蓋璞 (GPS) 2019 Q1 法說會逐字稿

Good afternoon, ladies and gentlemen.

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

At this time, I would like to welcome everyone to The Gap, Inc.

First Quarter 2019 Conference Call.

(Operator Instructions) Today's call is being recorded.

I would now like to introduce your host, Tina Romani, Senior Director of Investor Relations.

Good afternoon, everyone.

Welcome to Gap, Inc.'s First Quarter 2019 Earnings Conference Call.

Before we begin, 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 the description and reconciliation of the non-GAAP financial measures, as noted on Page 2 of the slides supplementing Teri's remarks, please refer to today's earnings press release as well as our most recent annual report on Form 10-K and our subsequent filings with the SEC, all of which are available on gapinc.com.

These forward-looking statements are based on information as of May 30, 2019, and we assume no obligation to publicly update or revise our forward-looking statements.

Joining me on the call today are President and CEO, Art Peck; and Executive Vice President and CFO, Teri List-Stoll.

As mentioned, we will be using slides to supplement our remarks, which you can view by going to the Investors section at gapinc.com.

With that, I'd like to turn the call over to Art.

Good afternoon, everyone, and thanks for joining us.

I'll begin the call with a discussion of some of the macro industry-wide influences on the quarter and the performance of each of our brands, then I'll ask Teri to walk us through detailed financials, and we'll finish with an update on our previously announced plans to launch 2 independent, publicly traded companies.

You've seen our press release, and obviously, we're disappointed in our Q1 results.

Not unlike others in the industry, our results highlight some of the macro challenges we all faced.

As you know, this was one of the coldest, wettest quarters in memory.

And while traffic and sales trends improved as we moved through March and April, it was difficult to overcome the extremely slow business that we and others encountered in February.

In addition to the poor weather, we had late spring breaks, a late Easter and delayed and lower tax refunds thrown into the mix as well.

We also missed opportunities on our own, and we could have executed as always better across places in our brands.

We recognize that the needs of our customers are changing, and we're not waiting around hoping that we muddle through.

We're running towards what we see as an exciting next step in our evolution.

As you remember last quarter, we announced our intent to launch 2 new companies that will be uniquely positioned to compete in the evolving retail environment, Old Navy and the NewCo, comprised of our specialty brands.

The rationale behind the separation is simple, and we will continue to reiterate it: the needs of our specialty and our value customers are diverging, and the pace of change in retail continues to accelerate.

Our planned separation will enable each brand to move more quickly and efficiently to maximize focus and flexibility, to align investments to meet unique business needs and to optimize cost structures to deliver profitable growth.

We'll come back to the separation in a moment and give an update on our progress later in the call.

Now let's turn to results specific to the quarter.

Beginning with Old Navy, our results not -- were not what we expect from this powerhouse brand, though we did see improvement during the Easter season.

When I look to Old Navy, I see a brand with a strong track record and a long, clear runway for growth ahead.

The underlying fundamentals that made the brand so successful over the years have fundamentally not changed.

Old Navy has a powerful, almost unique 4-wall model, a highly valued value proposition for our customers and strong brand health.

Even with macro headwinds and some product misses, Old Navy's traffic was flat to the industry for the quarter, and we modestly gained market share in the brand.

Part of the growth plan for Old Navy is simple store penetration.

We expanded our retail footprint with 6 new stores in Q1 and with plans to open 20 in Q2 and a total of 70 forecast for the year.

While new stores offer a clear path to growth for Old Navy, e-commerce also continues to expand with impressive double-digit comps online in both traffic and conversion, reinforcing our view that stores and online are complementary channels when paired thoughtfully.

The Buy Online Pickup in Store program continues to help us better understand the intersection of off-line and online shopping behavior for the Old Navy customer.

Turning to Gap brand.

While the comps for the quarter were disappointing, the story at Gap brand, as we have continued to say, is that of a brand focused on regaining profitability.

The brand has made significant operational improvements in inventory, product assortment and expense reduction.

Our aggressive store closure plan to rationalize the specialty fleet is on track, and we remain committed to quickly, thoughtfully and decisively eliminating stores that are underperforming.

It's through these tough actions that we set the stage for additional progress and for the rejuvenation of this brand.

Let me then turn obviously to traffic, which was a major challenge at Gap quarter -- Gap brand for the quarter, though some of that weakness was expected.

We intentionally shifted marketing resources out of the first quarter and into late Q2 and Q3, and this was aligned with revamping our marketing efforts to match the continuing improvements in product and importantly a strong denim presentation.

You'll also see Gap brand reinvest in marketing at kids and baby business with a strong back-to-school push later this year.

This is especially important given that market share is now up for grabs, and this is a clear opportunity for Gap brand given its strong equity in kids and baby.

Banana Republic also experienced the impact of the unseasonably cold weather in February and March.

Customers wanted more wear-now items, such as outerwear, at a time when we were offering spring fashion.

As weather improved in April, so did performance.

Despite the weak quarter, I'm pleased with our progress at Banana.

Just a few years ago, there were questions about the core viability of the brand.

We moved in a new management team, got back to the fundamentals of delivering high-quality, reliable products, and today Banana Republic is earning its place in the Gap, Inc.

portfolio.

Athleta continues to be north -- one of North America's fastest-growing athletic brands and is positioned to capture share.

Despite unseasonable weather, growth continued to outpace the market by a factor of 2. We're obviously all committed on Athleta.

And in 2019, we are accelerating store growth with approximately 25 new stores versus our historical average of 15 to 20 openings per year.

Part of the Athleta magic is its clear brand identity and its commitment to sustainability.

Athleta just celebrated its first year as a B Corp by announcing progress against its sustainability goals, including 60% of materials now being made from sustainable fibers.

Customers connect with the fundamental ethos of the brand in a way that is difficult to duplicate or replace, and that connection is part of why we're so bullish on the Athleta opportunity moving forward.

We have tended over time to focus our calls on the larger brands as they have the greatest impact on our economics, but we're also seeing significant and interesting progress in our smaller properties.

We're seeing positive trends at Intermix, where fresh inventory, on-trend product assortment and an improved e-commerce platform and stronger digital marketing strategies led to both growth online and in-store.

We also have our new digitally native men's active brand, Hill City.

Again there, we're only a few months in, but as the brand develops, we look forward to sharing more on the progress of what we believe is a very exciting opportunity.

And last, I'd like to formally welcome and discuss for a moment the latest addition to the portfolio, Janie and Jack.

Janie and Jack is a high-end children clothing brand with about 140 locations across the U.S. and an attractive, profitable online channel.

The brand sits at a premium, higher price point for kids and baby than the offerings currently found at Gap and Old Navy and was a great tuck-in and we believe significant potential acquisition for us going forward.

Finally, I'd be remiss to not address the topic that impacts the entire industry, recently announced intent on tariffs on clothing manufactured in China, which largely translates into a tax on American consumers.

As you're hearing on many of these calls, there is significant uncertainty around what goods the tariffs may apply to and at what level they may be applied.

But we've been migrating sourcing out of China for the last several years, and we'll continue to do this responsibly going forward.

As recently as 3 years ago, about 25% of our product was manufactured in China.

In our most recent disclosure, that number was down to 21%.

And if you include only apparel, our penetration is approximately 16%, which is significantly lower than the relevant portions of the industry.

Our current guidance incorporates the impact of List 3 goods but does not include the proposed List 4 changes.

We're actively monitoring the issue.

We're actually actively engaged in the conversation, and we're managing our sourcing operations accordingly.

I do want to speak for a moment on the separation, but I think it's important that Teri take us through financial results for the quarter and our outlook for the year.

Teri, over to you.

Thanks, Art.

Good afternoon, everyone.

As Art said, we're not pleased with our results this quarter.

Similar to the complexion of our fourth quarter results, there were several industry-wide macro factors contributing to our performance as well as areas of opportunity within our control where we could and must execute better.

As we previewed on our last call, the historically cold start to the year negatively impacted all of our businesses, particularly Old Navy, which tends to see outsized impacts from unseasonable weather patterns.

While we did see an improvement from February into the combined March and April period across all of our brands, the improvement was below plan and was not enough to offset February softness.

Let me take a moment to walk through some of the drivers of brand performance before going to the specific results, beginning with Old Navy.

As we talked in the back half of last year, we had identified product softness in certain areas of our women's assortment, which have been addressed with leadership and process changes that will show up in the assortment as we move through the year.

During the quarter, these challenges were exacerbated by a generally soft apparel retail environment, which we attribute primarily to a much cooler weather pattern than a year ago.

We saw the weather impacts most acutely in looking at the spread between wear-now and wear-forward category comps, which were about 7 points different.

While online delivered a high-teens comp with growth in both traffic and conversion, store performance was much more challenged driven by negative traffic trends, which we also partially attribute to weather.

As you know, the specific diagnosis and quantification of weather impacts in our business can be tough, particularly with the variability we have seen across the competitive sets.

From a product perspective, the team identified that our product offering was too narrow and lacked diversity in silhouette, prints and pattern and color.

Our Old Navy customer responds to a broad assortment.

And overall, we did not provide her with enough choice.

With these key insights derived from customer response to holiday and spring product, the design and merchandising teams were able to significantly redesign the fall season with even more ability to influence holiday.

Additionally, while we entered the year clean from a liable perspective, we were heavier in inventory than we would have liked coming into the quarter, especially given lower-than-expected traffic trends.

As a result, we were significantly more promotional in the quarter to move through units, resulting in meaningful product margin compression in the quarter.

We've adjusted Old Navy's inventory buys for the balance of the year, and they now are much tighter to match industry trends and drive inventory productivity.

For perspective, unit inventory comps were up mid-single digits in Q1 and are planned to be flat and down mid-singles for Q2 and the back half, respectively.

As a result, we do expect sequential merchandise margin improvement as we move through the year.

One of the key strengths of the Old Navy model is the robust and repeatable product-to-market process.

The leadership team has taken the learnings from these last 2 quarters to infuse more rigor around their established processes that drive the business.

Importantly, the Old Navy brand fundamentally remains strong as it continued to build share on a rolling 12-month basis with consistently strong NPS and YouGov indicators.

Old Navy continues to leverage its unique positioning in this sector at this intersection of value, speed and curation.

The brand remains grounded in creating affordable, on trend, high-quality fashion for the whole family while ensuring the customer feels fun at every touch point this $8 billion brand provides.

We continue to see a long runway for growth with share growth opportunity through improved comps, new store openings and continued online strength.

Turning to the Gap brand.

While top line was negatively impacted by weather and traffic trends, we were able to improve the brand's overall profitability through gross margin expansion and continued expense reduction.

The team has been focused on improving inventory composition and product assortment.

During the quarter, we had particular focus on yield management despite the tougher traffic trends.

As we move throughout the year, we have particular focus on reestablishing our strength in denim with improved quality, fit and silhouettes.

We remain focused on driving improvement in the brand with cleaner inventory positions, better product assortment, leaner inventory buys and continued cost discipline.

Moving to Banana.

Similar to Old Navy and Gap, unseasonably cold weather negatively impacted spring product sales for much of the quarter.

As weather improved, we saw an inflection in trends but recognize there are still opportunities for improvement in terms of product, assortment and marketing.

As our fashion product acceptance continues to improve, the team is focused on balancing our inventory mix and offering more of the fashion she wants by increasing the depth across key fashion buys and marketed styles while driving overall inventory productivity.

Lastly, with regards to Athleta.

While February was tough, we saw a sequential improvement in comp trends as we moved through the quarter with a 12-point comp improvement from February to the combined March-April period.

The swim category was soft largely related to fit and coverage product challenges.

The team is evaluating how we can best serve our customers in this challenging category with several in-store test programs that will help us inform strategy for next year.

Fundamental brand health remains strong as evidenced by market share gains, continued customer file growth and strength in other key health metrics such as average spend per customer and frequency.

Let me move to overall performance.

Just as a reminder, you saw in our disclosures, during the quarter, we completed the sale of a headquarters building we owned but did not occupy as part of a tax-efficient exchange for the Old Navy headquarters building we purchased at the start of the year.

We completed the sale for $220 million, which resulted in a gain on sale of $191 million and is included as an offset to operating expenses within our reported results.

So starting with sales.

Our net sales for the quarter were $3.7 billion, down about 2% to last year.

Comp sales were down 4% compared with a positive 1% last year.

Spread for the quarter was largely driven by new store openings at Old Navy and Athleta as well as noncomp Janie and Jack sales, partially offset by the Gap store closures.

The by-brand comps clearly were below our initial expectations, and we're working aggressively to adjust our plans to respond to the macro trends and strengthen our product and marketing plans for the remainder of the year.

Moving to gross margin.

Our first quarter gross margin was down 140 basis points to 36.3%.

Merch margin was down 120 basis points primarily driven by Old Navy, partially offset by Gap brand margin expansion.

Rents and occupancy deleveraged 20 basis points primarily driven by the lower sales.

On SG&A.

On a reported basis, first quarter total operating expenses were $1 billion, which included the $191 million benefit from the building sale gain.

You will see that we have separately called out the costs associated with separation as well as specialty fleet restructuring costs.

Together, these were only $5 million on the quarter, but we wanted to provide visibility as we move through these important transformational steps.

Excluding those items, our adjusted SG&A as a percentage of sales deleveraged 110 basis points, reflecting the lower sales and increased expenses related to technology investments, the addition of Janie and Jack and a modest increase in Old Navy store labor, which we are rightsizing to match business needs.

Two additional points on this.

First, we continue to believe that marketing is a key element of our business model, and investment there is required to keep our brands healthy and traffic strong.

Clearly, to yield the best return, those investments need to be matched to strong product and customer experience.

During the first quarter, that wasn't true for Old Navy and Gap.

So we held back on marketing and will reinvest as the product fundamentals improve.

Second and importantly, our productivity efforts remain a key priority with savings goals in place for the year.

Inevitably, there will be some inefficiencies as we move toward the launch of Old Navy and the NewCo as stand-alone entities, but we are looking at that as a catalyst for even more dramatic changes to the operating models that will optimize the unique strengths and respective scale of 2 more focused companies.

On taxes.

Our effective tax rate was 24.8% on the first quarter.

The lower rate versus our original guidance was primarily driven by the jurisdictional mix of pretax earnings.

We expect our full year reported effective tax rate to be about 27%.

When we exclude certain noncash tax impacts related to expected restructuring charges, we continue to expect our full year adjusted effective tax rate to be about 26%.

On earnings.

On a reported basis, our earnings per share were $0.60.

Excluding the building sale as well as costs associated with separation and fleet restructuring, our adjusted earnings per share were $0.24.

Foreign exchange was a benefit of about $0.01 for the quarter but is not expected to be meaningful for the year.

Our free cash flow was negative $136 million but an improvement of $68 million over last year.

This reflects the lower bonus payout, partially offset by an increase in capital spending primarily due to earlier planned store openings and timing of technology and supply chain projects.

We ended the quarter with $1.2 billion of cash, cash equivalents and short-term investments, comfortably within our target cash threshold.

Consistent with our commitment to returning cash to shareholders, we completed $50 million of share repurchases in Q1 and paid dividends of $92 million.

We continue to expect to repurchase approximately $50 million per quarter.

We ended the quarter with 378 million shares outstanding.

Regarding inventory.

We ended the quarter with inventory up 10% compared to last year.

There are a couple of drivers behind the increase, including about 1-point impact from store openings net of closures; about a 2-point impact from the Janie and Jack acquisition; about a 2-point impact driven by an increase in in-transit times.

As others have noted, ocean freight carrier bankruptcies have resulted in carrier consolidation and larger vessels used for transport.

These larger vessels generally take longer to load and off-load, resulting in an overall increase in in-transit time of about 3 to 4 days.

While we have not seen an increase in ocean freight costs, we did begin to see the longer in-transit times beginning in Q4 of last year.

While this normalized 5% increase is better than the reported, it still is too high against our near-term expectations for growth given the current dynamics in the market.

As we mentioned for several brands, we are buying inventory tighter over the remainder of the year.

Our inventory productivity has slipped for a number of years, and we must get back to best-in-class levels.

We have invested in the necessary responsive tools to improve productivity.

We have designed improved operating processes and put in place controls to deliver improved operating discipline.

And now we are focused on rightsizing our inventory levels to the appropriate channel demand to improve yield and return.

Regarding capital and store count.

Our year-to-date capital expenditures were $165 million.

At the start of the year, we guided to fiscal 2019 capital expenditures of about $750 million, which includes about $650 million of base capital and $100 million of nonroutine expansion costs related to one of our headquarters buildings and a build-out of our Ohio DC.

Excluding the $100 million of nonroutine costs, we have reduced our base capital to be about $575 million.

The reduction in capital spend is primarily driven by changes in our key priorities and timing of Old Navy remodels.

We remain focused on 2 key priorities: continuing to tap the profitable growth opportunities for Old Navy and Athleta retail footprint and investing prudently in technology and supply chain initiatives that position all of our brands well for competitive differentiation.

It's important to note we expect the separation to affect capital requirements, which we are currently assessing and which could impact future spending levels.

As we have better visibility into these potential costs, we will provide more information as relevant.

On a net basis, we added 9 Old Navy, Athleta and Banana Republic stores during the quarter, and we acquired 140 Janie and Jack locations.

At Gap brand, we closed 8 stores primarily in North America, net of openings, primarily in Asia.

We ended the quarter with 3,335 company-operated stores.

We've added about 10 new store openings for the year at Old Navy and Athleta and now expect 30 net store closures for the year.

With regard to our earnings outlook for the remainder of the year, given the disappointing start and with unseasonable weather trends continuing through May, we are reducing our full year earnings per share guidance.

On a reported basis, we now expect earnings per share to be in the range of $2.04 to $2.14 for the full year.

Excluding the gain on building sale, the restructuring costs and any costs associated with preparing for and executing the separation, we now expect adjusted earnings per share to be in the range of $2.05 to $2.15.

We now expect net sales to be about flat for the year with comp sales for the full year to be down low single digits and spread up low single digits driven by new store openings.

We now expect adjusted first half earnings per share to decrease approximately 35% relative to EPS for the same period last year, and we continue to expect an improvement in second half comp and margin trends compared to the first half of the year largely for the reasons I described at the start of my remarks.

In closing, as we said, this was a difficult quarter.

However, we have clear line of sight to the actions that we need to take both to strengthen our operating performance and respond to the retail environment we currently are facing.

Importantly, we remain focused on the actions that we believe will set all of our brands up for long-term value creation.

What we are seeing in the industry today supports our view that to position our current brands for sustained growth, they are best served by launching Old Navy as a stand-alone company with a single-minded focus on winning with its unique value proposition and strategies in a growing retail segment.

And the NewCo is a portfolio of brands with a scaled operating platform that can leverage an attractive customer base and pursue enhanced margin opportunities.

So with that, I'll turn it back over to Art for an update.

Thanks a lot, Teri.

Obviously, we are not pleased with this quarter, but I do want to spend a moment on the separation, which we announced during our last call and we've made quite a bit of progress on over the course of the last couple of months.

This decision to launch Old Navy as a stand-alone public company is not, and I repeat not, a reaction to short-term trends.

And we believe what we are seeing in the industry today validates our view that to win in apparel retail, you need to be focused on unique competitive differentiation against a targeted customer base.

This is the logic that we have used, it's the analysis that we have done, and we're doubly committed to making this happen.

Importantly, we remain on track as we work towards executing the separation into 2 independent companies in 2020.

As part of the separation work, we formed a project management office with a dedicated team to minimize distraction to the current business operations.

The team's charter is clear and simple: plan the separation efficiently and set up each company for success.

We look forward to sharing additional updates on progress over the coming months.

And Sonia Syngal, who will lead the independent Old Navy, and I will host an investor event in mid-September to continue the conversation.

With that, let's open the line for questions and answers.

(Operator Instructions) Our first question will come from Kate Fitzsimons with RBC Capital Markets.

Just given the reduction in guidance, could you just speak a little bit to maybe some of the trends you're seeing here in May?

And then, Teri, just as we're thinking about the inventory x transit and Janie and Jack upside, can you speak to where it maybe is concentrated by the brands and how we should think about 2Q gross margins relative here to what we saw in Q1?

Sure.

So with regard to the start of May, we are seeing kind of a repeat of some of the macro factors of Q1 with the colder, wetter weather, and it has been very much unseasonably so.

And so that's basically the story as we sit here today.

We do see bright spots when the weather turns.

So we remain convinced that it is primarily weather related, but we need to ride that out.

Obviously, on the inventory [plus 5], going into the quarter with those kinds of trends, we do find ourselves in a bit of the same cycle where we're probably going to end up having to be a little more promotional than we would like to continue to move through the units and make sure that we're getting into the second half, again, both clean from a liable perspective but also more rightsized against the expectations for growth in the second half.

And so my expectation is we'll continue to see some of that margin pressure.

I definitely think we can do it in a more targeted manner than we might have done in Q1.

We certainly learn as we go.

And as we think about our commercial plan for Q2, we're definitely taking all of our learnings from Q1 and making sure that we optimize yield as we continue to move through those units.

(Operator Instructions) We'll go next to Dana Telsey with Telsey Advisory Group.

As you think about the Old Navy business and the changes in trend over the past 2 quarters or so, how much of it do you feel is due either to the distraction with the separation, internal product issues in the consumer or is it external factors?

How do you unpack it in order to say, here's how it gets back on track?

Thanks, Dana.

And Teri, you can jump in here, too.

To point number one, which is distraction, minimal to de minimis.

I mean really, truly, it's why, Dana, that I highlighted the fact that we've followed best practices.

We've talked to a number of other companies that have gone through this process as well as outside advisers and really set up a project management office that is with a specific intent to isolate the separation work from the operations of the business.

We were acutely aware of the fact that there's a ton of work here that needs to happen and that it is not allowable to let it bleed over into the operations of the business.

And so, so far, I'm pretty confident that we have a structure that has really protected the operations of the business and that the team is really focused on not just the in-season management but obviously making corrections in out seasons for the business.

I never like to play the macro factor, but it's a legitimate play in this case.

Whatever article you read on weather, we saw unprecedented levels.

And I won't go into it because, Dana and all the rest of you, you've seen it and you've tracked it here, of moisture, of temperature, obviously the violent weather we're seeing in parts of the country, et cetera.

It's clearly an issue.

And Old Navy, given its locational strategy, which is you have to work to get there; number two, the fact that the kids/baby business, which is an important part of the Old Navy business, tends to be more of a wear-now business, both of those factors kicked in at Old Navy.

I'm not going to say it was entirely, as I've said all along the way, and I will continue to say, we are never going to be perfect.

There are a couple of trends that we probably went with a little bit too long, especially in terms of the dress business.

That all said, we're playing well in the bottoms business right now across all of our brands where we're seeing the proper silhouettes in denim, the proper rise, et cetera.

So to me, I'm not going to give you a split.

But the great majority of this, I think, as we've seen again with other people reporting, was really a factor that the -- it was just a very tough environment for apparel.

The independent data shows that, that was the case.

And we planned for a better month and to move the units.

We obviously, in Old Navy in particular, put some pressure on margins to move the units through the business.

Teri, do you want to add any more than that?

No, I think you said it well.

And we'll go next to Susan Anderson with B. Riley FBR.

You talked about, I guess, the baby business being a little weak at Old Navy.

I guess I was kind of curious, and maybe it's more kids related too across your format, did you see any impact potentially from the Gymboree liquidation?

Absolutely.

Hard to quantify it, but there was a ton of inventory that got pushed through the system in a short period of time.

And if you were in those stores, what you would have seen is that it was kind of 3 seasons that moved through simultaneously.

There was some fall and certainly holiday merchandise.

There was spring merchandise, and then there were the longer lead-time buys that they already had in the pipeline in terms of some summer product as well.

I can't tell you what the exact quantification of it is.

But as we looked at it when it was happening acutely, we saw it clearly in the business, and we saw it in the traffic numbers as well.

There was a distortion, we believe, in industry traffic associated with that liquidation.

So the good news is that's behind us.

We don't know if the consumer's going to sit on the sidelines having just eaten a big meal, if you will, in participating in the liquidation.

We're not really seeing evidence of that right now.

But if you have somebody like that with that many stores and that much product in the system pushing it out at very, very deep discounts in a short period of time, it is going to have an impact on anybody playing in the same space.

Great.

That's helpful.

And maybe just one follow-up, if I could.

If you could maybe just give some color, I was curious how the active wear category performed both at Gap and Old Navy versus fashion apparel.

Yes.

I don't want -- I'm not going to go into specific numbers.

We don't obviously give those out.

I would say that what we really saw in active is the same proportional performance that we've been seeing there, which is active as a category has for a while been growing above the rate of the overall ready-to-wear category.

We have experienced pretty consistently performance that has matched that.

And while even active, as you know, looking at us and others, has come down over that quarter because of it, we did see positive comps in Old Navy in that category, and we are continuing to be bullish across the entire space where we play in active.

It's a segment that is lifestyle-based.

It has above average growth, and we're going to continue to put our shoulder against it.

We'll go next to Paul Trussell with Deutsche Bank.

I know there's only so much commentary at this juncture to share around the split, but just curious around why we are waiting to the split to maybe take some of the more aggressive and dramatic actions around structural -- or around the structure of the business and some of the operational changes.

That seem to be coming once you all actually get to that point.

Well, let me just highlight where we are on the split is maybe the best way to do this because it's actually -- Teri is sitting here with a smile on her face because we're pushing, in many respects, harder than the comfort level is of the organization to move forward.

And I want to post as many points as I can as we're going through the split.

We're only a matter of a couple of months into it right now, since we announced it.

We did make it clear that we needed to announce before we could begin the real work.

We have what I describe as a bit of a luxury that you rarely get to really think deeply and do the analysis in the face of this catalytic event to drive very, very aggressive change, and that is the work that is underway right now.

I am concerned around obviously delivering performance quarter over quarter over quarter, but I am at least equally concerned about making sure that we're making the right structural decisions for both of these businesses in light of the environment that we're in, the evolving environment, the changing customers, to set these companies up for success.

And everything that we have heard and seen and talked with companies that have been through this is the caution to make sure that we are keeping our eye on the long game here that is going to be played out after both of these companies separate and become 2 separate operating companies.

So I would then -- also then caution you, which is just because it isn't necessarily public right now, don't assume that we're not doing very, very aggressive work under the covers.

And then the last thing I would say is respect the fact obviously that this has this kind of a split.

And the work that we're intending to do with respect to the operating model and the overhead structure, it has pretty -- a pretty profound impact on lots of people in this organization, and we are going to manage our way through that respectfully in terms of communication and making sure that the impact is managed appropriately as we work our way through this.

So we are certainly not throttling our ambition or throttling our work, but I want to manage through this in a -- yes, it's a very complicated thing, and I want to make sure that we get through it in a way where all the parts work when we come out the other side.

Absolutely.

And then just a follow-up, maybe just quickly update us on the store closures and what you're seeing from new store productivity with Old Navy.

Yes.

So on the Gap fleet restructuring, we said we expect to close about 230 specialty stores over the next 2 years.

Most of those -- many of those, 150 or so, will occur with natural lease expiration, and the remainder will be ones that we actively negotiate to close.

The closures for 2019 will largely happen in the fourth quarter.

So I would overall just call the program on track to deliver what we said that it would, and we definitely will keep you posted as we move through the year.

On the Old Navy new store productivity, as Art referred to earlier, they have a very attractive 4-wall model.

And that shows in the new stores we are opening, which is a part of what gives us such great confidence as we think about the growth prospects ahead for the brand.

So we are seeing the new stores perform at or above our pro forma expectations.

We're also seeing that as we invest in remodeling, which we've done initially quite thoughtfully as we tested the power of the remodels but then did in a larger scale last year and are continuing this year, and even there, we're seeing a meaningful lift in the sales as we invest in those stores.

So it just confirms that stores remain a very important part of the overall operating model not just for Old Navy but for all of our brands.

And so we're really pleased with what we're seeing there.

Yes, I would just pile on this one because it's super important.

And obviously, as we get to the September meeting that Sonia and I will host and then go into spring of next year as we're talking in more detail about both companies, one of the most important foundational cornerstones of Old Navy as a business is an exceptional 4-wall model.

And I'm a big believer that we are still a bricks-and-mortar retail -- retailer with an incredibly successful, fast-growing, complementary online business, but it all starts inside the 4 walls.

And nothing, and I would just underline nothing, has done anything other than give us confidence about the growth opportunity as we've continued to roll out stores in smaller markets and infill opportunities.

And as Teri mentioned, even very low scope remodels, which are largely a can of paint and a paintbrush, have yielded really good returns in terms of the lift in the business and the return on investment that we're making.

So -- and this is pretty foundational obviously to the growth thesis in front of the business.

We'll go next to Simeon Siegel with Nomura Instinet.

This is Dan Stroller on for Simeon.

On the DTC channel, I guess is there anything you can parse out with trends within that channel or expectations for the year?

And how should we think about margin dynamics in store versus online?

Yes, so no meaningful change there.

We did -- we continued to post strong results in online.

We -- the margin dynamics there are -- as we've said before, it's a profitable business and incrementally profitable.

An incremental sale in the online channel is accretive to us so really nothing new to report there in general, it just is a large attractive business and, as Art said, very complementary to how we think of our overall approach to the customer, which is she is using the online channel even if she's not shopping in the online channel.

And so we continue to learn from the customer journey to be able to tailor our response and provide an experience that is satisfying for her as she makes her final purchase.

And I would just add to that and say we're -- we are where she wants us to be, which is if she's moving and shopping more on her phone, we're definitely there with her.

We're seeing pretty encouraging metrics coming out of that mobile customer.

BOPIS, which, as you know, we lit up in Old Navy first, we're continuing to see the penetration go up there.

As you know again, and I'll just reiterate it right now, Old Navy is kind of -- BOPIS in Old Navy and BOPIS in any of our brands is a win-win-win-win.

It's getting a customer into our store who's highly qualified.

It's eliminating the below-the-line expense.

It gives us an opportunity to sell to the customer immediate gratification.

And as we continue to increase penetration there, we're really seeing how to tailor that capability for her, how to market it to her, et cetera.

So we're nothing but bullish on the continuing progress and stay the course aggressively on the DTC overall business that we have for all of our brands.

Okay.

Awesome.

And if I could just get one more, given the Gap brand marketing shift, how should we think about SG&A growth for the year?

Yes.

So we deleveraged this quarter.

As we look forward over the remainder of the year, obviously, we'll be continuing to drive operating cost discipline.

But inevitably, we will probably see some deleverage on the year, which is contrary to the trends we had been driving and really the objective of our productivity program.

So we'll be doing everything we can to bring that number down.

But at the moment, I think it's safest to expect some amount of deleverage as we really continue to invest in the marketing that we do think is important particularly as the product assortment strengthens in Old Navy and Gap.

And we'll go next to Ike Boruchow with Wells Fargo.

This is Lauren Frasch on for Ike.

I wanted to ask about Athleta.

Sales growth in the other segment slowed pretty precipitously to mid-single digits in the quarter.

Could you provide a little more color around Athleta's performance and how that reconciles with the accelerated openings this year?

Well, the accelerated openings are in front of us.

We did note the fact that this quarter, and the weather trends in the quarter, has broadly impacted the apparel sector.

I have 0 concerns about the health of Athleta, 0 concerns about the health of the brand, 0 concerns about customer engagement.

If I had to call something negative out other than macro factors is swim, partly also by weather, but swim was a tougher category this year, and it's something that we'll continue to look at.

I made some changes to the swim business when I was running Gap brand, and it can be challenging.

But that's really the place where I'd have to put my finger.

I think overall, again, we think Athleta is well positioned in the space that it's in.

It's got an incredibly loyal customer.

It is truly omni.

When you're dealing with some unprecedented unusual weather and she is standing on the sidelines for a moment, it is going to impact people, and I think you've seen that more broadly.

But 0 concerns about Athleta and nothing but absolutely bullish in the same way we had been about what that brand has in front of us.

And we'll go next to Randy Konik with Jefferies.

Teri, real quick, can you just reclarify the gross margin impacts from Old Navy versus Gap in the quarter?

And then as we think about the annual guide change, are we expecting most of the disruption in the earnings per share for the year to come out of -- mostly the second quarter or with gross margin the primary culprit and deleverage from lower sales?

I just want to kind of think through Old Navy versus Gap on the margin impact and then how we should think about the flow of the year on an earnings front to the annual.

That's a pretty complicated question, Randy.

Do you want me to just send my model over for you?

Well, it's a little bit of a complicated quarter.

It sure is.

It is indeed.

So let me kind of walk through how we see the quarter.

I -- we didn't get down to the specific margin delineation between the brands.

But as I said, the Old Navy inventory situation did drive a level of promotion that significantly affected the margin.

And as we've said before in this -- given the size and mix of the portfolio, as goes Old Navy, so goes the company.

And in this case, if you excluded Old Navy, we probably actually would have had some gross margin progress on the quarter.

So you can sort of take that for what it is.

As we move through, I see Q2 being our next most challenging quarter given the start to May coming in with a little bit heavier inventory and still having some of the lingering product challenges in some of those key brands.

Then as we move through the second half, and I realize the second half definitely looks like a bit of a hockey stick, but you have to keep in mind we're comping a second half of 2018 that was not our strongest.

And so we're effectively -- when you model all the way through it, saying we're going to do about the same as last year in the back half, so not a particularly aspirational goal at this point.

Certainly, what we're sitting here doing is figuring out how we can do better than that.

But that is kind of the construct that we see, with the back half showing the benefits of improved product, tighter inventory, better marketing plans, some specific programs in Gap, for example, as we really drive changes we've been making in the denim program there, so really driving those loyalty categories that have higher margin potential.

So the back half should be us getting back to better operation of the business model we know can win, and that's really sort of how the construct comes together on the year.

Understood.

Any other nuances just that we should be knowing about regarding the annual outlook?

Or is it just plainly the $0.40 reduction or whatever it is, is purely just a lower sales and just a mostly gross margin impact item?

I think that's largely what you're seeing.

We'll continue to work on the expense discipline of it.

But it's always a challenge, right, how aggressive do you want to be on short-term decisions that hurt long-term health.

And we just fundamentally believe, particularly as we go into the separation and we want these brands to be strong and healthy, that we're going to cut back but not do things that hurt the long-term health of the brands.

And we'll go next to Jay Sole with UBS.

I just want to follow up on the margin question.

So for the full year EBIT margin, it sounds like that the -- what was implied in the guidance before was around like an EBIT margin in the low 8% range, maybe now we're talking about something in the high 6% range.

If we look at the impact by brand, based on the commentary you're making about Old Navy, is it fair to say that, that brand will have a bigger EBIT margin decline for the year than the other brands?

Well, I mean, you're asking me to get down to a level of detail we wouldn't normally do.

What I would say is that given what we saw in the first quarter for Old Navy and how we would expect with the start of the second quarter for that to transpire, even though we will continue to get sharper on how we handle the inventory movement, we'll continue to have that pressure.

And just given the size of the business as we do that, you're likely to have a disproportionate impact on Old Navy versus what we expect to see in the other brands.

Got it.

And then maybe, Art, if I could follow up on just some of the opportunities created by the separation.

What will it mean for the type of opportunities and things you could do with real estate by having Gap sort of -- and Banana unencumbered from Old Navy and vice versa to give you some flexibility to maybe drive profitability or different improvements?

Yes.

I mean I would go less to real estate because I think we're pursuing the real estate objective quite aggressively right now.

And again, a big part of that is reducing our exposure to specialty while continuing to grow the channels that we believe are the future, obviously, including the direct-to-consumer, our franchise business, et cetera.

I would go a little bit farther upstream and just talk about our tech and logistics investment portfolio where we see pretty significant divergent needs between the business.

And we're already looking at those decisions that we're making right now whether it's systems or capabilities and thinking about how do we start mapping those decisions against the needs of the business as we separate the 2 companies.

Another place that again we'll talk about, and I don't want to get out ahead of where we are right now, is to really rebase the operating structure of what will be the remainder of Gap, Inc.

And this is something that I know Teri is passionate, and I'm passionate about it.

We've put it out there before.

There will be, as we communicated, some level of dissynergies, but at the same time, we're really going to use this as an opportunity to run the portfolio of brands differently to lighten up on corporate overhead and brand overhead as much as possible, as quickly as possible.

So stay tuned on this one, we'll obviously have more specifics.

Again, I would caution everybody that as impatient as you are, we're a couple of months into the work.

We want to do this work thoughtfully.

We want to do this work well.

But I can assure you that we're also doing this work very, very aggressively.

And I've used internally the expression that we're going to break some things, and I feel really strongly about that.

I do think when you're 50 years old as we are this year, that there are some things that you accumulate over time that become very comfortable, and if you don't break some things, therefore, that the organization can't go back to, you aren't going to achieve the kind of enduring change that we need and that this opportunity of the separation presents to us.

And we'll go next to Matthew Boss with JPMorgan.

This is Steve Zaccone on for Matt today.

So we just had a follow-up on gross margin.

Is your expectation for similar merchandise margin performance in 2Q relative to the first quarter?

And are you embedding merchandise margin expansion in the back half, once Old Navy is on better inventory footing?

And then outside of your own inventory actions, what is your view on the current promotional activity in the mall right now?

Yes, I'll start with that one.

Nobody is in a different position, quite honestly, than we are.

Maybe somebody got lucky and bought the quarter tighter or happened to have extraordinary marketing, but we've clearly seen promotional pressure as people have worked hard to get through the units that they had for Q1 against a lower consumer demand.

And then on top of that, the Gymboree liquidation and other liquidations that are going on.

So promotional pressure is going to be out there.

We've been watching very carefully as people have come out with their numbers to see where they are in inventory levels to get calibrated on Q2.

And then as Teri had said, we're taking a pretty aggressive approach towards our inventory levels in Q3 and Q4.

I would expect that other people would be doing that as well.

The good news from our standpoint is that we can take those units out but again, as we've referenced before, leverage our responsive capabilities if we start to see places in the business where we can put units profitably back in closer to the time that those units need to be in the store.

But it's -- it was clearly a promotional environment.

And that is, if you really wanted to wrap a bow around Q1, you would say depressed demand due to weather and aggressive promotions to move units through the system.

And that's really the story of where Q1 came in at.

Yes.

And unfortunately, that is kind of how Q2 starts as well.

So to your direct question of do we expect Q2 margins to look like Q1, no.

We do get smarter with each iteration of this, and so we would expect to be able to handle it with building on the learnings from Q1 in terms of how best to optimize margin while we move through those units.

So that's really what we're very much focused on, and we'll take that through the whole year.

As I said, we're very much focused on rightsizing our inventory buy, and we were able to effect that to some degree for Q3 and certainly for Q4 to reflect the revised expectations we're seeing in the market.

And so that should play through on the margin delivery as we move through the year.

We'll go next to Paul Lejuez with Citi.

Your guidance already assumes some declines in EBIT margin, I think operating cash flow as well.

And so I guess I'm curious, as you think about the synergies that are yet to come or if you don't see that hockey stick in the second half, does it make you rethink the ability of the organization with declining EBIT margins to -- the ability to absorb the dissynergies that might come with splitting things up?

Do you rethink things a little bit if the second half doesn't work out as planned?

Yes.

So maybe a couple of ways to think about that -- and Art, feel free to chime in -- is as we thought about the separation and we modeled the likely implications of dissynergies and the cost to actually effect the execution vis-à-vis the value-creation opportunity that it presented, nothing has changed with respect to our assumptions there because we've started the planning work.

There's nothing to indicate that what we thought we could achieve by virtue of launching these 2 companies with the ability to more effectively compete in their respective spaces within the industry.

That all remains intact, so I don't see anything about our performance over the course of this year that indicates that fundamentally, the decision we've taken should be changed or reconsidered.

We do have, obviously, the luxury of a very strong balance sheet.

The choices we've been making to invest are all investments that we feel good about the ability to deliver a return on over time, and that's exactly how we view the cost to execute the separation as well.

If we moved forward, and for some reason something changed with regard to our expectation for value creation or the cost to separate, we obviously would be responsible and look at that and reconsider.

But we're just nowhere near that at this stage with everything we know about the potential for the business on a combined basis and on a stand-alone basis and the ability that -- or the expectation for cost to separate.

Yes.

I would just -- I would actually start this with looking at the consumer.

And I think that you can largely explain what happened both to us and to others in Q1 by the consumer rationally slowing down her apparel purchases because of volatile and unusual weather.

There are some other factors out there as well, which is we are in an environment that's a bit of a flat spot relative to a compelling trend, especially in bottoms, that is causing her to get out and go shop with urgency.

We've seen those things before.

They come along once in a while.

Inevitably, they're overtaken by the fact that a compelling trend does come along and she wants to refresh her wardrobe.

I think it would be profoundly shortsighted to question the wisdom of the separation of the company, which we've looked at from upside down and center and every place else around the business logic of doing this on the basis of a very, very unusual quarter.

If I thought that somehow that quarter represented a fundamental overnight step-function change in the structural profitability of this industry, that would be a different consideration.

But consumers don't change their spending patterns overnight.

This is imminently explainable, and we are staying the course because we are absolutely convinced that this is the right thing to do for long-term value creation.

I guess, Art, the context is that -- it's like -- I think this will be the sixth year of EBIT margin contraction.

And so I guess is there anything that you're seeing if things were to accelerate in the back half that would make you take that longer-term view of what's happened to the business and think that you just don't have the cushion to absorb the dissynergies to take margins down further?

We're not going to do something that imperils the company.

That would be irresponsible.

And Teri will nod her head when I say that people have been hearing the words cash flow coming out of my mouth a lot right now because that is my starting point for looking at the launch point for these 2 companies and to make sure that we have strong cash flow and forward-looking cash flow out of both organizations.

Of course, if there was something that caused significant deterioration that imperiled the viability, the cash flow production, the operating profit of these businesses, we would take a second look at that.

I don't anticipate it.

To me, in a way, again, as I said in my comments, that you're noting of the continued divergence and the impacts on operating profit, which, as we've indicated over time, has been significantly driven not out of Old Navy, which has been largely healthy, but out of Gap brand, increases the urgency to get this done because it allows us to maneuver differently and to operate differently.

And if anything, it's overdue.

Our last question will come from the line of Janet Kloppenburg with JJK Research.

Teri and Art, I heard a different strategy about the Gap brand in the first quarter, maybe profitability improved, comps fully depressed.

I'm wondering if this is something we should expect going forward that you want to lower the promotional profile of the brand?

Or if we should expect a pivot in comps as we move forward?

Perhaps you could talk a little bit about the strategy that you engaged in, in the first quarter and what we should expect for the brand as we go through the remainder of the year.

Yes, I don't -- thanks for asking the question.

I actually don't think it's a different strategy at all.

I mean taking the decision to close stores, stores that were unprofitable.

And in many cases, stores, the reason that they were unprofitable was a combination of the productivity of the store but also the promotional intensity of the store.

A lot of these stores are in places where the center that they're in has become more of a value-oriented customer, more of a promotional customer.

So our willingness to take unprofitable top line out of the business to restore the health of the brand, that is what we're committed to right now.

We do need to lower the promotional intensity of the business.

I don't know that, that necessarily means that we have to take the kind of negative comps that we've been looking at over time.

But we are going to continue to push to restore profitability in the business partly because we want the brand to be profitable and partly because profitability of the business and seeing a positive margin comp relative to the sales comp is an extraordinarily important, leading-edge indicator of the health of the business.

So I'm not going to signal what our comp objectives are going forward.

Obviously, I'll be the first one to say I want positive comp.

But more importantly, I want a positive foundational core to the business where we're establishing pricing authority and customers are paying us for what our product is worth.

So are you confident that the new team that's operating Gap will be able to make progress on the merchandising front so that the brand resonates better at a full price level going forward?

Yes.

You used a bit of a loaded word there, which is full price.

The great majority of the industry is what they call blended, which is a combination of full price and promotional.

Do I think we're going back to a -- what somebody tells me existed somewhere back in the dawn of time, a full price business?

I don't think that's the reality of these categories that we play in right now given the competitive environment that we're in.

And I'm confident that the team in New York through the merchandising strategies that they have, through the tools we've put in place, through the operating discipline, the marketing, store presentation, all the pieces that have to come together, that we can increase our yields.

I am absolutely confident, and you saw proof of that happening while we were moving through units in Q1.

Thank you.

That does conclude our conference.

You may now disconnect.