Good afternoon, ladies and gentlemen. My name is Justin, and I will be your conference operator today. At this time, I would like to welcome everyone to The Gap Inc. Third Quarter 2021 Earnings Conference Call. [Operator Instructions]. I would now like to introduce your host, Joe Scheeline, Head of Corporate Finance and Investor Relations.

Good afternoon, everyone. Welcome to Gap Inc.'s third quarter 2021 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 any forward-looking statements as well as the description and reconciliation of any financial measures not consistent with generally accepted accounting principles, please refer to Page 2 of the slides shown on the Investors section of our website, gapinc.com, will supplement today's remarks, as well as today's earnings release, the company's annual report on Form 10-K filed with the Securities and Exchange Commission on March 16, 2021, and any subsequent filings with the Securities and Exchange Commission, all of which are available on gapinc.com. These forward-looking statements are based on information as of today, November 23, 2021, and we assume no obligation to publicly update or revise our forward-looking statements. Joining me on the call today are Chief Executive Officer, Sonia Syngal; and Chief Financial Officer, Katrina O'Connell. With that, I'll turn the call over to Sonia.

Thank you, Joe, and good afternoon, everyone. Thanks for joining us today. As I reflect on the last 18 months, I'm inspired by the incredible transformation our teams have made in such a short time, despite an ongoing pandemic-related disruption to our business and the broader economy. Coming off record sales performance in Q2, we had accelerated momentum heading into the back half before facing disruption to our supply chain, driven by the 2.5 month closure of our top manufacturing country, Vietnam, as well as port congestion, both of which affected our ability to fully meet strong customer demand. While we had planned into the known supply chain constraints as we entered the quarter, including COVID-related closures in Vietnam, the shock to our business persisted longer than anticipated as weeks turned into months. We have been all hands on deck to address these headwinds and the resulting impact on our business, proactively navigating holiday and beyond, ensuring that the customer is at the center of every decision we make. To secure our supply and meet the needs of our customers, we chose air freight over ocean vessels for a significant portion of our assortment, taking on extreme transitory costs. We're disappointed in the short-term impact on earnings. We made the choice to invest in our customer promise and build loyalty that will help sustain growth over the long term. Katrina will go into greater detail on our mitigation efforts later. Overall, we continue to believe the scale of our supply chain is a material advantage. We have deep relationships with our manufacturers across multiple countries of origin optimized for cost, speed and expertise. And we have strong transportation partners, offering speed advantage and industry-leading rates. That said, learnings from this crisis will not go to waste. We're using them as…

Thanks, Sonia, and good afternoon, everyone. As Sonia said, we're deeply proud of the progress we're making to transform Gap Inc. through our Power Plan 2023. We have strong demand for our brands and our fleet optimization through store closures, international partnerships and divestitures is progressing well and adding value. Our operating margin remains on track to hit 10% by 2023, in line with our plan, even as we navigate these near-term disruptions. Our balance sheet fortified with our recent debt restructuring enables us to invest in our business to drive growth while returning cash to shareholders. The core tenets of our Power Plan 2023 strategy are well underway in delivering value. While we're confident with our strategy, widely reported worsening global supply chain issues meaningfully impacted our third quarter performance. We lost approximately $300 million of revenue or 8 percentage points of sales growth on a 2-year basis due to longer transit which led to on-hand inventory. The backlog at U.S. ports to half of the year, resulting in up to 3 continuous weeks of unanticipated delays to fall product deliveries throughout the quarter. In addition, while our production capacity is largely globally diversified, approximately 30% of our product is produced in Vietnam, where factory closures extended to over 2.5 months, significantly longer than initially anticipated. Our average on-hand inventory in Q3 was 11% below fiscal year 2019. So despite strong sell-through trends, we lost volume as a result of limited supply. While our brands all experienced delays in styles and sizes that limited their ability to fully meet strong demand, Old Navy was disproportionate. We believe these supply chain disruption impacts to our sales and margins are transitory, although will persist in Q4 and potentially into early next year. With that, we've taken some near-term actions to proactively…

Sonia, Katrina, I was wondering if you could help us a little bit with understanding the impact of some of these inventory planning and supply chain delays? As you're thinking about the inventory cadence into the fourth quarter and holiday, it sounds like there may be some shipments that may be stuck on boats in the ports right around the time where those customers are really looking for that holiday season. How are you thinking about carryover inventory into January and February? And perhaps the more lapsing impacts of some of these supply chain delays and Vietnam's slow restarts into 1Q of next year?

Hi, Brooke, it's Katrina. So as we said on the call, we have amped up the airfreight for holiday in an effort to really navigate the lengthening port delays as well as the late opening of Vietnam. And there's a range of possible outcomes for how that could play through the holiday season. And so we'll see where that lands with holiday inventory. As it relates to the carryover into January and February, the teams have been really looking at -- for Vietnam, in particular, what units based on the closures do we need to cancel so that we didn't take them at all. What units can get reflowed into a future season. And then what units are we going to potentially pack and hold for next year. We proved this past year in the front half that pack and hold was a good strategy for us. And so if we think that things are going to be too late for the holiday season, we won't put in stores or online and have them generate markdowns and said we'll hold them for next year. So we're using a variety of things to help really navigate the current inventory situation so that we don't end up with a January or February inventory liability issue.

And our next question will come from Lorraine Hutchinson with Bank of America.

When you think about the supply chain cost, how much of these costs do you view as structural? And are there any actions you can take to take price points higher to offset some of the headwinds?

Hi Lorraine, it's Sonia here. So we do think that the Q3 miss and the cost that we're incurring with air is transitory. And that's why we have made that bet. We wanted to maintain the customer promise. Our brands are resonating. We have a 10-year high margin through price realization. And so our bet was to stay on the office and have products here to service in holiday, and that's what's included in our outlook. We do think that even with the lumpiness of the quarter, we are on track to our power plan first year. And as we move into next year, we'll share more at the year-end, but we're confident about navigating that. So I think that through the price gains we've seen across all 4 of our brands, as exemplified by the Q3 margins. We think that, that can continue through a combination of the investments we've made in marketing, the strong product acceptance we're seeing as well as the enabling capabilities such as personalized pricing and inventory management optimization are key levers to continue the charge over the coming years, and price gains across the company. We're really pleased with the level of discounting we've been able to sign, and we expect that, that -- in order to drive health and brands sequentially that, that will continue.

And next will be Matthew Boss with JPMorgan.

Sonia, at Old Navy, if we think about the 12-point sequential deceleration in comps, how much exactly was due to inventory? And what was the time line of exactly what went wrong versus the plan that you had in late August? Have you seen trends improve at Old Navy in November? And then, Katrina, on the 10% operating margin target, what's the split of the 500 basis points from here if we think between gross margin and SG&A?

Thanks, Matt. So as you know, we left the first half of this year with really strong momentum [indiscernible] maybe with 24% sales growth. And when we guided, we had baked in some disruption from Vietnam as we've seen in other countries, about 2- to 3-week closures as well as a 5-day port delay because that is what we have seen, that's what we had forecasted, therefore, go forward. What actualized was, as we know, much more dramatic. We had a 2.5 month shutdown of Vietnam, which is our top sourcing country, and for Old Navy, the slightly higher, particularly for women. And so the compounding effect of that as well as the worsening port is the new news. And so as we thought about the palpable maybe, the momentum, even in Q3, the growth in the Net Promoter Score and the growth and brand awareness through its BODEQUALITY launch, we made the decision to invest in airfreight in a substantial way to compete in holiday. So that's where we are right now. We think that the majority of the -- all the sales loss, in fact, is due to supply chain loss and Old Navy entered the quarter quite lean in inventory because of the strong demand in the first half, leaner than the portfolio. And then you exacerbate that with the out-of-stocks due to the supply constraints out of Vietnam and the port. And so that's really what we're navigating in the short term. We do believe it's transitory. We do believe that maybe is incredibly healthy, and has had, I think, all the indicators, the price realization, the brand health, the Net Promoter Score, the loyalty customers, the age of the customer with new customers joining that are younger, all of that abodes to the right bet to play offense for Old Navy.

And then, Matt, as it relates to the 10% operating margin, we remain confident in that for 2023. When you look at our guidance for this year with a 5% operating margin, that includes about a 270 basis point impact from the transitory airfreight cost that we're incurring this year. And then in addition to that, it includes the close to $500 million of sales impact from supply constraints. And so all of that gives us confidence that this year, when you take out the supply chain impacts, would have been well ahead of our original Power Plan 2023 for this year and more in line with the guidance we provided back in August. So we're confident that we'll get through this. As we talked about before, we are looking forward, we're adding the supply chain delays from the ports to our buying timelines for summer. And then Old Navy is accelerating its move to digitizing product creation for fall, all of which we think will enable us to navigate next year with much less air freight, and we can see line of sight then to recovering the lost sales with better supply. So more to come when we get into next year, but we do see that this year would have been ahead of plan, and we have line of sight to mitigating these costs and sales losses going forward.

And our next question will come from Kimberly Greenberger with Morgan Stanley.

I wanted to ask about the level of SG&A spending that we're seeing. Should we assume that this is the new baseline of spending going forward? And when you realized during the third quarter that Old Navy would be low of inventory, was there any thought to perhaps cut back on marketing during the quarter so as not to disappoint the customer? Because, obviously, with the lack of inventory and driving traffic to the stores through marketing, the potential certainly would have existed.

Yes. So on the SG&A side, Kimberly, as we said, the SG&A deleverage in the quarter was impacted partially by the drop in sales. And then partially by the commitment that we had to really seeing the course on marketing as you call out. And then it was offset by pullbacks in stores expenses, which we did do in the quarter, we really targeted anything that was not customer facing to try to pull back on the SG&A in the face of the sales declines that we were seeing from the supply constraints that emerged in the middle of the quarter. I'll let Sonia talk a little bit about the marketing piece.

Yes. And I'll just add on, look, we pulled back on payroll and other fixed costs that don't add value in the base of lower sales, as you suggest Kimberly. But fundamentally, our strategy is working. And we have a fair amount of rigor around marketing effectiveness and marketing spend that gave us confidence that it was at a level of investment. And as we look at Q3 for Old Navy, in particular, with Net Promoter Score being up despite the fact that we have stock outs would probably know we did, we had some disappointment. And with the fact that the brand awareness is up 3 points for a brand that will maybe size, that's really dramatic and strong based on BODEQUALITY, the BODEQUALITY launch. So we think the marketing investments are right. We're focused on fixed cost elimination that's automating our stores processes, that's removing unproductive sales to store closures and the transition of our unprofitable international markets. So those are areas that we've made a lot of progress on that affect broad SG&A as well as our store operations. That's where that gives a little bit more color on SG&A. We're very, very committed to digitizing our core operations so that our fixed SG&A costs in our 3-year plan continue to be a competitive advantage.

Great. And I just wanted to ask a clarifying question, Katrina. Could you just tell us what the AUR increase was in third quarter?

Yes, no problem. We didn't quantify that. What we did say, though, Kimberly, is that in our merchandise margins, they were only down 10 basis points on the quarter, and that was with 200 basis points of online deleverage as well as 250 basis points of the transitory airfreight costs. So hopefully, that's helpful. But we -- so that would tell you that the AUR was up meaningfully if with that 450 basis points of headwinds, we only lost about 10 basis points emerge margin.

And moving on to Ike Boruchow with Wells Fargo.

So Katrina, I wanted to ask about two questions on margin. Just trying to understand the airfreight dynamic. I mean, is this transitory in the sense that it is, in your mind, onetime? I'm just trying to bridge the 5% margin today versus your 10% target in 2 years. That's 250 basis points, I think, for the full year. If my math is right, that would get you halfway there to 7.5% and then to 10%. I guess, that's my -- I guess my 2 questions. One, is that the right way to think about it? Is it onetime? Or is some of it is going to stick? And then as we build to 10%, is this going to be kind of an even build over the next 24 months? Or is this more back loaded to '23? Just to help us think about that would be great.

Sure. So you're thinking about that right, Ike. This year includes 270 basis points of headwind from what we would say is airfreight cost that is solely attributable to navigating the supply crisis. And so not something that we would see continue. We'll see next year how much of it continues in the front half of the year. But fundamentally, this year would have been that 270 basis points higher without having to navigate these current issues. So you're thinking about that correctly. And then we'll give you more on how it will pace out 2022 versus 2023. But I think what Sonia and I would say is by the end of this year, we're really proud that, I would say 75% of the core restructuring of the company is largely behind us. When you think about closing the North America stores, divesting of our 2 smaller brands, getting our 3 countries in Europe partnered, we do feel like we got the debt restructured in the third quarter. We do feel like we've made really good progress against the restructuring plan. And so the next 2 years really are going to be about driving now the optimization of that healthy core with these digitization efforts that we think will start to add value, as we talked about through inventory management, through lower return rates and through automation of some of our core processes to try and drive cost out. But we'll talk more about pacing when we get to the end of the year, but that's the way to think about that 10% operating margin.

Yes, I'd just add on, I think, fundamentally, going through a quarter like this, we have looked at our strategy and are very resolved in that it is the right strategy. We are putting the customer at the center, our commitment to sales growth driven by these 4 brands that are growing in health with a double-digit operating return is our objective. And we think we're still on plan to meet that. The quarters are lumpier than we would like, certainly, not happy with this quarter. But if you step back and you look at the year, we will still be on track to that plan that we communicated last October. And so there is, I think, that to look to as well as the commitment to the next couple of years.

Our next question comes from Adrienne Yih with Barclays.

Sonia, I'm trying to understand, for the quarter, you had probably one of the biggest deltas versus other retailers on the third quarter in particular. So I'm wondering, is there something that's happening with your lead times? I know that there was an initiative to shorten up and tighten up those lead times? Have they become too short that these types of events can actually have a very near an impact? And then, Katrina, we didn't talk much about any average hourly rate pressure in that SG&A line. Numbers are floating out there $15 to $17, and historically, Gap's been at the forefront of leading that AHR initiative. So how are you thinking about that? And how should we think about that wage inflation annually?

Well, certainly, as a vertically integrated apparel retailer was about 30% of our manufacturing in Vietnam and we were disproportionately impacted, as those who don't manufacture there had a natural advantage. We continue to believe that the scale of our supply chain has always been an advantage right? It shows up in better rates and better unit cost and access to last mile. And so that's advantage. Now that said, we are using this as an opportunity to find ways to further insulate ourselves. And so while we expected the shutdown to be similar to other countries, a couple of weeks, for example, I think the government delay was substantially longer in Vietnam, especially South Vietnam, where we were most exposed and in maybe women's where we were most exposed. So it was outside of our expectations. Going forward, we're focused on multinational vendors as opposed to single point partners as well as the digitizing of the product creation process, which will really let us reduce cycle times and lead times in our product-to-market model. So I think we're using this crisis as an opportunity as we did last year to accelerate some of the key components of our Power Plan 2023 including digitization, including supply chain, transformation and inventory management transformation, which are all opportunities that we see leaning into to move us forward.

And then on the AHR pressure. I mean we are definitely seeing average hourly rate pressure, primarily in our distribution centers, but in our stores as well. And so far, the teams are doing a good job navigating that. And we haven't called it out, but it's not sort of one of the biggest headlines, but it is definitely something that we are navigating within our cost structure as others are.

Yes, and it's contemplated in our outlook. And what I would say is the automation levels we have in our DCs are a great hedge for us. That being said, we are absorbing some of those AHRs and then our stores, we have embedded some headwind into the back half.

Okay. Have you given what your AHR actually is?

No, we haven't.

And we have a question from Dana Telsey with Telsey Advisory Group.

As you think about the supply chain obstacles that happen now and you think about going forward into 2022 and even into 2023, what are the learnings from this that adjust that how you adjust your supply chain going forward? How do you operate differently? Do you think that may help to manage the inventory even better going forward?

I would say, first and foremost, it starts with digitizing the information so that we know exactly where every unit is in our end-to-end supply chain. We had that information, but now we're going to a greater level of detail and more real-time visibility. And that all links to the technology investments we're making in digitizing our end-to-end supply chain. So I'd say that's first and foremost. Second is we've always had a supply chain that has given us cost advantage. And now we'll be putting a greater emphasis on resiliency and flexibility. And so whether that's sourcing more in your store, whether that's multiple countries of origin, we look at a variety of levers to enhance our competitive advantage in our scale supply chain.

And Dana, in particular to 2022, for spring, we have moved a lot of our West Coast port volume to the East Coast, which we believe will help us navigate better. And in summer, we've built in the much longer port delays lead times into our buying cycles. And then as we said, for fall, the Old Navy team fully pulled forward the digitization of their fall line so that they are seeing much better speed and flexibility. So I think sequentially, next year, we feel like we've been incorporating the learnings. And then as Sonia said, digitization has always been that next leg of Power Plan 2023, but we've used this as a way to really accelerate some of that work to make sure that we're getting more advantage faster.

Yes. And as we reflect on the 18 months, I would say, I'd much rather have a supply problem than a demand problem. And on the demand side, we've been, I think, pleased with the response and the customer sentiment. And so really, it's about navigating the short-term transitory use as we lean into the pricing power, the brand helps the customer acquisition into our loyalty program, which has exceeded our expectations.

And our last question will come from Paul Lejuez with Citi.

I'm curious how you go about measuring the miss sales in the quarter? And wondering on a related note, can you maybe talk about by brand traffic versus conversion and how that differed in 3Q versus 2Q?

Yes. The missed sales, Paul, we took a pretty literal approach to really looking at what inventory wasn't here to sell and quantifying what that would have sold for. You could say that there's actually a larger impact than that when you think about the fact that our customers don't often buy just 1 unit. They often buy a basket of units. And so there's what you would consider maybe a halo effect to not having those units. But the way we quantify the sales loss is really that literal don't have the unit, don't get the sale. And then as it relates to brand by brand, maybe Tony can talk about brand by brand. I don't know that we'll break out the components, but we're certainly happy to give you our thoughts on the Q2 trend versus Q3.

Yes. I mean I'd say, really pleased with 3 out of 4 of our brands [indiscernible] with Gap North America showing a nice acceleration at 13% comp in North America and a great quarter for partnerships for Gap, whether it's the Walmart Home, growth or the Yeezy Gap icon item with the hoodies being launched. And then the stores really have continued to build momentum. So I'd say Gap, we feel great about in terms of the momentum. Banana Republic since relaunch, the positioning in successful luxury, we've been pleased with the momentum there with customer response. And Athleta really just had a spectacular quarter with 46% sales growth over 2019. And the partnership that have been a cornerstone and a tailwind for us across the company the Simone Biles and Allyson Felix partnerships, which accelerated the brand awareness for Athleta, which has been a driver of their sales momentum. So I'd say for our brands and to maybe I think while we've had as I said, healthy customer indicators, we simply were just not able to meet the demand to the level that we wanted. And we'll continue to navigate that for the back half and are planning to compete as best as we can in Q4.

But did that show up in lower conversion in 3Q versus 2Q? Or lower UPTs? Any metrics you can share that help quantify the decel from 2Q to 3Q as a result of this lower inventory?

Yes. I know, Paul, we don't actually break out those components. So I think what we've said is the deceleration that we saw from Q3 was totally attributable to the lack of supply. And inventory was down 11%, and Old Navy was down more than that. So hopefully, that's helpful, but we don't, as a practice, break out traffic and conversion.

And that does conclude the question-and-answer session. I'll now turn the conference back over to you for any additional remarks.

Thanks for joining and have a great Thanksgiving.

Thank you. And that does conclude today's conference. We do thank you for your participation. Have an excellent day.