蓋璞 (GPS) 2008 Q3 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.

third 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 third quarter 2008 earnings conference call.

For those of you participating on 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 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 August 2, 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 November 20, 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 principle measure, free cash flow, 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 on 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.

Thank you, Evan.

Good afternoon, everyone.

We're pleased that in the third quarter we were able to achieve earnings growth.

Our focus on driving healthy merchandise margins and cost management has served us well in a challenging environment.

I'll begin today by reviewing the third quarter performance and then provide an update on our full year guidance.

First, highlights for the quarter.

Diluted earnings per share were $0.35 versus $0.30 last year.

Gross margin improved by 120 basis points to 38.7%.

Operating expenses decreased by $95 million we repurchased 5.7 million shares.

For webcast participants, please turn to slide four.

Third quarter net earnings were $246 million, the effective tax rate was 38.2% and weighted average diluted shares were 712 million.

Please turn to slide five, sales performance.

Third quarter net sales were $3.56 billion, down 8% to last year.

Total Company comp store sales were down 12% in the quarter versus down 5% last year.

A contributor to the spread between net sales and comp sales was the continued growth of our online division which grew 15% to $284 million.

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

Turning to slide six, gross profit.

Gross margin was 38.7%, up 120 basis points compared to last year.

Merchandise margins improved 270 basis points, which was partially offset by 150 basis points of occupancy deleveraging.

The drivers of merchandise margin improvement were increases in both regular and markdown margins.

Gross margin dollars decreased 5% to $1.38 billion.

Please turn to slide seven for operating expenses.

Operating expenses were $984 million, down $95 million from last year.

Despite the decline in sales, we still leveraged operating expenses by 40 basis points.

The drivers of the decrease were lower corporate overhead expenses and reduced store related expenses.

As sales fall, we make an effort to ensure that store related expenses that are largely variable with sale, such as store payroll, packaging, and supplies, stay in line as a percent of sales.

Marketing expenses were $121 million versus $124 million last year.

While we're pleased with the results of our ongoing cost management efforts, I'd like to reiterate that our cost reduction efforts are executed in a manner that is mindful of preserving the quality of both our product and our customer store experience.

We're careful to ensure that the reductions we are making do not jeopardize the long-term health of our business.

Turning to inventory on slide eight.

We ended the third quarter with $2.22 billion in inventory, down 10% over the third quarter of 2007.

Inventory per square foot was about $51, 13% less than last year.

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

Year-to-date capital expenditures were $315 million, Company-wide we opened 92 stores and closed 69.

Included in these numbers are 16 repositions.

We ended the quarter with 3,190 stores.

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

Regarding cash flows on slide 10, we're pleased with our cash flow generation and the strength of our balance sheet.

Year-to-date free cash flow defined as cash from operations less capital expenditures was an inflow of $519 million compared with an inflow of $484 million last year.

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

We ended the third quarter with $1.6 billion in cash and short-term investments, above our cash target of about $1.5 billion.

As a reminder, we keep enough cash on our balance sheet not only to fund all of our working capital needs, but also to have a cash reserve that will sustain us through a prolonged downturn.

We only had $188 million of debt on the balance sheet at the end of Q3, and we intend to pay down $138 million of this debt on December 15, when it matures, leaving us with virtually no debt.

Despite the turmoil in the markets, we remain confident in our cash flow as evidenced by the continuation of our share repurchase program.

We repurchased a total of 5.7 million shares in the third quarter for $100 million.

Year-to-date, we've repurchased 33.4 million shares for $600 million.

Turning to slide 11, our outlook for 2008.

As we mentioned in our October sales press release, our full year 2008 diluted earnings per share guidance remains at $1.30 to $1.35.

Embedded in this guidance is an expectation that it will be a challenging holiday season and that achieving this range will require continued discipline in our expense management efforts for the balance of the year.

We are reaffirming our guidance for the following metrics.

Operating margins about 10%, free cash flow, about $1 billion.

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

Full year capital expenditures, about $450 million.

New store openings, about 100, store closures, about 115.

Net square footage, about flat.

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

Depreciation and amortization, about $550 million, interest expense, about $5 million, effective tax rate, about 39%.

We're also providing our initial inventory guidance for the fourth quarter.

We remain firmly committed to disciplined inventory management as we believe that it's an important risk mitigator in the current environment.

We expect the percentage change in inventory per square foot at the end of the fourth quarter to be down in the high single digits on a year-over-year basis.

This reduction is on top of last year's 15% decline.

I'd like to close by saying that we're really pleased that we were able to deliver year-over-year earnings growth in a quarter that proved to be more volatile than any of us anticipated when we entered it.

As we manage through what we expect will be a difficult holiday selling season, we will continue to take the responsible steps to mitigate the impact of the macroeconomic headwinds.

Our healthy balance sheet and continued strong cash flow generation provide us with a solid foundation as we navigate through these challenging times.

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.

Good afternoon, everybody.

Thank you for joining us after another volatile day on the markets.

I wouldn't mind making just an additional comment to what Sabrina spoke about and also give you just a very quick update on our brands.

Since we embarked on our current financial strategy last summer, which is driving healthier margin business, reducing cost, and improving our return on invested capital, which has served us very well, what's unique about the third quarter was it's the first time we've anniversaried that strategy, one.

And the second thing that was unique about the third quarter was without doubt of the five quarters since we've been on that financial strategy, it's been the one that's been the most challenging environment that we've traded into.

So while we're pleased with our results, as Sabrina mentioned and we mentioned in our press release, I think the management team here at the Gap finds that that much more gratifying that we're able to improve our results year-over-year, while we had those two unique factors we're faced with in the third quarter.

Just to give you a quick update on our brands I want to talk about Old Navy first.

As we mentioned in previous conference calls that Old Navy's new product flow that's really focused on its recently redefined target customer, which is a 29-year-old woman who's on a budget, who buys for family and for herself, that new product flow which is not completely aligned to that target consumer but is starting to get closer to where we want to be, hit the stores in October.

And inside of the October product flow, there's a couple of categories we felt good about.

We are starting to see the improved performance.

But again, I want to be clear, it's in a few categories.

It's not going to happen overnight.

It's the first months of product being a lot more closely aligned to this target consumer.

One of the areas I want to highlight is we introduced a new five, 10 and 15 shop and that in particular has done very well for us.

So in January is where more the product that you're going to see flowed into our stores, probably in late December but really as we call it here our January flow will be more 100% aligned to that target consumer.

As we look at our next week, coming into Thanksgiving and into the holiday season, one thing we've also done some work on is our marketing.

And I think you'll find even though, again, it is not the kind of marketing that you're going to expect from us going forward in 2009, it is certainly an improvement from the messaging and the unique voice, and that unique energy that is synonymous with Old Navy.

Also, part of the marketing, there's been a lot more amped up messaging on our value proposition and really trying to play that personality of Old Navy a little stronger on its value messaging so you'll see that coming in to Thanksgiving where last year we really played more for Black Friday as a day.

This year you'll see much more commitment to the Thanksgiving weekend and also last year in December we were not that aggressive when it came to the value proposition and really more aggressiveness on price and this year you'll see we're a lot more continuing that value message right after Thanksgiving, right into the end of the holiday season.

As I start thinking about Banana Republic, in the third quarter we were disappointed in our results of Banana Republic.

The luxury segment has been the segment as we look at the business in a larger context, it's been the most severely affected and when we think about Banana Republic and its accessible luxury position, we think they're ideally positioned in the market to be able to play to that financial impact that's affected the luxury consumer and also the psychological impact so we believe that that's a you unique opportunity for Banana Republic.

Having said that, as we recognize the opportunity going forward, we know that Banana Republic's core assortment also has to make sure it has enough emotion to it and enough emotional pieces.

The team recognizes that and going forward I think in order for them to become a more attractive alternative to the luxury segment, they have to find that right balance between their core assortment and these emotional pieces.

As we look at their holiday marketing, they're definitely going to have a lot more frequency of message out to their target consumer, speak to them more often and really try to emphasize what their value proposition is, which is not overpaying for quality.

That really is what at the core of what Banana Republic is, when it comes to their target value messaging.

And lastly, as I look at Gap, it's the brand that we have been working on for the longest period of time.

And still continue to feel quite good, actually, about what we're seeing from a product perspective, feel quite good about the feedback we receive inside our stores from our customers.

Recently you've seen them really make an effort in their marketing message.

It started out in late October, into prior to the election with their vote campaign, more digital, more viral, and right now for holiday they have their Merry Mix campaign out which also is receiving a lot of good feedback from our customers.

Next week, as we approach the beginning of the official selling season, you won't see Gap return to the behavior they demonstrated in 2006, but at the same time they're not going to be as quiet as they were in their promotional opportunities in 2007.

So I think they've got to find the right balance, something that's Gap-appropriate where they can speak about the value that is available at Gap but at the same time recognize that they have to do it in a Gap appropriate way.

So in closing, there's a few things I want to talk about.

Mostly that during these times it's difficult sometimes to look at the silver lining and look at the things that are going well inside your business because you're faced every day externally with so much negative news.

What do we feel good about, even though we understand it's a very difficult macro environment?

We feel good about the fact we achieved the earnings results that Sabrina spoke about in the third quarter.

We feel good about our strong cash flow and our solid balance sheet and we feel good that as we look at the fourth quarter we are definitely more competitive than we were last year.

More competitive in terms of the product being right on for our target consumer, more competitive when it comes to the definition of value by brand, which is different, so we're in a better position than we were last year.

Having said that, there's no question the fourth quarter is going to be challenging.

As we look into the early part of 2009, we don't see any near term improvement as we look six months out into the new year.

We do feel good about the work we've done.

We feel good about the team we have in place, the focus we have, and the results we've produced so far.

And we hope that we can continue to push hard on those three financial tenants we've spoken about before, healthier margin business, reducing costs, and showing we can improve our return on vested capital.

With that said, back to you, Evan, and we'll take some questions from the analysts.

Thanks, Glenn.

That concludes our prepared remarks.

We will now open the call to questions.

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

(OPERATOR INSTRUCTIONS) And your first question will come from the line of Dana Telsey with the Telsey Advisory Group.

Good afternoon, everyone.

As you look at your business in terms of the improvements and enhancements you've made both on the merchandise margin and on the expense structure, for each of the businesses, what opportunities do you see going forward in this new environment of value?

Is there room on infrastructure or is there room on merchandise margin?

Thank you.

Yes, I'll start, Dana and I think across the board, we believe that there is still opportunity with regard to average unit costing.

So we have put a big focus against that in 2008.

We have made some good progress across all of our divisions and that has supported the year-over-year margin expansion that we've seen year-to-date and every quarter and we still believe that there are opportunities that exist out there.

So that is one area that we will continue to focus on with regard to our margins.

With regard to infrastructure, a big piece of our expense, about 50% is related to our stores and a big piece of that is going to vary with stores.

So we've been very disciplined about trying to keep those expenses in line as our sales this year have come down.

And in addition to those store related expenses, we really are focused on every single line item of expense and we've had great success there, becoming more disciplined, simplifying our work, working more efficiently to bring expenses down across the board.

We've made a lot of progress but we think there is still some room left.

Let me just -- maybe I can adjust a couple of comments to that.

That when we look at our business, Sabrina mentioned protecting the long-term health of our brand and I think that's critical, of our brands.

We're not making just short-term decisions.

One of the things that we have committed to ourselves internally under the definition of long-term health is we really want to make sure that as we take cost out of the business, and I agree with Sabrina whole heartedly, there is still cost to come out of this Company.

We want to make sure that we do not take away too much of our marketing budget and do not take away from our customer service models.

We've obviously just changed in the last six or nine months our customer service models.

We've introduced a brand-new computerized scheduling system.

I think that that would be long-term damage to the brand if we went after that.

There's a variability to labor.

We want to make sure we play that properly with traffic.

Those are two areas of our business we're trying to put a sort of ring fence around and go after everything else that's on the table as far as we're concerned.

Because we recently at an analyst meeting in October talked about one of our top priorities.

And everybody who was there heard from our brand Presidents traffic is important to us.

And by getting down our cost within the Company, getting down our cost structure, we can at least give ourselves the options to look at some offensive minded initiatives in 2009 as opposed to continuously playing defense as we have the last number of years.

Thank you and good luck.

Your next question comes from the line of Jeff Black with Barclays Capital.

Hey, thanks, good afternoon, everybody.

Glenn, it looks like, or Sabrina, inventory looks like it's higher than sales are trending now in the quarter.

What kind of assumptions are baked into the merchandise margins side of the coin and what kind of clearance do you guys think you have to go through right now?

How much, in other words, do you have of clearance in the inventory, any color on that would be helpful.

Thanks.

Let me start by grounding, Jeff, again, we just guided to ending inventory per square foot in Q4 in the high single digits.

So we're going to start anniversarying, we already have begun to anniversary very low levels of inventory.

So if you take what we've guided to and combine it with the fact that last year we were already down 15%, that implies inventories on a two-year basis being down over 20%.

That's actually very similar to what we just reported in Q3, with inventories down 13% and LY being down 8%.

So there's really not that much difference in the cadence overall of our inventory and we feel like from any historical measure, these inventories are extremely tight.

Now, of course, and especially true in this environment, we're going to stay focused and intent on moving holiday liable product as early in the season as we can.

That's obviously critically important and we have our goals with regard to how we'll enter January and we have our goals with how much liable we'll enter February with and we're going to stick to that.

Fair enough.

Good luck.

Thanks.

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

Great, thank you and congratulations on a well-managed quarter.

The SG&A dollars on a year-over-year basis were down almost $100 million.

Sabrina, how much of that was that you had not yet anniversaried all of the major cuts that you initiated in the middle of the year last year and how much of that do you think can actually continue through I guess the next three quarters?

We are starting to anniversary those levels, Kimberly, because we finished our cost initiative actions at the end of Q2 for the most part last year, as you know.

So we actually are already at this level of savings, we are already lapping savings in Q3.

Now, we were able to achieve that, again, as we said, a good chunk of that is store-related expenses that we're very committed to managing responsibly as sales decline.

We would expect them and we'll manage them to decline to a threshold level which doesn't damage our customer experience.

But there's a chunk of that, and then there's also a chunk of as we said, we're just -- we really embraced a new culture and discipline around cost and so even though we are lapping the cost initiative from 2007 now, we are just finding other areas where there remains opportunity to save expenses and that's what you're seeing come through.

How far that continues, definitely the bar gets higher and it gets tougher but I think as Glenn and I have both said, we still feel that there's opportunity.

Great.

Thank you and good luck for holiday.

Thank you.

Your next question will come from the line of Adrienne Tennant with Friedman, Billings, Ramsey.

Good afternoon, and let me add my congratulations.

It's a tough environment out there.

My question is what comp range is the guidance, the implied $0.29 to $0.34 for the fourth quarter, what comp range is that predicated on?

And can we assume that your inventory guidance kind of leads us to believe that that might be the negative high single digit to low double-digit range.

I guess the way to answer that, Adrienne, is to say that our assumptions for the fourth quarter are that the season remains difficult and that there is no improvement in the macroeconomic environment that we experienced in the third quarter.

And I'll try and frame that even more definitively by saying in the third quarter overall, at the Gap, Inc.

level, our traffic trends were down 9.

And they range from, depending on the division, from about down 6 to about down 10.

So we're fully assuming that that level of negative traffic continues.

However, I'll also say that we're assuming that there is not a significant worsening beyond that in those traffic levels.

So is it fair to assume that we've heard about this early November drop-off that you've maintained trends out of the third quarter into early November?

You know what, we're We're not going to talk mid-month.

There's so much shifting going on right now with the calendar.

We'll talk with you more about that when we do our November sales.

Fair enough.

Good luck.

Thank you.

Your next question will come from the line of John Morris with Wachovia.

Thanks.

My congratulations too on a tough environment.

I think one of the things that took place in the quarter was instituting some vacation days at corporate, if I'm correct about that.

It was reported in the press, in the trade press.

I'm wondering, did that help in terms of basis points, was it significant in helping in the quarter?

Were you accruing for that, that it would come back in the fourth quarter?

And then a follow-up, so I'm wondering how significant that was?

It wasn't significant, John.

I think that as Sabrina said, as we continue to embrace this new culture and not just rely on the two of us or the 15 of us on management, rely on really the larger Company, actually with somebody who is much more junior around the executive leadership table thought this might be a good idea.

Not only good for our employees in terms of all the hard work they've been doing.

They're for the most part responsible for the results in the quarter.

But also as you mentioned, we accrue these vacation holidays so it had some benefit also to the health of the third quarter.

But it wasn't a big number.

It's more a psychological embrace we have here.

We're looking for every opportunity we can possible to do a couple things.

One, make sure we're doing the right thing for our customers, always make sure we're treating our employees fairly and respectfully and then try to find a way through driving incremental margins, reducing cost and commit ourselves to return on invested capital.

That idea, which again was small in scope relative to all the other ideas we put forward, to hit that close to $100 million reduction in SG&A is just us embracing the fact that everybody here is looking for ways during these difficult environments for us to give ourselves the flexibility and the fighting chance to make our numbers.

And just to be clear on the accounting, Jeff, that's just a Q3 event because when people record that PTO, we call it paid time off or vacation time in the quarter, we just take that time against the accrual they've already built up versus taking salary expense so that's behind us now.

Okay.

Helpful.

The other question I had, Sabrina I think for more you, you talked about the average unit costing initiatives earlier that are really helping the very good performance in gross margin.

Can you dive a little bit deeper on that?

You talked a little bit about this at the conference day, analyst day.

What are you doing with vendors to help support your initiatives there?

Art, go on take that.

John, I'll stop in for a second.

I think that there's a bunch of things we've been doing, as you pointed out rightfully so, for the last 12 months we've put together a strategy on a number of different fronts.

One was how do we make sure we are improving our quality, getting more flexibility, which is actually key to us.

We never had a flexible model and flexible relationship with vendors and then reducing average unit cost.

And what we've embarked on since that 12 months has produced good results for us and I think that's baked into the P&L results you've seen.

Going forward I think what you're seeing going on is a dynamic shift.

A lot of people are reducing inventory, canceling orders and for a Company that maybe had a head start on that, particularly in the flexibility side and is a little closer to the market, us being in 48 countries, having 5 hubs around the world, we are finding opportunities now where people are vacating some capacity in the first quarter and the second quarter.

We can step in and actually make sure we can be opportunistic and fulfill some of that capacity that's been left behind.

That certainly has been helpful to us.

E-Sourcing which is something we've been very excited about in our outlet business for the last 12 months, we are carefully, not across the board, but carefully expanding that to our other brands.

That also, given I think the -- I would say the uncertainty that's going on in the vendor community because there's so many people who are now considering their inventory levels more seriously, looking at the macroeconomic environment and making some changes, being on E-Sourcing which also produces speed has been good for us and we now have as part of a long-term strategy, we have sort of broken out the fabric component to the cut and sew component of us getting product done.

And the fabric piece and trim, we've got a really talented team and there just happened to be a meeting with them last week telling me about their travels around the world and some of the opportunities they've uncovered.

So our view is that given our size, and the fact that we had head start in a lot of this, more because we were lucky than good, start doing some work on it because the state of our business 18 months ago, we are in a pretty good position to continue to take the opportunities that now, lower oil, lower commodity prices and a reduction or sorry, increase in capacity, have really bought to somebody who now has a more flexible model.

That's great.

Good luck for holiday.

Thank you.

Thank you.

Your next question will come from the line of Richard Jaffe with Stifel Nicolaus.

Good morning, guys.

We say -- sorry, good afternoon.

We say Stifel.

I guess a quick question on some of the initiatives we've seen on the merchandising front, Todd Oldham and his contribution to Old Navy and wondering how that's playing off, if we should assume that Todd is still a key force here and some of the initiative Patrick Robinson's brought to the table, particularly on the initiatives we're seeing in stores today, the stripe scarf, the stripe sweaters and what should we look for going forward and how impactful have these guys been?

First off, I would say that it's definitely a team effort.

I mean, there's always going to be somebody at the head of design, Patrick's case for sure, who will get a little more attention but Patrick would be the first person, given his incredible skill and I would say matched by his large degree of humility to say that it's a team effort.

Todd is involved.

Todd played a role in what you're seeing in the store right now, a little role.

I think he is just more of what you'll see with Todd has brought to the business will be seen more in January.

But he has been involved in October for sure.

We have a really good merchant team inside of Old Navy that really has embraced the brand and I think that the merchants play a large role in interpreting what the designers want to do, what their ideas are inside the store.

Actually, I think we've seen, as I mentioned, are at the beginning of some better product presentation, more aligned with our target consumer inside of Old Navy.

Patrick's case, he's been at it much longer.

He's been here 18 months.

Definitely his aesthetic and his view of turning basics into classics and returning Gap to what it is but really with a modern twist, I think you're seeing that inside the store.

I think the holiday product, the feedback has been very good.

He also has an amazing team in New York in design, added somebody new i body in the last six months, somebody new in accessories in the last six months, added some bench strength in mens.

But he has a very cooperative and talented merchant team here in San Francisco, led by Karen Hillman and together under Marka's leadership I think that we're starting to see definitely some feedback traction inside our stores and feeling better about the path that Patrick's taking that brand.

Thank you.

Your next question will come from the line of Randy Konik with Jefferies.

Good afternoon.

This is (inaudible) here filling in for Randy.

I guess the question we had was you guys have done a pretty good job of repositioning the Gap brand over the past year or so.

I guess in the context of the often mentioned four criteria of marketing you guys always talk about, how would you guys gauge the health of the brand today?

I guess in other words, we're still waiting before our increasing the investment there, which criteria do you think needs the most improvement before making the call to step up marketing spend at Gap brand?

Thanks.

Well, I would say that we're feeling step one being the product, we definitely as I mentioned previously feel pretty good.

Product success is measured on sustainability, not just any season, but I think Patrick and Karen and under Marka's leadership think that we're feeling a degree of confidence there, no question.

Second part is store execution.

We put the new brand customer service model in place, added the computerized scheduling system.

Are we there yet in the stores?

Spent two and-a-half days with the Gap team last week.

Feeling better.

Definitely great attitude inside the stores but I would say that that's not quite there.

The marketing message you'll see in this holiday season, the Merry Mix work we've done, how we've gone a little more digital.

The reinvestment of marketing isn't singularly defined by television.

It's defined by a step up in our marketing spend.

Here I think we're changing our mix a little bit in our marketing so we feel confident of the product, change a little bit of the mix, a little more traffic-driving, a little more aggressive than we've seen before.

Not back again to the days of 2006 which are solely promotional.

I think a little more thoughtful.

So I would say the marketing heart and soul of what the brand is all about is getting pretty darn close.

Then the last step, which is one I was hoping I could have talked about positively six months ago, which is the consumer responsiveness.

And those are all the stars, at least is our formula that need to be aligned in order for us to really step up.

We're definitely not going to be into cutting mode when it comes to the margin right now.

We would like to hold the level we have.

But we also believe there's a need down the road to step it up in marketing and, but we're going to start with the mix of our marketing as opposed to increasing the dollars right now.

And I think part of that driver is stores have a little bit further to go in terms of day in, day out execution.

Not quite there yet.

And obviously your guess is as good as mine in some ways for when we'll see a more responsive consumer.

Because what you don't want to do is spend $1 incrementally in marketing when really the psychological value of that is $0.25.

So two out of four, good and still working on one which we can control and hoping and praying every night the other one improves.

Very helpful and good luck.

Thank you.

Your next question comes from topline of Barbara Wyckoff with Buckingham Research Group.

Hi, everyone.

Good job.

On the comp decline, I know we talk a a lot about traffic but there's got to be some other factors at play here.

How much do you think outside of traffic, do you think is due to the environment, low inventory, merchandising issues?

And that's one question and then I have a follow-up.

It's really hard to untangle all the variables at play and to be quite candid, we know that we have had traffic issues long before the macroeconomic situation got as severe as it has become.

So that has simply exacerbated an issue that we know that we've had to address for some time.

But I will tell you, what we've been really pleased with year-to-date until probably really, Barbara, October was average unit retail were really a big driver for our divisions across the board for most of the year.

Those have been really strong.

In October when we saw the traffic decline more precipitously, and more customer resistance to buying, as we said on our sales call we had to be more in season promotional than we had originally anticipated.

So we got a little bit more pressure on AUR but our conversions and our UPTs have mostly really improved across the board.

Okay.

Great.

And then just if you could talk briefly about the progress in negotiating with the mall developers on your sort or store reduction plan?

I would say there's two parts to that, Barbara.

One is the ongoing negotiations we have, given the 3,000 or so leases we have that come up somewhere between 400 to 600 a year.

There's the natural laws of supply and demand have started to kick in over the last couple of months, where a lot of people who were growing and adding square footage have now reconsidered that as a strategy, maybe permanently but definitely for the near term.

There has been some people who have vacated square footage already and declared they're going to be vacating square footage.

I think there's a pretty large question mark in January and beyond about how many retailers may be forced to make the same decisions in the spring that a lot of retailers made this fall.

I think that puts us in actually a good position for the renegotiation.

We have the 40 million square feet.

We have this incredibly strong balance sheet.

We've never defaulted on any of our leases.

So I think that puts us in a good position to make sure our renegotiating team uses that leverage as best they can.

That kind of goes hand in glove with this parallel strategy that came up about three months ago which is the ability to reduce 10 or 15% of that square footage, somewhere between 50 and 75 stores will be touched in 2009.

And whether -- I look at it this way.

You could argue it's the best of times, it's the worst of times.

The fact that it's the best of times is that landlords are really trying to hold onto people like us.

Maybe our productivity is not as world class as it used to be but our brands still resonate.

We obviously have good quality real estate.

We pay on time and we have a strong balance sheet.

Therefore, we're dependable.

So I think that people would rather keep us in their mall, maybe with reducing 5,000 square feet, than have us be given an option that may not have existed three months ago, to go across the street or go somewhere else because of the supply and demand change that's currently going on in the marketplace.

So I would argue that we're still in a good position.

Those negotiations are going on.

We have no reason to change.

We put forward obviously if there was a larger opportunity to execute this because of the reason I just gave at a faster rate, we have the people in place and the ability to do that.

But right now, it's still full steam ahead.

The landlords certainly appreciate, A, our clarity because we've never been historically clear on where we're going and secondly the transparency.

But we know that we have to be firm in our negotiations to execute on both of those points I just made.

All right.

Thank you.

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

Yes, first I just wanted to clarify something, Sabrina, during the analyst meeting that you guys had here a few weeks ago I think you mentioned about mid-October that the fourth quarter guidance, you were maintaining but there was some assumption that the volatility in sales at that time would need to stabilize.

I can't remember the exact language but I think you made some comment to that in that direction.

Just given the fact that things have deteriorated even further since then, what seems to have changed or what is going better for you operationally that enables you to hit these numbers even with the further deterioration?

It's a great question, Jeff.

I think that what we're really pleased with is that even in the third quarter, which was extremely volatile, and had varying weeks of performance, we, as a management team and all of our employees together, had such a commitment to really driving our business forward that we were very pleased that we were able to drive at the end of the day in Q3 this kind of earnings performance against that backdrop and even though it is true that the volatility has not subsided, to some degree our performance through the third quarter gives us confidence that the intensity at which we're going to pursue our biggest selling season can result in this range.

Now, again, I say we have assumed that the environment does not improve, that it remains as it did in the third quarter, but we also are assuming that it does not significantly deteriorate from the current state.

Okay.

Great.

Just one other thing.

You said the online businesses or direct businesses were up 15% in the third quarter; is that right?

Sales were up 15% correct.

Any context beyond that in terms of the brand performance or more importantly the kind of trends through the third quarter, because we've been hearing a lot about pretty rapid deterioration of online businesses.

Well, we've certainly seen some market information that shows the online business is not immune to what's going on in the retail business.

We get that, I think it's every two weeks across Toby's desk and he's very quick to share it with us.

I think one thing that we've done, one is obviously we have a stellar team in our online business.

The other thing that we've done is this universality platform that we put into place in May I think has differentiated us in the marketplace and one thing that that team has always said to me and to Sabrina is that business is all about innovation.

It's all about trying to bring something new to the marketplace.

It's not just a business where you can have a site and offer some price on delivery or free delivery.

What are you always innovating on.

People who shop those sites like that.

Universality for us, which as I think everyone on the phone knows is the ability to toggle across our four tabs, with flat out to be eventually our fifth tab sometime next year and to check out one time is a very positive offering.

And that's not the end all, be all, but it certainly is a positive event and investment and an innovative idea that probably positions us better than most.

Okay.

Any brand color?

I think the brands online for the most part shadow what you see in the retail stores.

I think that the Gap business, when the people from the online business were here right now they would feel pretty good the direction they've seen in the product and the feedback they get from their customers and that Old Navy is again, from their perspective, they'd say starting to show signs of at least improving of what offering they have online and that's consistent with some of the feedback we get from our online customers.

I would say for the most part it emulates what you see in the stores.

Your next question will come from the line of Brian Tunick with JPMorgan.

Thanks, hey, Glenn, hey, Sabrina.

I guess our question really is around Old Navy from a capital and I guess pricing perspective, maybe you can just update us sort of on what's happening Old Navy to the new format that you were testing in a couple locations and how that maybe helps you think about store refreshes and capital expenditure next year.

At the analyst day you talked about the new pricing architecture.

Just maybe where are we on the roll-out there and any learnings?

I'll start with the second part first, Brian.

I'd say the pricing architecture is really in the early days.

I referenced the 5, 10 and 15 shop that Tom and his team introduced last month.

I think that's pretty much a great idea for that business, very consistent everyday value.

They can plan into it, they can buy into it.

That's rolled out everywhere.

That would be the only sort of initial component of what next year will be a completely redone pricing architecture.

Personally, and I'm sure people on the phone might agree with this around I hear it in the stores I'm in on a regular basis, Old Navy's pricing architecture could be confusing.

You can walk into any concept room on any given day and get five or six different messaging coming at you.

From a value perspective, one thing I know about the value business, clarity is critical, not just depth of pricing and offering but clarity and consistency.

We've really got what I think is a pretty good plan worked out.

We decided to go with 5, 10 and 15 because we thought it was a good idea coming into holiday season and again, we plan six months, we bought into it, negotiate into it.

We feel good about it.

On the capital front, even though we did throw out two stores or Tom might have at the analyst day, I really would say there's one store.

One we dabbled in with a few ideas, more or a laboratory.

The other one, by the end of this month we'll open up close to our head office and we're going to watch it carefully.

Old Navy, all our brands, to be honest with you, have an opportunity to reposition themselves physically to the consumer.

Old Navy hasn't been touched in 14 years and it's tired.

When it came out it was really world class.

It was different.

It had a different way to speak to somebody, fashion at a price and we've lost that over the last number of years.

That's part of the reason the brand has not been performing.

What I've seen so far and I've played a role in it is not taking Old Navy back to where it was but keeping the ingredients that make it special and different and a powerful brand, not a retail store that sells product at a cheap price, but a real brand.

What I've seen is something that for now I feel good about but we're going to have to roll it out to more stores in 2009 and that's certainly something we're looking at when it comes to traffic being one of our top priorities.

One of the derivatives of getting to the traffic number is making sure we have a compelling physical offering, and Old Navy has 1,050 stores and physically there might be a handful that we like.

Terrific.

Thanks and good luck.

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

Hi, Glenn, hi Sabrina.

Congrats on a good quarter.

Glenn, you talked about some of your objectives to drive healthier margins and higher returns on invested capital.

I'm wondering if Old Navy will be a contributor to those goals in fiscal '08?

And if not, when you think the timing of the brand boosting margins for the overall corporation can occur?

And also, with respect to those parameters and Banana Republic, I think it felt for a while like they were a contributor but it feels like that brand is slipping a little bit and I'm wondering if that -- if there is something fundamental going on at Banana Republic or if you think it's just macro-driven with respect to the luxury customer?

Thank you.

I think I'll start and then Glenn can jump in.

I'm going to take it kind of to a high level because as you know, we don't segment report so we don't speak very specifically to each division's margin structure.

But I will tell you that across the board, again, we've been very pleased with our results in bringing average unit costing down and Old Navy in particular, most recently has really done a terrific job as Gap had earlier in the year and continues to do.

At really looking at what their customers value, how they reengineer their product, how they bring that costing down without in any way compromising their quality and they've been highly successful.

So even though there has been pressure and we've had to move units through promotions, et cetera and we've had product acceptance challenges, there has been some air cover that's given by our strong management on the average unit costing side.

And I would say Banana Republic, up until most recently when we saw their traffic really start to drop off into the third quarter, had a very healthy profile as well.

Both on the average unit costing side but also on the average unit retail side.

So on the ROIC front, that formula really has two levers, it's the earnings lever and the capital lever.

So on the Old Navy, because we've really held back this year quite a bit, waiting for a new prototype to come, we haven't expended so much capital as we have in past years in Old Navy.

We're not growing the fleet that big this year.

I think we're only net openings maybe 5 to 15 or something and we haven't done much remodeling.

So the capital spend against the earnings is much lower.

What I would add to what Sabrina just said about Old Navy, I think all our brands are going to have to contribute in order for us to hit that key financial priority of ours, improving return on invested capital.

Having said that, Old Navy has a big role to play in that in terms of getting its customer back, its brand positioning bought into by people who used to shop that store frequently over the last number of years and we've lost some of that traffic which has cleared us and we're expecting it to play a leading role on behalf of the portfolio of brands we have on a number of different fronts but also as you suggest, contribute to return on invested capital.

It's a key to us achieving that goal.

You add to that the environment in which we're currently trading, we look to Old Navy.

We look to all our brands but we look to Old Navy during these times to say this is really one of the reasons it exists inside the business is during these times when people are a little more careful about what they spend and might need a little more convincing and the price component of the -- the price part of the value equation becomes more important, we count on it.

So knowing that what we're going through right now is not going to come to a screeching halt in the holiday season, this is the macro environment, will likely continue for sometime into 2009, that's why we feel a bit of a sense of urgency to make sure what we saw in October which is not completely done yet, as we come into January to make sure that Old Navy steps up on behalf of the portfolio and carries a fair share of its weight to make sure that it's not only getting some momentum on the traffic front, but actually plays a role, a disproportionate role of our portfolio because it's the reason it exists.

On that front, Glenn, any progress with respect to bringing in a new GMM at Old Navy?

You know what?

We've had a number of great meetings.

I think October was sort of a shock to the system for people on a number of different fronts.

Definitely anybody who was thinking of switching companies it was certainly a shock to the system.

So we might have lost a few weeks of momentum.

But at last report when I was with our team reviewing some candidates, I think they've got a strong list.

I think that Tom is working very hard, knows it's the most important hire he's ever going to make because it truly is going to be his partner inside that business.

So I'm impressed with who they have on the list.

We're working hard at it.

Hopefully we'll have some news in the near term.

Thanks, lots of luck.

Thank you.

Your next question will come from the line of Marni Shapiro with Retail Tracker.

Hey, guys, congratulations in this tough environment.

Good job.

I'm curious about your international business, if you could remind us as of today what percentage of your sales are coming from your international businesses in total and was there any foreign exchange impact, particularly as it relates to Canada?

I know several other retailers have commented on this.

And then any insights as to the trends internationally, whether it's traffic or reaction to product in Canada, Europe and Asia that differ from the US across the brands?

Hi, Marni, it's Sabrina.

With regard to the international business, as you know, the foreign exchange rates have been incredibly volatile lately.

So on the revenue line, for the first half of the year we actually got benefit from foreign exchange and as the dollar has strengthened quite a bit, especially against the Canadian dollar where we have a very healthy business with all our three brands as well as the British pound, it did hurt us on the revenue line but not that materially.

It was about $15 million for the quarter.

Overall, international tends to represent about 10 to 12% of revenues in total.

What I can add to I guess the trading climate outside of the United States, we do go to Canada quite a bit to look at our sales there because the Canadian marketplace that I actually know quite well has not economically been affected as badly as we have seen here.

I think mostly grounded, in fact, their housing crisis is limited or non existent compared to what we're going through here.

So we actually look often.

In some cases, back to the earlier question Janet asked about product, knowing the macro environment, while it's not bullish in Canada, it hasn't gone through the events that we're going through here.

It's a good chance sometimes a more normalized state to look at your product and see how consumers are reacting.

So I'd say Canada effective to what's going on here but still actually a pretty good retail environment for us.

The UK is as bad as it is in the US.

We have a business there, mostly rooted in London but it's not a good trading environment and I would say that the UK retailers have shown a level of aggressiveness that is unprecedented.

Japan business, I'd say the trading environment there from our perspective is actually not too bad, trading environment, feels pretty good to us.

Not immune but actually feels good, actually had the head of our Japanese business in this week and he gave us an update on the marketplace in general.

Then we trade in only a few other countries with our franchise business and that's really a mixed bag, from the Russian economy which has really come to a quasi screeching halt, to some other markets we operate in which to them it almost seems seamless so that's a mixed bag after that.

Would you say generally the product is being better accepted across the board excepting for the pockets, the UK, the environments are bad, generally would you say the product's being better accepted.

I would say that's true, yes.

Congratulations and good luck for the fourth quarter.

We have time for one more caller.

The final question will come from the line of Lorraine Maikis with Merrill Lynch.

Thank you, good afternoon.

Now that you're almost debt free, can you talk a little bit about your uses of capital going forward and should we expect more share repurchase in the near term?

Yes, we're really committed.

I think the headline, Lorraine, is that we remain committed to our balance sheet philosophy and our cash distribution philosophy.

So our two biggest principles are we made a decision long ago when I was Treasurer that we weren't going to be reliant on capital markets so we're always going to keep this big tranche of cash on our balance sheet as said in my remarks for both working capital and for a reserve.

Above and beyond that we remain committed to distributing excess cash to our shareholders so every year we'll first look at what capital investments can we make that we firmly believe will drive an improving ROIC and will drive our business forward in terms of that metric and what investments are important.

So once we set aside that capital, we have generally found that we do end up still with excess cash so our philosophy is the same.

We expect to continue our share repurchases.

We always have -- for a long time, we've proceeded with those on an opportunistic basis, always tricky to quite know the timing and the pacing but we certainly remain committed to share repurchases and distributing excess cash.

Thank you.

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

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

Thank you.

Ladies and gentlemen, this does conclude the Gap Inc.

third quarter 2008 conference call.

You may now disconnect.