Good afternoon, ladies and gentlemen. My name is Celestina, and I will be your conference operator today. At this time, I'd like to welcome everyone to The Gap, Inc. Second Quarter 2018 Conference Call. At this time, all participants are in a listen-only mode [Operator Instructions]. As a reminder, please limit your questions to one per participant [Operator Instructions]. I would now like to introduce your host, Tina Romani, Senior Director of Investor Relations.

Good afternoon, everyone. Welcome to Gap, Inc.'s second quarter 2018 earnings conference call. Before we begin, I'd like to remind you that the information made available on this webcast and conference call contains forward-looking statements. For information on factors that could cause our actual results to differ materially from the forward-looking statements, as well as the description and reconciliations of non-GAAP financial measures, as noted on page two of the slides supplementing Teri's remarks, please refer to today's earnings press release, as well as our most recent Annual Report on Form 10-K and our subsequent filings with the SEC, all of which are available on gapinc.com. These forward-looking statements are based on information as of August 23, 2018, and we assume no obligation to publicly update or revise our forward-looking statements. Joining me on the call today are President and CEO, Art Peck; and Executive Vice President and CFO, Teri List-Stoll. As mentioned, we will be using slides to supplement our remarks, which you can view by going to the Investors sections at gapinc.com. As always, the Investor Relations team will be available after the call for further questions. With that, I'd like to turn the call over to Art.

Hi, everybody, and thanks for joining us for the call today. We are pleased to report our seventh consecutive quarter of positive comp sales. You know, our quarterly results came in largely as we expected them to, and we are positioned for continued improvements in the back-half of the year. Today I will talk through some key highlights, and Teri will, as always, follow-up the detailed results for the quarter and guidance for the remainder of the year. But before we discuss the performance of each brand, I would like to pull us up for a moment and talk just a bit about a broader view of our foundational assets. First, on our supply chain, and I'm not going to dwell on this for a long time today, but this has been a huge focus of mine from the moment I stepped into this role. And we have made huge strides forward in terms of responsiveness, platforming, testing, vendor consolidation, quality improvement, and product cost. There is no question that this is an important factor powering Old Navy's consistency, Athleta's growth, and Banana's continued turnaround. These are real capabilities driving real outcomes. Second, and I have to be honest here, it perplexes me to continue to hear over and over that stores are a liability. They are an asset, not a liability. Sure, and if you have got a store in a dying mall, that store needs to go away, and that's the work that we have got on early, and we will continue. But the simple factor is that most apparel is still sold in stores, and will continue to be sold in stores. That said, the definition of shopping continues to change. She wants to do more than just walk in, pick a product, and exit. She wants…

Thanks, Art, and good afternoon everyone. So I kind of look at our quarterly results through the lens of our balanced growth strategy, are we executing against the priorities we agreed, are we seeing the progress we expected? While we continue to have opportunities for improvement, we are pleased with the progress we are making, and confident in the appropriateness of our priorities. Specifically as you heard from Art, our focus on growing and the value in active space is working, demonstrated by the continued strength in Old Navy and Athleta. Our investments in our digital business and customer experience will provide a unique and seamless shopping experience that will support continued differentiation and growth. And we saw some specific examples of that in the quarter. Underscoring these efforts is our heightened focus on improving the profitability of our specialty fleet as well as our productivity initiative. These efforts not only benefit our current results, but will truly optimize processes to create a more nimble and efficient organization going forward. Obviously, we have to acknowledge the challenges at Gap brand, the business is not yet where it needs to be. Team remains focused on where they can have the most impact to optimize margin dollars and deliver continued improvement through the back-half. As we reflect on our historical performance, simple put, there have been too many instances where the businesses suffered because we failed to execute effectively. This is a key priority going forward, and we are using the current Gap experience to establish stronger operating discipline across all of our brands, often leveraging the best-in-class processes at Old Navy. We do remain confident in the balanced growth strategy and the focused actions that it drives. We are maintaining our outlook for the year against the backdrop of first-half results…

Thank you. [Operator Instructions] And we will take our first question today from Mark Altschwager from Robert W. Baird.

Good afternoon. Starting out just regarding Gap brand, it sounds like some lingering problems, but the worst probably past. So bigger picture, as we think about the margin delta between Gap brand and the rest of the organization, what's the reasonable goal in terms of the pace of margin improvement over the next 12 to 18 months? And then, separately, Teri just to clarify real quick, I apologize if I just missed this, but regarding the comp sales spread, can you clarify, was there a calendar shift benefit this quarter as you pulled over that back-to-school week? I mean if you could quantify that, that would be great. Thank you so much.

Yes. So the second question first, so I don't forget that you have asked, there was no significant impact in the quarter from the shift. And part of that of course is because the back-to-school season is really lengthening out, it's less impactful in any given week as it may have once been. Broader question on the Gap brand margin is obviously a very fair one, you heard us mentioned a number of times on the call that we are very focused on getting through these inventory units, getting back to normal on inventory as quickly as we can, but in the first quarter we actually sold through some inventory because we knew it was right to get through it. This quarter we made a more different conscious decision because of the composition of the inventory, and the weather to hold that inventory a little longer to be able to optimize margins. So every single thing the team does is with that margin progression goal in mind. And we do -- now, if we think about where we are this year, I honestly do believe we have the opportunity to make very significant advancements in our margin over the next 12 to 18 months. I mean that is goal to regain some of the lost profitability that we have experienced in such a short period of time.

Thanks for the color, and best of luck.

And we will take our next question from Matthew Boss from JPMorgan.

Great, thanks. Art, I guess beneath the surface on your core Gap performance, I guess maybe any color on how comps progress by month in the quarter, maybe any learnings from back-to-school, and I guess if you think a positive comp is possible by year-end at this concept?

Matt, I always admire your persistence. And I think those are all reasonable questions. We are not going to break it out, I think we have been pretty clear here saying that we expect to see sequential improvement here as to whether a positive comp is possible. Anything is possible, but I am not going to call it right now. As Teri said, we are focused first and foremost on getting through the units that we have in the business with maximum yield. I know that we took a boatload of styles in CCs out of the business as we got into Q3. And we continue to balance the assortment as we get into Q4. So we are looking for that sequential improvement. And we are hopeful that it comes back fast, but I am not going to -- I just can't sit here and try to call an exact number for you.

Great. And then, just a follow-up, Teri, on the SG&A front, I guess as we think about the investments to drive top line versus the productivity savings, is there a comp that we can think about as the best to leverage SG&A on a multi-year basis, just in terms of a fixed cost hurdle?

And looking at Tina, I don't think we have provided that metric, and it's sort of I don't have any color I can provide at the moment, Matt, sorry, but we are really -- I mean, as you can see, the reversal of the de-leverage that we have been experiencing historically is quite dramatic, and we do expect to be able to maintain that through the back-half of the year.

Great. Best of luck.

Thanks.

[Operator Instructions] And we will take our question from Dana Telsey from Telsey Advisory Group.

Good afternoon, everyone. As you think about the Old Navy business and the $10 billion sales target now expanding into plus sizes, how do you see the classification opportunity in getting into that $10 billion? And the remodel store performance that you have seen in Old Navy how is that tracking and how do you see the progression of store remodels? Thank you.

Thanks, Dana, I appreciate it. If I think about the progression, and we have said this I think pretty consistently is the good news about continuing to drive growth in Old Navy is that it's very diversified, and we have confidence in that diversification. It's diversified across categories. So if you just look where we are seeing strength over the last quarter, knits and woven tops, big category, outerwear and sweaters, denim, woven bottoms, mens, knits and wovens, denim, woven bottoms, you see that strength in those categories and those are foundational loyalty categories, and it makes us feel really good about that strength. We have added plus to it. We have been looking at plus. We think the plus base is the big opportunity. We have not built big number, to be honest, four plus into achieving that $10 billion goal. And then we are continuing to obviously build stores which have exceeded our expectations. And the remodel program, as I said, is driving a five point comps spread. So those are dollars that I can spend all day long to continue to remodel stores. We have a pretty aggressive plan. We have -- I think the number is something on the order of -- several 100 stores at least, that are what we call the Old Old Navy which are oftentimes where we do a light touch remodel, which is really not structural. What it is paint and lighting and where we do the cash wrap, so it super efficient from a cost per square foot standpoint. And those remodels are performing just as well as when we go and do a full gut structural remodel and put in our new P3 concept. So I think we have a tiger by the tail in the remodel program in terms of really driving tangible sales improvements, and most importantly, obviously giving the customer a respectful refreshed experience that they are really engaging on.

Thank you.

And then I would remiss not to say the online business, because I think we have said Old Navy has the lowest penetration of online. We are looking at, and feeling like how do we continue to accelerate our online growth rate? We feel really good about the work that we are doing, and there is a reason that we launched BOPS inside of Old Navy first, because we drive that business, and we drive big numbers. So we are really super excited about the integration of the digital into the physical, and the fact that really one plus one, is we believe is way more than two as those businesses come together and create converged experiences.

Thank you.

We will take our next question from Randy Konik from Jefferies.

Yes, thanks a lot. I guess, Art, when you look at the traffic indicators that you presented in the PowerPoint, and Gap and Banana are lagging the industry average, how do you think about long-term positioning of these businesses? It seems like the market keeps thinking Gap Inc. is Gap yet the company is really Old Navy. So how do you think about kind of almost the position of how much real estate should be dedicated to those businesses? You have obviously worked on already communicating to us taking down store counts there, but what does it say about the long-term? And it's also really interesting that Old Navy has the lowest Internet penetration continues to be very strong, and shows no sign of slowing. So I was just curious how you are going to think about this all kind of melt together or you can separate the power of Old Navy and Athleta and kind of pull more of the exposure to Gap and Banana?

Yes. So let me just do a little bit of maybe correcting a misconception on the traffic. So if I look over the last four quarters, back to Q3 2017, to the most recent quarter, and I go by brand and by quarter, the only two quarters, where we did not beat industry traffic in two brands. So if you think about that as a metrics of 12 dots, there are only two that are red relative to the other. So we got a very good run, and I believe we can continue that run. And largely it is due to the many things that I have talked about, right, it's the bringing the digital and physical together, targeting our marketing, really put in place performance marketing capabilities, where we are targeting our marketing and increasing the effectiveness for acquisition, retention, and activation, pivoting the great majority of our dollars into digital channels versus traditional marketing. And then the focus that we have in stores through our rewards program, loyalty program, and customer information, we are building and we have positive momentum in building our customer file. And that is paying off in our traffic. So I don't view the -- I think that maybe overall, the industry is going to see negative traffic. I don't view it as an inevitable in any way, shape or form that we have go in the direction that the industry is going, because we have ample evidence that we can consistently beat the industry traffic trends. Now that said, the balance growth strategy is about managing a portfolio and allocating our resources and our investment both OpEx and CapEx to where we believe there is growth and continuing to reduce our exposure in places where we believe there isn't growth. And we have…

Can I ask one follow-up then?

You got it.

Yes, sorry. If you then look at -- it's very helpful, one thing that really stands out is if we kind of go back to when the company disclosed the segment profitability by division, I guess we could have seen probably that the Old Navy margins have probably increased since then, but yet the Gap division margins have likely probably decreased. So really why Gap -- no pun intended of maybe 1,500 basis points, it's hard for me to tell between Gap and Old Navy at this point, I am just trying to figure out how you think about you positioning the business of Gap either from a real estate perspective or as you said, OpEx, what can be done to kind of just really get a little bit of that profit back and those margins back up?

Yes. I mean there is number of things, as you could imagine the equation, and let me point out that just the highest -- shareholder value is delivered tomorrow by beating expectations. And we believe we can, and we will see it, the sequential improvement in the business. If you go through the P&L, it's the things that you would expect, which is we do believe we owed some margin back in the business. And as we get the inventories in line and the assortment balance, we expect to see that. We are obviously taking out and we will continue to take out unproductive real estate, which has an impact on ROD. We do believe there is an opportunity in the overall cost structure of the business as well. And then, importantly again, back to the idea of managing the portfolio is we are aggressively managing the channel shift and the mix of that business from specialty and continuing into outlet and online, and we have already told you that the outlet business -- I'm sorry; the online business is growing at a rate that is significantly greater than the rest of the industry. And so, it's a combination and there is more to it than that, but what I would tell you is I have been super pleased with Neil, as Neil is very thoughtful and very methodical about how he sees the waterfall and the P&L and where we have opportunity whether as to margin or cost in order to get some of that probability back.

And Randy, if I could just add, you are exactly right that since we disclosed margins last fall, there has been a shift, and we have been mixing into the healthier margins of Old Navy, Athleta. I wouldn't downplay the benefit of Banana on a rebound as well, which we do look at, and our objective as managers of the portfolio is to rewrite those contributions, so that Gap is going back to a more representative contributor to the portfolio earnings than it is today. But it is great to have the engines of growth we do have in Old Navy, Athleta, and the rebound in Banana at this particular time, and the productivity effort really just gives us some additional cushion to be able to continue to drive earnings progress in the face of this challenge, and knowing that we got upside from where we sit on the Gap brand given a lot more contribution today.

Just underlying the whole balanced growth strategy is about managing the portfolio and the mix of the portfolio to continue to pivot where there is profitability and attractive return on invested capital.

Very helpful. Thank you, guys.

Thanks, Randy.

And we will take our next question from Lorraine Hutchinson from Bank of America Merrill Lynch.

Thank you. Good afternoon. I wanted to follow-up on the Gap inventory. You talked about the word, "Imbalances" on the product assortment. And so, I guess I was just curious what we would see in the stores, how you expect to work those out, and if you expect to see continued sequential merch margin improvement in 4Q even on top of the very difficult comparisons?

Yes. So let me just provide a little bit more granularity on the inventory, because it's little easy to get twisted up than I suspect. So, first of all, we have carried some inventory that we felt was seasonally quite saleable over, rather than liquidated at a sort of an artificial threshold. And we believe that we are not encumbered with liability, but we have saleable merchandise, and we can work our way through. So that's part of the issue. If I look at the assortment imbalance, it's really not about the level of inventory largely, because we did bring levels down, it is about using our responsive capabilities, what we were able to cut in a relatively short period of time. And different products run different cycles, and as a consequence, the imbalance that we are referring to is really about having not the proper tops to bottoms ratio in the business that we feel we should have, we should be about 3 to 1, and we are lower than that. So the short-term implication of that is maybe a little bit harder to complete an outfit, but it's not crippling by any stretch of the imagination, but it isn't ideal in terms of where we want to be. We have solid inventory in our bottoms business. We have solid inventory in our kids and baby business. But if you think about the architecture of the assortment is, tops to bottoms, your outerwear business, your wovens business, and how they all relate to each other, we are not quite in the place where we should be from the standpoint of the composition of the mix. And we are confident again that, that gets better as we get obviously through the back-half of the year and in the spring of next year. We did feel that to maximize margin, it was the right thing to do to really tighten up CCs and programs. And so, we took that action frankly knowing that we're going to be looking a little bit imbalanced, but still believing that was the right thing to do. And Teri, I don't know if you want to jump in on the part of that…

Yes, I would just confirm, Lorraine, that we do expect to see sequential progress, and even against the Q4 compare, we would expect to be able to have positive compares there as well.

Thank you.

We will take our next question from Chethan Mallela from Barclays.

Good afternoon, I wanted to follow upon a comment in the prepared remarks about the benefit of online sales that involved your store because of the enhanced profitability. Is there a way to frame how much of the $3.5 billion of online sales this year you expect to involve your physical store? And how you are thinking about the relative growth rates of online only or digital and physical going forward? And if you could give on high level, just frame the magnitude of profit differential. That would be helpful as well. Thanks.

Yes. So let me try to way through this, and I will let you know if Teri kicks me out of the table here. So I think we've been reasonably forthright in saying on an ongoing basis that our online business we have traditionally and historically run, and pretty consistently run with a margin advantage above the line. And a lot of that has to do with the inventory dynamics of one pool of inventory, you don't have stranded inventory. You can price more dynamically and that kind of thing. And that above the line advantage on merch margin has more than compensated for the incremental fulfillment cost below the line. And so, if you think about it in what the advantages that we've showed before relative profitability without going -- because I don't think we have released the specifics on the margin differences and the channels, merch margin differences.

This is Tina. We did with our presentation -- layout channel profitability and growth.

Yes. So it's probably best to refer back to that as to get an indication of the direction. And so, it's why we've always said, and we continue to believe that the volume that we continue to generate in our digital business can and will be accretive as it has been. On how much of that, so then you go through how much does a package cost below the line to fulfill, that's money that we don't have to spend and that will be, that's flow-through. The magnitude, it's just too soon to tell quite honestly. We've looked at analogs across other industry segments where they've turned on BOPS. And you can see penetration in ranges from 20% of your online business going that way to 50%. It depends on the category. I'm just not good, and it's even hazard to guess right now. We are very early days; we only turned on the marketing for BOPS, which you'll see if you engage on the Old Navy Web site. We only turned it on in the last couple of weeks. I would say all indicators are that this is something that she loves. But in no way, shape or form, have we really found out what the level of the lake is going to settle out at the end of the day. The other thing that's exciting here is the opportunity to build a basket when she comes into the stores. And again, in early days, we are finding that 20% of our customers on average are buying incrementally when they come into the stores. And so, if you think about the quality of that traffic, the opportunity to build the basket, the incremental profitability, it's something I think that has a long-term big potential for us, but it's again it's just very early days.

Great, thanks so much.

We will take our next question from Kimberly Greenberger from Morgan Stanley.

Great, thank you so much. My question is on Gap brand, Art, and I wanted to just ask if you and Neil have any sort of initial diagnosis of what's wrong and what's the likely fix here at Gap brand? And just looking over the last decade, it looks like Gap division has had more years of negative comps and positive comps. So, is there something more endemic there that you think is making that path a little bit more choppy? And then just a clarification, Teri, on the gross margin, I think you said that the 70 basis points of merchandise margin decline was driven by Gap, but then you talked earlier about trading comps for margin dollars with Gap brand. So I guess I'm not really sure how I can reconcile those comments that seem to be slightly contradictory, anything you could help us would be great. Thank you.

And Kimberly, maybe I'll just close that out quickly. So I mean I think it implies what you're probably presuming, which is that the fact that we've worked to optimize margin doesn't mean we have made it positive, right, we continue to have pressure. Without those choices it could have been worse than it is.

And then on the deeper question, I don't think I'm slow and I don't think I'm stupid, and so I've been asking this question very much, because I'm pretty relentlessly objective and I want to love Gap brand, but I also want to be objective around whether there is something more wrong there than execution. And so, actually to that effect, I felt like it was super important to understand what the health of the brand was with this transition with Neil coming in. And we worked with an outside firm, bought apparel there with about 13,000 consumers, where we did a quantitative evaluation of the functional and the emotional equities of the brand. And we found that the emotional equities are actually quite strong that we have some issues on functional equities, where in one case, we might have customer perception of quality issue or fit consistency issue or that kind of thing. That actually was encouraging to me because I believe that functional equities are easier to address than the emotional equities of the brand. And so again, I'm not saying this is easy at the end of the day, but I just want to communicate here that Teri and I, along with the Board quite honestly are relentlessly objective around this business, both what we need to do and what its role in the portfolio is as we look at the performance of the business relative to creating shareholder value. And so there's no dilutions, no emotional attachment. We do believe we have an opportunity to claw back some of the profits that were deserved here, but we're also objective about the business and about the potential of the business.

Thank you.

And we'll take our last question from the line of Oliver Chen from Cowen and Company.

Hi, thank you. Art, regarding Gap brand and the operating discipline, it is out there and I know you do some innovative technology in terms of test read and react to customer trends. How can those principles be applied to Gap? And as you think about a lot of the tools you have with data science and customer lifetime value, what do you see happening with those products in the back-half? Any areas you could highlight? Has that seems like a very powerful and differentiated competitive advantage just to understand existing versus new customer and lifetime value and analysis? Thank you.

Yes. I mean let me take the customer one first, and I'll be sort of little simple about because I can go way deep on this one. But again, I've highlighted our data assets, it's a data asset that we just -- we're really just scratching the surface, we're just starting to explore. Individual leads or data sciences team we're building that team up pretty aggressively. But really for the first time in the history of the company, we do have a 360 longitudinal view of the customer. And we know that customer's psychographics and demographics. We know how they do or don't crush off our brands. We know the -- and are learning the sort of gateway product purchases for our brands that result in continued engagement. And the exciting part of that is more than interesting facts, it's -- and then we're able to target through digital channels pretty surgically look-alike customer segments that may not be engaged with the brand that show the characteristics of our best customers. And that is a very different approach to marketing, and I suspect most people in this industry have followed and certainly that's been our history at the end of the day. It is very aligned with what you would think about new economy company doing with respect to separating marketing out into performance marketing versus brand marketing. And that's very much how we're thinking about it going forward. So it is behind, the continued building of our file and the continued positive traffic that we're looking at. And then, Oliver, I know you had asked the first question, why don't you repeat it again, because I'm not quite sure I understood it, and I want to make sure I'm getting my answer right.

The framework around the operating discipline opportunities at the Gap division and what principles at Old Navy are important going forward in terms of those being kind of the framework for thinking about recovery opportunity for improvement at Gap? And I imagine…

Yes, and I'm…

- aspects of test [indiscernible] are important.

Yes, and we are very much using that, and I think again, Mark and the work of the team at BR have been largely built on the Old Navy framework, and it's why I think we are seeing a nice balance, and why I have a lot of confidence in terms of what they can continue to deliver. First and foremost, we noted at the beginning of the year we had receipt timing issues. And we are on that. Again, we said that's going to get better quarter-over-quarter-over-quarter, as unacceptable and it's not going to continue. That is really just operating discipline, and it had to do with a new tool that we have been introducing. We have largely worked our way through that. Customer respond is super important. I just had my Board of Directors with Old Navy last week, and we showed them some of the test and response and capabilities we have and how much of the assortment is being tested. And there is a clear line of sight between testing and product performance, margin performance, sell-throughs and APS. And we are bringing those tools into back into Gap as quickly as we possibly can. The other good thing I would say is that this is not we hired Neil and then we threw him in and come tell us when you are turning the business around. Neil is tightly integrated with the other three brand Presidents to make sure that we are leveraging the work that's working in the other brands as quickly as we possibly can, and we have transferred some on a short-term basis and some on a long-term basis talent into that business from other parts of the company. It's one of the most effective ways to cross-ref capabilities is to bring in some key players and to see them into the organization. So I can go a lot more, and we don't have time for it right now, but there are clear principles here, and it's brought the business some problems at the moment, because we did not adhere to those, we let the assortment architectures slip, et cetera, but the path forward in terms of what we need to do and how we need to do it I think is very clear.

Thank you. Best regards.

Thank you. And that does conclude our conference. You may now disconnect.