蓋璞 (GPS) 2009 Q4 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.

fourth 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, Mark Webb, Vice President of Investor Relations.

Good afternoon, everyone.

Welcome to Gap Inc.'s fourth quarter 2009 earnings conference call.

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

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

Because these forward-looking statements involve risks and uncertainties there are important factors that could cause our actual results to differ materially from those in the forward-looking statements.

Information regarding factors that could cause results to differ can be found in our annual report on Form 10-K for the fiscal year ended January 31st, 2009.

Investors should also consult our quarterly report on Form 10-Q for the quarter ended October 31, 2009 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 February 25th, 2010 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 measures 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 Glenn.

Thank you, Mark, and good afternoon, everybody.

In a few minutes I'll turn it over to Sabrina.

Before that, I thought I'd spend a few minutes personally on 2009, which was a very good year for business.

We feel good about our accomplishments, our execution level, and more importantly how we've positioned the business for 2010.

Then I will spend a few minutes on 2010, because there's a bit of an evolution to how we're approaching the business.

First on 2009 financially, we were pleased by our financial performance.

You have seen the press release.

Again, you're going to hear from Sabrina.

On some of the key metrics that any good retail organization looks at, we had a good year.

We started to see the comp performance of the business move.

But as you heard us talk about in 2009, we're beginning to work on traffic, starting to plant the seeds.

And now as our economic model is in place, and the consumer looks to us to be a little more responsive in 2010, I think it was a good sign in the fourth quarter Gap Inc.

was able to achieve a plus 2% comp.

Our free cash flow was $1.6 billion.

We maintained our cost discipline.

Granted, we had some target investments that we made.

We felt they were important.

But we maintained that discipline inside the business, which is critical for me.

We worked so hard to take out the SG&A we've taken out the last two years.

Now the money only goes when there's a justifiable, strategic reason and we can quantify the return.

With these results and a third year in a row of improving financial metrics, you won't hear anybody in this business talk about a turnaround plan.

We put our plan into place in 2007.

We've executed it.

We've been disciplined.

We've been committed.

In our opinion, we can now evolve the business and start talking about how the business is going to grow and move forward and compete and win.

We know the work going forward is still going to be challenging.

We accept that challenge.

But the business now is better positioned.

It's got a leaner, better economic model.

The balance sheet is strong.

The management team is secure.

And now we look forward to the next set of challenges in 2010.

Speaking of 2010, we're definitely going to keep these key financial metrics -- they're going to be top of mind with us.

We're going to continue to work hard to improve every single one of them, and we will continue our commitment of redistributing cash to shareholders.

We just authorized another $1 billion of share buyback program and we're increasing our dividend by 18% in 2010 up to $0.40 per share.

That's the commitment we've had for greater than five years.

And we will continue to have that commitment going forward.

As we've talked before at either industry conferences or on these quarterly conference calls, we look at our business in two different ways.

We have our North American bricks and mortar business and we have our international and online business.

First of all, in our North American bricks and mortar business, we need and we will gain market share in 2010.

And instead of taking you through brand by brand -- I'm sure there will be questions later on brand specific -- let me take you through some common themes on how we're looking at our business.

First and foremost, stores.

In 2009 we developed new prototypes, new store models, for every one of our brands.

Old Navy started with five.

We finished the year with 60.

We will now do 180 additional Old Navy remodels within the first half of 2010.

There will be 20 additional stores which are relocations and repositions to bring the total Old Navy new project ones to 200.

And by the end of the year, of Tom's 1,000 plus store fleet, there will be over 250.

That's a big commitment for us.

We put the team in place, the processes, we got the cost down per foot.

We know the return.

We know what it's worth to us and how customers respond to it.

That's a commitment for us at Old Navy.

Again, plan to gain market share.

The Gap store prototype was done in Dallas in September.

Gap business is about consolidations and reduction in square footage.

Anytime we get a consolidation or reduce square footage, we will put our new store model in place.

Banana Republic has a brand-new store model that was done in three locations, most recently in Scottsdale.

I was there checking that out with Jack and his team.

And our outlet business also has brand-new innovative current relevant look.

Mostly the outlet business will be new locations.

But also we plan to do some remodels and some relocations.

The second common theme you're going to hear about is marketing.

How do we make use of the money, make sure it's cost effective, make sure there's a return -- but make sure that it actually has as you heard us speak about before, a call to action.

We're just not going to arbitrarily put marketing out to our consumers if there is not a call to action.

I think we really started the year off right in 2009 with the SuperModelquin campaign.

It's been a very successful creative platform for us.

We're going to continue to evolve it and challenge it and make it invigorating, and I think you'll see that right now with the campaign that's going on today, which is the SuperModelquin Search.

That's a good marketing platform to express our strong value, be aggressive Old Navy, but have a way to do it in Old Navy's language.

The Gap relaunch on denim provided to us a very good marketing platform.

You saw us come out in February to launch of Baby Gap denim, off the same 1969 platform.

We'll be relaunching Kids denim in the summer, off that platform.

And we're just now starting to find a way to speak more about product at Gap and use the marketing as a means to communicate the unique product, the value behind it, and the attributes that make those products special.

Banana Republic's new marketing platform you might see it in our stores, so I think we feel good about that.

Third theme is we spent a lot of time last year, and continue to tighten this up in 2010, is what is the value proposition of our brands?

This is again -- value is not just about price.

Value in a larger scheme is not overpaying for quality.

Whether that is in Banana Republic, about some of the products in there, some of the quality and the detail that the designer merchandising team puts in -- it is of incredible value.

So these value propositions we're going to make sure are very well-known, very well understood by our customers and we'll continue to evolve them in 2010.

Lastly you're going to see us take much more of a category focus.

It has been my observation in the last year that we're not as clear -- particularly when you want to gain market share, who has the market share, what categories are you going to go after in the competition, how are you going to differentiate, how are you going to beat them, and how are you going to take a category approach to making sure you gain market share?

More about that to come in the future, but I think you saw that on denim at Gap.

What's the right category?

It's foundational.

It's premium.

Make it affordable, and then go after it, month after month after month.

So these are but a few of the common themes that we're going to be taking on in 2010.

Every single brand has their own set of priorities.

The reason behind that is every single brand is at a different stage of its evolution and a different stage of what it wants to become.

Certain brands we've got to continue to put a little more work, a little more emphasis, a little more focus from me in particular, to make sure that they can achieve what their plans are.

So that's just the nature of this business.

It is one of the advantages.

We have multiple brands.

You've seen it in the last couple years -- one brand may not be performing well, but the corporation still delivers results.

We get that.

Obviously our goal is for every brand to move in a very positive direction, every one of our channels to move in a very positive direction.

But we know our focus needs to go on to the businesses that at this moment in time are still putting work together to get the business to the right position and to get it to gaining market share.

As I think about international and I think about online, there's only one theme there.

It's growth.

We need to make sure that beyond the gaining of market share in North America, we have growth initiatives in our business.

Two new countries we're going to go into in 2010 happen to be two of the top five apparel markets in the world, China and Italy.

In the last 12 months, we've been putting the pieces together.

What is the right team?

What is our strategy?

How do we go into the market?

How do we make sure we win and we're successful?

We've been working on that the last 12 months.

Those pieces are in place.

We have a strong European team.

We're going to built off their success, particularly in London and Paris, to go into Italy and that's going to happen in the fall of this year.

And off of our Japan team, we built a team now in China that is a very good team and very motivated.

Been working the last 12 months strategically to open stores in the fall of 2010 in China.

Our global outlet business is a big growth opportunity for us.

Underdeveloped in Canada, we're starting to grow there.

Underdeveloped in the UK and France and in Japan, and will be part of the formula of us going into our new countries.

Very pleased with that team, great return on invested capital, definitely a growth opportunity for us.

Global online -- we will open up in Canada this summer.

We're going to come out very strong in the Canadian market and we will open up with a business based in London, but it's going to be a European site and it will serve 10 countries in Europe.

That's a big move for us.

For us to have operated this many years without an online presence is, to say the least, disappointing.

But the investments are being made now, the teams are motivated.

Athleta business that we acquired has been fully integrated.

It's gone from mostly a catalog business to a full e-commerce business on our universality platform.

Now we're into Athleta Phase II.

How do we take that brand to a whole new level?

And again, more about that to come this fall.

But the work's been put into place, led by Toby Lenk and his team.

Lastly, our franchise market, which we currently operate in 19 countries, was a little slow in 2009.

A lot of markets pulled back.

Russia in particular comes to mind, where construction just stopped.

Now having met with our team in the last six weeks, you're seeing some confidence come back in those markets.

You're seeing real estate opportunities open up.

There's new countries we're going to go into, new exciting countries with big opportunities.

While we have a comprehensive set of international and online investments, our capital expenditures are only going to $575 million.

So that is a strength of this business.

We can take up our CapEx by close to $250 million, still generate a significant amount of free cash flow, and return that free cash flow as we have in past years, excess free cash flow to our shareholders.

When I look at this, my view is that the business has worked very aggressively in a very committed way with a lot of discipline to change its economic model in the last two years.

The most important thing in our business is to make sure that our North American brands stay strong, stay relevant, stay innovative, that they differentiate themselves, and that we grow market share in North America.

There's never a day that goes by that the brain trust of the organization, the nucleus of its management team isn't entirely focused on its North American business.

But we like our opportunities outside of that and we do see our business now sort of evolving and changing.

In 2007 and 2008 and 2009, we generated incredible strong cash.

We took a lot of cost out of the business, not only in SG&A, but in product cost.

That's always foundational to who we are, which is being disciplined in the financial side and returning cash to shareholders -- but our growth was missing.

I would say this is the most comprehensive international and online activity we've had pretty much in the last decade.

I'm excited about that.

But now we have to become more of a market share gaining organization in a mature North American market.

And we're prepared to do it.

We have the team.

We have the ideas.

We're putting the stores together and everything else I talked about to gain that market share.

And lastly, we're opening the door now with this more robust international and online program of ours to generate growth day one, and earnings at the appropriate time.

I'm going to turn it over now to Sabrina, who is going to give you the details on the financial performance of the business in the fourth quarter, give you some guidance about 2010, and then we're all happy to answer any questions you have at the end of her comments.

Thank you very much.

Thank you, Glenn.

Good afternoon, everyone.

I'll begin today with a review of our fourth quarter and full year results and then provide an overview of our outlook for 2010.

In retrospect, 2009 was a year of two very different halves.

The first six months of the year we played primarily defense to manage through the deep recession we all faced.

Our focus was on leveraging our strong economic model to deliver healthy merchandise margins while continuing to manage expenses tightly.

The back half marked an important shift with greater focus on improving our top line.

Please turn to slide four as I take you through how we performed against our financial goals for the full year.

First and most importantly, we improved our comp store sales trend.

We had a flat comp in Q3 and a positive 2% comp in Q4 and we're very pleased that our largest division, Old Navy, delivered a positive 3% comp for the full year.

Second, we delivered healthy merchandise margins.

Full year merchandise margins were up 290 basis points.

Third, we maintained our discipline around cost.

Full year expenses were about flat despite a $78 million increase in marketing.

While we're pleased that we maintained this discipline, we're very proud that our earnings growth for the year was driven entirely by higher gross profits.

Fourth, we generated strong free cash flow of $1.6 billion.

And finally, we meaningfully improved return on invested capital.

Here's some additional highlights pertaining to the fourth quarter.

We improved our operating margin by 410 basis points to 13.9%.

We grew EPS by 50% over last year and by 46% over 2007, and we returned nearly $500 million to shareholders through dividends and share repurchases.

Please turn to slide five for earnings results.

Q4 earnings were up 45% to $352 million.

Full year earnings were up 14% to $1.1 billion.

Full year EPS grew by 18% to $1.58 and full year weighted average diluted shares were 699 million.

Turning to slide six, sales performance.

Fourth quarter total sales were $4.24 billion, up 4% versus last year.

Full year total sales were down 2% to $14.2 billion.

Please refer to the press release located on GapInc.com for total sales and comps by division.

Turning to slide seven, gross profit.

For the quarter, gross margin was 39.5%, up 550 basis points, with merchandise margins up 500 basis points and occupancy leverage of 50 basis points.

Gross profit was up $284 million or 20% to $1.7 billion.

For the year, gross margin was 40.3%.

Gross margin improvement was driven by merchandise margins up 290 basis points, offset by occupancy deleverage of 10 basis points.

Gross profit was up 5% to $5.7 billion for the year.

Please turn to slide eight for operating expenses.

Fourth quarter operating expenses were $1.1 billion, up $95 million to the prior year, driven by $44 million more of marketing.

Total marketing expenses in the quarter were $182 million.

Full year operating expenses were $3.9 billion, about flat to the prior year despite the increase of $78 million in marketing, to a total marketing spend of $513 million.

Turning to inventory, on slide nine.

We ended the fourth quarter with $1.5 billion in inventory, down 2% versus the prior year.

Inventory per square foot at the end of the quarter was down 1% compared to 2008.

Please turn to slide 10 for capital expenditures and store count.

Full year capital expenditures were $334 million.

We opened 47 new stores and closed 101 and ended the year with 3,095 stores.

Total square footage was down about 2% to last year.

Regarding cash flow on slide 11, full year free cash flow, defined as cash from operations less capital expenditures, was an in-flow of $1.6 billion.

Over the course of the year as our business improved and the broader economic climate stabilized, we increased our share repurchase activity.

For the full year, we repurchased 24 million shares for $510 million, of which 19 million shares were bought in the fourth quarter.

Now I'd like to share with you our outlook for 2010.

Please turn to slide 12.

Our economic model is strong, as evidenced by three years of double-digit EPS growth even through the deep recession.

Our specific financial goals for 2010 are as follows.

First, grow top line while we continue to deliver earnings growth.

Second, make prudent investments for our future growth.

Third, maintain discipline on costs and expand ROIC.

And fourth, return excess cash to shareholders.

Let me expand on each of these priorities, beginning with the fourth -- returning excess cash to shareholders.

As evidence of our commitment to distribute cash, since 2004 we have returned about $8 billion through share repurchases and dividends, and we certainly plan to continue returning excess cash to shareholders in 2010.

We're increasing our annual dividend by 18% to $0.40 per share.

This represents a payout of about 25% of our 2009 earnings, and a yield of about 2%.

We also just announced a $1 billion share repurchase authorization.

Now I'd like to return to our first three priorities, starting with growing top line.

One of the ways we will grow top line is to sell more units.

To support this, we'll be making targeted investments in inventory.

As a result, we expect inventory per square foot at the end of Q1 to be up in the mid single digits compared to last year.

For context, this compares to inventory per square foot down 12% at the end of Q1 last year.

We also believe we still have opportunity for gross margin expansion.

This opportunity comes from continued average unit cost savings, and occupancy costs which should leverage on higher sales.

Our second goal, invest in growth.

We will strike a balance between delivering short-term results and making investments that drive shareholder value over the long-term.

We're investing now for initiatives scheduled to launch in the back half of 2010.

Namely, our online business in Canada and Europe, and our first stores in two new countries, China and Italy.

We're also excited to continue the roll-out of the new Old Navy store design to nearly 200 more stores, almost all of which will be completed in the first half.

We expect all of the investments we've outlined to drive healthy returns over time, but they will be dilutive in 2010.

Our third goal is maintaining discipline on costs.

While we expect variable expense dollars to increase as sales grow, it's our expectation that total operating expenses in our base business will leverage as a rate of sale.

However, given the growth initiatives we've just outlined, there may be some deleverage in total operating expenses, especially in the first half.

Given our strong economic model and the 2010 priorities I've just outlined, we expect earnings per share to be in the range of $1.70 to $1.75.

To be clear, this guidance includes the dilutive impact of our growth initiatives.

Please turn to slide 13 for a list of our 2010 guidance metrics.

We expect operating margin to grow to about 13%.

Driven by our investments in growth, we expect capital expenditures to increase to about $575 million, and we expect depreciation and amortization of about $550 million.

With regard to stores and square footage, we plan to open about 65 stores, weighted to international and outlet.

We intend to close about 110 stores, weighted to Gap brand.

And we expect full year net square footage to decrease by about 3%.

We expect our full year effective tax rate to be about 39%.

Turning to the last slide.

In conclusion, we're proud that this Management team has consistently demonstrated our commitment to driving shareholder value by delivering on all of our stated goals over the last three years.

We intend to do the same in 2010.

Thank you, and now I'd like to turn it over to Mark.

Thank you, Sabrina.

Operator, that concludes our prepared remarks.

We'll now open the line for questions.

And in the interest of time, we would like to remind everybody please keep your questions to one each.

(Operator Instructions).

And your first question comes from the line of Michelle Tan with Goldman Sachs.

Great.

Thanks.

And thanks for the detail.

I was wondering if you could give us a little extra clarity on your thought on SG&A dollars for 2010 and also how you think about the marketing plans for the year as you work to gain market share?

Thanks.

Sure.

I'll start with the SG&A dollars.

So as I mentioned, Michelle, with a goal of increasing unit sales and increasing top line, we certainly would expect nominal dollars of SG&A to increase, because as you know, about 50% of our total expense pie is related to stores and a large piece of that is variable.

So that's why we're going to expect nominal dollars to increase if we meet our goals.

That said, it's important to emphasize that we are expecting our base businesses to leverage total expenses as a rate of sales, but again, especially in the first half, we're going to get some offset in pressure from those initiatives that we're investing in.

So dollars will rise.

With regard to marketing, I'll turn it over to Glenn.

On the marketing front, I think I mentioned in my opening comments -- that's one of the key areas we're going to focus on, not only the financial component, making sure we make good, targeted investments and get a return.

But I think that we're spending a lot of time on Old Navy, what's the evolution of the SuperModelquin campaign which has been a great creative platform for us.

You're seeing a little bit of that on the airways right now, but I know that there's a lot of good ideas, stay aggressive at Old Navy, continue to drive its value message using Modelquin as a voice, and I think you're going to see that evolve.

I feel good about it.

At Gap, I think we're going to build on the 1969 campaign that we had in August of last year.

You saw some movement of that in -- Baby Gap campaign is out now, followed by the denim-on-denim campaign which starts this weekend and build into a Kids 1969 campaign.

Big foundational push on the marketing rooted in denim, but there's other marketing components that you'll be seeing complementing the denim marketing.

Banana Republic, I think their marketing's actually improved quite a bit in the last number of months.

We have new leadership in marketing.

I think it's appropriate.

I think when I go to the stores the fully integrated campaign through the magazines, billboards, social media, into the store, I actually think Banana's marketing is really resonating.

I think it's been part of the reason you've seen an improving performance in their business the last couple months.

We're still committed to managing our brands, to getting the message out right.

But we know we have to stay current, we have to stay relevant.

And I think the marketing teams -- from what they're showing me right now, they're showing me a nice path over the next 12 months.

Great.

Thanks and good luck.

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

Good evening and congratulations on a great year.

Glenn, I wondered if you could spend a few minutes and talk about the Gap brand.

It's been a point of controversy on the stock, that business has not evolved or improved at the rate that perhaps we thought it might.

And if you could touch a little bit on how you see the product assortments evolving through the year, what steps you're taking there to drive market share gains, and to be innovative and to be a leader in the business.

Some of the criteria you placed on all the brands, perhaps you could talk about those touchpoints for the Gap brand.

And also, if we should look forward to TV advertising for this brand in the spring season -- maybe if you could talk a little bit about the spring season marketing program and the fall?

Thanks so much.

You're welcome.

I think you said a keyword there is the Gap business has not been improving at a rate that I think people in the analyst and maybe shareholder community some had expected.

To get grounded, it has improved.

I think it was fairly noticeable improvement in December, positive comp, fairly noticeable improvement in January, positive comp.

So Old Navy started out their journey back in March of 2009 with some positive comps.

Actually did not gain market share in June and July, but we said with Old Navy it might be a little choppy because it had been a number of years since it returned to a positive comp environment.

We had to make the adjustments internally and it had to continue to press forward.

I think we mentioned about the last conference call that the Gap journey might be -- this is not technical language -- might be a little lumpy, which means that it's going to go through its own version.

But I think with the marketing that we put forward in December and continuing focus in January and we'll see what February brings, we'll be giving those sales out next week, that I think it's starting to at least improve its position and give us a foundation from which we can springboard from.

So I think that, look, it's going to be maybe a bit of a longer journey as I explained earlier with Gap, but I am encouraged with what we saw in December and January.

There are no plans for television advertising this spring, and that's not because we didn't feel there was a worthwhile investment in December.

Spring television is not normally the kind that we invest in the past anyways.

But there is a marketing investment being made I was saying earlier to Michelle's question.

I think we came out with a denim message in January, which was Patch and Repair.

We came out with a Baby denim launch, 1969, in February.

Right now, we've got probably the biggest of our campaigns so far, which is the denim-on-denim campaign, which actually officially starts in our stores today.

So there's a continuation, Janet, of that really rhythm, a cadence and a drumbeat of making sure the denim message stays front and center.

And that's where the product innovation, that's the pressure on Marka and Patrick and the team to make sure there's news in our most important category.

I'm actually thinking that there is other marketing, which I can't give out today, that's going to come and complement.

Because we don't want to end up one dimensional business and only relying on denim and the marketing associated with it.

I think it's critical to get the Gap back to the trend and the trajectory it needs to go on.

You'll be seeing more about how we're going to treat marketing, the voice we're going to use, probably in the next few months, which will complement this ongoing rhythm we're going to have on denim.

So you feel pretty good that Gap's making progress, maybe not at the pace that we all had expected, but from the inside of the Company -- from what you look at, you feel like the brand is evolving and improving?

Look, I do think there are some evolving and improving components of the Gap brand.

Where you and I -- where we come apart a little bit is just the pace that maybe you're expecting versus me.

Where we're both aligned I would say to me it's still not as much as I hoped it was going to be.

Again, I think that there's signs, which is good.

But to be completely honest and transparent, no, I expected more and I do expect more, and Marka and the team know that and we made some slight structural changes recently to, again, align ourselves.

Because I think that we'll take the performance the last few months, but we're not in this game for two or three months of performance.

We're in this for the long-term, and there's higher expectations from them going forward.

So I think on that front, I agree with the statement, but I think your expectations might have been slightly higher than what I put forward to them.

Thanks for being so candid and lots of luck.

Thank you.

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

Thanks, guys.

Just wondering what level of share repo does your 2010 EPS guidance assume?

And also wondering how many of the 110 stores closing are actually losing money and are those closings coming at the end of leases?

Are you paying anything to get out of them?

Thanks.

Sure, I'll start with the share repurchase.

So we don't actually guide to an amount because we've always approached our share repurchases opportunistically, Paul.

But in that guidance range of $1.70 to $1.75, there's certainly lots of scenarios there.

Historically, most recently in our history, we have tended to load our share repurchases in the back half, because that's kind of the seasonality of our cash flow.

So we're entering with a healthy level of cash.

So we'll see how it goes and we'll report out every quarter on how much share repurchase we've achieved.

With regard to the stores, there's very, very few stores that are closing that are actually four wall cash negative, because there's very few stores in our entire fleet that are four wall cash negative.

So it's going to be less than a handful of those closures, but they are bottom performers.

So we always do want to crop them out and look to reposition to improve overall the overall returns on our fleet.

But very few cash flow negative stores.

Any buying out of leases there?

We don't do that.

Because they're not cash flow negative.

It really doesn't make sense to pay money to get out of our leases.

So we generally will do them on a natural option or an expiration.

Great.

Thanks and good luck.

Your next question comes from the line of John Morris with Bank of Montreal.

Thanks.

Good afternoon.

Congratulations as well on the quarter and the year.

My question I think would be really for Sabrina.

Great -- you guys -- and Glenn, because I know Glenn you've talked to this initiative as well.

You've done a great job managing product costs down and the initiatives that you highlighted for us through the course of the year.

As you look, you commented a little bit about that in your prepared remarks.

I'm specifically thinking now looking at the back half.

Do you still see some benefit on out into Q3 and especially Q4 as you're putting your buys in place now?

We're hearing that there is a little bit of pressure potentially.

And specifically if you could talk about the areas of labor, fabric, particularly as it relates to cotton, so your thoughts there?

Thanks.

Yes, sure, of course.

I mean, I think this is the strength, one of the strengths of our Company being larger.

We've been positioning our average unit cost for the full year for some time, and I've talked about I think with you all that for the first half we're highly confident, because most of that is bought that we achieved some nice savings.

We talked about earlier that the whole 2010, the savings would moderate.

We are on our third year of average unit cost savings, and now that there is more demand coming into the system and as you note, John, there's a little bit more pressure on commodities -- so you have seen versus prior years fuel move up a little bit, but it's volatile.

Cotton moved up a little bit.

Wool moved up some.

So there is more pressure and that's the very reason it's moderating.

However, with the size of our Company and with our negotiation tools that we talked about over time, we still feel confident that we are going to achieve average unit cost savings for the full year, albeit at a more modest rate.

And there is probably three other -- every year we have a plan and a strategy when it comes to our global production people about not only delivering on time, giving us flexibility with vendors, making sure they hit the quality standards we expect, but also how do we make sure we get the cost of goods that is appropriate given the size of the business?

Three things that for 2010 we're going to spend a little more time on.

One is the number of fabrics we use in the business.

To say the least, we have multiple fabric choices the Company uses.

And I think through narrowing that while maintaining our quality standards across all of our brands, that's going to give us some additional leverage.

That's a positive.

I think we're much more willing these days to make longer term commitments.

I think in the past, while we narrowed our base and I think we were better partners with our vendor partners, there is some work going on now where you see us going out a little longer in terms of commitments with vendors and giving them understanding of the kind of volume they could get from us, beyond a six to 12 month understanding we have today.

That I think is going to bring us some benefit.

And thirdly, this will be the first year since I've been here we're actually going to be operating an environment where we're buying more units than the year before.

As Sabrina said, the last three years we've done I'd say a pretty admirable job from the global production team in terms of getting us the cost of goods that we've enjoyed, but in a declining unit environment.

With improving units in 2010, I think that gives that team a little more leverage to try to make sure they protect the cost base of the organization.

Very helpful.

Good luck for spring.

Thank you.

Thank you.

Your next question comes from the line of Christine Chen with Needham & Company.

Thank you.

I was wondering, with respect to Banana Republic and the new prototypes, I know it's still early, but have you seen increased productivity in those locations?

I was just there.

I was there at store number two -- store number one was in Las Vegas.

I was just in Scottsdale with Jack and his team for our third trip to make sure we actually agree on the prototype going forward and get to the right cost, get to the right layout, and our third store was in Soho.

What I can tell you is the response from consumers has been very strong.

Noticeable traffic changes inside the business, and other metrics I would say are positive.

Soho was -- is a tougher read because we decided to open it before the holiday even though the construction was not 100% completed.

We had issues with the city in terms of getting some walls down and other factors, which now have been rectified.

But all three, from how we judge them, what our expectations were, what's the return going to be, how are customers going to respond -- because it is quite a bit of a different model, it stands out to me when I walk the malls -- I'd say has been quite positive.

There will be more in 2010.

But as you know, of all our stores and all our brands, Banana Republic is the one that actually has the freshest fleet.

And we measure that on a number of different fronts, but it is the one that's in least need of capital investment to keep it up to our standards.

With that said, I think Jack and the team have developed a very unique Banana Republic appropriate store design.

So we look forward to putting more into North America in the next 12 months.

And how -- did you say how many are going to be remodeled in 2010?

If you did, I apologize.

I missed it.

We're still working on the exact number.

It will be a handful for sure.

It will be more than the three that we tested in 2009.

But because the fleet is in decent shape, it won't be 15 or 20.

Okay.

Got it.

Well, I thought the Vegas store looked great.

Good luck for the rest of the year.

And your next question comes from the line of Michelle Clark with Morgan Stanley.

Yes, thank you and good afternoon.

Glenn, we've heard a lot of retailers over the past week or so talk about looking to gain market share in 2010.

So two questions for you on the core Gap brand.

One, where do you expect to take the market share from?

And then secondly, how much merchandise margin are you willing to give up in order to go after that share?

Well, I wouldn't have much respect for any retailer who is not talking about gaining market share.

I can't believe anybody gets into this to lose it.

As you know, we have been appointed in the last number of years as the business, at different times by different brands, have been willing to give up market share and have not defended our position.

With that said, all of us come into a fresh year trying to get market share, particularly in an environment where growth in the United States for sure will be limited.

So the Gap brand, because you asked specifically about them -- before I get to the Gap brand, just mention we've had success doing this at Old Navy.

We've had success doing this in our online business.

We've had success in these last 12 months with own international business.

We're had success gaining market share in our outlet business.

And now in The Gap, when you look at it, we don't target the total business in its entirety against another competitor.

As we spend more time looking at our business category by category, what we've been doing is saying okay what categories do we believe we can differentiate ourselves on, have a reputation like denim, can go out and win and take market share?

And then I put this into two buckets.

There's the first bucket is from the -- once you identify the category, who do we admire.

Who do we follow?

Who is doing a really good job?

And that bucket is probably different than who do you actually want to take share from.

Because we may admire somebody and there are people out there obviously we admire in key categories.

But their share could be so small -- even if we were to cut their share in half it's going to mean nothing to us given our size.

So we spend a lot of time the last six or nine months taking more of a strategic approach to our business, looking at the categories we want to win on, so let's say that was five key categories at Gap.

Who do we want to make sure we learn from?

And then as we get into the year, and you'll see some of that happen in Q1, but I think we get a little more aggressive in Q2.

Who are we actually going to target and how we're going to go after their share.

So that's proprietary competitive information.

I'm not going to give it out on the phone.

Just to let you know, we've been working on this for a number of months.

We have the process.

It's done by brand.

So Gap, no different than BR, Old Navy, outlet, or international business.

They all have these plans that are written, and they have milestones, and we expect Marka and her team to go out and execute on them.

Just a word on margins.

We feel confident that there's an opportunity to maintain and even expand our margins as we do this, and I'll tell you the reasons why.

A, we are lapping a lot of promos we did last year, and we actually learned a lot and we know now which promos are more effective.

We plan for those.

We bought into them.

And as I just mentioned, we do have average unit cost savings, so that gives us flexibility to really still pursue market share gains and scream value to our customers while still delivering very healthy merchandise margins.

And second, I think it's important to point out that our merchandise margins over the last two years have been working really hard.

They've actually expanded 600 basis points since 2007.

And at the same time, because our sales have come down, our rent and occupancy has deleveraged about 200 basis points.

So again, when we're successful bringing in unit sales and increasing our top line, we have a nice opportunity to leverage rent and occupancy.

So between the merchandise margin not being out of gas yet and then the rent and occupancy opportunity to leverage, that's where we see the real opportunity on our gross margins as we gain market share.

Great.

And then one last question.

Any commentary on February sales?

No, we'll get there in a couple weeks and report out.

Great.

Thanks and best of luck.

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

Thanks, good evening.

Glenn, you talked about a number of strategic long-term growth investments that you're going to start making this year.

You're expecting them to generate growth it sounds like in sales sooner at maybe dilutive near term to EPS.

I'm wondering if you can just go through your various initiatives and talk to us in general terms about when you would expect those initiatives to start contributing profit growth for you guys -- maybe outlets are sooner?

And then maybe from the earliest contributions to a more longer term contribution, just so we can think about that as we're looking at our models?

Thanks.

Thank you.

That's a good question that likely should have a very long answer.

But why don't I say this?

We've been very thoughtful I believe about what are the right investments we need to make outside of our gaining of market share in North American business in order to position the Company for the future.

Where do we feel that we could be successful?

What kind of channel, or what kind of brand, in what country do we think we can go into?

We've been spending a lot of time analyzing it to get to a point where we could make some announcement about it today.

Economically to the dilution question, I think we struck a very good balance.

The decisions from my perspective were made on what's strategically right, but then working with Sabrina as my partner, she's been able to say how do we balance it to make sure that we can manage the dilution that comes with it?

So you're absolutely correct.

On the one side of the dilution scale, you have Old Navy, the 200 stores we're doing, and a global -- a push on global outlet.

Those will be pretty quick in order for us to be able to manage the near term investment, get a return on them, get them on the path to profitability.

On the other side of the scale, you have China, which is a big country.

Again, we've done our homework.

We want to go in there and compete.

We don't want to skim in China.

We actually want to have a meaningful business over time.

And to do that in some of the markets, particularly a market like Hong Kong, it's going to take a while in order for you to put investment in place that actually will return -- not the ultimate return on capital, but again an immediate return on four wall contribution.

So I think we've lined them up, and we tried to do it again -- number one gate we cross was what's strategically right, how do we become successful, and how does it hit the long-term five year plan we have.

And number two is working with Sabrina to make sure there's a nice balance in investments, so when she looks at it, when something comes off from dilution, it contributes enough in its second year and in its third year to afford the decisions we're going to make in 2011, 2012, and 2013.

This is not a one year plan.

So we have other plans we'd like to put in place for growth.

She is the one that has to find that balance.

And from the work I've done with Sabrina, there's no question, I think we've struck a very nice balance in 2010.

That's helpful.

Thanks.

Good luck for spring.

Your next question comes from the line of Sam Panella with Raymond James.

Thank you and congratulations.

Can you talk about the opportunity to keep the momentum going at Old Navy as you start to face more difficult comparisons, same store sales leader this year?

Thank you.

Well, the encouraging component for Tom and his team, and I support them entirely is that Old Navy's been down in terms of its total sales for the better part of four years.

So while it had a nice return in 2009, and it was well executed -- I think from a store investment, the 60 stores we did, the new product that's been positioned, the categories they've been more aggressive on, I would say the move to an offensive minded approach that team that Tom and the team has taken versus being a defensive retailer we were in many years, between 2003 and 2007 -- I think that there's a lot of room still for them to at a minimum get back to where we were in terms of sales.

I can't give you a timeline on that.

But they are -- now you've got another 180 remodels coming plus 20 relocations and new stores -- that's 200 stores incrementally in 2010.

That's a significant amount of the fleet.

As I mentioned earlier, I believe the messaging and the marketing and the aggressiveness is going to be there, plus a little bit more in 2010 as we go after the competitors we've identified, to answer a question earlier from Janet, and what categories we're going to take share from and who are we going to target.

I think there's a lot of room on product in key categories.

We've been testing a lot of categories in the last six months.

In 10 stores here we've tested this category, another 10 stores we've tested other categories.

We learned some of those are going to roll out fleet-wide between now and the fall, which also will give us a lot of total top line opportunity, but also be good for customer management to be able to take that customer and fulfill her total needs as opposed to just the selected needs we fulfill today.

So there's a lot of opportunity at Old Navy still.

I think we feel good about it.

Time will tell.

You will judge us on a quarter by quarter basis.

Again, as I said earlier, we didn't get into this to have a one year turn of a brand as important as Old Navy.

There's multiple years of opportunity at Old Navy.

Great.

Thank you and good luck.

Thank you.

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

Hi.

Thanks.

I guess one for Glenn and one for Sabrina.

I guess Glenn, when you look at the improvement in traffic at the Gap division over the last three months, how much of that do you think came directly from the TV campaign?

And is there any reason to think that traffic shouldn't remain here at improved levels, around flattish?

And then maybe for Sabrina, can you give us a better sense by any way on either the basis points or maybe the earnings impact from these new investments in your full year guidance?

Brian, first on traffic at Gap, in no order of importance, but it would be inappropriate for me not to mention that part of it is we're lapping easier comparisons to last year.

So at some point, we do believe the traffic trajectory will turn.

I think that's one component.

The other one is we did ride some momentum coming off the launch of denim in -- 1969 Denim in August.

I think that the continuing willingness to commit to what we put in the store, the space we gave it, the marketing that went behind it, the buzz, the social media marketing that we did, I think that did contributed to more people coming in looking for that category.

Every retailer fights so hard to turn their business from wants to needs, and I think we were able in a small way to get people who needed denim to come into Gap.

So I think that was helpful.

The holiday TV, while it had a return, and it probably hit the lower end of my threshold, but it had a return, I'd say was responsible but not in any large part responsible.

Definitely the Kids and Baby component of that campaign was very successful.

I think that did bring in traffic.

That did bring in mothers and young women who were attracted to some of the marketing and messaging and the direct product messages that were in there, and there's a bunch of other components that could be contributing to traffic.

I think we were more offensive minded.

We protected our business where necessary.

We did the right thing in big, high holiday seasons.

I think those four in combination helped.

And look, we've got to maintain it.

We've made it clear in the conference call here, and just so we're clear, we're not going to measure success by every single month has to have a positive traffic comp.

We're saying we're going to gain market share over an extended period of time.

There's going to be months where it may not look at robust as the previous month, but when you average it all out, this brand and the other brand are going to have the traffic that is necessary to drive market share performance.

With regard to the growth initiatives, Brian, we made the choice to provide you guys guidance instead on the high level bottom line.

So again, in our guidance of $1.70 to $1.75, which is about an 8% to 11% growth rate on EPS for the year, we included that dilution.

So what we're focused on is despite the investments, we realize that it's our responsibility to still deliver healthy earnings growth to our shareholders and that's kind of the focus.

What I'll tell you, though, as Glenn mentioned, we're very careful to strike a healthy balance between driving short-term results and making these investments for our long-term future value.

And the investments are not insignificant, but they're not bet the farm either.

Okay.

Terrific.

Very helpful.

Thanks and good luck.

Operator, we have time for just one more question.

Your next question comes from the line of Adrienne Tennant with Friedman, Billings, Ramsey and Company.

Good afternoon.

Let me congratulate you also on a great fourth quarter and year.

My first question is really quick.

On the Old Navy remodels, what type of sales lift are you seeing on those?

And then Glenn, can you talk a little bit more about -- going back to the Gap product, Patrick's been there for I think we're going up on three years now.

What type of progress do you think the design team is making?

Is that up to your standards?

And the leadership changes, is there anything we should read into that in terms of how that design team plays into the Gap product?

Thank you.

I'll start with the Old Navy remodel.

The way we think about that is any capital investment we make in our fleet, anywhere, especially with these Old Navy remodels -- we want to get a return on.

So the return is going to come in the form of incremental sales and margin, when compared to a control group, and let's call that for simplicity the rest of the fleet.

So our internal hurdle rates are quite high.

They're much higher than our long-term weighted average cost of capital.

What we're confident about is based on the 55 to 60 store test that we had going with Old Navy in 2009, we have seen impressive returns based on the hurdle rates that we are looking for.

So we are seeing against the fleet the stores that have been remodeled have a very nice meaningful incremental lift on both sales and margin, and that's what makes us confident about the remaining 200.

Okay.

Great.

And on Gap with the design team, I've got full confidence in Patrick.

And he has done a remarkable job when he first came in under what I would say very difficult circumstances.

It took him the better part of a year just to put his team together, and he had to make some changes.

We were still evolving the brand and the positioning we wanted Gap brand to have in the marketplace.

So I think there was a lot of work in the first year which was cleanup, repositioning, getting ourselves clear on what we had to get done.

And from my perspective, even though -- even if I was disappointed in Patrick, which is not for me to have a conversation about this on a conference call because I have full respect for him and I believe he is going to get the job done, he is his harshest critic.

That's what I love about him.

I think he really knows the brand, knows it instinctively, spends time with the customers, spends time in our stores, and he personally wants to make sure the brand is successful.

He is self motivated.

I know he wants to see the brand have a better year in 2010.

He knows I feel the same and I believe he's been given the tools and the opportunity to get that done.

I think moving Pam Wallack from Kids and Baby over to Adult to work with Patrick and to partner with him, I think is nothing but a positive from his perspective, his design team's perspective, and Marka and I share that.

I think it's a positive move, and I'm confident that he, his leadership, and his design team will be able to get things done for us so we'll see the improvements we're all expecting in Gap in 2010.

What do you think his critique of 2009 product would have been?

Probably not fair for me to mention, but again what I like about him he shares one of the same attributes that I have is he's very self critical.

In that business, there's a lot of subjectivity.

I think he would like to have some redos as I would in some of the decisions I made in 2009.

At the end of the day, 1969 was a very big success.

I think he has a lot of ideas to build on 1969.

He has other complementary product categories he's been working on that I've seen, I've been privy to.

I'm in New York.

I quite often spend time with him.

At the end of the day the combination of Marka, Pam, Karyn Hillman, and Patrick's leadership, I'm confident that you'll see what we're all expecting to see at the Gap in 2010.

Denim has been a huge success, so congratulations on that.

Good luck.

Thank you.

Thank you, everybody, for joining us on the call today.

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

Thank you.

And this does conclude today's conference call.

You may now disconnect.