蓋璞 (GPS) 2008 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen, I will be your conference operator today.

At this time, I would like to welcome everyone to the Gap Inc.

second quarter 2008 conference call.

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

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

Good afternoon, everyone.

Welcome to Gap Inc's.

second quarter 2008 earnings conference call.

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

I'd 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 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 February 2, 2008.

Investors should also consult our quarterly report on Form 10-Q for the quarter ended May 3, 2008 and today's press release.

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

These forward-looking statements are based on information as of August 21, 2008, 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 the non generally accepted accounting principal measures, free cash flow, and diluted earnings per share excluding expenses related to the Company's cost reduction initiatives which under SEC Regulation G we are required to reconcile with GAAP.

The reconciliation of this measure to the GAAP financial measure is included in today's earnings press release which is available on Gapinc.com.

Joining us an the call today are Chairman and CEO Glenn Murphy; and Executive Vice President and CFO, Sabrina Simmons.

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

Thanks, Evan.

Good afternoon, everyone.

We're pleased that in the second quarter we again delivered on our strategy of achieving bottom line earnings growth driven by strong merchandise margins and cost management.

I'll begin today by reviewing the quarter's results followed by an update on our full year guidance.

First, highlights for the quarter.

Earnings per share were $0.32 versus last year's $0.19.

Excluding last year's $0.02 per share of expenses associated with the Company's cost reduction initiatives, last year's EPS was $0.21 versus this year's $0.32.

Please refer to our press release for a Reg G reconciliation of EPS.

Driving our earnings, gross margin increased 390 basis points to 38.2% versus 34.3% last year.

Operating expenses decreased by $74 million to $965 million and we purchased 16 million shares for $284 million.

For webcast participants, please turn to slide four.

Second quarter net earnings were $229 million, the effective tax rate was 39% and weighted average diluted shares were 719.

Turning to slide five, sales performance.

Second quarter total sales were $3.5 billion, down 5% versus last year.

Total Company comp store sales were down 10% in the quarter versus down 5% last year.

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

Turning to slide six, gross profit.

Second quarter gross margin was 38.2%, up 390 basis points compared to last year.

Merchandise margin improved by 560 basis points versus prior year, driven by improvements in both regular price and markdown margins.

Although occupancy costs deleveraged by 170 basis points, second quarter gross margin dollars increased by 6% to $1.3 billion.

Please turn to slide seven for operating expenses.

Second quarter operating expenses were $965 million, down $74 million versus the prior year.

Largely driven by reduced expenses related to our stores.

Some of which are driven by the decline in sales.

Please note that last year's reported expenses included $20 million in pretax dollars related to our cost reduction initiative.

Second quarter marketing expenses were roughly the same as last year.

$82 million this year, versus $88 million last year.

Turning to inventory on slide eight, we ended the second quarter with $1.7 billion in inventory, down 14% versus the prior year.

Inventory per square foot was $39, down 17% versus down 6% in 2007.

Entering August, we remain comfortable with our overall inventory levels.

As we have shared previously, we've adopted a principle of buying inventory broadly in line with current traffic trends.

That discipline continues to serve us well in the current macroeconomic environment.

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

Year-to-date capital expenditures were $208 million.

We've opened 55 stores and closed 52 stores this year.

And ended the quarter with 3,170 stores.

Total square footage is flat to prior year end.

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

Regarding cash flow, on slide 10.

Year-to-date free cash flow defined as cash from operations less capital expenditures was an in-flow of $354 million compared with an in-flow of $347 million last year.

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

With regard to share repurchases, we repurchased a total of 16 million shares in the second quarter for $284 million at an average price of $17.45.

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

Turning to slide 11, our outlook for 2008.

Although we're pleased with our first half performance and the progress we're making, there is still much work to do.

Especially at Old Navy.

Our second half financial strategy for the Company remains anchored in delivering healthy margin and managing cost tightly.

Given the volatile macro environment and recent economic indicators like housing and unemployment which don't seem to point to any improvement in the second half, we believe our short-term strategy is prudent.

We took both these internal and external factors into account in developing our full year EPS guidance, which as previously stated on our July sales call, is $1.30 to $1.35, up from $1.20 to $1.27.

We are also updating full year guidance for the following metrics.

Operating margin, increased to about 10%.

Full year capital expenditures, down to about $450 million from $500 million, driven by fewer new stores and remodels.

Our guidance by category is about $110 million for new stores, $190 million for existing stores, $100 million for IT and $50 million for headquarters and distribution centers.

Free cash flow, about $1 billion, up from $900 million.

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

The number of new stores we expect to open in 2008 has decreased by 15 stores to about 100 for the year, driven primarily by Banana Republic.

The number of closures has not changed from last quarter's guidance and remains at about 115.

These figures include about 15 store repositions which are reflected as both an opening and a closing.

Please refer to our press release for a summary of store activity and gapinc.com for 2008 store guidance by division.

There are no changes to our guidance for the following full year metrics.

Interest expense remains at about $5 million, effective tax rate remains at about 39%, net square footage remains about flat and depreciation and amortization remain at about $550 million.

We are providing our initial inventory guidance for the third quarter and expect the percentage change in inventory per square foot at the end of the quarter to be down in the mid-teens, compared to last year.

Driven primarily by reductions at Old Navy.

In summary, we're pleased with our second quarter earnings results.

As we move forward into the second half, we remain focused on successfully executing against factors that we can control, such as cost and inventory management and returning excess cash to shareholders.

Now I'd like to turn it over to Glenn who will provide an update on our brands and our business.

Thank you.

Thank you, Sabrina, and good afternoon, everybody.

I have a few comments I want to make before we get to the Q&A session of the call.

I want to build first off on a few of the comments that Sabrina made, particularly when we look at the macro environment.

There's nothing new from our perspective looking to the second quarter as we were living through the first -- sorry, living the second half as we lived through the first half of 2008 and certainly nothing new from what you've heard from other retailers over the last number of months.

The environment is still challenging.

We don't see any reason for any optimism in the back half of the year and we're managing our business accordingly.

As you can see from our results, we have been very focused on the three key financial pillars that have produced the results you've seen over the last four plus quarters.

Namely, driving on trying to improve and grow margin dollars in our business.

Certainly been the number one pillar of our financial strategy.

Secondly, reducing real dollar cost.

And as we mentioned before on other calls, we believe the base inside the business was too high and we have done some work on that in the last 12 months and there continues to be a runway and more work to be done on reducing real dollar cost inside the Company.

Lastly, improving our return on invested capital.

That current financial strategy is one that's carried us well so far.

We believe we're going to continue on that front as we look forward to the back half of 2008.

The one thing beyond that, we want to make sure everybody is clear on, we recognize the fact that the trajectory of our traffic in our business is unacceptable.

While there are definitely consumer sentiment issues, and macro economic issues, as we look at the traffic in the business and look at the market share leader that we are, it's unacceptable we've been on this trajectory for a number of years.

We always want to reassure people, we are doing work behind the scenes and we are getting ourselves ready to play more offensively minded when it comes to getting traffic through the front doors and across the lease line of the malls in which we're in.

As I said at the last call, the decision as to when to do that by brand or by month is really premised on when is the product right and all the work we've done on brand positioning, target consumer and product aesthetic.

When are the stores right.

Want to make sure that the product that gets developed by our talented teams gets presented right to the consumer.

When is the marketing message correct.

And are consumers really willing to respond and be attentive to the messages we're going to have.

And those four components, we feel comfortable and confident on, you will see us having to add a fourth component to our three key pillars, which is reversing the trajectory of traffic that we've been on for the last number of years.

Let me shift gears and talk about the brand updates.

This morning we put out a press release that announced that Tom Wyatt has become and was announced the President of Old Navy.

Tom has done an amazing job the last six months.

He went in clearly as you all know as the interim President of Old Navy.

Has done a great job, getting the team focused on their target consumer, their brand positioning, rallying them around a vision that we think is appropriate for Old Navy.

It's important for everybody to know, we in the last six months had a full slate of candidates which we met with.

We've actually been pretty impressed with the candidates that came forward and a number of people actually wanted to run Old Navy.

This impressive list, therefore made it a tough decision to get to where we got this morning.

The one thing I do know it's nice to have choices and nice to be in a position where we could choose the best candidate for the brand who would give us the best chance to be successful going forward.

Tom has exhibited that.

He's been tested the last six months.

He's done an incredible amount of positive work.

The first day he went in there I told him to run it like he owns it.

He's demonstrated to me that he gets that premise in the work he's done to position the brand for future success.

Now, also in the release we were very clear that we are actively looking for a senior seasoned merchant to work alongside of Tom and to pick up that critical part of the business.

In the last six months, through the search we've done, we've met a lot of great candidates.

There's been a lot of people who may not have been particularly appropriate to step into the ultimate role but have great experience and will be considered as part of this active search we have going on to bring in this senior, seasoned merchant to work alongside of Tom in the future.

Let me shift gears and talk now about Gap.

At Gap the business, consumer acceptance was still very positive for the product in July.

I think that's evidenced by us by not only the time around stores and talking to customers and talking to our employees, but also by the metrics we look at like cost sales and rank and the healthy margins that business has been running.

I was in New York recently and talked to the teams who do the work for us in product design and in merchandising.

And I really believe the work Mark has done to get them so focused on their customer, on what Gap is all about, you can really feel it inside that building.

Hopefully July consumer acceptance is the beginning of Gap returning to being very consistent in how they approach and how they design into what their ultimate target consumer is and the brand positioning of Gap brand.

Looking forward, there's been some work done over the last year on what we call the influencer campaign.

Examples of that are the collect work that's coming up in September, the Pure Hardy bags that we've done, the artist teas, a lot of those influence or ideas received a lot of positive PR and in the markets in which they were in were well received by consumers.

But in fairness, they were limited in their scope.

I think that Mark and the team are looking forward in the fall and the holiday season of continuing along that relationship that Gap has always had with culture and building on that and finding how well that resonates with its customer and looking to do that in the Fall and going forward in a much more macro way and not as selective as it's been done over the last six to nine months.

Speaking if I could about Banana Republic, traffic continues to be the issue of Banana Republic.

We've spoken about that for the last number of months and we've been very focused on the external impact to our traffic.

People who are in our competitive set in specialty apparel, some department stores that we consider to be direct competitors of Banana Republic have been much more promotional than we've seen in the past.

There is no question that has put pressure on the traffic at Banana Republic.

Having said that, as we're talking about traffic declines going on to a number of months now, we have an equal amount of work on our own side of the business, looking at ourselves internally as we have been looking at the business externally over the last three or four months.

As recently as last Friday, I was in some stores with our leading merchants, talking about the business, looking at the hindsighting, talking to Jack Calhoun who is our President and I can guarantee in the (inaudible) is there's a lot of effort going on being aware how we manage our business and how Banana Republic shows up against these external forces.

But also, not being delusional that there is always, as a business we should always be looking internally to what the missed opportunities may be for us.

Lastly, I felt it was appropriate to speak a little bit about real estate.

Last couple of quarters, we've talked about the real estate strategy work we've had going on.

That work is now completed.

Got done at the end of July.

I had meetings in the last two weeks with all the brand leaders and the real estate representatives.

And I want to just refresh everybody that we've never had a clear real estate strategy for our 3100 plus stores and our 40 million square feet.

That was one of the first observations that were made when new management came in.

And that work is now completed.

It was very much done to what is the role of every single store from its simplest form, rolling that up, what's the role of every store in every market, what is the right size for every single store.

How do we take a more consistent approach by market, by store and now that we have that clearly articulated that fits with the overall brand position of each brand, the real estate strategy is a derivative of what the brand position is, we now have that information.

That's going to make our lives so much easier and provide clarity inside the business, allow us to make the quicker decisions and ultimately become the kind of Company we should be which is one that's more agile and nimble and a simpler structure than we've had historically.

One element of the real estate strategy I can report on, but clearly not the reason why we did it was one of the outcomes was what's going to happen with our square footage.

And as we've foreshadowed in the past, we believe our points of distribution are fairly appropriate.

There's always going to be some culling of stores that's going to take place over the next number of months and years of underperformance.

That's always going to happen for any retail Company.

Our conclusion was we had more square footage for point of distribution than we needed.

It looks to us like we will have the potential to reduce somewhere between 10 and 15% of our square footage over the next three to five years.

The work now is really how are we going to execute on this strategy we have in place and what is the sequencing of getting that done.

One of the outcomes, and I want to make sure I'm clear on this is not the reason to do the real estate strategy.

Real estate strategies are critical to any business like ours, need to have a clear understanding about how your portfolio is going to be managed looking forward.

But from our perspective, at 40 million square feet, looking at a potential opportunity between 10 and 15% square footage reduction over the next three to five years.

So those are my opening comments.

Again, thank you for your time.

I know there's questions coming.

Before we do that I want to hand it back over to Evan.

Evan?

Thanks, Glenn, 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) Your first question comes from Lorraine Maikis with Merrill Lynch.

Good afternoon.

Just wanted to ask a question about the SG&A opportunities going forward.

You've managed to hold the dollars pretty flat in a tough environment and I was just curious to see what other areas you're looking at for the back half and into '09 and if there are other opportunities for cutting there?

Yes, so I think with regard to the back half, as a reminder, I want to be helpful because we don't explicitly guide to SG&A dollars.

As a reminder in the back half we are anniversarying our Company-wide cost reduction initiatives from last year.

So the comparisons do get more difficult.

As we said before, Lorraine, we are kind of looking at across the board every line item but with some of the bigger buckets being focused around driving continued efficiency in our store payroll, our logistics spend, we think we have opportunities there and then on our cost sales line, really our average unit costing and continuing to keep a strong, strong focus on that.

I do want to also mention, though, it's important to remember that in Q3 of 2007, we actually brought down our marketing expenses significantly.

So in that area of marketing, you shouldn't expect any greater significant reductions in Q3 of '08, given that we have already brought those down quite a bit.

Thank you.

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

Good afternoon.

I wondered if you could talk about the kind of reception you've had at your shopping made simple web redesign campaign and what learnings you've had from that?

Thank you.

If you're referring to what we call internally as universality, I think the response -- it's difficult to measure after five or six weeks, but initial response, certainly the buzz that's going around from people who are heavy users of eCommerce Internet is very positive.

For some people on the phone who may not know what Jennifer is asking about, is right now you have the ability, which we didn't have the ability before and no other eCommerce business with multiple brands like we do all have developed an ability to go into Gap and Banana Republic and Old Navy and Piperline and buy something from each one of them and check out once and have one shipping fee.

That is really, from our perspective, in a world where you're always trying to be innovative and the word we use internally, transformational, we don't have as many transformational ideas and concepts as we would like to have going forward, that's really something that Toby Lenk and his team worked very hard in the last year to develop.

Initial feedback from customers is very positive.

I think it's a little early to get a really good read but you can trust us that we have every metric possible looking at it in terms of the baskets and the cross-shop between brands and every metric you would imagine, we're looking at intently.

I will say I'm pleased we did it.

Makes absolute sense.

I think what universality allow us more than anything else is the ability to consider, down the road, if there was another tab that we wanted to develop beyond Piperline.

Those are trends that give us the flexibility to look at that.

Right now we're very content with the four brands we have.

But the actual platform gives us those flexibilities that we could consider down the road.

Thank you very much.

That's very helpful and good luck.

Your next question comes from Barbara Wyckoff with Buckingham Research.

Historically Gap and Old Navy operating margins were kind of close together and I'm sure they're far apart now.

How should we be thinking about margins by division, Banana at the top and then Gap going down the line like that or is the potential -- can Gap and Old Navy get back together at one point?

Is there anything standing in the way of that right now?

Yes, I don't want to get too far into that because as you know, Barbara, we don't segment report.

But I think it's fair to say, as you've noted, that directionally, given where Banana Republic is positioned in terms of affordable luxury, that from a merchandise margin perspective they have tended to have the highest merchandise margins and it moves on down, as you would expect, sort of Banana to Gap to Old Navy.

Now, from an operating margin profile, those -- that merchandise margin profile doesn't necessarily hold because of course the operating expense profile for each of the divisions is different as well.

What I will tell you is most recently we've been very pleased with the progress both on merchandise margins as well as operating margins, that the division with the exception of Old Navy have been making.

So with the improvements that we are working on, we certainly hope that the profile improves not only on the merchandise margin line but also on the operating margin line for Old Navy.

Thank you.

Your next question comes from Michelle Tan with Goldman Sachs.

Thanks.

Sorry for the voice.

I'm a little under the weather.

I guess my couple questions would be what does the inventory look like if you look at it on a units basis and then how does the inventory look by division and if you look at the Gap brand specifically, is the fact that the comps are still so significantly negative continuing to be the lack of clearance in the stores or what needs to happen?

I know you mentioned getting more -- going more on offense.

What needs to happen to drive more traffic, beyond the fact we've already seen the product improvement?

Let me start with just a reminder on our principles.

So we have adopted a principle, and it's broad, it's not a policy, it's a principle but broadly we begin our inventory conversations by looking at our unit buys being in line with traffic.

Now, our inventory per square foot, given that we've been very focused on our average unit costing, our inventory per square foot that we report can actually be down further than our units are down as we gain traction on the average unit costing.

But that said, we feel comfortable that in this macro environment, we want to stay broadly aligned with that principle.

What we will be doing as we gain confidence in the product acceptance for example at Gap brand is we do take into account many other metrics and levers, conversion, UPT, percent sales at Reg, markdown margin and when we see consistency in those levers, other levers improving, then of course that would give us confidence to begin potentially buying more units into the system.

And the driver, again, for the inventory being down, both in Q2 and in Q3 is of course Old Navy.

Since we have lots of work to do there to improve the assortment and we've been talking about that in the first half.

We think it's an important risk mitigator to actually hold their inventories especially tight and even below traffic.

Okay.

Great.

That's helpful.

And then any color on where the inventory sits by division?

I know you mentioned most of the reduction came from Old Navy.

We report traffic.

So again, I think it's broadly speaking, it's fair, since we report traffic, to be broadly in line with that.

With the exception of Old Navy, where we've made a conscious decision to bring the units much further down.

Okay.

That's helpful.

Thank you.

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

Yes, thank you.

I just wanted to follow-up a little bit more on the margins on the merge margins.

Clearly, very impressive results.

Despite this negative traffic environment and I was just curious if you could share just a little bit more detail on -- or perhaps a few examples, success stories on is it system enabled, process enabled, are you going back and working on your lead times.

It just seems, very, very strong merch gains and wondering what you have changed in the process to drive that in this environment?

Yes, I would say, Jeff, that although of course we continue to work on bringing tools on board, that will help us in the future and as you know, we are in the midst of rolling out a new planning and allocation tool that will help us drive greater localization in our stores and better distribution.

I would say that to date, certainly in the quarter, the margin improvement we've seen is a result of progress we're making at divisions, especially like Gap on actual product acceptance.

So we've seen strong AURs across the board and that actually is driven of course by much stronger markdown margins and we've seen very healthy regular margins as well as we've worked hard on our AUCs.

So less about technology this quarter and more about better product.

Sabrina, following up on that, there's certainly a lot of discussion and some evidence already of these costs increasing, sourcing cost increasing, so what's the strategy now to continue driving down those AUCs in the face of that inflation?

Jeff, it's Glenn.

I think that we were achieving some success over the last nine months, what I would consider to be a more rudimentary, traditional approach to getting our cost down with some evidence that we had that a little bit of our own making, by not having the structure in place and the people in place and I think I may have mentioned a while ago, just too many cooks in the kitchen in terms of one voice to the vender.

Some of that work is now in place.

That's produced some of the results you see in Q2.

Going forward we've talked a little bit about e-sourcing.

We've talked about the consolidation of some vendors.

We've talked about how we're going to go to the market and I personally have spent time with our global sourcing team, trying to help them along on what is the best way for us to achieve the kind of cost by product that we believe we deserve, given the size of our business.

We've always been very flexible and more flexible today as an organization how we can move from country to country, that's appropriate.

I think we're approaching it much more strategically.

Spent some time the last six months working with our team on how we come to market, so some early wins, absolutely, on a traditional approach to try to make sure we can maintain AUCs.

There's some further benefits to come.

But having said all that, we recognize that it's a tough market out there.

There's certainly pressure on our vendors and they have to find some relief.

Given our size, there's a lot of other relationships where they can find relief before they come presenting cost increases to us.

So we continue to work aggressively at it, in an accretive way and there's going to be a law of diminishing returns at some point but we're just not faced with that just yet.

Thank you very much.

Your next question comes from Kimberly Greenberger with Citigroup.

Thank you.

Good evening.

Glenn, you talked about driving traffic into the stores at some point in the future.

Obviously, the first thing that comes to mind would be an increase in marketing dollars and I think you've contemplated potentially Gap brand as the division that you might do that first.

Is there anything else that you think you can do beyond marketing that would help improve those traffic numbers?

And secondarily, when do you think Gap might be in a position for you to go back to that marketing budget?

I think there's lots we can do besides marketing.

Marketing is definitely a significant tool in the chest for us to pull out and actually use to drive traffic.

But there's a store role in driving traffic.

In the past, our conventional wisdom has been that stores are really focused on UPTs and conversion and service.

And at Old Navy we have spent some time with Tom in the seat over the last three to six months going to stores and speaking to our stores about their role they have to play on traffic and there's some things we've done that have not been positive to us, having what I would consider be repeat purchases, getting traffic back in the business.

One of the big issues on that is we've been out of stock at an unnecessary level in some basic categories and that is even though if you had great marketing programs that drove in traffic, you may be eroding some of our loyal customer's belief in your brand if you don't have the product available when they come in.

We've suffered from that, I'll be honest with you, definitely at Old Navy, and to a smaller degree at the other two brands.

So we have a multi-dimensional approach.

That's why I've been saying that if the product is right, and the store is right, one component store is not only the presentation of the store and the store caliber of the individuals who are there to receive customers, but also availability of product.

Sometimes we have product that's in the store, just not on the shelf.

Which is unfortunate but true inside our business.

As we work our way down how we're actually going to get the traffic, all the brands have been told, until product and until store conditions and until the appropriate marketing message have been identified, there's going to be no release of funds to drive marketing.

Gap brand, as you suggested is one that I suggest is getting a little closer to being prepared for that and marketing will certainly be a tool.

We have been very dogmatic and tenacious on cost across the entire business.

One of the reasons to do that is when the time is right, if we were to use marketing as a step-up investment, we've been able to reduce the overall cost base in the organization where an investment will not be as significant a hit to the Company when it comes to our SG&A as it may have been in the past because we've done such a good job so far.

Being honest with you we have way more work to do on getting non-marketing costs still out of our business.

That will give us more flexibility than we've had in the past.

So we're working our way through that sequential order.

We're cutting costs to make sure when the time is right we can afford it and I think Gap is a brand that they are pretty close -- they're much closer in the way of the journey of product, store, what's the message, than if there's a return for that marketing there's no question we'll spend it.

Great.

Good luck here.

Your next question comes from John Morris of Wachovia.

Thanks, congratulations in a tough environment.

Sort of a follow-up on the marketing unless I missed it in the prepared remarks, maybe if you could give the marketing spend and timing comparison to last year, for Q3, but really also your thoughts at this point into Q4 as well?

So what I said about Q3, because we don't guide to explicit dollars for marketing, but what I did say, John, was in Q3 of last year, we reduced our marketing expenses significantly.

So last year in Q3 we spent $124 million and so you shouldn't expect significant savings below that in marketing in Q3 this year, given that we've brought it down so much last year.

And the timing?

In terms of some of the campaigns, the print.

Okay.

Yes, so I'll begin with Old Navy.

So we're on television for about three weeks this year versus four weeks last year.

So we're losing a week that we were on TV last year in September.

And so most of our TV is in August and then we have three circulars this year in the fall versus four circulars last year.

Direct mail and all that is about the same and at Gap brand we're actually doing quite a bit of print.

More print this year than we're doing last year.

At Banana Republic, most of the Fall advertising campaign is similar.

Great.

Thank you.

Sure.

Your next question comes from Marni Shapiro with The Retail Tracker.

Hey, guys.

Can you talk a little bit more on the direct.

I was curious, just about the expense structure and the operations behind it as you've linked your websites.

Is it impacting your shipping revenue at all?

Are you looking to consolidate your DC to ship out of one place for all of the brands?

I guess I'm looking forward a bit because I'm actually one of those shoppers that thinks this was a brilliant move on your part.

I'm curious how it's impacting you on the profit side and what the thoughts are going forward on the operational side?

We actually we already ship out in the one DC in Columbus all three brands and Piperline is also in Columbus.

What we've been able to do in order to join all four together under this again, internal acronym of universality, is all four do ship together, having been -- I can attest to it.

I've been a loyal weekly buyer to make sure it was working properly.

I do know that all four come together, t's beautifully packaged.

That works extremely well for us.

The issue on the shipping revenue is simple for us.

We look at it and we look at the combination.

You can imagine when you're talking about the people who are doing this work and the analytics side of our online business clearly understand the benefit of gross margin dollars to the expense of shipping.

If you can get the UPTs and therefore the overall basket size at a certain level, it pays for us to have one shipping fee.

So the incentive is for people to go in and accumulate across the brands and have the one shipping fee.

I think it's a nice incentive for people.

I think your comment, which is the reason I would do it, shipping fee aside, because I still go for the 24 hours, which costs $17 instead of $7.

What I like about it is the convenience of it.

The convenience is phenomenal.

It's well packaged, the product comes in.

In my case it's delivered in one day.

You can have one day, two day or traditional four day delivery.

I think the idea while early we've taken a prudent approach to make sure all the logistic work effectively.

I think Toby and his team really have a marketing opportunity, back to the previous question on marketing, a real opportunity, the little bit we've done now to really get people excited about the potential of this investment and this transformational initiative that Toby has put together.

Can I just follow-up a question with that.

I actually must have had an experience, I had different packages come but I still thought it was excellent.

My other question is I love the cross shopping functionality.

Does it put more pressure on Gap and Old Navy down the line to really make sure that that product is differentiated?

Because I find once you're on this cross shopping site, and you look at, say, I'll use the men's as an example, because there's less fashion there, but you look at a men's cargo short and you're on that site it's much easier now to click over the to Old Navy and see if they have a cargo short and it's less expensive.

The reality is it makes it easier, which we actually think is a good thing.

The value expression of each one of the brands is obviously in the quality of the garment.

We're looking at more as the incremental sale as opposed to people buying down inside the business.

If that's what we choose to do, we're still keeping it inside of Gap, Inc.

So we thing that's a positive.

Your point is a good one.

I know we've had this conversation internally is now that you can toggle so easily between all of the screens we've got to make sure that the brand as we've defined it comes across very well.

Banana right now and Piperline stand out very clearly.

You go on that site you know exactly what site you're on.

I think actually your point is a good one.

We've had the conversation internally.

By making it easier, got to make sure the individual personality of each brand now comes across very well and that's probably some work that Toby and his team would acknowledge they have to get done.

Just one more follow-up on it.

Does that mean go forward can you link marketing campaigns as you've done friends and family in the past, I notice this year you did the 25% off and highly successful.

But are there campaigns go forward in the future that could now link all your brands together with one discount because you have it online like this?

I think that you're spot on.

I think that gives us a lot of flexibility to get people.

We have the information on what brands people are buying, why they're not participating in one brand and not the other or maybe they're in one category and not the other.

It really takes our CRM efforts to a whole new level, allows us to get diagnostic information we never had before.

Thanks.

Good luck with rest of season.

Your next question comes from Jeff Black with Lehman Brothers.

I want to say, Mr.

Murphy, that's one heck of a performance with this level of top line.

I guess my question relates to guidance, just trying to square up over the second half.

The gross margin part of it.

When you talk about taking Old Navy inventory down, has that been done through cancellations already or are we to assume that you're planning for a higher level of markdowns than we saw in the 2Q?

And as another question, on the 560 basis points of merchandise margin improvement, can you give us a sense of how much of that is regular price and how much is markdown?

I get that that there's less markdown there but I'm less certain and I'd love some comments on how are we to understand that the product has really improved.

Thanks.

So Jeff, I'll start with Old Navy inventory.

So as you know, we have been successful in shortening the pipeline for Old Navy.

So the good news is, when we started hitting really tough headwinds for Old Navy, even in Q1, we were still able to affect and incorporate decisions with regard to our Q3 inventory buys.

So we were able to make decisions to buy less inventory.

We're not doing a lot of last minute cancelling.

The bringing of the inventory down has been planful and has been enabled because of our shortened pipeline.

So that's Old Navy.

And then with regard to how we've delivered our margins in the quarter, we have gotten a little bit more regular price selling in the quarter across the board, which is good.

But the increase is really driven by the expansion in our regular margins and much healthier markdown margins.

And as I said before, part of that is that the customer is willing to come in and purchase at regular price.

Some of that expansion of regular margin is simply that we have been successful in negotiating our average unit costing more favorably.

Okay.

Fair enough.

Thank you very much.

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

Hi, guys.

It sounds from your comments that the margin improvement in the second quarter was entirely Banana and Gap division.

Can you give us a sense as you move into the back half of the year, given the improvements those two divisions have already seen, where are you in a continuum of where you would like those businesses to be?

And then secondarily for Old Navy, is it reasonable to assume that there would be improvements, that they are in the back half or are you pushing the turnout?

So I would say, Dana, without going into too much detail, I would say that actually our margins have -- our merchandise margins have been strong across the board.

So we have been managing our inventory tightly at all of our divisions and even with the headwinds that we've been experiencing, even at Old Navy, I would say across the board on a merchandise margin level, we've been pleased with what we were able to achieve in the second quarter.

Now, what we're facing, again in the third quarter, is more difficult comparisons.

But we do feel that there is still opportunity in our margins given the fact that we are continuing to buy inventory very tightly, that we do believe that our product assortments are improving.

And that we are starting to implement as we roll out some of these tools, we are starting to implement better allocation and planning of the inventory that goes into our stores.

Thank you.

Your next question comes from Brian Tunick with JPMorgan.

Thanks.

I guess first for Glenn, maybe just talk about the time line for Tom, maybe to fully affect the merchandise at Old Navy.

When does the balance shift away from what you guys have been saying too much fashion in the stores, for what mix you think you need for the offering?

And maybe just for Sabrina, can the operating margins be up next year if these current sales trends continue?

Thanks very much.

To answer the first question, the balance for the first month, this month, was an improvement of fashion which we were calling four week buys to seasonal basics to basics, this is the first month we've seen improvement.

It's not where we want it but it's off of the historical highs of four week fashion product in our stores.

We'll get better again in September and then in October we get a combination of that still improved balance of the mix between those three different product types inside our store but also the beginning of -- I want to make sure I'm clear on this, just the beginning of the product that Todd Oldham and Doug Howe, and Tom worked on to get to the new, which was our historical, but the current new target consumer and brand positioning.

So an improvement in the mix going forward but October as you get the first shot of Todd's involvement and it's early days but its first impact on the business from a product perspective and continued improved balance right to the end of the year.

And with regard to the operating margin, Brian, it's pretty early to start talking about 2009 but clearly it's our objective to keep improving our operating margin.

And our two big levers will continue to be growth margin dollars and cost.

Over the longer term, clearly, it would have to be about gross margin dollars.

So the way forward is we need to maintain these very nice, healthy margins rates that we have been achieving and then we need to in time, as we drive more traffic into our stores, buy more units and drive greater velocity that will drive greater gross margin dollars.

All right.

Thanks, good luck.

Thanks.

Your next question comes from Richard Jaffe with Stifel Nicolaus.

Hi.

We say Stifel, Stifel Nicolaus.

Hi, guys.

Just a follow-on with Old Navy.

Clearly, there's a large transition going on.

Could you spend a minute and just talk about the repositioning of the brand, how you envision Old Navy should look perhaps by fourth quarter, certainly in '09, the focus on the customer, the balance in the merchandise and some of the initiatives we should expect from Tom to get there?

I was just mentioning to Brian that I think the balance in the fall as defined by October for us will be an improvement.

The balance will definitely start to see improvement.

I think the product will be the beginning of going after the target consumer we've defined which is a young woman between the ages of 25 and 35 who is on a budget who shops for family and shops for herself.

On top of that there is a fun component.

There's all these other attributes to Old Navy's personality.

Just from a pure, simple demographic, that's the one we're going after.

Product will be in keeping with that not forgetting about the fashion component of Old Navy.

We've got the family and the fashion part of its personality.

So that will be more visible for October.

The next step for us back to where October is, ow are the stores going to present themselves.

I think some changes we've made recently at Old Navy and the team I've spoken to of district managers, regional directors, zone VPs and Jeff Kerwin as our head of field operations, I really believe they understand.

They have a huge role to play going forward and how the store gets presented, how it comes across and the kind of people and service expectation that customer's going to have and then the marketing message which has been changed slightly, coming into the marketing of this weekend and into Labor Day and will continue to evolve.

You won't see -- I'd say back in the holiday season, that will be the last piece you'll notice is the marketing will shift, be more appropriate to not only that demographic but to the brand personality that Old Navy has, which is one of its strongest attributes.

We've kind of abandoned that a little bit over the last number of years but it's going to return and be appropriately presented and what is that unique energy that Old Navy has.

You're going to see that in our media.

You're going to see that inside the store.

And in 2009, to complement all of those, the work that Tom is leading for us, is how is the store going to look because we basically have been building the same store since 1994.

Now, that store model and that merchandising presentation served us well for the better part of a decade.

But I was just in a store nine months ago, one of the last ones we're going to open that's new and looks exactly like the one we opened in 1994 except for the Autumn refresh.

The reality is that store, because of how important the physical volume of space is to the Old Navy brand, I think you'll see that in 2009 as we start a manageable remodel program, that we'll have to hit our return thresholds in order for us to put the capital forward.

That's another missing component that will make Old Navy more exciting.

That's for 2009.

I look forward to it.

Thank you.

Your next question comes from the line of Janet Kloppenburg with JJK Research.

Good afternoon.

I had a couple of questions.

First, in terms of Gap and completing its turnaround, I wonder what variables or criteria you're using to determine if you should build inventory?

Right now the inventory levels are down and traffic is down.

I'm wondering if some of that traffic being down and comp being down is associated with the lean inventory levels?

And secondly, is it correct to assume on Old Navy that there's a lot of room for margin and -- margin improvement and expense savings that could help you leverage operating margins for that brand and for the Company in fiscal '09.

Thanks.

Okay.

So I'll start with Gap brand, Janet.

And so we look at many metrics.

So, the buying of inventory is one of the most important decisions we can make, obviously, in the Company, so we take it seriously and we look at lots of metrics.

We begin our discussions with this principle of what is traffic, because traffic we see as a proxy for demand.

So we begin our discussions around looking at units in line with traffic, but as I said, we look at many other metrics, including inventory turns which is really important, obviously, because if we saw our turns speeding up a lot, that would be cause for us to pause and consider whether we need to start buying more inventory units in.

If we saw conversion consistently improving or a combination of conversion with UPT consistently improving, that would be another cause for us to consider buying more inventory.

So we are watching as we speak all of those metrics and the teams are hard at work at looking how they can move those comp levers today to give us confidence around our buys in 2009 to begin to move the needle on that.

So that's Gap.

And then with regard to Old Navy, I think we have opportunity in both the areas you called out.

So both the areas of improving our margins as we improve our product assortment and hopefully the product resonates more with our customers.

We should be able to do better on our merchandise margin.

But as well, we think there's opportunity on cost and I think you saw Tom Wyatt take some important steps today in terms of looking at his organizational structure and in some cases taking action to simplify and take out layers that we felt very comfortable we could operate just as well or better without those layers of management.

Great.

And then Sabrina, or Glenn, as we look into fiscal '09 and your goal of increasing operating margins further, I'm wondering how important the comp variable is?

I mean, can you increase operating margins in '09 if comps remain negative?

Is it something that's more necessary for fiscal '10 to keep margins moving higher?

Perhaps you could give us some idea about how important comp improvement, positive comps would be in fiscal '09 to help deliver improved results?

Thanks.

Again, I'll talk directionally.

Because again, it's a little early to be talking about '09.

We're just kicking off our budget process internally.

What I think is worth stating is although we have fully embraced this notion that we're going to perpetually be good cost managers and be very disciplined about cost, that is not a strategy upon which to build market share and top line.

We know that we need to get that back.

And part of what I've said, stated before, is part of our objective is to of course not lose ground on the great progress we have made of achieving healthy margin rates.

We want to keep that margin rate and see these other levers coming through for us as far as traffic and conversion to give us the confidence to buy units where we can move them at this healthy margin rate and that actually obviously drives comps and we want to be driving comp in our future.

We don't know how much of that will come and we'll be working on that and talking to you more about it as the quarters follow.

Thanks very much and good luck.

Thank you.

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

Good afternoon, everyone.

As you right-size the real estate, how is the reception from the real estate development community and is it different for mall versus the off-mall formats and the time frame in terms that it takes for you to dispose of the square footage that you like?

And I think, also, you had mentioned in one of your recent meetings, besides the average unit cost as a driver to margin, price optimization mix is also important.

Do you look at one more important than another?

Thank you.

Definitely the real estate square footage all comes down to the quality of the mall and the quality of the real estate.

Landlords are going through their own version of the headwinds which we're all facing.

That's why we defined today this is going to be a three to five year process for us to do this.

We have engaged some people preliminarily.

I was at a meeting recently, just had some discussion, tried to explain at a very high level what our strategic thinking is.

I think they appreciate that.

They love the clarity, like transparency.

And I mentioned on previous calls and having been to the over 500 stores I've been to, it's clear to me, we just have good, quality real estate and I think the landlords are the first place we go to because they know other tenants who may want to relocate.

They know of other people who are looking to maybe expand their businesses and go from a model that's small to a model that's mid-sized.

They are well connected.

At the same time, in order to hedge our bet because we have flexibility in most of our leases is who else could we want to bring in.

Who else would we want to bring in, besides a strip in the strip center that you referred to of Old Navy that could be a national player that could be complementary to some space, excess space that we don't need at Old Navy.

First step it with the landlords.

Second step is we do have the ability and have already had some positive signs of people who may be willing to have conversations with us about that.

It's going to take some time to get done.

The good thing is the work's been done.

It might get tweaked.

For the most part it is established now and we're going to be able to have those meetings ongoing with landlords to find out what's the best way for us to offload that operating space, which is good for us but only from a rent perspective but the variable costs that are associated with.

It's also an easier business to run.

Easier to run a 10,000 square foot store than a 17,000 square foot store.

That work is on the way.

Price optimization is -- I would say AUC is a known, so therefore is more important in the equation of margin because if you get something that is 5% less in cost, that's an absolute known that goes right to the P&L.

Price optimization, which we've adopted recently which started off with localized markdown, that has been very helpful for us and Old Navy is going through that in the fall.

I know there's a question that just came up.

One of the benefits to Old Navy's gross margin, because all other brands adopted this year is going through the price optimization on localized markdowns this fall.

Eventually you get to localized promotions.

And then beyond that, we know there's a lot of pricing opportunities for us.

It's not one of -- as being a great cost retailer, may not be one of our core competencies, pricing, because we price so far out, is also compared to other retail segments that either I've been in or who I observe and admire, admire, it's not one of our strengths.

So we're going to start with markdowns and promotions and we're going to go from there from an optimization perspective.

Operator, that will be our last call for today.

Yes, sir.

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.

That concludes this evening's teleconference.

You may now disconnect.