The Gap, Inc. (NYSE:GPS) Q3 2023 Earnings Call Transcript

The Gap, Inc. (NYSE:GPS) Q3 2023 Earnings Call Transcript November 16, 2023

The Gap, Inc. beats earnings expectations. Reported EPS is $0.59, expectations were $0.2.

Operator: Good afternoon, ladies and gentlemen. My name is Brianna, and I will be your conference operator today. I would like to welcome everyone to The Gap, Inc. Third Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] I would now like to introduce your host, Emily Gacka, Director of Investor Relations.

Emily Gacka: Good afternoon, everyone. Welcome to Gap Inc.’s third quarter fiscal 2023 earnings conference call. Before we begin, I’d like to remind you that the information made available on this 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 press release. The risk factors described in the Company’s annual report on Form 10-K filed with the Securities and Exchange Commission on March 14, 2023 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 16, 2023, and we assume no obligation to publicly update or revise our forward-looking statements. Joining me on the call today are Chief Executive Officer, Richard Dickson; and Chief Financial Officer, Katrina O’Connell. With that, I’ll turn the call over to Richard.

Richard Dickson: Thank you for joining our third quarter earnings call. In the nearly three months since I joined Gap Inc. as CEO, I’ve hit the ground running, immersing myself in the business, assessing brands and functions, and meeting people in every corner of the Company. I’ve met many of our customers and employees, visiting stores across the country. I’ve also met with many of you, our shareholders, to hear your views and understand your perspectives, and all of this has been incredibly insightful. Today, I’ll share my initial observations and priorities. Then, I’ll hand it off to Katrina, who will walk you through more detailed financial results, before we take questions. The four areas I’ll discuss today are: one, maintaining and delivering operational and financial rigor; two, the reinvigoration of our brands; three, the strength and continued evolution of our operating platform; and four, reviving our culture.

Let’s start with maintaining operational and financial rigor. As you know, this has been a core priority, and we’ve made significant progress which has strengthened our financial footing. Examples of this work include, actioning over $550 million in expected annualized cost savings, realizing margin expansion through lower air costs, improved discounting and more effective sourcing strategies combined with recovery of commodity costs, and we’ve reduced our inventory by nearly $800 million versus last year’s peak. Our efforts to date have resulted in better working capital and a stronger balance sheet, and this discipline of controlling the controllables will continue to be a priority for us as we aim to increase the consistency of our performance both near- and long-term.

Our focus on operational and financial rigor benefited our third quarter results, particularly in terms of improved margins, expenses, and cash flow, and I’ll briefly review highlights for the quarter. Revenue was down 7% versus last year with comp sales down 2%, ahead of expectations. We grew market share both overall and at Old Navy and Gap brand. We expanded adjusted gross margin by 260 basis points, driven in part by improved promotional activity, enabled by leaner inventory and better assortments. We maintained well-controlled expenses, resulting in an improved adjusted operating margin at 6.8% and we ended the quarter with a strong cash balance of $1.4 billion, generating free cash flow of over $500 million year-to-date. Old Navy delivered a positive 1% comp for the quarter with momentum in women’s, driven in part by our active business combined with strength in kids and baby during the back to school season.

Gap brand saw strength in women’s and baby. Comp sales for Gap were down 1% in the quarter, despite anniversarying the final quarter of Yeezy sales last year. Banana Republic comps were down 8% for the quarter as the brand undergoes deliberate and ongoing repositioning. Athleta’s performance in the quarter was disappointing with comps down 19% as we lap a period of heavy discounting last year. I will provide a more detailed update on our brands in a few minutes. Looking out to the full year, as we enter the fourth quarter, we have a balanced view of the holiday season. Inventories are well controlled and our financial position is strong. However, we remain mindful of the uncertain consumer environment. We know that great brands can win regardless of the environment, and execution is everything.

I’m working with our teams to react and respond in real time to consumer and competitive dynamics, ensuring our brands break through this season with relevant campaigns and touch points that matter. With the progress we achieved in the third quarter and our measured expectations for the holiday season, we are comfortable reaffirming our full year revenue outlook and expect strong progress in our margin recovery. Katrina will provide more detail on the outlook in a moment. Let’s turn to brand reinvigoration. Brand reinvigoration is about driving both, relevance and revenue. Now, it’s early days and our playbook is still in development, but I will give you some insight into how we’re thinking and where we are headed brand-by-brand. Old Navy, Gap, Banana Republic, and Athleta are all brands with incredible heritage.

Brand reinvigoration will build on that heritage and will include a number of priorities. We need to strengthen our portfolio of brands with crisp, identities and purpose. We need to create trend right product assortments with a clear point of view to deliver beyond just needs to also deliver on wants. We must consistently deliver merchandising presentations and product storytelling that excites our customers. We have to create a better, more engaging omnichannel experience with a clear and compelling pricing strategy. We have to communicate through innovative marketing to regain a powerful ongoing voice in the cultural conversation, and we need to do this, while consistently executing with excellence at every touch point and interaction. I’ve seen areas where our brands do this well, but I’ve also seen opportunities where they can do significantly better.

It’s not enough to get it right in one or two of these areas. Effective brand reinvigoration is about getting it right holistically and consistently. Execution will differ brand-by-brand, but that’s a good overview of how we’re thinking. And with that backdrop, let’s take a look at where our brands are today, some of the meaningful progress we are making, and also the work ahead. Beginning with Old Navy, the number two apparel brand in the U.S. and the largest brand in our portfolio. Old Navy is a family destination with 94% U.S. brand awareness according to YouGov, a multi-billion dollars e-commerce business and an impressive retail footprint that includes more than 1,200 locations with 240 million customers entering our stores in the last year.

We have a loyal following and a great brand heritage rooted in fun, fashion and value for the whole family. Old Navy has a strong and distinctive brand positioning in the value space. However, the execution of that positioning is a significant opportunity. We need to be more deliberate and consistent about how we express the brand through bold and breakthrough narratives, something the brand is known for. We also have to improve our product assortments, balancing essentials with exciting new trends, and a pricing strategy that clearly communicates jaw-dropping value. All of this to remind customers, why they love Old Navy and give them compelling reasons to love us even more. As we begin to execute the work around these initiatives, we were encouraged to see signs of progress in the third quarter.

We created stronger product storytelling through a dedicated women’s marketing campaign, featuring on-trend product. We also improved site execution and online marketing with compelling creative and value messaging, all of which drove positive momentum and share gains in the quarter. Looking ahead to holiday, we believe the brand is ready to compete with high-quality inventory composition offering consumers great fashion at a great value. Our efforts at Old Navy come down to unlocking and reasserting a great brand. Moving on to Gap. Gap brand, as you know, has tremendous heritage as a pop culture brand that delivers, leads trends, celebrates individuality, and self expression. The brand enjoys 90% brand awareness among U.S. consumers, but lately, Gap has been far too quiet in the cultural conversation.

We need to reignite that dialogue, offering confident, trend right assortments, priced right, and expressed through big ideas and culturally relevant messaging. Our holiday campaign, which debuted October 23rd, is an early example of this. It demonstrates creative consistency, building on brand heritage, and championing originality with relevant individuals of style and substance, and I encourage you to check it out. A more inspiring and integrated creative narrative is also showing up online. And while we have much more work to do, it’s great to see progress taking place as we work to reignite this iconic brand. Now turning to Banana Republic. I’m encouraged by the team’s vision, aesthetic direction, and enhanced focus on fabrication and quality, and our cashmere and leather product offering is translating well.

While this repositioning is the right direction for the brand, there is work to do on execution. Comps are down as we continue to refine our assortment architecture, work on the brand’s price value equation, and improved marketing and merchandising effectiveness. We think Banana Republic has an opportunity to thrive in the quiet luxury space, and represents a unique position in our portfolio. This evolution will take time to manifest as we transition away from what was previously a highly promotional and transactional experience. Now, taking a look at Athleta, a brand with significant growth potential and the number five brand in the highly attractive U.S. women’s active segment. More so than any of our other brands, Athleta has a clear and distinctive brand positioning rooted in the power of she, an authentic and highly differentiated platform that plays extremely well across performance, outdoor, and travel.

As you know, the brand has gotten off track with challenged performance caused by a misfire on product, marketing that didn’t resonate, and retail execution that didn’t connect with customers. In the first half of this year, the team took action, marking down products and cleaning up the brand to pave the way for long-term success. We utilized the third quarter to reset the baseline of the brand by eliminating off-brand fashion products and focusing on our key categories. At the same time, we began to refresh store presentations and the brand’s website to better delineate our active segment with narrative-based merchandising that pulls Athleta’s focus back to its performance roots and winning platform. We are seeing early indications that customers are responding with positive NPS scores and positive sales growth in certain key products that we marketed in the new brand voice.

Despite the favorable reaction to our cleaned up brand aesthetic, lapping last year’s heavy discounting is weighing on performance. We see this headwind continuing at least through the fourth quarter. That said, I’m encouraged by the brand execution of new digital dialogue, store experience, and holiday product assortment. While we are progressing each quarter, we know that a full brand reset will require a more comprehensive approach and will take more time. Moving on to the third discussion area, we are continuing to strengthen our operating platform. We will build on and leverage operational capabilities to increase efficiency and support high-performing brands. In some areas, we are in good shape, but we have more work to do. Our supply chain is a pillar of strength at Gap Inc., where our scale gives us unique cost leverage, but we need to accelerate innovation.

Our financial strategy is driving early value, but we need to continue our focus on rigor and efficiency. In technology, we’ve made strategic investments and now it’s about optimizing those investments and driving adoption across the organization. In addition to these existing capabilities, media and marketing is another area where we can up our game, leveraging the scale of our media spend to derive greater efficiency and effectiveness overall. And let me be clear, it’s not about spending more, it’s about getting more value from what we spend. The fourth area I’d like to address today is culture. Culture is the bedrock of every successful company, particularly one that is creatively driven. And that’s why I’m laser focused on reviving a culture of creativity at Gap Inc.

One that embraces change is obsessed with our customer, relentlessly curious, highly collaborative and eager to imagine better led by the industry’s best talent. More than an objective, culture is an everyday pursuit, fueled by shared values and a belief system that unites us as one company. The intention is there, I see it, but we’ve got to better articulate it and then own it, building on our story past to create an even more vibrant future. In summary, it’s impossible to ignore the impressive scale of Gap Inc. We have four billion-dollar brands with nearly 2,600 company operated stores and 1.4 billion visits to our websites every year. And we have 58 million known active customers who rely on us for fashion that both functions and makes them feel good.

We also have an impressive team around the world and I want to take a moment to thank everyone for welcoming me and recognize the team’s commitment to delivering a solid third quarter performance. Among the insights I’ve gained in the last three months is a recognition that Gap Inc. has weathered a lot of disruption over the last several years, both external macro factors as well as execution missteps, and strategically well-intended initiatives have impacted the company. All that said, the opportunity is clear, and I have conviction that we can reinvigorate our portfolio of brands, while we lead a creative culture that attracts, retains, and develops the best talent in the industry. I’m encouraged by the early progress we’ve made to date, but we have a long way to go and a lot of work to do, and I’m looking forward to sharing updates with you on our progress in the quarters ahead.

Thank you. And now, I’ll pass it to Katrina. Katrina?

Katrina O’Connell: Thank you, Richard. We’re pleased to report third quarter results ahead of our prior expectations, gaining market share despite overall declines in the apparel market. We remain focused on the discipline we’ve created around margin recovery, expense actions, inventory management, and maintaining a strong balance sheet. As Richard noted, our operational and financial rigor will be foundational as we turn our attention to the reinvigoration and relevance of our storied and important brands. Let me start with some highlights of our third quarter financial performance before going into more detail. Net sales down 7% and comparable sales of minus 2% drove market share gains in a challenged apparel market and exceeded our prior expectations with recovery at Old Navy and consistent execution at Gap brand.

Old Navy drove a positive 1% comp with strength in women’s and kids and baby during back to school, meaningful improvement from the first half, resulting in market share gains. Gap brand showed underlying strength in performance with women’s resonating as the brand lapped the last quarter of the Yeezy product sales last year, with only a negative 1% comp for the quarter. We drove 260 basis points of adjusted gross margin expansion, resulting from assortments that resonated with customers, which combined with well-managed inventories, led to improved promotional activity. Margins also benefited from the beginnings of lower commodity costs. We delivered on our SG&A expectations of $1.3 billion despite sales above our prior guidance, all of which resulted in the Q3 adjusted operating margin of 6.8%, a 290 basis-point improvement versus last year.

Inventories were down 22% year-over-year and remain well-controlled, driving better profitability and working capital. We ended with $1.4 billion of cash on the balance sheet, up 99% to last year, and we are pleased to have repaid our asset-based line of credit as we previewed. Year-to-date free cash flow is $544 million and we are maintaining our competitive dividend, an important part of returning cash to shareholders. Let me now turn to our third quarter results. Net sales of $3.8 billion decreased 7% versus last year, with comparable sales down 2%. As a reminder, the sale of Gap China last year had about a $70 million or 2-point negative impact to Gap Inc. total net sales growth. Let me now provide sales results by brand. Starting with Old Navy.

Net sales in the third quarter were $2.13 billion, down 1% to last year. Comparable brand sales were up 1%. For the third quarter in a row, Old Navy gained market share, an encouraging early proof point that work to improve both product assortment and brand messaging are driving results on the path to unlocking Old Navy’s potential. Turning to Gap brand. Gap brand total sales of $887 million were down 15% versus last year. Excluding the estimated negative impact to sales of 7 points related to the sale of Gap China and 2 points due to the shutdown of Yeezy Gap, net sales were down 6% versus last year. Comparable sales were down 1%, and we believe signs of progress in building momentum at Gap are beginning to emerge. Banana Republic third quarter sales of $460 million declined 11% versus last year.

Comparable sales were down 8%. As Richard noted in his prepared remarks, Banana Republic has made progress in elevating the brand aesthetic and product offering. However, evolution takes time, and we know that there is work to be done to evaluate how to best engage and retain the premium customer. Athleta sales of $279 million declined 18% from the prior year. Comparable sales were down 19%, as we lapped elevated discount levels, while we work to reset the brand for the long term. We will continue to lap elevated discounting that took place last year for at least the fourth quarter. Now, turning to gross margin in the quarter. Gross margin was 41.3%, an increase of 390 basis points versus last year’s reported gross margin. Compared to last year’s adjusted rate, gross margin expanded 260 basis points.

Merchandise margin expanded approximately 340 basis points versus last year’s adjusted rate in the quarter, driven by approximately 180 basis points of leverage from improved commodity costs and lower air utilization, with the remaining 160 basis points of leverage, primarily driven by improved promotional activity, enabled by our better inventory position and stronger assortments. This was better than our expectations, particularly as Old Navy and Gap outperformed in the quarter. Rent, occupancy and depreciation declined on a nominal dollar basis versus last year. As a percentage of sales, ROD deleveraged 80 basis points, better than previously expected, given the stronger sales. Now let me turn to SG&A. Reported SG&A of $1.3 billion includes approximately $5 million in restructuring charges.

On an adjusted basis, SG&A declined 7% compared to last year, as a result of our organizational changes and other cost actions. As a percent of sales, adjusted SG&A of 34.5% improved 30 basis points versus last year’s adjusted rate. Reported operating income was $250 million. Adjusted operating income, which excludes restructuring charges, was $255 million in the quarter, up $99 million versus last year. Adjusted operating margin improved 290 basis points from last year to 6.8% in the quarter, driven primarily by the improvement in adjusted gross margin. Third quarter net interest was flat, as interest expense was offset by higher earned interest on cash deposits, which we expect to continue in the fourth quarter. Our third quarter tax rate of 13% included a benefit from the impact of foreign operations.

Reported EPS was $0.58. Adjusted EPS, which excludes restructuring charges, was $0.59. Share count ended at 371 million. Turning to balance sheet and cash flow, starting with inventory. Ending inventories declined 22% in the third quarter versus last year. We will maintain this inventory discipline, utilizing our responsive levers to chase trends and continue to expect that we will end the year with inventories down roughly 15% from the prior year. Quarter-end cash and equivalents were $1.4 billion, an increase of 99% from the prior year. Year-to-date net cash from operating activities was $832 million, driven primarily by lower inventory levels. Capital expenditures were $288 million. We are pleased to have generated free cash flow of $544 million year-to-date.

We remain committed to delivering an attractive quarterly dividend as a core component of total shareholder returns. During the quarter, we paid a dividend of $0.15 per share. On November 7, 2023, our Board approved maintaining that $0.15 dividend for the fourth quarter of fiscal 2023. And finally, we’re pleased to have paid down the remaining $150 million balance and are now undrawn on our asset based line of credit. Now, turning to our outlook for the remainder of fiscal 2023. Starting with sales, the following factors are considered in our outlook: one, we are mindful of the mixed economic data and uncertain consumer trends in the marketplace, and as a result, we continue to take a prudent approach to planning the business. Two, while we are encouraged by the improvement in performance at Old Navy and Gap, we now anticipate a longer recovery time line for Athleta and Banana Republic.

At Athleta, we’re lapping elevated discounting and believe net sales for the brand could be down in the low double-digit range for the fourth quarter. And three, as a reminder, we expect the 53rd week to be worth approximately $150 million in sales. These factors, along with November month-to-date sales trends which have modestly improved versus Q3 results, have been contemplated in our outlook, and we are estimating fourth quarter total company net sales growth inclusive of the 14th week to be flat to slightly negative. We remain confident in and are maintaining our prior sales outlook for fiscal 2023 of down mid single digits compared to last year’s net sales of $15.6 billion. Turning to gross margin. We expect gross margin expansion for the fourth quarter compared to the 33.6% gross margin in fiscal 2022, driven by merchandise margin expansion of approximately 280 basis points due to improved commodity costs and lower air utilization, with ROD deleverage of approximately 40 basis points.

We expect promotional levels to be roughly in line with last year as we take a measured view given the uncertain consumer environment. For fiscal 2023, we expect gross margin expansion to exceed our prior expectations. And compared to the 35% adjusted gross margin in fiscal 2022 to be driven by an estimated 200 basis points of leverage as we lap last year’s elevated airfreight, approximately 10 basis points of inflationary cost deleverage versus last year, at least 170 basis points of leverage from improved promotional activity versus last year enabled by lower inventories and better assortments, and ROD as a percentage of sales is now planned to deleverage roughly 60 basis points compared to last year. Turning to SG&A and capital. We continue to expect fiscal 2023 adjusted SG&A of approximately $5.15 billion and estimate fourth quarter SG&A of approximately $1.4 billion.

We now expect fiscal 2023 capital expenditures of about $475 million for the year, below our prior range of $500 million to $525 million, due in part to fewer store openings. In closing, we are pleased to deliver solid financial results during the third quarter, demonstrated through gross margin expansion, expense discipline, lean inventory and strong cash generation. The operational and financial rigor that we’ve worked to develop and will continue to pursue is enabling us to focus on reinvigorating our brands with the goal of generating sustainable profitable growth and delivering value for our shareholders over the long-term. With that, we’ll open up the call for questions. Operator?

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from Adrienne Yih with Barclays. Please go ahead.

Adrienne Yih: So, Richard, here’s a question I have for you. I get where the brands are pretty well established or maybe Banana, Athleta. But the one that really, for 20 years, has sort of wandered, I would say, like, kind of moving up, moving down is Gap. But, you’ve been there a 100 days or three months or so, can you give your sort of like initial kind of feeling on what Gap stands for? And how do you corral sort of the entire Gap for an organization to get to that 10-point target? And then, for Katrina, are your inventory turns back to pre-pandemic levels? If you are going to end the year at down 15%, can you structurally comp all year, just by turning faster? Is that how we should think about that? Thank you very much.

Richard Dickson: And I do appreciate the question specifically on the Gap brand, which really is an incredible heritage brand in our portfolio, let alone a heritage brand in pop culture. And really to understand where we are with Gap, you really need to unpack all of the puts and takes. We’ve taken serious steps to meaningfully change the health of Gap brand. And over time, this has created what we believe is a much healthier core from which we’re now enabled to really reinvigorate the brand and grow. We strategically moved to a more profitable model, and we took action to optimize the retail footprint, and we’ve closed hundreds of stores. We’ve moved to a capital-light, international franchise model and partnered with our China and European markets.

We’ve also been growing our online presence, but we recognize that we have been not as prominent on top of key trends, and we need to market our core categories in a much more relevant and meaningful way. This is going to take time. The third quarter results do provide some really early proof points that our healthy core is showing signs of strength. We are going to continue to build upon this, as we reignite the brand. As we talked about and as you call out, the reignition of a brand when we sum it up, stands for relevance and revenue. And each one of our brands is in a different place of reinvigoration, but the methodology to reinvigorate our brands is similar. And in Gap’s case, we are really building upon defining a stronger, more crisp identity, working on trend right product assortments with a very clear point of view, that will deliver not just on the needs but also on wants.

Our merchandising presentations have already improved in our stores. They are starting to deliver great storytelling that excites our customers with a real edited point of view. If you go online today and if you’ve been tracking our brand, you will see a much more definitive, creatively consistent marketing story in our online experience. So, our storytelling is going to be much more prominent. And we are going to start to really infuse Gap in the cultural conversation. So stay tuned and keep watching all the touch points as we continue to reinvigorate the brand.

Katrina O’Connell: And then, Adrienne, as it relates to inventory, if we end down 15 at the end of this year, that translates to being down about 6% to 2019. So, I would say, we are back to having reasonable inventory levels for the Company. And, as I said in my remarks, our goal will be to remain very disciplined on inventory. I think, we continue to see that that enables us to grow gross margins through lower promotions, but it also allows us to utilize our responsive levers to chase trends closer into consumer demand, which also allows us to be more relevant and also allows us to then achieve higher gross margins. So, we’ll see where the inventories land for next year, but overall that inventory discipline will remain. And I think chasing trends through inventory responsiveness will be the lever that helps us turn faster.

Operator: Our next question comes from Ike Boruchow with Wells Fargo. Please go ahead.

Ike Boruchow: I guess, one for Richard and then a follow-up for Katrina, if that’s okay. So, Richard, so, you guys as a company now posted your first positive comp at Old Navy in a few years. So without being overly specific on the fourth quarter or next year in regards to guidance. Can you say at a high level, do you feel that the business has really turned a corner strategically? Do you believe this is back to a positively comping share-taking business, once again, as you look forward? And then the follow-up for Katrina. On the credit side, there’s been a lot of questions, in retail, on credit and delinquencies going up. Can you just give us some context on how you think about the potential headwinds to margins from here maybe?

I don’t know if you would be comfortable giving us what credit income was as a percent of sales in ‘19, where it’s planned to be at the end of this year, or how much margin pressure should we expect if credit trends were to fully revert to ‘19? Just something that would give us a little understanding of what that potential mean reversion could look like to the margins next year would be really helpful. Thank you.