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Good afternoon, ladies and gentlemen. My name is Melissa, and I'll be your conference operator today. At this time, I'd like to welcome, everyone, to The Gap, Inc. Fourth Quarter 2017 Conference Call. At this time, all participants are in a listen-only mode. As a reminder, please limit your questions to one per participant.
I would now like to introduce your host, Tina Romani, Director of Investor Relations. Please go ahead.
Good afternoon, everyone. Welcome to Gap, Inc.'s fourth quarter 2017 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 descriptions and reconciliations of non-GAAP financial measures, as noted on page two of the slides supplementing our 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 March 1, 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 I 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 with further questions.
With that, I'd like to turn it over to Art.
Good afternoon, everyone, and thanks for joining us. I really appreciate you spending some time with us this afternoon. I'm going to speak for a few minutes and then turn it over to Teri, who has a slightly longer conversation today just because of the various moving parts associated with this. But the capstone is that we're pleased to share the results of another very strong quarter. While the fourth quarter is an important one for all of the obvious reasons, posting such strong results is especially notable as we lapped a strong holiday last year.
In a moment, I will turn it over to Teri, who will share more details, but before I do, as we close out 2017, I'd like to reflect on our progress in the quarter and in the year.
Similar to last quarter, I'll be using the framework of our balanced growth strategy to walk you through some key takeaways. First, we are growing value in Active, beginning with Old Navy. During fiscal year 2017, Old Navy grew 6% and surpassed $7.2 billion in sales. Old Navy is the fastest-growing major apparel brand in the U.S. among major retailers. The brand continues to win by focusing on loyalty categories, delivering on assortment with clear filters focused on fit, quality and value, and I have to point out that more than half of Old Navy's assortments sits on our responsive capabilities, allowing us to feed units into the business, minimizing risk and maximizing margin, and successfully chasing market share opportunities.
Nearly all categories comped positively this last year, and importantly, both stores and online saw strong top-line and bottom-line growth. We also accelerated Old Navy store openings, as we had indicated in our strategy presentation back in September, with all the – over 30 new stores in 2017. Given the excellent returns we're seeing and the fact that the brand remains under penetrated versus peers, we see significant expansion opportunity and plan to double the number of openings in 2018.
I must remind you, however, that value with Gap Inc. does also include Gap and Banana Republic Outlet and Factory Store businesses. Complementing the strong results at Old Navy, those businesses also delivered positive sales growth in 2017.
Now, let me quickly turn to our Active businesses. It's hard not to have anything but positive things to say about Athleta. The brand's performance to the year was extraordinary. Notably, Athleta moved from mid-teens sales growth in the first half of 2017 to mid-20s in the back half of the year.
The response and engagement we're seeing from new and existing customers at Athleta has been outstanding, driven by the highest percentage of product and responses in our portfolio, exceptional product, powerful storytelling, and a unique experience both inside and outside of our stores. The brand design's way to becoming known for powerful and strategic fabric innovation, particularly in bottoms.
In 2017, new fabric information, much of it proprietary to the brands, drove a significant amount of top-line performance. The girls business, an important – an increasingly important business for Athleta, more than doubled and exceeded expectations during the year. Again, given that this business was added to the portfolio with no incremental ROD and minimal expense, this growth is highly accretive. The success we're seeing in Active and performance lifestyle isn't limited to Athleta.
Together, the Active businesses within Gap and Old Navy also delivered high single-digit growth in 2017. Supporting that growth, last year, we created a small very focused innovation center that will enable Gap, Inc. to build a competitive advantage through proprietary technical fabrication and sustainability innovation, not only for activewear, but also for our core ready-to-wear businesses. The success we've seen this year with innovation, such as Powervita and our Sculpt fabrication makes me very confident and very optimistic in the potential for industry-leading innovation across the portfolio.
Let me move to our next pillar of balanced growth, accelerating our accretive online and digital businesses. We set a goal publicly for this business to reach $3 billion in 2017, and I'm pleased to report that we exceeded that goal by over $100 million. Capping a year of sequential quarterly growth, we closed out the fourth quarter with nearly 30% growth of our digital and online businesses. This is a great year for our highest growth and highest return business.
We have a history of being a digital innovator and we will continue to invest in this area given the outsized returns. This year, we delivered capabilities that continue to more effectively monetize visits, so that's such things as: first of all, driving traffic; secondly, improved conversion across a number of different facets of technical capabilities that we have; and the third is bigger baskets, among many. This is part of creating a unique and differentiated customer experience to grow our loyal customer base and encourage cross-channel and cross-channel – cross-brand shopping.
As we shared back in September, we know that customers who shop across channels in a single brand are worth eight times more than the customer who only visits us in a brand, and that multiplies to 10 times more when they shop across channels and multiple brands. We are very focused on migrating our customers from single brand connections to multi-brand, multi-channel connections. These intentional investments are already delivering a great return.
We're seeing growth in our Active customer base across the portfolio and this was, I must point out, a transformational goal for the organization, where we have blended financial and non-financial goals together to drive progress against our balanced growth strategy.
In addition to crossing the $3 billion threshold, our e-commerce business delivered high teens growth for the year and again, saw sequential improvement throughout the year. Our investment in native mobile apps drove meaningful mobile revenue growth across brands, garnering on average 4.8 stars from our customers.
And finally, we're seeing the benefits of investments in an improved site speed. Site speed is critical to monetizing visits. We improved our mobile page loads down to 3-second page load timing and estimate this has delivered approximately $300 million of sales growth. Really, this is only the beginning, and there's nothing but opportunity in front of us.
Customer behavior and customer activities continue to evolve rapidly and we remain confident that the investments to deliver a truly differentiated customer experience across digital, mobile and stores will continue to deliver strong returns.
Moving to our third pillar. We are continuing to reduce our exposure to challenged real estate through specialty store rationalization. Let me start with stating the obvious. Stores remain a highly relevant component of our business. Over 80% of apparel purchases are current stores and an even higher number of purchases are influenced by physical stores. Stores matter. This is however why we remain committed to providing our customers the experience they demand. We will be investing selectively in the disciplined store remodeling program as well as in store technology.
Based on testing we are conducting, these investments yield attractive returns through both improved labor productivity and customer experience. Having said that, across the industry, and we are no exception, there are problems with stores in the wrong location, not priced to market or oversized for current customer demand. Since 2008, we have been dealing with our real estate portfolio and getting rid of challenged real estate and we will continue to do so.
Last quarter, we announced plans to accelerate our target of 200 closures, largely in older, specially Gap and Banana Republic fleet locations by the end of 2018, a year ahead of expectations.
Now, let me take a moment to talk about the final pillar of our balanced growth strategy, productivity. This is a high priority for me, as I know it is for you. Teri will give you extensive further detail on SG&A for the quarter; and there are some unusual items that are distorting it, like increased bonuses and reinvestment of top-line upside towards work against our productivity initiative.
Putting the unusual items aside, normalized spending is up and that spending increase represents intentional investments we are making in the business. These investments are paying off, as evidenced by our comp results and by healthy underlying drivers, including traffic. Some of the spending is variable expense like store labor. Beyond just keeping up with traffic, we are also investing in additional labor to enhance the customer experience. There's a quick payoff to that. It's a pretty low risk bet, and when it pays, we put the money in. We have founded in some cases, we've taken out too many store hours and we can quickly see the benefit of adding hours back selectively to match peak traffic times.
Some of the SG&A investment is marketing. We've talked to you about the importance of brands and brands require effective marketing investments to remain healthy and to drive customer engagement. We carefully monitor our return on advertising spend and believe the investments we are making are sound.
The traffic trends we're seeing are clear and direct support of this. Our traffic consistently outpaced industry metrics throughout the year and we achieved positive traffic across the company in Q4.
A meaningful portion of our investment is in customer and digital. It is a big opportunity and one that we will pursue aggressively, but also with discipline. The remainder is overhead, and this is one of the areas where we clearly see opportunity to drive productivity savings. Some of that will be low-hanging fruit, which we expect to see even beginning next year. Some of it will require more fundamental reengineering of our work, which we are pursuing aggressively, but the savings will flow back over multiple years.
Overall, our goal is to continue to provide operating margin expansion, while also investing to sustain our growth, our differentiation versus our competitors. We built our productivity initiative into our 2018 transformation goals, a key part of our bonus structure. And the entire organization's incentive pay will be tied to progress against this work.
Let me talk for a moment about both Banana Republic and Gap. Banana, I will be quick on. Evidence the comp in Q4, we are seeing progress on the turnaround that Mark and the team are executing. I'm pleased with the progress and I expect to see more.
Now, let me turn to Gap brand. To reiterate, we are seeing progress in the brand. The operating model is evolving. We're more responsive. We've dramatically improved product and we've seen improved traffic and customer engagement from our marketing investments.
That said, as you saw last week, I made a change at the highest level of leadership in Gap brand. In fourth quarter, we began to see some operational missteps that hindered the brand's ability to positively comp and finish the year strong. These missteps were primarily related to inventory management that resulted in late product deliveries to stores.
Frankly, I have zero patience for a lack of operating discipline. We dug in, I diagnosed the situation, we made a change and we intend to move very quickly forward. We are carrying more inventory at Gap brand right now and we expect to see some promotional pressure in the first half until we correct the flow timing.
Obviously, we're all over this. We see the fix. It's not a difficult one, but it won't be immediate. We have put aggressive productivity actions also in place and expect year-over-year profit progression in the brand with sequential improvement as we move through the year.
Before I turn it over to Teri, I'll quickly touch on tax reform. Like many retailers, we are pleased with the expected benefits from tax reform and are committed to investing in the long-term health of our brands and growth of the business. A lower rate enhances the return on investments and reinforces our ability to grow the business and further enhance shareholder, customer and employee value, while keeping our fundamental strategies unchanged.
The proof points I talked about today are evidence of the fact that the work we've been doing and the investments we have been making are the right ones and that they are beginning to yield positive business outcomes. We remain focused on balanced growth, doubling down on Active and value, accelerating our progress in digital and customer experience, rationalizing non-performing real estate, and driving productivity.
I want to close by pointing out something that I want to make very, very clear, and that is that the elements of our strategy and the impacts of tax reform, as they come together, they represent a material and persistent expansion of the earnings capacity of this company.
Teri, let me turn it over to you.
Thanks, Art. As Art said, there are a number of moving parts here. So I'm going to walk through them I hope with enough transparency, and then obviously, Tina and I and others will be available as necessary to help walk through in more detail, if needed, after the call. But as I've mentioned, we're pleased to deliver another quarter of strong results as we continue to make progress against the balanced growth strategy we outlined in September.
Our brands are stronger than they've been in many years and our efforts are focused on where we can have the most impact. With our productivity initiative available to fund our investments in the business, we expect the benefits of recent tax reform to provide a meaningful increase in future earnings and cash flow, a step change in our value creation model.
Moving through the fourth quarter and full-year performance to start. Just note that all the results reported today are inclusive of the 53rd week, with the exception of the comp sales metrics. So, let's start with sales. The fourth quarter marked our fifth consecutive quarter of positive comp sales and our sixth consecutive quarter of gross margin expansion. This was a very strong holiday period for us, particularly considering, it's against our most difficult comp comparisons for the year.
Net sales increased 8% to $4.8 billion for the quarter and 2% to $15.9 billion for the year. Comp sales were up 5% for the quarter and 3% for the year. The addition of the 53rd week was the primary driver of the positive 3% spread in the fourth quarter. Regarding the sales growth for the year, the impact of the 53rd week was largely offset by the impact from our international closures last year.
Going to the brand level. As Art said, Old Navy had an outstanding quarter, delivering a positive 9% comp against last year's positive 5% comp. We were pleased to see an acceleration in their already strong year-to-date performance, with continuing broad-based category strength throughout the assortment, as well as stable or improving trends in traffic and AUR. Gap comp was flat against the flat comp last year.
We saw some encouraging positive momentum in the holiday season, but the January results were disappointing given the operational issues largely related to inventory management that Art spoke about. Underlying this, we are pleased with the improving brand health, as evidenced by traffic trends and stronger engagement. For the year, we saw a two-point improvement in Gap's comp, reflecting the improving brand health.
We were pleased that Banana Republic delivered positive comp sales, positive plus one against a negative three last year. This primarily was driven by improved AUR. We also are pleased with the improved traffic trends we have seen, beating industry for the past two quarters. We're focused on strengthening our pillar categories and saw particular strength in sweaters and bottoms over the holiday period. As Art mentioned, online had a remarkable quarter, closing out the year very strong with nearly 30% growth.
Moving to gross margin. We remain pleased with our gross margin trends, with this quarter representing our sixth consecutive quarter of gross margin expansion and an adjusted rate at the highest fourth quarter level since 2012. When excluding 2016 restructuring costs, fourth quarter gross margin was up 310 basis points from last year to 36.8%. Excluding 2016 restructuring costs, merchandise margin expanded 180 basis points versus last year. We saw a higher percentage of sales at reg price, an indicator of underlying health in the business.
Excluding 2016 restructuring costs, rent and occupancy leveraged 130 basis points, primarily driven by sales growth. For the full-year, gross profit was $6.1 billion and gross margin was up 200 basis points to last year, excluding the 2016 restructuring costs. On the same basis, merch margin was up 120 basis points and rent and occupancy leveraged 80 basis points.
Now, let me take a minute to walk you through Fishkill. During the quarter, we reached a final settlement with our insurance providers, covering all impacts including any future elevated cost that we may incur until Fishkill is fully operationalized. The recovery exceeded our original expectations by about $0.03 for the year, which is recorded as an offset in SG&A.
The majority of proceeds offset incurred elevated costs that were recognized in either costs of goods sold or SG&A, depending on their nature. We had a modest positive impact on gross margin from the Fishkill proceeds in the quarter as the costs were spread throughout the year, while the recovery was concentrated in Q4. For the full-year, there was no material net impact on gross margin.
Moving on to SG&A. In the fourth quarter, our total operating expenses came in at $1.36 billion, up $187 million when compared to 2016 adjusted operating expenses. This is about $100 million above our prior expectations. So, let me take a minute to just walk you through the incremental spend.
First, naturally, we saw an increase in variable store and DC expenses with the increase in sales versus our original expectations. Similarly, we saw higher bonus expense as we exceeded our internal goals for the quarter. Together, these expenses represented over half of the incremental spend.
Secondly, we saw a decrease in our credit card income of about $20 million, which is an offset to SG&A. Consistent with the industry; we've seen a decrease in fee and interest income as well as an increase in loss rates. Third, as I mentioned, we received the Fishkill insurance settlement. For the quarter, the excess of recovery over costs was about a $0.04 benefit in SG&A as the recovery was a catch-up of expenses incurred throughout the year.
With our strong topline results, as well as the additional insurance proceeds, we made the decision to reinvest some of the upside to kick start our productivity and balanced growth strategy actions. As part of this, we accelerated store closures, took actions to streamline the organization and we find our technology portfolio to better focus on key priorities. We incurred approximately $40 million in lease and employee-related costs and asset write-offs, more than offsetting the excess Fishkill settlement.
I'll talk more later, but I'm pleased with how the organization is adapting our productivity mindset and that we were able to leverage the strength of the quarter and the added benefit of Fishkill proceeds to accelerate some of this work.
For the full-year, total operating expenses were $4.6 billion, which includes the second quarter benefit of $64 million from insurance proceeds primarily related to a gain on fixed assets destroyed in the Fishkill fire. Excluding this benefit, operating expenses were up $397 million when compared to 2016 adjusted operating expenses. The increase versus the prior year is primarily a function of increased variable costs on higher sales in the 53rd week, higher bonus payments from improved performance, increased advertising investments and, lastly, increases in overhead costs, inclusive of both the incremental costs associated with acceleration of our productivity work and on investments against our customer and digital initiatives that are showing real returns.
Now, let me move to taxes. Our fourth quarter effective tax rate was 46.5%. This rate reflects a net provisional income tax charge of $34 million for the net tax impact related to tax reform as a result of the enactment of the U.S. Tax Cuts and Jobs Act of 2017 referred to as TCJA. The net impact is primarily related to the one-time transition tax on foreign earnings not previously subject to U.S. tax.
Re-measurement of U.S. deferred taxes, which is partially offset by the reversal of deferred taxes previously provided on certain foreign earnings; and a one-time tax benefit related to the legal entity restructuring also impacted by TCJA. Excluding all of these impacts, our adjusted fourth quarter effective tax rate was about nine points lower than the reported rate.
Our fiscal 2017 effective tax rate was 40.4%. Again, excluding the net impact related to tax reform, our adjusted effective tax rate was about two points lower. We will continue to analyze the impact of tax reform and the fiscal 2017 provisional amounts will be finalized in fiscal 2018.
Now turning to earnings. Including the net impact related to tax reform of $34 million, our fourth quarter EPS was $0.52. When excluding the net charge, adjusted fourth quarter earnings per share increased to $0.61 compared to an adjusted $0.51 in Q4 of 2016. Reported full-year EPS was $2.14. When excluding the net impact related to tax reform of $34 million and the second quarter gain from insurance proceeds related to fixed assets, our adjusted full-year EPS increased about 5% to $2.13 versus 2016's adjusted EPS of $2.02. The 53rd week was a benefit of approximately $0.05.
Additionally, FX negatively impacted Q4 and 2017 full-year EPS by an estimated $0.02 and $0.08, respectfully – respectively as well respectfully. Regarding cash flow. Fiscal 2017 free cash flow was $715 million, which includes approximately $66 million of insurance proceeds related to property and equipment. The decrease from last year is primarily due to the timing of lease payments and the year-over-year increase in inventory. We ended the quarter with about $1.8 billion of cash.
During the quarter, we completed $15 million of share repurchase. While this was below our original guidance, it was related to restrictions around changing our 10b5-1 repurchase program outside the open window. There is no change to our overall philosophy around share repurchases or our commitment to returning cash to shareholders.
We ended the quarter with 389 million shares outstanding, and year-to-date, we paid dividends of $361 million and repurchased $315 million of shares for a total cash return to shareholders of $676 million. Regarding inventory, we ended inventory up 9%. There are a few drivers of the increase. About three points of the increase can be attributed to timing as we have more receipts in the 53rd week of this year than in the last week of 2016.
Also FX negatively impacted inventory by about two points. Overall, we do feel comfortable with the composition of inventory as we enter the New Year, considering planned store closings – sorry, planned store openings, relative liable levels and sales growth plans.
Regarding capital and store count. Our fiscal 2017 capital expenditures were $731 million including about $170 million of spend related to rebuilding our Fishkill distribution center. This is lower than our previous expectations largely as we slowed down spending a bit to reorient our IT priorities to the highest benefit investments under our balanced growth strategy. On a net basis, we closed 35 company-operated stores in 2017 and ended the year with 3,165 stores.
And now moving on to 2018. Before we get to guidance, I want to cover out some changes to our P&L as we incorporate the new FASB revenue recognition standards that are effective in the beginning of fiscal 2018. This adoption is not expected to be impactful to our earnings, but it will change the classification of certain line items in our P&L.
The most significant impact comes from the recognition of income related to our credit card and loyalty program. Historically, this income was classified as an offset to SG&A and COGS. Under the new rules, we will be presenting this income in net sales. This classification, again, does not impact our earnings, but naturally, it will impact the margin calculations and magnitude of expense leverage.
To give you a sense of that magnitude, in 2017, we earned $412 million in gross credit card income recorded as an offset to SG&A. Additionally, as part of our credit card program, we received some reimbursements for loyalty program discounts earned by cardholders. This loyalty program income previously recorded as a reduction to the impact and cost of goods sold will now be presented in net sales.
In 2017, we recognized approximately $174 million of income related to our loyalty program. Again, loyalty program impact offsets redemption costs, so this change will not impact our earnings but will impact gross margin rates given the larger net sales increase. We do not expect other aspects of the adoption to have a meaningful impact on our consolidated financial statements.
As we discuss our 2018 outlook, the basis for our guidance incorporates these two key impacts to the P&L that I just discussed. To be helpful, we've included a couple of slides in our presentation to illustrate these two key impacts.
And now for guidance. We expect reported earnings per share to be in the range of $2.55 to $2.70 compared to adjusted earnings per share of $2.13 in 2017. We currently expect that foreign exchange will be a benefit of about $0.07. The expected EPS range assumes 2018 comp sales are flat to up slightly. Adjusting for rev rec, we also expect spread to be up – to be flat to up slightly as we expect the loss of the 53rd week to be offset by new store sales growth and the translation benefit from foreign exchange.
Regarding the 53rd week in 2017, our guidance range includes the negative impact from the loss of the 53rd week of about $0.06. It's worth noting that timing shifts associated with the 53rd week are expected to be impactful to both Q1 and Q4 in 2018. In the first quarter, we expect to benefit from the timing shifts associated with the 53rd week into 2018 as we lose a small week in February and add a much larger week in May. Additionally, the fourth quarter is expected to be negatively impacted by the loss of the 53rd week.
Now on tax reform. Based on provisional estimates of the impact of the new tax legislation, we expect our fiscal year 2018 full-year effective rate to be about 26%. However, this rate may also be impacted by changes to our fiscal 2017 provisional estimates as new guidance is issued for the impacts of tax reform.
At the midpoint of our guidance, we currently estimate the reduction in tax rate to yield about $116 million in cash benefits or about $0.42 per share. While this benefit represents real year-over-year earnings progression, if you normalize for this, plus the 53rd week, we expect EPS growth of about 6% at the midpoint on 2017's adjusted EPS of $2.13. As Art mentioned, tax reform does not fundamentally change our long-term growth strategies.
Our reliable cash flow generation and strong balance sheet history, historically, have allowed us to make investments needed to win in the evolving retail landscape. Going forward, the planned savings from our productivity actions should largely fund our investments in the business to realize the market share growth we believe is possible, which means our lower tax rate meaningfully increases our earnings capacity.
We expect, particularly given the additional flexibility provided by tax reform, to increase our capital expenditures to $800 million. More than half of this spend is related to IT and supply-chain to support our product and digital strategies, with the remainder largely related to store investments. As Art mentioned, our productivity initiative is a focus of the organization.
With regards to SG&A, for the full-year, we expect SG&A as a percent of sales to be about flat as productivity offsets increased investment. We're excited not just about the savings our productivity initiative will provide but the way it can change our culture to drive a focus on better, faster and cheaper. We have kicked off a new initiative to identify low-hanging fruit that literally has identified hundreds of ideas for improving our work. The savings from these can range from thousands to millions and many can be done very quickly.
Alongside this, we are working to do more fundamental reengineering of our processes. We already are seeing some of the benefits. If you look over the last several years, our SG&A has been de-leveraging approximately 170 basis points per year. This year, we're striving for modest to no de-leverage. That change in trend is worth somewhere north of $250 million. Now, we're not thinking of all of this as savings, but it demonstrates the power of the work we are doing on productivity.
Going forward, we are tracking the specific savings amount versus the transformational goal that Art mentioned. Some portion of the savings is going to fund our investments in supporting business growth, customer and digital, investments in products and supply-chain, advertising, et cetera.
Net, we should, over time, be able to deliver sustained and meaningful investment in the business without the de-leveraging effect we've been seeing historically. Obviously, this approach means that the tax benefits from TCJA become an immediate and meaningful change in our net earnings capacity, which we expect will deliver more than $0.40 of incremental EPS in 2018 and a meaningful increase in our future value creation model.
Just on a couple of more details around the 2018 guidance. Our guidance range embeds the impact from current inflationary pressures such as oil, transportation, and raw material costs. We're working aggressively to offset these pressures through logistic network optimization, strategic sourcing initiatives and the productivity work I just mentioned.
We also have built in the expected implications of the recent operational challenges at Gap brand, which results in slower than previously expected margin growth for that brand. We expect to add 25 net new stores. In line with our strategy, openings will be focused on the value in Active space, particularly Old Navy and Athleta, while closures will continue to be weighted towards Gap and Banana Republic.
As I mentioned, there is no change in our philosophy around uses of cash and we're pleased to have announced our intent to increase the dividend by over 5% to $0.97 per share. Further, similar to our cadence last year, we plan to complete approximately $400 million in share repurchases in 2018.
In closing, overall, we're very pleased with the solid fourth quarter results and are focused on continuing to drive momentum in the business through 2018, while making decisions to support long-term growth through our balanced growth strategy. Our outlook for 2018 demonstrates our confidence in the strategy, the investments we're making in the business and the increased earnings capacity afforded by both productivity and tax reform.
With that, I'll turn it back over to Tina.
And that concludes our prepared remarks. We will now open up the call to questions. We'd appreciate limiting your questions to one per person.
Our first question will come from Randy Konik with Jefferies.
Yes. Thanks a lot. Art, when you were at the competitive conference of mine, you gave some very helpful color around divisional margins, which I believe were from 2016 calendar. The glaring opportunity it seemed in that chart you put up was in the Gap division, where I believe the segment margin was in the low single-digits, which contracted with Old Navy, where the margin seemed to be in the mid-teens area. So clearly, it feels like you're getting nice operating leverage in the model for Old Navy, good AUR increases and, obviously, some difficulties, you mentioned, in the Gap division.
So, I guess, just want to get some color on what you think can be done or you're doing around driving divisional margins higher in Gap, what type of timeframe we should expect around those strategies, and what you think would be a more normalized type of rate that we could maybe expect over the medium term? Because that could be a very good opportunity for the whole organization, corporation to drive further value, cash flow higher in the future? Thanks.
Yes. Randy, I actually was – I sort of stop listening. No, I'm kidding. But when you said, you had competition, I got hung up on that. So let me just – let me give you a few comments on this and I'm not going to give you an update on a rate perspective as we haven't refreshed that information.
But again, I want to point out the fact that the issues were operational. We've started to see this really, as in later parts of Q4, Teri and I dug in, saw what we saw. I made a very quick change. It is not a product aesthetic issue. We're not seeing product acceptance issues. We are not having quality issues or fit issues, so that's the good news.
I would look at this, and in some respects, it's quite similar to what Old Navy – the bump that Old Navy hit in the road in Q4 of 2015, which was, at that point, from the port crisis where we had quite unpredictable and late arrivals of product coming in, it is not to the scale of what we had going on at Old Navy. But the thing that gives me confidence here or frankly getting our legs back under as quickly, is that it was less than two quarters when we had that business back on the rails and running well. Product reboots, creative reboots, we've seen them across the industry. Those take a long time. This is nothing like that at the end of the day.
So – and then underlying that, obviously, is we're continuing to see strong results in the online business, which is margin-accretive as we go down that path. We're continuing to grow the value sector underneath the covers inside of that business and rationalizing specialty. So those are the longer-term aspects of getting margins back up again. You're right that it's a big opportunity and I am relentlessly focused on it. This did not make me happy. I took action and I'm in it with a good leader, and we feel like we can get things moving pretty quickly.
Appreciate that. Thank you.
Next, we'll take a question from Matthew Boss with JPMorgan.
Thanks. Congrats on a nice quarter.
Thanks.
Thank you.
At the Gap concept, can you speak to the performance in your more loyal categories, jeans, lingerie, baby? And then separately at Old Navy, can you speak to the cadence of business as the quarter progressed? And did you see the momentum from the fourth quarter carry into February so far?
Yes. I mean, if you look at Gap, we've seen good performance across a number of the key categories. We're seeing the body business lift. We're seeing outerwear – I'm sorry, the Active business quite strong. KB (43:13), we've cleaned up the aesthetic a little bit but it's always a franchise category in there, and we've seen some very good performance out of women's denim as well, with knit and woven tops and dresses and skirts.
We've struggled a little bit in the men's business. Part of that has been service levels. And then we've seen very good business in men's wovens bottoms as well. So it's been of a mixed bag but most of the key franchise categories we feel like we continue to have strength in. And again, we're always going to have opportunities when you walk a store and you say, jeez, did that execute well or was that the best idea, but we do not have any broad scale product acceptance issues really across any of the divisions in the business.
On Old Navy, I'm not going to – I don't – we don't guide for it on the quarter and things like that. So I just don't really want to go there. They, obviously, had a super strong Q4 and it was very diversified, which was the point of my message in terms of the performance across the key divisions in the business. It was not relying on any one particular horse to pull the cart. And a diversified portfolio with good product acceptance, good success, good inventory levels, et cetera, we feel that's the strength they carry, obviously, coming into 2018.
Our next question will come from Ike Boruchow with Wells Fargo.
Hi, thanks for taking my question. Teri, you help us out – you gave us a lot of information. I was just hoping sort of – my question just to focus on the merch margin line. Can you just take a part – the 180 basis points of merchandise margin that you saw in Q4, how much of that is core go-forward GPS merch margin? And how much was related to any kind of insurance gains or one-time gains you might have saw?
And then just stick with merch margins. The comments that were kind of made about Gap brand and inventory, does that make us think that the merch margin plan for the fiscal year is more of a first half versus back half kind of setup? Or are you going to be able to smooth that out with strength in Old Navy and whatnot? Thank you.
Yes. So on the Fishkill impact on merch margin, 180 basis points, it was a very modest impact because the proceeds are largely offsetting costs and it's really just a timing issue when those costs recognize. So I don't know, maybe 20, 30 basis points, nothing major.
In terms of how we look forward on merch margin or gross margin, given the Gap situation, we are not going to get into quarter-by-quarter guidance. But what I would say is that I look at them as somewhat independent, so in Gap brand, we do fully expect or probably have a little more promotional pressure in the first quarter or two.
Expectation, as I've said, is we should be able to work through this. The Old Navy momentum, we have every reason to believe we'll continue to see that strength, are positioned well coming into the year. I don't know that I would necessarily say they're going to be able to offset each other. I think of them as different. On the other hand, as Art said, we're going to be working super aggressively to get Gap on track as fast as possible with as little impact.
Great. Thanks.
Lorraine Hutchinson from Bank of America Merrill Lynch will have our next question.
Thank you. I wanted to ask a question about wages. With many competitors both on and off-mall increasing salaries and hourly wages, are you seeing any of that pressure? And also, you mentioned service levels at the Gap. Are there places or pockets of your stores where you do need to continue to invest?
Yes. On wages, we had wage initiatives several years ago where – when Glenn, before me, took some action on wages. And what I would say is that we're always – the average of our wages isn't meaningful. We're always making sure that we're competitive in any given market that we're in and we'd seen significant differences across geographies.
What I would say is we are not seeing any particular acute wage pressure anywhere right now other than the normal market forces of, if you're hiring in downtown San Francisco, there's a lot of competition and it's different in other parts of the country. But none of those are anything that are different than what we've continued to see. So I wouldn't signal something that's discontinuous there at all.
On service levels, I did mention the fact that we were putting some payroll back into our stores, and I just want to clarify that because there's two components of service levels. One is the payroll in our stores facing our customer and a lot of that has really been highly aligned with making sure that we're matching hours to footsteps to maintain or accelerate conversion. And that is the line of sight to a return that is very easy to see, and we'll do that. And I always – I'm always focused, as I am with a dollar of marketing, which is, if I spend $1 and get $2 or $3 or $5 or $10 back, that's an easy thing to do.
The other component of service levels is inventory depth, and that's where we have had some issues, both in Gap Outlet and Gap Specialty. And some of the incremental inventory is against bringing our available inventories up on the floor so that people have a better chance of finding their size, style, color combination and can walk out with a bag in their hand. And much of that is not in fashion. It is much more oriented towards basics and seasonal basics, where there's relatively minimal liability risk.
Thank you.
Chethan Mallela from Barclays has our next question.
Hi. Good afternoon. I wanted to ask about the Buy Online, Pickup in Store test that you've launched in a couple of cities. Can you just talk about how that's gone so far and any initial learnings that you've had? And also how you're thinking about may be the pace and magnitude of rolling that out and any commensurate investment?
It's really been in two cities so far and constrained to Old Navy. We put no marketing against it other than the availability as we see people geographically where they're coming in. So far, without giving you numerical specifics because it's early days and a relatively few number of stores, we've been extremely encouraged by the results that we've seen here.
And the encouragement is the uptake, number one; number two, obviously, the number of people who then come into our stores and build a basket around something that they've already bought online or are picking up in the store, that's very encouraging. We are going to operationalize it, both at the store level and the technical operationalizing it, which we're still working on, but it's been pretty seamless so far. As we get to the middle of the year, we're looking at a broader-based rollout in Old Navy and then we consider when we go to the other brands.
I don't have a hard schedule yet because we're just not there yet right now. I mean, the biggest issue is you're taking, you're connecting digital to physical. And when you go from 2D to 3D, there are always challenges just to make sure the customer's experience really delivers the way that you wanted to deliver, and that's what we want to make sure we get right before we present it to all of our customers.
The other thing which is often not talked about is we're also excited about it because it does give us a safety valve for fulfillment capacity for our direct business without significant incremental expense below the line. And that's a really nice economic benefit and investment benefit. As volume pivots to BOPIS, it does allow us to take some of the pressure off of our direct fulfillment centers. And again, it doesn't drag through fulfillment cost below the line. So it's very attractive from an economic standpoint.
Great. Thanks so much.
Cowen and Company, Oliver Chen has our next question.
Hi. Thank you. Art, regarding Gap division, what are your thoughts on how you are monitoring the conversion versus traffic and what we should expect to see over time there within that division? And any goalpost in terms of what you're looking for as we monitor on the Gap division over time?
And a second related question is on the consumer engagement model. You mentioned engagement a few times in your prepared remarks and a lot's been changing with engagement and the integration of data and the CRM. Could you just elaborate on what you're seeing with engagement and where you see the opportunity is? Because you have a lot of very good technology that you've been ahead of the curve on there? Thank you.
Yes. On Gap, as we noted, our traffic has been strong, and that's probably the most frustrating part for me here is because of some of the operational difficulties, we don't have the product fully presented in front of our customers, frankly, to monetize the traffic we have in our stores. That said, we're not having to interrupt planned marketing efforts coming out with the Sarah Jessica Parker line. We worked very hard to make sure that we had the product there to align with the marketing. Same is true on our colored bottoms message that we're coming out with now as well.
So, I don't want to go into specifics here. But if you have misses on product deliveries, obviously, that has the potential to impact your conversion. But at the moment, what we're really trying to do is to make sure that we build a plan around the product that we have and that we don't over-discount product even if it comes in late relative to its out dates because much of the products in the spring and summer time period is not immediately acutely liable. So we think that it's saleable. So again, traffic is strong and we're working to make sure the rest of the levers in the box don't move negatively as well, but we do expect there to be some promotional pressure.
On the engagement part of it, this is really important. We talked about this back in September and I have referred to it again. We now have and have pulled together, as we built some pretty significant analytics capabilities here, and data science capabilities, a few of the customer longitudinally that we've never really had before. And that is across brands, across channels, across categories and divisions. And we have a much better sense of, as an example, what's the first purchase that brings a man into Old Navy?
What's the time you have to bring him back in, in order to begin engaging him and maximizing his value as a customer; what's the value of a customer, as I mentioned, 10x that is rather than a single brand, single-channel customer, a multi-brand, multi-channel customer? And we are able to start pointing our investment dollars from the standpoint of our marketing spend, et cetera, much more surgically at those customer value profiles. And so it is a level of precision that we are continuing to develop in customer acquisition, customer activation and purchase frequency. It is a level of precision that we have not ever had as a company and it is super exciting to continue to push down this path.
We also built into our transformational objectives this year across the entire portfolio, a migration goal, which is to say how do we move a customer from being, number one, a single brand, single-channel customer to a multi-channel customer to a multi-brand customer to a multi-brand, multi-channel customer, and that is new muscle, but we know today what the value is of that multi-brand, multi-channel customer and we increasingly know how to move them down that migration path and very few of our customers are in that sweet spot.
So we see it as a very significant economic and loyalty and engagement upside opportunity for the company. So it's early days. It is, I would point out, a structural advantage that we have with multi-brands, multiple brands and multiple channels. We can monetize a customer relationship much more extensively than a company that is a single-brand company and that we participate in more parts of their life.
People talk share of wallet. I call it share of life. And with our brands that span the family, which span work, which span Active, value and premium, we have an opportunity to have a much deeper share of life than many of our competitors do. So it's super exciting. The data is not the end all and the be all because the data always has to blend in with the art of the business. But the art and the science coming together, we believe that the product of those two things coming together is way more than the sum of the parts and it's very exciting for us.
And Art, just a quick follow-up. I mean, you mentioned share of life. It just begs the question with your interpretation of experiential retail, what do you think that means to Gap division and Gap, Inc. at large just because a lot of your brands are iconic and have participated in so many parts of life and how you're thinking about that with millennials and Gen Z?
Yes, what we find and this isn't just Art saying it because Art wishes it to be true because that usually doesn't achieve anything. This is Art saying it because our customers tell us this and our non-customers tell us this, which is we have the permission across a very broad demographic to participate in our customers' lives, and they are giving us that and not all of our brands are that way.
The fascinating thing about Gap brand is that many millennials haven't experienced Gap brand except when they were kids and their parents were dressing them in Gap brand clothing and yet there was a very positive orientation towards the brand.
And I come back to a couple of pretty simple principles, especially when it comes to physical retailing, which is stores are relevant if stores offer something that you cannot find anywhere else that is relevant to you as a consumer, and high touch is one of those things. It's part of the reason we're continuing to put some payroll dollars back where we see a payoff. But then, we, as retailers, broadly create a lot of friction in our store experiences. So our mantra inside the company right now is high touch and low friction, and we think that actually defines a pretty compelling opportunity for converged retail.
Thank you. Thanks for all the details on LTV.
Our last question today will come from the line of Brian Tunick from the Royal Bank of Canada.
Great, thanks. I guess first, maybe for Teri, lots of real estate projects, some puts and takes including, I guess, we're lapping Times Square. Can you may be talk about how we should be thinking about ROD and leverage opportunities into 2018?
And may be Art, can you talk about marketing as a percentage of sales or increase in dollar spending in 2018 versus 2017? And how you're sort of measuring the ROI on this increased marketing spend? Thank you very much.
Yes. So happy to spend some more time off-line in terms of some of the puts and calls we watched through today.
But broadly speaking, as we think about ROD in particular, we will continue to have a little bit of, I guess, a little bit of ROD pressure, as you think about the investments we're making, many of them are capital investments that then come into the asset base and so there's some depreciation there. But having said that, nothing has really changed in terms of what it takes for us to leverage ROD. So it really is a function of how we deliver the sales growth.
Then a comment on marketing as well?
Yeah. Again, we've talked quite a bit during the course of this year about stepping up our marketing spend, and as both Art and I alluded to, we feel very good about the returns we are seeing on those investments.
You can see them in the brand engagements and sense of the brand health and then, obviously, very visibly in the traffic trends. I mean, we included a slide in our presentation with traffic trends across the brands and it's pretty remarkable to see a chart with so much green and particularly to see a meaningful number of periods and brands with absolute positive traffic in this environment that's quite good, and we attribute that to some of the advertising activities we've been willing to invest in.
So, we'll continue to be super disciplined about balancing out that spend and making sure that we continue to see an attractive return before we step up and expanding for sure. For the most part, it's continuing at about the same rate as we have seen.
Thank you. That concludes our conference. You may now disconnect.