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Edited Transcript of GPS earnings conference call or presentation 22-Aug-19 9:00pm GMT

Q2 2019 Gap Inc Earnings Call

San Francisco Aug 27, 2019 (Thomson StreetEvents) -- Edited Transcript of Gap Inc earnings conference call or presentation Thursday, August 22, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Arthur Peck

The Gap, Inc. - President, CEO & Director

* Teri L. List-Stoll

The Gap, Inc. - Executive VP & CFO

* Tina Romani

The Gap, Inc. - Senior Director of IR

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Conference Call Participants

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* Alexandra E. Walvis

Goldman Sachs Group Inc., Research Division - Research Analyst

* Dana Lauren Telsey

Telsey Advisory Group LLC - CEO & Chief Research Officer

* Irwin Bernard Boruchow

Wells Fargo Securities, LLC, Research Division - MD and Senior Specialty Retail Analyst

* Kate Bridget Fitzsimons

RBC Capital Markets, LLC, Research Division - Associate VP

* Lorraine Corrine Maikis Hutchinson

BofA Merrill Lynch, Research Division - MD in Equity Research and Consumer Sector Head in Equity Research

* Mark R. Altschwager

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Matthew Robert Boss

JP Morgan Chase & Co, Research Division - MD and Senior Analyst

* Oliver Chen

Cowen and Company, LLC, Research Division - MD & Senior Equity Research Analyst

* Paul Lawrence Lejuez

Citigroup Inc, Research Division - MD and Senior Analyst

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Presentation

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Operator [1]

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Good afternoon, ladies and gentlemen. My name is Cody, and I'll be your conference operator today. At this time, I'd like to welcome everyone to The Gap, Inc. Second Quarter 2019 Conference Call. (Operator Instructions)

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

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Tina Romani, The Gap, Inc. - Senior Director of IR [2]

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Good afternoon, everyone. Welcome to Gap, Inc.'s Second 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 contain 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 non-GAAP financial measures, as noted on Page 2 of the slide 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 August 22, 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.

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Arthur Peck, The Gap, Inc. - President, CEO & Director [3]

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Good afternoon, and thank you for joining us today.

I'll start with an overview of the quarter at the enterprise level and then walk you through our performance by brand, and there, Teri will take you through the financials.

Our separation activities remain on track, and we're making excellent progress. We'll provide more details at our September 12 Meet the Management event.

Turning to our results, traffic remained a challenge, which contributed to overall demand falling below expectation. Our inventory levels going in, combined with the competitive environment, resulted in elevated promotional activity to clear through inventory once the weather turned. We have more work to do to position ourselves for consistent delivery in this challenging retail environment, but we have a clear action plan in place and are seeing sequential improvement in the areas that will drive improved results, better product quality, acceptance, increased responsiveness, marketing effectiveness, improved productivity and an optimized store fleet.

We'll talk about these as Teri and I go through the brand results and even more at our Meet the Management event in September, but let me spend a moment on inventory productivity, which is a key element in improving our go-forward results.

In the quarter, we were disciplined in managing inventory, and I'm pleased that each of our brands ended the quarter largely clean from a liability inventory perspective. We've adjusted back half inventory buys to better match the traffic trends that we're seeing, adjusting Q3 as much as possible and even more aggressively adjusting Q4. As it stands today, we have planned our back half inventory to be down. We will use our responsive capabilities to chase into units as the quarters actualize and demand materializes. Increased focus on operating discipline, improved execution and measured investment in marketing and talent across all brands is driving slow but positive momentum that gives me confidence as we head into the important back-to-school and holiday seasons.

While I'm optimistic about the progress we'll see in the back half, our results and performance across the industry demonstrate the need for continued discipline around SG&A, reducing inventory commitments, increasing store conversion and improving marketing effectiveness.

With that in mind, let me take you through how we're thinking about our current performance and positioning, beginning with Old Navy.

Just to start and to remind you, Old Navy is an exceptional business with exceptional economics. It's a big box, family value, category killer with excellent 4-wall economics and a disciplined cost structure. It's grown sales and comp over the last 3 fiscal years, and we see a lot of white space for continued store expansion that you'll hear about in September. We know the fundamental economic model works, and we have had some significant misses on execution. Let me remind you of where we've been so you can better understand our outlook for the second half of the year.

As we moved into Q4 last year, softness in women's became more broad-based. The team quickly began to diagnose the drivers of the issue and determined the product offering was too narrow. She wanted more choice and more newness. Because this diagnosis came over holiday, we were limited in our ability to meaningfully impact the first 2 quarters of the year from a product design and merchandising perspective, and this is reflected in our results.

The teams began a redesign of Q3, incorporating the key learnings to the extent that they could. And since work on Q4 had not yet begun, the holiday assortments, the commercial and marketing plans were all built from the ground up with the benefit of key learnings from Q4 2018. In addition, as we saw slowing traffic trends at the start of this fiscal year, we worked to cut units out of Q2 and brought inventory leaner to reflect trends.

So coming back to Q2, while I'm obviously not pleased with our performance, we did come into the quarter knowing it would be challenging. We knew the product wasn't quite where it needed to be, and we reacted quickly.

During the quarter, the teams appropriately focused clearing through summer product and ending the quarter clean in order to better position the redesigned fall product for the important back-to-school season. As we look ahead to Q3, we are still facing some challenging traffic trends. Teams are hyper-focused on this.

And while we hit a bump in the road in the past with product issues, there has been predictable latency in terms of traffic catching up. Understanding this dynamic, we're leading with our strengths in the back half from a product perspective, specifically leaning into denim, where we are pleased with the results; active, which is performing; and fleece, which we believe we have a lot of upside in, all of which had positive comps in Q2. We're amplifying our category strengths with focused, powerful marketing to drive brand relevance and buzz, and we're also implementing traffic-driving initiatives to bring her back into the store.

Most recently, we remerchandised inside the store in terms of product placement 50 Old Navy locations. And while we did this very recently, we're seeing very early but positive results that we will intend to roll across the Old Navy fleet as we read the test results.

While the first half has been challenging, there's a lot to be proud of, and even more, we're excited about the future. Our views on the fundamental strength of the business and the power of the Old Navy brand remain unchanged. Old Navy's market share position holds strong at 3.1%. It remains the #2 largest apparel brand and the #9 largest retailer according to NPD.

Before I move from Old Navy, I also want to talk about the talent shift we recently made as the brand moves toward operating as a standalone public company.

Last month, we announced that Nancy Green, who has served as Brand President of Athleta for the last 6 years, will join Old Navy. This is Nancy's third time at Old Navy and unites the product and marketing functions under a single leader. This will provide significant support to the Old Navy CEO, Sonia Syngal, as her remit expands to leadership over a public company.

We've not yet named a replacement for Nancy at Athleta, but this is quite honestly a coveted role and interest has been tremendous. In the meantime, we have a strong aligned senior leadership team guiding the brand, and I am providing additional support to that team until we're ready to name a new leader.

Now let's turn to Gap brand. Traffic remains challenging, and it's the biggest challenge of the brand. But it's also important to note, as we've previously called out, that we intentionally shifted marketing dollars to very late in Q2 and into Q3, corresponding with Gap brand's new denim launch and back-to-school. Despite the traffic challenges, we did see all channels of the brand deliver positive sales over traffic for the quarter, indicating improvement in the customer respond to product.

Gap is an excellent example where the intense focus of the team on operational discipline is beginning to show results. We've made meaningful improvements to the product and to the brand with tighter strategic priorities, process improvements and talent and structure changes.

Women's bottoms is a bellwether category. When a turnaround starts, it's around the bottoms customer. That's why we've been so focused on accelerating denim. While the product has only been in stores for a few weeks, early returns are very encouraging.

As we look ahead to the back half of the year, we have a better assortment, increased marketing investment, momentum building in denim, a tops-to-bottom ratio that is in the right balance and inventory's in better shape, leaner and with liable down 25%.

In terms of product marketing at Gap brand, our focus for the fall is clear: kids and baby for back-to-school and denim. There are clear areas where we can and will win and where we're ready to reassert the authority of the brand. Over the past few weeks, you may have seen our marketing campaigns in both of these areas, and we'll continue to turn up the volume in this space.

Our specialty store fleet rationalization efforts at Gap brand are also on track. We'll provide more detail here in September. And we're also experimenting with some promising new store formats of the brand as well as low-investment improvements that make a major difference in the experience of our customers.

For those of you in New York, please consider visiting our Flatiron location at 17th and 5th to see how minor changes can make a big difference when you put great products, in this case, denim, front and center. For those of you outside of New York, I would encourage you to stop by Garden State Plaza and see how this concept executes in a traditional mall environment.

Gap is a large and complex business. And when we say Gap brand, we're really referring to an assortment of components, including a specialty business, an outlet business, online channels and an international footprint. To that end, let me highlight an area of demonstrable progress, Gap Outlet.

We brought that part of the brand under new leadership a little over a year ago, and now we've seen 5 consecutive quarters of positive SOT and 4 quarters of positive gross margin over traffic. Trend is improving. Finally, while the comp sales at Gap brand this quarter were unsatisfactory, this is a brand that remains powerful and relevant. To give just a couple of examples, while anecdotal, our loyalty program has now launched across all Gap brand stores and, in July, surpassed 5 million members, who tend to spend 20% more than nonmembers.

We also see strength in demand globally for Gap logo product. Based on units sold in fiscal '18, an interesting statistic is that we sell 1.3 Gap brand logo products a second, 365, all around the world.

Let's move to Banana Republic. While Q2 results at BR are disappointing, we did deliver a positive June, cleared inventory and settled in the new field organizational structure, which had gone through significant changes in the first quarter. The first August flow hit stores, the initial response is positive, though traffic remains down at the brand.

As we've already discussed, increasing traffic starts with improving product. From a product perspective, we've had a carryover of basics at Banana that we referred to previously, which has made it harder for newness and fashion to cut through in our stores. We're addressing that by working to grow capacity with our fastest spenders, to have more depth and confidence in key products with a clear point of view and to cut through in stores with a flat or higher gross margin.

We're also innovating at Banana to make it easier to shop and to attract the younger customer. Buy Online Pickup in Store will launch later in August in BR. And in September, consumers will be able to take advantage of a rental subscription service we're calling Style Passport.

Finally, to Athleta. I'm pleased with the acceleration of the Athleta business from Q1 as we cleared through the softer swim categories and the momentum we see as we head into the second half of the year. We've reinvested in marketing of the brand, which drove increased demand and healthy customer growth. And we're on track to end the year with 185 Athleta stores, and we're accelerating store openings with approximately 25 new stores this year.

As we look at the second half, the team is excited about the launch of SuperSonic, a new, highly technical, fair trade-certified fabric made with recycled nylon from pre-consumer waste designed specifically for high-intensity activity. This has helped reduce 15 tons of waste to date, which interestingly is enough to wrap around the earth 247 times. More importantly, the early reads on consumer acceptance and engagement with the various products that this fabric is in has been very positive.

Perhaps one of the most exciting developments for Athleta this quarter was the announcement of our first-ever athlete sponsorship with Allyson Felix. Allyson is the most decorated female track and field athlete in U.S. Olympic history. Allyson, who we'll as an athlete and as a mother and an activist, will wear Athleta in competitions and in her daily life and will continue to work with us to enhance the technical performance of all of our products.

I'm really excited about our partnership with Allyson and all the new programs we're launching across NewCo brands like inclusive sizing at Athleta; the rental subscription service we're launching, first at Banana; a personalized digital experience we're testing in Athleta; and the loyalty program being offered across all Gap brand assets.

Programs like these will provide key learnings and insights that can be leveraged across the portfolio to drive process improvement, innovation and growth.

We're also incredibly proud of new initiatives announced this year that highlight our commitment to inclusivity and sustainability across the company. In June, we partnered with the United Nations Foundation during Pride Month to raise awareness and funds for the United Nations Free & Equal campaign to promote equal rights and fair treatment for lesbian, gay, bisexual, transgender and intersex people globally.

We also see climate change fundamentally as a human rights issue as well as an environmental and business issue. We recently announced the signing of our largest renewable energy contract, which is one of the largest offsite renewable energy contracts by an apparel retailer and is the third renewable energy contract signed by the company in the past 18 months.

Building on the commitments established by several of our brands, Gap, Inc. also announced an enterprise-wide goal to source 100% of cotton from sustainable sources by 2025. By sourcing sustainably farmed and sourced cotton, we're supporting farmers who use water efficiently through better irrigation practices.

As we move towards separation, investments like these are one thing that won't change as we become 2 independent companies. There are commitments we have made to our employees, our shareholders and our customers around the world.

I look forward to talking to you more about the planned separation when we meet in September.

And now I'll turn it over to Teri to take you through the detailed financials. Teri?

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Teri L. List-Stoll, The Gap, Inc. - Executive VP & CFO [4]

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Thanks, Art, and good afternoon, everyone.

As Art indicated, our results this quarter are not where we want them to be. We talked about the tough start to May in our last call. And despite sequential improvement in comp trends at all brands, with the exception of Banana Republic, the tough start weighed on the quarter. That said, I am pleased that we have continued to make progress in 2 key areas: operating discipline and productivity. Let me use inventory as an example.

Again, while not fully where we want to be, we made progress with ending inventories clean and second half planned receipts much leaner. We ended the quarter with inventory favorably positioned versus Q1.

In the productivity area, we continue to leverage the work initiated last year to inform the operating model design and spending targets of the 2 planned new companies. We are seeing meaningful cost savings in the current year, but more importantly, the productivity mindset is taking hold as a part of our culture.

Turning to second quarter performance. As a reminder, our reported results include approximately $70 million in costs associated with our planned separation, certain tax adjustments related to new guidance from the Tax Cuts and Jobs Act of 2017, and costs related to our previously announced fleet restructuring. We've excluded these costs in our adjusted results and comparisons to provide a better view of the base business.

So starting with sales. Net sales for the quarter were $4 billion, down 2% to last year. Comp sales were down 4% compared with positive 2% 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 Gap store closures.

As Art talked through, while disappointed with the by-brand comp performance in Q2, we're more confident with the setup heading into the third quarter with the work the teams have done to strengthen product, particularly in key categories like denim, in addition to the adjustments we've made to our inventory levels and in our commercial and marketing plan.

Moving to gross margins. Our second quarter gross margins were down 90 basis points to 38.9%, an improvement from our original expectation. Old Navy continued to be the primary driver of deleverage in the quarter. Merch margin was down 70 basis points, primarily driven by Old Navy, partially offset by Gap brand.

As Art discussed, the margin deleverage at Old Navy was primarily driven by our efforts to clear the underperforming women's products and summer liable in order to end the quarter clean and to better position the improved fall product.

At Gap brand, the team continues to focus on maximizing yield through improving product assortment and a leaner inventory composition.

Rent and occupancy deleveraged 20 basis points, primarily driven by lower net sales.

Regarding SG&A. On a reported basis, second quarter total operating expenses were $1.3 billion. When excluding costs associated with our planned separation and fleet restructuring, SG&A as a percentage of net sales deleveraged 40 basis points, again primarily driven by the lower sales.

Given the challenging business, we remain prudent on expenses within our control, which helps drive the improvement from Q1 trend.

Moving to taxes and interest. The effective tax rate was 38% for the second quarter. Excluding the impact from adjustments to our fiscal 2017 tax liability related to tax reform guidance issued during the quarter as well as the noncash tax impacts related to restructuring charges, our normalized tax rate was about 12 points lower. We expect our full year reported effective tax rate to be about 30%.

Excluding the current quarter onetime adjustment to our fiscal year 2017 tax liability for tax reform guidance and certain noncash tax impacts related to expected restructuring charges, we continue to expect our full year adjusted effective tax rate be about 26%.

Turning to earnings. On a reported basis, earnings per share were $0.44. Excluding costs associated with separation and specialty fleet restructuring, our adjusted earnings per share were $0.63. FX was a detriment of about $0.01 for the quarter, though we do not expect FX to have a meaningful impact for the year.

On inventory. We ended the quarter with inventory up 6% compared to last year. Consistent with Q1, there were a couple of drivers behind the increase, including about a 3-point impact driven by an increase in in-transit time, about a 2-point impact from the Janie and Jack acquisition and about a 1 point impact from store openings, net of closures.

On a normalized basis, that means inventory was about flat to last year, a significant improvement from normalized Q1 levels, which were up 5%. While we have more work to do, I'm pleased with the progress and the engagement within the organization to improve inventory productivity. We've invested in many of the core capabilities that should eliminate the waste in our buying process, including responsive capabilities that allow us to reduce the risk in our buys and chase into styles that are working. We're driving leaner initial buys and building stronger open-to-buy processes that better leverage the responsive capabilities we have built. We expect inventory levels to continue to decrease in the back half to approximately negative low single digits while noting that in-transit could cause fluctuations in this point-in-time metric on a reported basis.

Ultimately, over time, we would target inventory growth at less than the rate of net sales. We also will be working to improve allocations based on channel demand and localizing our assortment. Improvements in each of these areas are expected to drive higher yield and gross margin return on investment as well as improve our working capital profile.

Turning to cash flow. Year-to-date, free cash flow was $259 million, an increase of $39 million over last year. We ended the quarter with $1.5 billion of cash, cash equivalents and short-term investments, ahead of our historical target of $1 billion to $1.2 billion. Year-to-date capital expenditures were $324 million.

As we mentioned last quarter, there are meaningful capital investments needed to facilitate the separation, primarily in technology and logistics. We continue to assess the expected capital needed to execute the separation, and we'll provide updates as we move forward.

We continue to expect our fiscal 2019 capital expenditures to be about $675 million, inclusive of: $100 million of nonroutine expansion costs related to one of our headquarters buildings and the build-out of our Ohio distribution center; and $575 million of base capital, with priorities continuing to be focused on profitable growth opportunities at Old Navy and Athleta, and investing prudently in technology and supply chain initiatives that position each of the future companies for sustainable growth.

Additionally, we remain committed to returning cash to shareholders. We completed an additional $50 million of share repurchases during the quarter, and we continue to expect to repurchase approximately $50 million per quarter for the balance of the year.

Our philosophy has not changed, and we remain committed to our dividend. Year-to-date, we paid dividends of $183 million.

Regarding store count. Year-to-date, we added 39 Old Navy and Athleta stores on a net basis and acquired 140 Janie and Jack locations. At Gap brand, we closed 16 stores, primarily in North America, net of openings primarily in Asia. We ended the quarter with 3,356 company-operated stores. We continue to expect 30 net store closures for the year.

With regard to our earnings outlook for the remainder of the year. On a reported basis, we now expect earnings per share to be in the range of $1.88 to $2.08 for the full year. For the full year, we now expect restructuring-related costs to be about $0.14 versus our prior guidance of $0.29. This reduction in cost is primarily related to the shift of certain lease buyouts from 2019 to 2020. We remain on track to close about 230 specialty stores by 2020, and we continue to expect total cost of the program to be about $250 million to $300 million, with the majority expected to be cash expenditures.

For the full year, we now expect costs associated with preparing for and executing the separation to be in the range of $0.20 to $0.30. I would caution that this is still a preliminary estimate, and we'll provide additional information and context as we move forward.

Excluding the first quarter gain on the building sale, costs associated with preparing for and executing the separation, restructuring costs and any related tax impacts as well as the second quarter tax reform adjustment, we continue to expect adjusted earnings per share to be in the range of $2.05 to $2.15.

Regarding gross margin, let me take a second to give you some color around the cadence of the back half of the year.

For the third quarter, we expect gross margin deleverage to be slightly better than our first half trend. For the back half, we expect year-over-year leverage to be about flat as we lap the easier fourth quarter compares from last year.

Regarding tariffs. As others have mentioned, we continue to closely monitor the tariff discussions. Our teams have contingency plans in place for the back half related to the List 4 tariffs, including partnering with our vendors to share in the cost as well as pricing actions.

On pricing, the teams are working on a targeted pricing strategy in certain categories where we have pricing authority versus a broad-based increase in pricing. The unmitigated impacts of List 4 tariffs would be an incremental $0.06 impact to our guidance based on current estimates, though through our mitigation and contingency plans, we would expect this impact to be much lower.

Let me close by reiterating our confidence and conviction in our plan to launch Old Navy as a standalone public company. We believe this best positions both companies to compete effectively in this evolving retail landscape. Our short-term priorities remain unchanged, and we expect that focus on operational discipline to deliver continued progress as we move through the year.

And with that, we'll open it up for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question will come from Mark Altschwager with Baird.

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Mark R. Altschwager, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [2]

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Looking at Old Navy, I know you are planning a tougher quarter there, but can you give us a sense of what you're seeing behind the scenes that's giving you the confidence that some of the process and assortment fixes are in place? And any lingering issues that would keep Old Navy from comping positively in the back half?

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Arthur Peck, The Gap, Inc. - President, CEO & Director [3]

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Yes, thanks. I sort of detailed a bunch of things, obviously, that we've been working on for a while as well as moving Nancy in there as well. And I think it's really a combination of all of the above as we look at really understanding and diagnosing where we had issues. And again, as we noted, they're primarily in places in the women's assortment and making those changes as we got into Q3 and Q4.

What I didn't spend a lot of time on -- also on in the call is -- or in my statement is that we're looking at really digging exceedingly deep on our marketing effectiveness to make sure both that we've optimized the mix, that we have the right amount of money going against marketing, and that we're getting the pull out of the creative content. So this is a no-stones-unturned basically push against the business to make the business perform the way that we know it can perform.

So I'm not going to make a call here on what we expect to see in Q3 and Q4, but I have confidence in the business, as I stated upfront. It's an exceptional 4-wall model. I know what the runway is in front of the business. And as I noted again, there are some foundational categories where we have continued to see strength, denim being a critical one, active and fleece being other ones as well. And those are really important loyalty categories.

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Teri L. List-Stoll, The Gap, Inc. - Executive VP & CFO [4]

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Particularly as we go into fall, those are the categories we'll be leaning into, as Art said in his comments. And while we expect to see progress in the product assortment in fall, I just wanted to point out that it was really holiday when we had the opportunity to really start from scratch. So it will be more like sequential progress from fall into the holiday assortment.

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Arthur Peck, The Gap, Inc. - President, CEO & Director [5]

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And then the other piece is just -- Teri went into this and I mentioned it briefly, is where we are on liability. And we feel like we're in a very good spot from an inventory standpoint. And when you're pushing a bow wave of liability and you're trying to fix a product problem simultaneously, it's tough. We are not pushing a bow wave of liability. We're in very good shape from a clean inventory standpoint.

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Mark R. Altschwager, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [6]

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That's great color. Maybe just a quick follow-up. The other revenue really reaccelerated this quarter. I know there's a few things in that line, and you mentioned some positive trends at Athleta. But any more detail you can share on the drivers there?

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Teri L. List-Stoll, The Gap, Inc. - Executive VP & CFO [7]

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Yes. The biggest piece of that, of course, is Athleta, and we are very pleased with the growth. But as you'll recall, with the revenue recognition changes, that's also where our credit card income is as well now. And so there were some stronger trends there as well. Largely due to some timing issues, we don't expect a big change in credit card for the year. But definitely, in the second quarter, first half, there were more favorable trends playing through. But the bulk of it is Athleta, and we feel very good about what we're seeing there.

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Operator [8]

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We'll take our next question from Paul Lejuez with Citi Research.

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Paul Lawrence Lejuez, Citigroup Inc, Research Division - MD and Senior Analyst [9]

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Can you share your assumptions maybe where you expect, by brand, to see the biggest improvement in the back half? Are you looking for positive comps for any brand by the time we get to the fourth quarter? And then just separately, I'm just curious if -- right now we're dealing with a 10% tariff situation. Art, if we were faced with the 25%, does that change your view on the split of the company into 2? Is that something that's better to tackle as a combined entity? Or do you just stay the course?

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Arthur Peck, The Gap, Inc. - President, CEO & Director [10]

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Yes. So on the first one, I don't -- we're not going to call out comp trends in the back half. We've been -- I think we've been pretty clear that we want quality revenue and that we are focused on yield. And an early indicator to me of getting strength back in the business will be, and in places we've seen this, where we're seeing a positive spread over our gross margin dollar comp versus our sales comp. Called that out in Gap Outlet.

And so I think in this environment, you have to focus on quality revenue, first and foremost. And that's why we've been super tight and lean on inventory, why we are keeping inventory open, why we are reserving the right to use responsive capabilities where we see that we can feed some fuel into the businesses. And right now we're using that, as we've seen some success in Gap denim, to put some additional units to support the denim business with the fall launch.

So it's really a quality revenue issue, first. And do I hope for positive comps? Absolutely. But I want to see that on a foundation of quality revenue rather than we're out there getting a bunch of units through system, and it's low-quality revenue. So that's number one.

On the tariffs, we're -- we are -- as Teri noted, we're steadfastly focused on executing. I'm pleased with where we are on the tactical work associated with building the platform for the separation of the companies. The business reason, which is what we've been calling out all along for doing so, remains intact.

We're going to use all the weight of this company to participate in the conversation to protect the American consumer. We do not think these tariffs are a constructive -- they have a constructive impact on the consumer. Teri noted that we're working to mitigate them.

Rather than speculate about contingencies, I'd just say we're focused right now, and obviously, we're reading all aspects of the environment that we're operating in as we do the work to make sure that we are confidently that on the right course. And we are quite confident that we're on the right course now.

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Operator [11]

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We'll take our next question from Dana Telsey with Telsey Advisory Group.

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Dana Lauren Telsey, Telsey Advisory Group LLC - CEO & Chief Research Officer [12]

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Just going back to Old Navy for a moment. I think when the quarter started, May started off soft. What did you see as you went throughout the quarter? And I saw the denim customizations studio in Flatiron, so definitely experience is becoming more part of it. Are we going to see anything like that in Old Navy? And with the down 5% comp that you had, should it improve as we go through basically from product or promotions? How are you thinking about it?

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Arthur Peck, The Gap, Inc. - President, CEO & Director [13]

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That was a lot of questions, Dana. So I'm glad you saw Flatiron. We were pretty excited about how that store showed up. And obviously, there are some elements in there that you're not going to see every everywhere, which is why I called out Garden State Plaza, which is a pretty traditional mall-based store in a center that's been around for a long time, just to see how the presentation shows up there.

What you will see executed in every one of our Gap stores is a proud front-and-center denim moment where we stand for denim and windows that support that. And we feel like she's getting that and she's seeing the new fits that we have, and she's reacting to it quite well.

On Old Navy, a positive comp is going to come back, first and foremost, because of product acceptance. We are tight on inventories, but we know we have room from an AUR and a yield standpoint even with tight inventories, plus bringing to bear our responsive capabilities to feed units into the business.

So I don't want to call -- again, I'm not going to call what we're going to see in the back half, but I am confident in the business. And all the consumer metrics, the NPS, et cetera, et cetera, are all still very strong in the business. And we know we've got some product issues that we're well into the way in fixing. And like I said, we're turning every other stone as well just to make sure that we're not missing something along the way where we need to be. And then we're continuing to put marketing in to support the business really across all of our businesses.

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Teri L. List-Stoll, The Gap, Inc. - Executive VP & CFO [14]

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And with that, Dana, to your first question of what did we see within the quarter. We definitely saw sequential progress as we moved from May. Once the weather inflected and the product was more seasonally appropriate, we definitely saw sequential progress from June and then into July.

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Arthur Peck, The Gap, Inc. - President, CEO & Director [15]

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And I would -- let me just comment on weather for a second because I just had my senior leadership team together yesterday as we were looking at the business and looking forward. And the weather for the rest of August, September, October, November, December is right in the middle of the table, which -- and we've increasingly built this into how we think about our commercial plan, whether we should put the pedal down and move some product if we're going to be looking at unseasonable weather, or whether we should keep our powder dry if we know that the weather is going to turn.

As we look at September, we believe that the weather pattern should be favorable and should, for most consumers around the country, really pretty definitively signal a seasonal change into fall. And that is something that has historically been a good indicator for the business.

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Operator [16]

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We'll now take our next question from Matthew Boss with JPMorgan.

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Matthew Robert Boss, JP Morgan Chase & Co, Research Division - MD and Senior Analyst [17]

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Maybe, Teri, on the gross margin. So slight improvement in 3Q relative to the 122 basis points of contraction in the front half implies roughly 100 basis points of expansion in the fourth quarter. How would you rank the drivers of that inflection and just your level of confidence?

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Teri L. List-Stoll, The Gap, Inc. - Executive VP & CFO [18]

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Well, maybe slight, we have to define better. But I would just point out that as you think about the compares we're going up against combined with the sequential progress we expect to see in the business, there would be meaningful margin expansion in Q4 versus last year just because of when you look at the combination of those 2 factors. But the slight might be a bigger improvement in Q3 than you're factoring in.

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Matthew Robert Boss, JP Morgan Chase & Co, Research Division - MD and Senior Analyst [19]

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Okay. And then maybe, Art, just to follow up. In light of your comments regarding the challenging traffic trends heading into 3Q, just any early thoughts on back-to-school for either Gap or Old Navy and just your confidence as we head into that important season?

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Arthur Peck, The Gap, Inc. - President, CEO & Director [20]

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Yes. I've watched as I've seen other come out and give some pretty definitive statements about how they see the business based upon pretty short amount of selling. And I think as I've mentioned in previous calls that we've had, is that year over year over year, we've really seen back-to-school become a less acute event and for that demand to spread out really from a July period into post-Labor Day, depending upon climate, school openings and those kinds of things.

So we're -- frankly, we're focused on driving traffic and driving sales across of that whole period. Labor Day is big for us. We think the weather trends are going to be attractive. We've adjusted inventory trends to match with where we think the Q3 is going to come in. So I'm focused frankly on delivering the entire quarter, to be honest, and would rather not comment on what's really only a couple of weeks as the season starts to spool up.

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Operator [21]

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We'll hear now from Kate Fitzsimons with RBC Capital Markets.

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Kate Bridget Fitzsimons, RBC Capital Markets, LLC, Research Division - Associate VP [22]

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Art, definitely appreciate the more conservative view on inventory units into the back half. Just as we work to get Old Navy back on track, can you speak to chase capability at that brand that makes you think that you can access the units you might need in order to drive comp improvement? Or should we think of the back half as really more of exclusively an AUR recovery story? Just where are we broadly with lead times in that business and flexibility on the sourcing side? And how are you feeling about the supplier base there, or just any disruptions to note in light of the trade tension?

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Arthur Peck, The Gap, Inc. - President, CEO & Director [23]

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Yes. I'm -- it's a category-specific capability because if you're looking at outerwear, as an example, that tends to be long lead times. Sweaters are long lead time just because of the nature of the manufacturing process.

If you look across key categories in the business, denim in particular, we have adequate capacity to put more than enough units into the business if we saw that we were reading upside there.

Now I can't put it in, in a week. But if I look at Q4 and reading trends in Q3, we have plenty of open and plenty of vendor capacity to put units in the business. Knits would be the same thing. To a certain extent, certain types of woven tops as well. Less capacity in the active space, but still some capacity there, and that would really be across the entire family.

So we can feed the beast, and we have demonstrated our ability to do that as we see the demand there. And that's really, as we -- and we'll talk more about this as we get into our Investor Day and Meet the Management along the way. This is something that we've been building over time. We know what the peak looks like in terms of full penetration of responsive. We know where we are. We know what the business comes are -- outcomes are associated with it. And we're going to give a much more granular perspective about where we are and where we're going on this.

But we do have the capability to put units into the business in many parts of the business right now. I was going through some numbers the other day in Athleta also, and they've had an incredible bottoms business in the Powervita fabric, and that's really been based on buying conservatively, but then a near-season and an in-season response capability that's allowed us to grow that in -- way into the double digits season over season over season.

I'm pretty optimistic, quite honestly, about Old Navy's Q4 comp. We've got the fuel there to do it. We've got the responsive capacity. I think we're planned well. But again, I don't want to call it right now. I just want to deliver it.

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Operator [24]

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We'll take our next question from Omar Saad with Evercore ISI.

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Unidentified Analyst, [25]

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This is [Wes Gerbershed] on for Omar. You recently have brought in an outside creative agency, Johannes Leonardo, I think for the first time in several years. If you think about running that internally versus externally, especially under your new CMO, how do you integrate those -- how does that change the process as you integrate the strategy? And looking at the new campaigns, seems to be really focused on denim. Denim is really a focus category with multiple places. What -- what do you think you'll need to do to really emphasize the strength and the heritage of Gap denim kind of going forward to make it stand out and win that customer back?

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Arthur Peck, The Gap, Inc. - President, CEO & Director [26]

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Yes. So you are correct that we brought in JL. Really, they and our new CMO kind of came in midway in the process. And I'm going to be just completely, just get it off the top of my head on this one, honest with you, which is that is always a little scary to do, especially for a big season like we had with fall where we're really relaunching denim and coming out strong and proud about denim.

You'll be the judge on the content. If you see the 60-second anthem, that's been cut down to 6 seconds -- all the way down to 6-second product videos for social. I was super pleased with how Alegra, as our CMO, and the agency got up to speed and really understood what we were trying to do and balanced the need for a brand message along with a need for a call to action to get in our stores and try our product on. And it makes me feel pretty optimistic because I've been through agency startups before, pretty optimistic about what we can get done as we really start to season in with each other and they get dialed in.

I will tell you, because you called it out, that on my mind absolutely is more aggressively mining the heritage and the legacy of the brand. Our consumers tell us that it is something that they want to connect to and that they want to understand. Take a look at the denim through the ages that we've done. There's a display of this in a few stores, 17th and 5th has it, where we've also brought products that we've modernized out of the archive. And customers are loving it. And I'm -- always one of my measures is how much of it I'm seeing in the building, and I'm seeing a lot of it in the building.

So we think that is a very, very deep vein that can be mined. I know JL feels exactly the same way about it as well, and they're already building that into some ideas for our holiday campaign and as we get into spring and summer next year.

And as you know, the CMO came from adidas. A lot of the research -- a lot of resurgence there really came out of reasserting the legitimacy and the relevance of the brand based on the heritage of the brand. And we're not copying that playbook, but there's a lot of good ideas there, I think, that absolutely apply to Gap brand as well.

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Unidentified Analyst, [27]

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The spot does look good, and wish you luck on the fall campaign and going forward.

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Arthur Peck, The Gap, Inc. - President, CEO & Director [28]

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Thanks.

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Operator [29]

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We'll take our next question from Ike Boruchow with Wells Fargo.

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Irwin Bernard Boruchow, Wells Fargo Securities, LLC, Research Division - MD and Senior Specialty Retail Analyst [30]

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Teri, I think for you, I think you've mentioned some marketing pullback -- or maybe it was Art, some marketing pullback when you saw the demand and the product wasn't really there in the second quarter, and then you can kind of see it in the SG&A line. Just my question, when we think about SG&A, are you pushing some of those marketing dollars into holiday? Meaning should we kind of expect the SG&A growth to maybe tick up a little bit when we get into Q4? Just kind of curious how those marketing dollars are shifting around.

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Arthur Peck, The Gap, Inc. - President, CEO & Director [31]

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Yes. Let me clarify, and then I will turn it over to Teri because the big one really was intentionally going pretty dark with Gap brand really in the first half. And we saw a direct connection to that in traffic, marketing does matter, with the intent being that we would return to more normal marketing levels in Q3. And you will note that we have an adult campaign, a social campaign shot separately but related to it, and then a kids and baby campaign, which we haven't had for a while. And so far, the early returns have been very encouraging.

I'll let Teri talk about the specifics here. But for Gap, it was really a return more to normal than it was as far as any acceleration or anything like that, with an intentional dark period over the bulk of the first half.

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Teri L. List-Stoll, The Gap, Inc. - Executive VP & CFO [32]

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And as we look at the back half, we will have some, I would call it, modest uptick in advertising that you'll see in the SG&A line for the reasons Art described and we've talked about in terms of matching it with the product improvement. There will also be some deleverage in SG&A. As you remember, in the fourth quarter of last year, we had some adjustments to our bonus accrual that came through. And obviously, as we re-establish that this year that will put some pressure on the back half as well.

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Operator [33]

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We'll take our next question from Oliver Chen from Cowen & Company.

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Oliver Chen, Cowen and Company, LLC, Research Division - MD & Senior Equity Research Analyst [34]

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The Banana Republic adding rental subscription service sounds quite innovative. What are your thoughts on recommerce and rental subscription? And also, as we are doing a lot of work on the circular economy, like what will be your guardrails and framework for thinking about success with the rental subscription on Banana Republic? And how might this apply to your larger framework for the other brands and how you see customers focus on sustainability and what that means to them?

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Arthur Peck, The Gap, Inc. - President, CEO & Director [35]

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That was a very rich, very rich question, Oliver. Thank you. So the subscription service, let me start there. We are looking at it at the moment as a customer acquisition opportunity. And we're doing some pretty rich thinking that I'm pleased with on how we think about customer acquisition, the role of our stores and how do they satisfy a customer in a store with less than 20 minutes of immersive experience and what would they be willing to pay for that. And it helps us to think about the value of our stores beyond simply the pure momentary 4-wall contribution. But also things like this, a service like this that gives customers the ability to participate in the brand with less of a permanent financial commitment potentially.

So we'll read it. And first and foremost, we're going to look at customer acquisition metrics. Can it grow into being a significant and profitable business? The economics certainly work. It will just be a question really of what the uptake is as we get it dialed in.

So starting in Banana, given the price points and given the use occasions. Does this have some applicability in the other brands? It might. It's intriguing in my mind to think about right now with a newborn -- not a newborn, but a 2-year-old in the house, sort of. It's not mine. It's my daughter's. How fast babies go through clothes as well and how many of those clothes have a way to get handed down or turned in. Is there something interesting there also? So we're really looking at it, and we thought that this was a good place to read. And I'm excited to see what the results are. Obviously, we're just kicking it off.

On the sort of the resale and stuff like that, we're watching all of these things, and we talk to everybody out there. Where I do believe there's an opportunity -- and we had some of this a little bit in the Gap brand with some vintage items that were bought and then up-cycled. We do think there's a vintage play largely around our brands that we're exploring. And we have been buying some items out of the flea markets and other places and bringing them in. I'm not sure there's a big resale market opportunity for us, but our eyes are wide open, and so we're looking at it.

The -- clearly, sustainability is a huge issue, and we're increasingly seeing that as we talk to our customers. We think we have an excellent sustainability record, and we know we can do a lot more, and we intend to do a lot more. I think as you probably heard me say before, one of the biggest elements of waste in our industry is the -- is not the clothing that's bought, it's the clothing that is bought but unwanted and the long tail that we and many other companies have that end up sad and lonely in the clearance section of the store. And the good news is that limiting that waste also improves our inventory productivity, our margins and our working capital efficiency. And so that's another place where we're focused, which I think people really don't understand, but it's a big economic driver for us and a big waste eliminator.

So you've got your arms around an issue. We think we're well positioned to really move on this and move aggressively. Obviously, subscription service first, but then the whole issue of inventory productivity is kind of the industry's dirty little secret that we're committed to tackling.

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Oliver Chen, Cowen and Company, LLC, Research Division - MD & Senior Equity Research Analyst [36]

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And a quick modeling question. So as we think about the back half, you've had a nice Q2, which beat relative to Street estimates, and then you reaffirmed your EPS guidance. But has a lot changed as you're through first half versus your prior expectations in the first quarter as we model the back half?

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Teri L. List-Stoll, The Gap, Inc. - Executive VP & CFO [37]

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I don't think a lot has changed, really. We actually had a little bit better margin performance in this quarter than we had originally expected. But as we've modeled the back half, we -- there's a little bit of a shifting, I guess, between Q3 and Q4. But generally speaking, I wouldn't call anything notable as a change.

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Operator [38]

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And we'll take our next question from Alex Walvis with Goldman Sachs.

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Alexandra E. Walvis, Goldman Sachs Group Inc., Research Division - Research Analyst [39]

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I had a question about the impact of tariffs on the business. You helpfully suggested that it might be around a $0.06 impact to the business, if unmitigated. I was wondering as you seek to offset that, how much of the $0.06 can be offset by pricing versus other strategies to offset? If there are price increase, where in terms of categories and banners are you likely to be able to take the most price?

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Arthur Peck, The Gap, Inc. - President, CEO & Director [40]

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Let me take that. Let me start, and then I'll hand it over to Teri as well. There are various ways to mitigate it in the world of if. Number one is sharing this with our vendors, which is where we're starting the conversation. Number two, certainly that we've looked at is are there places where we should be adjusting tickets and adjusting those either at the factory or in our DCs or in our stores. We have the capacity to do all of that. But what I would also say is that, by far, the bigger lever is continuing to tighten up our inventories, first and foremost. That allows us to improve our yields and reduce our promotional intensity and recover it that way as well.

And again, we try to be really forthright about this and play it right up the middle in terms of what we think the impact is. And we do think that we have ample levers to mitigate this. Obviously, first and foremost, would be that we get into a more predictable environment where we aren't sort of constantly being whipsawed by what's going to happen tomorrow. But we're very flexible, and we can deal with it as it comes along. We have a bunch of levers to deal with it. You want to add to that, Teri?

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Teri L. List-Stoll, The Gap, Inc. - Executive VP & CFO [41]

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No, I think you've covered it well.

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Arthur Peck, The Gap, Inc. - President, CEO & Director [42]

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Okay.

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Alexandra E. Walvis, Goldman Sachs Group Inc., Research Division - Research Analyst [43]

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Great. And then maybe one more for me. You're leaning into denim at both the Gap and Old Navy brands. Can you give us some color on how big denim is for those brands at the moment? How big can it get? Has there been material variance over time and the importance of that category within your assortment?

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Arthur Peck, The Gap, Inc. - President, CEO & Director [44]

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Yes. We don't -- I don't really see a limit, frankly. Old Navy has continued to gain market share in denim and still has single-digit market share. And Gap had significantly more market share before the sales issues of the last couple of years, and so we have seen denim penetration inside that business substantially higher.

So I guess my starting point with Gap is to say what's our fair share and where we've been even recently, and we're well below that. And we know have authority in denim. We've done the customer research. We know what our functional and emotional equities are. We know where people connect with the brand. We are in an interesting denim trend cycle right now with the diffusion of trend across rise, leg shape and silhouette. You would see us aggressively embrace that inside of Gap. And we're seeing her respond to that, and it's a real great opportunity. Our tagline is denim -- our denim now, and we're really trying to focus on denim for all, including inclusive sizing that allows us to reach up to a larger-size customer. So I don't see a limit.

We've also been in a cycle where denim's been in a bit of a flat cycle, which has always historically been then followed by something that really motivates the consumer to get out -- off her couch and into the stores. And we're seeing some of that right now in leg shape and rise, certainly. But we anticipate that we're going to see some trends emerging in the springtime that are going to play into our denim authority. So I'm excited about it, and it's a loyalty category.

And last thing I would say is on Gap, is that we knew we were having issues on fit consistency. And with this new flow -- again, early days. We're seeing ratings online, et cetera, to be quite positive in terms of how she feels about the fit, which is always a good indicator for us.

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Operator [45]

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We'll now take our final question from Lorraine Hutchinson with Bank of America Merrill Lynch.

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Lorraine Corrine Maikis Hutchinson, BofA Merrill Lynch, Research Division - MD in Equity Research and Consumer Sector Head in Equity Research [46]

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I just wanted to follow-up on the comments that you're continuing to work on the third quarter inventory. Are there particular categories or brands where you feel like you're still too heavy? Or have you been able to get into chase mode as you move to the back-to-school season?

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Teri L. List-Stoll, The Gap, Inc. - Executive VP & CFO [47]

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Lorraine, I would say that we still have opportunity in each of the brands. Obviously, the least being Athleta just given their inventory productivity continues to improve as they leverage their capabilities and, frankly, have strong growth tailwinds behind them. But as we look at each brand, and we've said this before, is our productivity has declined. And in a time when we've invested in the many capabilities that Art has mentioned, we really would set much higher standards for our ability to operate with leaner units and not miss a beat in terms of demand, that we can chase into it, frankly, with better styles and better knowledge about what that demand is, not just quantity, but also trend.

So I could see opportunity literally across the brands. I think specifically going into the back half, what we would see primarily is that Old Navy and Gap brand probably have the opportunity just to move through their carryover units and make sure that they are best positioned to be able to capture the product improvements we see in the fall. But it really is across the brands.

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Arthur Peck, The Gap, Inc. - President, CEO & Director [48]

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Yes, I'd just add to that, that as we said, both Teri and I, we do feel like we exited the quarter in pretty good shape. We are focused on clearing. I don't think you would say, Teri, you feel like we're super heavy in any place else. But we aspire to a higher standard in terms of inventory productivity. It just isn't where we need to be, and we know we can do better right now. But I'm not concerned about -- as I said, I'm not concerned about a bow wave of liability that we're going to be fighting our way through during this quarter.

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Teri L. List-Stoll, The Gap, Inc. - Executive VP & CFO [49]

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No. In fact, I think what has been encouraging is to see the organization embrace that as we think about how do we think about it differently, how do we drive accountability in different ways. There's huge receptivity to the ability to better leverage what we have.

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Operator [50]

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Thank you. That does conclude today's question-and-answer session as well as that does conclude our conference.

Thank you for your participation, and you may now disconnect.