Highlights From The GAP's (GPS) Q3 Conference Call: Total Comp-Store Sales Were Flat Vs. Down 12% Last Year

November 20, 2009 12:01 PM EST

Gap Inc. (NYSE: GPS) reports Q3 EPS of $0.44, even with the analyst estimate of $0.44. Revenue for the quarter was $3.59 million, which compares to the estimate of $3.57 billion. Shares are currently trading flat on the session.

Highlights From GPS's Q3 Conference Call:

• Introduces new $500 million buyback program.
  
• (CFO) We met our goal of improving our comp store sales trend and we did it while delivering the highest third quarter gross margin rate in the past 10 years. These two factors drove a 25% increase in net earnings.
  
• Diluted earnings per share were $0.44, versus $0.35 last year. Gross margin improved by 380 basis points to 42.5%. Operating margin was 13.9%, versus 11.1% last year, and year-to-date free cash flow was 931 million.
  
• Q3 net earnings were 307 million, compared to 246 million last year. Third quarter effective tax rate was 38.6%.
  
• Q3 net sales were $3.59 billion, up 1% to last year. Total company comp-store sales were flat in the quarter, versus down 12% last year.
  
• Gross profit was up 146 million, or 11%, to $1.52 billion. Gross margin was 42.5%, up 380 basis points, with 360 basis points from higher merchandise margins and 20 basis points from occupancy leverage.
  
• Merchandise margin improvements were driven by more goods sold at reg and promo, and higher regular price margins.
  
• Operating expenses were $1 billion, up 40 million from last year, driven by increased marketing.
  
• Marketing was up 20 million to 141 million, with the increase being driven by Old Navy and Gap. Foreign exchange also drove about 10 million of unfavorability.
  
• We ended Q3 with 2 billion in inventory, down 10% over the third quarter of 2008. Inventory dollars per square foot were down 9% versus the prior year.
  
• Year-to-date, capital expenditures were 221 million. We opened 36 stores, weighted toward international and outlet, and closed 42, weighted toward Gap brand.
  
• Year-to-date, free cash flow, defined as cash from operations less capital expenditures, was an inflow of 931 million, compared with an inflow of 519 million last year.
  
• At Gap, we added a fully integrated marketing campaign which includes holiday TV for the first time since 2006. The TV commercial started on November 12 and runs for about five weeks.
  
• At Old Navy, we're continuing with our successful SuperModelquins campaign and added about a week of TV compared to last year. Given these investments, we expect Q4 marketing expenses to be up about 45 million compared to last year.
  
• In total, we expect Q4 operating expenses to be up about 100 to 120 million versus last year.
  
• For context, operating expenses year to-date through Q3 are down 85 million, and due to the fact that Q4 operating expenses last year were down 217 million, on a two-year basis, operating expenses are still expected to be down about 100 million in Q4.
  
• We expect the percentage change in inventory dollars per square foot at the end of Q4 to be flat compared to the end of Q4 last year.
  
• We now expect depreciation and amortization to be about 575 million. The increase from our previous guidance of 550 million is driven in part by accelerated depreciation associated with our Old Navy remodels.
  
• Our guidance remains unchanged for the following metrics. Effective tax rate, about 39; capital expenditures, about 350 million; new store openings, about 50; store closures, about 100, net square footage decline, about 2%.
  
• In closing, we're pleased that this quarter, we achieved our best Q3 operating margin in 10 years, driven by continued gross margin expansion. We'll closely monitor the returns from the investments we've made to drive traffic and sales during this holiday season, and of course, we'll maintain our operational discipline as we focus on our top line.
  
• (CEO) We are very focused on top line, but it's good to see, with the work we've done most recently, we improved the trend on the two-year comp in Q3.
  
• Feedback from our customers has been very strong and very positive. So the challenge for us is, how do we take that relaunch of denim and get that incremental sale? That incremental sale through the right marketing inside the store.
  
• And lastly, we've been very pleased with the introduction of the Stella McCartney line in conjunction with GapKids, and we look forward to working with Stella and her team for spring season launch on collaboration with GapKids.
  
• Other development in the third quarter for them has been a launch of their new prototype store. We opened first in Las Vegas, and then Scottsdale, and just last Saturday, we opened up in SoHo. I think that's all positive. It's a new prototype of Banana Republic.
  
• (Q&A) My question would be regarding the operating expense guidance going forward. We're seeing no change on the marketing spend, in terms of your plan, but can you give us a little bit more color on the higher variable store costs that you're referring to for Q4, and what does that entail?(A)Yes, John, those are just simply associated with our goal of continuing on this path of improving our comp-store sales trend. So we are - if we're fortunate enough to sell more units, you would expect nominal dollars of SG&A to increase with the store-related part of our structure. That said, it's always our objective to keep those in line with sales. So we wouldn't want to deleverage that piece, but from a nominal dollar perspective, they would go up.
  
• Okay, pretty clear. And then on the gross margin, the IMU benefit? You did give us a little bit of description about the components to gross margin. Can you give us a feel for how much of a magnitude better IMU contributed? And could we expect to see the same kind of magnitude continue in Q4 and even in Q1?(A)Yeah, I think the structure of our gross margin, as a reminder, is, this year, we've been benefiting strongly from average unit cost reduction, and those are really meaningful reductions. And the good news is, during this recessionary time where our customers are really looking for value, that has afforded us the opportunity to be out there proactively with planned promotions and giving our customers planned value, which we did all throughout Q3. That means our AUR was actually down, but despite that, we actually delivered this great margin expansion, and that's our very plan as we move into Q4.
  
• Glenn, I just wondered if you could comment a little bit more about the Gap domestic business? And more specifically, adult. The launch of denim was a big accomplishment for you this year. I know there's a lot of enthusiasm about the initial sell-throughs of that product. Could you talk about your own expectations for the - how that evolves, and eventually brings back more of the core business to Gap? I
  don't think the intent was that it - was an immediate overnight success, but that it's a gradual build and you're going to drive trial in it. Could you just describe that process a little more and what metrics you're looking for over a period of time? (A)No, there's a lot of metrics we're looking at in denim, first and foremost. I think the reason it was chosen was that it's a dominant part of our business. We have heritage and credibility in it. Don't feel necessarily good about how maybe we've come across to our customers in the last five years. So the reinvention of it by the Gap team was the right decision. And I think all retailers do this. They look at, what are the categories that will draw people into their stores, so we're always trying to find needs versus wants, and if we can be a dominant player again at a higher level we are today in terms of market share when it comes to we think denim, is pretty close to a need component when it comes to apparel and fashion. And I think the upside for us is getting people in at a regular rotational basis, probably helping us with our frequency, so it has a real category management strategic value. Now ongoing, the real focus, and I'd say the commitment we have on denim, was not to relaunch it in August, ride the wave in September, and then basically move on to the next big idea. The commitment we made to each other, and you'll see a little bit of that coming up in our holiday marketing as we turn November into December, is how do we continue with a constant reinforcement.
  Innovation, good product, and differentiated ideas when it comes to denim on a month-by-month basis as we turn the page and look at 2010. And again, on our holiday, you would expect - I think the natural feeling in apparel is, we can't sell denim in December. And I think maybe it's not the best month for denim, but if you're the dominant player and you want to be known for that, we should be finding ways, through product development, through messaging and marketing, to make sure everybody knows every single month is denim month inside of Gap. So I think the team has done a nice job. As you said, the reception has been positive. We felt good about customer feedback. We have been chasing into inventory in September, October. Probably not, Jeff, till this week, and maybe the latter part, definitely coming into Thanksgiving weekend, do we actually feel we have the inventory by size, by fit, by wash, that we started out in the first week of August, because we thought we did a very good job of building inventory, but we learned a lot, and we'll be in a much better place in November. Now we got to continue to be innovative and keep pushing it and keep marketing it and keep speaking to customers, because that was not a one season wonder, it is a permanent part of our marketing messaging going forward.
  
• Hey Glenn, can you - it seems like you've expanded the focus I mean clearly to gaining market share, and I think we understand the marketing elements behind that. But what about the merchandise margin side of the equation? I mean, can we expect a more value-focused element at the store level? And just how much merchandise margin are we willing to give up in order to gain share? And is that in fact what we should expect in 4Q versus 3Q? Or are there mix shifts that you talked about that can benefit the margin and costing that might benefit the margin? Thanks.(A)Jeff, just to turn it as a parallel comparison to SG&A, we worked really hard for two years to take out of our business approximately $700 million of SG&A, and the benefit of that is it's given the company flexibility to make good decisions,
  whether it's marketing investments or other investments we want to make in our business. The comparison to average unit cost is identical. We - back in '07 and '08, and as Sabrina just said, a good chunk of 2009, have really put a big focus on that through changing the processes internally about who
  negotiates what, be much more tough minded, introducing reverse options, all of the things we've done is to make sure that we are getting the best cost, while protecting our quality in the business. What that's given us is the flexibility, as you suggest, to make sure the business now with the margin rate we have in the business and how we've built that over the last couple years, now it allows us, as we talk about market share, to make sure that we're not irresponsible, but we get the business talking about market - talking about gross margin dollars per foot. So now we can make the right decisions, and I think we've proven that at Old Navy, as the first brand. I think they have gotten a lot of cost benefit with the work they've done. But now, as you saw their performance in the months of September and October, with those sort of low teen comps, I think Tom and his business are able to make those trade-offs between where do you want to be a little more aggressive to get to market share, all part of a larger value proposition that that brand stands for. Now he's in a unique circumstance, but the theory also applies to Gap, Banana Republic, our online channel, and of course our outlet business, which is a dominant player in value. It is with the added benefit of the gross margin rate, driven mostly from AUC and strong inventory management, how do we make better decisions now to get market share by focusing the company on gross margin dollars per foot. One last thing I'll also say to you, and I kind of said this in my opening comments, we've expanded our thinking quite a bit now when it comes to gross margin. What are the other levers the business needs to pull and be thoughtful about? So I think I might have referred to, in the opening comments, on mix, the mix inside our business, and again I think the best retailers are always thinking with a merchant lens on what they present to their customers. But behind the scene, there are good people - more category management type people, who are spending time going, what's the category trade-off that can satisfy the customer, get the incremental sale and conversion, maintain loyalty, stand for what the brand proposition is, but get an added economic benefit by doing the right mix inside the four walls of your business. So we're spending a lot of time on that, which I hope, as we get skilled at it, and we're not there today, will give us even more gross margin rate benefit, which will allow the company even greater flexibility to make these further decisions we have to make to gain market share.

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