Good afternoon, ladies and gentlemen. My name is Hannah, and I will be your conference operator today. I would like to welcome everyone to The Gap Inc First Quarter 2022 Earnings Conference Call. At this time all participants are in a listen-only mode. [Operator Instructions] I would now like to introduce your host, Cammeron McLaughlin, Head of Investor Relations. Please go ahead.

Good afternoon, everyone. Welcome to Gap Inc's first quarter fiscal 2022 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 that are subject to risks that could cause our actual results to be materially different. 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 the cautionary statements contained in our latest earnings release, the information included on Page 2 of the slides shown on the Investors section of our website, gapinc.com, which supplement today's remarks the risk factors described in the company's annual report on Form 10-K filed with the Securities and Exchange Commission on March 15, 2022, 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, May 26, 2022, 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.

Good afternoon, everyone, and thank you for joining us. Our Q1 results and updated fiscal 2022 outlook primarily reflect industry-wide headwinds as well as challenges at Old Navy that are impacting our near-term performance. While we're disappointed to deliver results below expectations, we are confident in our ability to navigate the headwinds and restabilize the Old Navy business in order to deliver on our long-term strategy. This current period of acute disruption has clarified the urgency of improvements necessary to put us back on track towards delivering growth, margin expansion and value for our shareholders over the long term. We have updated our full year outlook to reflect the following factors that are impacting near-term performance. First, the majority of the sales and earnings reduction from our prior guidance stems from Old Navy, primarily assortment imbalances and lower than anticipated demand in key categories like active, fleece and kids and baby. Secondarily, product acceptance issues and thirdly challenges related to the launch of BODEQUALITY, Old Navy's extended size initiative. We expect the issues at Old Navy, which we estimate are negatively impacting fiscal 2022 diluted EPS and by approximately $0.90 to $1, to largely resolve by the end of the fiscal year as we take necessary actions to right size the assortment and reengage responsive supply chain capabilities and I will address this in more detail shortly. While the primary impact of soft demand in active, fleece, and kids and baby is being felt at Old Navy, our Gap and Athleta brands are not immune to this customer shift. Second, we are keeping a conservative posture as it relates to the impact of inflation on our cost and on our customer. Our revised fiscal 2022 outlook contemplates modest incremental fuel costs and hourly labor headwinds, consistent with many others in…

Thank you. [Operator Instructions] Our first question will come from the line of Matthew Boss with JPMorgan. Please proceed.

Great. Thanks. So Sonia, now that you’ve taken a more direct role within the Old Navy brand, on the confidence that you cited in restabilizing that concept, I guess what areas within the assortment do you see the most opportunity for improvement relative to where we sit today? And how would you characterize the health of your women’s business or customer today?

Matt, thank you for the question. So, as the team and I have dug in, here’s what we can see go forward, first and foremost, as you know, we’ve been grappling with late inventory since the fall of last year, that stabilizes. We should have our inventory on time starting June onward, which will allow us to compete in the right – seasons for the right moment such as back-to-school or the seasonal shift for fall or holidays. So late inventory largely solved by Q2. Sizing imbalances will we be better – we will be better bought to the size curves that our customer wants beginning Q3 onward, and then the category imbalances and assortment mix we have a broader range of assortment mix, including dominance and key bottoms that will be important for where to work and to different use occasions starting – sequentially starting in Q3, but more so in Q4. So, I think the fashion choice is improved with Q4 and more into Q1. The team is expecting, season over season improvement starting with size, size imbalances, and then category and fashion. And then in terms of the health of women’s customer – yes. Great. Thank you.

Thank you, Mr. Boss. The next question is from a line of Ike Boruchow with Wells Fargo. Please proceed.

Hey, thanks. Two quick ones, just on, first on Athleta, just a little bit more color on Athleta maybe versus your plan in the first quarter. And then I think Katrina, you talked about the long-term CAGR being intact, but maybe not in the near term, if you could just add more contexts around what exactly you’re meaning for the year? And then on the air freight, looks like it’s about a $100 million lower than what you guys had talked about three months ago, just trying to understand that. Is that just because the revenue base is lower, so instead of $150 million in 2Q, it’s only $50 million, just trying to understand that too? Thanks.

Okay. Thanks, Ike. Let me start with Athleta. So Athleta is up 60% compared to pre pandemic levels and it just reflects the strength of the brand and the authority it has in athleisure and its growing customer base. As you know, last year it was really strong for active across the sector and all of our brands benefited from that Old Navy, Athleta and Gap. And as we anniversary that, we’re seeing a slowdown in performance active. And we think that’s transitory, look, there’s nothing wrong with the athleisure category. We see it as the biggest in apparel and the highest growth over the long term. There’s just some transitory issues anniversarying last year that we’re feeling in the short term as well as Athleta anniversarying, strong mass sales last year in Q1. So we see a path towards continued growth and in the near term, we’re just taking a little bit more of a conservative stance on the performance active side of things, their active lifestyle product that continues to have a lot of versatility and response. And so whether it’s commute wear or dresses or different occasions that they service, we do think that assortment mix is an advantage. Over the long term, we think there’s tremendous opportunity in Athleta to capitalize on that multiyear tailwind that we spoke about and their market leader. And we expect them to maintain the market share growth that they’ve seen. Katrina O’Connell: And then Ike your question on air freight is a good one. I’m glad you asked it. So we do expect to have still about $350 million of total air freight this year. That’s up against $403 million of air freight last year. The numbers we quoted in this speech were incremental to prior years. So quarterly Q1 incrementally is $170 million, Q2 $50 million. And then if you remember, because we’re up against that significant amount of air freight in the back half. We actually get a benefit of $70 million in Q3 and $245 million in Q4. And that should get you to the $350 million on the year.

Got it. Thank you.

Thank you, Mr. Boruchow. The next question is from the line of Dana Telsey with Telsey Advisory Group. Please proceed.

Hi, good afternoon, everyone. As you think about each of the brands, Sonia, how would you describe the consumer health at each of the brands? What’s – how it’s changed in the first quarter? Then I have a quick follow-up. Thank you.

I mean, Dana, we’ve seen growth in brand awareness across all of our brands and two of our four brands grew with Banana Republic and Athleta in Q1. So we’re seeing high engagement, I’d say depending on the sector certainly in the premium or occasion wear space and where to work, we saw really great engagement leading with Banana Republic. And then in terms of the other brands, look, I think there’s a lot of loyalty with the brands we’ve got 55 million customers that are engaged with us through our loyalty program. And it’s really about navigating some of the short-term product preference shifts, but there’s a lot of love for these brands and we see that from our customers.

And then as you think about the gross margin and inventory levels going into the back half, how do you think about discounting in each of the brands and promotions? Where would you like to see inventory levels as we move through the year? Thank you. Katrina O’Connell: Yes, Dana, this is Katrina. I’ll take that. So from an inventory standpoint, our inventory levels at the end of the quarter were higher than we had hoped. I would say, two – a third to half of that is transit times, which continue to be very long. And so some portion of the inventory that we owned at the end of the quarter is just based on those extended transit times. The balance of the inventory we’re addressing in two ways. First of all, as we think about the lower revenue trend for the balance of the year, we are packing and holding fashion inventory that we think we can sell next year or at a relevant season. And we employed that during the pandemic. So we know we know how to do that, but rather than try and really push that through the system at lower margins. Each of the brands has taken an eye towards packing and holding fashion. And then in addition to that, we’ve been reflowing and cutting our basics inventory. And so sequentially throughout the year, we should see those come back in line. So quarter-over-quarter, you’ll start to see inventory levels. Think they’ve peaked in Q1. They’ll still be high in Q2, but they should get better throughout the year. And then as it relates to margin and discounting, what I would say is the following. So the gross margin guide that we gave at the midpoint shows about a three percentage point decline to prior year. That’s almost equally attributable to the higher commodity costs that we’re seeing in the business, ROD deleverage on the lower sales, and then discount in the business. And the way I think about it is the discount fluctuates depending on sort of which portion of the guide you’re looking at. But I don’t think it needs to get meaningfully better in the back half for us to deliver the margin. The biggest benefit to margin comes in the air freight, which we talked about in the last question, meaningfully reverts in the back half.

Thank you.

Thank you, Ms. Telsey. The next question is from the line of Lorraine Hutchinson with Bank of America. Please proceed.

Thank you. Good afternoon. I was just hoping to get a little bit of context on your view around raising prices. Can you talk to your average unit cost pressure that you’re expecting through the year and then what proportion of Old Navy’s product is in this price lock program and is there an opportunity to raise prices on the remainder of the assortment?

Thanks, Lorraine. That’s a great question. As we’ve guided, we are expecting mid single digit AUC pressure throughout the year due to commodity cost. And we bake that into our forecast. When we think about pricing, there’s opportunity across the entire portfolio and our brands are actioning that. So for example, Banana Republic prices are significantly higher than they’ve been both ticket as well as reduced discount. Athleta has taken the opportunity to increase tickets where it has authority as well, specifically going into the back half of the year. Gap as well has seen great price adoption and I think has seen the incremental AUR in its specialty business, which is, I think bodes well for the back half of the year. And then Old Navy, has the opportunity on both sides. We spoke about the price unlock that is targeted at kids basic product probably represents, yes, about a third of the Kids and Baby business. So maybe 10% and 15% of the total, and that’s really for the back-to-school time period. Conversely where Old Navy has authority, particularly in bottoms, we’re seeing good success in terms of raising tickets in a moderate way, as well as some fashion items such as outerwear. And then lastly, I’d say there’s a lot of opportunity to improve yield through more disciplined inventory management, such as markdown management and having supply and demands that are in line, which we are planning on having in the back half, all of that should enable us to manage the margins to the guidance we’ve provided. And the only other thing I’ll add is, the commodity pressure on the profit of the company is big. When you think about the two big headwinds, we have our – the 350 million of air freight. And then if you do the rough math of low, excuse me, mid single digit commodity pressure. And I define commodities as raw materials as well as freight. It’s about $400 million of pressure on the profit of the company this year. So two big things that have impacted the profit of the company this year. And then in addition to that, we’ve got the consumer slow down and then the execution issues that we have at Old Navy.

Thank you.

Thank you, Ms. Hutchinson. The next question is from the line of Bob Drbul with Guggenheim Securities. Please proceed.

Hi. Good evening. I got two questions for you. I think the first one’s more bigger picture, but can you give us any insight into profitability by brand, how you’re thinking about it for the year and sort of where these businesses might go? And then the second question that I have for you is, when you think about the portfolio of brands that you have, can you just help us understand the strategic rationale that you have with keeping Athleta as part of the blended portfolio at this point? Thanks. Katrina O’Connell: Hi Bob. So I’ll talk a little bit about the profit by brand, and then I think Sonia can take the next part of the question. When we entered the year, we said we were going to have all four growing profitable brands. The revenue part of the algorithm has been a little bit disrupted by the slow down at Old Navy and some of the Asia pressure. And as it relates to the profit picture though, we still believe that all brands will be profitable this year. Maybe with the exception of Gap that is feeling a little bit more of the profit pressure from the Asia market decelerating so significantly. And then I don't know, Sonia, if you want to take the next question.

We're committed to our strategy, Bob, and having these brands as part of the portfolio they all leverage the platform capabilities that we have, our strong tech stack. Our e-com site benefits like our cross-brand credit card. And Athleta has had the investments that it's needed to continue the growth rate that we spoke about, whether it's the launch into Canada, whether it's the site traffic that it benefits from et cetera. So I would say that there's a lot of synergies across our brands that we capitalize on, at the same time we are always looking at maximizing shareholder value and will always monitor and consider strategic options to unlock that value at the right time. In this time of disruption we're very committed to our strategy and believe that Athleta is positioning in the premium space, nicely balances our value side of the business and gives us a balanced portfolio.

Thank you.

Thank you, Mr. Drbul. The next question is from the line of Brooke Roach with Goldman Sachs. Please proceed.

Good afternoon and thank you for taking our question. Sonia, Katrina can you please contextualize the importance of the low income demographic consumers to your business across each of your brands? What are you seeing among each of these customer cohorts exiting 1Q and what consumer outlook is embedded in your updated guidance for the tougher consumer macro in the back half? Thank you.

Yes. Brooke, thank you. Listen, this is a very, very dynamic situation and new news for all of us in Q1, right? With the rising inflation, the impact on the consumer, particularly the low end consumer. And when we think about Old Navy and our Gap outlet business, those segments are the most affected. I'll give you an example. I was in an Old Navy store where the average income was about $100,000 and really very little shift in consumer behavior in terms of buying – buying routines. And also then went into an Old Navy store that had a $50,000 consumer and you could see basket sizes down, you could see frequency down and this is a strain of inflation on that consumer. So we had embedded some conservatism in the outlook as Katrina and I articulated in our prepared remarks. And so we will continue to monitor, monitor very, very closely. Now that being said, our brands do, I think, benefit from a broad range of consumers and whether it's in the premium space with Banana and with Athleta as well as the mid-market with Gap, and Old Navy also has as many customers that earn over $100,000 as they do below 75, so because of their strong Kids and Baby business. But we'll continue to watch it and I think that this is everyone is – I think talking about the fact that there's a fair amount of uncertainty out there, but for us the range in value-to-premium is part of the benefit of the portfolio, and so we will continue to monitor closely.

Great. Thank you. And then just as a follow-up; Katrina, can you help quantify the growth outlook that you're embedding for Old Navy for the year and perhaps the magnitude of growth inflection that you're anticipating in that brand in the second half? Katrina O’Connell: Brooke, we didn't go by brand to quantify sort of what would change. But we did say that we expect our revenue in the back half to be, call it flattish to 2019. The reminder I have is Q1 was significantly impacted by stimulus, so that rolls off. And then I would say that's the biggest change in second quarter. And then our expectation as we said is that the back half gets better and that's really driven by the stocking of product being more on time. And we start lapping last year's missing product and delays. So we have – we have – we think more opportunity in the back half as we really start to go up against the significant supply disruption, and that's really true for all of our brands.

Thanks so much for the context. I'll pass it along.

Thank you, Ms. Roach. The next question is from the line of Kimberly Greenberger with Morgan Stanley. Please proceed.

Great. Thank you so much. I wanted to ask how much flexibility you have to cut back on third and fourth quarter order quantities. I think particularly Old Navy, but given the softness at Gap, let's say at Gap as well. And how much flexibility do you have in inventory composition as you sort of reposition the kinds of categories that the merchants are buying?

I could start Kimberly and then maybe you can respond a little bit more on our responsive levers. I think what I would say is when we began to see this slowdown, the primary lever we used for summer and fall is pack and hold as a way to really take the categories that we're overstocked in. So active and they're good categories and the product's fine, it's just that we have too much for the current trend. Those are really being packed and held until next year. And then the cuts primarily take place starting with our fourth quarter and holiday buys. And I think we feel pretty good that we were able to get those buys much more in line with the demand that we're expecting for fourth quarter in all of our brands. And then I don't know if you want to talk over those... Katrina O’Connell: Yes. And then what I will say after that is starting spring especially we are rebuilding a very important lever for us, which is our responsive supply chain. As we've seen the stabilization in manufacturing and logistics lead-time stabilize as well. We're able to get after reading and reacting to fashion trends with much shorter lead times, as well as chasing inventory. And then lastly, we are building up our capacity in approximate manufacturing that will give us a shorter time to market as well. Again, so all of that we believe will start to ramp up in spring. But we will also engage in vendor managed inventory in the Q3 and Q4 timeframe, which should give us some flexibility as well. But important to note that those capabilities really did cease to be able to be used beginning in third quarter of last year when we saw the supply disruptions. And so much of our category imbalances are a result of our inability to read and react as we would have historically. And so we're really looking forward to being able to start to stand those up again, as Sonya said really hopefully beginning next year.

Okay, great. That's great color. So is the plan to also pack and hold this summer excess inventories, and then also the third quarter excess inventories where you have sort of imbalances that you referenced earlier.

Yes. So I would say we packed and held some spring. It's mostly summer, and then some fall, we were able to impact some fall and then by cutting and then we're packing and holding some fall. And then really by holiday, it was cuts that we were – we were able to implement. So it was – it was all seasons, but I would say summer is probably the peak of the pack and hold.

Okay, great. Thanks for the color.

Thank you, Ms. Greenberger. The next question is from the line of Mark Altschwager with Equity Research Analyst. Please proceed.

Hi, Mark Altschwager from Baird. Thanks for taking my question. Was something you could talk a little bit more about how you're thinking about kind of operating margins in the medium term here? I guess just maybe putting together all the headwinds quantifying what you see sort of transitory this year, whether it be air freight or some of the Old Navy issues specifically. Any incremental actions you're taking at SG&A? I know it's too early to get a 2023 outlook, but I'm just – as we sort of look at what's a reasonable baseline as we look beyond a lot of the cross currents this year and get back toward – on the path towards your longer term margin ambitions? Thank you.

Yes. Mark, I mean, it's certainly heavy on our minds getting back to the profit levels that we aspire to. I would reiterate the two big things that are weighing on the P&L independent of sort of the Old Navy performance, the $350 million of air, which is transitory and we do believe will go away. So that'll be a benefit to operating margin next year. And then we said there's about $400-ish million of commodity pressure. That piece, I don't know, I mean, it's hard to know how long that's going to hang around and whether we believe that fuel will revert and that with lower demand, the supply impact to commodity prices will start to revert. So too early to say on that portion, but those are two big things that I would isolate. And then the balance is really about recovery in Old Navy, which as Sonia said, we're sequentially seeing better improvement throughout the year. And certainly by Spring of 2023, we aspire to have a lot of the execution issues behind us.

That's helpful. Thank you. And then just as a follow-up, can you update us on sort of the profitability in the e-commerce channel, I guess, some of the puts and takes this year as you manage through the tougher domestic freight backdrop and any progress you're making on some of the kind of efficiency initiatives there. Thank you. Katrina O’Connell: Yes. I don't – the e-comm calculus hasn't changed that dramatically from what we've said historically, which is that our e-comm channel is profitable. And when you put a unit through e-comm, it's about as profitable as putting it through a store. The weight on the P&L comes when you actually shift the unit from the store to online. And much of that shift has already been contemplated in the past because we went from 25% online to call it, 39% online. That weight on the P&L is already in there. As the reason being obviously, that the rent and the packaging and the shipping sort of match off unless you're shifting. We've closed a substantial number of stores, which has really helped our ROD line and really helped to offset shipping and packaging. So we feel like we've balanced that fairly well. What was the second part of your question?

Just more related to some of the efficiencies you might be seeing on the supply chain front offset by just the domestic freight backdrop, but I think you covered some of it. Katrina O’Connell: Okay. Well, Sonia is happy to.

Yes. I mean listen, I think that e-commerce, we're focused on getting more efficient and the teams are oriented around shipments, returns improvements, ensuring that we've got high efficiency distribution centers and last-mile logistics. And I think because we've been in the e-commerce business for so long, we're feeling good about some and we've got opportunity to get more efficient in others. So it is a big focus for us, and we see that as opportunities ahead in terms of positive impact in the out years.

Great. Thanks again.

Thank you, Mr. Altschwager. The next question is from the line of Jay Sole with UBS. Please proceed.

Great. Thank you so much. My question is about how you're viewing the back-to-school season. Obviously, lapping stimulus proved to be a challenging compare. But now as we get into back-to-school and you have the child tax credit, maybe a lot of pent-up demands from last year because there wasn't a lot of in-person school in 2020. How do you think the back-to-school season is going to play out? Thank you. Katrina O’Connell: Yes. No, we're excited about back-to-school, Jay. And Old Navy is the number one kids brand in America, and our stock will be on time. Last year, we missed quite a bit of selling due to late back-to-school stock. So we're in a better stock position. We have authority. We have a great value proposition with our price unlock as well as great fashion. And so I think we feel good in Old Navy and Gap to compete. We do think it's going to be a season where so many kids are going back to school in a greater quantity than they had. And I think we're excited to play there across the portfolio.

Okay, thank you so much.

Thank you, Mr. Sole. The next question is from the line of Corey Tarlowe with Jefferies. Please proceed.

Hi, good afternoon and thank you for taking my questions. Firstly, can you talk about the shift that you've witnessed into occasion and work-based categories and the impact that you anticipate that to have on the business as we look ahead? And then secondarily, can you provide us an update on the impact that China lockdowns have had on the business and what you're expecting going forward? Thank you very much. Katrina O’Connell: Yes. Thanks, Corey. I think we've seen it industry-wide, right? The high occasion and work categories are really winning right now and as evidenced by Banana Republic seeing a 27% comparable sales growth in Q1. And so along with their strong showing, they're capitalizing on that shift. And we're seeing it in categories such as work bottoms, khakis, dresses across our portfolio. So I do think there was a very big consumer focus on active athleisure last year. This year, right now, it is about occasion, back to work as the primary drivers of selling. Now it's going to continue to be very dynamic. Back-to-school is going to be a moment. Certainly, summer stock-up and summer vacations are always a moment for key shopping. So we're going to have to stay very close to this. I do think occasion and work categories will stay strong throughout the year, and we're leaning into that across the company in terms of a strong bottoms offering as we head into the back half of the year. And then in terms of China lockdown, it's one of the factors that affected our guidance as Shanghai shut down. And while we're expecting some reopening there, there's some question on Beijing. And Asia for us is sizable for Gap brand. And so it's been one of the drivers for the more conservative outlook. We're hearing about reopening certainly in June but really have to see how the consumer will respond to those reopenings and monitor carefully the impact to demand.

Great. Thank you very much and best of luck.

Thank you, Mr. Tarlowe. The next question is from the line of Janet Kloppenburg with JJK Research Associates. Please proceed.

Hi, Sonia, Hi Katrina. I just wanted to ask a couple of refinement questions. In terms of Athleta, I heard something about Active versus athleisure balance. Do you feel that there is some imbalance in the assortments? And do you think you'll have that balance back in the second half of the year? And on Old Navy, do you feel like those investments in wear to work in the bottoms category, in particular, will be in time for the important wardrobing season in September, October? Just lastly, Katrina, how should we think about marketing for the second half of the year for both Old Navy and Gap? Thank you. Katrina O’Connell: Yes, Janet, let me start with Athleta. So my comment was that Athleta benefits from both performance active product as well as active lifestyle. And active lifestyle is about perfect to wear the PETs, PET performance fabrics, but you can wear it to commute. You can wear it to vacations. You can wear it for different use occasions and pure performance. And it's always enjoyed roughly a 50-50 split there. While we're seeing some, relative to last year, reversion on pure performance active, the active lifestyle product is resonating. And so it's not about an imbalance. It's more about what is in the here and now driving the customer response. As we look to the second half, we certainly expect the versatility in the Athleta assortment to build from performance to active lifestyle to give the choice. And by the way, Active is – it's here to stay. This is really just about the fact that last year was over 100% growth in women's Active as a category. And this year, we're just seeing some slight version there. We do expect it to normalize over time.

Great. Thank you. Katrina O’Connell: And then your question on Old Navy, wear to work and bottom, Old Navy has been very focused on bottoms authority, whether it's range of denim with a versatile end use or expanding its pants category. So we are expecting key pants to introduce in the fall holiday time frame, and we look forward to seeing the response to that.

And then for marketing, Janet, as a way to manage overall SG&A to the lower level of sales, we have pulled marketing dollars out of the business. I would say it's probably logical that we're seeking more marketing in Banana Republic and Athleta, given their disproportionately better performance. And we are definitely being more conservative at Old Navy, and I guess, to a lesser degree, Gap domestically, but certainly more internationally. But overall, marketing as a percent of sales is probably still in that 6.5% - 6%, 6.5% range for the year, but it's very different by brand. And as I said, we've really pulled back the dollars based on the lower sales.

Thanks.

Thank you, Ms. Kloppenburg. That concludes the Q&A session as well as today's call. Thank you for your participation. You may now disconnect your lines.