Earnings Transcript for GPS - Q2 Fiscal Year 2024

Whitney Notaro - Director, IR:

Richard Dickson - CEO:

Katrina O'Connell - CFO:

Robert Drbul - Guggenheim:

Alex Straton - Morgan Stanley:

Matthew Boss - JPMorgan:

Ike Boruchow - Wells Fargo:

Lorraine Hutchinson - Bank of America:

Adrienne Yih - Barclays:

Mark Altschwager - Baird:

Jonna Kim - TD Cowen:

Dana Telsey - Telsey Advisory Group:

Operator: Good afternoon, ladies and gentlemen, I would like to welcome everyone to the Gap Inc. Second Quarter 2024 Earnings Conference Call. At this time all participants are in a listen-only mode. [Operator Instructions]. I would now like to introduce your host, Whitney Notaro, Head of Investor Relations.

Whitney Notaro: Thank you, and good afternoon, everyone. Welcome to Gap, Inc.'s second quarter fiscal 2024 earnings conference call. Before we begin, I'd like to remind you that the information made available on this conference call contains forward-looking statements that are subject to risks that could cause our actual results to be materially different. For information on factors that could cause our actual results to differ materially from any forward-looking statements, please refer to the cautionary statements contained in our latest earnings release. The risk factors described in the company's annual report on Form 10-K filed with the Securities and Exchange Commission on March 19, 2024, and any subsequent filings with the Securities and Exchange Commission, all of which are available on gapinc.com. These forward-looking statements are based on information as of today, August 29, 2024, and we assume no obligation to publicly update or revise our forward-looking statements. Our latest earnings release and the accompanying materials available on gapinc.com also include descriptions and reconciliations of any financial measures not consistent with generally accepted accounting principles. Joining me on the call today are Chief Executive Officer, Richard Dickson; and Chief Financial Officer, Katrina O'Connell. With that, I'll turn the call over to Richard.

Richard Dickson: Good afternoon, and thank you for joining us. Gap Inc. delivered another successful quarter that exceeded financial expectations and we gained market share for the sixth consecutive quarter in comparison to where we were only one year ago, we are in a stronger position across key metrics that matter, including net sales, margins and our cash position, and we're making consistent progress in the reinvigoration of our brands. These results give me confidence that we are on our way to unlocking Gap Inc.'s full potential. On today's call, I'll provide an update on our second quarter performance and progress in the context of our four strategic priorities

Katrina O'Connell: Thank you, Richard, and thanks, everyone, for joining us this afternoon. We are pleased to report second quarter results ahead of our expectations with another quarter of positive sales growth and market share gains. In addition, we remained focused on the discipline we've created around margin expansion, expense and inventory management and maintaining a strong balance sheet, which resulted in further operating profit expansion and strong free cash flow. As Richard mentioned, the rigor we've developed is becoming core to how we operate and is enabling us to perform as we transform. Some key highlights from the second quarter include the following

Operator: Thank you. Ladies and gentlemen, I will now hand it over to Whitney Notaro, before moving into the question-and-answer session.

Whitney Notaro: Before we open it up for Q&A, I want to briefly address the earlier-than-planned posting of our Q2 financial results to our website this morning, which is due to an administrative error. As soon as we saw the error, we immediately rectified it and notified the NYSE. We issued our earnings press release as promptly as possible rather than waiting until after the market closed to ensure widespread access to our results. With that, I'll turn it over to Richard and Katrina to begin the Q&A session. Operator?

Operator: [Operator Instructions] Our first question will come from Bob Drbul with Guggenheim. Please go ahead.

Robert Drbul : Hi, good afternoon. And just on the morning release, a little bit earlier at an 8

Richard Dickson: Yes. Thanks, Bob. First off, in general, we had another successful quarter. We exceeded our expectations, net sales up 5%. That's great growth, especially when you consider we're operating on 5% less inventory, 500 basis points of gross margin expansion, and we also expanded operating margin by 490 basis points. Important to note also, this was our sixth consecutive quarter that we grew market share. It's a real indication that customers are responding well to our brand reinvigoration efforts. As you asked, Old Navy and Gap in particular, each of them posted quarterly positive comps, and it's a real demonstration of the continued consistency in the results that these brands are showing up with. On Old Navy, we saw a particular strength in women's as the team is really focusing on reasserting Old Navy style authority, and we're dialing up fashion. We're also seeing broad strength across important categories

Operator: Our next question comes from Alex Straton with Morgan Stanley. Please go ahead.

Alex Straton : Great. Thanks a lot for taking the questions. Congrats on a great quarter. Maybe one for Katrina and then one for Richard. So Katrina, I'm just trying to understand the third quarter guidance on sales. I think it's just up slightly, which seems to be like a bit of a slowdown from the second quarter level. So can you just kind of give some color around what's driving that guide by banner, maybe what you're seeing so far? And then just for Richard, on Athleta, this return to positive comp growth for the rest of the year. Can you talk about where that brand is at in its transformation story? I feel like it's a big margin lever. So I'm just curious kind of how you're feeling there? Thanks a lot.

Katrina O'Connell: Yes, sure. So I'll take the first one, Alex. I'm really glad you asked this. There's a few drivers. First of all, I would start by saying we're very confident in the brand reinvigoration work that we're doing but we remain balanced in our view of the consumer as well as the macroeconomic environment in which we operate as we head into the second half of the year. I think more specifically and to get into more detail, just a reminder, we did experience about 2 percentage points of incremental sales growth year-over-year from the credit card agreement that was specific to Q2. Second, we do begin to lap our better performance from the early reinvigoration efforts in the third quarter at Old Navy in particular. And then third, while we expect to return to positive comps, as we said at Athleta, the magnitude of the third quarter recovery has a range of outcomes. So we'll see where that lands. And then year-to-date, as we talk about sort of comments by brand, we've seen really strong performance at Old Navy and Gap. And I think, as I just said, we are lapping some of those reinvigoration efforts in Q3. Banana is focused on fixing the fundamentals. We talked about that. And I think I'll let Richard talk a little bit about as we exit lapping this highly promotional environment, how we're feeling about Athleta.

Richard Dickson: Yes. Thanks, Alex. We're gaining much more confidence in Athleta as net sales in the quarter were down 1%, comps down 4%, but really important to remind that we're lapping a period of very heavy discounting last year, and there is a lot of good progress being made. We've successfully broadened our consumer base. We're seeing much better sell-throughs at full price. Our marketing, which has been totally refreshed is gaining traction, and most importantly, our fashion product is resonating. And given the success that we're seeing with our new product, notably in core bottoms and the limited edition drops that we've been doing, we now expect to see positive comps for the remainder of the year. The team has been focused on resetting the brand and setting the brand up for sustainable growth in the long term, and we're very excited about the progress and the future of the brand.

Operator: Our next question comes from Matthew Boss with JPMorgan. Please go ahead.

Matthew Boss : Great, thanks. So Richard, on your targeted consistency, can you elaborate on maybe the structural changes that you've made across merchandising and marketing at Old Navy and the Gap that you see driving sustainable, profitable growth in the back half and then into next year?

Richard Dickson: Thanks, Matt. I would focus our answer to that on our strategic priorities. We have been incredibly disciplined in maintaining focus around our four strategic priorities and the execution of that, I believe, is really showing up in the metrics that matter. Maintaining financial and operational rigor, as I've said in my opening remarks, is really becoming the way in which we work better processes, much more cultural accountability. And again, as you see the performance that we have in the quarter and consistently, it's really due in the context of how we're working with much more disciplined process. That is really enabling the second priority, which is reinvigorating our brands. We've spoken a lot about our playbook and ultimately driving relevance and revenue to be on this journey to become a high-performing house of iconic brands that really shape culture. Our two biggest brands, which we've noted, Old Navy and Gap are furthest along multiple quarters of positive comps and market share gains. And I'm encouraged, as I've said, with the improvements that we're making on Banana and Athleta. The third piece, strengthening our platform. We've talked a lot about the greater value of our capabilities and leverage that we have to drive individual brand growth. A particular note, I mentioned our new media partner, Omnicom, it's going to help us really drive efficiencies and effectiveness and amplify these brand narratives and become a strategic differentiator as we drive more culturally relevant conversations and a much more innovative media mix. Those examples will start to really show up in the second half. And then the last piece I'd talk about is our culture. We're seeing really strong signs across our organization and notably in our recent employee survey, which received nearly twice the engagement that we had compared to last year. I talk often about our people and our talent. They're really the gateway to the pursuit of our vision and ultimately really driving better work and we're working as a company around new values, new vision, new mission. We've added with precision, new talent. There's extraordinary talent within the company. And together, that mix is really driving executing with excellence. So all in all, I'm very pleased with the progress. We have a lot more work to do, but teams are really focused on executing and certainly this quarter shows up on the scoreboard.

Matthew Boss: That's great. Maybe Katrina, to that point, could you elaborate on just further areas of potential efficiency across the expense structure? Or just help best to rank multiyear leverage opportunity across whether it's technology, marketing or corporate?

Katrina O'Connell: Yes. Thanks for that question. So after the last two years or over the last two years, we've really worked on increasing the financial rigor as we've talked about. We've actioned about $550 million in cost reductions. We know that the $5.1 billion of SG&A that we guided to this year does reflect lower nominal dollars versus last year and is leveraging, and that's all despite higher incentive compensation accruals. So we're pleased with the progress. But as you say, we do realize that SG&A as a percentage is still high. And we believe our cost structure can become more efficient. So we're deeply engaged in identifying the next phase of savings to drive value creation over the long term. So we look forward to getting back to you when we have a more articulated plan, but we are deeply focused on efficiencies for the future.

Operator: Our next question comes from Ike Boruchow with Wells Fargo. Please go ahead.

Ike Boruchow : Hey everyone, congrats. I guess I'll take Bob's question, just take it a little bit more detail just because I know the ships are in there, and it's a little hard to tell. But Richard, can you say specifically now that you have the tougher compares coming up specifically at Old Navy, do you expect Old Navy to continue to comp positively? And do you expect the company to continue to comp positively as we get into the back half? And then a follow-up question for Katrina. Just on the ROD line, you can see with the operating lease costs and the rent costs, those continue to go up by a decent amount, but the ROD dollars are going down and you're getting good leverage. What exactly is going on, on the occupancy line that you guys have done to create a more leverageable model and how sustainable is that? Thanks.

Katrina O'Connell: Yes. So I'm happy to talk more specifically to the comp in the back half. So we did guide to sales in the Q3 time frame, up slightly. What I would say in general is, I would think about a spread that is sort of relatively neutral. So we'll let you do the math on whether or not that means positive comps. But particular to Old Navy, and Gap, we feel very good about where we are in the brand reinvigoration process. And I think as Richard said, there's lots of really exciting things happening from a product and marketing standpoint as we head into the back half, they've been most consistent in their performance. So we'll see where that lands us, but we feel very good about those two brands. As it relates to ROD, right now, ROD leverages on about flat to modestly positive sales growth. And as you know, we've done a lot of work in the store part of the business where we've closed over 350 stores as we went through the pandemic, primarily at Gap, and that has given us a lot more flexibility in that line to save not only rent and occupancy dollars but to get leverage on much lower sales. So that's been a real benefit.

Operator: Our next question comes from Lorraine Hutchinson with Bank of America Global Research. Please go ahead.

Lorraine Hutchinson : Thank you. Good afternoon. I just wanted to focus on Old Navy for a minute and the profitability, where do you see the largest opportunities to improve margins at Old Navy? And is this one of your key goals in terms of improving consistency?

Katrina O'Connell: I'll start and Richard can pile on. I think in general, the rigor that we're putting in place across the company around inventory management, expanding gross margins being prudent about SG&A and overall growing operating margins, I think, is leading us to impact all of our brands. So we're focused on driving profitability across our portfolio. Old Navy, obviously, is the biggest brand in the portfolio is quite important on that journey. I think overall, when you look at the company and you think about the guidance that we put out, our gross margins for the year are approaching historical highs. And so we feel very good that we've made a lot of progress around gross margins for the company. And our bigger focus, I think we talked about just a minute ago is really turning our attention to further work we can do around the expense structure of the company.

Richard Dickson: Lorraine, I'll just add, we're running a fundamentally stronger business. And obviously, the metrics that we're posting are indicative of the efforts that we've been making. But of particular note, we're driving a 5% net sales growth on 5% less inventory. We've been working on our inventory and inventory management for quite some time as the composition that we have is much stronger. We have better product better sell-through in general at full price and therefore, less discounting. And obviously, the impact on margin is there. As we continue to drive consistent deliverables on Old Navy, Gap and across our portfolio, we expect that type of rigor to remain consistent. This is our fourth consecutive quarter of positive comps for Old Navy. It's the sixth consecutive quarter of market share gains as well for Old Navy and for the company. Again, as a reminder, it's also the seventh consecutive quarter of women's gained share in Gap. So consistently doing what we say we're going to do driving leaner, more inventory that is precise and better storytelling, and we're getting that resonance with consumers.

Operator: Our next question comes from Adrienne Yih with Barclays. Please go ahead.

Adrienne Yih : Great, thank you. Congratulations on the progress. Richard, I can appreciate very much the market share gains at the Gap brand. I was wondering after a year with the comp over a year, can you talk about kind of the descriptors for what is the core target demographic, the core market for Gap? Because I feel like that is the one brand that maybe has moved around a bit over the past decade. And then secondly, Katrina, just some clarification on the onetime benefit of the credit card revenue, 2 percentage points to sales, but you said, I think you said 240 basis points on the merch margin. So should we just net -- should we take that out of the operating margin and think about it that way for an adjusted basis? Thank you.

Richard Dickson: Thanks, Adrienne, for the question. And in particular, on the Gap brand, which we're so proud of the progress that we made. And as I mentioned, I really do believe we're well on our way to revitalizing this iconic American brand. It's also important to note, the brand is 55 years old or young. We just celebrated our 55th anniversary. And I think in the context of what that represents, it's a multigenerational brand. And we've been focusing on returning to our roots as a pop culture brand. And so trend-right products and creative expression that is supported by big ideas and culturally relevant messaging. It's less about age and more about brand persona and brand identity. And I've been really pleased that the brand has delivered these consistent results in the quarter. Net sales up 1%, comps up 3%, gaining market share for the fifth consecutive quarter across women's, men's, kids and baby. These are real indications that we're starting to get it right. Our Get Loose campaign, which is out there now just launched last week, it's a declaration as gap as a destination for trend, baggy and oversized trend. But when you talk to different consumers in different age brackets, they're all really enthusiastically excited about Gap narrative and about where we can potentially go with this brand and its heritage. As mentioned again, the collaborations, Doen, Mad Happy, it's a key part of our brand strategy. It's broadening our reach. It's strengthening our cultural relevance. It's opening up consideration for generations that might not have considered Gap. So it's a multi-tiered approach. I'm very confident in how the progress is delivering to date, and there's a lot more to share in the future.

Adrienne Yih: Super helpful.

Katrina O'Connell: Sure. As it relates to the credit card benefit, yes, so it was about 2 points to net sales year-over-year, and that was driven by incremental revenue related to the credit card agreement. And it was basically we have contract provisions within the arrangement of our credit card agreement that impacts the timing of how we recognize certain revenue. So it was unique to the quarter. As it relates to the margin piece, however, we did break down the merch margin into 410 basis points of benefit. We said 170 was commodities and 240 is actually about half the credit card dynamic and the other half is actually better promotional performance. So I wouldn't take all of that too far out. You can use about half as an example to adjust for that onetime benefit.

Adrienne Yih: Okay. Thank you so much, I appreciated. Best of luck for the holidays.

Operator: Our next question comes from Mark Altschwager with Baird. Please go ahead.

Mark Altschwager : Good afternoon. Thank you for taking my question. So we look across the apparel space here, we've seen several examples in the last couple of months about how value is really taking share with consumers in this backdrop. Old Navy clearly known for value, well positioned there. So I was wondering if you could just sort of speak to your opportunity to lean into that over holiday with your marketing messaging. And just also, what are your expectations more broadly for the promotional backdrop for the holiday season? Thank you.

Richard Dickson: Thanks, Mark. As far as we're concerned, we haven't seen anything that would warrant any changes or new factors that are influencing our outlook for the year. As always, our job is to create the interest in demand and capture consumers' attention. And we've been really encouraged specifically to see growth across all income cohorts. That's really a reflection of the strong value proposition across all our brands, not just Old Navy. Traffic remained similar to last year, and our strength in the quarter is really been driven by the average transaction as customers are responding really well to our products. And customers react to newness, innovation and great storytelling. The apparel market, as you know, is down 2% in the quarter and Gap Inc. and our brands gained share. And it was strengthening categories such as denim, active and kids and baby, which have been strategically really well intended. And it indicates that our reinvigoration is resonating with consumers. This conversation around trading down, we haven't necessarily seen evidence of trade down. Customers are continuing to have positive response when they're offered the right price at the right style at the right value equation. Our portfolio, we believe, is really well positioned and particularly with Old Navy as the largest brand in the value space. And so if there is a flight to value, Old Navy is there with a welcome mat.

Operator: Our next question comes from Jonna Kim with TD Cowen. Please go ahead.

Jonna Kim : Thanks for taking my questions. I would love more color around how your promotional strategy now is structurally different from before and just related to merchandise margin, if we should start to see moderation in the promotional benefit and how we should think about that as we model as well? Thank you very much.

Katrina O'Connell: Yes, sure. So I think as we think about what's happening in the industry overall, it appears the industry is controlling inventories well and generally, that helps make for a more rational promotional environment, I think more particularly to us, our inventory is well controlled, and we're very focused on executing our reinvigoration playbook. Again, as we think about the second quarter we had very strong beats in gross margin. A portion of that driven by commodities. And as we just talked about, a portion of that driven by the credit card activity, but also by better performance in gross margin. As we think about the year-to-date performance for the company, we've gained about 450 basis points in gross margin overall due to a strong recovery in commodity costs as well as better inventory management. So we feel very good about the progress that we are making in being able to control inventories, offer better assortments and really generate less promotional volume. I think in addition to that, we see continued benefits heading into Q3. We just provided an outlook that shows a range of possible outcomes around margin, which could grow somewhere in the 50 to 75 basis point range. And we attributed that upside to really improved promotional activity as we head into third quarter. So when you take the first half performance and our third quarter raised outlook, we've actually raised our full year outlook on gross margin again. And we now expect gross margins to be up about 200 basis points year-over-year. So all of that, I think, is a reflection of the rigor we've put into the inventory management side as well as the reinvigoration work that the brands are doing to offer great product at great value through great marketing.

Operator: Our next question comes from Corey Tarlowe with Jefferies. Please go ahead.

Corey Tarlowe: Great, thanks. Good afternoon, and thank you for taking the question. I wanted to ask about the right way to think about what the potential EBIT margin or profile of the business could be. Given I think this is the first time in the first half of the Gap's fiscal year in a very long time, if ever, you've had gross margins average over 41%. So curious to hear how you think about the additional levers that you can pull to drive higher EBIT margins sustainably for longer?

Richard Dickson: First of all, I think we're proving with the consistent deliverables quarter after quarter that we do what we say we're going to do. This quarter, in particular, was a real success story in relation to 500 basis points of gross margin expansion, and of course, our operating margin expansion of 490 basis points. We've held our view on revenue and SG&A, and we've raised our guidance in relation to higher gross margin outlook. And we expect to expand roughly 200 basis points year-over-year for '24, and that will result in EBIT growth in the mid-to high 50% range. As we continue to deliver against our priorities and over the long term, we're working on multiple initiatives especially in the expense structure. And we'll be getting back to you as to the targeted ways that we're going to continue to drive efficiencies and effectiveness. And as we continue to deliver what we say we're going to deliver, we see the ability for this portfolio to deliver historical references and ultimately, new chapters of growth for the company.

Corey Tarlowe: Got it. And then just Katrina, as a follow-up to that, what's the comfortable level of cash for Gap Inc. going forward?

Katrina O'Connell: Yes. Well, first of all, I would say we're very pleased with the health of the balance sheet. $2.1 billion of cash is a meaningful growth year-over-year. And so that certainly feels good. I think about minimum cash balance is somewhere in the $1.2 billion range. That gives us a level that ensures we have the cash to service our working capital fluctuations and general business volatility. And then when I think about cash, we sort of have a balanced framework for capital allocation. First, we invest in the business through capital to the degree we feel like we can get a good return. And this year, we've said we're spending about $500 million in capital. Second, we believe in paying an attractive dividend as a key component of shareholder returns and we have paid out about $112 million so far year-to-date, and we just approved another $0.15 a share dividend in third quarter. So I think so far, we feel very good about the way we've been managing the balance sheet. And all of that management this year so far has given us about $400 million of free cash flow. So hopefully, that's helpful.

Corey Tarlowe: Thank you very much and best of luck.

Operator: Our last question will come from the line of Dana Telsey with Telsey Advisory Group. Please go ahead.

Dana Telsey: Hi, good afternoon everyone. And very nice to see the progress. Richard, I've been in the stores in the new Banana Republic and Soho and in Century City that you just opened. And certainly, the physical store footprint is important for the new enhancements to the products that you're advancing. How are you thinking about the retail fleet? In the past, it had been thought that Old Navy would go into some more rural areas, too. What's the status of the fleet of each division? Were the remodel smaller size and where you're taking it going forward? Thank you.

Richard Dickson: Thank you, Dana. I really appreciate you visiting our Soho store and Century City. We're really proud of those expressions. And I think Soho and Century are great examples of immersive experiences that we're trying to create. It certainly has a new aesthetic which we believe, again, has the right elements for the new direction that we're taking, and we're planning to roll out similar elements inspired by those two doors to the rest of the fleet. As it relates to retail stores in general across our fleet, we are in the sort of studying stage, if you will, of optimizing our retail footprint. There's a lot of work that we're doing to understand productivity, store experiences, traffic and all the variables, as you can imagine with a fleet and presence that we have we believe very strongly in retail and the balance of the omnichannel experience being both bricks and mortar and digital and the connection between the two, but we have work to do. We have a lot of work to do across our fleets to make sure that these stores reflect the brand reinvigoration that we've been working on. Each one of our brand leaders is paying incredible attention to the store experience the service levels, the aesthetics, the sites, the sounds, these are all really important parts of our consumer journey and the reinvigoration of our brands. So while we made progress, and we've got some great indication on some of our stores. We do have a lot of work to do, and we'll be sharing a lot more of that in the quarters to come.

Operator: Thank you. We've reached the end of the question-and-answer session. That does conclude our conference call. You may now disconnect.