蓋璞 (GPS) 2011 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen. My name is Kristin and I'll be your conference operator today. At this time I would like to welcome everyone to the Gap Inc third-quarter 2011 conference call. At this time, all participants are in a listen-only mode. (Operator Instructions). I would now like to introduce your host, Katrina O'Connell, Vice President of Investor Relations.

Good afternoon, everyone. Welcome to Gap Inc's third-quarter 2011 earnings conference call. For those of you participating in the webcast, please turn to Slides 2 and 3. I'd 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, and our most recent quarterly report on Form 10-Q, all of which are available on GapInc.com.

These forward-looking statements are based on information as of November 17, 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'd like to turn the call over to Glenn.

Thank you, Katrina, and welcome, everybody. In a few minutes I'll hand the call over to Sabrina, who will take you through the key metrics in the third quarter. She will talk about the fact the business delivered $0.38 earnings per share, slightly above consensus.

She will certainly reference the fact the Company leveraged SG&A and did a good job on expenses. She will talk about the fact that our inventory is in decent shape coming into the Fourth Quarter. She will reference that we use $700 million in cash to buyback shares and to pay out a dividend. Those are a number of financial metrics that Sabrina will take you through.

To me there's only one metric that matters. The Company had a -5 comp in the third quarter and that is unacceptable. Now inside of that, our Women's business had a negative double digit comp in the third quarter, and that's where a lot of energy and time is being put in by our Brand Presidents, our Senior Merchants, and myself to reverse that trend which is the largest contributor to the minus comp that we experienced in our business in the third quarter.

If you look at our two biggest brands, talk about Gap brand, which is as we said on the last two calls, at our October meeting with analysts, is work in progress. I'd like to think that when people go to stores in December, they will start seeing the beginning of some changes to the business when it comes to its aesthetic, in terms of the quality of the product, in terms of the acceptance of color, you'll start to see the beginning of some changes in the month of December.

I'm feeling better about what I'm seeing coming in Spring, so between the product improving at Gap and a global marketing platform that I think we can stand behind, I'm feeling better about 2012 when it comes to Gap.

At Old Navy, we are still struggling with the affects of the marketing campaign that we launched back in February. We sunset that campaign, have a brand new campaign called Funnovations, Inc. that started this month. We had to get back to the core of what makes Old Navy great, so we made that change with our campaign. And one more thing about Old Navy. Just over a year ago, the team at Old Navy made the decision to broaden their assortment, which strategically, I believe is absolutely the right decision.

Our assortment and our price points at Old Navy have been consistently too narrow, but with the input costs faced by us and other people in the sector, and with a very tough economic environment for that consumer, that shift in our assortment has proven to be a bit of a challenge for our consumer.

Now, we really kept tight a lot of opening price points. That's critical. You're in the value business, even though the inflationary pressure from our input cost was very high in the third and fourth quarter, we're still selling lots of denim on a ticketed price of $29.94. We still believe in those price points.

The only way you could have an assortment that has more product in the best bucket, more product in the better bucket is for your good bucket, your opening price points to be strong. All that means for me is we got to make sure we're competitive in Holiday, make the right promotional decisions fourth quarter, They are going to have to make sure they are aggressive in their promotional offering when it comes to those products in the better and best bucket.

Now, as I look at the third quarter, there's a glass half full part to the quarter. Our e-commerce business was up 21% in the third quarter. We've made great investments and good decisions on mobile technology. We've made very good decisions when it comes to online media investments we're making in marketing. Those decisions have really helped propel a [plus 21] performance.

We opened up some great Athleta stores in the third quarter, and we feel very good about every location and market we've been into in Philadelphia, in Georgetown, in New York City, in LA, we're about to open up in Minneapolis. So, I think the Athleta store openings, and the potential for that brand, we continue to feel very strong about.

Our franchise business was up 47% in the third quarter. New countries, new stores, all contributing to that kind of performance. Our China store performance, from a sales perspective, has been very positive. We're very pleased what we're seeing in China. Sabrina will talk later on about China, the investments we have to make, brand awareness is really strong, the acceptance of the American style is very positive.

Obviously, as we said in October at the Analyst conference, we feel good enough we are going to open 30 new stores in 2012. But you have to invest in China. It's a busy market, and there's lots of brands coming in. You have got to put marketing money into that business in order to make sure that long term, you have a sustainable, healthy profitable brand.

Now let me close by talking about Banana Republic. Had a -1 comp in the quarter. Had a +1 comp in October. And even though I know Jack Calhoun and his team want to do better, and I think can and will do better, I was encouraged by the performance of Banana Republic in the third quarter.

Now, looking forward, we're in a brand new quarter. Everybody knows the importance of the month of November and December to retail in general. From a business perspective, we all believe it's going to be a very aggressive fourth quarter.

I think we can feel that right now, and we've already got a sense of what we're going to do on Black Friday, and from my perspective is, can you find the right balance between your store business and your online business? I think that's critical.

We've got to make sure that our marketing works harder, that our windows are great, that our store presentation is stronger than you've seen. I know that the state of readiness is very high. We have to make sure we're making very good decisions, and that our brands and their value propositions are strong in the fourth quarter.

With that said, we have two different streams of work going on in the business right now. You have a lot of the organization who are working on it right now. How do we make sure that everything we do today allows us to maximize the Company's performance in the next 12 weeks?

And you have another stream of work going on which is very important to me, which is, let's make sure all the lessons learned from 2011 get applied, as many of them as possible, to 2012. Momentum matters in business. We like the plans we've put in place for 2012.

The Company's not executed so far this year the way it should and the way I expect it. Everything that I talked about in Q3 that didn't go right is absolutely correctable, and it will be corrected. We're going to compete aggressively in the fourth quarter and we're going to build momentum in 2012. Those are my goals. Sabrina, over to you.

Thank you, Glenn. Good afternoon, everyone. Our third-quarter performance demonstrates a continued focus on investing in our future, returning excess cash to shareholders, and maintaining expense discipline. Specifically we continued on our path of executing against our strategic goals to support our long term growth while returning $700 million to shareholders with $645 million in share repurchases and $55 million in dividends, and we tightly managed our operating expenses, which leveraged 40 basis points.

Please turn to Slide 4 for our earnings recap. In the third quarter, net income was $193 million and earnings per share was $0.38, down 21%. Turning to Slide 5. Third-quarter net sales were down 2% to $3.6 billion. Comp store sales were down 5%, with a differential due primarily to non-comp stores, growth in our franchise business, and our Athleta and Piper Line businesses. Total sales in comps by division are listed in today's press release.

Turning to Slide 6 for margins. Third-quarter gross margin was down 450 basis points. Merchandise margins were down 400 basis points, and rent and occupancy deleveraged by 50 basis points. Third Quarter gross profit of $1.3 billion was down $191 million to last year. As we foreshadowed all year, though our average unit retails were up, the increase was not enough to offset even higher average unit costs.

Turning to Slide 7 for inventory. At the end of the third quarter, inventory units per store were down, and inventory per store in terms of dollars was up 6%. Please turn to Slide 8 for operating expenses. Total operating expenses for the quarter were $968 million and leveraged 40 basis points as a percent of sales. This includes $149 million of marketing, up slightly to last year.

Please turn to Slide 9 for Capital Expenditures and store count. Year-to-date, we spent $416 million on capital, focused on Old Navy downsizes, international stores, and global online expansion. As we discussed in detail at our investor meeting in October, in North America, our goal is to reduce our square footage overall, leading to strategic closures and consolidations at Gap Brand and downsizes at Old Navy.

Reducing our square footage should not only provide a better shopping environment for our customers, but should also support improved productivity per square foot. Year-to-date in North America, we've closed 20 stores on a net basis.

Outside North America, our goal is to grow through both Company-operated and franchised stores. In line with this strategy, year-to-date on a net basis, we added 17 international Company-operated stores and 33 franchise stores. We ended the quarter with 3,276 stores in total, including franchise. Total Gap Inc. net square footage was down 2% compared to Q3 2010.

Regarding cash, on Slide 10. We ended the quarter with $1.4 billion in cash and short-term investments. As continuing evidence of our commitment to return cash to shareholders, year-to-date we've repurchased 107 million shares for $2 billion. Our Q3 weighted average diluted shares were 505 million. Finally, we're pleased that our Board has authorized another $500 million share repurchase program.

And now, I'd like to discuss our outlook for the remainder of the year. Please turn to Slide 11. We are reaffirming our full-year earnings per share guidance of $1.40-$1.50. It's important to note that we continue to anticipate significant pressure on our margins. As we've said previously, our average unit costs escalate each quarter during 2011 and we may therefore face our greatest merchandise margin pressure in the fourth quarter.

Here is some additional information for the rest of the year. Regarding our store guidance, while we still expect store openings to be about 125, we now expect about 150 closures versus our previous guidance of about 125. This is due primarily to timing of Gap specialty store closures and consolidations.

As a reminder, our strategy results in a Gap North America fleet size of about 950 stores by year-end 2013, made up of about 700 Gap specialty stores and about 250 Gap Outlet stores. We continue to expect our full year net square footage decline to be about 2%.

Capital Expenditures are still expected to be about $575 million. Depreciation and amortization is now expected to be about $510 million with a decrease driven primarily by the Gap specialty store closures I just discussed, as well as a greater number of assets reaching the end of their useful lives. Our effective tax rate is now expected to be about 40%, up from our previous guidance of about 39%, driven primarily by greater than expected start up costs associated with our China business.

Finally with regards to inventory, our Q4 planned inventory unit buys are down. Similar to Q3, we expect our inventory dollars per store at the end of the fourth quarter to be up in the mid to high single digits. In closing, as we enter our most important selling season of the year, we remain committed to executing on our financial goals while continuing to make improvements and investments in our business. Thanks, and now I'll turn it over to Katrina.

That concludes our prepared remarks. We'll now open up the call to questions. We would appreciate limiting your questions to one per person.

(Operator Instructions). Your first question is from Marni Shapiro with The Retail Tracker.

Hi guys. Congratulations on some progress and looking forward to seeing what you have in store at Gap. Could you talk a little bit about your online business as you think about the holiday season? You've put a lot of levers in place, free shipping and different kinds of campaigns.

As you think about it holistically, will you separate out what you're doing at Piperlime, Athleta? Will you be more aggressive at Old Navy? Is it easy to do that when they're intertwined on the website? Just how you're approaching the whole business online.

It's actually, it's not only easy to do but it's what we're doing right now. First and foremost we approach the businesses as a holistic brand, Old Navy, Gap, Banana Republic are a brand, and we run three brands, that's why we moved our outlet business and their infrastructure into the specialty store business at the beginning of this year, to make those two which were previously distinct teams operate as one business, because the brand matters the most.

Under Toby's leadership, I think that first him and his team look at what's the right thing for the brand? How can we come across to customers as a business because we've learned over the last three years that our customers increasingly cross-shop between our online business, our specialty business, and our value expression of the brand. So, recognizing that, we've got to make sure we aren't disconnected.

Now, with that said, it's a unique channel. We have a separate team that runs it. While they buy the same product, they take different tacks, in terms of their marketing. So, we certainly have -- because -- let's start with the first two you asked for, Marni.

Athleta is completely disconnected from the other three brands. So, it runs its own business, it has its own P&L, and it takes different tactics than you'd see at our three more established businesses. That's critical for us, because I think you may have heard us mention this before, as we start mentioning stores of Athleta, we start putting in new ideas, new processes, a brand new operating model, because we believe some of the ideas and the lessons learned that Toby, and Scott Key, who runs our Athleta business, are going to get on a smaller fleet, could be applied into our three established brands over time.

Piperlime, also completely disconnected from the business. Obviously, not a vertical business, but a horizontal business. I think now that we added Men's Apparel, Exclusive Brands, Private Label, we're stepping up our marketing. That also is something we believe, as we look at the model that's been established by Asos in the UK, and they come into the US, Piper Line has certainly taking on a lot of that, those lessons, and applied it to their business. I actually feel good about the direction of the growth we're seeing there.

And when it comes to the holiday season, we know there's Merry Monday which happens before Cyber Monday, and Toby and our brands will be participating through that channel aggressively. They will be competing, and when you look at the third quarter you heard me say in the opening comments, I mean we had a 21% growth rate in the third quarter, and this is one of the quarters, I would actually say, they had a spectacular performance.

Because the delta between the negative comp and our specialty business and the growth in our e-commerce business is the widest I've seen in a while. So, as I was mentioning earlier, we're disappointed and it's unacceptable and the performance we're having in our traditional bricks and mortar business here domestically in North America, but I will take my hat off and applaud the work that our e-commerce team has done by generating a 21% comp in Q3.

Best of luck guys for the holiday. I think the websites look very good.

Your next question is from Brian Tunick with JPMorgan.

I guess Sabrina, any comments you could make regarding what you're seeing for AUC as we move into the Spring season, particularly at Old Navy, and then for Glenn, it sounds like you're contemplating an aggressive Q4. Does that mean your implied guidance for Q4 assumes you can comp, let's say, down mid single digits again like you did last quarter, and still hit your numbers?

So, Brian, I'll start with your first question about Spring. I think similar to what you've heard from a lot of people in our sector, Spring pricing is definitely better. The underlying cotton prices are definitely down from the holiday peak. They are, however, definitely still up versus Spring 2011 in Spring 2012.

But improving, and as we know we're glad to see that overall cotton is staying at a good position, so that foreshadows good things for us as we move forward in time. But Spring 2012 is definitely above Spring 2011.

And on the comment about aggressively competing, I think there's a motherhood component that everybody, given the environment in which we operate in and given in our case, the situation which we're coming from, with this performance in Q3, we were going to be aggressive anyway.

We've just decided, particularly when you look at Old Navy and their - 9 comp in October, we going to have to step up our aggressiveness in the fourth quarter in order to get a better performance. And everything I talked about, or will talk about now in reference to my opening comments, that's all assumed in the Company's guidance.

We've been looking a lot at the Old Navy business, and if you look at it they comp'd in 2010. They had about a, give or take a - 2 comp in Q1, they had a flat comp in Q2. And this is, as Sabrina said, Q3 and Q4. We knew that's when the highest costs were going to be felt in the Old Navy business, and greater in Q4 than in Q3.

So, if you just take the numbers we guided to back in May, that we said the back half our average unit cost would be up 20%. We said a big driver of the 20% increase in the back half was our value business, and if Q4 is greater than Q3, you can deduct pretty quickly the kind of increases Old Navy would be facing in the fourth quarter, and our AUR at Old Navy was up in the first quarter. It was up greater in the second quarter than the first, it was up that much greater in Q3.

But now you get to a point where the model we've put together economically at Old Navy, that Sabrina and I have signed off on, with AUC being up at a very high level in the fourth quarter and then you pull back units aggressively, because that's the right thing to do inside the business, and then you get an AUR that is intended to be up in Q4 greater than Q3, those were the plans the business had.

Now we look at it and go, we have to actually make some adjustments, again all assumed in our guidance, you have to make adjustments to the plan we initially put together six months ago, given the performance in October. Because in October, as we looked at our business at a - 9, obviously the aggressiveness, the value proposition of Old Navy was not strong enough to generate a better performance than that.

So, we're going to have to make sure we're making -- this is, you hear us talk all the time, this is retail. You put your plan together. Consumers respond to it, or in some cases, in Old Navy's case in October with their comp, did not respond to a level we had hoped for, so we have to make some adjustments and make sure we're aggressive in terms of our pricing, sharpen up our value proposition, and make sure we're prepared to compete in the fourth quarter.

That's very helpful. Thanks very much. Good luck for holiday.

Your next question is from Dorothy Lakner with Caris & Company.

I just wanted to follow-up on the question on Old Navy and Glenn, if you could just -- want to make sure I understood what you were saying earlier in your remarks about Old Navy and the good, better, best. Is what you're saying that the better and best is a little bit too pricey for that consumer, and you will need to get more aggressive in the fourth quarter, or are you talking sort of longer-term you need to find a better balance between the three buckets at Old Navy?

Dorothy, this is the ongoing challenge of a business like the apparel sector, where the timeline between when you put your plans together and you actually get your product coming in is broad. Therefore, when we planned out Old Navy's assortment and Tom Wyatt, and Nancy Green made these decisions in 2011, they just looked at price bands that were just too narrow, and I agree with that.

Strategically, I said in the opening comments, we have to broaden the bands of our pricing. We've been testing this, we just didn't do it all of a sudden. We've been trying that in certain categories and we've been getting good response.

Now, when you make that decision, and then it was all in advance of us recognizing and understanding the kind of cost increases we would see in the business, what was intended to be a band of, maybe, better pricing above the good of X percent greater, and best pricing of X percent greater than the better pricing, and when your costs come up at a much higher level than we anticipated a year ago, the answer is that as a percentage of the business, these are small shifts.

We would never let any of our businesses swing the pendulum dramatically. But moving some of the unit assortment into better and into best, which I believe is absolutely strategically correct. But the pricing that had to go into that to get a gross margin we're comfortable with, in some cases is more of a challenge for our customer, and we're hearing that, so what I'm saying is, strategically, the assortment and the management of it going forward, Old Navy will be continuing that strategy going forward.

They will have to make some adjustments in certain categories, because it's just -- particularly as cotton comes down, that will be helpful to us, make some adjustments, based on the learnings they've had in Q3 and Q4. But one data point that's worth acknowledging, because we didn't take these increases and just apply them to a gross margin rate and then round up to the nearest $9.50.

Old Navy last year, 90% of its Women's assortment in denim, 90% was priced at $29.50 or $29.94. This year, that number is just a little less than 80%. So, strategically, on a category as important as denim, Old Navy held its price points at a much greater rate than the average unit cost would have dictated, if we just allowed pricing to flow through.

So, there has been strategic decisions made, so I don't want people to think we had everything flow through based on cost increases, but where we've moved in the right categories to more of a better/best strategy, some cases that hasn't worked out, and we've got to make some adjustments in that price points to either promotions or through reticketing in order to go forward.

Okay, so in some categories, you've made more adjustments than in others?

Yes, definitely Women's. I mean if you look at this assortment shift, is certainly broad-based. It's in Kids, it's in Babies, it's in Mens but certainly in Women's and I don't want to leave anybody with the impression that the only issue we're dealing with at Old Navy, in its Women's performance, as I quoted a Gap Inc. number, but it applies to Old Navy which is double-digit negative comp in Q3, that the issue is broader than just consumer acceptance of the value proposition.

I'd also say, and so would Nancy, and so would Tom, that some of the choices that were made, the product acceptance is also an issue at Old Navy. It's a combination of both.

Okay, great. Good luck for holiday.

Your next question is from Paul Lejuez with Nomura Securities.

Can you maybe give a little bit more detail on the costs you're anticipating in China, and just wondering how does this impact when this business turns profitable for you? Thanks.

Yes, Paul, we said for a long time that China is definitely our longest-term investment, meaning, like when we started several growth initiatives in 2010, we knew China would take the longest to become accretive, and that's actually precisely how it's turned out. Almost every other growth initiative we've launched is now healthy performance, not dilutive.

China, as predicted would take some time. So, definitely dilutive this year, likely dilutive next year, as well, because again, it's a very long-term investment, although we're very pleased strategically being in the country, pleased with store performance. What we know in a developing market, and it's even in some areas more challenging than we envisioned, doing business in a developing market is very different than a developed market.

It's taking more headcount. It's more burdensome administratively. So, those costs are heavier than initially envisioned. We're also putting a lot of money into marketing, of course, because we're trying to build our brand.

So, we believe in the country. We think it's really important for our long term. As you know, we're happy. We aren't really hugely exposed. We haven't been overly aggressive with our store growth.

We should end this year with about 15 stores. So, it's not like we have been overly aggressive in our view, in our exposure to it, and as predicted, will be dilutive given the importance of really investing correctly in the overhead structure and marketing in particular.

I'd add to that, Paul is if we felt there was some issue in terms of brand awareness, and I think Sabrina was right, one of the big investments we've made and I'm comfortable doing it, is to make sure we continue to keep up a fairly aggressive level of marketing in 2011, 2012, and probably beyond. Big country, love the American brands but we have to make sure our brand, because a lot of new brands are coming into China, and every time something comes in, that is the bright shiny object.

So, we're keeping our name front and center, and really putting money behind marketing has been a strategic call we've made. Probably a little greater dollar investment than we envisioned two years ago, when we first put this on a piece of paper.

But we are getting the benefit of brand awareness, and if we weren't getting that, we would be the first people, because most people on the call know us well, we would not be advocating and telling everybody that we will open 30 stores in 2012, if we didn't feel the acceptance of the brand and the performance of the top line right now has given us the indication and the motivation to double our store count from the 15 we're going to end with this year to open 30 new stores in 2012.

Got you. Thanks guys. Best of luck.

Your next question is from Stacy Pak with Barclays Capital.

Hi, thanks. Just a couple follow-ups and then my question. On the promotional bent you have to take at Old Navy, is it really centered in Women's? Or, is it the whole family? I wasn't clear on that.

And if the pricing needs to be below your expectation in Q4 at Old Navy, what's the offset? And then more broadly question, can you comment on what you're seeing Internationally, particularly UK and Italy? Weather impact, what you saw during the quarter, what you're seeing from that consumer, ticket traffic, anything you can talk about?

All we were indicating on the call about Old Navy is that there is always a plan to be aggressive. Old Navy has something in its association with Black Friday, Thanksgiving weekend, and holiday, so there's always a plan to be aggressive.

I think what we're looking at right now is, when you read the business, and we got some early reads in early October, as we were putting together the assortment, as I was explaining to Dorothy earlier, and had a small shift to better and best, we aren't talking about anything significant here. All we're doing is being transparent, that when we look at that, some is being accepted, fine, that's great, because the product is right and the value proposition is exactly what somebody will pay. In some cases, in this environment, those are not being as accepted as well as we would have liked.

So, we're targeted. The marketing campaign and the promotional elements that gets to Old Navy's value proposition for the family is absolutely intact for November and December. Over and above that in a small way, we're going to have to be targeted in Women's in particular, to make sure that we bring the pricing in the few categories and the small number of styles in the better and best bucket, to make sure we're more competitive than we were in October, to make sure we move those through.

And also, what's important to me, not derail the ultimate strategy, which is to broaden our price points over the long run. So, you don't want anybody's perception in those few categories and few styles to hurt the overall strategy. So, by sharpening those up, that will not only help for the fourth quarter but will help with the brand image for Old Navy going forward.

And Stacy, just to underscore what Glenn said, we have contemplated several scenarios in the range we reaffirmed, and as I mentioned we fully anticipate continued pressure on our margins in the fourth quarter. And I said, in particular, on the merchandise margins, because of some of the scenarios embedded on making sure that we're being very competitive in the promotional environment we expect.

In Europe, if you look at our business right now, there's two things we've been doing in Europe, which we still feel very confident in even though the economic situation and the consumer sentiment is very difficult in the European market. One, we continue to make investments in our value business, so our factory stores, our outlet stores in the UK, we've opened up the power centers recently, we still believe that's absolutely the right thing to do, particularly in this environment, so that will continue in 2012, as well as factory stores and outlet stores in Italy.

Our online business is only a year old, so we're going to make the investments as you heard us in October for language and some other investments we're going to make on our site to make sure it's as strong in Europe as it is in the US, and those are going to continue.

With that said, given everything going on, and we're very happy with our Italian business right now, we're fast approaching 10 stores, we're being a little more careful. It's kind of double-edged sword, I guess I would position it as. We've got to be careful of the number of new stores we're opening up in Italy, in particular.

We're only going to open up one store this month, sorry, early next month in Paris, a Banana Republic. Maybe that will lead to a couple more stores down the road, but I think there's an overall, more of a cautionary tone for us when it comes to our bricks and mortar business in the European market.

So, I think that Italy is doing well and we'll add a few more, definitely more stores in 2012 and we'll be a little more cautious. Banana Republic, I hope gets off to a great start in Paris, so we'll watch that carefully to see if that drives us to any more stores but we are watching it carefully. And our value business I think is full steam ahead, because that makes absolute sense.

The great side about this, is given the current state, there's a strong chance that rents may come down, so we have to be opportunistic. We'll be careful. If we can get the right store in the right market, and we notice rents come down as a percentage of what we thought they would have been 12 months ago, that would be good news.

Now we're much more focused on being cautious about the consumer than we are about being opportunistic on rent, but that could be one of the outcomes that comes out similar to the US three years ago, where we are presented with opportunities we never would have had in 2007. We were presented with opportunities in 2008 and 2009, given the recessionary times we lived through here.

Okay, thank you.

Your next question is from Lorraine Hutchinson with Bank of America.

Sabrina, I just wanted to ask about SG&A. Dollars went down in the third quarter, and that continues to be, I think somewhat surprising given all the dramatic cost cuts over the past few years. Can you talk a little about what you've been able to cut, and then perhaps what's left to cut if sales don't come in, in line with expectations for the next few quarters?

Yes, I'm glad you asked that question, Lorraine. We're really pleased with how we managed expenses with great discipline again in the third quarter. I definitely would caution against extrapolating that trend forward into Q4. Just underscoring your point, we definitely want to be careful in our most important biggest quarter, that we're not cutting into areas like marketing and payroll, and you know that our SG&A can vary quarter-to-quarter.

So, although the result was terrific in terms of leverage on a -5 comp in the third quarter, just as a reminder in Q1, we only had a -3 comp, and we actually didn't leverage. Expenses were flat as a percent to sales. So, it can definitely vary quarter-to-quarter. You can count on us to continue to be disciplined, but I wouldn't extrapolate that strong of a trend forward, or I would caution against that.

Thank you.

Your next question is from Barbara Wyckoff with Credit Agricole.

Thank you, everyone. Can you talk about the learnings of the active categories, the denim and accessories and Gap Women's? How important were they during the Fall season and what could have been done in these categories better to drive sales? And then given the price action in the mall in the mid market, how aggressive is Gap prepared to get during the holiday season? Thanks.

Well, on the two categories you highlight on Gap, on the active business, we've actually been pleased. It's in 100 stores now, and I believe we're on our way to put it into another 100 stores early next year. That's the re-launch, or the actual launch of Gap Body Fit and that's a sub-brand that is working well in bottoms in particular, and I would say my --the opportunity for them and one of my concerns is that the pant launched well, no different than when 1969 denim was done, but we didn't follow it up with all of the other components that she was looking for.

But it's a good business. I think we have a great price point of $49.50 which is, relative to where some of the market leaders are that would be about 50% of their price point. So, I think the stores have done a great job displaying it. The marketing has been very strong.

Now, like all great retailers who launch new categories, how do you follow that up? What are the other categories? How do we create in the 200 stores we will have some time in 2012, how do we create a business that's much more grounded than simply in a great pant with a great fit with great fabric?

So, fit is something that Gap brand has talked about a lot from its denim, to its black pant re-launch, to, now the Gap Body Fit. So, I think that is something that they can clearly get known for, and should be reemphasized in their marketing, but they need to add more categories around it.

Accessories, I was sure if Mark Breitbard or Pam Wallack were on the phone right now, they would say we have a long way to go in accessories. That's not anything that we would say was a strength of the business. We need to did a lot more work.

You'll see a little bit of that in the holiday assortment that's in right now. You'll see some greater emphasis on the assortment category, sorry the accessory categories in the assortment in Spring, but I still believe very strongly there's a huge opportunity for Gap brand.

I've seen the research from customers. I speak to people in the store. I do know people want to complete their purchases, and are looking for certain key categories under accessories that we don't deliver right now.

It may be an opportunity as we've talked about, at either these phone calls or we definitely talked about in New York at the Analyst meeting, maybe an opportunity for third party brands because certain categories are not part of the core of what Gap does, and I know that Art and the team are testing in some of our stores in third party brands to find of whether that may be part of the overall shift in our merchandising model, to complement the assortment we have today.

But I see accessories as a very big opportunity for Gap, and they got to pace it in, but I think you'll see a little bit of that in the fourth quarter, and hopefully a lot more to come in 2012.

And the pricing? How aggressive is Gap prepared to get?

Gap is in the malls, they have seen throughout this year, how a lot of their either direct competitors or indirect competitors. By that I mean some of the department stores, and the level of aggressiveness they've had. What I said at the beginning, and it applies to all of our businesses, we're prepared to compete in the fourth quarter, and we have to.

Last year, I would say Gap was quite aggressive in November, and we're putting our plans, our plans are put together now. There's always little adjustments you could make, and what I've encouraged the team to do is not look at any given day, or any given month that the fourth quarter is made up especially of November and December. And to make sure we don't try to actually go out there in any given short period of time, like the morning of Black Friday and try to win that four-hour period.

Gap is a different brand and that's not how they compete. So, they have to make sure they are offering great value, but try to make sure they look at it a little more midterm and across the overall eight-week period. Gap is much more of a brand that consumers respond to more strongly in the last week in December when people are in the mall looking for last minute gifts.

It's a brand that's recognized, it's comfortable. And so, trying to learn some lessons from last year, where those are maybe better timed, to make sure that our value proposition is more competitive, is probably a better strategy than trying to win on one given day.

Okay, thanks.

Your next question is from Janet Kloppenburg with JJK Research.

Glenn and Sabrina, Glenn first, I'd just like to make sure that as we listen to what you're saying about Old Navy and its pricing that there will be some directive for the brand's pricing as we go into the Spring to reflect some of the problems that you're talking about. So, if you could talk about that for a second it would be great.

And Sabrina, I appreciate what you're saying about expense management but I just wanted to make sure that if top line continued to be compressed, that you would be able to adjust your infrastructure costs in line with that? Thanks so much.

I'll start with the second one, Janet. So, just to be clear, I think we've demonstrated, gosh, for many, many consecutive quarters now, our commitment to expense discipline.

You've been terrific at it, really. Fantastic.

Yes, that's not going to change. I'm just saying that I would caution against relationships of being able to leverage 40 basis points on a - 5 comp. You can absolutely count on us to continue to do our best and flex all of our levers within our expense management to make sure that we stay just as disciplined as we have quarter-in, quarter-out, year-in, year-out.

Given the step up in sales, Sabrina, in the fourth quarter versus the third quarter you would think there would be some leverage opportunity, no?

We'll continue to say, Janet, if we positive comp, we always feel confident we can leverage both ROD and expenses. If we don't positive comp, it becomes much more difficult to pull off.

Okay, I'm sorry, Glenn.

And on the assortment just go back to one thing I said. I think Old Navy, when they had to make their decisions on pricing, let's all admit it's been a unique time, in terms of the cost increases that we have lived with. As I referenced earlier, a 20% -- increase of 20% on AUC in the second half for Gap Inc., driven by our value businesses that were a large part of the contributing factor for that 20% increase, Old Navy has had fairly sizeable increases in the third and fourth quarter.

So, when you have a slight shift, I want to emphasize a slight shift in assortment strategy, and then you have all these increases in AUC, they've had to make a lot of decisions that in fairness, might be a little foreign to them. The first time that probably anybody inside that business has lived through their cost of goods from year-over-year going up to 20% at a minimum inside of a business. So, they've had to make choices.

I think they made a lot of good choices, like the denim example I gave earlier. In some cases the combination of a slight shift in assortment and a significant increase in AUC, your customer will give you the response, and what good retailers do is to make those adjustments. We have the ability certainly in Spring to make any retail adjustment you choose to make, if it's appropriate.

The assortment is the assortment. That's done. It's bought. It's on the water, or it's coming into our DC in the next 30 days, but any pricing adjustments are definitely easy for us to make as we learned lessons from October and we'll learn more lessons from November to December.

Okay, thanks so much and good luck for the holidays.

Your next question is from Jennifer Davis with Lazard Capital Markets.

Hi, thanks for taking my question. I was wondering if you guys could talk a little bit about, you've talked about Jenny at Old Navy. So, I was wonder if you could talk about your target Gap Women's customer. Who she is, what does she want from Gap, and if you've done any focus groups, what she's saying she likes, what she doesn't like, and what she wants from Gap? Thanks.

Well probably Tom and his team talk about their customer more than any of our brands. I wouldn't say that's because they know it any better, but it's a large part of the personality of Old Navy, and how Old Navy can compete in the value business without having to necessarily just be the lowest, but find it a way to make sure they have very strong aggressive pricing but also bring the personality of Old Navy alive, as you referenced for Jenny, because that's how she responds very well.

Whether that's the store environment, whether that's the type of Marketing we put forward, whether that's unique categories we put into the store, whether that's the type of people we hire. I think that gets a lot of airtime, as it should. Because Tom is in the value business, and you can't strictly compete on price. Some people can, but long term Old Navy's multiple personalities are critical for its success.

At Gap and Banana Republic, both Art Peck, Steven Sunnucks internationally, and Jack Calhoun have all done the same work. Who is their customer, exactly what do they believe in, what is our positioning with them? So, when it comes to Gap, the Number One thing that we are working on to make sure that customers see, One is, this is a customer that has multiple opportunities. We don't have any other business like this, where you really are going after a customer who's about Kids and Baby.

But even inside Kids and Baby, you would get somebody who comes in for the gift aspect of Baby. So, you have a very broad customer base, and that's why it's always dangerous when we talk about Gap, and I know we've done it to make sure that our design teams are focused by talking about a 28-year-old, to make sure the teams are focused. But to me, Gap is a very broad brand, and that is Kids and Baby, and that is the Women's and the Mens business.

So, making sure that we acknowledge that, not trying to be too narrow. Some people see that as a risk, and I see that as one of the advantages of the brand, is that it has that. The second thing about the size of this broad customer that appeals to, is something we have not done as well this year, and that's the missed opportunities, the aesthetic of the brand, because it still resonates very strongly when it's done right, and we did a 1969 re-launch two years ago.

When we go after the optimistic American casual style, we hit that right as we did on denim, and then customers resonate with that. It is ultimately, there's an association with the brand when it comes to that aesthetic and definitely a demand for it inside the marketplace.

There's other people we compete against. I get that. We'll never have a monopoly, but those two in combination which is the broader demographics, even though there's a central approach by design of a 28-year-old but looking at these multiple categories, and then making sure the aesthetic, which has been a shortcoming of our team this year in 2011, is hitting the sweet spot of optimistic American casual style.

Thanks, and good luck.

Your next question is from Christine Chen with Needham & Company.

Thank you. Glenn, maybe you could share with us your philosophy on how you want to use promotions. We've seen you go back and forth between the broad-based promotions where the entire store is a certain percentage off versus targeted categories and I'm just wondering, what do you find more effective?

And is the goal really to drive traffic, or is the goal to kind of leave the customer wanting more, maybe trying to drive full-price selling in the better categories and I'm sure it differs by brand. Thank you.

That's a big question that I don't have time for a fulsome answer, but I will say to you that I don't think we've necessarily changed. I think there's nothing wrong, and I'm not trying to be defensive here. I'm just trying to give an explanation that in no time, certainly I've been doing this for 25 years, in no time has the environment been as erratic and volatile as its been, and that's caused retailers, including us, to make sure you're making adjustments into how you present.

What's your voice of your brand? So I always go to, what's ultimately what's your value proposition? Secondly, what's your brand positioning, and then what's the brand platform you're going to use to go and tell to the consumer why come into Gap, Old Navy, Banana Republic. Either you're telling them externally, or when they're inside the mall, what are you telling them, that this is a day they need to come in?

If you were to rank them, because you mentioned it, no question one of the strongest reasons that you do promotional activity, which I'll talk to you in a second is not only about that discounting as a percentage off, but one of the number one reasons you send a message in your window, you send an e-mail, you run something in a magazine, you use television, is to get people inside your store.

Now there's a brand enhancement component to that, but you'll see at Old Navy, when we try to talk about the brand a little bit more, in the first three quarters of this year, we still mentioned value, but it was a brand message first, and a product message second, and the value part of the Old Navy communication in the old campaign we had, the value was the third most important message in those, in the order of what we did for the campaign. It did not work.

So, you're right. Every brand is different. It comes down to, if you went through that hierarchy I just went through, what's the health of your brand, and how do you use promotions, which could be again multi-faceted, could be a gift card, could be a give away, could be a promotional percent. It could be a friends and family message.

So, this, starting today at Old Navy for the next five days, is redemption time on something they're calling super cash, spend $20 get $10. So, there's different levers, they have to be right for the brand, that hopefully are innovative.

I would say from a Marketing perspective, and I believe this strongly, it's something hopefully your competitors are either unwilling or unable to do. And so we put that all into sort of a pool of opportunities, and a menu for each brand that's different, and how they want to come forward over a 52-week period.

Now, 2008 and 2009 and 2010 have certainly been much more promotional from a pure discount perspective for Banana Republic and Gap as we would like. We had to compete. We had to make sure that we didn't get left behind. You've seen other brands who probably never promoted for the longest period of time, and now they are promoting.

We are working hard to make sure that anything we do in those two brands in particular, they are innovative, they are different and that we move over time as the consumer environment improves, to less and less of a dependence on a percentage off as one of the tools in our toolkit.

Great. Thank you, that was helpful. Good luck for the holidays.

Your next question is from Erika Maschmeyer with Robert W. Baird.

Thanks, good afternoon. Could you talk about your thinking around your additional store closures, what the catalyst was there, and can you give us any sense of the characteristics of the 150 stores that you're closing this year versus the rest of the base in terms of productivity or profitability? And how many of these closures are consolidations versus just pure closures? And then also how are you thinking about Old Navy remodels for next year?

That's a whole host of questions.

Sorry.

I can probably pull a bunch of detail and take you through that offline, but I'll tell you at a high level, the additional, because the only real news here, right, is that we're closing 25 more stores, and that's principally Gap specialty stores. And that really is all under the same strategic umbrella we have laid out. So, it's just that we've accelerated the timing opportunistically, given some of the discussions with our landlords. We had a lot of short-term keepers.

I think at Analyst day in October, I got the opportunity to speak to some of you one-on-one, to talk about the path to the 700 Gap specialty stores is made up of quite a few stores that we've had on our list of underperforming stores, which doesn't mean that they're losing money, by the way on a four wall-basis, it just means that the contribution is very, very low and the return is low.

But many of those we've kept short-term because our landlords have wished us to stay a little bit longer, and we've negotiated some good rents in the short-term, so it's really that group of short-term keepers that we just had opportunity to say, quite frankly it's not worth continuing to put the payroll and energy and resource into those stores to just keep them over five or six more months, whatever. So, it's just timing really. So, there's no big news around the closures.

And on the Old Navy remodels, we don't have a final number just yet. We've been averaging, give or take 100 stores a year. A lot of what we've done, and they will finish this year around 375 stores under their new prototype, a lot of what we've done have been reductions in space, which everybody knows we've had a goal since the new management team has been in place, to not only close stores but dramatically reduce the square footage we have. So, there will be -- we're pleased with it. It's going well.

I think, as I said earlier to a question that came up, it really helps define the personality of what Old Navy stands for, and when you go in the store it's unique, against people they compete on directly who their goal is to go out and compete and steal market share, I think it's a unique store experience.

So, we'll do more next year, probably less and less of these reductions in space, So, we've always said day one, there's never been an intention that the whole fleet will get done, that's a thousand stores. We don't see the need to put the new look into a thousand stores. So, we'll see how real estate team does and how it plays out. We have the capital available to do another range of stores, another tranche, I mean, and how big we'll know the next two to three months.

Thanks so much.

Your next question is from Evren Kopelman with Wells Fargo.

My question is on inventory strategy. As you look, out given your comp trends have been soft, but you're optimistic about some of your initiatives into the Spring season. How should we think about your inventory strategy for the next season?

Well, Evren, we only give out one quarter at a time, so we'll give you a lot more color on our Q4 call about 2012. We told you that we expect to end the fourth quarter similar to the third quarter basically. But overall, philosophically, what we want to do is never get too far ahead of demand in terms of inventory, and that's why we've put a lot of focus on our fast pipeline and enhancing our ability to chase.

And really, that's the vehicle that, as momentum gains, because you're right, we do feel like as we move into 2012, our assortments are improving. As that momentum improves, we're going to initially buy fairly tightly, as we have been buying this year, and then use that ability to chase and use our fast pipeline to increase the inventories.

Thank you.

Your final question is from Kimberly Greenberger with Morgan Stanley.

Great. Thank you. I'm wondering if you can comment about the direct sales growth. You indicated Gap, Old Navy and Banana were are all positive. Has that been consistent all year, or was there a change in trend? And lastly, on your balance sheet, you're showing now about $240 million of net debt, cash net of debt. It's the first time we've seen that since Q1 of 2003 and I'm wondering if you can just talk about how you think about the leverage on your balance sheet, and what level strikes you as comfortable? Thanks.

Well, I'll start with the second part, Kimberly. So, we are very comfortable with our capital structure. We raised some debt for the first time in a very long time in the Spring opportunistically. For a Company of our size, $1.650 billion, which is our total debt level, is not, it does not feel at all imprudent to us. In our history we've carried much more leverage than that.

What we have continued to say is from a cash perspective, we want to continue to be conservative with our balance sheet. We want to continue to hold on cash on our balance sheet, $1.2 billion is our cash target, and we're comfortable that's plenty to fund all of our working capital needs.

As you know, most of our debt, $1.250 billion of the debt is in a 10-year bond so it's very long-term money and then we have that smaller tranche of $400 million, which is a short-term piece or a shorter-term piece. It's a term loan of which only $40 million is due every year. So, we're very comfortable with our capital structure, and we think the leverage we took out actually helped optimize our weighted average cost of capital.

On the online we don't, as you know, we don't give out information to disclose that. What I can say is, it would be very rare on any given month or quarter for one of our brands to have a negative comp online. The online business is growing somewhere depending on the year, growing between high single digits to low double digits, and that's how the apparel online business has grown at that level.

So, one thing we've been very pleased with, and I will obviously throw in a compliment to our team at the online led by Toby Lincoln, and they certainly deserve the compliment, I've said a number of times on these calls and in meetings, is that they've been a perennial market share gainer in the whole time I've been here.

Again take out any given month, but on a year-in, year-out basis, relative to the growth of e-commerce in apparel, they've been a market share gainer, and we feel very good about that. The challenge for them is the way for them to maximize their growth and their sales, is for our brands to have great product, be healthy, and the healthier our brands are in the physical manifestation of the brand, the better we do e-commerce. So, I was trying to say earlier the 21% total growth of our online business in a quarter in which we're quite disappointed in our sales in bricks and mortar, I was impressed with.

Great, thank you.

I'd like to thank everyone for joining the call today and as a reminder, our earnings press release which is available on GapInc.com, contains a full recap of our Q3 results, as well as the forward-looking guidance included in Sabrina's remarks. And as always, the Investor Relations team will be available after the call for further questions. Thank you.

Thank you. This does conclude today's conference call. You may now disconnect.