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Good afternoon, ladies and gentlemen. My name is Corina, and I will be your conference operator today. At this time, I would like to welcome everyone to The Gap, Incorporated Third Quarter 2018 Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions]. As a reminder, please limit your questions to one per participant. [Operator Instructions].
I would now like to introduce your host, Tina Romani, Senior Director of Investor Relations.
Good afternoon, everyone. Welcome to Gap, Inc.'s third quarter 2018 earnings conference call.
Before we begin, 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 the description and reconciliations of the non-GAAP financial measures, as noted on Page 2 of the slides supplementing Teri's remarks, please refer to today's earnings press release, as well as our most recent Annual Report on Form 10-K and our subsequent filings with the SEC, all of which are available on gapinc.com. These forward-looking statements are based on information as of November 20, 2018, and we assume no obligation to publicly update or revise our forward-looking statements.
Joining me on the call today are President and CEO, Art Peck; and Executive Vice President and CFO, Teri List-Stoll. As mentioned, we will be using slides to supplement our remarks, which you can view by going to the Investors sections at gapinc.com. As always, the Investor Relations team will be available after the call for further questions.
With that, I'd like to turn the call over to Art.
Good afternoon, everyone, and thank you for joining us today for our Q3 conference call. You’ve obviously seen the press release with our third quarter results which generally fell within our expectations and reflect the continued positive performance of Old Navy, Banana Republic, and Athleta.
That said, I suspect you like we are most focused on the results of Gap brand. While the performance of Gap brand this quarter was not entirely surprising, clearly we’re disappointed and we need to do better. We continue to feel the impact of last year’s operational missteps in the business, but we also face more fundamental issues with the brand namely the specialty fleet.
I’ll talk first about the current performance, trends, and then I’ll turn to the more significant structural issues. As we said on our last call, once we identified the operational issues we made the decision to make aggressive but necessary cuts to rightsize the assortment including reducing SKU count by 30%.
The Q3 assortment was affected most dramatically as we have less flexibility to pullback units without impacting the overall assortment architecture. As such, entering Q3 we had some known imbalances in the assortment. We made these cuts intentionally and these imbalances were known. This mainly affected tops but it also impacted the assortment breadth and depth behind key styles.
For perspective, the average tops to bottom ratio is generally about 3:1 and we are at about half that in Q3. This has an impact on conversion which was more severe than we anticipated driving sharper discounts to clear inventory and position ourselves for a healthier Q4. I now have the benefit of hindsight, and with that hindsight I am still quite confident that the decisions that we made were the best financial decisions.
I want to share, however, where the assortment is in Q4 compared to Q3. Programs and CCs are down 30% providing a narrower but better architected assortment. Tops to bottom ratios have moved from about 1.7 to 2.8, which is much closer to the norm. Depth behind CCs and our key items which particularly impacts service levels is up 18%. With that, Q4 is better positioned. We expect an improvement from Q3 trends in both comp and margin and the early reads of our Q4 product flows are encouraging.
Let me take you back and review a few things about Gap brand over the last several months. In late June, we named a new brand President at Gap, Neil Fiske. Stabilizing the business has been his first priority. As you would expect, he’s assessed the business, the organization, and the underlying processes and is well into developing his plans.
Over the last several weeks, we’ve landed additional key leaders with impressive credentials, including, and I’m very excited about this, Pam Wallack from Children's Place to lead North American specialty. This is a role similar to the one that she previously held when she was working directly for me when I was running the brand in 2012.
I’m pleased with the progress that Neil is making. Importantly, the actions we’re taking are the foundation for improved margin, expense reduction, and the increased profitability that is required for the brand to be a contributor to shareholder value.
Okay. All that said, the biggest challenge with Gap brand is largely a function of certain legacy elements which we understand and recognize of the brand. A big one specifically is the real estate obligations that currently encumber the business.
To be clear, the average of Gap doesn’t tell the story and I want to tease the brand apart for a minute and talk about the parts. We think of it as three interrelated pieces on which we can and will make discrete decisions.
There is a healthy and growing online business which constitutes about 20% of the total revenue of the brand. There is a profitable business in the outlet space with about 500 stores globally that represents about 30% of the revenue. The remainder is the specialty business, which is currently underperforming.
The specialty store channel is also a tale of two businesses. We have 775 Gap brand specialty stores globally. On a cash basis, this part of the fleet returns a very modest contribution. But importantly, the range from the very best to the very worst stores is extremely broad.
Addressing the bottom half of the fleet could represent over $100 million of earnings contribution opportunity and it is that portion of the fleet that is dragging down the brand. This is the piece of the business that we are firmly committed to addressing with urgency.
It includes some amazing flagship stores around the world that we’re evaluating with an objective eye on which ones provide sufficient value to keep. Collectively, the flags have meaningful negative contribution.
Beyond that, there are hundreds of other stores that likely don’t fit our vision for the future of Gap brand specialty store, whether in terms of profitability, customer experience, traffic trends, importantly the ROD structure and/or near and long-term relevance to the brand. These stores are a drag on the health and a drag on the performance of the brand.
At the same time, we know that stores are an important part of the customer journey. And importantly, we have a significant number of specialty and outlet stores that are cited where customers lead their lives, that have attractive four-wall economics, that operate at brand standards, that have positive trajectory and long-term relevance. It is this healthy core of the brand that we will focus on to deliver future value.
You have my commitment that while this type of strategic action on the fleet is overdue, I am going to take the action to get this one done and get this one behind us. There likely will be a cash cost to exit many of these stores, which we will attempt to minimize with appropriate sequencing. But I plan to exit those that do not fit the future vision quickly.
I’m going to move thoughtfully, but aggressively. We will come back to you with more detail on our planned actions by the time we lay out our guidance for the coming fiscal year. It was important to address Gap brand first, and I want you to go back and again look at my words, but I also want to touch briefly on the great majority of our portfolio which is working and working well.
Old Navy continued its profitable sales trajectory in Q3, with 11% sales growth and four comp despite warmer-than-anticipated weather for much of the quarter. Even with weather challenges, nearly all divisions inside the brand positive comped in the quarter and product margins continued to expand, which has been true all year, demonstrating the broad-based product acceptance in the box.
In women’s, dresses and woven tops, we saw some softness. It was driven by fabrication and some of the choices of print. The team recognized it and the team got on it and has largely corrected this for Q4 and going forward.
Building on strong and consistent product acceptance, store traffic at Old Navy continued to outpace industry trends. And online saw a meaningful acceleration in Q3 building momentum as we head into holiday.
I and we continue to be pleased with Old Navy’s consistency and consistently positive results, the clear positioning, the connection with customers and the operational discipline.
Let me turn to Athleta. It remains a growth engine in the portfolio. During the third quarter, 95% of the Athleta business comped positively demonstrating the underlying health of the business.
Last quarter I mentioned that the girl’s business was going to come out and seriously play in the back-to-school space and it did not disappoint with an over 60 comp in that business. The brand continues to see solid growth in its customer file, specifically new customers and is on track to exceed its 2018 customer acquisition goals.
While we’re on the subject of active, I also wanted to briefly mention the launch of Hill City brand in October. It is very early days, so I won’t spend a great deal of time on the call about the brand but the $22 billion performance lifestyle space is growing and is a key pillar of our balanced growth strategy.
We saw white space opportunities for men’s premium performance active brand and paired that opportunity with our operating platform, our size, our scale and our talent. Early product feedback has been positive. Customer engagement has been very strong and we’re taking advantage of the millions of visitors coming to our e-commerce platform to expose the brand to new eyeballs.
We brought Hill City to life in little over a year with a team of less than 20, something that would simply not be possible without the advantage of the underlying Gap, Inc. platform and customer base.
To round out the portfolio, Banana Republic just delivered its fourth consecutive quarter of positive comp, all while continuing to expand gross margin. I want to elaborate a little bit because I believe that the Banana Republic story is in fact quite relevant to Gap.
There are absolutely parts of Banana Republic revitalization story that we are replicating at the Gap brand. We brought Mark Breitbard back two months ago to lead the brand and similar to Neil, his early priorities was stabilize the business and assess the talent. Early on, he made a series of leadership changes in the brand across design, merchandizing and marketing.
He leveraged the best people, processes and tools from across the company as a shortcut to bring the brand back to health. That effort includes everything from the full adoption of Old Navy’s product to market process to integrating Athleta’s fabric technology and innovation into ready-to-wear BR product, as well as instilling operational excellence from other processes that we have built inside the company.
The changes required at Banana were not easy but we are now seeing wins in our product and in the customer experience that give us confidence in the ability of BR to deliver improved profitability and contribute meaningful to the Gap, Inc. portfolio.
Before Teri takes us through the financials, I want to take a moment to describe two critically important priorities for me as the leader of Gap, Inc. First, within the company we are continuing to build aggressively a culture of accountability. I take this very seriously and I know Teri takes this very seriously as well.
A good example is our performance this year. You saw that we continued to be committed to delivering results within our original guidance range. Clearly the year hasn’t come together in quite the form that Teri and I expected it to or wanted it to, but we remain committed to responsibly delivering on the commitments that we have made to you.
Second, consistent with this effort we are focused on driving shareholder value. We believe firmly in the size and scale advantage of the Gap, Inc. platform, our strong and loyal customer base and our iconic brands. But as I have said previously many times, each brand must earn its place.
This year, our earnings are coming from our healthy brands and our expense discipline. We are focused on margin and profitability improvement not necessarily growth at Gap brand and we will take the necessary actions to bring the brand to a profitable core that unlocks shareholder value and forms the basis on which to evaluate its long-term place in our portfolio.
With that, let me turn it over to Teri to walk us through the financials for the quarter.
Thanks, Art, and good afternoon, everyone. As Art said, although weakness at Gap brand pressured our results in Q3 we do remain encouraged by the results throughout the rest of the portfolio, including Old Navy’s continued momentum, and acceleration in trends at Banana Republic, another strong quarter delivered by Athleta and the underlying expense discipline we’ve demonstrated.
Turning specifically to the third quarter performance. Just as a reminder, our reported results include the impact from the adoption of the new revenue recognition standards which changed the classification of certain line items in our P&L.
For the third quarter, the presentation changes resulted in an increase of $170 million to net sales, an increase of $128 million to gross margin and $128 million increase in operating expenses.
To be helpful, we’ve included a slide in our quarterly earnings presentation that details Q3 2018 results with and without these significant presentation changes from adoption and that can be found in the Investors section of gapinc.com.
So let me run through the results, starting with sales. Net sales for the quarter were $4.1 billion. This represents growth of about 2% over Q3 2017, excluding the presentation changes from the adoption of the new rev rec standard.
Comp sales were flat compared with positive three last year. Again, excluding the presentation changes from rev rec, spread for the quarter was largely driven by new store openings.
At the brand level, Old Navy had another strong quarter delivering a positive four comp and 11% sales growth. This double-digit sales growth includes 54 new stores year-to-date demonstrating strength in our runway for growth. Despite weather variability throughout the quarter, the brand continued its strong track record delivering another market share gaining quarter across all divisions.
At Gap, comp sales were down 7% against positive one last year driven by the assortment architecture issues that Art discussed. It’s worth noting that at Gap brand we did see an improvement in comp trend as we moved through the quarter and the initial reads following the new holiday flow have been in line with our expectations.
Banana Republic posted its fourth consecutive quarter of positive comp with a plus two comp against last year’s negative one. As Art mentioned, we were pleased to see continued expansion in gross margins as the brand focuses on driving consistency, increasing productivity and reducing the breadth and depth of promotion across the assortment. We’re encouraged by the positive customer response as we head into holiday.
Athleta delivered another impressive quarter with broad-based category strength. The team remains laser-focused on growing market share by continuing to provide innovative product design and a compelling customer experience.
Momentum in online also continues delivering solid double-digit growth with all brands contributing positively. We continue to focus on providing a seamless shopping experience that offers convenient capabilities on our industry leading platform. We remain confident in our goal to reach over $3.5 billion in online sales this year.
Moving to gross margins. On a reported basis, gross margin was 39.7%, a 128 million or about 160 basis points of expansion were driven by the presentation changes from revenue recognition adoption. Excluding that impact, third quarter gross margin declined 160 basis points driven by a merch margin decline of 180 basis points partially offset by 20 basis points of rent and occupancy leverage.
There are some countervailing elements to the merch margin trend, so let me walk you through the components. The underlying product margin is down about 30 basis points driven by the Gap brand which more than offset expansion at Old Navy and Banana Republic. This reflects the continued challenges in the business, but as we expected shows sequential progress to the Gap brand.
As Art mentioned, given improvements in our tops to bottoms ratio along with additional color in brand appropriate product throughout the assortment, we continue to expect sequential improvement in Gap’s margin trend in Q4. The remainder of the merchandize margin deleverage was largely due to increased shipping expense.
As we mentioned last quarter, we started off our Fishkill DC with significant new automation. As we fully operationalized the new equipment and technology, we experienced pressures from increased splits for our online business, meaning more packages and higher shipping costs.
This widely affected Old Navy given their strong online performance in the third quarter and the brand’s high UPT. Going forward, we would expect the Fishkill impact to moderate, although we will continue to have opportunities to optimize our shipping costs. Rent and occupancy leverage was primarily driven by the sales growth.
Moving to SG&A. On a reported basis, third quarter total operating expenses were $1.3 billion. The presentation changes from rev rec resulted in a $128 million increase in operating expenses and accounted for 190 basis points of operating expense deleverage. Excluding that impact, third quarter SG&A as a percentage of sales leveraged 100 basis points exceeding our previous guidance.
We continue to make nice progress against our productivity initiative with expense discipline, particularly around discretionary and controllable expense with bonus favorability also helping to drive leverage in the quarter.
As I mentioned last quarter, internally we set a goal for the organization to identify and action $200 million in productivity savings. We remain on track to exceed that goal for the year.
As I’ve discussed since initially introducing our productivity initiative, I’m really pleased with the organization’s adoption of this work supporting both near-term results while building a simpler, faster, more efficient organization over time.
Moving to taxes, our third quarter effective rate was 24%. This lower rate reflects a reduction in our fiscal year '17 TCJA transition, tax, liability due to recently released IRS guidance and finalization of calculations for our federal tax return.
With better visibility to the adjustments to these provisional estimates for TCJA, we now expect our full year effective tax rate to be about 25%. We’ll continue to analyze our tax return positions under TCJA as guidance is released and we’ll finalize our provisional estimates in Q4.
For completeness, I do have to remind you that adjustments to these provisional amounts, for additional guidance, technical corrections or new legislation could materially impact our Q4 and annual tax rate.
For earnings, our third quarter earnings per share was $0.69, including about $0.03 of benefit from the lower tax rate versus our expectations compared to earnings per share of $0.58 last year.
FX was a benefit of about $0.01 for the quarter and $0.03 year-to-date. Given the strengthening of the U.S. dollar, we now expect a $0.04 benefit from FX for the year versus our original guidance of $0.07 benefit.
Regarding cash flow, our year-to-date cash flow was $57 million compared with $197 million last year, which included $60 million of insurance proceeds related to property and equipment.
Lower free cash flow year-over-year was driven by an increase in capital spending and a lower bonus accrual in 2018. We ended the quarter with $1.3 billion of cash, cash equivalents and short-term investments.
With regard to the earnings outlook for the remainder of the year, as you know the volume and impact of the fourth quarter is substantial and our performance in the quarter is important to our delivery of the year.
While challenges at Gap brand have continued to impact our performance beyond our original expectations, the underlying fundamentals of the other brands remain strong and we’ve been able to leverage our portfolio consistent with our strategic priorities to deliver the first three quarters of the year largely in line with our expectations.
Given this, along with the benefit from a lower tax rate offset by FX, we are narrowing our full year earnings per share guidance to be in the range of $2.55 to $2.60. As a reminder, our annual guidance range includes the negative impact from the loss of the 53-week of about $0.06.
Just as the first quarter benefitted from the calendar shift, the fourth quarter is expected to be negatively impacted both from the shift in the calendar and the loss of the 53rd week. We continue to expect the spread between comp and total sales in the fourth quarter to be negative.
Additionally, given the impact of having one less week in the fourth quarter and the calendar shift, we expect deleverage in rent and occupancy in the fourth quarter. We continue to expect meaningful expense leverage in the fourth quarter despite headwinds from the loss of the 53rd week as we lap some unique incremental spend in the fourth quarter of last year that we do not expect to recur.
We continue to expect full year comp sales to be flat to up slightly with a modest positive strength. Given the way the year has unfolded, I thought it might be helpful to have a little more specificity on the expected composition of Q4 revenues. Based on current projections, we would expect Gap brand to show sequential progress but still be down for the year. A good estimate is probably closer to the first half trend.
We expect Old Navy to continue its strength, building on an amazing 9% comp last year and forecasted to deliver sequential progress from Q3 with another double-digit two-year comp. Banana Republic strength is expected to continue also with sequential progress. And finally we expect strong Athleta trends to continue.
Before I – let me go back to the balance sheet. I realized that I didn’t cover inventory and finish off our cash. So starting with cash, we did continue our commitment to returning cash to shareholders by completing an additional $100 million of share repurchases during the quarter.
We ended the quarter with 382 million shares outstanding. And year-to-date, we paid dividends of 281 million and currently have a dividend yield nearly 4%. On the inventory front, we ended the quarter with inventory up 8% compared to the third quarter of 2017.
Similar to last quarter, Old Navy, which represents about half of our total inventory, is carrying higher balances to support new growth. Additionally, at the Gap brand to mitigate some of the lateness we experienced in the first half, we intentionally made the decision to increase the dwell time of inventory in our DCs ahead of the important holiday season.
This resulted in a pull forward of receipts and an increase in the brands ending inventory balance. Together, new store growth and the intentional decision to increase dwell time for Gap brand represent about half of the total inventory increase. The remaining increase positions us well for holiday and we feel comfortable with the composition of our inventory heading into Q4.
Regarding capital and store count, year-to-date capital expenditures were $510 million. We have reduced our expected capital spending for the year to be about 750 million versus our original guidance of 800 million.
Year-to-date, we’ve opened 109 company-operated stores, largely Old Navy and Athleta, while closing 56 stores primarily Gap and Banana Republic. We ended the quarter with 3,218 company-operated stores.
We continue to expect 25 net new stores, but we now expect Old Navy to open about 70 stores versus our previous guidance of about 60 while accelerating the closure of some additional Gap brand stores.
With the balance sheet finished, let me close out here. As Art mentioned, we have significant work underway on the Gap brand both operationally and more strategically to identify and action the more radical but necessary steps to unlock shareholder value by establishing a healthy core business from which we can profitably grow.
We understand the nature of the problem. We have some but not all of the initiatives in place to get the brand back on stable footing and we’re in process to evaluate all possible options to make the hard decisions and deliver the right results to our shareholders.
So with that, we’ll open it up for questions.
Thank you. [Operator Instructions]. Please limit yourself to one question. And we’ll take our first question from Matthew Boss with JPMorgan. Please go ahead.
Great. On margins, what’s the embedded expectation for merchandise margins in the fourth quarter? And I guess larger picture, how best to think about freight and wage pressure relative to this year as we think beyond?
Yes, so we typically don’t guide to that level of specificity, but I know that we were kind of closing in on the end of the year I can tell you just – as you look at the full year given the trends through the first three quarters, we don’t expect to have an expansion of gross margin on the year. We do expect sequential progress. And it really does come down to some of these shipping trends that we talked about more so than actual product margin beyond what we’ve seen in the Gap brand. So that’s general guidelines as you think about the remainder of the year and the full year look.
Minimum wage, this is one where we tend to be ahead of minimum wage actions. I think it’s well over 70% of our employees are paid at market wage today which means we’re already well ahead of that. We typically have been – it’s one of the reasons why we’ve been investing in automation in the DCs is it does allow us to drive productivity as an offset to some of those minimum-wage pressures. So, so far, particularly in 2018, we haven’t seen a lot of pressure. Same with the transportation. Is that the other part of what you asked, Matt?
Well, the freight and the splits I think was part of that. If I go to that on the freight and splits from an overall just factor standpoint, we’re not seeing significant pressure in freight expense. What Teri highlighted, Matt, was that as we brought Fishkill up and we were managing fulfillment direct to consumer from different pools of inventory, we did see what we believe is a relatively momentary thing around packaged splits because of how we were bringing it up at the end of the day. And we’re very much on it.
We’re very much focused on managing packaged economics. We’ve done an excellent job of that over time. And particularly as we are also working to be able to light up the ability to take orders on proximate inventory that will help us down that path, which is something we’re focused on bringing up to speed next year as well. So we think it’s more temporary than anything permanent.
Great. Best of luck.
We’ll take our next question from Mark Altschwager with Baird. Please go ahead.
Great. Good afternoon. Thank you. Teri, just first clarifying the comment you made on the Old Navy comp in Q4. Is your expectation to show sequential improvement relative to the plus 4% reported in Q3, or was that sequential improvement specifically referencing the two-year stack?
Well, actually both, but more focused on the sequential improvement over the Q3/Q4 comp.
Got it. Thank you. And then circling back on your comments on Gap specialty, the bottom half of the fleet that you mentioned, the 350 plus stores, I guess how quickly do you think you can exit those? And what does the comp trajectory look like in the top half of the fleet as it sits today?
Yes. Let me answer the first question first, which is it’s still a mixed comp trajectory. But the important thing to think about, and I’m giving you proportional numbers. We’re still doing the work and we haven’t made any decisions to figure out exactly where we’re going to go with this. And obviously our landlords are our partners also in moving down this path.
The best way to really think about that top half is those are stores that we believe will do today have a four-wall return that allows us to operate them profitably and to continue to reinvest in those stores appropriate to maintain them to brand standards. We have had a lot of stores that are in the bottom half of the fleet that have continued to deteriorate over time.
And it is my strong belief that we’ve kicked the can down the road on this and offered a deteriorating customer experience and it does have a negative effect on the health of the brand. As to comp trends, we have some of those bad stores that are comping positively but that could be local circumstances. A lot of them were negative. But the trends overall are more positive in the upper half than they are in the bottom half.
That’s helpful. Best of luck over holiday.
Let me add one more thing too. Again, because we have at times kind of crossed our fingers and hope to grow our way out of the problem. As we look to getting Gap brand to a place where it creates shareholder value, we are not building a plan here that assumes all of a sudden a miracle happens and we start positively comping and we get a profound expansion of the margin and we grow our way out of the problem at the end of the day. I have my hands as does Teri on things that are structurally addressable that have a set of consequences and a set of outcomes associated with them. Of course, I am always hopeful that as we improve the product and get our marketing in line, et cetera, that we start to get positive lift out of the business. But I believe we owe our customers and our shareholders better as we put a plan together here to address the structural changes that we can make, a lot of which is again around really getting on the fleet and getting this done and getting it behind us.
Thanks, again.
As a reminder, please limit yourself to one question. We’ll hear next from Dana Telsey with Telsey Advisory Group. Please go ahead.
Good afternoon, everyone. As you think about the merchandise margin and the buckets that you had, it seems like the Gap brand was the negative impact to the merchandise margin. What did you see and how did it compare to the other quarters this year of expansion at Old Navy and Banana Republic and how are you thinking about that going forward? Thank you.
So if I understood the question, Dana, so on the Gap brand itself as we’ve said we have seen this sequential progress that we expected in the brand although it’s still negative versus the prior year. So obviously more work to do. But we do feel good about where we’re set up for Q4 and then obviously going into 2019 for that continued progress. As I think about the other brands, we – Banana in particular has really been on a very consistent and positive trend both with delivering the positive comps but importantly delivering the margin expansion ahead of that comp sales growth. And the same with Old Navy. It just continues to be very healthy and strong with the market share growth that I talked about and the good focus on product margin expansion.
And how is the Old Navy plus size doing and if you see other category expansion opportunities for Old Navy to continue to grow? Thank you.
Yes, I’m glad you asked. As you know, Dana, it’s very early days in plus size and we put it in a limited number of stores, roughly about 75 stores, because we wanted to get it right before we committed a huge inventory bag and rolled it out across the fleet. And so we’re in learning mode right now. I hope by this time and as long as we’ve known each other that one of the things you should know about me is test, test, test until you get it right and then put the hammer down. And so we are still in learning mode. There is nothing, however, in our experience so far in the stores that we have put the product in that suggests anything other than we have a significant opportunity here and the customers are really responding to it.
And moving on, we’ll take our next question from Randy Konik with Jefferies. Please go ahead.
Yes, thanks a lot. Art, a big change in your statement putting that stake in the ground to really address the Gap division which I really appreciate, I think the market will appreciate that. Just back on the idea of pace, if you could give us maybe some perspective on your vision on your pace to completion or duration to completion on getting this done, just trying to get a sense of do you think this is a one-year, two-year, three-year – what type of timeframe are we looking toward in getting these closures out of the way from a Gap division standpoint? And then I have a follow up.
Yes, as we said and Teri reiterated and I did also, Randy, we’re going to give you more information as we get towards wrapping up the year because we are still doing the work right now. And as you can imagine – so I’m going to frustrate you a little bit because – but I will say sooner rather than later is what is on my mind. Obviously, our landlords are involved in this and they’re very important partners in figuring out how we move down this path. And so we’ll be having conversations with them about it as well.
But in saying all that, I do believe that it has been a significant issue and a drag on this business by the incremental year-over-year-over-year approach that we have taken. And I am committed to moving much more aggressively than that at the end of the day. I think it’s stating the obvious that it’s somewhat unsaid that we have a store that is rundown, does not present the product in a respectful way to our customers, that is not a positive brand experience and we believe and I believe quite strongly it does impact the brand.
So I’m anxious to get this done and get it behind us as soon as possible. But there are financial consequences. We do have our landlord partners in the tent with us on this one, so we have a lot of work to do to figure out how to pace it. But urgency is on my mind.
Got it. And then when you think about partnering with Neil, how you kind of instructed him to kind of focus on product architecture, pricing architecture, marketing, brand positioning, et cetera, while you kind of focus with the troops on the real estate side? Just curious on how you guys want to kind of attack this. And then, Teri, is there anything you can give us in perspective on – as you laid out that the outlet business is about $1.5 billion business, the e-com business is about – I’m talking about Gap brand; Gap e-com is about $1 billion revenue business it sounds like and Gap outlet is about $1.5 billion revenue business. Is there any kind of perspective on maybe not giving us the exact margins of those businesses, but maybe how they are different from maybe the specialty part of the Gap brand just to give us some perspective on just how much profit margins can improve as this company really undertakes this strategy to close the unproductive real estate, just curious there? Thanks.
Yes, let me take a shot at this one and by the way that was three questions, but we’ll let you off the hook this time.
And also it reminded me how many of you know that children’s book if you give a mouse a cookie, like we gave you a split, Randy, and now you want margins by channel of a brand.
Let me address it more honestly. We’re not ready to break that out right now. But Teri and I both believe and we’ve heard this message in talking to many of you face-to-face that there’s value in greater transparency here and we want to make sure that we do that in an appropriate way. We obviously did a bit of an unveil a year ago at September and we want to continue to do that. I will say I believe that you are appropriately you and everyone is filling in the blanks and we want to make sure that some of those blanks potentially get filled in more accurately and really reflect the true profit composition of the company across brands and channels and the geographies. So we’re going to move down that path. But at this moment, I don’t want to go into a much greater level of detail.
On the split between Neil and me, I would say we’re pretty much together here. That said, Neil’s in the building and he is, as you said, really focused on what is impactable today in terms of product assortments. We mentioned the functional equities of the brand on making sure his team is in place. And I am really excited to have him in the building. I think Pam and Neil have gotten to know each other. She will be an excellent complement to the skills that Neil has. And worked for me and was just terrific in managing the overall product process and P&L, so I’m excited to have her back. We’re together on this real estate one as you can imagine, but this has bigger and more strategic consequences for the company in total since our relationships with our landlords are all cross brands. So that is a place where Teri and I and our central real estate team are running some interference for Neil.
Great. Thanks, guys.
We mentioned it in the script, as you think about this specialty channel vis-à-vis the others, you can sort of – with the data we provided last fall, you can kind of put together the pieces and understand when we say it’s underperforming what that means. And if we really can’t address this bottom half performance, as we said there’s $100 million of contribution benefit there, so that gives you a sense of between that and then the right-sizing of the overhead structure of the brand and then margin improvement. You can see the path quite easily too, a smaller but certainly more profitable core.
And just to be clear again because I’m not sure everybody heard us is that it’s not about growth here right now. I do believe there is growth in this brand but we’re not building a plan that’s predicated on growing our way out of the problem. We are building a plan that’s predicated on making structural changes that bring the P&L structure more in line and deliver an improvement in profitability and that’s what we’re committed to deliver. It’s the last time you get to ask three questions.
We’ll take our next question from Marni Shapiro with Retail Tracker. Please go ahead.
Hi, guys. Best of luck for the holiday in case I forget and I won’t ask three questions. I’m just curious if you guys could address at the Gap brand, we’ve talked a lot about the real estate, we’ve talked a lot about the product, little less about the marketing, but I guess is the problem at the Gap brand weakness across all of the categories? So is it hitting kids and men and active and women’s fashion and intimates? Is it hitting outlets and street locations and mall locations and international the same?
If you could just give us – is there any variances I guess within the store itself and then within the locations that would give us a better idea of understanding? Because it sounds like online you’re getting a good reception which you’re online assortment are a little more focused, a little bit more fashion, that leads me to think that maybe your fashion customer is still coming in. I’m trying to figure out where the weakness really is coming from?
Yes. So I would point out that just because you don’t put a period at the end of all of these sentences, you still bundled several questions there because really it was very clever. So let me tease that apart a little bit. Outlet performs consistently and it performs consistently frankly across all categories and profitably in all locations. And a lot of that has to do with the fact that the product has been more consistent and is getting better and the broad structure of the business allows for a four-wall out of each store that delivers at the end of the day. And I would focus the attention, because this is part of what we’re focused on here is the wide structure inside the P&L. And so there are some differences but they really are not meaningful differences. The story is more about consistency than not.
Online, the advantage online is that we have the ability to curate and present the product where we’re actually able to overcome some of the issues around assortment balance and those kinds of things and present the product not entirely consistent with ownership, if that makes sense, so we can tweak it a little bit. When you get to a specialty store, you would have seen in Q3, specialty in women’s it was super flat. We were bottoms heavy.
We really took – a lot of the things we took out of the assortment, some poly, dizzy-print blouses and some other things didn’t belong in there in the first place. That ended up taking some of the color out of the assortment. When we flowed the holiday flow, you would have seen in an average store almost 90-day in terms of the balance of the assortment tops to bottoms as well as some excitement in the assortment with a more sophisticated crazy stripe presented upfront in the first 20 feet and then far fewer CCs and styles, as I referenced, which allows our bigger ideas to cut through.
And if you go, then dig down into it, it’s cliché but if you don’t have a women’s business that’s checking, you don’t have a business and the biggest issues have been in the women’s business. Kids and baby has been solid. We have strength in the intimates business. The active business kind of chugs along and then men’s business is going to be a reflection of the women’s business, but it has not had the same weakness nor did we make the same inventory cuts in the men’s business. So not all the energy is exclusively focused on women’s but we need a healthy women’s business which is what the whole business then sits underneath from an umbrella standpoint.
And an improved women’s business, it’s easy to see where that $100 million can come through because the women’s business should in part lift all of these sub-businesses even further, because they’re not even going the wrong direction today.
They move behind but they are solid. If you look at kids and baby, the baby and toddler business is super solid. Girl’s has been a little softer. Boy’s is strong. We just go through that way. So yes, the idea is on restoring the health of the women’s business.
That’s great. Best of luck for holiday, guys.
Yes, thank you.
We’ll take our next question from Adrienne Yih with Wolfe Research. Please go ahead.
Thank you very much. Good afternoon. I was wondering if you can talk about the Gap and who the target consumer is, how you can tap into the millennial with sort of the buying power? And Old Navy did a fantastic job of really defining, articulating and then going right after that. So just wondering if we’re fixing the result of the problem as opposed to if you could address sort of the crux of it which is the demand side? Teri, I wonder if you can help us just parameters for 2019. We’re hearing a lot from other companies. Just as guidelines; wage pressure, freight pressure, AUR and just wondering if you can give us some help there directionally. Thank you very much.
Yes, on the first point I think it’s a good point. I like to think about what’s the addressable market space for a category by price point for our brands and that is the starting point for understanding where we believe the brand can play. Here’s what I would say answering your question on Gap brand. I do believe that the specialty space that Gap occupied when we had close to 1,100 stores in North America that that space has contracted somewhat. And some of that has gone to value; some may have gone to premium.
Part of right-sizing the fleet and frankly walking away from some significant amount of unprofitable top line is recognizing the size of the market that Gap can play in. Now that all said, if you look at the information by category, by price point, our businesses, all of them, still operate in the low to mid-single digit share positions and I do believe that we have ample opportunity to continue to play. So is it addressing – is it the outcome? I don’t think it actually is.
I think, Adrienne, a big part of this issue is – and again, it’s been sort of the unspoken but clear moves on the table is we have stores that we have allowed to continue to age in locations that have also continued to age. And at some point those stores become toxic to the health of the business and that’s really what we’re stepping up and addressing here right now.
At the same time I can show you, as I said, a significant number of stores that are in locations that are fresh and relevant and current for the consumer that are generating very nice consistent four-wall contributions, are very healthy, have a significant component of known customers that shop there. So we have proof points about the health of the core and we know what the dots are that we can act on the unhealthy component of the fleet as well. And I think the lesser effect is just overall market size and the greater effect is wrong stores in the wrong location that were too big and have run down.
Mindshare --
Sorry.
Is there a risk that you lose mindshare as you shrink the footprint?
I don’t think you lose mindshare on Gap brand. I think there is a risk that you don’t recapture some of these sales. And again, I’m not saying never that we wouldn’t backfill some stores, but right now what I’m telling you and I want everybody to hear is this is not a growth story. This is a contract to improve overall profitability and return on invested capital story.
Thank you.
And moving on, we’ll take our next question from Brian Tunick with Royal Bank of Canada. Please go ahead.
Great. Thanks. Good afternoon. I guess maybe one for Teri on the SG&A opportunities beyond the 200 million this year, there are other buckets or other points of leverage going forward. And maybe Art could talk a little about sort of Old Navy, curious – you’re obviously optimistic already about how the quarter started, but curious about Q4 lapping last year’s 9%. Are there marketing or product initiatives you’re most excited about? And then longer term, what are the puts and takes to Old Navy’s mid to high-teen operating margins potentially getting higher? Thanks very much.
So what order do you want to take those questions?
Go for it.
So the first question was about SG&A and how we feel about it. Having the leverage this quarter of 100 basis points, looking for leverage next quarter as well and being ahead of our goal of 200 million on the year are all good positive indicators. But it isn’t the end of the story. We really do see a lot of runway ahead to continue to drive productivity. A lot of what we’re seeing this year is just good old fashion expense discipline and low-hanging fruit as we improve processes quite simplistically to be honest.
And what we haven’t really gotten the benefit yet is the broader reengineering efforts that will not only make our processes more efficient but also more effective, so there’s a real benefit there and those are projects that take a little longer to implement and get rolled down the organization. So that’s kind of year two plan to work against the $500 million in total savings that we laid out. And frankly, as I’ve said before, I think there’s probably more than that available to us as we look forward. So I think for us productivity is a multiyear journey and I think we’ll see continued benefit there.
And then on Old Navy’s margin, that was the other question, do we expect to see improvement?
Yes, as we think about it, Old Navy is very much focused on how do you drive its margin levers, which is a variety of things from mix to AUR improvement to AUC discipline. So we do see continued levers for product margin expansion at Old Navy. We’ve demonstrated that and it’s a clear focus. Obviously, a big piece of that is continuing to drive yield which we’ve been investing in some proprietary tools and work to help accommodate. So it is top of mind for the brand and we don’t see any major --
The only thing I would say here is that I think there’s a sense sometimes that I run into that Old Navy is sort of defining the odds and running perfect right now, which is why I included the fact that we did have some issues in the assortment with that, and there will be those occasional issues where we get a print wrong or a silhouette wrong or we miss a trend. Old Navy has continued to deliver and deliver consistently. So our investment thesis in Old Navy is not based upon continuing perfection. It’s based upon solid operating discipline that delivers consistently quarter-over-quarter. And as Teri said, as we continue to do that, we do see opportunities to continue to drive some expansion of margin at the end of the day in a number of different ways.
Art, anything about fourth quarter here at Old Navy what you’re most excited about lapping against the 9%?
Yes, the 9% was like a big number, but if you go – I think I’m getting this right is that over the last couple of years we’ve had a big number in December or a big number in November and what we’ve demonstrated is that we can deliver the quarter between the three months that we have and deliver it with consistency. So I think to your stack as we said, we’re pretty confident in being able to deliver very solid two-year stack for the quarter. Early indications on the product assortment are strong.
Obviously we’re coming into Black Friday and Cyber Monday and then the rush to Christmas. Weather is always a factor but everybody plays the weather card at the end of the day. So I’m optimistic from what we see. I don’t see structural issues in the assortment, I don’t see trends that we’re not playing in. I see us properly loaded with respect to inventory. The stores are fired up and ready to deliver. And then as of tomorrow, I’m out in the stores for the next five days. So ask me after that.
The only thing I would say is Old Navy has cozy done right this year; cozy socks and jammies. It’s the place to be. I think we have one more question.
And our last question will come from Chethan Mallela with Barclays. Please go ahead.
Hi. Good afternoon. So I think you cited some negative impacts from warm weather on the Old Navy comp in the third quarter. I’m just curious. As the quarter progressed and the weather cooled if there was any sort of progression or change in that trend? And then as a follow up; in the slides it looks like the overall company underperformed the industry on traffic in the third quarter and I think you had outperformed on that metric since at least the beginning of 2017. So maybe just discuss what drove that and how you’re thinking about relative traffic performance during the holiday period?
Yes, so on the weather thing, again, it’s stating what everybody knows. But as you get into the fall assortment, I think the weather turned cold and ideally being relatively dry gets people into stores and gets people to start shopping for seasonal items. Now the overcorrection that I experienced last Thursday in New York of that very early wet snowstorm, that doesn’t help. The general trends we see from long-term forecast would suggest that they are going to be positive which is relatively cool and relatively dry through most of the cold parts of the country, which should support the business. On the traffic trend, I would focus really on the longer-term trend and what we’ve consistently delivered quarter-over-quarter-over-quarter-over-quarter. I’m less concerned about a short-term aberration than they are about the consistency of what they’ve delivered. And what I’m seeing with respect to product acceptance as we lit up Q4. I don’t know Teri if you want to add anything on that?
The only thing I’d add about this most recent quarter is obviously we’ve had quite a significant negative traffic impact from the Gap brand for the issues that we talked about. And then even if the Banana, and this is a good thing at the end of the day, as we’ve been thoughtfully and intentionally pulling back on promotions a little bit, that can have an impact on traffic. It’s a fair tradeoff when you are still getting the comp and you’re getting the gross margin expansion. As Art said, we look at the longer term. But in this quarter particular those were two of the more significant factors that would have --
Yes, especially on Old Navy and Banana as well, I don’t see warning bells right now. I am not seeing alarm bells going off. Quite the contrary. Okay.
Perfect. Thank you.
Thank you. That does conclude our conference. You may now disconnect.