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Gap Conference Call

Shazir Mucklai

Gap (NYSE: GPS) reported its second quarter earnings on Friday. Shares of the company traded up 6.10 percent, or $1.94, to $33.72.

Below are some key takeaways from the company's conference call:

Glenn Murphy, Chairman and CEO

• Everybody here was actually pretty disappointed in our earnings results for the quarter. And we were below last year, and that hasn't happened to us since the first quarter of 2011, and that was driven by the cotton crisis. So in spite of the fact that the operating conditions were challenging, especially in the first half of the quarter, I expected that we would do better.

• Now upon reflection, and we've been doing this now for the last number of weeks, looking at the business, because our business is all about continuous improvement. And what are we going to do to move our business in the right direction.

• The product was a little too spring-forward, and something that's in our control. I think our customer communications could have been better. And that's also something within our control. And our margin management, I really thought the team could have done a better job working through the inventory we had, especially as it got backed up after the month of February.

• All three of those points are completely in our control in areas that the business has embraced and are making necessary changes as we come into Q2. With that said, I think we have pretty good plans across the business in the second quarter. We're in the business to gain share. And our goal is gaining share in the second quarter, third quarter and fourth quarter to finish the year strongly.

• When I look at the business, Old Navy is the one brand that's furthest along. I think that they've made some really good decisions, and that's evidenced by their performance in April, which was a plus 18% comp. And that's pretty strong. They made some really good decisions on their assortment that's rooted in fashion essentials.

• And I like what I'm seeing as they evolve and improve their assortment between now and the end of the year. And when I think of their marketing going forward, I like what their team's done. They've got a really good creative platform right now at Old Navy.

• I think that's going to become even more compelling as we move through the year, and more aggressive. And the Old Navy team is revamping their whole online site, which you'll see next month. So I think their digital presence will be even stronger going forward.

• Now at Banana Republic, the good news in that business is that women's has turned the corner. It seems like that's been a long journey. But we have it going in the right direction, and customers will truly notice the difference in our August delivery. And everybody in that team and myself are pretty excited about that.

• Now, as I promised at the beginning of the call, I want to give you an update on Gap, Inc.'s global priorities. They are: global growth, omni-channel, responsive supply chain and seamless inventory. I spent quite a bit of time at the recent Analysts Meeting explaining to everybody why we chose these initiatives and the value we're going to create for Gap, Inc. shareholders going forward as each one of these become part of how we operate every single day.

• Old Navy performance so far in the franchise market in the Philippines has been very good. Excited about what we're seeing in Shanghai with the first Old Navy store opening. And the only news is that in the last 30 days we've added five new Athleta stores to our planned list in our guidance. And now we're going to open 35 Athleta stores in 2014, which will allow us to end the year with 100 Athleta stores.

• On the omni-channel front, reserve in store has been rolled out to 500 Gap stores. That just started a few weeks ago, so now on top of those 500 Gap stores and 400 Banana Republic stores, the marketing just started behind that to start telling customers. Because if anybody tries it, loves it. And our goal is to get awareness and trial behind it. And we will be piloting next month order in store. If you look at the apparel business there's a conversion number and then there's customers who come in and don't convert.

• And a portion of the customers who don't convert is because they couldn't find their size, couldn't find their color, couldn't find exactly what they were looking for. So this pilot is digital, it's quick and our employees are able to carry that with them on the floor to close the sale.

• And lastly, on responsive supply chain, we've had meetings, Sabrina and myself, the last 30 days to get updates with each one of the brands. Really good momentum. There will be some benefit to our operating margin in 2014 in the back half and will really benefit 2015. So the momentum is moving in the right direction.

• Now, I want to close by telling everybody we're still very confident here. We mentioned that last month but we're confident in our full year guidance. We're committed to our full year guidance. So if you allow me just a little history lesson, in 2008 and 2009 during the depths of the recession we did better than pretty much any other retailer by managing our P&L, managing our costs during difficult consumer times.

Sabrina Simmons, Executive Vice President and CFO: • Regarding earnings for the quarter, in the first quarter operating income was $443 million versus $530 million last year. Net earnings were $260 million and earnings per share were $0.58 versus $0.71 last year. And as a reminder, we were lapping $0.04 of benefit to last year from the favorable resolution of tax issues. Additionally, we estimate that the impact from foreign currencies reduced our reported EPS growth rate in Q1 by about 5 percentage points.

• Sales for the first quarter were $3.8 billion, up 1%. Comp sales were down 1% for the quarter. The translation of foreign revenues into dollars negatively impacted our reported net sales by about $20 million in the first quarter. On a constant currency basis, net sales were up two percent. Total sales and comps by division are listed in our press release.

• Moving to gross margin. First quarter gross margin was down 260 basis points to 38.8 percent. Merchandise margins were down 230 basis points for the quarter, driven by a challenging February and March, which could pressure on our ability to move as many units early in the quarter. Importantly, we did end the quarter with inventory in line with our guidance.


• Our objective overall continues to be delivering modest positive comps on a full year basis. In addition to our comp base, we plan to drive increased revenue through our multiple channels, newer brands and geographies. Given our remarks just a few weeks ago, I'm sure it comes as no surprise that we are once again reaffirming our full year guidance of $2.90 to $2.95. At its midpoint, this equates to seven percent full year EPS growth on a reported basis.

• On a constant currency basis the growth rate is estimated to be five percentage points higher or a solid double-digit growth rate. Underlying this guidance is the following. First the expectation that we make progress against our goal of tightening our inventory levels with each quarter. At the end of Q2, we expect year-over-year inventory dollars per store to improve by a few points versus the year-over-year increase in Q1.

• Second, the expectation that our supply chain initiatives will begin to deliver benefits in the second half of the year especially at Old Navy. Finally, we remain committed to managing SG&A in a disciplined manner. However, recall that leverage is likely to be very modest this year as we moved a portion of our credit card income out of SG&A and into gross margin.

• We still plan to open about 185 company operated stores and close about 70 net of repositions. Store closures are weighted towards Gap North America and store openings are weighted towards China, Old Navy in Japan, Athleta and global outlets. We expect capital expenditures to be about $750 million and depreciation and amortization to be about $520 million. We expect our full year effective tax rate to be about 38.5 percent.

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