蓋璞 (GPS) 2011 Q1 法說會逐字稿

Good afternoon, ladies and gentlemen.

My name is Kristen, and I will be your conference operator today.

I would like to welcome everyone to the Gap Inc.

first-quarter 2011 conference call.

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

(Operator Instructions).

As a reminder, please limit your questions to one per participant.

(Operator Instructions).

I would now like to introduce your host, Mark Webb, Vice President of Investor Relations.

Please go ahead.

Good afternoon everyone.

Welcome to Gap Inc.'s first-quarter 2011 earnings conference call.

For those of you participating in the webcast, please turn to slides 2 and 3.

I would like to remind you that the information made available on this webcast and conference call contains forward-looking statements.

For information on factors that could cause our actual results to differ materially from the forward-looking statements, as well as reconciliations of measures we are required to reconcile to GAAP financial measures, please refer to today's press release, as well as our most recent annual report on Form 10-K, both of which are available on gapinc.com.

These forward-looking statements are based on information as of May 19, 2011.

And we assume no obligation to publicly update or revise our forward-looking statements.

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

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

Thank you, Mark.

Good afternoon everyone.

In the face of a challenging quarter, we continue to focus on levers that drive long-term value.

On the balance sheet and capital structure front we repurchased 25 million shares during the quarter, and we raised $1.65 billion of debt, providing us the flexibility to deliver additional cash to shareholders.

On the operating side we continue to drive forward on our long-term growth initiatives, while maintaining expense discipline and delivering operating expenses below the prior year.

Please turn to slide 4 for our earnings recap.

In the first quarter net income was $233 million, down 23%, and EPS was $0.40 per share versus $0.45 last year.

Turning to slide 5, first-quarter net sales were down 1% to $3.3 billion, and this includes the impact of the events in Japan.

Comparable store sales were down 3%.

Online sales grew 18% overall, and had a positive impact of 2 points on comp sales in the first quarter.

Total sales and comps by division are listed in today's press release.

Turning to slide 6 for margins.

First-quarter gross margin was down 250 basis points compared to last year's strong first-quarter.

Rent and occupancy deleveraged only slightly by 10 basis points.

Merchandise margins were down 240 basis points, driven by rising cotton prices, which in turn increased our average unit costs.

First-quarter gross profit of $1.3 billion was down $97 million to last year.

Turning to slide 7 for inventory.

At the end of the first quarter inventory per store was up 9.9%, with the increase in North America several points below that of Gap Inc.

This is a bit higher than our expectation we laid out in February, with the variance driven by the unit sales missed in Japan, which was worth about 1 point.

Please turn to slide 8 for operating expenses.

We continued our commitment to managing costs tightly in the first quarter, and delivered operating expenses down $9 million to last year, and about flat as a percent to sales.

Total operating expenses for the quarter were $918 million, and included $119 million of marketing, up $6 million to last year, driven by Athleta and China.

Please turn to slide 9 for capital expenditures and store count.

We ended the quarter with 3,245 stores, including franchise stores.

Net square footage for wholly-owned stores was 37.8 million, down 2% compared to Q1 2010.

First-quarter capital expenditures were $127 million.

Store count and square footage by division are listed in today's press release.

Regarding cash on slide 10, for the quarter free cash flow was an inflow of $104 million.

We repurchased 25 million shares in the first quarter for $548 million, and ended the quarter with $2.5 billion in cash.

Now I would like to discuss our outlook for the rest of the year.

Please turn to slide 11.

As we stated on our fourth-quarter earnings call, we continue to expect 2011 average unit cost increases to more than outweigh offsetting average unit retail increases, especially in our sizable value channel.

This is, in fact, how Q1 played out, driving our merchandise margins down 240 basis points.

At the time of our fourth-quarter call, we had only completed purchases for our spring and summer seasons.

Although we anticipated escalation of average unit costs for the back half, our costs are now actualizing well above our initial expectations at about up 20% versus last year.

Due to the sharp escalation of second-half costing, we are ever more focused on increasing our average unit retail.

In addition, you can count on us to remain disciplined in managing our operating expenses tightly.

Also come as a reminder, we will incur about $70 million in interest expense as a result of our recent debt issuance.

Driven primarily by the higher back-half average unit costing, we are revising our full-year 2011 EPS guidance, which we now expect to be $1.40 to $1.50.

It is important to note that we see the significant costing pressure as temporary.

Therefore, we remain steadfast in supporting our long-term brand health through marketing (technical difficulty) and investing in initiatives that will enable future growth.

Regarding inventory, we plan to buy units down to last year for the remainder of the year.

However, given the sharp increases in average unit costs I have already discussed, coupled with international store openings, we expect Q2 ending inventory per store to be up in the teens.

We anticipate the increase in North America to be several points below that of Gap Inc.

Regarding stores and net square footage, for the full year we now expect net store openings, including franchise, of about 75, up from our previous guidance of about 65, driven primarily by more outlet stores in North America.

As a result, we now expect full-year net square footage for wholly-owned stores to decrease by about 2%.

The following full-year guidance metrics remain unchanged -- depreciation and amortization, about $550 million; effective tax rate about 39%; capital expenditures about $575 million.

In closing, in the face of a very difficult costing environment, we will stay focused on managing average unit retail and maintaining expense discipline.

Of course, we have remained committed to our financial framework, including distributing cash to shareholders.

Thank you, and now I will turn it over to Glenn.

Thank you, Sabrina, and good afternoon everybody.

There are a few things I want to talk about today before we hand it over for questions.

First and foremost, I want to talk about Q1.

A lot of events happened inside our business in the first quarter, and I think it is important for me to put some color around that.

And then we will reference the guidance that you heard Sabrina gave for the full year.

And then I want to come back to our strategy and reinforce how strongly we still feel about Gap Inc.'s mid- and long-term strategic plan.

So in Q1, as everybody knows, we dealt with the absolute tragedy in Japan.

I was in Japan, met with our team in April, spent time with them.

You know, the Japanese business is -- from a consumer perspective, it is going to go through a slowdown well beyond May, June and July.

As a matter of fact, the consumer confidence numbers came out in Japan at the lowest numbers in seven years, which you would expect.

So this is not going to change anytime soon.

We are planning our business accordingly, knowing that the consumer is not going to show up, traffic is going to be down.

To that point there is five stores we planned on opening in Japan in 2011.

They were value stores, that we will not be opening now in 2011.

They're just not to be ready.

But I do want to reinforce that our old Navy strategy to open stores in the fall of 2012 is still absolutely our intention to do that.

The second thing I want to talk about is sales.

We were minus 3% comp in the first quarter, which is not good performance.

For the last six quarters we have been either flat to positive 4% comp up until this latest quarter.

As I sit back and take a look at it, we were just more dormant than we should have been in March as a business.

We made some adjustments in April.

You saw that with a plus 14% comp at Old Navy, plus 11% comp at Banana Republic.

We have clearly met with the teams and told them that when we get these calendar shifts, which are rare, to make sure that you make the right decisions through the whole quarter and not rely too much on, in this case, April which benefited from the shift.

We made a change to our Old Navy marketing platform in February and March.

I feel really good about the change.

And really the strategic thinking behind it was that the Modelquin campaign we had was really rooted in fun and value.

But as we have been changing our assortment, we had to make a slight shift to fashion and value, never, ever giving up on the value piece.

And whatever you make these changes to a platform it is always likely that you're going to lose a little momentum.

You have to make some tweaks.

Make sure that it is resonating with customers, that they actually start seeing the new platform in as positive light as the one that you have left.

I now see that those have been made, as it mentioned earlier, evidenced by the performance of in I believe the team continues to make those adjustments going forward into Q2.

In the first quarter, as everybody knows, we made some changes to our organizational structure.

Now the first decision we made was to consolidate all of our creative activity and decision-making in New York for Gap brand in our new Gap Global Creative Center.

Secondly, strategically, we brought together our specialty channel and our value channel, and making sure that comes together under two leaders.

Jack Calhoun and Art Peck now control all those stores, have to make the right decisions for customers, the right decisions for the brand, and the right decisions for return on invested capital.

We then turned around last month made some changes to our international team, consolidating two divisions down to one.

All decision now for international business being made by Stephen Sunnucks out of London.

Simpler, cleaner decision-making for the overall business.

Two weeks ago we made some changes to our design team at Gap Global.

Those were changes that I support.

They needed to be made.

What I am really asking the team to do is consider what is the right structure going forward.

Now that we know exactly the global potential of Gap brand, what kind of structure do we need in our design team?

What is the design operating model for the business going forward?

And they're giving that a lot of thought.

And, lastly, as you have heard from Sabrina, in the first quarter we did get lift and improved performance on our AURs.

But the input cost, or AUC, made it difficult for us to hold onto our margin rate in the first quarter.

We have been trying things in different markets, whether it is opening price points.

We have been looking at promotional levels, marketing ideas to drive traffic that do not involve discounting.

What I can tell you, and I may come back to this at the end, I will not allow anybody in the business to compromise the long value proposition of each one of our brands for what turns out to be a near-term shift in our economic model.

Let me talk about our full-year guidance.

I will be quite honest with you, i don't feel good about having to come here today and reguide.

For 14 quarters in a row this management team that is in place have either delivered or exceeded what we said we were going to do.

We have taken a business from a 7.7% operating margin to 13.4% last year.

So we don't feel good about that, but the 20% increase in our average unit costs in the back-half is real.

And as you heard Sabrina said, it is being driven by our two value businesses, Old Navy and our outlet channel.

As further evidence of that, Banana Republic's increase in their cost of goods as we are forecasting it right now, is going to be mid-single digit.

So if that kind of performance applied to our total business, which is not realistic given how invested we are in the value segment, obviously, we would have a different discussion today when it comes to guidance.

Also, I think you need to know that we are making changes to our assortment in every one of our brands and divisions.

What is the right assortment as we stretch the assortment of our business towards more better and best price points?

That alone is causing some pressure on the increase in our average unit cost.

It is not the driver, it is just another reason why you are seeing these 20% increases for Gap Inc.

in the back-half.

What I can say in closing is that the recent 35% decline in the commodity pricing of cotton tells me this is not a structural issue.

We said that to analysts six months ago.

We reiterated it three months ago, and now we have the evidence.

But it is not a structural issue, so we have to make sure we are clearly concentrating and never getting off our long-term value proposition for what is going to turn out to be a near-term, significant increase in our input costs, but it is near-term.

Lastly, let me talk about our strategy.

In China we opened our fifth store this quarter in Beijing.

The four stores prior to that are still performing very, very well, and we are committed to doing 10 stores in 2011.

Italy continues to do exceptionally well in Milan.

Both the Gap store and Banana Republic store and the top stores we have around the world.

We should do 8 to 10 new stores in Italy.

Our franchise business, we had committed to 75 stores in our guidance.

Our Athleta business, we should do between 8 and 10 stores in 2011.

Fillmore stored, our flagship we opened in San Francisco, is performing ahead of our expectations.

And, lastly, our online business has been very strong.

I think that is partially driven by the introduction of free shipping last fall.

It has a lot to do about the work that team is doing on mobile and other means to get our brand messaging up in the different mediums that they are using.

I'm very, very pleased what I am seeing, not only here domestically on our online business, but globally around the world.

So in closing, I was talking to some people this weekend in the business.

I was telling them, as we were going through the strategy and the direction and the work the Company is doing, that without doubt you can't ignore what is in front of us on this near-term, significant shift in our input costs in the business.

But it is near-term, which means we have to do everything we can in terms of managing costs, execution, product, marketing -- everything this business does has to be at a very high level this year to try to offset those costs as much as we can and still deliver a respectable performance in 2011.

But that doesn't change our strategy.

The strategic framework that we have laid out for people on the phone, for our investors, for the Board of Directors and for our employees is still in place.

We believe in it.

This is just a moment in time that we're going to have to deal with to the best of our abilities and then continue to move forward.

So with that said, I am happy to take any questions from the analysts.

Okay, operator, that concludes our prepared remarks.

We will now open the call up to questions, and would like to get to as many questions as we can, so we would appreciate it if everyone could limit their questions to one each.

(Operator Instructions).

Jeff Black, Citigroup.

I guess, Glenn, costs moved from 10% to 20% in pretty lightning speed here.

And what was the disconnect?

What did you not anticipate?

Why is this happening, and when do we see any cost moderating?

It just seems to me it has been there in front of us.

Either you guys weren't prepared for it or you weren't talking about it, which one was it, I guess?

Thanks.

I will start on that.

At the time of our Q4 call we had only bought spring and summer, and we just started buying fall.

We made the assumption at that time that holiday pricing would ease, because we were buying fall into what we believed at the time was the peak of cotton.

We do most of our holiday buying -- and as you guys know, our holiday buys are our biggest buys of the year.

We do most of our holiday buying through the months of March, April, May.

We are actually not all the way done, and we still have our trends and spring assortments that come into Q4 still to go.

But we had made the assumption at the time that our fall buys would be the most expensive, and that we would get some easing in our holiday buys.

And it turns out we were just absolutely wrong on that assumption.

Holiday got worse, and that costing came in much higher than we expected, and higher than fall.

As we said on in the opening comments, the real focus here is Old Navy and our outlet business.

As you look at it in hindsight, for the last three years we have done a lot of work, whether it is on fabric, on trim, on choices for that business.

We've got -- we've gotten some of our benefit on the operating margin of the business to 2010 by some of the work that all our teams did.

Maybe we were a little ahead of the curve, because when new management came in in 2007, and then the recession started to show its -- show up at our door, we started to move on a number of different fronts.

One was SG&A and one was AUC, which we talked about on all these calls.

And we did some good work.

Do I still think back then we had the lowest costs?

No.

Do I still think today there are always opportunities for the business in terms of two ways of coming to market through negotiations for us to get better costing.

I mean, that is what we always have to believe when you're dealing as a retailer to a vendor.

But at the end of the day when cotton went above $2 around that February mark and sustained itself for almost 12 full weeks, which was around the time, as Sabrina said, we were in the midst of negotiations for our holiday product, we didn't have any leverage.

And I am with her.

I really thought when we were looking at it -- I think we said this on a call in February, we know a lot more about cotton than we did a year ago.

We have been talking to everybody.

I was out for 12 days out in Asia, in our hubs, meeting with vendors one-on-one, trying to understand what options we had, what could we do, all the different tools available to us.

Even then, Jeff, in fairness -- that was two months ago, and even then meeting with vendors and talking very specifically about what was going to happen at holiday, even they didn't have the clarity that people like me would want, given the responsibility I have in the business.

Our team is still there today working very hard to try to still -- because holiday, as Sabrina said, is not complete -- but there is no way we were going to come on the call today and not let people know with all the information we have.

And it is in real time this information.

I mean, it is changing every single day.

So we are giving the best information we have today.

There is still a huge amount of pressure on our team.

And I'm obviously disappointed at the numbers we are giving today.

We've got a huge amount of pressure on our vendor community, because we are disappointed in the numbers they're quoting back to us, and how they are taking like-for-like product up that 20% level or greater in Old Navy and in our outlet business.

So, look, we haven't all of a sudden gone brain-dead when it comes to our ability to negotiate, the 50 countries we use, the hubs.

But we are very cotton invested as a business in those two brands, more than anybody else.

Definitely a much bigger part of anything in our portfolio.

And our teams are not giving up, but as we sit here today, this is the best information we have and the forecast we wanted to come forward with.

But it is continued -- tomorrow I will have new information.

It continues to move.

We continue to fight the good fight.

But cotton at almost a 300% increase versus LY -- I may be off a little bit on that, but directionally correct.

And given the amount of cotton [means] to our product, we took a holiday hit much bigger than we thought three months ago.

But it is based on the information we have today.

All right, thanks.

Good luck.

Paul Lejuez, Nomura Securities.

Can you actually differentiate between the cost pressure that is coming from cotton versus wage pressure that might be a little bit more structural?

Are you seeing that from your vendors when you get pricing?

And, second, I am just wondering what you can tell us about China.

What are they buying in those stores?

Do they like the local product?

Thanks.

Look, it is not easy.

We may have said in some past calls is that what I like about our model is -- our buying model, that is -- is that we can move from country to country.

And we've been moving into other countries outside of China now for the better part of the last 18 to 24 months.

There is wage pressure, no question about it.

Our teams on the ground are keenly aware of that.

And we have moved to other markets.

Now we are well-invested in Vietnam and Cambodia, in other parts of India and Bangladesh and Sri Lanka.

So we are moving business around where appropriate.

So there is some wage pressure there, there is no question about it.

But at the same time we are assuming, but we don't know, when the year plays out there is also going to be some further, we suspect, demand destruction, which maybe will open up some capacity, which would then also have an impact on the wages and the labor line.

But I'm not here to predict that today.

That is just a theory that could happen with further demand destruction.

In our China stores, and I was there in March on the way back from the hub and the sourcing visit that I did, still to this day the percentage of purchases in the fashion part of our business, and as I was saying earlier, part of the assortment moves that we are making that is a driver of the 20% increases -- part of the assortment moves we are making is being driven by your international business.

So definitely in China, which is -- we were a little caught off guard.

We really thought that the balance of fashion to basics would be somewhat similar to our US business.

But the fashion business is very strong, which is reassuring for us.

We are going to, obviously, set a good price point when it comes to basics, make sure we have a good entry price points.

Compete against who we have identified as our competitors in China, but the fashion -- the American fashion product is differentiating us.

So what we are encouraged mostly about is when we get our fashion right.

As in women's today, our fashion in Gap, while though selling successfully in China, is not to our standard and expectation.

That really provides a nice opening for us from a marketing perspective and a differentiation.

We opened our fifth store two weeks ago, and the same sort of split of business between fashion and basics.

That is a very encouraging sign.

Do you have a lot of local product in the stores -- I haven't seen the stores -- and is that working?

Anything with a logo on it -- and, obviously, we customize that and localize it.

So I was there recently -- you know, Gap Shanghai, Gap Beijing, Gap China, New York of course, San Francisco, we probably do a double-digit percent of our business on logo in some of these markets initially -- our franchise markets, our China markets.

Because that really is what -- denim and logo bring people in.

And then you sell them the fashion, because that is what the brand is known for.

Even though our marketing was not emphasizing that.

But in our franchise business -- still our European business today, our Japanese business, and China is playing out the same way, logo and denim are very, very popular with consumers.

Great, thanks.

Good luck guys.

Edward Yruma, KeyBanc Capital Markets.

I know you made a number of very significant personal moves.

Glenn, at this point is your team stable?

And can you also give us some insight into what other types of personnel moves you have been making, maybe below that kind of very most senior level?

Thank you.

Mostly the focus, as I mentioned at the beginning in the commentary, was the integration and the merger of our specialty and our value business.

That was very important.

So that was a big move, because Art Peck took over Gap North America.

Then that was followed up by the international changes we made with trying to simplify our structure internationally.

And Stephen Sunnucks is taking over international in London.

So I would say from a stabilization perspective, those two senior leaders are in place.

We put out a fairly large announcement internally just about a month ago, which establishes all of our senior positions in international, in our Gap's Global Creative Center in New York, and the team here in North America.

So that has all been done.

So I am actually quite pleased with the moves we made.

I think people are hitting the pavement running, as they have to.

They're very focused on the Gap business, and inside of Gap business very focused as a top priority in product in women's.

So Mark Breitbard running merchandise.

And I feel great about [Kevin Commos] -- that is in North America -- Kevin Commos running the international team.

Seth Farbman joining us as our first ever Chief Marketing Officer for the global brand.

So there are a lot of strategic reasons we made the changes.

We were fortunate to being able to fill most of those internally.

A couple positions we went outside to get done.

So this was a nice shift to get the international team done.

The right call, long-term to merge our specialty and value business.

And there is always going to be some one onesies and twoies, but at the end of the day I think the team is very much intact and working well together.

Thank you.

Stacy Pak, Barclays Capital.

I guess I'm curious how much of the hit to 2011 is Japan?

That is sort of one thing.

Just on the AUC, what do you think accounts for the difference between Banana and Old Navy?

And I guess how much of the sudden 20% increase, which honestly is higher than I've heard anywhere, has to do with how much you guys cut on sourcing in the past and maybe pushed too far, and it is sort of payback time?

So, I will start with your first question on Japan.

So we called out, I think on March sales call in April that we thought it would be about $0.04 to the quarter.

It turned out around in that ballpark.

We did a little bit of cost cutting in Japan to offset the gross margin hit, but that is the right ballpark.

Embedded in new range is the fact that we don't think that Japan will perform to the level that we would have thought when we -- pre-earthquake and tsunami.

It is actually recovering nicely, so we are pleased to see that there is some recovery, but we do not believe that the year will perform to the level pre-earthquake tsunami.

And there is a little bit of a range in there.

But that is not a big driver to the revision in guidance.

The revision in guidance is driven by the AUC.

To give you some color on Old Navy versus BR, there is just some old-fashioned math in this.

Old Navy's beginning AUC, as you can imagine, is far lower than Banana Republic.

So I'm going to make up numbers right now hypothetical.

If you take $1 increase on a beginning average unit cost of $5 versus $1 increase on a beginning average unit cost of $12 to $15, your percentage is going to be much bigger at an Old Navy just because the base is so low.

That is some of what we are definitely experiencing as we have worked through the last three years bringing cost down, especially at Old Navy and outlet, to really low levels.

Glenn, did you want to comment?

The only thing I will add on Old Navy as well is that we have quality standards.

I think everybody's business does.

It is our view that, while there were still choices available to us that they have allowed us to mitigate against the 20% in the back-half, that would just be crossing the line.

Right now the quality standards, we have a lot of meetings with focus groups and other means to identify how our consumers view our quality upfront through either hand feel, through stretch and recovery, all the different parts that define your quality through fit.

As Tom Wyatt knows, who runs Old Navy, we are -- I would say an acceptable level today.

It is not as probably as strong as Tom Wyatt and Nancy Green would like it, but it is acceptable.

So there is no way that some of the choices that either vendors or our hub leaders in production presented to us that is -- I mean, I saw some of the choices we could've made for fall.

Again, holiday is still in motion, and so I am not close enough to see some of the choices, but I know that in a lot of the cases they just don't feel comfortable making those trade-offs.

So that is really how it played out from an Old Navy perspective.

On the payback commentary, all I can say about that is I don't believe it; I hope not.

We did some e-sourcing that a lot of other companies did in 2008 and 2009 to find out what the right price was.

When we made our statements publicly about our AUC cost opportunity, that was driven by our own personal internal how we structured ourselves, how we came to market.

The fact that we felt we were not getting recognized for the size of the business and getting the costs we should be getting.

But just one more time to re-emphasize, we have teams right now in the field meeting with vendors, because as Sabrina said, holiday is not completed yet.

But, obviously, with the decrease of cotton by about 35% that came down from that peak period that was around the end of April when it was well over $2, and it peaked and it started to come down fairly quickly for the last five or six weeks.

Our teams are certainly having conversations with vendors, because I am a little bit like you, Stacy, 20% is not a number that has been quoted publicly.

So we are looking, and internally we are talking to our teams.

I'm not necessarily happy right now with our production teams.

They're talking to their vendors to say -- in light of the fact that cotton has come down -- it is not down to anywhere near where I think it is going to get to eventually, but it has come down substantially -- what does that truly mean for the price that we are going to pay when those goods get delivered in October?

So we are working all angles on that front.

What we did was -- I don't think we had the lowest cost back in '08 or '09.

We were just taking a correction from a poor process, and not being as aggressive a negotiating team as we should have been back three years ago.

Okay, thank you, Glenn.

Lorraine Hutchinson, Bank of America Merrill Lynch.

I was a little surprised to see that you expect to end the second quarter with inventory up in the teens and even ex'ing out a couple of points for international.

I guess I was just hoping to get the rationale for buying inventory dollars up so high for the North American business.

I am glad you raised that, Lorraine.

I want to make it really clear that North America -- we keep saying North America units are definitely down further than international.

So we have been buying North America units down.

We are going to continue to buy them down.

And, of course, facing this AUC, they're coming down further in the back-half in North America.

The $1 per store that we give at the Inc.

level is being impacted, of course, by this very high AUC, but also by our international growth, which you might be surprised how much that impacts us.

We are opening, for example, about 20 new stores in the next three to five months internationally.

Some of those are important flagships, like Rome.

They require quite a bit of inventory buy.

So that is definitely impacting us is that international store growth.

In addition to that, with the weakening dollar, that inventory that we buy is getting translated at a higher US dollar cost.

So, again, I want to leave you with a message that North America comp store units we are definitely buying down.

We are trying to balance that, because we still have our full-year goal of trying to deliver as a total company revenue growth.

So we are doing the balancing act between not going so severely down so quickly that we have no ammunition to meet that goal, but they're definitely down tightly.

Thank you.

Evren Kopelman, Wells Fargo Securities.

A question on expenses.

First, on the SG&A expenses, they were down 1%.

Is that possible to see down SG&A for the rest of the year, given you have square footage growth internationally?

Along the same lines, depreciation was also down 12%.

If you can touch on what drove that kind of decline in the quarter.

And same question for the rest of the year.

I think based on your guidance you don't expect to see such a decline.

If you can touch on those that would be great.

Thank you.

We are not fighting specifically to SG&A, but we have demonstrated, I think, quarter-over-quarter, year-over-year a lot of discipline when it comes to expenses.

I think the important thing to point out, as Glenn said in his remarks, we are very committed to our long-term strategies and to supporting our brand health.

So what we're most proud of is in Q1 we delivered expenses flat as a percent to sales, and below last year, even as we invested meaningfully in our growth initiatives internationally and for global online, and also while we increased our marketing spend.

So that shows your determination and our discipline on expense.

I am not guiding that is going to be so every quarter.

There are different dynamics that happen quarter-over-quarter.

But I think you can absolutely count on us to continue with that kind of expense discipline.

With regard to the depreciation, that also can be bumpy quarter by quarter, so we are sticking with our full-year guidance.

But, certainly, we benefit from store closures.

We are lapping last year.

We had a lot of depreciation write-off because we were doing a lot of remodels for Old Navy in the first half.

We don't have that this year.

And we have some asset depletion.

But that is going to be a little bumpy, but we are going to hold to our full-year guidance on that.

Dana Telsey, Telsey Advisory Group.

As you think about the new cost structure for the business, how does it differ by brand?

And as price points get adjusted, how do you think about product category basic versus fashion for each brand and what you want the assortment to look like?

Thank you.

Well, look, our economic model is based on the culmination of all of these different parts in our business.

So our online business is obviously one we have always put out there as a very strong return on capital and return on sales.

The same with our value business or outlet business.

Even though we are going to go through this period of time, as we highlighted them, given the nature of their business -- and I have what I talked about earlier about Old Navy, the same thing applies at the outlet business -- there is only so many trade-offs they can make given all the ones we have made the last three years.

But that economic model is still very strong.

It is still something we believe in, not only here domestically, but globally.

The same with the Old Navy business.

What I do, and we have tried to do in the last couple of weeks as we got ourselves ready for this call and stuff started to become clearer to us in the last few weeks about early numbers coming through for holiday, and we started looking at it.

Sabrina and I have sat back off and looked at our business on a pro forma basis.

And do we still feel very confident -- and the answer is yes -- in our economic model, in the business, as we look at what is a normalized trend that is going to happen on AUC as we go forward and take out this moment in time.

So I think all of those components -- there is nothing going on right now in the business, what we are talking about today, that changes our view of the mix, and the businesses we have, the portfolio we have, the multiple brands and the multiple channels.

There is nothing on that side.

On pricing, that is a great question, because obviously that is one thing that people should be looking at when it comes to our guidance.

Some other people have been able, maybe different businesses than ours and different models, have come forward recently and said they are going to hold margin rate.

I guess the squeeze we're into right now is we do not want to take some of the choices that have been presented to us when it comes to product, because the quality piece of the outlet business in Old Navy is just too important to us, as I stated earlier.

At the same time, on the other side of that coin, we don't want to take bad decisions on pricing on key categories for us that we believe in.

They are volume drivers.

They define the business.

I was talking to Sabrina earlier -- just to lighten the mood, I was telling her that would be like us going out for Old Navy on something that they're known for, which is the $1 flip-flops and selling them at $1.50.

There are certain things that you believe in the business and you have to stick to those principles.

And we are looking, but we have been testing every opportunity we can on pricing.

We have been testing the depth of discount -- frequency and discount, longevity of our discount and promotional cadences, but we all come back to our pricing architecture.

At the end of the day the competition that we have identified, that we have to beat and that we have to make sure that our value proposition is equal to or better than theirs, if there is no wiggle room for us to make moves in key categories -- that applies to Banana Republic, Gap, Old Navy and our value channel and Athleta and Piperlime.

In all those brands there are certain things that are -- to different levels that we hold near and dear and are critical to the value proposition of that brand.

During this moment in time we believe that would be irresponsible for us to put that at risk, when we firmly believe, what will be proven out to a level over the next three to six months, but we would do believe that input costs are going to subside even further than they are today.

Given what we believe, that we are not going to take these chances on our value proposition.

Adjustments we are making on these tests we are doing, some are working out successfully.

We are able to actually learn from it and maintain our unit volume and get the incremental gross margin dollars in AUR.

And in some cases, particularly given in the US right now where we are looking at fuel and food pricing going up, in some cases and some brands the consumer is not at a place where that can happen.

Globally there's different stories.

We've got more leverage in our franchise business.

China has some opportunities for us.

Japan, of course, we wouldn't even think about changing our prices right now.

The UK, with their austerity programs, it is little tough right now when it comes to traffic and comes to consumer confidence in England.

So we wouldn't be making any irresponsible changes there too.

So it is a big board that we look at by brand, by geography, by category, versus the competition, and where we can make adjustments we are making them.

Thank you.

Jeff Klinefelter, Piper Jaffray.

Glenn, can you talk a little bit more about your -- maybe on a longer-term basis your international growth plans?

You are clearly accelerating those openings this year.

And it sounds like those stores in both Europe and Asia are trending very well in terms of productivity.

You have also talked in the past couple of years about reducing your footprint in the US, particularly for Old Navy, where there are less productive stores.

Maybe talk about that cycle.

And to the extent that you can accelerate that, the expansion of international, the reduction of the US, in order to drive the overall productivity higher.

And I bring it up because internationally that it seems that it is getting more and more competitive every quarter in terms of real estate.

So how are you positioned to take advantage of that?

I would say that we haven't made the decision to push any further on the speed and the pace in which we are going to expand internationally.

Now 2012 is a long way off, although plans are being put together.

In no order of importance, we are very excited about our franchise business.

We are up 43% in the first quarter in our franchise business.

As Mark touched on, I think, in his opening comments, we were thinking that we would do 75 stores.

It was a shot, now maybe 80 stores.

We are adding the right countries in place.

Franchisees, with the exception of maybe Greece, that are going through a real tough time right now -- we have not hit any wall that I can tell with any of our franchise markets that are in 23 countries today.

As we sit here today, we will add another 5 or 10 over the next year or so.

So that is a very strong business for us.

Online international, we're pushing, I would say pretty aggressively into it.

We are in Europe in 22 countries.

We are going to be looking at making that site into local languages, which I think is only going to help.

And we are getting a great read from our online site in Europe to indicate to us what would a next country after Italy we would consider going into.

That is a great way to get that read in our business.

But we are -- you know, Canada online is very strong, with more to come on there.

Feeling good about Europe, and then China.

It is -- basically our online site is our number one store.

So Sabrina and I have been talking about, let's set a target of what actually online should be in China.

So, yes, it is 10%, 11% here in North America.

We've got to set a bigger target.

We really believe in our online site and our online innovation that happens.

China, five stores.

One just got added this year.

10 -- we are having a good look at 2012 now.

Second-tier cities, which I hate to call some of those cities second-tier cities, but that seems to be common language, but China looking at other opportunities outside of Shanghai, Beijing and Hong Kong.

I have been to three markets outside of those three big cities.

We are definitely going to go in there in 2012.

How many stores is to be determined.

Definitely outlet will open in 2012.

There is a lot of good outlet centers today with more to come.

We are keeping Banana Republic probably a little bit on the back burner for now, but maybe in 2013 that could be an option.

Italy, 8 or 10 stores.

And I would, all in good sense -- I'm going to Italy for four days in June, a good sense of what 2012 can look like.

But Sabrina and I are always battling is every local team wants to step on the accelerator.

Because once you feel like you've got a tiger by the tail everybody wants to get more and more store openings and capital, and we've just got to find the right pace.

As we have said before, if you're doing well and you are meeting pro forma, you've got a good return on capital, you're running the business well, and the brand is actually resonating with consumers, we will give you the capital.

We've got to make those decisions.

The last thing I want to mention, two things in North America.

Athleta looks like a solid nine stores now, maybe 10, in 2011.

That is one that I would say Sabrina and I both agree with Toby Lenk and Scott Key who runs that business, that is one we are pushing on the accelerator.

That is -- although everybody has a perception they have a tiger by the tail, the one that we can clearly look at today is Athleta definitely has that.

The store opportunity is significant.

The consumers love it.

The sales per foot, we are getting the returns, are all very strong.

And we think we've got a lot of whitespace.

And anybody who is in our way competitively we think we have a better model.

So your point on Old Navy, I would say it is more of a Gap play.

In terms of store closures, consolidation of Kid's and Baby to Adult, that is really where the closures are coming.

Recently at a conference I said in 2013 I could see us getting to around 700 Gap stores through that consolidation play, and then beefing up our specialty stores to around 250.

So getting almost closer to a 3 to 1 ratio.

Which when I started here the ratio of specialty to value was 6 to 1.

So that is a strong signal from us to the market and to our customers, most importantly.

As Jack Calhoun and Art Peck run these businesses holistically -- as opposed to by channel, they are running them by brand -- they will make the right decisions for those brands about when to go value and when to go specialty.

Old Navy is a square footage play, but very few store closures.

Thank you.

Michelle Tan, Goldman Sachs.

I was wondering if you take away the product cost issue, can you give us a sense on what you guys are seeing with respect to markdowns and depth of promotions against last year, and how you think about that through the balance of the year?

I think as we have been saying on the monthly sales call every month, February and March in particular we weren't happy with the performance of Women at Gap and at Banana Republic.

We really need to make those Women assortments more appealing.

And so our performance in those departments, in those two brands, we have been disappointed.

We have had to go more at markdown than we wanted to.

Our markdown margins are impacted when the assortment and the styling doesn't resonate with the customer.

So we have our work cut out for us in those two brands.

At Old Navy we actually feel really good about the product assortments across the board, and in particular in Women.

So when we get her in the box we have seen throughout the quarter very nice conversion, very nice AUR.

What we thought happened at Old Navy was really more of a marketing, as Glenn talked about in his remarks.

In our evolution of that marketing campaign we lost some momentum on the traffic.

We got a lot of that back in April.

And we hope to keep that momentum, obviously, as we go forward.

We have some lessons learned in February and March.

But we really happy with that product assortment.

And, of course, team at Gap are hard at work with all the changes on the leadership side.

And then at Banana, that definitely is the focus of the team at Banana is to get that Women's product back on track.

On a promotional front, my view is we have every intention to be less promotional.

That is our goal.

We know what we did in 2008, 2009 was to compete.

And I would argue that maybe the second half of 2010 there was, through better innovation, better creativity, better focus on just the product and not the promotional idea that may have come forward, we probably should have started to move a little bit more in that direction in the latter half of 2010.

The teams are committed to that.

And as Sabrina said, what we would have done a year ago is, if we wanted to be promotional to drive traffic or to move through some inventory, we would have holistically had a 40% off total store.

Now I think we go right to where inventory could be -- 40% off Women's, excluding denim.

That would be an example of what is happening at Gap.

Now the goal is we have to -- there is no question -- we are -- we get the whole issue of what does our customer want, what kind of frequency?

Yes, she needs some incentive to get off the couch a little bit more than usual.

That hopefully will wane over time.

But how do we, through some very creative means -- and I think I am starting to see that at Old Navy in particular through some of the partnerships they are doing, which I think will really benefit us this summer and this fall by not actually just going to a traditional way of driving traffic and describing your value proposition, but getting much more creative.

Everybody on the phone has heard me say this before, and there were times where we have actually delivered on it.

There were times I have been disappointed that we go to the lowest common denominator at times.

But the business and all the leaders that I deal with are very committed.

We are going to see more of that in the back-half of the year, shifting the conversation to less about discount and more about product.

Great, thanks.

Then, Sabrina, just a quick one.

If you could quantify the impact of international on the inventory dollars, that would be really helpful.

We haven't quantified that.

I would tell you the foreign exchange piece by itself is 1 point.

And, again, I will just emphasize that the units in North America are very tight and definitely down -- down much more than international.

Great, thanks.

Good luck, guys.

Janet Kloppenburg, JJK Research.

I have heard a whole lot about cost today, but I haven't heard a lot about topline.

So I would love you to give us some idea about how you're feeling, the confidence you have in the brands, Glenn, domestically for the rest of the year.

And if some of this earnings revision has to do with a less optimistic outlook in terms of your topline performance.

And with respect to the cost coming down in the first-half of fiscal 2012, I am just wondering are we just supposed to adjust our models and get back all the margin that we are taking away, or perhaps you could help us rationally develope a model for next year.

Thanks so much.

It is probably a little premature, obviously, coming here today three months after we gave guidance to have to reguide, because I said earlier -- because holiday is just happening real-time, and still happening now.

The last thing that I want to do is try to be predictive on spring and summer right here -- right now.

As information becomes available, and as we get clarity, we will absolutely, the minute we have clarity and know exactly what spring is going to look like, and which would probably be at our next conference call.

We will be able to at least identify whether this 35% drop in cotton which, again, the futures are around $1.10 to $1.15 in December, if that trajectory was to continue, we would have a much better sense of what will that mean for our AUC.

Sitting here today, I just find it hard to believe that through the fiscal year 2012 -- and this is -- again, this is no evidence, but sitting here today with what I know, if it was to keep coming down at the rate that it is supposed to come down from people who are experts in these fields, how could our AUCs not be below through a whole -- through all of 2012 versus 2011, how could they not be lower?

But that is -- we are going to give information as we know and as we meet with our teams and as we negotiate.

You are absolutely right to bring up topline.

We knew today was going to be a lot about -- obviously, the news today was about the re-guidance and the reasons behind it.

From a topline perspective, I would look at it this way to say that Sabrina is right.

The Old Navy business, you put a new marketing platform in place, I mentioned earlier.

It didn't have the needed effect immediately.

We made those adjustments.

But we are actually feeling with the work Nancy Green and her team have done, under Tom's leadership, we are starting to see that [from] a conversion perspective and a UPT inside of our stores.

So I am feeling that Old Navy -- and they have got more innovative ideas coming.

They're massively embracing new category introductions.

The marketing team, even though they had to bridge from the old to the new platform, they have so many other ideas coming that I think that team in this environment, from a topline perspective -- because we need Old Navy to do what Old Navy has done.

I think it was either -- Mark will either correct me in a second.

I believe -- either flat performance to positive comp, 18 of the 24 months.

We need Old Navy to have that kind of performance in order for us to grow in 2012, which is our goal.

Our goal is to go grow topline sales in 2012.

Gap right now is obviously going through quite a bit of change.

Art Peck and Stephen Sunnucks in conjunction together from a global perspective are trying to use our Speed platform to help out a little bit in fall, but it will be a little bit.

They're mostly taking Women's non-denim for holiday and just tearing it apart, trying to do the right thing so we can get the best chance to have an assortment that we can feel good about for holiday.

I was telling Sabrina, this notion in our business that anytime you make a change you have to wait 12 months for something to happen, I just don't accept it.

And the team has been in New York.

I have been there a few days over the last few weeks.

But they have been there for the last three or four weeks under clear direction, under Stephen and Art's, working with Mark Breitbard and working with Simon -- sorry, Kevin Commos, making the changes to make sure that we fix the one area of business that we are very unhappy with today.

On the other side, Kid's and Baby is doing well.

Our Body business, typically Gap Body Fit is doing well.

Our denim business in Men's and a number of woven tops in Men's and knits are doing well.

Our denim in Women's coming out of our LA design office, led by Rosella Giuliani, is doing well.

But that size of the assortment, women's, non-denim, is a big pull for Gap, and it really defines your fashion message for the season.

And I am hoping the small adjustments in fall, but holiday they can show us what that brand needs.

So their goal, keep the strength we have right now and make those adjustments in product to get to a better sales performance.

And Banana Republic, as you know, for the last six to nine months our Women's business has not resonated.

Our Men's business is on fire.

I think Women's in general is in a bit of a malaise just market-wise.

But regardless of that, some people are gaining share and are growing Women's.

But in general, Women's from an MPD perspective looks a little down right now.

But our team, I think we will see -- a new flow just came in now.

I saw some real adjustments they made for July, which I felt actually good about, that Julie Rosen and Jack Calhoun have done.

So all of that -- that is a little trip around every single one of the brands to get to the point is that we are still committed, even in the face of these cost increases, still committed to getting total topline growth in the full fiscal year at Gap Inc.

That is a critical message for us.

And, for Sabrina, I was wondering if we should consider the inventory levels domestically -- which I know are down somewhat less than they are on a global basis -- but we should consider those in addition to AUC, at least for our gross margin estimates in the second and the third quarter, would that be appropriate?

Well, we haven't guided to inventory beyond end of Q2.

But with these AUC levels the way we have described them for the back half, you're definitely going to have inventory higher than cost.

Because we are also -- basically we said since actually the fourth quarter earning call pressure on merchandise margins, pressure on operating margins.

It is just that now with the AUCs coming through at much higher levels, that gap is even wider.

But I am speaking to the question of promotions to bring that inventory down.

I think that it is more than just AUC that is driving the inventory, isn't it?

Because you came into the year with more than you expected domestically and you needed to get -- you need to get them in line with sales.

We won't have them in line with comps, because our margins are not going to be flat or up to LY.

They are going to be down to LY.

So the inventories will remain above the comp.

Now we are taking units down for sure.

We keep reiterating that in North America, especially, our comp store units will be down.

But the cost is up such that -- and the ADR we won't expect to come up as much as would make that -- [up] that comp.

That you're going to have margin pressure on the merc margin, just like we did in Q1, and that is going to flow through the operating margin line.

Now we are bringing the units down.

We are trying to balance, again to your first question on topline.

We want to keep enough units in the system to give us an opportunity to meet our overall goal of driving topline.

But the units are down.

We are not bringing them down severely.

I mean, they're done a lot in North America, but we don't want to go so severe that we have no opportunity to drive topline overall.

That is the balance that we are trying to achieve.

Thank you very much and lots of luck.

Brian Tunick, JPMorgan.

Just a quick question, I guess.

It looks like the cash flow -- the free cash flow this year, I guess, on your new $1.40 to $1.50 would be under $800 million.

I was just wondering, Sabrina, given the bond offering and given your share repurchase program announcement does is at all change your appetite or pace of share repurchase program?

We are very committed -- as I said in my prepared remarks, we are very committed to our financial framework.

We are very disciplined about distributing cash to shareholders.

The debt issuance just gives us more flexibility with regard to how much we achieve.

But we have demonstrated over a decade that through many cycles of positive comp, negative comp, global recession, our cash flow is very strong.

So it is strong enough that we remain confident and comfortable that we can continue on our path of distributing cash to shareholders.

Operator, I think we have time for just one more question.

Kimberly Greenberger, Morgan Stanley and Company.

Just under the wire.

I wanted to ask, just philosophically about how -- what benchmarks do you use in order to guide your inventory by?

I'm just looking at the last four quarters, where we have had total sales growing faster than total -- I'm sorry, rather, total inventory growing faster than total sales.

So I understand that there can be a quarter where there is some timing differences or an international impact, or Japan, etc.

But to have a persistent growth in inventory above sales, it strikes me that there might be something different today about the way you are managing inventory.

And I'm just hoping you could step back from the noise of the quarter and help us understand how you're thinking about that going forward.

That is a great question.

So it has been our long-held philosophy that we want to try and keep inventory units in line with demand.

There is a lot of noise now with AUC, which I will get to.

But our underlying philosophy for many years has been to buy inventory units in-line with demand.

Last year the management team broadly speaking at Gap Inc.

held hands to make the decision to err on the side of the customer, and buy units to make sure we were in stock in our stores.

So last year we began to depart a little bit from buying the units in-line with our traffic.

We were not happy with the results.

And we talked about that, and we definitely also decided, given the results of that, that we would go back to our practice of bringing the units down.

Just at the time we brought the units back down, we are getting faced with this very high average unit cost.

So that is frustrating, because we are not reporting -- we are not reporting the dollars as far as the units are down, but the units, again, I will say are definitely down.

We are getting back to our principal of getting back down in-line with traffic for certain.

We realize that cost is up much.

We are in many cases bringing them down below traffic to account for the fact that average unit costs are up so much.

I feel like they are in reasonable shape in North America.

We have actually bought them quite conservatively, especially at our largest brand, Old Navy.

The other dynamic that is happening that is masking that discipline is this commitment to international growth, and the pressure that is putting on a per store basis as we try and open these stores internationally in our back-half, some of which are flagships and bringing inventory in.

So we will consider going forward whether we just get more transparent about telling you about our units in North America down, because it obviously is an important point to make.

And it might be helpful in future as we consider actually just being more clear about how far those units are down, because I think you guys would gain comfort from that.

Great.

Thanks, Sabrina.

Okay, we would like to thank everybody for joining us on the call today.

As a reminder, the earnings press release is available on gapinc.com.

And it contains a full recap of our Q1 results, as well as the forward-looking guidance included in Sabrina's remarks.

And, as always, the IR team will be around after the call to take questions.

Thanks.

Thank you.

This does conclude today's conference call.

You may now disconnect.