 2006.

Due to a number of factors within our operating division, substantially all or $75 million of the expected second half savings were realized in the third quarter.

As a result, we do not anticipate further significant reductions in marketing expenses in the fourth quarter versus last year.

I would like to draw your attention back to slide 11.

As you'll see in the second half of 2006, we increased the marketing spend by $48 million in the third quarter and $33 million in the fourth quarter.

This equates to about $0.04 and about $0.03 of earnings per share respectively.

Given the timing of when the marketing savings were realized this year, that implies about $0.03 of earnings that you may have expected in the fourth quarter have been achieved in the third quarter of 2007.

This shift is the primary driver of the unusual weighting between the two quarters.

Turning to slide 12, the balance of our guidance metrics.

We still expect expenses related to our cost reduction initiatives to be about $35 million pretax for the full year with approximately $6 million of related expenses in the third quarter.

This brings our year-to-date total to about $32 million.

Excluding about $0.07 per diluted share of expenses associated with the cost reduction initiatives and the closure of Forth & Towne, we've revised our full year 2007 guidance to $0.99 to $1.05 diluted earnings per share from the previous guidance of $0.90 to $0.95.

Please refer to our press release for a Reg G reconciliation of diluted earnings per share excluding Forth & Towne and our cost reduction initiatives.

We now expect gross interest expense for the year to be about $28 million, down from $35 million due to the reduction of interest accruals resulting from tax audits and other tax resolutions completed during the quarter.

Due to our upward revision in earnings coupled with a continuation of disciplined inventories and the change in our payment terms, we now expect free cash flow for the full year to be about 900 million.

Our press release contains a Reg G reconciliation of free cash flow for your reference.

We are reaffirming our guidance for the following metrics.

Full year operating margin in the high single digits, percent change in inventory per square foot at the end of the fourth quarter down many the mid-single digits on a year-over-year basis, stores we expect to open only 30 stores on a net basis yielding a full year net square footage increase of about 1%.

Store guidance by division is available on GAAPInc.com.

Full year capital expenditures about $700 million.

Full year depreciation and amortization about $550 million.

Full year effective tax rate about 39%.

I would like to close by saying that while we were pleased with some of the progress we made in the third quarter, we recognize there is a lot of work ahead of us.

The volatile and uncertain macroeconomic environment reinforces our commitment to return excess cash to shareholders and to maintain disciplined inventory management and expense control.

By focusing on what we can control our intention is to improve our margins as we deliver for our customers.

Now I will turn it back over to Evan.

That concludes our prepared remarks, we will now open up the call to questions.

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

(OPERATOR INSTRUCTIONS) Your first question is from Dana Cohen with Banc of America.

Hi.

Good morning, guys.

Two things on the SG&A.

Can you just talk about with marketing having been up $35 million in Q4 last year, not seeing the payback why you would be spending the same amount, and then as well there has been the $100 million of SG&A cuts coming out of home office.

Doesn't sound like you got any of the benefits in Q3.

Should we start to see that in Q4?

Thanks.

On the first piece, Dana, on Q4 SG&A, we are realizing some savings in some divisions.

Obviously Gap brand isn't running four weeks of television in Q4 that they ran last year.

That said, we have seven operating divisions, and so we're choosing to make some selective investments that are offsetting some of the savings, for example, in Gap brand, so one example that I will take as Glenn mentioned, we did launch our co-brand credit card in the third quarter, and so we are choosing to make selective investments in that program in the fourth quarter, and then just remember we have the other operating divisions internationally as well as outlet as well as online, so there is lots of moving parts, but we are reducing, for example, the television at Gap brand, so that's the first question.

On your second question, regarding overall savings, as a reminder we said that given our head count elimination we would expect savings of about $100 million on an annualized basis, which using simple math is about $25 million a quarter.

What we're seeing in the third quarter is we were still finishing some of those cost initiatives, so we wouldn't anticipate the full effect.

What we've seen in savings in non-marketing areas is $7 million, but remember in our reported SG&A we have about $5 million of kind of severance one-time cost initiative expenses included.

What you really have is about $12 million of non-marketing savings in the third quarter.

There too we are electing to make certain investments that are offsetting some of the savings we're seeing in areas in our online division, for example, that's driving very healthy 36% revenues improvement we're selectively making decisions to invest there, so we think that the number makes sense.

That said, we of course, are very focused in continuing as Glenn has said to manage our expenses on every line item.

Great.

Thank you.

The next question is from Brian Tunick with JPMorgan.

Thanks.

I guess our question sort of is on Old Navy.

We went back and listened to what Dawn had said a couple of quarters ago and talked about the strategies and processes, so we're just trying to understand what do you think, Glenn, is happening in Old Navy, and besides macro, why don't you think that business is getting any better?

Well, what I would say, Brian, is that down is that Dawn is going through quite the evolutionary change in our brand, and these things take time.

What you probably witnessed in the third quarter was not across the entire offering within Old Navy.

There was challenges within womens in particular, and not within mens and babies and kids.

She is really trying to institute again, it is an evolutionary change in our business to get it focused on our key core customer going forward, and these changes take a little bit of time.

As I mentioned in my opening comments, I am finding from a marketing alignment to what the brand targeted customer is going for at Old Navy, I am going to see that we're going to see the first of that really hitting this holiday season starting with the Thanksgiving program she has in place and running right to the holiday.

That's the first time that she will have everything fully integrated to where the brand positioning needs to be, so if she was talking September, Octoberish, and there was some challenges on women's, I think that we'll get a better read on her new marketing position to her key brand customer in this fourth quarter.

Thanks and good luck.

The next question is from Jeff Black with Lehman Brothers.

Thanks.

Good afternoon, everybody.

Glenn, I know it is early on, but can you tell us at least your thoughts about the existing remodel program?

What might be the fate of that program as we head into next year?

Do we morph into something a little different?

Do we table this until we get something better, et cetera?

Any thoughts on that much appreciated.

Thanks.

Well, I am waiting to get a better read to be honest with you, I guess we're not different than many other retailers.

Some of the remodel program is back end loaded, and I hate to make any harsh decision.

After a month of sales or even three months of sales.

So I will have a much better read for you sometime early next year about the remodel activity we've gone through.

Having said that, I do support the fact that there is an aging component to our fleet.

There is certain amount of remodel capital we have to put into our stores, whether that is wholly defined as maintenance capital in fitting rooms and cash wraps and H racks, some of that has to takes place.

We're also spending quite a bit of time with the teams right now defining what different levels of remodels which I don't think we've really had in the past and trying to define as we have our real estate strategy set and better understood by market what kind of capital should we be spending, if any, in selective stores that will support our overall market strategy.

That work is being put into place right now.

What we're going to end up with is some stores may not be worthy of a remodel, in some cases it may be a minor remodel, what people in the industry call a cheap and cheerful.

In some cases it might be worthy of a full gut.

These are all decisions that I think when you really understand what your strategy is by each one of the brands, by market become much easier decisions to make.

So more to come on this when we speak to you at the end of our fourth quarter and at which point we'll be talking a little bit forward about 2008.

Great.

Good luck in holiday.

Thanks.

The next question is from John Morris with Wachovia.

Thanks.

Good morning.

Have -- I guess first of all relating to the cost savings as we look out into next year, have you identified further potential for non-marketing cost savings into next year?

And Sabrina assuming that that's kind of the $25 million quarterly that you're talking about, would you continue to reinvest some of that into further investments like you talked about the co-branded Visa card into next year, and what would those investments be?

So really kind of cost savings into '08?

John, just a quick comment just before I hand it over to Sabrina to get into some of the detail.

One thing we have done over the last number of weeks is we've sort of broken down SG&A.

I think it's -- SG&A is a total pool of costs.

We've worked hard with the teams here to get down to 30 to 50 significant cost centers, and ultimately those all add up to an SG&A number, but we've really got the focus and the business down to much more detailed information, all the elements that make up SG&A.

So that work again has just begun, and we're going to be looking at all of those elements cross all of our brands from the Corporate entity all the way down to the divisional business and finding ways to take out non-value-added costs and make sure that we are simplifying the business and working hard to get more productivity and efficiency out of the Company.

I will let Sabrina answer the second part of your question.

John, overall as a reminder, we definitely have eliminated the positions that represent about $100 million in annual savings.

That said, as we enter every year, just like every retailers, there is momentum for pay raises, for inflationary items, et cetera, that we have to battle against, so part of our job as we enter a new year is to make sure that we're really capturing these savings and working really hard to offset the natural momentum on expenses that you have as you enter each and every year.

We're very focused on that.

In addition, we will make choices where we believe we will get a return for making the expenditures, so I used again online business and our investment in marketing for our co-branded credit card as examples.

We think those are smart decisions, so there will be some of those shifts, but overall as Glenn said, we will be looking on a continuous basis to every line item to look where we can simplify and reduce, and as a reminder, again in '07, not only did we eliminate the head count, but we also closed a distribution center, and then we've consolidated some of our office space.

In San Francisco and San Bruno, in particular, and that should bring us about $10 million in annualized savings as well.

So you are saying that you would continue to see further non-marketing cost savings into next year, correct, because of some of those head count reductions?

We're absolutely working to reduce our cost base.

That said, we have some offsets that are going to go on in terms of momentum entering a new year and investments we choose to make, but we are capturing savings on an annualized basis from our actions.

Thanks.

Sorry.

Go ahead.

Also, we're trying to shift the notion of one time to the concept of perpetual, and this is just the market in which we operate in.

We're against a very highly competitive set of competitors here in North America and around the world.

We have to make sure we're perpetually trying to find ways, innovative ways, creative ways to get costs out of our business.

The business is committed to doing it.

These things do take time.

Round one is just identifying what we're willing to do, and then we choose a time in which we're going to execute on taking those costs out of our business.

Very helpful.

Good luck for holiday.

The stores look great.

The next question is from Paul Lejuez with Credit Suisse.

Thanks, guys.

Can you just give us a breakdown of how many Gap adults versus kids, baby, bodies there are, maybe talk about what the the right numbers are for each of those going forward, Glenn?

Maybe you have some initial thoughts.

Then just second, you're a few months into monthly flows at Old Navy.

Are you finding that the systems and DCs in place are adequate to handle that or are there pieces missing?

I will just start just reminding Paul of sort of where we're at in store count.

I will talk more in concept because many of our boxes contain kids and body and adults, so overall we have about 750 adult concepts.

We have about 700 kids and baby concepts, and we have about 200 body concepts.

I would think that if Marka was joining us today, she would admit that per portfolio stores is a little bit more disaggregated than she would like it to be, and that's why the work has begun led by Eric Bauer within The Gap brand business to really be crystal clear on what the outcome on the real estate strategy they would like to have over the next five years.

That will drive decisions and will drive priorities, but there is definitely a need to make that portfolio a little more in keeping with how we believe we should be presenting ourselves to the consumer going forward.

On the distribution center front, Dawn's work at Old Navy from in terms of a monthly flow there has been some of that taking place in November and December, but the real move to her new flow of products on a monthly basis will begin in February.

Yes, our distribution centers have been working in a parallel way with people in Old Navy to make sure they're prepared.

We didn't have to make any significant capital adjustments inside the DCs.

They're really just process adjustments from the vendor to our DCs out to the stores and all that work has been going on for the last three to four months.

What about the design system in general?

Is everything smooth flowing on the Old Navy side with the monthly flows?

Again, I think it is early days.

We're making quite the change from the way we used to flow goods, the way we flow goods today, and I think there was some categories we're embarking on the monthly flow this fall, but in terms of the entire store we'll see that starting in February, and of course we've made knowing that we didn't want to do the whole store immediately, we wanted to get A, some sort of category by category test this fall.

We'll have a much better read, but yes, whatever adjustments, and they were not significant.

Again, they're more process adjustments from the vendor to our DCs and into the stores.

Those are still being worked on, but I would say are well under control.

Thanks.

Best of luck.

The next question is from Janet Kloppenburg with JJK Research.

Hi, Glenn, hi, Sabrina, how are you?

Good.

Thanks.

Glenn, I was wondering if you could talk a little bit about the repositioning of Old Navy?

We don't have the advantage of seeing the product for spring and the go forward, and I am wondering if you have confidence in this new positioning of targeting a younger customer and a distinct customer from the Old Navy kids customer, and I am wondering if we don't see improvement there in the holiday season or in the first quarter if you would consider cutting the marketing expense for this brand as well?

Thanks very much.

No problem.

First of all, I want to say that I think when you make the changes that are going on in Old Navy, nothing is set in stone permanently.

By that I mean there is always going to be minor, I want to emphasize minor adjustments as Dawn and her team learn how customers react to this evolution they're going through at Old Navy.

I know the key thing is that we're very focused on the 20 something customer, and I think I believe in that.

I think that is the right strategy.

Without giving up on the mum which is a critical component to what Old Navy is about, and I think trying to find that right balance is something that the marketing campaign will see a little bit this fall, but definitely into next spring is what Dawn and the team are going to strike.

I am actually feeling that they are making the right strategic decisions now like anything, once the strategy is understood inside that business, is how does the execution now in terms of product and marketing and how does that resonate with customers and how do we make along this journey the minor adjustments that need to be made as we get good, solid feedback from our customers.

I don't believe personally, and I am sure Dawn feels similar, this is not a massive departure from where we were before and what customers Old Navy have always had and have been loyal to that brand.

Yes, it is an adjustment and evolution from where we have been over the last twelve years, so more to come.

We're definitely committed to listening to customers, hearing what their feedback is, and making necessary adjustments.

Overall, at a very high level strategically I think Dawn is and her team are on the right course.

And the marketing?

Marketing decisions I think that again we're going to get a very early read as I mentioned in my opening comments, and starting this Thanksgiving her first five-week campaign that is fully integrated to her new customer positioning.

We'll see that into the new year, and all of us agree that if for some reason the marketing, whether it is the medium or the overall message is not resonating appropriately, we're more than prepared to make the adjustments necessary, but let's get a read first, and see what customers have to say and see how the stores perform and look at gross margin dollars per foot, and once we have those indicators, obviously we want to be successful, so we'll make the appropriate adjustments.

Thanks very much.

The next question is from Adrienne Tennant with Friedman Billings.

Good morning.

My question is on the guidance for the fourth quarter.

So on a similar comp as the third quarter, are you kind of telling us to think that we would not see leverage on the SG&A line?

Is that kind of how we should read it?

Adrienne, we're trying to be helpful by guiding to the operating margin line as well as the EPS line.

Just as a reminder, what we said is a lot of the leverage because we got over 2 points of leverage on operating expenses in the third quarter, and some of that leverage came from the very large marketing expense decrease and the shift out of the fourth quarter into the third, so I will just leave you with that notion.

Okay.

And then I guess as you're looking at the, mall traffic is obviously still down it seems, are you seeing kind of an offset uptick?

Clearly the direct business is growing, but are you seeing even more so offsetting some of the weakness that's happening in the malls?

That could be part of our online increase.

It is always hard to say.

There has been a decline in overall mall traffic, but our traffic has been negative for quite some time, so we work all of our other comp levers to try and offset that.

Overall in the quarter in the brands where we were able to overcome and deliver a comp that was better than their traffic comp, we've actually seen both conversion and AUR support the delivery of that.

Okay.

Thanks so much.

Good luck.

Thanks.

The next question is from Lorraine Maikis with Merrill Lynch.

Thank you.

Good morning.

You've been very smart about your inventory buys in this tough macro climate, and we were just curious to hear when you'll feel confident enough in the product and in your traffic levels to start boosting that buy a little bit to support comp?

Thank you.

That's a great question.

Our position currently is that we want to continue to buy our inventories at a high level sort of in line with current traffic.

We feel that it is really important in driving to our strategy of supporting the probability of getting better regular priced selling and also improving our margins overall.

We would rather error on the side of running out of a few items than having too much and having to drive back down to markdown and increase the amount of costs sold at markdown, so I think time will tell.

We're watching it closely, but in the near term we're very pleased, especially given the macroeconomic climate.

In the near term we don't have an intention of moving off of that.

Thank you.

The next question is from Kimberly Greenberger with Citigroup.

Thank you.

Glenn, your comments on The Gap real estate strategy were very helpful, and I was just wondering if you could just help us think big picture about what your view is on the Old Navy store base and the future growth there?

Well, I think that my comment about The Gap brand when it came to its real estate position really applies to all brands, and I think that Dawn and her team and Jack and Banana Republic and Tom Wyatt and outlet and our international businesses, they are all going through the same exercise, and in terms of whether there are new store opportunities for Old Navy, whether there is chances for relocations or expansions or reductions or remodels, will all come out of this strategy.

It is too soon to predict.

When we're together in February we'll have a much better indication of what our 2008 capital program looks like, what kind of investments we feel are necessary and needed, and subcomponent of that will be whether there is new store opportunities.

I will say to you that there are all over North America there are communities that are growing, that are establishing themselves in different states, and I think that we would be, I think it would be inappropriate for us to not consider opportunities where the average disposable income of that marketplace and the population trends indicate that it is appropriate for one of our brands to enter into that new and developing market.

So we're going to consider those.

We don't want to say there will be no new store opportunities, but as everybody on the phone knows, that the focus over the last number of years has been in reducing the fleet and now I think we're going to become a little more disciplined going forward on a return on invested capital.

When you marry that up with our real estate strategy, I think we'll have much better answers for the long-term, and I am talking about a three to five-year internally understood plan of how we're going to invest our capital and ensure we get a return for that capital.

Terrific.

Thanks, Glenn, and good luck here at holiday.

Thank you.

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

Good morning, Glenn and Sabrina.

My question really is are -- what kinds of things if any new things are you doing to drive traffic at Gap?

And then what kind of reaction have you had to the more subtle sales signage at the Gap brand?

Thank you.

So what we find, Jennifer, is that traffic is typically for us a lagging indicator, so Marka and the team have been very, very focused obviously in improving the product assortments and improving the store presentation, and what we look to initially as signs of improvement is whether we're actually driving healthy margins, whether we're driving gross margin dollar improvement.

We feel that when those signs appear and we start driving a healthier business in terms of more regular priced selling, you would naturally start to get back some of your traffic.

We saw this path with Banana Republic several years ago, so traffic again will be more of a lagging indicator.

That said, we're still committed to doing what we can with the marketing dollars that we have committed for the seasons to drive traffic, so we've chosen not to do television, but we very much are investing in marketing for the important holiday season.

We're continuing to do magazines, I am sure you have seen, newspaper, outdoor, so we are committed to keep our brand top of mind and present to the customer the more improved product assortments and store experience.

Great.

And the subtle sales signs in Gap, have you had any response?

You know what, we'll probably talk about what's gone on recently on November sales, Jennifer.

Okay.

Great.

Thank you very much and good luck.

Thanks.

The next question is from Jeff Klinefelter with Piper Jaffray.

Yes, just a question on sourcing.

Hearing more about some sourcing pressures coming out of Asia and specifically China, and curious more on Old Navy where it seems to be impacting the lower cost providers in the apparel industry.

As you look forward into '08, are you anticipating that there would be some of these pressures and are there strategies to sort of diversify your sourcing base to avoid that?

I think there is always going to be pressures.

This is the never ending tug between suppliers and retailers.

There is no question we're aware of commodity price increases, but I will say that we're a large Company.

We should be bringing increasing level of efficiency and leverage given our size into the marketplace.

Have we seen any signs today?

The answer is no.

Are we as a business very prepared and poised to make sure that we can -- if there was to be market increases across the board, that we can make sure those are minimal inside our business, and we would have offsets against it.

The answer is also yes.

But right now no indications.

Again, we are benefiting from $16.5 billion in sales we can bring to the marketplace.

We have very strong sourcing hubs around the world, and they're working with the vendors to make sure that we're getting speed, the quality that we ask for when it comes to our relationships with these partners and making sure we're getting the cost of goods that we actually deserve given the size of this business.

So we're aware of the macro issues, but we believe we're well-positioned to manage accordingly coming into the new year.

And, Glenn, just one other thing in terms of your Asian expansion through licensing franchising, would any more aggressive expansion on that front wait until after you see more of a stabilization or recovery in your U.S.

business?

Is that what it is contingent on?

I think it is early days.

We've definitely dipped a toe in the water in Asia with some franchising arrangements we have made.

We'll have definitely more to speak about on that front in 2008 because most of those stores didn't open until this late summer and early fall, and it is too soon to get a read on them, but we're believers in the initial strategy.

We think there is some long-term potential in our franchise business, and as we get a better read, we'll be happy to discuss them in forums such as today to let people know what the long-term opportunity may be for an expansion similar to the one we've currently embarked on with franchise businesses in Asia.

Thank you.

The next question is from Todd Slater with Lazard Capital Markets.

Good morning.

Good morning.

I want to be the first to predict crazy fair aisles for holiday '09.

I was going to ask a little bit more about the international, the piggyback on the return on capital because you have got both owned and franchised stores obviously depending on the geography, although most of the newer initiatives have been on the franchising side.

So maybe you can just tell us how much income that is generating from franchisees, and what line item does it hit in the P&L and maybe you can also just talk about what your outlook is for Piper line?

Thanks.

Just on the franchise side, we don't break it out right now, and have no intention of doing that going forward.

What I would say, again, it is early days.

It is obviously a business that we're going to be watching carefully, reading it, understanding it, we have a very talented team under the leadership of Art Peck who are doing some work on the franchising side, it's got an attractive return on capital as you would expect which is good to see, and I think we're going to be looking forward to anniversarying some of those stores early part of 2008 and getting a better understanding of what the potential growth opportunities and investments will be in franchising.

On the owned side, do those stores have -- I don't think those stores have comped positively since 2000.

Is the return on capital anything to talk about on the U.K., Japan, Ireland, France?

Todd, we've been working on our fleet internationally.

Japan is actually a very healthy business in terms of return on cash flow in particular.

If you think about their model, we're often within department stores so we have a variable rent agreement within those department stores, so that it is a pretty solid healthy model, although there is always opportunities to improve it.

In Europe there has historically been more challenges.

Those leases are longer term in nature, and the rents can be high, so we have been working in Europe to improve the state of the fleet.

We're looking -- we've been looking at some closures, and those are within our closure count.

We also think there is still great opportunity within Europe.

We've opened some concession stores, so in Ireland, for example, and that's been going very well.

Great.

That it helpful.

On Piper line?

Well, Piper line, I think we just had the anniversary of the Piper line launch.

Toby has a great track record of bringing new brands to market on the online business.

So far so good.

He is exactly on the plan he would like to be on, and I think he will continue to grow that business.

It is a very nice complement to our apparel brands, and I think that we are -- even though it's not a very large opportunity, I think it is a nice complement to what we have today, and Toby certainly is putting the right steps in place to get us to the sales level we want to get to and ultimately to the profitability level we believe we can get out of Piper line.

Thank you.

Your next question is from Michelle Tan with UBS.

Thanks.

I was wondering if we could get a little more color on the merchandise margin improvement in the quarter?

I think you said it was up 100 basis points.

What did it look like on an IMU versus markdown basis?

And also the occupancy deleverage was higher than I would have thought given the comp.

Perhaps a little more color that we could get on the occupy deleverage in the quarter and how we should think about it for fourth?

Thanks.

Sure.

A couple things, Michelle.

On the merchandise margin side, I would say overall we were pleased that that was -- that improvement was driven by a higher percent of goods sold at regular price, so that is right on with our strategy.

The second lever that supported the improvement in merchandise margins was our markdown margins were very healthy, so those are the two primary drivers.

I wouldn't say there is any major change in IMU.

Certainly from a pricing perspective overall we're not looking to change that significantly.

We're working always to reduce our average unit cost, but I would say overall it is more regular priced selling and better markdown margins.

With regard to the raw deleveraging, if you're comparing it perhaps to Q2, we did deleverage a little bit more, and some of that is simply attributable to higher remodel activity in Q3 of this year where we accelerate depreciation.

So you get a little bit more depreciation going from that activity.

Great.

Thanks.

I guess just looking at Q4 also, it seems like the gross margin compares pretty meaningfully easier.

I was wondering if there is any major offsets either because of the 53rd week or anything else that we should be aware of that make fourth quarter more challenging on the merchandise margin side?

I don't think there is anything to call out in particular at this time.

Perfect.

Thank you.

The next question is from Lauren Levitan with Cowen and Company.

Thanks.

I also wanted to follow-up a little bit more on the merchandise margins given in Q4 you're up against I believe it's about 450 basis points in decline over the last two years.

On the lean inventories we would hope that you would show again those merchandise margin improvements.

I am just curious if you can give us some sense as to whether or not there is anything in the competitive environment, in the pricing environment that would prevent you from over the next several quarters from getting back to sort of average merchandise margins that the businesses have generated?

And then related to that with respect to Black Friday, just curious if the stores that opened, the outlets that opened at midnight last year and the Old Navy that opened early last year if the sales in those incremental hours were sufficient to justify being open and what kind of offers are going to be out there to compel people to make those kinds of trips versus going to a big box retailer in the hard goods side or a discounter who might have much higher ticket items discounted during that door buster kind of timeframe?

Thanks.

Hi, Lauren.

It is Sabrina.

I will start with the margin question.

I think the best way to answer that is it is clearly our objective to improve gross margin dollars, primarily also gross margin percent.

Part of that strategy is supported by our lower inventory levels, so a lot of the results of course depends on how the customer will vote, and that is uncertain especially in this environment.

So do we feel like we are taking the correct steps, not only with our inventory levels, but also with the teams in the brands working on the assortments and improving the assortments and the point of view in the store and how we're presenting that.

We absolutely feel like we are moving in the right direction and taking those steps.

That said, there is a lot of uncertainty with regard to, A, how the customer will respond, and, B, we do anticipate that this holiday season as an example will be highly competitive, so we have to be prepared to take the action that will be necessary to move through our unit.

On the store openings, it is a combination of being competitive to what's going on in the marketplace, and I think we were proactive historically when it came to store hours.

The outlet business for sure makes sense to open at midnight.

That's really the cache of what those outlet centers are all about, and I think we were leaders to get 70 outlet malls last year to move up to 170 this year.

I think that we really believe working together with all the other brands inside those centers, that is a real plus.

I am going to be in Florida for the opening at midnight of one of our big stores in Orlando, and I am very impressed what I heard about last year.

We think that's actually going to be a net positive for us on the outlet business.

On Old Navy, the hours just keep sliding on us.

We thought 5:00 when the decision was made by Dawn and her team about eight weeks ago was more than appropriate and competitive and now you have some retailers opening at 4:00 in the morning.

There is a point, and I can't tell you just yet, particularly until we see the results, but I think from an industry point of view there is a point where you do get a lot of diminishing returns.

I think right now we don't believe that's going to be the case because we're going to manage our labor appropriately over the 5:00 opening to the 11:00 closing to make sure there is in incremental labor dollars for us, and the customer is going to respond positively.

I think we have a great program in place.

As I mentioned, it is fully integrated.

That brand lends itself, and I think in some of our locations too, we find ourselves -- I don't know the exact number but we can get it later on, the percentage of our 1,000 stores are located right adjacent to a Best Buy which we think we get the nice drafting off of the partnering that goes on with some of those locations.

I think we feel good about, it but to be fair given the fact it is two hours earlier than last year post Black Friday, you can bet there is a number of people in Old Navy who will be tearing through the numbers, doing the right analysis, and making sure that we make good, sound economic decisions going forward.

That is very helpful.

Thank you and good luck for holiday.

Thank you.

Operator, that will be the last call.

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

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

Thank you.

Ladies and gentlemen, thank you for participating in today's Gap Inc.

third quarter 2007 conference call.

You may now disconnect.