The Gap - Earnings Call - Q2 2012

Transcript

Speaker 1

Good afternoon, ladies and gentlemen. My name is Kristen, and I'll be your conference operator today. At this time, I would like to welcome everyone to Gap Inc.'s second quarter 2011 conference call. At this time, all participants are in a listen-only mode. For those analysts who wish to participate in the question and answer session after the presentation, you may now press star one to enter the Q&A queue. As a reminder, please limit your questions to one per participant. If anyone should require assistance during the call, please press the star key followed by the zero key on your touch-tone phone. I would now like to introduce your host, Katrina O'Connell, Vice President of Investor Relations.

Speaker 7

Good afternoon, everyone. Welcome to Gap Inc.'s second quarter 2011 earnings conference call. For those of you participating in the webcast, please turn to slides two and three. I'd like to remind you that the information made available on this webcast and conference call contains forward-looking statements. For information on factors that could cause our actual results to differ materially from the forward-looking statements, as well as reconciliations of measures we are required to reconcile to GAAP financial measures, please refer to today's press release, as well as our most recent annual report on Form 10-K and our most recent quarterly report on Form 10-Q, all of which are available on gapinc.com. These forward-looking statements are based on information as of August 18, 2011, and we assume no obligation to publicly update or revise our forward-looking statements.

Joining us today on the call are Chairman and CEO Glenn Murphy and Executive Vice President and CFO Sabrina Simmons. Now I'd like to turn the call over to Sabrina.

Speaker 6

Thank you, Katrina. Good afternoon, everyone. Though we're certainly not pleased with an earnings decline, our second quarter performance does demonstrate a continued focus on our stated goals, including growing the top line, maintaining expense discipline, investing in our future, and returning excess cash to shareholders. Specifically, we're pleased that we were able to achieve net sales growth of 2%, driven by our new international stores and our online and franchise businesses. We tightly managed our operating expenses, which were flat to last year and leveraged 50 basis points. Finally, during the quarter, we returned $880 million to shareholders, with $820 million in share repurchases and $60 million in dividends. Please turn to slide four for our earnings recap. In the second quarter, net income was $189 million, down 19%, and EPS was $0.35 per share versus $0.36 last year.

Turning to slide five, second quarter net sales were up 2% to $3.4 billion. Total sales and comps by division are listed in today's press release. Turning to slide six for margins. Second quarter gross margin was down 270 basis points, driven entirely by declines in merchandise margins. Second quarter gross profit of $1.3 billion was down $63 million to last year. Turning to slide seven for inventory. At the end of the second quarter, inventory units per store were down, and inventory per store in terms of dollars was up 5%, in line with our revised guidance. Please turn to slide eight for operating expenses. Total operating expenses for the quarter were $917 million and leveraged 50 basis points as a percent of sales. This includes $114 million of marketing, up $13 million to last year, driven by Old Navy and our online businesses.

Please turn to slide nine for capital expenditures and store count. In the first half, capital expenditures were $261 million, focused on international stores, global online expansion, and Old Navy downsizes. As a reminder, our goal is to grow our store base internationally through both wholly owned and franchise stores. In North America, our goal is to reduce our square footage overall, driven by downsizes at Old Navy and closures at Gap Brand. True to our goals, year to date, we've opened 15 international stores and 18 franchise stores. We've downsized and remodeled nearly 40 Old Navy stores and have closed about 30 Gap stores in North America, driving a total net square footage decline of 2% compared to Q2 2010. Regarding cash on slide 10, year to date, free cash flow was an inflow of $298 million, slightly above last year.

We ended the quarter with $2.2 billion in cash and short-term investments. As continuing evidence of our commitment to return cash to shareholders, we've repurchased 67 million shares in the first half for $1.4 billion. Our Q2 weighted average diluted shares were 545 million. At the end of Q2, we had about $670 million remaining on our current $2 billion share repurchase authorization. Now I'd like to discuss our outlook for the rest of the year. Please turn to slide 11. We are reaffirming our full-year earnings per share guidance of $1.40 to $1.50. As a reminder, our back half assumes average unit costs are up about 20%. Given our focus on targeted price increases and promotions, we expect our average unit retails to be up, especially as we bring our unit sales down.

However, we do not expect average unit retails to increase enough to offset the average unit cost increases. Therefore, our guidance reflects significant pressure on our margins. We have a goal of leveraging rent and occupancy and operating expenses. We're confident the goal is achievable on a positive comp base, but it's more challenging if comps remain negative. Our planned inventory unit buys are down across all divisions in Q3. Despite this, we expect our inventory dollars per store at the end of Q3 to be up in the high single digits, driven by average unit costs up about 20%. The following full-year guidance metrics remain unchanged: depreciation and amortization about $550 million, effective tax rate about 39%, capital expenditures about $575 million, net store openings, including franchise, about 75, and net square footage decline about 2%.

In closing, we remain committed to our 2011 goals of growing top line, maintaining expense discipline, investing for long-term growth, and returning cash to shareholders. Thank you, now I'll turn it over to Glenn.

Speaker 5

Thank you, Sabrina, and good afternoon, everybody. Before I hand it back to the analysts for any questions on the second quarter, I want to just give you some opening comments. I'm going to start talking about our international business because there's been a lot of progress in the second quarter, and then I'm going to come back and talk about our domestic business. First, on the international front, we just recently opened our sixth store in China, and we're excited about that. We have 10 more stores to open between now and the end of the year, with the key of those 10 store openings being the major flagship in Hong Kong. Also, something that's different, I think, from the last conference call we had, we were pretty much set on opening only in three cities in 2011: Shanghai, Beijing, and Hong Kong.

We've now made the decision, as we've been presented incredible opportunities, we're going to open up in two incremental cities in 2011: Tianjin and Hangzhou. Now, for Italy, we've also, as of today, opened six stores, with the key opening in the second quarter being Rome. We have an amazing site in Rome. It's doing really well. It's a flagship location, just like Milan's. We feel very good about our Italian strategy right now, and we will open up five more stores between now and the end of the year. Our franchise business, we're going to open up in seven new countries in the second half of this year. That's the most new countries we've done in any single six-month period. Our global outlet business, we did six stores in the first half. We'll do 15 stores in the back half.

Our athletic business, we just opened up in New York City, so we're now on the East Coast. Two stores in New York open back to back, and we're very excited. Strong response from the consumers in New York, and we will do six more stores by the end of the year. Our Piperlime business, we're adding more and more exclusive brands. The news on Piperlime was we're adding men's apparel this month, which I think will be a nice complement to the business we have. Our online business globally is doing very well. We are in 22 countries in Europe, and our China online business is just super impressive between our own site and also we're on Taobao.

The penetration in China is very strong, and that is part of our long-term strategy to get major high-street locations like the store in Hong Kong complemented with core mall locations, with outlet, and with a very strong online presence. Okay, let me switch gears now and talk about our domestic business. We've negative comped two quarters in a row now, and that's not good performance, and it certainly is below our standards. We've been very clear internally and externally. Our goal is to have moderate, steady growth in our domestic business, and we've not achieved that. What's critical is our business needs to comp in North America, and that is something that the teams and the brand presidents clearly understand. As I look forward to the second half of the year, there are really just two key priorities for us in the second half.

One is marketing, and the second one is women's product. Our women's business, we're disappointed with our performance. If you look at the key categories at Gap Inc., kids and baby did not negative comp in the quarter. Men's did not negative comp in the quarter. It's our women's business that's a drag on the total company's performance. We need to get better right away in our women's product. We understand that. Our teams understand that. We need to have great product in our stores. Banana Republic, I'd say of the three brands I look at them, I'd say Banana Republic is the furthest ahead in terms of achieving that. When I saw the product that was in stores this weekend with the team, I think it's a good flow, and particularly in pants.

Where to work, women's pants, casual, and going out, I'd say Old Navy is the next one. There's a lot of great work going on by that team when it comes to product, but I really see it now in their denim. A lot of new fits, a lot of new washes, great color denim coming into Old Navy in the next few weeks, which I know the team is very excited about. Gap Brand, for their women's product, I think we've been telling everybody who's an investor that the Gap Brand team is working tirelessly. Team in New York, led by Pam Wallick, have been focused on making sure that the Gap product in women's American casual style that gets designed right by the team in New York, and we get that right product in our stores. Mostly, our customers are going to see that in spring.

Having said that, I do believe that there's going to be improvements in holiday from the last nine months in which we've been operating in 2011. Lastly, we've had some ineffective marketing in the first half. Not that it was bad, it was just less effective than we wanted it to be. Now, our marketing dollars are up versus last year, but most of that has gone towards Piperlime, Athleta, Old Navy, and has gone towards opening up our stores in our new international markets. Gap had some very limited marketing spend, particularly in the second quarter, because there was not a lot of news at Gap. We're strong believers philosophically of not putting money in marketing just for the sake of doing it. There has to be something to talk about.

Old Navy, we had some storylines, but the marketing did not pull, did not drive traffic as much as we wanted. We're still very fixated on getting new customers in our stores. We know that's important to us. The 1969 campaign really was an example of that, telling that LA design studio story, but telling it in a unique way. That's something that a lot of new customers, they really gravitate to that. They love how genuine it is, how real it is. You're going to see more of that type of marketing, not only from Gap, but from other brands, because people are telling us they respond very well to that genre marketing. You'll see a shift in our media mix in the back half. Definitely a lot more online media. We've been testing that for the last six months. We like the early response.

Most importantly, the Old Navy creative and marketing messages and the strength of Old Navy's aggressive marketing to drive traffic to their key customer across their lease line. It needs to get better. There's a lot of good stuff going on in Old Navy right now. I see it in the product. I see it in the fact we have 300 stores now that have been remodeled, new categories coming in. At the core, its marketing needs to find who they are, and there's a big value component to that, but also it's the spirit and the personality of Old Navy. That's a big priority in the second half. In conclusion, I believe the company is making a lot of great strides overall on its corporate strategy, which is to be dominant in multiple brands, multiple geographies, and multiple channels.

I highlighted that at the beginning when I talked about the countries we're in, our franchise business, which is a unique channel, online, outlet, and our new brands, Athleta and Piperlime. Domestically, prior to coming into 2011, we had not negative comped for six quarters in a row. That's good. We're really not off to the kind of start that we feel good about so far in 2011. Granted, there's been huge fluctuations in input cost. Yes, the economy in the U.S. has been a little lumpy in the last six months, but here's what I tell everybody internally, and I mean it. There's business out there. There is business out there in the U.S. market. I look at other retailers, other brands, not everybody, but certain ones that I watch closely, and there's business out there.

Besides following all the initiatives we put forward, we have two priorities right now: marketing in North America being more effective and our women's product going from being okay to great. Those are two key priorities. I'm now going to turn over to Katrina, and I'm happy after that to answer any questions from anybody on the phone. Thank you very much.

Speaker 7

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

Speaker 1

At this time, I would like to remind everyone, if you would like to ask a question, please press star followed by the number one on your telephone keypad. Your first question is from the line of Lorraine Hutchinson with Bank of America Merrill Lynch.

Speaker 3

Thank you. Good afternoon. Glenn, I just wanted to follow up on the comment you made about there's business out there. You just need to go get it. Who do you think your female customer is who should be shopping at Gap, and where is she shopping right now, and what do you think you need to offer her to get her back in the door?

Speaker 5

Let me think. I'll come back to the question two ways. I'll answer it from a Gap Inc. perspective first. When we look at our business today, we believe that even though the women's business, from an industry perspective at a very high level, seems to be lagging the men's business, we seem to be in a bit of this down cycle. I think all of us are going through that. When you see the reports from people who are in multiple categories, such as department stores, that seems to highlight a lot about their accessory business, their cosmetics business, their men's business, and not much about women. In general, I think women's is in a bit of a down cycle, and there's not a lot of business, relatively speaking, from a growth perspective, as we've seen in the past.

I would say the people who are getting the traffic right now are probably benefiting by their multiple categories that they offer, and they are taking share. That would be the department stores, and some of the ones that I think are in Gap Brand's direct line of sight would be a department store like Macy's. When you think of Old Navy, I would say that today, and again, there seems to be from the research we've done, plus the trips we make to stores, the people we speak to, not just customers, but our own store managers and competitors, seems to be a little bit of a deceleration in the number of trips people are taking. I think that's driven a bit, Lorraine, by the economic times in which we're in, obviously in the second quarter by gas prices.

When that happens, and over the last decade or two, there's always cycles like this where I think people pull back a little bit, and when they pull back, trips come down. When trips come down, if you are a multiple category retailer, such as department stores or a one-stop shop retailer like a Target, who would be a direct competitor to Old Navy, that for this moment in time seems to be a benefit. If trips are down a bit, and we're seeing that, obviously with our traffic, but also with some of the research we've done at this moment, that's what's going on. I'd say those are two examples of retailers and brands who, in my estimation, in the category when it comes to women's, seem to be doing better than our two main brands, Gap and Old Navy.

Speaker 1

Our next question is from the line of Evan Koppelman with Wells Fargo Securities.

Speaker 4

Thank you. Good afternoon. Sabrina, I think you said you expect to leverage on the rent, occupancy, and operating expenses in the second half, but that requires positive comps. I'm just curious, isn't that a little aggressive given the negative comp performance in the first half and kind of the seems to be an increase in our uncertainty in the economy?

Speaker 6

Yeah, Evan, thanks for the opportunity to clarify. What I said was we have definitely a goal to leverage rent and occupancy and operating expenses, and we feel confident about meeting that if we positive comp. If we don't positive comp, it's definitely more challenging. What we're very proud of in the second quarter from an expense management perspective is we actually achieved 50 basis points of expense leverage, even though we had a negative 2% comp. That gives us some evidence that, you know, when we really put our minds to it, it's doable, but it's very difficult on a negative comp. We do feel much more confident if we achieve the positive comp. Thanks for letting me clarify that.

Speaker 1

Your next question is from Janet Kloppenburg with JJK Research.

Speaker 4

Hi, everybody. I had a question about the opportunity for positive comps. It sounds like the women's business is going to be tough. I think Glenn said we should expect it to get better in the spring. If the women's business doesn't improve from the levels we saw in the second quarter, is there an opportunity for positive comps? Secondly, perhaps you have some vision or confidence that it could improve a bit from the second quarter. I'd like to sort of get a feel for the confidence level you have in the ability to see some progress made in that category in the second half of this year. Thanks so much.

Speaker 5

Thank you, Janet. If you're referring to Gap Brand, because that's the brand I talked about more in spring, when it's the sort of Lorraine's question on Gap Inc. was more about women's in general in our total business. I think there's a bit of a lull going on in the market right now, but in spite of that, we need to perform better at Gap Brand.

The team led by the global team, but the North American team led by Art and Mark Breitbart and the work being done by Pam Wallick in New York, I would say that they start to feel much more confident about the fashion and trend decisions because they've been working at this now for five months, trying to transition the brand aesthetic, which got a little out in terms of its evolution of the women's aesthetic, got a little too modern for our customers. We want to be relevant. I think the new team has really done a much better job on the aesthetic, and we're going to start seeing that show up in our stores in the spring. What I was saying, and the comp question is still to be determined because you heard earlier about the environment in which we're dealing with.

These are all questions I think all retailers have right now. What I do know is when I look at what work has been done in the last five months, and the immediate focus when they got in was to do some work on holiday. The holiday work and the product that's coming in, the categories we're focusing on, the reversal of the aesthetic that was in place and changing it to concentrate on some categories that are really appropriate, not only trend right, but appropriate for Gap, I believe gives a much better chance to reverse the fortunes of the women's business inside Gap Brand.

Speaker 6

How do you feel about it at Old Navy, Glenn?

Speaker 5

I'll be honest with you, Janet. I'm disappointed in the number of customers who are not getting into Old Navy to actually see the product.

Speaker 6

That's the marketing issue you talked about?

Speaker 5

Yeah, you know, I think at the end of the day, to be quite frank, whenever we have a traffic issue like this, I always go to product first. Even though I have to be honest with you, I think our women's product at Old Navy in the last three months has improved, and I see that clearly. I think right now there's some challenges in women's wovens, but in general, our women's product is actually pretty good at Old Navy. I always go to that first because it's so easy to blame this on store execution and ineffective marketing. The ineffective marketing is certainly something we are fixing as we speak. The women's business, I think in my opening comments, I've seen an improvement in this most recent flow at Banana Republic, and I've actually felt good the last three months.

There's always a category here or there of what the work that Nancy Green has done at Old Navy. The biggest frustration is that we have to get more people in the store. We have to find for all the different mediums and levers we have to get people in online, and the marketing we spend, the social media work that we do to get more people in to give that product a chance to be experienced, tried on, bought, and spoken about because you know word of mouth is still a powerful vehicle inside of our business. I'm kind of disappointed in the brand. I'm disappointed in the leadership that we've been unable to get enough people and the customers we target to come in and see what Nancy has actually put into the store. With that said, it always has room for improvement.

It's still, you know, as I ranked them earlier, I think Banana Republic is the furthest ahead. I think Old Navy has been good, but has some room to still improve, but I think it's good right now. Gap is a redo, which I hope to see noticeable improvement in holiday.

Speaker 4

Can you change the marketing for Old Navy in time to make it effective for third quarter?

Speaker 5

Here's what I'll say to you. Basically, the campaign that we have been playing with since March, we shifted formats and platforms everybody knows. We tried to make it stronger in the last five months, and last weekend, we decided to just put it on the back burner. We had another campaign we were working on, and I think this weekend you're going to see a new campaign come forward for Old Navy as we put the other one on the back burner. Either it will be once and for all as a platform fixed to drive traffic, or when we come out very strongly in October and November and December, we'll have a brand new campaign. The one we have now, I think, is a nice stopgap you'll see this weekend, but we can't fix the one we have. We'll have a brand new one.

Speaker 6

Great, thanks so much and lots of luck.

Speaker 5

Thanks, Janet.

Speaker 1

Your next question is from Michelle Tan with Goldman Sachs.

Speaker 2

Great, thanks. First, Sabrina, maybe you could clarify just on the comment around positive comp and being confident in the achievability of your goals if you get the positive comp. I know it's a comment about leveraging rent and occupancy, but is it also applicable to your broader financial goals for the year as a result of leveraging rent and occupancy, or is it just specific to that component? Glenn, I had a follow-up for you as well.

Speaker 6

Yeah, tell me if I'm not hitting your question correctly, Michelle, because I'm not sure I'm understanding it. My comments were all with regard to how we would leverage rent and occupancy and operating expense. We're always going after the discipline in reducing square footage, shedding unproductive rent and occupancy, and trying to leverage that. As you've seen, though, both in Q1 and Q2, if we don't positive comp, both Q1 and Q2 negative comp, we don't get raw leverage. It's very difficult to get the raw leverage if you don't positive comp. On operating expenses, we've done better in Q2. We actually leveraged with a negative comp, but it's not easy. My comments were very specific to that.

With regard to our view overall for the rest of the year, just to underscore what Glenn responded to in the last question, we have not given up on our goals, certainly of total revenue growth for the full year. That's an important goal for us. Even with a first half comp of negative 2%, we have achieved total revenue growth. We're pleased with that, and we're definitely focused on delivering that for the full year. The comp piece of it is challenging given that the first half is in at a negative, and you know the second half we've got our units down, and it's kind of a bumpy road ahead, but we're going to aspire to that.

Speaker 2

Okay, got it. Glenn, in a related question, you've talked about some of the challenges that the consumer has been living with and the sector has been living with for a little while now. Can you give us any perspective on what you're seeing in the last several weeks or in the back-to-school season in terms of volatility? Do you see signals that some of this turmoil is taking a greater toll on the consumer in terms of traffic or in terms of just those consolidated trips or whatever?

Speaker 5

Let's answer this in two parts. I'll give you sort of a broader answer about, I think, of the consumer more midterm. From now to the end of the year, Sabrina can speak more specifically about any recent volatility we may have seen in our business. There's been a lot of mixed economic news, and there was a bag full of mixed economic news today, and there are issues across the pond which affect the stock markets here in the U.S. We're certainly thinking the sentiment in the back half relative to the first half will be neutral at best. It's going to be a similar sentiment from a consumer perspective. We are certainly nowhere near that it's going to be an improving sentiment to what we had to operate in and compete in in the first half.

If you were advised to lean on one side or the other, I'd say it's more likely to be slightly more negative from a sentiment perspective in consumers in the U.S. I'm not speaking globally right now, just in our home country, which is a significant part of our business, more likely to be slightly negative than it was in the first half. We'll see how things progress over the next number of months, and I'll keep our fingers crossed that good decisions get made and the better economic data comes forward, and maybe the holiday season could be slightly positive, but we're not counting on it right now.

Speaker 7

Okay, operator, next caller.

Speaker 1

Our next question is from John Morris with BMO Capital Markets.

Speaker 0

Thanks. Question, I think, for Sabrina. You did talk a little bit about SG&A, and you know really good job there on controlling the costs and managing it. I'm stepping back and looking at my model, and with the increased marketing that you do have going on, first kind of part to check with you is, are you also including in some of that spending some of the upfront costs for international expansion? If so, all the more reason to suggest that you're doing a great job managing costs there. Where is that coming from? Where are some of those improvements coming from given the weakish comps?

Speaker 6

Good question, John. Yeah, definitely all of our expenses are included in our operating expense number, including our investments in international. Now, that's not necessarily putting a whole lot of pressure on this year because, of course, we began those investments last year. We're anniversarying the investments, but they absolutely are happening within that bucket. We have increased by about $13 million in the quarter of the marketing spend. There's no really big one factor that's helping us deliver all-in flat operating expenses. I think it speaks to the culture that we have been developing over the last few years together and that the company's fully embraced. I think all the teams just do a fantastic job. It's just, you know, a million here, a million there, making sure we're responsible in every form. There's really no big callouts other than that.

The total expenses definitely include the investments in international as well as marketing.

Speaker 0

Great, thank you.

Speaker 1

Our next question is from Erica Moshmeyer with Robert W. Baird.

Speaker 2

Great, thanks so much. You mentioned that Banana Republic was further ahead. Have you done more across your teams to maybe take some of those learnings to the other concepts on the design side? Could you also talk about, on the speed side, on the initiatives there, where you're at from a speed perspective with each of your concepts and how that might help as we get into the spring?

Speaker 5

The comment about Banana Republic was that I think we would all collectively agree from a women's perspective that team, which you know their women's business has been soft for quite a while now, they have really, I mean, everybody in the company, when there's a missed opportunity, whether it's we're off fashion or the trend's not right or somebody competitively is beating us and doing a better job, that in this company, at least, that brings a lot of focus to bear. The big light shines on it. It has been at fairly aggressively now for the last six plus months trying to get better momentum on their women's business. We'll see if it develops into momentum.

When we walk in the store and the consumer comments, and I'm in stores a lot, we'll be hearing from our store manager and our teams, is that they feel this is a much better flow that was received 10 days ago than they've seen in a while. I think that's positive news. In terms of cross-communication in the business, our merchants get together on a regular basis. My job is to make sure that they spend a lot of time, when necessary, speaking to one another about each other's businesses, talking about broader trends, but then really go into their own corners because each brand has to stand for something completely differently. The only thing the three brands have in common is, well, there are two things they have in common. One, they're owned by Gap Inc. Secondly, they're American brands. After that, their consumers are different.

Their age profile can be slightly different. Their average household income is different. I think it's good if they get together and compare trends, but then apply that. How do you bring that alive within your own brand and aesthetic guardrails? In terms of speed, you know we've been, for the last six or nine months, really questioning our merchandising model inside the company. The first thing we did when it comes to our merchandising model was to push hard on speed. We're getting some benefit coming through this fall and holiday. Some brands are further ahead than others. I'm actually anticipating that in this holiday season, when we take our pipeline, which we cut down by a third of the weeks, and then you take our speed pipeline, that's another 40% less weeks than our new core pipeline. We're going to make better decisions.

Those are better decisions, and a lot of it is fashion product. Better decisions on fashion and trend, better decisions on the inventory buys, better decisions on allocations to stores. This is not rocket science. There have been two outstanding retailers in the last 15 years who actually built their business on this. This is not the Gap Inc. model. As we continue to evolve our merchandising model, speed and getting much faster, making much better decisions, getting closer to customers is key to us delivering on our modest, steady growth in our North American business.

Speaker 1

Is it Old Navy that's further along?

Speaker 5

It's Old Navy that's further along.

Speaker 2

Great. Could you rank the other two behind that?

Speaker 5

Let's just say that Gap Inc. has work to do.

Speaker 2

Great, thanks so much.

Speaker 1

Our next question is from the line of Brian Tunick with JPMorgan.

Speaker 0

Thanks. I guess, two quick ones. Sabrina, did you mention what your lead times are on buying at Old Navy? When should we expect some relief on the AUC side? Is that second quarter next year? Glenn, you talked about some hope that AURs will be up at Old Navy. Have you or Tom been testing any specific categories, looking at some of the competitors and seeing what they're doing, maybe denim? Give us some confidence that you guys have some visibility there.

Speaker 6

Okay, on the first part, Brian, we're not going to get too far into 2012. This is just a Q2 call. Certainly, we're in the midst of doing some of our spring 2012 buys. I think it's a good thing, obviously, that we've seen most commodities, including cotton, of course, come way down from their peak. I think it's important to remember, though, that for spring 2011, when we made those purchases, cotton was probably $0.90, $0.95. Today, you're looking more like $1.05, $1.10. It's fabulous that it's come down. It's still up year over year a little bit. We won't try and have a crystal ball on upcoming seasons, but we would certainly hope when we anniversary the very sharp peaks we experienced for fall and holiday next year, we're going to look at some significant easing. These are volatile times in the market. It's too early to say.

Speaker 5

On the AUR front, AUR in the business, excuse me, in the second quarter was up. We are seeing our AURs are up to LY. Just specifically about Old Navy, I think when it comes to AUR and when you start stretching price points, there are a lot of tools in AUR. One is, as Sabrina mentioned earlier, managing inventory very tightly, not only to the economic conditions, but the traffic in which we're seeing. That's one measurement of AUR. The second thing, to your point, Brian, is can you get more initial price, which is what's known as, everybody knows as AUR?

I think the Old Navy team have probably been a little conservative in that front on the first half, which I'm supportive of because I think we mentioned in the last call if we felt, which we did at the time, but luckily we were not wrong, that we were going through a cyclical change here when it comes to our input costs on cotton. We didn't want to make any midterm or long-term decisions to our most important value brand on something that's going to pass and is a moment in time. While there were some selected pricing decisions made in the second quarter, there are probably a few more that Tom has certainly been testing. When you test these pricing challenges with your consumer in the value segment, you hope they work. In some cases, to be quite honest, they don't.

If they don't work and you can't get the reaction you want, then you have to stay at that pricing level because consumers have the muscle memory, which is a lot greater than you might suspect it is when it comes to pricing in this particular environment. The third thing is just looking at the assortment and what do we want to do on better pricing and best pricing in terms of the assortment. Nancy has made some changes at Old Navy as all the merchants have. Our value business, which is greater than 50% of our North American business, they got to be careful because there is a halo effect if you start to get too much assortment in the better best categories. It can be negatively viewed on your overall value proposition inside your store.

I encourage them to do it, and all brands are certainly doing that and making good decisions. I think on our value business, they should do it, but be careful. I think that AUR up in the second quarter, and hopefully that's a trend we could count on going forward.

Speaker 1

Our next question is from Adrienne Yih with Janney Capital Markets.

Speaker 2

Good afternoon. Glenn, I just was wondering internationally, as you pursue that strategy, how are you feeling about the strategy for franchising versus owning the stores? Sabrina, if you can just talk about, you've been very aggressive with the share repurchase activity. Typically, you guys step it up in the back half of the year when you have more free cash flow. I'm just wondering if we should expect ongoing aggressiveness on the share repurchase activity. Thank you.

Speaker 5

On the franchise versus corporate, we agreed with our board about three years ago what the criteria is. What are the criteria of each country? There are multitudes of ways to do this that would determine whether we should go in as a franchise operation, as a channel, or go in corporately. I think I might have mentioned in a call or at a conference a while back that we have this debate when it comes to Russia. We had the debate when it comes to China because these are not clear decisions. Big countries, and obviously China with not only big countries with the growth and the potential. In Russia's case, when we ran it through our criteria, we decided to go franchise. In China's case, we decided to go company-owned.

We have two very large countries, which we have not determined yet, but down the road, we will be faced with decisions in those countries. That will be Brazil, and that will be India. I think that we've made some really solid decisions right now. I feel very good about the decision we made in China. The other thing worth remembering when it comes to our franchisees is we always have the option at a time of a mutual choosing between ourselves and our franchise owners to turn that into a joint venture or to take it over completely corporately, which has been something Inditex has done a very good job of.

To date, our franchise arrangements continue to be franchised, but if we felt there was a country down the road that tipped in from a criteria perspective and therefore was more appealing for us to operate on our own or in a joint venture, we're happy to do that at any given time.

Speaker 6

With regard to the share repurchases, Adrienne, you're definitely right that in more kind of normalized market conditions in our history, we have tended to repurchase probably more in the second half that matches our cash in our free cash inflow. I think this year, what you've also seen from us is we've always taken a position that's opportunistic, and we've always told our shareholders and investors that we try and really buy on dips more aggressively when we feel like the stock is at a particularly good value. I think those opportunities presented themselves in Q2. We were out there, delivering on the same principle we always have, which is to get excess cash off of our balance sheet and utilize it. Our authorization is $2 billion. We're pleased we still have about $670 million left.

I think if and when we complete that authorization, we will review the circumstances and conditions that exist in our company and in the marketplace at that time and decide whether it's appropriate to go back to our board with another ask.

Speaker 2

Okay, great. Thank you very much.

Speaker 1

Our next question is from Jess Kleinfilter with Piper Jaffray.

Speaker 0

Yes, thank you. Glenn, just a follow-up on the international comments that you made. Given the growing importance and visibility of this, of the growth of international, both franchise and company-owned, could you talk a little bit more about the profit consideration here? At some point, we're going to see an inflection, I think, in your consolidated operating margins, given the more profitable nature of some of these markets. Can you talk about where you are, what sort of contribution it's having today, and at what point you could see that accelerating?

Speaker 5

Jeff, I think the one thing we've talked about is that we really wanted to make sure that the model we went into in our new countries was different than the model we went into in the mid-1990s. The difference there is that we go in right now with city strategy when it comes to our high street stores. That's followed, which is, you know, a very strong brand message. You heard me mention the call: Milan, Rome, Shanghai, Beijing, Hong Kong. Get really flagship locations in that city center, on the right street, on the right corner. Now, onto itself, if we emulated that as we did in our past, that alone is probably not a path to great profitability.

When your second-tier core stores, which are in malls, which are smaller stores, in a lot of cases on percentage rent deals with return on capital and the presentation of the brand is still strong, but not as strong as the flagship, you further the next ring, complement that with outlet stores very quickly. In Italy, we went in six months after we launched the brand, marketed, got it done, we opened our first outlet store. We're going to be opening our first outlet store in August of next year in China, and the outlet opportunity in Italy and in China are going to be robust.

Last and most important to me is the online business, which when you look at the numbers Sabrina gives out, if I think of the last conference we were at, we talked about getting our online business in the United States up to 15% by 2013. When I started, that penetration was just above 5%. The key now is to look at these countries and say, one, because it is part of our multiple brand, multiple channel, multiple geography strategy, but also the outcome of that, to your point, is the economic return. Return on sales and return on capital is so much better. Right now, early days to tell. We like the start we've had in the two new countries, in Italy and China. You love our franchise business because it's what we call internally a capital-light strategy.

It's cost very little to no capital for us to do what we've done. You heard me in the call say that we're going to go into seven new countries in the back half. You heard Sabrina say we'll probably do close to 75 stores this year. That's a big program for us in the franchise business. It's also a different way of going in. It's smart. It gets the brand out there, but also it's a very good return on sales and a very good return on capital. I think we're thoughtful. To me, all this stuff starts with strategy. What are the right countries? What's the competition? Can we go in and win? Will our multiple brands that are American, that stand for different things, that are truly brands and not retail stores? Can our three brands as part of Gap Inc.

go in and win in these new countries? Once we feel strongly through the work we do that we can and look at the competitive landscape and do our research, then coming in with the formula I just described gives the chance to produce for the total company incremental earnings.

Speaker 0

Glenn, all in today, is your international business more profitable than the domestic business? What are your targets going forward?

Speaker 5

Yeah, we don't give that out. Here's I think what I've said before is that where we've taken a component of that formula. Let's just give you an example. Paris, where we just have a city strategy, selected stores, core mall stores complementing it. That is very profitable business relative to our total company's business. I'm not talking about a country. I'm just saying we've obviously, before we decided to go down this path, we had little pockets of examples about how our international business, as we roll it out, could become an incremental contributor. We don't break out for purposes of these calls the difference between the two. Suffice to say, we're not in the international business just to drive sales.

Speaker 0

Thank you.

Speaker 1

Our next question is from Paul Lejuez with Nomura Securities.

Speaker 0

Hey, thanks, guys. Just continuing on the international theme. I'm just wondering which countries you would say you've had your strongest openings. I'm also wondering if there have been any openings where you would call it not so well received. Thanks.

Speaker 5

It is mostly very positive, Paul. The differential between an absolute phenomenal start like we had in Italy and maybe some odd countries, very few on the franchise side where maybe we did not register as strongly, really comes down to brand awareness. In Italy, our brand awareness was always very strong. I think there is a natural connection between the two countries. Obviously, there is proximity to Paris and close proximity to our business in London. Milan and Rome, both for Banana Republic and Gap, have been outstanding openings, and we feel very good about that. China, I mean, we have said before, I do not know if we have, I think we have said how pleased we are. We think we have said how it ranks in the top 5% of the first four stores we did of the total Gap Inc.

portfolio, three of those four stores in the top 5%. That really speaks to how big the opportunity is, the size of the cities in which we are dealing with. The marketing we did was great. I think we are off to a very good start in China. I am looking forward tremendously to our opening in Hong Kong, which is one of the best corners in the world. We are going to open on November 1 of this year. There have probably been a few countries in the franchise business, not a lot. As I mentioned earlier, we are struggling in Greece right now, but I think that is a common problem for everybody. We got off to a nice start, but right now it is not going that well. There are a few franchise businesses that did not get off to the start we wanted.

I think we mentioned probably well over a year ago, the reason we went franchise first was to go into some countries and learn. Learn how to open a store. How does the American casual style component of Gap come through? How do we make sure that it gets registered and we win competitively? As we take those lessons, those can easily be applied to the current countries we are opening and the future countries we plan to open in.

Speaker 0

I'm certain you don't want to share those countries with us, but just figured I'd ask again what those were.

Speaker 5

In the early days of the franchise business, when maybe this plan I talked to you about, about going in with a great high street store first to really identify the brand and get great traffic and great awareness for people who might be more close in proximity to the second or third store you might open, some of those were in, by the way, we're on fire now in Southeast Asia. Four years ago, when we opened in some of the smaller countries there, we had some of those issues. We're doing very well in the Middle East right now, but two of those countries we opened in four years ago didn't get off to the best of starts, but we're doing very well now, which again proves to me that you're going to learn. As you make mistakes, you can recover.

If you are willing to put the money behind it from a marketing perspective, and if it doesn't get off to a good start, change your real estate plan or reintroduce yourself to the customer. These brands are so strong on Gap in particular worldwide that it doesn't take a lot to get it back on track. Those were two geographical areas around the world where maybe the start was not as good as we'd hoped, but they've since clearly recovered.

Speaker 0

Thanks, guys. Good luck.

Speaker 1

Our next question is from Dana Telsey with Telsey Advisory Group.

Speaker 6

Good afternoon, everyone. Hi, Glenn. Glenn, on the process of the business changes, you've talked about changes in vendor base to help reduce the AUC pressure and the new design center to facilitate the flow of ideas between domestic and international. Can you talk about how each of those are going, how it's impacting the business, and what changes you expect? Thank you.

Speaker 5

We talked at the last call coming off of the holiday buy that we were disappointed and that we made some decisions that going forward we wanted to make some adjustments to our supply chain. Some of these are not going to be happening immediately. They're going to happen over a period of time. Initially, the first things we wanted to do was deal directly with mills as opposed to just vendors. I think, and I guess within our defense, for the better part of two decades, with the fabric pricing being pretty constant for the most part because our number one commodity price was constant, the negotiations that really took place were through vendors and through vendor relationships. As the commodity prices went up and yarn pricing went up, we were probably less quick as we should have been to deal directly with mills. That's going forward.

We've made some changes to that in the new year for the new year buy. We made some changes to that three months ago, and we're going to continue to make more changes with direct mill relationships. I'd also say that there's some consolidation going on. We're taking our volume as Gap Inc. more than we have in the past. Sometimes we do act as one total conglomerate. Sometimes we act as separate brands. In order to leverage our size, I think the supply chain team has worked more closely, going to meeting with vendors and offering up our entire book of business as opposed to by brand and by style. That is certainly something we've done going forward and want to do more of in the future.

There's a lot of other changes that I think that I've been clear on that were probably changes we could have made a year ago, but with cotton and the commodity crisis we're going through, it was better to just stay as we were. Now we've made some with a lot more to come. When it comes to New York, that's a major change that we went through back in the spring, putting our whole global design team, our whole global marketing team, which was nonexistent because we've created it, and our global production team in New York. I think under Pam's leadership, I'd be lying to you to say there wasn't some dark days in order to bring that together. They're in a really good place now. The reason this was done was very clearly. This is an American brand with an American aesthetic with global aspirations.

I think we're going to eventually introduce that team to some people on the call today, but putting them together in one office and thinking about the larger business and getting input from our Asian business, from our European business, from our franchise business to come into New York. Now, instead of the New York product design being 100% driven out of San Francisco, it is its own independent body. That takes time. It's certainly a big shift inside the business strategically to make that the creative center for the brand. After five months, I'm actually quite pleased. I'm going to be there on Sunday meeting with the team to go through some progress. I've not been there in well over a month, but indications to me are that we can expect some pretty good work out of New York City, certainly in the spring.

As I highlighted earlier to Janet, I have some expectations that things will get slightly better in holiday. For spring, which I will be seeing on Sunday, there's certainly some good signs.

Speaker 6

Thank you.

Speaker 1

Our next question is from Betty Chen with Wedbush Securities.

Speaker 2

Thank you, and good afternoon, everyone. Glenn, I wanted to go back to the marketing topic if we could. I think you've mentioned that you felt the Old Navy marketing was somewhat ineffective in the first half in driving traffic. Have you been able to get any learnings on maybe what elements of the campaigns were not effective? Also, as we shift into the back half, how should we think about the marketing dollar spend in total, and how does that break down by brand? I had also a follow-up in regards to the international business. Are you seeing any differences in the online customer base versus some of the brick-and-mortar locations? Thank you.

Speaker 6

I'll just start, Betty, with a quick answer on the go-forward spend. We don't give a lot of color on the marketing breakdown, but I will tell you that for Q3, you can probably expect overall marketing to increase in the same ballpark that Q2 did versus last year. It probably will be driven by the same two divisions that drove the increase over last year in the second quarter, which is namely Old Navy, as we really try and get that really hyper started again and get those traffic in the door, and also our direct business, including online media spend. Those are the two areas that are probably going to come up a little, but it's relatively modest and in the same ballpark as Q2.

Speaker 5

On the marketing, I'd say a couple of issues happened. One, as we switched to the new platform, the actual messaging to our key customer was more about her and less about her family. When we do marketing that registers about her family, she tends to respond quite well. In fairness to the team, and you've heard us say this before, there's always this ongoing balance when you have a value brand. I see it when I watch Target's marketing. I see it when I watch Kohl's and other people. There's always that balance between brand marketing and what's the strong value message. You've heard us that we've been trying to find that right balance. The environment got a little worse than we had anticipated.

The message, while people thought it was good and they remembered it, it wasn't anywhere near the call to action it needed to be to get somebody to get into a car and make a trip to Old Navy. That is critical for this business, as the store is the brand. The product defines the brand. The people in the store define the brand. The marketing certainly tells the voice and the story of the brand. One thing that Old Navy will never ever lose is its value proposition. It has fun, it has fashion, it has family. All three of those step on top of a foundation called value.

Sometimes campaigns that you put together are good, but in this environment, and as I mentioned earlier, with what seems to me to be some slight reduction in the number of trips that our key customer is taking, the value part and the aggressiveness that Old Navy can demonstrate needs to come forward. That is the comment that underlines the point I made on being ineffective. As I mentioned to, I think, Janet, we're making quick adjustments. We're going to, I think, the tapping on the edges of the platform wasn't good enough. We had to really just get rid of it and bring something else forward in order to get the traffic that that brand deserves. On the international front, it's a little bit what I was answering earlier. I'm not sure it was Paul who was answering the question, but no doubt about it.

If you could do it all over again, you would set up your structure in your existing countries and make sure your online business was set up for a much bigger share of your total business. As I said, by 2013, in the U.S., we're planning to get that penetration of 15%. Sabrina and I and Katrina agree that we don't give out too much information on certain areas of our business. What I will tell you, though, is that in Canada, that has been opened less than a year, it will get to the 10% very quickly. It took us nine years to get it here in the U.S. It'll get there very quickly. In China, it's unfair to give the number because we only have six stores.

For example, just hypothetically, if the steady state in China was a couple hundred stores, hypothetically, I would be very disappointed when we had those stores if we didn't have a much more significant penetration in the mid-double digits in China. Our goal is to market it and keep driving it and keep reminding people that the stores talk about online. I think that it's a different breakout of the tools and the channels the company has. Now, we're catching up very quickly in the U.S., but the new countries or existing countries that just recently received online, it's going to become a much more significant part of our business.

Speaker 2

Thank you, and best of luck.

Speaker 5

Thank you.

Speaker 1

Operator, we have time for one more question, please. Yes, our next question will be from Kimberly Greenberger with Morgan Stanley.

Speaker 6

Great, thank you. Glenn, I think I understood fairly well in the late 1990s what the casual American aesthetic was for the Gap women's customer. I'm just wondering if you can help us understand today what that team is looking at for inspiration because you know it's dangerous to go back to what made Gap great, let's say, 10 years ago. You've always got to move forward. I'm sure the team's doing just that. I'm just not sure I understand exactly where Gap fits within the mall today in terms of its brand positioning.

Speaker 5

I would say if you're in the mall today and you're thinking of women's only, then I completely accept your comment at face value. Let me just take it up a notch. I think that the first thing is that this is a multi-gender and multi-generational brand, and that's key to the overall brand. Women's is a big part of that business, and I think everybody on the phone knows that we are more disproportionately invested in the women's business than most other retailers. I don't want them to lose sight of kids and baby, of body, of men's, and of women's, which creates the holistic message and brand positioning for Gap. If you start at that point, then you bring it down. The words are important to me.

Some people may not think they are, but American casual style, and there's other words we're using to make sure the aesthetic is right, is something that we've proven in a number of cities in the U.S. Even as we negative comp in the second quarter, we have a number of stores, and I'm not going to give you the number. We have a number of stores in a chain of 889 stores that had very nice positive comps. We are positive comping in a lot of places internationally, franchise business I talked about earlier. I think that when, and this is what product we don't feel great about in women's, it's off. It's not on trend.

I've sat down with New York and the team, and we brought in a lot of people who were with the brand recently and people who we've added to the brand in the last year. We've run through the aesthetic. We look at the competitive set. We've talked to lots of customers. Kimberly, there's an interpretation issue we went through this spring and summer. The pure definition of American, first and foremost, casual, secondly, and style, and there's other words, to me, that still resonates. This has nothing to do with going back to the past. We're not going to go into the bag of tricks and pull out crazy stripes. This is not what this is about. I'm not sure if that was exactly the filter that drove the aesthetic in the 1990s.

All I know is going forward, that filtering mechanism, focusing on that, and making sure that, A, it's relevant for today's consumer. Secondly, there's competitive advantages to it. That's the reason you open up a studio in LA. Because under American, there's the word denim. If you're going to want to be dominating on denim, you go to LA, you make a bold move, you hire a whole bunch of great designers, which is in the marketing campaign as we speak. You create an environment for them to be close to the customer to develop one of the more important categories, if not the most important category we have that defines American casual style. I'm just using denim. I could take you down that through knits and take you that through to khakis and chinos. There are categories that just belong to that brand.

That is not going back to the past. There are other new categories we're going to be bringing in. Unlike you, when it comes to the question, when you walk the mall most recently and you run it through the filter of aesthetic and relevance and where I know the brand needs to go, it doesn't register. This is why design guardrails and clarity are so critical in our business. I'm obviously the one who's 100% accountable over the last 18 months that I allowed who was coming out of New York, driven by San Francisco, to not deliver 100% to the filters we had in place.

I don't run the brand, but ultimately, I'm accountable for anything that happens in the company. That is why I feel confident that Pam Wallick, the new design team, the new creative, the new marketing team, and the design executives from around the world we put together in New York with the key merchants for international and North America are actually going to get that clarity, and they're going to deliver it season in, season out. Some of the brands that I have a lot of admiration for and are consistently delivering every single season are the ones that actually stick to who they are. We know what that feels like. Every now and then, a brand gets off. There are other brands who we can talk.

Speaker 1

I'm not going to. I've gotten off recently. It can happen. Inexcusable. Nobody's happy about it. I think you're going to see that team get back to the core part of what I just talked about, the brand really stands for.

Speaker 7

Thank you. All right. I'd like to thank everyone for joining us on the call today. As a reminder, our earnings press release, which is available on gapinc.com, contains a full recap of our Q2 results, as well as the forward-looking guidance included in Sabrina's remarks. The investor relations team will be available after the call for further questions. Thank you very much.