Good afternoon, ladies and gentlemen. At this time, I would like to welcome everyone to The Gap Inc. Third Quarter 2014 Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] I would now like to introduce your host, Katrina O'Connell, Vice President of Investor Relations.

Good afternoon, everyone. Welcome to Gap Inc.'s third quarter 2014 earnings conference call. Today's call is intended to cover both our third quarter earnings results and the company's organizational announcements issued today in separate press releases. Before we begin, I'd like to remind you that the information made available on this webcast and conference call contains certain forward-looking statements. For information on factors that could cause our actual results to differ materially from the forward-looking statements, as well as reconciliations or descriptions of measures we're required to reconcile to GAAP financial measures, 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, 2014, and we assume no obligation to publicly update or revise our forward-looking statements. I also want to mention that Sabrina will be using slides to supplement her remarks, which you can view by going to the Investor Relations section at gapinc.com. Joining us on the call today are current Chairman and CEO, Glenn Murphy; Art Peck, current President Growth, Innovation and Digital and future CEO; and Executive Vice President and CFO, Sabrina Simmons. As usual, Glenn and Sabrina will share the earnings results for the quarter. In addition, both Glenn and Art will also share their respective views on the announced leadership transitions. Please note that Art is joining us on the call from New York today, so he will make his comments and then turn his attention to the teams in New York. Therefore, he will not join for Q&A; however, after our prepared remarks, we will open up the call and Glenn and Sabrina will be available for questions. Now I'd like to turn the call over to Sabrina.

Thank you, Katrina. Good afternoon, everyone. As usual, I'll begin today by reviewing third quarter performance and then provide an update on our full year guidance. While we're not proud of our third quarter sales performance, driven by a particularly tough result at Gap brand, we are pleased that the team has demonstrated strong discipline on both expense and inventory. Net income for the third quarter was $351 million, and we delivered earnings per share of $0.80, up 11% to last year. As a reminder, our Q3 earnings per share of $0.80 includes a non-recurring benefit of about $0.06 from a lower effective tax rate of 34.5% in the quarter. Regarding sales for the third quarter, total net sales were flat at $4 billion and comp sales were down 2%. For the quarter, the translation of foreign revenues into dollars negatively impacted our reported sales by $31 million, primarily due to the weakening yen and Canadian dollar. On a constant currency basis, therefore, our revenues were up 1%. Moving to gross margin, third quarter gross margins were up 20 basis points to 40.2% with a favorability versus our prior outlook being driven by non-merchandise items like shrink and shipping. Merchandise margins were up 90 basis points for the quarter with Old Navy delivering the strongest margin performance. Rent and occupancy deleveraged 70 basis points. Regarding SG&A, third quarter total operating expenses were $1 billion, up $29 million from the prior year. Marketing expenses were up $14 million to last year at $176 million. Excluding the credit card income reclass of about $40 million, operating expense dollars would actually have been below last year. Regarding the balance sheet, at the end of the third quarter, we're pleased that inventory ended down 2% per store, below our previous guidance. We ended the…

Thank you, Sabrina, and good afternoon, everybody. Earlier today, we put out two press releases, the first one that just Sabrina just covered off, our Gap Inc.'s financial results for the third quarter 2014. And the second press release that we put out is about two presidents who will be leaving our business, so Art Peck, our new CEO, who will be taking over from me on February 1st can put the team he wants to put together going forward that gives Gap Inc. the best chance to have innovation to win more customers, to grow internationally and to be a top global retail apparel company around the world. So at the end of day, I'm very supportive of what Art is doing. Conversations I've had with him have always been around, look, you have to put together the winning combination of existing executives, new executives that you think are right in order for Gap Inc. to achieve what I just said earlier to be the leading global retail apparel company around the world. Steve Sunnucks will be leaving us before the end of the calendar year. I've known Steve now for eight years. He's worked for me that whole time. He's gone from running Europe to running franchise to running Asia. And we put Gap global together in New York City, and Steve is overseeing that now for two years. A lot of the structural work to bring Gap together have been done under Steve's leadership, but there's more work to do. It's not quite complete. And certainly as Art and Jeff Kirwan, our new President for Gap Global, start working together, there's work to be done at Gap. Our performance has been a little less consistent we want it to be and there's definitely room for improvement. Under…

Thanks, Glenn. I really appreciate it, and let me echo Glenn's comments in his thanks to both Jack and Steve for their time with the company and service and commitment to the company. I want to spend a moment just talking about really why now, why I initiated these changes now. The first I would point out that while I've had the benefit now of several weeks since we announced the transition to get to know more about parts of the company and the situation in the company that I've not been close to and familiar with. Being at the company for the last 10 years and having multiple roles around the company has really given me very broad and oftentimes very deep exposure to the executives in our senior roles. And that applies obviously both to Jeff in his role in China and to Andi in multiple roles while we've worked very closely together. So I really appreciate the time to get to know things, but this is a change that is really based upon my deeper experience and knowledge of the company as well as knowledge of the talent that we have across the company. I also would just communicate to you that I have inherited an extraordinarily strong and deep bench, and it's something I'm proud of for us as an organization and it's a reason why I have confidence that even with two changes like this, we will not miss our stride as an organization as we go into next year with this senior team in place. But why now is very simple, which is I'm impatient to get the team in place for 2015 and ready to drive business results as we go into the new fiscal year. Let me spend a moment first then…

Thank you, Art. Art has to leave the call now, because he has to attend to a number of other matters. But Sabrina and I will be here to answer any questions related to the changes with our brand presidents. But before we get to that, I'd like to talk a little bit about Q3 and Q4. Then for sure we look forward to answering any questions you have. When I think about the third quarter, my observation is we weren't as successful commercially as I wanted the business to be. With a minus-2% comp on a two-year basis that was minus-1%, now inside of that Old Navy certainly was stronger than the other brands, but I think Stefan Larsson is doing some very good work at Old Navy that hopefully can build every single quarter as we go forward. So commercially, we learnt a lot of lessons. The team continues to commit to making our business stronger and stronger every single season. But a company like Gap Inc. with our six brands inside of our portfolio, I don't think anybody here ever thinks that we should negative comp, but it just makes no sense. So what does happen to us, I think the team gets more invigorated, more focused. Tenacity, which is such an important part of being a successful retailer comes through, but I think we're turning that tenacity to positive energy as we look at the fourth quarter. But I would then look at that and say we had a much better quarter when it comes to the work done by our finance team, the one-time tax benefit and the cash that we now have inside the company to buy back more shares or to give us flexibility to buy back more shares. And also the work…

Great. That concludes our prepared remarks and we'll now open up the call to questions. As a reminder, I have Glenn and Sabrina here to take Q&A. And we'd appreciate limiting your questions to one per person.

[Operator Instructions] We will go first to Ed Yruma with KeyBanc Capital Markets.

I think when you last spoke, you were looking for some sign of hope within product with Gap brand. Obviously you're not guiding to any kind of financial improvement. But are you starting to see either signs of greater customer acceptance? Are you seeing some of this more optimistic color palette work? Any insight there would be helpful.

We're not going to talk about, because the optimistic color you're referring to is the collection of the flow we just dropped about two weeks, which is anchored in crazy stripes, which is something we did seven years ago with fresh marketing. Look, we're pretty honest, I think, recently on the sales call that we really thought that we would see some signs of improvement in our September and October flow from Gap. I mean there's a few green chutes here and there in certain categories, which I guess when you look we're going to be investing our inventory going forward or in categories that showed a little bit of improvement in the third quarter. So I think that's a good sign. It's a combination of the aesthetic we know has to continue to evolve and evolve quickly. And I believe some of that improvement will be in place either in the store today or in separate flows we have come in on the Monday after Thanksgiving, I think, on December 15th and again in the first week of January. We're next to full this year for Gap, which will provide more newness to the business. I think that improvement is in place on the flows I just talked about, but it's not enough to take us to a place where we've been satisfied. There's been some better work done similar to Old Navy on the actual assortment and the investment of inventory in the parts of the business which we do feel good. So Gap brand, we feel good about our baby business. We feel good about our Gap fit business. We feel good about our outerwear business. There's certain parts we have with the inventory to match where we had evidence that we were starting to get the product to resonate much better than you've seen in the first nine months of this year. So a little early on Q4. I think the extra flow was going to help, but we look forward to talking to people every single month, because that's our commitment in giving you updates on our performance and trying to answer more specifically the question about signs of positive acceptance by customers at Gap brand.

We will go next to Anna Andreeva with Oppenheimer & Company.

Just on guidance for implied down earnings for the fourth quarter. Can you talk about if this is based on what you're seeing so far in November, or is this is a more conservative stance ahead of the holiday? And on the gross margin, the implied decline I guess in the range of 100 basis points, give or take, you guys have an easier comparison. Just trying to understand what is driving that degradation, given inventories are clean, and, Glenn, you sound more encouraged about the product at the Gap division.

Yeah, with regard to guidance, I would say we just saw that prudent given performance year-to-date to be grounded in that performance. And so the basis for the guidance is really our year-to-date performance in sales and comp. And then as I said, it also assumes Gap brand doesn't have any meaningful change in trend from what we've seen year-to-date. I would add to that comment, as I said in my remarks, the fact that in Q4 we really expect more foreign exchange headwinds than we did in Q3 as well. If you think about the yen alone, the average rate was about 105 in Q3. And as of today, it's about 118, which is a 12% depreciation. So that's an importance piece to keep in mind as well.

And we will go next to Betty Chen with Mizuho Securities.

I was wondering if you can talk a little bit more about the potential shipping benefit, Glenn, I think you alluded to earlier. We have also noticed that the brand started to test a lot more of the two-day shipping, which we expect shoppers to probably welcome. Can you talk to us about any initial learnings on the receptivity of the two-day shipping program and any quantification on what the potential savings could be for 2015?

I think this is all part of what I could call a longer-term plan under this definition. It's not a well marketed theme, but it's called seamless inventory for us. So how we've learned to get to this point, to the decision we made in our New York store distribution facility is China today runs in a seamless inventory, where the inventory for online customers and for stores are in the same building. As a matter of fact, the step to purity on this trend is on the shelf in the same building. Athleta runs this way. Japan runs right now not on the same shelf, but in the same building. And we just changed our situation in Europe about six months ago where we had a separate online building and we consolidated that into the store distribution center. So I think we've been thoughtful about going around the US and trying to get some learnings. And so far, it's what you want to get from this. Can you save money over time? The answer should be yes. But the real benefit here is the benefit on gross margin dollars basically sending a unit to, let's call it for now, the highest bidder, who will pay the highest AUR. That could be an online customer or could be a store that's exhibiting stronger AUR performance. And I think that's what seamless inventory eventually gets at. What we did the distribution center in New York, we had some excess capacity. Right now, we ship to online customers from Columbus and from Phoenix. As delivery time has become more of a table stakes, we decided to use some of that capacity in New York, but it's all part of the strategic direction on seamless, and we popped up about 300,000 square feet…

We will go next to Kimberly Greenberger with Morgan Stanley.

My question is on e-commerce. Sabrina, I just wanted to clarify, does your guidance imply that the negative-1% comp that we saw here in the third quarter continues into Q4, or were you not that specific? And, Glenn, I just wanted to ask about e-commerce. The e-commerce strategies and the digital strategies of this company have been really compelling here for a number of years. We're seeing a pretty big slowdown in e-commerce sales growth here in 2014, and I think the growth rate here in the third quarter was only about 5%. So is it simply product that is holding back the growth rate in e-commerce, or is there something else going on that's making it more difficult to grow that business over time?

I'll just start with a clarification, Kimberly. It is a range. So I would say that the range is kind of grounded on this year-to-date trend that yes we have seen a negative-1% year-to-date comp and a plus-1% sales. But you can get to numbers within that range with different configurations. But I would say, yes, it's grounded in that notion.

And on the 5% growth in the third quarter, part of my opening comments was we had some accomplishments in the quarter. There were some areas we were disappointed. That was clearly a disappointment. It's a little bit about product. Last year we had a 20% comp, which I think was a pretty strong growth, market leading, but something we should be doing, given the investments we're making. So a two-year 25%, we were not happy with that at all. And the team is very focused. And omni-channel initiatives are not all about driving online sales. Matter of fact, in some cases, reserve in store and order in store to drive more productivity inside our physical assets, but I completely agree with you Kimberly, and I know that brand presidents supported by Art have had lots of conversations about that particular 5% growth. We gained share in Q3 of 2013 and we gave up some of it in Q3 of 2014. And we're not into the borrowing share business. We're into the gaining share and keeping it. So I think that we're not happy about. I think it's a quarter. I agree with you, this year has kind of slowed down as well, but this was a particular quarter where we're not happy. And I think we're on it and some changes we made to make sure we get back to gaining share online.

We'll go next to Matt McClintock with Barclays.

One quick clarification question, Sabrina, is the one-time tax benefit and the asset sale in the second quarter both included in guidance for the full year?

Yeah, they absolutely are, and that's GAAP guidance. And the full year tax rate, as I said, Matt, has come down slightly from 38.5% to 38% to reflect the benefit of the Q3 non-recurring issue.

And then if I may ask a longer-term question, Glenn, as we look into the holiday season, it sounds like there's optimism for some of the e-commerce initiatives order in store, et cetera, to potentially benefit and drive holiday sales. Are you planning for any benefit from these initiatives, as you start your plans for holiday? And then now that you're rolling out order in store to over 1,000 locations, could you maybe give us some update on what you're seeing in terms of what you've seen in the benefit, how that's impacting sales in those stores?

I'd say, Matt, that we didn't plan for any of it, because we just turned the switch on to the 1,000 stores on, I guess, it was in the first day of the new quarter. So we worked our way from 10 stores to 50 stores to a couple of hundred. And then we made a big leap. Art's team did from just around 250 to 1,000 almost overnight, because we had everything set up and the technology was working. So our stores actually have been trained well before that. They were ready to go. They're excited about it. Here're the benefits as far as I can tell. Numbers that I've given internally and I think externally before are something like this, on average, in the apparel business, conversion is around 30%, which means that 70% of your customers that do not convert in that 70%, there's about 10 points of people who come in and can't find what they want. Purchase intent high, but unable to find, and now that could be in somebody else's hands, it could be in the fitting room, it could be in something in the retail business called the go-backs product that people did not decide to go with it, but to put back on to the shelf or could be and the highest percent of that is we just don't have that item in that size or color in the store. So order in store is intended to change the paradigm of the conversation that's been going on for multiple generations, which is can I get this in a size 8 and our natural answer is I'm sorry. While we could go to the phone and that takes about eight minutes to do, a charge sent from another store. So what's been developed…

We'll go next to Neely Tamminga with Piper Jaffray.

Sabrina, could we get a little bit more color on the reduction in CapEx either in terms of what the projects that might be canceled and/or delayed or reevaluated? Would you say, if there are delays that they delayed more kind of indefinitely, or just will we see another bump-up in next year's CapEx to make for that reduction?

Zooming out philosophically, it's just important to say, because we're strong believers in managing the ROIC. We just feel it's very important that if our outlook in earnings is coming down that we should be revising the amount of capital spend we have in a year. And so at the highest level, we felt like with the earnings guidance coming down, it was important to re-look at capital. And that's why we're cropping it back a bit. With regard to where it's coming from, it is primarily coming from Gap, because we also want to reward the businesses that are delivering return, and we look to crop back those where we are not getting return in the short term. Obviously we never want to do anything that damages our long-term strategies. So all of our growth areas, our growth initiatives, growth in China, our omni-channel, all of that is moving forward as planned. But we did crop back primarily Gap brand and primarily in the area of stores. Store remodels is where we've cropped it back and we'll be revisiting the importance of that in 2015 in terms of whether it becomes an incremental spend or whether it's just out.

We'll go next to Dorothy Lakner with Topeka Capital Markets.

I wondered, Glenn, you gave some thoughts, I think, about what categories in a larger sense are working at Gap brand. I wondered if you could drill down a little bit in terms of third quarter tops and bottoms, men's and women's, are there things within those categories that are working outside of the big buckets that you mentioned earlier?

The theme is pretty much the same as we've said in the first half of the year. We went to the third quarter still not happy with our women's business and it's important that we continue to try to grow upon it, especially when it comes to the aesthetic. But the point I was making earlier is even though everything starts with design aesthetic, if the product is assertive in categories that have natural growth, then that's also the job of a great merchant beyond just what the design team provides. We've had a tough year like so many others on just indigo five-pocket denims. We reward people quite a bit here in the merchant side and the inventory management side that turn that inventory down and to change the assortment we have. So thank God, we went to one tool in our tool set that helps us with response from supply chain, and that's vendor managed inventory. If we didn't have that, which we should have had, to be honest with you, a number of years ago when we've had it fully working for 12 months, that allowed us very quickly to turn off the tap of inventory on five-pocket denim and switching to not other denim, although we are seeing some performance across the total business on our fashion denims, especially in distressed, but we just switched that into pants. So I think that when you're invested in bottoms the way we're across our entire businesses, when you're invested in Gap in denim and indigo denim, the ability to be faster than we've been before and we're not going to set any land speed records today, although we are getting faster and I know under Art's leadership, we plan to get even faster in 2015. But we have…

We'll go next to John Morris with BMO Capital Markets.

Glenn, first of all, thank you for all your hard work and congratulations and we look forward to working with Art if he's still listening in. My question for Sabrina. Just rewinding on SG&A, we know that you had sort of walked that increase down a little bit part way through the quarter, quite a big move. Just refresh for us why it was going from about an 8% increase down to where you came in nicely at 3%. But more so the implications for fourth quarter, could there be also a little bit of wiggle room there as well beyond what you had implied with the guidance? I'm wondering if it has to do with maybe pulling back on the marketing spend, and maybe if Glenn can talk a little bit about whether or not this was a decision to pull back evenly across the brands.

You might recall we've often said that a large part of our expense base, so about 50% of our expense base is related to stores and over half of that is variable to sales. So part of the reason the expense came down, John, is one that we're not happy about, which is just as sales came down to flat, we actually gained more expense savings, given we have a variable chunk of expense to sales. So that's one component. The second component or the rest of the components were really a combination of old fashioned belt tightening, including savings in areas like bonus and areas like favorability in credit card income. Additionally, we got a little bit of foreign exchange favorability. So just as foreign exchange hurts your sales and hurts your earnings, when you translate to SG&A dollars, it helps your SG&A. So I'd say those were the biggest reasons that Q3 came in better. We have many of the same factors at work in Q4. We're going to continue to manage expenses tightly, but I think the important thing to remember about Q4 is it is our toughest quarter in terms of comparison, because now we are lapping the fact that we saved over $100 million in Q4 of '13 versus Q4 of '12. And we leveraged the 150 basis point. It actually was our lowest percent of sales clearly in the last five years and maybe even beyond that. So it's an extremely low base we're lapping on, which is why again we say clearly we expect to deleverage even as we do our best to manage expenses, as we always do very disciplined.

And I didn't know if Glenn wanted to comment on the marketing, if there was a pullback there?

I would say that some of our marketing is booked and planned. It's not like our store expenses has a variable component to it. But I think we're kind of coming into the year, flat to last year as a starting point. And the way Sabrina categorized return on invested capital and the decision to reconsider remodels for Gap, I think we look at marketing the same way. We have to invest where we think we're going to get the best return. So Gap is going to have marketing. We have a new gift guide out, which is doing really well and we feel very good about that. But it's electronic, so those are trade-offs we do. We could have gift guide distributed to our best customers, call it 3 million, 4 million people and that would have cost x per copy. So thoughtfully we actually put a little bit more money into the digital side of it. It's so far so good. The money we put into it when you have the digital gift guide, which changes every day on Gap, you can actually click on to something you love that'll take you right to our site. So we felt it was more prudent to put a little bit of money behind that choice as opposed to mailing out 4 million copies. So it's those kinds of choices we're making. We're especially bullish on the marketing quality we're seeing coming out of Old Navy. I think that I'm not translating that to commercial success for anybody on the phone. I'm just saying we're really feeling good about the work they're doing and the quality of content they're putting together, which you'll see some of the new content coming out next Wednesday before Thanksgiving. I was lucky enough to spend time with Stefan last night and saw the full December slate of content and he was excited, I was excited. So they're going to get their fair share of investment, because their business is stronger and their content is very good.

We will take our final question from Jennifer Davis with Buckingham Research Group.

Sabrina, I was hoping maybe for a little more color, I guess, or clarification around fourth quarter guidance. Can you at least maybe help us in terms of how much gross margin pressure you expect versus SG&A? And then on the third quarter gross margin or merchandise margins, is the credit card income in merchandise margins and how much did that impact merchandise margins?

Just a reminder, Jennifer, we do have that reclass going on all year in credit card income. So just like previous quarters, we have about $40 million that last year had all been in SG&A of credit card income going up into margin. So that's definitely happened in the third quarter. It'll happen again in the fourth quarter. I would say most of the favorability I talked about previously was really that hit mostly SG&A. A small amount also of favorability went into margins, but mostly SG&A. And then with regard to guidance, we really are trying to keep it high level. I gave you some points on my prepared remarks could be helpful about some of the underlying assumptions. But again, we just believe in this environment that we've been operating in all year that it's important to be prudent and grounded in what we've experienced year-to-date. So just to refresh a little bit on what I said, because I don't want to get into every single line item of the P&L that definitely that range is grounded in year-to-date trends in sales and comps. And no meaningful improvement in Gap, and I think the big change versus previous quarters, especially as compared to Q3, is the foreign exchange, because the dollar had strengthened considerably against currencies that matter to us, not only the yen, but also the pound and also the Canadian dollar. So I think those factors taken together against the backdrop this year, that's been not a bullish backdrop for our company and our apparel retailing. We thought that was an appropriate range to set for now.

Great. I'd like to thank everyone for joining us on the call today. And as a reminder, both press releases, which are available on gapinc.com, one contains the full recap of our third quarter results and the other contains a recap of today's leadership announcements, as well as the forward-looking guidance included in our prepared remarks. And as always, the Investor Relations team is available after the call for further questions. Thank you.

Thank you. That does conclude our conference. You may now disconnect.