Good afternoon, ladies and gentlemen. My name is Melissa, and I will be your conference operator today. At this time, I'd like to welcome everyone to the Gap Incorporated Second Quarter 2017 Conference Call. [Operator Instructions]. I would now like to introduce your host, Jen Fall, Senior Vice President of Corporate Finance and Investor Relations. Please go ahead.

Good afternoon, everyone. Welcome to Gap Inc.'s Second 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 our forward-looking statements as well as descriptions and reconciliations of 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 filing with the SEC, all of which are available on gapinc.com. These forward-looking statements are based on information as of August 17, 2017, 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 section at gapinc.com. With that, I'd like to turn the call over to Art.

Good afternoon, everybody, and thanks for joining us. I will turn the call over to Teri in a few moments, and she'll share more details on our Q2 results. But before we do that, I really want to zoom out for a moment and talk pretty specifically about what separates Gap Inc. from the retail apparel pack. I often see us referred to as a "mall-based apparel retailer". And I think that's one dimensional probably at best, but really, it's just flat out wrong. We have clear points of advantage that are intrinsic to our business and set us apart, first, our portfolio of iconic and I would underline, profitable brands; We're using our product capabilities to lead in loyalty driving categories to drive our business; We have a very robust, very profitable online and mobile business that meet our customers exactly where they are; and we have scale, and we're using that scale to drive advantage growth and profitability. Let me spend a moment on each of these. First, our brands. Again, we'll talk more about each brand's Q2 performance later in the call, but no other apparel retailer has a better, more diversified collection of profitable brands. Individually, they have unique strengths and unique opportunities for value creation. In Athleta and Old Navy, we have 2 growth brands, both have significant runway in front of them. Gap and Banana, they're more mature but also profitable and where we're focused on driving improved performance and cash flow generation and at the same time, responsibly and aggressively managing our exposure to struggling mall real estate. We also have a very strong value position in our portfolio. Over 60% of our total business is in the value segment across Old Navy and our outlet and factory expressions. I think people sometimes…

Thanks, Art, and good afternoon, everyone. We're pleased to deliver another quarter of positive results. And as we entered the second half of the year, I'd just like to take a minute and reiterate our financial priorities for 2017, first, to capitalize on our initiative to improve product quality in order to grow sales with healthy merchandise margins; also, investing strategically in the business to strengthen our brand equity and our customer experience and to support growth; maintaining operating discipline to drive efficiencies and leverage scale; and of course, returning excess cash to shareholders. So let's turn to the second quarter results. Continuing the trend of solid first quarter performance, we're pleased to have delivered another quarter of positive comps and to end the first half ahead of our original expectations. I'll walk you through the quarterly results and then talk about our expectations for the remainder of the year. As we noted in our press release, our second quarter reported results include a $64 million benefit from insurance proceeds primarily related to a gain on fixed assets destroyed in the fire at our Fishkill DC. We're excluding that impact in our comparisons to provide a better assessment of the base business. So starting with sales. Our comp sales were up 1%, and we're pleased to have delivered our third consecutive quarter of positive comp sales. Net sales for the quarter were $3.8 billion, a slight decrease from last year. The spread between net sales and comp sales is largely due to our international closures last year. Our Old Navy delivered a record net sales quarter with positive 5% comp. This is against a flat comp last year and is driven by positive AUR and conversion. In addition, the brand traffic trends meaningfully outpaced industry metrics throughout the quarter. Improving…

Thanks, Teri. That concludes our prepared remarks. We will now open up the call to questions. [Operator Instructions].

[Operator Instructions]. Our first question will come from the line of Lorraine Hutchinson with Bank of America.

As you look to the back half gross margin, how should we think about the impacts that the fire had by taking some of the inventory out of the picture? And what are your expectations for gross margin in 3Q and 4Q based on that?

Yes. So we're not going to provide specific guidance under the gross margin line. But as we said, we did learn something that we worked through the inventory reductions we experienced following Fishkill. And you've see us play that through this year as we've really driven the AUR and the margin expansion. The fundamentals of what we experienced in the first half will stay about the same. So we'll be pursuing the same strategies. And so from there, you can kind of draw your conclusions. But we generally feel good about the way the business has been approaching that margin expansion throughout the year.

And our next question comes from the line of Matthew Boss with JPMorgan.

Art, at the Gap brand, I guess, how would you rank assortment opportunities in the back half of the year? And then as you dissect the store, can you just elaborate on trends in some of your more loyal categories that you talked to and just how best to think about your ability to increase the mix towards some of these categories over time?

Yes. If I look at the assortment, and thank you, we're pleased with the improvement. We know we have more to do. If I look at the assortment, frankly, across the company but then focusing on Gap versus where we were a couple of years ago with the exception of a couple of categories inside of Banana, we didn't -- we are not experienced product -- we are not experiencing product acceptance issues either because of trend, fit, quality, whatever. And that would absolutely apply to Gap. We've had a little bit of softness in the Gap girls business, which we've been focused on correcting, rebalancing the assortment there. The bigger issue that I see, and I spend a lot of time in stores and talk to stores, is to continue to buy into some of the big ideas with more confidence. And that's where we've probably been leaving some money and some comp on the table. And you'll see that happen where we will come out with a new flow. And again, these are not seasonal, typically, these will be more monthly in nature. We'll get some cute women's woven top or something like that into the store, and then we sell down very rapidly. Now we're able to get back in oftentimes much more quickly. But we still need to put more confidence and depth behind some of these buys. And I do believe that it represents an opportunity for us for incremental comp.

As a follow-up on the expense front, how are you assessing some of the investments that you're making, particularly in marketing? And then just longer term, potential buckets of cost savings over time as we think about just the 4 concepts and the change that's taking place larger picture in retail?

Well, let me take the first one, and maybe I can talk the -- toss the second one to Teri. Marketing, obviously, traditionally was pretty traditional with print and TV. We still do some TV. But a lot of it is digital. And when we're doing digital marketing, we have a much more direct line of sight to returns, whether it's customer acquisition or driving conversion or whatever it is. And so I actually feel like we have continued opportunity in front of us given the returns that we're seeing from much of our marketing mix to feel very comfortable that we continue to support the brands. And then you have -- and I'm not signaling a large increase in marketing but to continue to support the brands. And then you have in both Gap and Old Navy very convincing traffic beats that give us confidence that our customers are responding and we're seeing the footsteps into the stores. And so we're very focused on seeing where the returns are. In the same way, that if we're putting any incremental payroll, we're looking for that to show up in the P&L, et cetera. Teri, I don't know if you want to field the second one.

Sure. So on the productivity front, as you know, we've got a long history of being pretty disciplined in delivering productivity savings year-after-year. We've largely done it at the brand level with each brand optimizing its own operations, and we've started to move toward more scale. But there's a lot more opportunity for us as we think about productivity on a sustaining basis and an enterprise level for us to really continue to tap into that scale, whether it's scaling the actual activities or whether it's really just reapplying best practices faster and creating more standard processes that can be better, faster and cheaper. So as we've started to look at this, we do see a tremendous opportunity, as I said, on a sustaining basis to be able to deliver additional productivity that can help us fund some of the investments that we think will drive growth.

[Operator Instructions]. Your next question comes from the line of Adrienne Yih with Wolfe Research.

Art, I wanted to ask about Gap brand. The second quarter Gap brand comp notably accelerated on a stacked basis. So can you talk about the product improvement, where you are relative to your expectation? And was the negative 1% hampered by lack of inventory units? And then very quickly, Teri, if you can just -- the ROD leverage has been at about a flat comp breakeven for the past 3 quarters. So is that something that we should expect going forward?

Yes. Let me talk with the first one, and I'll again hand the second one. I think that was 2 questions over to Teri, proving that I can count through the numbers. I'm not going to quantify the comp that we've left on the table, but my gut tells me in being out and talking to the stores that I've seen enough smoke where the stores feel like they haven't had the inventory to really support the business where I know that we have an opportunity in not so much more inventory but continuing to balance the inventory and get it more behind and confidently behind some of our big ideas. And again, our responsive capabilities allow us to get back in more quickly, but we still have times when we go flat because we've sold through some of the items that are moving the business. Where we are right now as Teri mentioned, I feel like we're in a very solid inventory position. I think we have very little inventory in Gap brand that we're going to be disappointed about its productivity. We were pretty light in some parts of kids and baby around the world. And we've gotten back in there as well. So again, I've learned my lesson in calling a comp turn, but as you noted, we are getting convincingly better season over season and on a stacked basis. And I'm really pleased with the progress that we're seeing, and I just want more faster. Teri?

So on the ROD question, we've been pretty consistent and nothing's really fundamentally changed relative to what it takes to leverage ROD. It's kind of likely in the low to mid-single digits, which reflects the fact that some of our store openings are in higher-end markets. We have the Times Square opening, so some of that's putting upward pressure. But in these last couple of periods, what we've had is the benefit of international closures that have offset it and brought us down to a lower leverage point. But on a sustaining basis, nothing fundamentally has changed. So it's still likely low to mid-single-digit comp to drive that.

Our next question will come from the line of Anna Andreeva with Oppenheimer.

We had a question about the comp metrics during the quarter. I guess, did traffic conversion and AUR all improve sequentially across the portfolio? And I think you mentioned focus on value at outlets. Just curious, could you talk about what kind of trends did you see in outlet versus various mall types?

Yes. So on the levers, without going into a lot of detail there, as I mentioned, Gap and Old Navy have seen nice traffic beats relative to the industry. And again, that's validation of what we're doing in product. It's also validation obviously of the marketing and the effectiveness of the marketing. What I can say is that we've seen across all the brands a positive sales less traffic, and so that would tell you we're also seeing excellent execution inside the boxes for the most part. We're monetizing the footsteps that are coming into the stores more effectively. And sales less traffic or sales over traffic has always been an important leading-edge metric to me because what it does is it equalizes for any product differences across the stores and talks about store execution and see that consistently across the portfolio. It's quite encouraging. As to the differences across outlet versus other types of real estate, I'll be very honest with you. We continue to disaggregate the data. I'm very big about the averages hiding the truth and look at different types of real estate, look at first quartile versus fourth quartile, and we really -- I really can't say and paint a very convincing picture for you that there is a -- there are big differences other than as you get into the C type malls, I think, we and other people pretty consistently see the fact that traffic is tougher there. That all said, those are the types of malls where we have continued to reduce our exposure over time, and we will continue to do that on a going forward basis.

Our next question will come from the line of Simeon Siegel with Nomura.

Art, what's your view on the right long-term margin just given your points on the advantages of gaining share and the benefits from scale? And then, Teri, if I can, to follow up, I think it was Lorraine's question. Just to clarify, with the fire impacting last year's comp and margins, is there any shift in 3Q trends that we should keep in mind just versus what's been happening in the first half?

Yes. And let me give you a specific non-specific answer to the first question, which is I'm -- I like margin dollars because, at the end of the day, margin dollars is what we put in the bank. So we're very focused in a relatively new way with analytically based functions on understanding elasticity and therefore, where our products points drive share maximization and most importantly, margin dollar maximization. And that's a metric that starts on the first 20 feet of the store with understanding what margin dollar output is per square foot on a table, and it goes all the way up to thinking about our stores and our brands at the end of the day. So this is work in process. But rather than focus on a rate, I would say that we really truly do understand and are thinking about everyday elasticity and yield management and about maximizing margin dollars to the system. Obviously, we've demonstrated our ability to open up some rate expansion, which we're pleased with, but we also don't want to get greedy at the end of the day. We want to make sure that we are focused on market share and margin dollar maximization.

So on the Q3 specifics, I'll give you a little bit of perspective that you will come to yourself as you do your modeling. If you think about it, on the gross margin line, in the -- in last year with the Fishkill and other things, our gross margin for Q3 '16 was up pretty substantially from Q3 '15. And so if you compare the magnitude of expansion you might see in Q3 versus what we've experienced in Q2 and Q1, it's probably not going to be as great. But we don't have anything that we would say in particular that would change the fundamentals of what we're doing on the business. We're still continuing to be focusing on AUR on these higher loyalty categories that drive higher margins. On the SG&A line, as I said, you're going to get a little bit more increase in Q3 versus what we've seen in Q1 and Q2, same fundamental drivers, just a higher magnitude as we've reallocated some of that advertising expense into the back-to-school season and also to see some of the engagement we want as we head into the holiday season.

Our next question comes from the line of Mark Altschwager with Robert W. Baird.

I wanted to follow up on inventory. You talked about more basics versus fashion or seasonal basics in the inventory mix. Maybe just talk about the decision to shift the balance of the assortment. Wondering if that's concentrated in one particular brand or across-the-board. And maybe contrast that trend with the opportunity you mentioned on buying bigger into some of the big ideas with more confidence in depth. And then just also on inventory, with the investments in the loyalty category, just curious how that's impacting your AUR outlook for the back half.

Yes. That was a complicated question. So I'll do my best to first remember it and then try to answer it. Yes, if you think about the comments on basics, so again, the traditional way of buying a season, you're buying preseason and you're going to be buying it against your traffic trend. And with traffic overall tending to be negative, although, again, we've seen some positives in our business, you're going to be buying your units very tight, particularly in Banana as an example. We had pivoted more of that open to buy, which is a finite pool of open to buy. It is supporting some of the fashion. Some of that fashion's been working, and some hasn't. So it's less about really adjusting the architecture of the assortment than about rebalancing the buy inside of it and taking some pressure off of those fashion categories and frankly, putting some basics inventory in to just get our service levels back up. It's an important part of the business. And we have places where we were running service levels that were unacceptably low, and we felt like if we took a little bit of pressure off of some of the fashion in particular that wasn't working and put the inventory back in responsibly to support the basics business, that would be good. The second thing to think about is where our responsive pipeline really kicks in is in supporting trend and fashion, and so that gives us the ability to invest later and put pressure into those categories if we see an opportunity. On the AUR -- or AUC, AUR, et cetera, I would say we're going to continue to look for opportunities from both mix. So I referenced the sculpt denim that we have across. That's our highest price point denim with the exception of selvedge in our business. And as we see that product and customer response to it, we're going to put investment behind it. That's going to pull our AUR up. The other driver of AUR is to continue to manage our yields through less promotional depth and less promotional breadth on an ongoing basis. And appropriately, we've been pleased that some of the notes that had been written have actually noticed the fact that we have been backing off of some of the promotional intensity versus a year or 2 years ago. And that is correct. That's been very intentional, and that will also be a contributor to AUR expansion as well.

I guess, I would just add, this is -- I mentioned this, but I know there's a lot to deconstruct in inventory and I'm sure the increase strikes you. And we, like you, are very cognizant of the need to remain very disciplined in our inventory levels. And so we are very thoughtful and very controlled at how we execute that growth. But just keep in mind, in addition to the in-transit timing piece, there is an FX piece, which is probably close to 1 point, I think, of negative impact. So when you net those 2 pieces out, you get down to a bit of a build, which is explained by the things we talked about but isn't so far ahead of our comp sales that when we look at the liable percentages being improved that we feel uncomfortable with where we are.

Our next question comes from the line of Brian Tunick with Royal Bank of Canada.

I was curious if you guys can talk a little more about Old Navy, maybe the second half expectations from a bigger picture perspective. But are there changes that you're making regarding marketing spend at Old Navy in addition to Gap brand? And maybe talk about either categories or processes that you think are the best opportunities as you look at the back half of last year.

Yes. Just let me throw a few things at you. We're always tuning our commercial plan and our marketing mix. And a simple example of that would be as we've seen back-to-school become less of a defined moment in time and more of an event that starts somewhere in later July and can oftentimes go through September week 1 or week 2, we've managed and tuned the marketing mix to also put some media in place to support the later back-to-school this year. So as an example, on the East Coast, a lot of the schools aren't starting until after Labor Day versus schools in the South -- in the Southeast that have started 1 week or 2 ago. So we're bouncing that regionally to support that. For the most part, the back half otherwise is, based on our learnings, tuned and tweaked but not necessarily any fundamental changes in terms of what we're doing. The only other thing I would just talk about is that we saw particular success and continue to, even recently, with key price point item promotions in Old Navy. We did a $3 dollar polo for back-to-school couple of weeks ago, and it was a blowout event. And so customers do respond to that. We find it's a very effective way to generate traffic and then build a basket around that. And we're, of course, looking at anything that works in saying how do we mix it up and how do we build some of that into our commercial plan in the back half. Largely with Old Navy, it has stayed the course with what's working and continue to support with inventory investment in the categories that are driving the business, which goes back to those that I mentioned at the end of the day. Kids and baby business is continuing to pull the train, and bottoms and denim business is continuing to pull. And we mentioned many times that we have an active business that we think has significant runway in front of us in that business as well.

Our next question comes from the line of Oliver Chen from Cowen and Company.

We were curious about your prioritization of different digital initiatives in the back half. What would you say are the more versus more significant factors? And any comments on what you want to do with mobile and what kind of opportunities you have? And also, as you have such stellar brands, would you look to partner with Amazon? Like, how would you think about a framework for considering that as an option?

On digital, it's -- digital and running a great digital e-commerce business and mobile business is about many things. And the wonderful thing about it is that because it's clean, you can put things into work, whether it's product recommendations, whether it's site speed, et cetera, A/B test, A/B placement test, A/B test video, et cetera, et cetera, and be very rapid and innovate very rapidly. And so it's hard for me to really look at it and say it's any particular thing at the end of the day because there's a whole bunch of things in work right now. I mentioned some of the customer facing capabilities, which have continued to be important for us. But the bulk of it is really about making sure that you've got an easy shopping experience that the customer can click through cleanly, where it's easy to check out, et cetera. If I go to mobile, everybody on mobile needs to continue to figure out how to effectively monetize that traffic, and that's what we continue to work on. Getting to a native app experience on our apps has been a big step forward. It's faster. It's easier. It's cleaner. It's more intuitive for our consumer. But there's going to continue to be work as to how do we build big baskets around our mobile shoppers, and we believe that it will continue to be a place where our customers go to at the end of the day. So we're excited about both. We're seeing traffic grow. We're seeing our e-mail acquisitions grow. We're seeing our SMS list grow, et cetera, to be able to feed that business, and then it's about really delivering a low-friction, high-touch experience in the digital world.

On Amazon, could you just speak to your thoughts there about a potential partnership? Or what distinguishes you most in terms of being -- having unique core competencies? I think you talked a lot about that in the beginning of your remarks as well.

Yes. And that really starts with brands at the end of the day, and we feel like very strongly that expressing our brands and controlling that expression of the brand and delivering an experience around that, whether it's an experience in e-commerce or mobile or experience in our stores, is really important. I've been open in saying that we will always be where our customer is, and so we are not close minded in making sure that because, first and foremost, we are a fashion apparel company, and people come to us to buy clothing. As to something on Amazon, I just really don't want to comment right now. I've commented where we have had effective third-party relationships like Tmall, which has been a wonderful relationship for us in China. We've done business with Zalando. At the moment, we're staying the course, and we're focused on delivering an exceptional brand experience, whether it's digital, in our stores or the combination of the 2.

Our next question will come from Ed Yruma from KeyBanc Capital Markets.

I know you guys have made significant investments in responsive and in speed. I guess, can you link at all the gross margin performance in the quarter or maybe kind of how we think about gross margin longer term with some of these initiatives and maybe how they're helping to drive gross margin?

Yes. So there's a bunch of things that are packed in the gross margin, and what I'm not going to do is I'm not going to assign a coefficient to each of them. I mentioned product acceptance. Start there. We believe that we are largely on trend with appropriate fit and quality and pricing on our products, and that matters. Responsive certainly plays into the equation, and I cited the numbers from Athleta, which is one example but representative of the kinds of things we're seeing in a number of categories right now where Athleta has the great majority of its bottoms complex on responsive, less than 8 weeks, oftentimes faster than that and has been driving double-digit comps now in a 2-year stack. And that has been, in that case, largely enabled by both great product but also able to feed units into the business close to demand. A third piece is I mentioned that we're focused on yield management, which is really continuing to be as selective as we can about the breadth and the depth of promotions. I'm not going to signal the fact that magically we're going to get back to a right price business. That's not the nature of this business. But there is a lot of money to be had through really being focused on yield management and continuing to back off of the promotional depth and breadth. And so it's a number of things that come together, also including being responsible on our inventories and not over broaden our inventories, which we are quite confident that we're not right now. So it's hard to break all of those out. We feel they all matter and they're all important, and we have to work all of them equally hard everyday.

Our last question will come from the line of Dana Telsey with Telsey Advisory Group.

Given your real estate outlook, Art, how do you envision the pace of store closings? Any change by division in terms of how you're seeing the base? And as you think about the online business and the profitability there, has it been improving? And with the initiatives in omnichannel, will that drive operating margins the same level or higher than physical? How do you think about it?

Thanks, Dana. And you are both consistent and persistent I would say. If I think about real estate, so let me just start with Gap. Gap's got the oldest fleet. We've had the greatest number of store closures in Gap, and yet almost by definition, Gap will continue to have the highest level of exposure into older centers. Some of those centers are fantastic, and some of those centers, at some point, are going to go away. So without giving you a store count because I don't want to do that right now but I will reassure you that we are working that everyday. We are, like I said, going to really aggressively and responsibly manage our exposure to real estate that is struggling, and we'll continue to do that. And we'll do that across all the brands, but it really starts with Gap and then Banana Republic. We had very little of that inside of our portfolio at Old Navy. We have very little of that, to be clear, inside the value businesses of Gap and Banana Republic, whether they're in traditional outlets or in non-traditional value locations. And of course, Athleta's fleet is very fresh. So we'll continue to work it. I'm -- like I said, I'm big about the averages hiding the insight. And so we're always looking at the trailing edge of our fleet and the leading edge of our fleet and understanding what the differences are in performance and really trying to identify places where we just shouldn't be at the end of the day and frankly, identify places where maybe the consumer has moved on and we could reposition the store as well. And you know all those tools have been in our toolkit over the course of the many years that we've taken a lot of square footage out of the space -- or out of the fleets.

All right. I'd like to thank everyone for joining us on the call today. As a reminder, the press release, which is available on gapinc.com, contains a full recap of our second quarter results as well as the forward-looking guidance included in our prepared remarks. As always, the Investor Relations team will be available after the call for further questions. Thank you.

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