The Gap, Inc.

Good afternoon, ladies and gentlemen. My name is Christy, and I will be your conference operator today. At this time, I would like to welcome everyone to the GAAP Incorporated Second Quarter 2020 Earnings Call. At this time, all participants are in a listen-only mode. For those analysts who wish to participate in the question and answer session after the presentation, you may now press star one to enter the Q&A queue. As a reminder, please limit your questions to one per participant. If anyone should require assistance during the call, please press the star key followed by the zero on your touchtone phone. Today's call is being recorded, and at this time, I would like to introduce your host, Tina Romani, Head of Investor Relations.

Good afternoon, everyone. Welcome to Gatling's second quarter 2020 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 reconciliation of the non-GAAP financial measures, as noted on page two of the slide supplementing your remarks, please refer to today's earnings press release, as well as our most recent quarterly report on Form 10Q, filed on June 9, 2020, and our subsequent filings of the SEC, all of which are available on GAAPing.com. These forward-looking statements are based on information as of August 27, 2020, 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 Singleton and Chief Financial Officer Katrina O'Connell. As mentioned, we will be using slides to supplement our remarks, which you can view by going to the Investor section on Gapping.com. With that, I'd like to turn it over to Katrina.

Thank you, Tina, and thank you, everyone, for joining us today. The COVID pandemic has been challenging for everyone, including impacting the gapping business, as I'll discuss in a moment. But more importantly, I want to acknowledge the tremendous effect this has had on everyone's lives from a health, economic, and social standpoint. At Gap Inc., we believe strongly in leading with our values, especially in this time of need for so many people. We hope you and your families are well and healthy, particularly as we recognize the continuing challenges we all face. For today's call, I'm going to start with a review of the company's second quarter performance, followed by our thoughts on the remainder of fiscal year 2020. Following that, Sonia will share her perspective and then we'll open it up for Q&A. Before I jump into our second quarter results, I want to share thoughts on the transition from the first quarter to the second quarter. We've been highly focused on executing steps to ensure liquidity for the company, including addressing the challenges of widespread store closures. We also recognize we have an opportunity to drive growth through focused investments and by leveraging our best-in-class capabilities to return the company to improve sales performance and margin improvement. I'm pleased to say we delivered on this in second quarter. So I'd like to touch on a few highlights. First, driven by the performance of our three, soon to be four, iconic billion dollar plus brands, in combination with the many steps taken across the organization in support of cash preservation and liquidity, we had the best second quarter of operating cash flow in at least five years. This has put the company in an excellent financial position. Second, our teams remain focused on driving the fundamentals of the business while also taking aggressive steps to support the company's financial stability in the midst of COVID-19. Our online sales grew 95% compared to Q2 2019, supporting our customers' choice to shop our brands in the channel platform or format where they're most comfortable. And we reopened about 90% of our stores providing safe places for our consumers to shop in person or curbside for the products they love. We also significantly improved our inventory position, following a turbulent first quarter marked by store closures, and we now have inventory levels that more closely align with customer demand. And lastly, while discussions with landlords continue, I'm pleased with the progress we've made towards our goal of a more profitable store fleet. We'll provide an update today, but we also look forward to sharing a broader, longer-term update with you during our virtual investor meeting on October 22nd. Now let me turn to our results in the second quarter. Total company net sales were down 18%, representing a significant improvement versus the preceding quarter. Online sales increased 95%, which modestly benefited from shipment timing. offset by 48% decline in store sales, reflecting store closures that began in Q1, followed by meaningfully improved results as stores reopened over the course of the quarter. It's worth noting the company delivered a positive 13% comp in the quarter, supported by our scaled online business, which represented roughly half of our sales this quarter. In particular, Old Navy and Athleta continue to outperform as customers respond positively to their strong product offerings and relevant marketing messages. Second quarter growth margin was 35.1%, down 380 basis points compared to last year. This reflects 270 basis points of deleverage increase in net sales, largely due to store closures as a result of COVID-19. Merchandise margins reflect an unfavorable impact of higher shipping costs in support of online sales, partially offset by product margin expansion due to lower discounting in response to strong demand for our products across nearly all of our brands. As we noted last quarter, we service a meaningful portion of our online orders through stores, which is a more expensive fulfillment option to support customer demand. As we look ahead, we've now better aligned our inventory to the elevated demand in our online channel. With that shift of inventory by channel, we expect shipping expense, while still higher than last year with continued growth in the channel, to moderate somewhat in the second half of the year. Before I touch on FT&A expense and the rest of second quarter results, let me update you on our focus to improve the profitability of our store fleet. As you know, we're committed to the rationalization of our Gap and Banana Republic store fleets as we look to improve the profitability of those brands. While landlord negotiations are ongoing, we currently expect to close over 225 Gap and Banana Republic During our virtual investor meeting in October, we'll be able to provide you with a further update. But all said, I feel very good about our progress here. Second, while we paused rent payments on store locations that were required to be closed due to the COVID pandemic, something we shared with you last quarter, we continue to reflect full rent expense on all stores in our financial statements as required by accounting practice. We continue to negotiate with our landlords to improve economics for all parties. To date, we've negotiated agreements on a number of our leases, and more agreements are anticipated over the next several months. Turning to SG&A, SG&A in the quarter declined by roughly $200 million, driven primarily by reduced store payroll and other store expenses related to closures. This included investing in in-store safety measures, something we led the industry in as we welcomed our customers back to our stores. sales from COVID-related store closures. So from an EBIT standpoint, with our improved sales performance versus the first quarter and tight expense controls, the company delivered second quarter operating income of $73 million for 2% of sales. first quarter earnings call, the company redeemed the $1.25 billion in unsecured notes due to mature in 2021 as part of a refinancing, reflecting the issuance of $2.25 billion of senior secured notes. In retiring the 2021 notes, the company incurred a $58 million make-hold premium. This charge is non-recurring and classified as a loss on extinguishment of debt on the income statement. Aside from the non-recurring charge, second quarter net interest expense was $56 million, reflecting increased interest expense as a result of our new financing. We expect net interest of approximately $55 million per quarter on a go-forward basis. The effective tax rate for the quarter was negative 51%, which reflects changes in the estimated benefit associated with the enactment of the CARES Act due to the company's strong performance in the second quarter from the geographical mix of pre-tax earnings. Our year-to-date effective tax rate was 23.5%, which represents a more normalized rate, given the impact of earnings variability and the CARES Act benefit on the second quarter. Earnings per share was a loss of 17 cents, a significant improvement from the first quarter. Turning to the balance sheet, on a reported basis, we ended the quarter with inventory down about 4%. Recall, as part of a disciplined approach to managing inventory in the face of uncertain demands, we implemented a pack-and-hold inventory approach whereby select summer product is being held and will be released during next year's selling season. As a result, pack-and-hold inventory will remain in our reported inventory numbers until the same time next year. End of quarter inventory excluding pack-and-hold was down about 10%. Looking ahead, we continue to expect inventory excluding pack and hold to be down mid-single digits for the remainder of the year. Let me turn to cash flow. As we discussed last quarter, fundamentally, Gap Inc. is a strong cash flow generator with over 10-plus consecutive years of at least $1 billion of operating cash flow. Our second quarter operating cash flow is a testament to the cash-generating power of our business. While we took important steps to preserve liquidity, as outlined last quarter, the strong cash generation we saw in the second quarter was largely a result of improved sales performance. Overall, with new financing plus strong operating results, we ended the quarter with a cash balance of $2.2 billion. Year-to-date capital expenditures were $208 million. For the full year, we continue to expect capital expenditures of approximately $300 million, with the majority of spend oriented towards technology and supply chain investments that support changing customer shopping habits and are aligned with our strategic intent to create a seamless journey for our customer across any touchpoint that she engages with, whether in our stores, on our sites, using our app, or through social media. And lastly, before I turn it over to Sonia, let me give you some thoughts on the remainder of the year. Given the high level of uncertainty in the current environment, we're not providing a fiscal year net sales or earnings outlook at this time. However, to be helpful, let me provide some thoughts on the back half. First, we expect net sales to continue to improve versus the second quarter, reflecting meaningful online sales growth coupled with continued recovery following the reopening of our stores. of unprofitable stores, as well as the potential for continued weakness of Banana Republic. Second, as it relates to expenses, it's important to note that we will continue to face higher operating costs as we serve our customers during the pandemic. In particular, we're now applying our best-in-class store safety measures to our largely reopened fleet, resulting in meaningfully higher store expenses than the first half. In addition, we continue to expect higher shipping expenses as online growth is expected to outpace last year. And lastly, we are strategically investing in marketing behind our brands as we focus on gaining share in this disrupted environment and at a time when trusted brands matter. As we look to the back half and beyond, we remain committed to amplifying our distinct advantages and scale to capture demand and gain shares. including leveraging our scaled and advantaged Omni capabilities across our stores and e-commerce, harnessing the power of our brands and enviable customer file to drive loyalty, engagement, and frequency, leading to our values at a time when trust matters, and continuing execution of our initiatives to drive profitable growth through streamlining our operating model and fleet optimization. We look forward to discussing more with you at our investor meeting in October. Thank you, Katrina. Good enough for a better partner, and good afternoon, everyone. I'm glad to speak with all of you today in a very different position than last quarter. We began Q2 with all North America stores closed to customers, and we ended the quarter growing sales and improving profitability. As we pivot to offense, I'm encouraged by three things. First, fundamentally, our business is healthy, and I'm proud of what the team delivered in Q2. I'll share more on this shortly. Second, despite uncertainty ahead, I'm confident that our unique strengths, our powerful brands, our size and scale, our relevant product, and our Omni capabilities are helping us win now and will position us well for the back half and will support this company in any environment going forward. This is important as it will allow us to take share as the apparel market reshapes itself. And third, the long-term potential for gapping in our brands is significant. We've been highly focused on crystallizing our strategy and plans for value creation, which we will look forward to sharing with you in October. Let me touch on each of these. We feel great about our performance in Q2 and our customers' loyalty to our powerful, purpose-driven brand. I'm really proud of our teams for rising to the challenge by relentlessly driving for growth, making opportunistic moves in crisis, and tightly managing cash flow to build financial resilience. This showed up in our top line with online sales nearly doubling versus last year, driven in part by year-over-year growth in our active and fleeced businesses, which in Q2 make up about 24% of total sales. We won in the value space at Old Navy, and we won in the premium space of Athleta in this very important category. At the same time, we strategically walked away from unprofitable sales by choosing not to reopen select Gap and Banana Public Stores as part of our ongoing fleet restructure. I am impressed with how quickly the teams moved across every aspect of our business. We launched new digital capabilities and shipping scale, safely reopened nearly the entire fleet of North America stores, and we pivoted to relevant marketing led by our values and chasing into products our customers want now. So we enter the back half in great shape, and understanding it will be unpredictable, filled with opportunities to grow sales, improve margin, and invest in the business. With the back half comes back to school, which looks different for many families this school year. What hasn't changed is the family ritual of shopping for supplies and cool clothes to allow kids to feel their best, whether they're learning at home or socially distanced in a classroom. Since our brands distort to casual, active, and relevant, we have the assortment that is needed in any learning scenario. We expect back-to-school season to extend over a longer period, and we're ready to deliver for our customers online or safely in stores whenever they're ready to shop. In a rapidly changing environment, we are playing to our strengths, focusing on the key advantages where we can differentiate and compete to win now and in the future. I'd like to talk for a minute now about our purpose-driven lifestyle brand, the backbone of how we meet customers' needs and ultimately create value for investors. And the connection that our customers have to our brand is strong and something we plan to amplify. First, Old Navy, representing more than 50% of sales, Old Navy is democratizing style, offering customers trend-right fashion in the value space and growing market share in core categories like active in fleets, lounge, and kids and baby. As customers return to stores, traffic in the brand's off-mall strip real estate locations, which make up approximately 75% of the fleet, ramps more quickly than other formats and continues to be an advantage. They dominated in online, and customers responded strongly to the marketing strategy to pivot to focus on brand values through the We Are We TV spot, and greater investment in digital channels to drive traffic. Next, Gap. Gap maintains strong emotional connection to its customers with its legacy of bridging gaps between individuals, generations, and cultures. As our second largest brand, there is demand for this brand, and we are committed to growing relevance and further reach through partnerships, licensing, and a greater focus on online. Gap Brand is maximizing online demand through fresh, energetic marketing and a decrease in discounting, and the customer is responding. Athleta, our fastest-growing brand, is clearly established as a lifestyle brand in a growing athleisure market and is extending its reach to women and girls through female empowerment, new experiences, and storytelling that meet customers where they are. Through a focus on digital marketing investments, the team unlocks significant momentum in new customer acquisition during the quarter. Banana Republic has the potential to take share in a rapidly evolving marketplace by delivering accessible luxury. While disadvantaged in the short term due to the shift toward casual fashion as people are working from home, the team is adjusting assortments quickly and pivoting storytelling with elevated product photography to drive online improvements. Longer term, we believe Banana Republic has a place to redefine workwear or work leisure in a post-COVID work environment. Together, our brands are well positioned across age, gender, occasion, and life stage, and each brand must deliver products and services that contribute meaningfully to our customers' lives through the strength-to-customer relationship. This is the cornerstone of how we will extend and monetize our brands. Another way we differentiate is through direct customer relationships. We have 60 million known active customers and a total customer file of 170 million, which we use to connect with our customers every day to increase our ability to tailor experiences, content, and product to a personalized journey. We're excited to expand our loyalty program in September, a capability that we will enhance and build over time, and one that is key to deepening our customer relationship and inviting more loyalists to fall in love with our brand. We're also expanding our reach to address market share opportunities, like Old Navy's recent tween launch with PopSugar, and the extension of Gap Teen with a new collection for boys in Q2. And we're excited about Gap Red's upcoming Yeezy assortment, which is another example of leveraging our brand power to reach new customer segments. Next, our expansive online business and Omni capabilities. Our unique scale across all digital platforms and in our stores gives us advantage to deliver seamless experiences to our customers no matter where they choose to engage and shop. And we will bolster this with the addition of two payment options, PayPal and Afterpay, which we will launch this fall. We're positioning our brands to be digitally led, and we're seeing that play out in our results, even as stores reopened. In fact, during the quarter, we're proud to say that we added 3.5 million new online customers. And in the midst of strong online growth, our stores matter, serving as an extension of our e-commerce experience and key to building customer relationships and community. At the end of Q2, we had activated curbside pickup and buy online pickup in store across 1,500 plus Old Navy, Athleta, Banana Republic stores, and as of this week, Gap Brand is now live with this capability. We know the value of our multichannel customers. Of our 1.8 million multichannel customers in Q2, 30% of them had only shopped with us in one channel prior to this. We can grow in each of these channels by differentiating our experience at the intersection of both, and we are focused on growing our customer and online talent in order to do this. Crucial for our success is relevant product. With an average customer review of 4.5 out of 5 stars, our style, quality, and fit are resonating with customers, which allow us to have greater pricing authority, resulting in less discounting. The casualization of American style, particularly in light of COVID-19, has played to our strengths, fueling our active and fleece and kids and baby business, which represent nearly $3 billion and nearly $4 billion last year, respectively. Going forward, we see room to grow share in these categories, even after the pandemic. And we can't talk about product without talking about masks and our commitment to encouraging health and safety. We sold about $130 million in masks in Q2 through compelling consumer marketing and digital storytelling that has us ranked as the number one Google search result for face mask style guides, as well as an aggressive B2B business launch. The work the team has done to stand up this business, creating brand-right designs that our customers love, continually improving them, and scaling the business is the ultimate example of how we want to operate as a culture, chasing big, audacious ideas with speed and clarity, all with the customer at the heart of our decisions. Which brings me to our lean operations. Our advantage across supply chain, sourcing, fulfillment, real estate, and technology enable us to unlock economies of scale unlike others. It is this scale that allows us to reopen nearly our entire fleet of North American stores with a safe retailing playbook, which is helping define the gold standard in our industry. We can get leaner, and as Katrina mentioned, we are making progress in optimizing our cost structure, particularly as it relates to our store fleet. And lastly, leading with our values. The past few months have highlighted the importance of companies with authentic values as consumers have become more in tune with how their personal values align with brands that they love. We've always tried to be a company where everyone is welcome, leading on issues like gender representation and pay equality, and our brands are positioned to stand out in front on these issues. We are fostering a culture where every employee has a strong appetite to win and to learn. And I see the team raising the bar here. I couldn't be happier with what I'm seeing. It is this that will allow us to build a larger platform, a larger business from which we can proudly share our values. So as we look to refashion Gap Inc. for the future, leveraging the power of our brands and leaning on these key differentiators, that's what's going to fuel our success. Since taking the seat in March, the management team and I have been crystallizing our long-term strategic view of the company, and we look forward to sharing our plans for value creation for Gap Inc. going forward at our virtual investor meeting on October 22nd. So with that, I think we will open it up for Q&A.