蓋璞 (GPS) 2009 Q1 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.

first quarter 2009 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 first quarter 2009 earnings conference call.

For those of you participating to 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 our results to differ can be found in our annual report on Form 10-K, for the fiscal year ended January 31, 2009, and today's press release.

Due to 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 May 21, 2009, 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're required to reconcile with GAAP.

The reconciliation of this measure to the GAAP financial measure is included in today's earning's 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.

I'll begin today by reviewing first quarter results followed by commentary on our outlook for the second quarter.

We entered 2009 prepared for a difficult consumer environment.

Although first quarter earnings are below last year, we're pleased that our commitment to operational discipline especially around inventory management and average unit costing resulted in merchandise margin improvements.

In addition, we're encouraged that our product and marketing efforts are beginning to show traction at our largest brand Old Navy.

Some highlights for the quarter.

Net earnings were $0.31 per share.

Merchandise margins increased by 100 basis points.

Operating expenses were $73 million below last year.

And operating margins were 11.3% equal to last year.

For webcast participants please turn to slide four.

First quarter earnings were $215 million or $0.31 per share compared to $249 million or $0.34 per share last year.

Please note that last year's earnings included about $15 million of pretax earnings benefits from a reduction of interest expense accruals.

First quarter effective tax rate was 39.1% and weighted average diluted shares were 697 million.

Turning to slide five, sales performance.

First quarter total sales were $3.1 billion, down 8% versus last year.

Total Company comp store sales were down 8% in the quarter.

Please refer to our earnings press release located on gapinc.com for total sales and comps by division.

Turning to slide six, gross profit.

Merchandise margins improved 100 basis points driven by savings and average unit costs.

This improvement was offset by 110 basis points from occupancy deleveraging.

Gross margin was 39.6%, about flat to last year.

Gross profit was $1.2 billion.

Please turn to slide seven for operating expenses.

First quarter operating expenses were $886 million, down $73 million versus the prior year.

About half of the reduction was due to lower store-related expenses, primarily a result of the decline in sales.

The balance was driven by lower corporate overhead expenses and about $16 million of foreign exchange benefits.

Marketing expenses were $96 million versus $93 million in 2008.

We kept marketing dollars relatively flat to last year while increasing our marketing efforts at Old Navy and adding Athleta marketing.

Turning to inventory on slide eight.

We ended the first quarter with $1.4 billion in inventory down 10% versus the prior year.

Inventory per square foot was $32 down 12% versus the prior year.

Entering May we remained comfortable with our overall inventory levels.

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

First quarter capital expenditures were $63 million.

We opened 11 stores weighted toward international and outlets and closed 11 weighted toward Gap brand.

Companywide we ended the quarter with 3,149 stores and net square footage remained about flat.

Regarding cash flow on slide 10, for the quarter, free cash flow defined as cash from operations plus capital expenditures was a inflow of $139 million compared with inflow of $62 million last year.

The difference was primarily driven by reduced capital spending versus last year.

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

We ended the first quarter with about $1.7 billion in cash and no debt.

Turning to slide 11, our outlook for the second quarter.

Regarding merchandise margins, we are highly confident that we can continue to deliver lower average unit costs.

However, given our goal of driving traffic, coupled with the consumer who is looking for sharp value, average unit retail, and therefore merchandise margin remain uncertain.

We expect second quarter operating expenses to be down 30 million to $50 million, compared to the second quarter of last year.

As a reminder, while we remain focused on our cost efforts, operating expense dollar savings may vary by quarter due to a variety of factors including sales and marketing investments.

We expect second quarter marketing expenses to be up 10 million to $15 million compared to the second quarter of last year, driven by Athleta and Old Navy.

We expect a percentage change in inventory per square foot at the end of the second quarter to be down in the low double-digits compared to last year.

Regarding share repurchases.

Because our Q1 ending cash balance of $1.7 billion is relatively close to our target of $1.5 billion, it's unlikely we will repurchase any shares in the second quarter.

For the full year our guidance for the following metrics remains unchanged.

Depreciation and amortization about $550 million.

Effective tax rate about 39%.

Capital expenditures about $350 million.

New-store openings about 50.

Store closures about 100.

Net square footage decline about 2%.

In closing, as we enter the second quarter, we will continue to focus on the levers we can control and are cautiously optimistic about the progress we're making in our largest division, Old Navy.

Thank you and now I'll turn it over to Glenn.

Thank you, Sabrina.

There's a couple of topics I could cover off in the time we have together.

First I'd like to give you my perspective of the first quarter performance here at Gap, Inc.

and also talk to you as I do normally do during these quarterly conference calls, just give you a brand update.

The market conditions from our perspective continue to be challenging.

With that said, I think our performance in Q1 was respectable.

None of us like to produce results in the quarter of below last year.

I don't think any business would ever want to produce any results below last year.

But with the conditions in which we're operating in, I think it was respectable and versus a lot of our competitors, I was pleased with our performance in the first quarter.

Part of the reason we produced the results we produced is we continue non-stop to produce a more efficient economic model to tighten up that economic model on a number of fronts we discussed before.

One on the margin front.

Getting a lower average unit cost on the business, still being smart on inventory, making good decisions on localized promos and markdowns.

Also taking our real cost dollars out of the business.

In this first quarter of 2009 we were able to take another $73 million of incremental SG&A.

That's on top of the $470 million we took out in 2008.

So when you add that together and then that gives you the flexibility to make targeted investments where we feel they are appropriate.

In the last quarter update we did tell you about an investment we were making in Old Navy, now the dollars in marketing were almost identical to the year before.

But still, having this new economic model that's much more efficient gives us the opportunity to make those choices.

So far obviously the evidence is in 30 days.

The investment of Old Navy is starting to pay off some early dividends for us.

I would like to now give you the brand update starting with Old Navy.

On the product front we continue to see some improvement being made by the team and Mike Breitbart has now been with us for just a couple of months but his influence and expertise is certainly being felt inside the business.

We look forward to Mark's personal touch on product coming through sometime later this fall.

On the marketing side the investment we've made in the first quarter we feel good about.

It was a good campaign.

I think it resonated on a number of different fronts, had Old Navy's personality, which is important for our brand, but most important it had a very strong, very direct, very clear product message and value message, which when we hit that right at Old Navy we can really change the course of the trajectory that we have been unfortunately on for the last couple of years.

What I'm most pleased about is that it is a fully integrated campaign.

So it is taking the external media that I think a lot of people have seen but it is taking it right down the store level, by introducing the suit mannequin right in front of our customers and engaging our stores and asking our store employees to be part of the campaign.

As we look forward to Q2 we need to continue to evolve the campaign.

Keep it fresh.

Keep it current.

Keep it active.

Allow the value message to come through very strongly and I think that's very important in order for this campaign to have sustainability.

At Gap brand I continue to see progress being made on the product front.

The real challenge for that team is how do we get more traffic through those doors.

You are going to see the Gap team relaunching denim in August with a new campaign.

I think that's important.

We were just introducing our whole new denim to the fashion press in New York two weeks ago.

And hopefully that will be the beginning of a series of investments that we can make with some breakthrough ideas in the fall and the holiday season to really get the consumers and that target customer back into our stores.

And at Banana Republic, Jack and the team are certainly working on getting the product right and getting a position for that target consumer, to make sure that we get there and achieve that goal.

We were really pleased to announce that Julia Rosen will be joining our team at the end of May as the senior merchant for Banana Republic.

Julia has an incredible taste level, really understands Banana Republic, has a great track record and even though she'll be joining us at the end of May, her real impact in the business won't likely be felt until the early part of 2010.

But having her on the team I think has given us an added level of confidence in Banana Republic's opportunity to get back on track.

Finally, one last brand update, Athleta came on to our Universality platform last month.

And now you enter into any of our brands on-line and you can get to Athleta and shop it, shop our other brands, check out one time and pay one delivery fee.

So that is pretty exciting actually.

It's a business that the integration has gone very smoothly.

They have very good team and I think it will be good for all of our brands to have Athleta as part of the family now.

So with all that said I look forward to taking a few questions in a couple minutes, but first let me turn it over to Evan.

So, Evan, over to you.

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).

Our first question comes from Janet Kloppenberg with JJK Research.

Hi, everyone, congratulations on a good quarter.

Glenn, I was wondering if you could address what it would take to, for the Company to invest in a traffic-driving marketing program for Gap?

If you feel good about the assortments, what is the catalyst you need for investment in this brand to perhaps bring the customer in and perhaps there will be a campaign around the denim introduction.

If you could elaborate on that, or what other traffic-driving motivators you might use to help build productivity in the Gap?

Thank you.

No problem.

Happy to answer that.

We look at it that since the beginning of this year we have certainly been making some traffic investments in the business and Old Navy has been the one we've mostly put a lot of investment behind, but we're now starting to put some investment behind Gap, as well.

And they're not big investments, I think it's just we're trying to learn -- we're making some traffic-driving ideas.

We have one for Memorial Day this weekend.

Mark and the team have a few other ones planned over the last -- next couple of months.

And you're right to zero in on the denim campaign.

Our 40th anniversary is in August, and as part of the 40th anniversary celebration and recognizing the heritage of the brand, denim is a key cornerstone of heritage in the brand.

So Marka and the team have put together and they have been working on it for the better part of a year, what is the right relaunch for the 40th anniversary.

Denim is the right category.

Some work has been done on it.

There is going to be a campaign but I would not say it is going to be break-through.

But there is certainly going to, as we talked about in Old Navy, a fully integrated campaign, there's some work being done on the stores to make sure the denim shows up.

It is going to have a unique look.

It is going to be brought forward to the front of the store.

There's going to be some incremental investments on top of that.

I would not characterize it as an Old Navy type campaign that we started at the end of February.

But as I said in the opening remarks I believe it is the beginning of a more confident approach to the Gap brand and I hope we have some early reads that are positive, would then lead us to make other sustainable investments after that.

So in August I think we're going to come through with the denim campaign as a marketing component.

It is not deep.

It is not rich.

But I think it is good enough for the brand right now.

And then we'll take a look at the back half of the year beyond that and whether there's reasons to make further investment in Gap brand.

Good luck.

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

Good quarter in this environment.

On the Old Navy, Glenn, obviously there's a productivity ramp, is there anything we're doing in Old Navy that would suggest, however, given the marketing spend and really where we are with the margin, that that business would be able to deliver the same level of profit that we were used to several years back when this thing was comping positive?

Thanks.

Yes, that's no problem.

That's way early for us to be predicting the kind of return on sales that Old Navy might get to.

You're right to suggest that obviously a number of years ago it was -- it was a great profit vehicle inside of the total corporation.

Still contributes quite nicely, by the way.

I think that, look, we're taking this one step at a time.

We told you in the last conference call that we felt that the product that is now currently in the stores back then, that was the March flow, was acceptable enough that we would make the investment particularly in this environment, and to just build on Janet's question earlier.

We did comment the last quarterly call that we felt given the value consciousness of consumers, the economic environment that we're operating in, that we would put Old Navy sort of first in, in terms of an acknowledged investment to drive traffic.

Other brands do have traffic initiatives, not to the level Old Navy enjoyed in the months of March and April and also the month we're currently in, in May.

So I think it is one step at a time, Mark, as I mentioned in the opening comments just joined us.

I think the test for Tom right now to ever get to what you're suggesting, which I'm not saying we're going to, but to get to that and continued momentum, now the trick for them is how do you keep the campaign -- any campaign relevant, keep it -- that it's disruptive in the marketplace, the people actually tune in and react to it, there is a call to action.

And on the other side is what are we doing from Mark Breitbart's perspective to bring the product up to a much higher level.

As we said in March the product was acceptable.

Now I think Mark is going got to get it to good and then the test would be Mark and his total team is to get it to great.

Now, if everything was aligned obviously we would like to see a little more profitability and contribution of Old Navy to the total business.

But I think we are a number of conference calls away Jeff, of getting to any kind of evidence to get to the answer to your question.

We're not in this business to have Old Navy be the same contributor as it has been for the last number of years, that's why we decided to make the investment in that brand and to put the new team in place, to at least get it back on track and be a much bigger contributor to the business than it has been recently.

Got it.

Good luck.

Thanks.

And our next question comes from the line of Stacy Pak with SP Research.

I guess following up on the earlier questions, I'm not hearing, Glenn, as much about how you feel for -- about the Old Navy product for fall and holiday?

Are you confident you have the product in place so we're going to continue to see an improvement there?

And just a clarification on what you said on Gap, does that involve TV, and if you're confident Gap product is right is there a metric, like conversion or something that you could share with us?

On the Old Navy product what I was saying to Jeff, is that back in March when we announced we would be coming back with some marketing, we were asked quite directly how do we feel about the product and maybe to some people it might have felt premature.

What we said is that Tom and his team crossed a number of different thresholds with us to the point that we felt confident to give him an equal amount of marketing money to last year.

And in fairness to them I thought they came up with a pretty good campaign.

We never would have produced the kind of change in comp numbers in March and April if the product was not at, as I describe it a minimum acceptable.

I do believe, and again I can't give you any metrics on Old Navy, but I do believe from the time I spent with that team which, is fairly -- a fairly high degree of time, that they are making some progress when it comes to product.

And that the next threshold, just to be fair, is going from acceptable to good product.

And then I think once they get to that level then they got to get to great.

And these things don't happen overnight.

But I do believe that they have got a really clear, more than anybody else in our business, and I don't mean to be disrespectful to our other brands, but more than anybody else in our business they really know their customer.

They've really zeroed in on who it is, who their competition is.

And I think they're designing now for Old Navy, what's right for Old Navy in order for them to regain their proper position in this value segment.

So I certainly didn't want to give you the indication that they're going to get to acceptable where they are today and then hold for a number of years.

I do believe they are on an upward trajectory and are really committed to improving that product and crossing and getting their -- themselves back to great.

No question about it.

On the Gap side, to your question, television is just one medium.

I'm sure if we were stalking on a conference call 10 years ago, everything we did revolved around television.

But there are so many other ways now to get your message out.

And Gap, in particular, where our mark as brand is such a cultural brand where social networking and other mediums can be used in order to get your message out, and I think the challenge to them has been could they use television at some point?

And, by the way, television is not part of this denim campaign in August.

It is a campaign, but it is not a breakthrough idea, but it is a campaign that I think is important and revolves around the heritage of the brand, and as well as a celebration of 40 years of very strong brand in the US.

But they have a campaign that I think is well thought through.

It is going to get the message out.

It is very solid inside the stores.

I've seen all that.

Going forward, as they come up with new ideas, what I'm kind of saying today is you don't just do a denim campaign and then do nothing.

So the challenge is beyond that what do they do?

How do they get on some momentum?

How do they continue to get their voice out to customers?

Therefore, if television was to become one of the mediums down the road with a breakthrough idea they felt was necessary, I would certainly support it.

Is there a conversion number, Glenn, or something you can share to sort of back up your confidence in the Gap product?

Conversion is a tough to be fair, to use in this environment.

I can give you a conversion number -- this is a hypothetical, by the way -- if I said a brand X's conversion was up 1% but its AUR was down because we became that much more promotional, then it is really meaningless.

What we've been doing, and because we don't -- I don't often come on calls like this and make bold statements if I don't believe them.

The statement I made the last call and I'm backing it up today too is, I do feel confident the product at Gap and the way we've done that is we've really ramped up all of our customer research it is at store level.

We have got way more consumer panels than we've had before.

We are really finding a way to speak to customers and talk to them about our product.

And our feedback and our research certainly points that people are seeing the product now being absolutely zeroed in on our key target.

That's what's important.

Is it hitting the target we want?

And our evidence right now, it is not perfect, by the way, no different than I said about Old Navy going from acceptable to good to great.

Marka and Patrick and the team have to keep climbing.

They can't stop right here and rest on their laurels but they have made a significant change and it is on target and we do feel comfortable enough.

And there is traffic driving events they're going to have in May, June and July.

But the real next step for them, I want to get everybody focused on the back half, is this beginning with in August this denim campaign and then hopefully that will give us the foundation to be determined, by the way, but I'm happy to report back in August when we're together again, to be determined, will that be the foundation and the beginning of future investments to get that brand getting the kind of traffic we think it should be getting given the improvements in product we've seen.

Our next question comes from the line of Dorothy Lakner with Caris & Company.

Thanks, good afternoon, everyone.

Just to follow-up, I don't mean to beat a dead horse but to follow-up on what you're saying about Gap's campaign, you did I think say that this would be followed through with breakthrough ideas for fall and holiday.

Is that accurate?

Or is it a case of you want to see how things go in August and then you'll kind of go from there?

Was that my understanding that you're starting to market the brand beginning Memorial Day, but with this big campaign on denim to start in August and then other ideas will follow through in the back half of the year?

Yes, it's definitely the latter what you said.

I wouldn't say it's a big campaign.

I would say for the first time since I've been here we can actually say that Gap has a campaign which is denim campaign in August.

No different than Old Navy.

I think that you have to be able to put something into the market and we take these things very seriously but then we have to read it.

We have to make sure that actually they have the right idea, the creativity, the store level execution, and obviously in the case of denim they have the products and the premium denim relaunch and the fit and the washes and everything appeals to our customer.

The challenge we have given that team and they don't need us here at Corporate to challenge them, they're self motivated but it helps with a little bit of challenge from us is if we're going to do this, and this is a step, please make it the foundation with proof points in your August launch that would give us confidence to spend more money going forward.

Because that's what we all want.

If the product has improved, and I've obviously expressed my perspective on that.

And if we're going to put some money and some effort and get our stores reengaged in this campaign in August, then let's make sure we do it, execute it well.

Make sure that it is absolutely a call to action.

With that evidence I am more than happy, because I'm a big believer on return on capital.

I'm a big believer in return in investment.

If we're going to make the investment I need to see the return.

There is a feel to this too.

It is not all mechanics, it's not all financial.

But I really believe that they're on the right idea and Marka is obviously thinking ahead but we're not going to give her any kind of green light beyond the denim campaign until we see the early results.

Right.

Okay.

Great.

Good luck.

Thank you.

Our next question comes from the line of Richard Jaffe with Stifel Nicolaus.

Good morning, all.

We say Stifel Nicolaus.

Thanks a lot, Glenn, and congratulations to your team.

Really excellent execution here.

Looking forward to Gap and there has been in the paper about resurgence of the khaki business, the CFDA effort.

Do you want to talk about what follows denim or what could follow, some of the iconic products that we saw at the Gap and whether they might be the future of Gap?

Well, I think that CFDA we had two good years of doing the white shirts.

It is something that we believe in very strongly on a number of different fronts.

One, it's not only the product in our stores but it's a chance to work with young designers.

So is it a big mover, the needle for us when it comes to our stores and our P&L?

The answer is no.

It is something that actually differentiates the brand and really says what Gap is all about.

I think, to be honest with you, the same thing applies to khaki.

I think the khaki -- khaki campaign with the designers for CFDA is brilliant.

I think it really is.

I'm glad we didn't do white shirts again.

I'm glad we did something else.

But, it only goes into about 120 of our stores and it really is all part of the overall brand image that Patrick and Marka are trying to curate and rebuild, to be honest with you, at Gap.

But there's between that, the artist Tease and some of the other work we've done.

The vote campaign we did in November, if Gap truly if one of its emotional cornerstones in retail is that Gap creates culture then there is always going to be some of these associations we're going to have, either with CFDA like I said, or with the vote campaign we did in November and some of the other ideas that have come out of that brand.

But to be honest with you, there are little pieces that help build a reputation of the brand, but they're not -- they're not in keeping with the campaign that we're going to do starting in August, which is really an all-store campaign, and that's attempt to not only to reestablish the brand but to actually move the needle on the P&L.

Very helpful.

Thank you.

Our next question comes from the line of Laura Champine with Cowen Incorporated.

I may have missed this, if you gave it, could you comment on merchandise margins and what your expectations are for product costs as we go through the year?

Yes, we did say our merchandise margins were up 100 basis points for the quarter.

What we said for our outlook for Q2 and the rest of the year is that we're highly confident that the average unit costing that has been driving that merchandise margin improvement in Q1, will continue through the rest of the year.

The tougher part to predict is that average unit retail which our product will ultimately sell at.

We haven't guided to that piece but we feel really good about the average unit costing and again, we were able in Q1 to accomplish our goal of delivering the increase in merchandise margins.

Sabrina, is that driven by consolidating your vendor base, or are you just seeing overcapacity in the supply chain?

It is a lot of levers we're using.

Over time we have been working to concentrate more of our buys with fewer vendors, but I think a big important piece of it this year in particular has been a supply and demand equation.

And in addition we have been talking about for some time our use of various tools, using our size importantly against our buys to get those savings.

But also tools like e-sourcing and counter-sourcing.

Got it.

Thank you.

Our next question comes from the line of the Marni Shapiro with The Retail Tracker.

Hey, guys, good job in a continued tough environment.

I was curious about, just to get back to the denim and I'm sorry to harp on it.

Did you wipe the slate clean at Gap and kind of start all over with new fits, new washes, new styles?

Or is this more an evolution of what you already have there?

And I noticed in the stores recently a white jean that had a premium label, premium fit.

I was curious if that was indicative of what is to come and if you could just touch on the same ideas at Old Navy?

Definitely what you saw in New Jersey, white denim is indicative of what's to come.

I would say it is an evolution.

We don't have to start from scratch.

We've been doing this a long, long time.

But I do believe Patrick really fundamentally in the last year has thought that as he looked at our business and looked at our assortment and looked at what was important, got himself confident what you saw in the store.

Premium denim.

I think he did do some work on the fit, he's very focused on the washes.

I'd say it's a little more women's than it is in men's.

Men's might be best to tweak here and there.

When you have fully integrated campaign it is nice to bring everything together.

When a Company like us, when you're rooted and our heritage category is denim, it is nice to come back every now and then and reclaim your rightful position and make some noise and let people know that not only do you have the fit and the washes and the selection people are looking for, which is obviously critical in this business, but I think there is also a good value message when it comes to Gap.

Denim is trending nicely and some people have obviously gravitated over the years towards $100, $150 denim.

I think also there is a good everyday value message here which is secondary to the fit and the washes and what makes Gap exciting.

But there is a value message.

So, yes, it's -- what you saw is absolutely an indication of what's to come.

Great.

That's good.

At Old Navy is there the same kind of push on denim or revamp of the denim for fall?

Not really.

I think Tom will always be introducing whether it is fashion denim.

He'll always be doing something, because, Old Navy's world famous jeans as we call them, is something that has been around for a long time.

But there is definitely no plan for a massive investment in denim.

I think it's just part of it is core message.

I think Old Navy is about product, key categories and really great, really great value.

And sometimes Tom will use denim to communicate that.

But this is -- it is completely different what we're planning to do with Gap.

Good luck, you, guys.

Thank you.

Our next question comes from the line of Jennifer Black with Jennifer Black & Associates.

Good afternoon and let me also add my congratulations.

Glenn, on the last call you talked about how vendors are bringing your Company more value and you talked about the average unit costing just now.

And I wondered when you are looking out what inning do you feel that you're in as far as the value realized, and also if you could give us an update on GapBody?

Thanks so much.

You know, it's tough to tell, because, I would have told you six months ago that we were getting into the middle innings and then the rules of the game changed.

And commodity pricing came down.

People really cut back on their orders through factories around the world.

Capacity opened up and then we went back down a few innings.

So really there is our own score card internally, about how we think we're progressing and we're always trying to look a year ahead, what else are we going to do next to make sure we strike the right balance, as I've said before in these calls, between quality, which we never want to lose sight of that, the flexibility to work with vendors, as we work on pipeline speed, particularly at Old Navy, and the last part of that equation is cost.

So all I can say, without naming an inning, I would say we were in the middle of the game and then it came back down a few levels when the world changed and we were able to take advantage, as other retailers are taking advantage, of some good costing opportunities right now.

What I do know, as a good Company, we're not just thinking about what's actually being ordered and placed right now for Q3 and Q4.

Our global production business, as you know, we operate in 48 countries, we're already talking about 2010, and what are we going to do and what else can we do to make sure on all three of those fronts strategically we can make sure that we bring the best quality, consistency, the flexibility we need, and continue to bring our size to market and get the best cost that we deserve, given the size of this business.

So my job with the global production team is always thinking ahead.

In the moment they know what to do.

12 months from now is what I'm interested in.

But I think it has been obviously a little wind at everybody's back in the last few months when it comes to get an average unit cost down.

Great.

And can you speak to GapBody?

GapBody is, Patrick went out about six months ago and hired a phenomenal designer to join us in New York.

I think that that's one of the benefits of getting great creative talent in our business and retaining it as I said at the annual meeting two days ago, talent attracts talent.

And I think that that's an example.

And there's many examples like that where we have been able to bring in really, either people who worked with us before, who have chosen to come back, and we talked about Julie Rosen earlier in my opening comments, we're going to go out and find really talented people who can help us and (inaudible) who has come in and working for us on Body.

Her first collection is now in the stores, the swim collection, what she has done for summer.

And, not that I'm an expert in the category but I've seen what she has done for fall and holiday and I think she's doing some really good work.

So that has certainly given us the confidence to go back to some of our stores and look at putting Body in some small concepts in some cases, only 300 square feet, to some mid-range concepts about 600 square feet and add that back into some of our stores.

To be quite frank, we lost our way a few years ago and to me that whole category is so synonymous with Gap.

It just fits so perfectly.

It may not be foundations that you need to have in there, but just some of the categories we're in now, just sleepwear, loungewear, some of the athleisure categories.

It just fits perfectly and we now have the leadership under Patrick, Marka really believes in it.

Great merchandising team and early days but we're certainly making a reinvestment in the store to give it more prominence.

Thank you very much and good luck.

Thank you.

Our next question comes from the line of Paul Lejuez with Credit Suisse First Boston.

I was just wondering if you're seeing any difference in the performance at Old Navy in malls versus off-mall?

And if you've detected any cannibalization in terms of maybe Gap customers moving over to Old Navy?

And then, second, just wondering if you can share with us the percent of markdowns currently in inventory versus last year?

I'll start with the real estate question and then I'll hand it over to Sabrina.

There really hasn't been a big difference.

We're about 70% invested in off-mall locations for Old Navy.

And I would say that trafficwise those are slightly better because the people who are neighbors tend to be a little more in the value segment.

Therefore, their ability to attract customers during these times we all know that's a growing segment here in the United States.

So I think the performance has been relatively better.

Whether that's because of the type of location or just the type of our neighbors I'd rather say it is the neighbors we have, are bringing in traffic that we can take advantage of.

So I think that would be the answer to that split.

Yes.

And then on the inventory at markdown, Paul, we actually did well on selling more goods in the quarter at regular price.

So another piece of our improvement in merchandise margin were healthy markdown margins and also selling more reg.

And reg of course includes promo.

We did a fair bit of that at Old Navy.

We did well on reg selling and we ended the quarter with less inventory at markdown than last year.

That's great.

Thanks, guys.

On that cannibalization, anything there, Gap versus Old Navy?

It's tough.

We don't -- I'll be honest with you, we don't spend a lot of time looking at it.

We have some numbers but nothing that we would see right now from Old Navy's very recent resurgence would be necessarily causing some of the declines that we are still experiencing at Gap.

It is a big, big market.

And we obviously are aware that our brands have to be differentiated to some extent but at the same time you're talking about a very large market where we have a relatively -- because it is so fragmented -- even with our combined strength and size a relatively small share.

But I don't sit back here today and look at any data that shows me that Old Navy is currently cannibalizing Gap.

I think they're complementary businesses and I think we like the way that they actually work in tandem together.

Okay.

That's great.

Thanks and good luck.

Thank you.

Our next question comes from the line of Brian Tunick with JPMorgan.

Hi, thanks.

Good afternoon.

I guess sort of two-parter.

I guess the first one on the return of sales discussion at Old Navy, would you say more of the erosion over the past few years has come from the sales deleverage on the comps, versus merchandise margin erosion.

And then maybe, Glenn, given the change in the real estate environment over the past couple of months, what is your real estate team telling you as far as the goal of shrinking the boxes or closing and combining doors?

Do you still think it is as big of an opportunity as you thought?

I know ICSC was last week.

Can you maybe just give us an update on what you think is going to happen on the real estate front among those divisions.

I'll start on return on sales for Old Navy.

I think both merchandise margin and deleverage have impacted Old Navy over the past couple of years where we were very unhappy with performance.

So obviously when our sales go down, and we have a fixed amount of rent and occupancy, you're going to deleverage quite a bit on the [rob] line.

But what's driving that drop in sales is also the fact that you're not achieving the merchandise margins that you want to be achieving.

Whether it's because you have to go at a lower markdown margin, or you're just not getting all the right selling you want.

So I think in the past couple of years we would say both were contributing to the decline.

And we're moving forward on our trajectory, as Glenn said, to improve that performance, certainly in the first couple months of this year.

And on the real estate front, it has been an interesting time, no question.

First off, we are completely committed to the five-year strategy we've been talking about for the last number of calls, which is to get our square footage down, do it over the next five years, combination of consolidation of assets, downsizes and closures.

So we're committed to that five-year goal.

If our new head of real estate, David Sobo, who is actually at the ICSC meetings in Las Vegas this week, and, well before he went there, what I would say were seen as more of a trend in our businesses, we were probably more focused on downsizes on the exact same site in which we're in, and we still believe there's lots of opportunities for those.

But now what is happening more than anything else we're getting opportunities for repositions.

And so I think there is a lot of tension in the landlord community about, they want to keep the best tenants, and obviously not only because of our 40 million square feet, but because of our balance sheet, we're an attractive tenant.

But I think we're getting a lot more opportunities now, where we're being -- if we were in 25,000 square feet and if we wanted to be in 17,500 square feet, and we're unable to get it done in a site in which we're in, we are being offered some opportunities to move across the street and do it because everybody would like to make sure they're holding on to as many of the best tenants during these times.

With that said, when you're in a location and have an opportunity to move, obviously the last thing that any landlord wants to do is lose an anchor tenant like we might be.

So I look at the environment and say a little more repositions than probably downsizes on sight we would think would be the way in which we would go.

But that's fine.

As I was telling the real estate team just a while back as one door sort of closes a little bit, another door opens.

And so there's a multiple different ways for us to get to our strategy, so if it means a few more repositions and downsizes at the end of the day we're going to get it done regardless.

All right.

Thanks and good luck.

Thank you.

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

Two quick questions.

One for Sabrina.

Can you give us an update on your occupancy and also operating expense leverage points for the Gap and Old Navy divisions given changes you've made here in the last couple of years.

Have there been any material changes in that leverage point that would help you recover that much faster now as you ramp back up comps some point in the future?

And then, Glenn, on international expansion, there's been some comments from you guys in the press and you've been a little bit more active there with some of your licensing, maybe a few thoughts on how you view that opportunity and maybe a use of capital in those markets going forward?

So I'll start, Jeff, with the question on deleverage abroad.

I think what's fair to say and we've been saying this for some time, it is going to be difficult to meaningfully leverage rod unless we get pretty close to flat to positive comps.

What we've seen recently of course and we are making progress, we didn't deleverage as much this quarter because our comp was obviously less negative this quarter than it was the last few quarters.

With regard to the relationship on how that moved, if you just calculate sort of what's been happening over the last couple of quarters, for every point of comp improvement we get, we tend to get 20 basis points less in deleverage.

So we're headed in the right direction as we did a negative eight this quarter versus a double-digit in past quarters.

We really need to get closer to flat to positive to make us stop deleveraging.

On the international front our franchise business is still something we believe in.

We're in 14 countries right now operating with about give or take 160 stores.

We will be in 20 countries by the end of the year.

So you're right to, every now and then we'll sign another country and put a press release out.

So we do feel that we've gained good momentum from the first store we put in the ground three years ago in Southeast Asia to the most recent store we did in Moscow.

So I think that that team continues to look at the world, and I think that from a capital perspective, the franchise business is obviously capital-like to us.

It is very little capital investment at all.

Very good return on invested capital.

For that reason we really love that business.

At the same time we have to make some bigger decisions on Western Europe where we have no presence.

We have nothing east of France all the way to the border of Greece.

So some decisions there, but are those going to be franchise, could they be joint ventures, would they be corporate controlled like our business in France and UK and the Republic of Ireland is.

And we're doing some exploratory work.

I'll make sure I'm clear on this, just exploratory work on China.

And just take a look at the Chinese market and one, how would we enter it structurally?

And secondly with what brands and what way and what sequencing.

So for now we continue to ride the success of our franchise business in those 14 countries, with six more to come.

But a lot of time is being spent here just what are we going to do in these other countries that may not be appropriate to franchise.

So more to come on that probably in the future.

Okay.

Thank you.

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

Thank you.

Glenn, it seems like the challenge of the Gap brand is traffic.

I'm wondering if you can talk about different ways or different strategies that you're thinking about to try to drive traffic across the threshold?

Well, to be honest with you, we've been for the last three months, I think trying a lot of different ideas.

Instead of -- instead of just trying to get to the silver bullet out of the gate, we've been trying different things in different markets.

Whether it's different promotional levels, some collaboration work we've done with Starbucks, whether it's the use of radio.

We've been trying, and that's what I encourage the team to do is we'd like to come out and just figure it out, out of the gate, but before we do that, we're trying different ideas over every single month.

We've got an idea this Memorial Day weekend that the team thought of and they're going to do that and we'll have to get a little more active on radio and media to see if we can move the needle on traffic.

We have some different ideas in June and July.

So I'm not -- I don't think there's any value in me going through the dozen or so different concepts they're trying.

The one thing I will say to you that I found has been effective and we have got to do more of is when they involve the stores, and not just make the stores responsible for conversion, service and getting people comfortably in and out of the store, but how do they actually engage them in dealing with people inside the mall or even outside the mall to get them to come in our stores.

That has certainly paid dividends for us.

I think that's something that not just Gap but all the brands are looking at.

I know Sabrina talked recently about our give and get promotion.

Those are the kind of ideas when you take something that we pioneered in friends and family.

But after 15 years of it it turns a little stale.

You turn it in to give and get, you give 5% back to charity and you have all our brands work together.

That certainly helps us with getting more traffic and people through our doors to see our improving product.

So lot of -- lot of creativity being applied to it.

A lot of tenacity.

Some things are working really well.

Some things, I think, whether it is the economic times or it is just not appropriate for the brand, we're shelving it and we're not bringing it back.

So as I mentioned on a question earlier, they will continue to provide different traffic ideas from now till about the third week in July and then we're going to go quiet for a bit and come back with our denim campaign.

So I don't want to wait until the denim campaign.

I would like to see them show some noticeable improvement between now and then.

They're working hard at it.

And we, as I said before, we're clearly committed to resolving this traffic malaise we've been under for the past few years.

Great.

Thank you.

Our neck question comes from the line of Dana Telsey with Telsey Advisory Group.

Good afternoon, everyone.

When you think about the message of value to the customers and the lower average unit cost what do you see as the opportunity by brand for each achieving value and the balancing of raising IMU through the lower average unit cost and the time frame to achieve that?

Thank you.

Dana what was the last part about raising the value of average--?

Raising as you look at initial markup and the opportunity for that, through the lower average unit cost as you work to gain even more economies of scale?

Well, the first thing I'll mention, I don't know if we talked about this a year ago, is we spent quite a bit of time a year ago really separating average unit cost from average initial retail.

I've been -- been pleasantly surprised about the work we've done in the last year, but I was a little, to be honest with you, a little shocked when I first came here, is that our pricing was really driven by our costing whereas our pricing should be driven by what we think the consumer is willing to pay.

That took us a while to separate the two of them.

So what I will say to you is just because we were able because of good economic conditions or the size of our business, or relationships with a smaller vendor base, get a 5% reduction on cost, this is hypothetical, by the way, that doesn't mean that we should have a 5% reduction in retail.

The two of them, they meet on the P&L but they're really two different metrics altogether.

So what we've been encouraging each brand to do, and obviously this starts with Old Navy and I'll argue our outlet business, too, is they have to be continuously trying to find a way to get their message across and bring real value to customers.

So, for instance, if Tom really felt that he needed to have a $10 price point on something, because that's what it takes to have a leading price point on that category in the marketplace against his competition, then he better find a way to get the right cost to be able to afford that.

So I think that we are looking at our business completely differently.

It's been -- it's been quite a bit of change.

We have a whole new pricing strategy for every single brand.

We've actually pulled pricing out of the merchandising team and allowed some pricing people to actually work on it.

Merchants have to be accountable at the end of the day for gross margin.

We have got pricing people in each brand doing the work so they're the ones who more than ever we have more information on the competition on a weekly basis, we know -- we've done a lot of testing, localizing to find out what works when it comes to promos.

So my point is that regardless of the AUC you're able to get, that shouldn't drive your AIRs.

We definitely have solidified a pricing strategy for Banana Republic, for Gap, for Old Navy, and for the outlet businesses and they are in the process now of making sure that pricing strategy gets to market over the next six months.

Operator, we have time for one more question.

Thank you.

Our last question comes from the line of Adrienne Tennant with Friedman, Billings, Ramsey & Company.

Good afternoon and congratulations.

My question is really on sales productivity around the divisions.

In 2008 it was kind of around $336.

I'm wondering if the three divisions are sort of clustered around there or if you can give us any idea of kind of relative to each other, where we're coming out in sales productivity?

Yes, I think you get a sense because we do report sales and square footage in our 10-K.

I think we're where we're at the highest level is we're disappointed that our productivity has declined.

Some of that over the last two years has been purposeful as we removed units because we felt like we were selling too much at markdown and we really wanted drive a better healthier reg business.

So we took units out, each selling at healthier margins, by the way, but our overall sales productivity has continued to decline.

So, the next stage of the evolution has to be really holding on to that nice mix we've gotten of reg selling and healthy margins, and then over time introducing more units to drive much more productivity per square foot into the box.

We'll achieve that in many different ways.

The downsizing of the boxes will help us.

Adding different categories into our boxes, like jewelry at Gap and some personal care at our brands.

Body in more of our Gap stores.

So we're looking overall to just drive productivity per square foot up.

Is there any color can give us on where the three Old Navy, Banana and Gap fall to that metric, that 2008 metric?

Or perhaps which has the most potential and has fallen the most, something like that?

Yes, I'm just trying to pull productivity.

Let's see.

Gosh, they've all fallen quite a bit.

So we have ample opportunity, some sort of peak levels in 2004.

We have ample opportunity in Gap, Banana and Old Navy.

Probably the most I would say -- gosh, they're all actually about the same.

So I think they all have ample opportunity to get back to sort of 2004 productivity levels.

Okay.

So the spread around that 336 is pretty tight around the three brands?

Yes.

You can calculate it all.

It is all calculable -- but yes.

It's pretty tight.

Great.

Thanks so much.

I appreciate it.

Good luck.

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, thank you for dialing in for today's Gap, Inc.

first quarter 2009 earnings conference call.

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