The Gap, Inc. (GAP) Q1 2019 Earnings Report, Transcript and Summary

Good afternoon, ladies and gentlemen, my name is Vicky, and I will be your conference operator today. At this time, I would like to welcome everyone to the Gap Incorporated First Quarter 2019 Conference Call. [Operator Instructions] Today's call is being recorded. I would now like to introduce your host, Tina Romani, Senior Director of Investor Relations.

Good afternoon everyone. Welcome to Gap, Inc's first quarter 2019 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 2 of the slide supplementing Teri's remarks. Please refer to today's earnings press release as well as our most recent annual report on Form 10-K and our subsequent filings with the SEC, all of which are available on gapinc.com. These forward-looking statements are based on information as of May 30th, 2019 and we assume no obligation to publicly update or revise our forward-looking statements. Joining me on the call today are President and CEO, Art Peck; and Executive Vice President and CFO, Teri List-Stoll. As mentioned, we will be using slides to supplement our remarks, which you can view by going to the Investors section at gapinc.com. With that, I'd like to turn the call over to Art.

Good afternoon everyone and thanks for joining us. I'll begin the call with a discussion of some of the macro industry-wide influences on the quarter and the performance of each of our brands. Then, I'll ask Teri to walk us through detailed financials and we'll finish with an update on our previously announced plans to launch two independent publicly traded companies. You've seen our press release, and obviously we're disappointed in our Q1 results. Not unlike others in the industry, our results highlight some of the macro challenges we all faced. As you know, this was one of the coldest, wettest quarters in memory, and while traffic and sales trends improved, as we moved through March and April, it was difficult to overcome the extremely slow business that we and others encountered in February. In addition to the poor weather, we had late spring breaks, a late Easter and delayed and lower tax refunds thrown into the mix as well. We also missed opportunities on our own, and we could have executed as always better across places in our brands. We recognize the needs of our customers are changing and we're not waiting around, hoping that we muddle through. We're running towards what we see as an exciting next step in our evolution. As you remember, last quarter we announced our intent to launch two new companies that will be uniquely positioned to compete in the evolving retail environment. Old Navy and the New Company, comprised of our specialty brands. The rationale behind the separation is simple, and we will continue to reiterate it. The needs of our specialty and our value customers are diverging, and the pace of change in retail continues to accelerate. Our planned separation will enable each brand to move more quickly and efficiently to maximize focus and flexibility, to align investments to meet unique business needs, and to optimize cost structures to deliver profitable growth. We'll come back to the separation in a moment and give an update on our progress later in the call. Now let's turn to the results specific to the quarter. Beginning with Old Navy, our results were not what we expect from this powerhouse brand, though we did see improvement during the Easter season. When I look to Old Navy, I see a brand with a strong track record and a long clear runway for growth ahead. The underlying fundamentals that made the brand so successful over the years have fundamentally not changed. Old Navy has a powerful, almost unique four-wall model, a highly valued value proposition for our customers and strong brand health. Even with macro headwinds and some product business, Old Navy's traffic was flat to the industry for the quarter and we modestly gained market share in the brand. Part of the growth plan for Old Navy is simple store penetration. We expanded our retail footprint with six new stores in Q1, and with plans to open 20 in Q2, and a total of 70 forecasted for the year. While new stores offer a clear path to growth for Old Navy, e-commerce also continues to expand with impressive double-digit comps online in both traffic and conversion. Reinforcing our view that stores and online are complementary channels when paired thoughtfully, the buy online pickup-in store program continues to help us better understand the intersection of offline and online shopping behavior for the Old Navy customer. Turning to Gap brand, while the comps for the quarter were disappointing, the story of Gap brand, as we have continued to say, is that of a brand focused on regaining profitability. The brand has made significant operational improvements in inventory, product assortment, and expense reduction. Our aggressive store closure plan to rationalize the specialty fleet is on track, and we remain committed to quickly, thoughtfully and decisively eliminating stores that are underperforming. It's through these tough actions that we set the stage for additional progress and for the rejuvenation of this brand. Let me then turn obviously to traffic, which was a major challenge at Gap quarter - Gap brand for the quarter. Though some of that weakness was expected, we intentionally shifted marketing resources out of the first quarter and in to late Q2 and Q3, and this was aligned with revamping our marketing efforts to match the continuing improvements in product and importantly a strong denim presentation. You'll also see Gap brand reinvest in marketing, kids and baby business with a strong back-to-school push later this year. This is especially important, given that market share is now up for grabs, and this is a clear opportunity for Gap brand given its strong equity in kids and baby. Banana Republic also experienced the impact of the unseasonably cold weather in February and March, customers wanted more wear-now items such as outerwear, at a time when we were offering spring fashion. As weather improved in April, so did the performance. Despite the weak quarter, I'm pleased with our progress at Banana. Just a few years ago, there were questions about the core viability of the brand. We moved in a new management team, got back to the fundamentals of delivering high quality, reliable products and today, Banana Republic is earning its place in the Gap Inc. portfolio. Athleta continues to be one of North America's fastest growing athletic brand and is positioned to capture share. Despite unseasonable weather, growth continued to outpace the market by a factor of two. We're obviously all committed on Athleta, and in 2019, we are accelerating store growth with approximately 25 new stores versus our historical average of 15 to 20 openings per year. Part of the Athleta magic is its clear brand identity and its commitment to sustainability. Athleta just celebrated its first year as B Corp by announcing progress against its sustainability goals, including 60% of materials now being made from sustainable fibers. Customers connect with the fundamental ethos of the brand in a way that is difficult to duplicate or replace, and that connection is part of why we're so bullish on the Athleta opportunity moving forward. We've tended over time to focus our calls on the larger brands as they have the greatest impact on our economics. But we're also seeing significant and interesting progress in our smaller properties. We're seeing positive trends at Intermix, where fresh inventory, on-trend product assortment, and an improved e-commerce platform, and stronger digital marketing strategies led to both growth online and in-store. We also have our new digitally native men's active brand Hill City. Again, there were only a few months in, but as the brand develops, we look forward to sharing more on the progress of what we believe is a very exciting opportunity. And last, I'd like to formally welcome and discuss for a moment, the latest addition to the portfolio, Janie and Jack. Janie and Jack is a high-end children clothing brand with about 140 locations across the U.S. and an attractive profitable online channel. The brand sits at a premium higher price point for kids and baby than the offerings currently found at Gap and Old Navy and was a great tuck-in, and we believe significant potential acquisition for us going forward. Finally, I'd be remiss to not address the topic that impacts the entire industry recently announced intent on tariffs on clothing manufactured in China, which largely translates into a tax on American consumers. As you're hearing on many of these calls, there is a significant uncertainty around what goods the tariffs may apply to and at what level they may be applied. But we've been migrating sourcing out of China for the last several years, and we'll continue to do this responsibly going forward. As recently as three years ago, about 25% of our product was manufactured in China. In our most recent disclosure, that number was down to 21%. And if you include only apparel, our penetration is approximately 16%, which is significantly lower than the relevant portions of the industry. Our current guidance incorporates the impact of List 3 goods, but does not include the proposed List 4 changes. We're actively monitoring the issue, we're actively engaged in the conversation, and we're managing our sourcing operations accordingly. I do want to speak for a moment on the separation, but I think it's important that Teri take us through financial results for the quarter, and our outlook for the year. Teri, over to you.

Thanks, Art. Good afternoon, everyone. As I said, we are not pleased with our results this quarter, similar to the complexion of our fourth quarter results, there were several industry-wide macro factors contributing to our performance, as well as areas of opportunity within our control, where we could and must execute better. As we previewed in our last call, the historically cold start to the year negatively impacted all of our businesses, particularly Old Navy, which tends to see outsized impact from unseasonable weather patterns. While we did see an improvement from February into the combined March and April period across all of our brands, the improvement was below plan and was not enough to offset February softness. Let me take a moment to walk through some of the drivers of brand performance, before going to the specific results. Beginning with Old Navy, as we talked in the back half of last year, we had identified product softness in certain areas of our women's assortment, which have been addressed with leadership and process changes that will show up in the assortment as we move through the year. During the quarter, these challenges were exacerbated by a generally soft apparel retail environment, which we attribute primarily to a much cooler weather pattern than a year-ago. We saw the weather impacts most acutely and looking at the spread between where now and where forward category accounts, which were about 7 points different. While online delivered a high teens comp, with growth in both traffic and conversion, store performance was much more challenged, driven by negative traffic trends, which we also partially attribute to weather. As you know, the specific diagnosis and quantification of weather impacts in our business can be tough, particularly with the variability we've seen across the competitive set. From a product perspective, the team identified that our product offering was too narrow and lack diversity in silhouette, print and pattern and color. Our Old Navy customer response to a broad assortment and overall we did not provide her with enough choice. With these key insights derived from customer response to holiday and spring product, the design and merchandising teams were able to significantly redesign the fall season, with even more ability to influence holiday. Additionally, while we entered the year clean from a viable perspective, we were heavier in inventory than we would have liked coming into the quarter, especially given lower than expected traffic trends. As a result we were significantly more promotional in the quarter to move through units resulting in meaningful product margin compression in the quarter. We have adjusted Old Navy's inventory buys for the balance of the year and they now are much tighter to match industry trends and drive inventory productivity. For perspective, unit inventory comps were up mid-single digits in Q1, and are plan to be flat and down mid-singles for Q2 in the back half, respectively. As a result, we do expect sequential merchandise margin improvement as we move through the year. One of the key strengths of the Old Navy model is the robust and repeatable product to market process. The leadership team has taken the learnings from these last two quarters to infuse more rigor around their established processes that drive the business. Importantly, the Old Navy brand fundamentally remains strong as it continues to build share on a rolling 12-month basis, with consistently strong NPS and YouGov indicators. Old Navy continues to leverage its unique positioning in the sector at those intersection of value, speed, and curation. The brand remains grounded in creating affordable on-trend, high quality fashion for the whole family, while ensuring the customer field funded every touch point, this $8 billion brand provides. We continue to see a long runway for growth with share growth opportunity to improved comps, new store openings and continued online strength. Turning to the Gap brand, our top line was negatively impacted by weather and traffic trends. We were able to improve the brand's overall profitability through gross margin expansion, and continued expense reduction. The team has been focused on improving inventory composition and product assortment. During the quarter, we had particularly focused on yield management, despite the tougher traffic trends. As we move throughout the year, we have a particular focus on re-establishing our strength in Denim with improved quality fit and silhouettes. We remain focused on driving improvement in the brand with cleaner inventory positions, better product assortment, leaner inventory buys, and continued cost discipline. Moving to Banana. Similar to Old Navy and Gap, unseasonably cold weather negatively impacted spring product sales for much of the quarter. As weather improved, we saw an inflection in trends, but recognize there are still opportunities for improvement in terms of product, assortment and marketing. As our fashion product acceptance continues to improve, the team is focused on balancing our inventory mix and offering more of the she wants by increasing the depth across key fashion buys, and marketed styles, while driving overall inventory productivity. Lastly, with regards to Athleta, while February was tough, we saw sequential improvement in comp trends as we move through the quarter with a 12 point comp improvement from February to the combined March-April period. The swim category was soft largely related to fit in coverage product challenges. The team is evaluating how we can best serve our customers in this challenging category with several in-store test programs that will help us inform strategy for next year. Fundamental brand health remained strong, as evidenced by market share gains, continued customer file growth and strength in other key health metrics such as the average spend per customer, and frequency. Let me move to overall performance. Just as a reminder, you saw in our disclosures, during the quarter we completed the sale of the headquarters building we owned, but did not occupy as part of a tax efficient exchange for the Old Navy headquarters building, we purchased at the start of the year. We completed the sale for $220 million, which resulted in a gain on sale of $191 million and is included as an offset to operating expenses within our reported results. So starting with sales, our net sales for the quarter were $3.7 billion, down about 2% last year. Comp sales were down 4%, compared with the positive 1% last year. Spread for the quarter was largely driven by new store openings at Old Navy and Athleta as well as non-comp Janie and Jack sales, partially offset by the Gap store closures. The vibrant comps clearly were below our initial expectations and we're working aggressively to adjust our plans to respond to the macro trends and strengthen our product and marketing plans for the remainder of the year. Moving to gross margin, our first quarter gross margin was down 140 basis points to 36.3%. Merch margin was down 120 basis points, primarily driven by Old Navy, partially offset by Gap brand margin expansion. Rents and occupancy deleveraged 20 basis points, primarily driven by the lower sales. On SG&A, on a reported basis, first quarter total operating expenses were $1 billion, which included the $191 million benefit from the building sale gain. You will see that we have separately called out the costs associated with separation as well as specialty fleet restructuring costs. Together, these were only $5 million on the quarter, but we wanted to provide visibility as we move through these important transformational steps. Excluding those items, our adjusted SG&A as a percentage of sales deleveraged 110 basis points, reflecting the lower sales and increased expenses related to technology investments, the addition of Janie and Jack, and a modest increase in Old Navy store labor, which we are rightsizing to match business needs. Two additional points on this. First, we continue to believe that marketing is a key element of our business model and investment there is required to keep our brands healthy and traffic strong. Clearly to yield the best return, those investments would be matched to strong product and customer experience. During the first quarter, that wasn't true for Old Navy and Gap, so we held back on marketing and we'll reinvest as the product fundamentals improve. Second, and importantly, our productivity efforts remain a key priority with savings goals in place for the year. Inevitably, there will be some inefficiencies as we move towards the launch of Old Navy and the new company, as stand-alone entities. But we are looking at that as a catalyst for even more dramatic changes to the operating models that will optimize the unique strengths in respective scale of two more focused companies. On taxes, our effective tax rate was 24.8% on the first quarter. The lower rate versus our original guidance was primarily driven by the jurisdictional mix of pre-tax earnings. We expect our full year reported effective tax rate to be about 27%. When we exclude certain non-cash tax impacts related to expected restructuring charges, we continue to expect our full year adjusted effective tax rate to be about 26%. On earnings, on a reported basis, our earnings per share were $0.60. Excluding the building sale as well as costs associated with separation and fleet restructuring, our adjusted earnings per share were $0.24. Foreign exchange was a benefit of about $0.01 for the quarter, but is not expected to be meaningful for the year. Our free cash flow was negative $136 million, with an improvement of $68 million over last year. This reflects a lower bonus payout, partially offset by an increase in capital spending, primarily due to earlier planned store openings and timing of technology and supply chain projects. We ended the quarter with $1.2 billion of cash, cash equivalents and short-term investments comfortably within our target cash threshold. Consistent with our commitment to returning cash to shareholders, we completed $50 million of share repurchases in Q1 and paid dividends of $92 million. We continue to expect to repurchase approximately $50 million per quarter. We ended the quarter with 378 million shares outstanding. Regarding inventory, we ended the quarter with inventory up 10% compared to last year. There are couple of drivers behind the increase, including about 1 point impact from store openings, net of closures; about 2 point impact from the Janie and Jack acquisition; about a 2 point impact driven by an increase in in-transit times. As others have noted, ocean freight carrier bankruptcies have resulted in carrier consolidation and larger vessels used for transport. These larger vessels generally take longer to load and off-load, resulting in an overall increase in in-transit time of about three to four days. Well, we have not seen any increase in ocean freight costs, we did begin to see the longer in-transit times beginning in Q4 of last year. While this normalized 5% increase is better than the reported, it still is too high against our near-term expectations for growth given the current dynamics in the market. As we mentioned for several brands, we are buying inventory tighter over the remainder of the year. Our inventory productivity has slipped for a number of years, and we must get back to best-in-class levels. We have invested in the necessary responsive tools to improve productivity, we have designed, improved operating processes, and put in place controls to deliver improved operating discipline, and now we are focused on rightsizing our inventory levels to the appropriate channel demand to improve yield and return. Regarding capital in store count, our year-to-date capital expenditures were $165 million. At the start of the year, we guided to fiscal 2019 capital expenditures of about $750 million, which includes about $650 million of base capital and $100 million of non-routine expansion costs related to one of our headquarters buildings and a build out of our Ohio D.C. Excluding the $100 million of non-routine costs, we have reduced our base capital to be about $575 million. The reduction in capital spend is primarily driven by changes in our key priorities and timing of Old Navy remodels. We remain focused on two key priorities, continuing to tap the profitable growth opportunities for Old Navy and Athleta retail footprint. And investing prudently in technology and supply chain initiatives that position all of our brands well for competitive differentiation. It's important to note, we expect a separation to affect capital requirements, which we are currently assessing and which could impact future spending levels. As we have better visibility into these potential costs, we will provide more information as relevant. On a net basis, we added nine Old Navy, Athleta and Banana Republic stores during the quarter, and we acquired a 140 Janie and Jack locations. At Gap brand, we closed eight stores, primarily in North America, net of openings, primarily in Asia. We ended the quarter with 3,335 company-operated stores. We've added about 10 new store openings for the year at Old Navy and Athleta and now expect 30 net store closures for the year. With regard to our earnings outlook for the remainder of the year, given the disappointing start and with unseasonable weather trends continuing through May, we are reducing our full-year earnings per share guidance. On a reported basis, we now expect earnings per share to be in the range of $2.04 to $2.14 for the full year. Excluding the gain on building sale, the restructuring costs, and any costs associated with preparing for and executing the separation, we now expect adjusted earnings per share to be in the range of $2.05 to $2.15. We now expect net sales to be about flat for the year, with comp sales for the full-year to be down low-single digits, and spread up low-single digits, driven by new store openings. We now expect adjusted first half earnings per share to decrease approximately 35% relative to EPS for the same period last year. And we continue to expect an improvement in second half comp and margin trends compared to the first half of the year, largely for the reasons I described at the start of my remarks. In closing, as we said, this was a difficult quarter. However, we have clear line of sight to the actions that we need to take both to strengthen our operating performance and respond to the retail environment we currently are facing. Importantly, we remain focused on the actions that we believe will set all of our brands up for long-term value creation. What we are seeing in the industry today supports our view that to position our current brands for sustained growth, they are best served by launching Old Navy, as a standalone Company with a single-minded focus on winning with its unique value proposition and strategies in a growing retail segment. And the new company as a portfolio of brands with the scaled operating platform that can leverage an attractive customer base and pursue enhanced margin opportunities. So with that, I'll turn it back over to Art for an update.

Thanks a lot, Teri. Obviously, we are not pleased with this quarter, but I do want to spend a moment on the separation, which we announced during our last call, and we've made quite a bit of progress on over the course of the last couple of months. This decision to launch Old Navy as a standalone public company is not, I repeat, not a reaction to short-term trends, and we believe what we are seeing in the industry today validates our view to win in apparel retail, you need to be focused on unique competitive differentiation against a targeted customer base. This is the logic that we have used, it's the analysis that we have done, and we're doubly committed to making this happen. Importantly, we remain on track as we work towards executing the separation into two independent companies in 2020. As part of the separation work, we formed a project management office with a dedicated team to minimize distraction to the current business operations. The team's charter is clear and simple. Plan the separation efficiently and set up each company for success. We look forward to sharing additional updates on progress over the coming months. And Sonia Syngal, who will lead the Independent Old Navy, and I will host an investor event in mid-September to continue the conversation. With that, let's open the line for questions and answers.

[Operator Instructions] Our first question will come from Kate Fitzsimons with RBC Capital Markets.

Just given the reduction in guidance, could you just speak a little bit to maybe some of the trends you're seeing here in May? And then Teri, just as we're thinking about the inventory X transit in Janie and Jack upside, can you speak to where it maybe it is concentrated by the brands, and how we should think about 2Q gross margins relative here to what we saw on Q1? Thanks so much.

Sure. So with regard to the start of May, we are seeing kind of a repeat of some of the macro factors of Q1 with the colder, wetter weather and it has been very much unseasonably so. And so, that's basically the story as we sit here today. We do see bright spots when the weather turns, so we remain convinced that it is primarily weather related, but we need to ride that out. Obviously, on the inventory plus five going into the quarter with those kinds of trends, we do find ourselves in a bit of the same cycle where we're probably going to end up having to be a little more promotional than we would like to continue move through the units and make sure that we're getting into the second half, again both clean from a liable perspective, but also more rightsized against the expectations for growth in the second half. And so my expectation is, we'll continue to see some of that margin pressure. I definitely think we can do it in a more targeted manner than we might have done in Q1, we certainly learn as we go. And as we think about our commercial plan for Q2, we're definitely taking all of our learnings from Q1 and making sure that we optimize yield as we continue to move through those units.

[Operator Instructions] We'll go next to Dana Telsey with Telsey Advisory Group.

As you think about the Old Navy business, and the changes in trend over the past two quarters or so, how much of it do you feel is due either to the distraction with the separation, internal product issues in the consumer, or is it external factors? How do you unpack it in order to say here is how it gets back on track? Thank you.

I'm sure, you can jump in here to point number one, which is distraction minimal to de-minimis, I mean really truly, it's why Dana that I highlighted the fact that we've follow best practices, we've talked to a number of other companies that have gone through this process as well as outside advisors and really set up a project management office that is - with a specific intent to isolate the separation work from the operations of the business. We are acutely aware of the fact that there is a ton of work here that needs to happen, and that it is not allowable to let it bleed over into the operations of the business. And so far, I'm pretty confident that we have a structure that has really protected the operations of the business, and the team is really focused on not just the in-season management, but obviously making corrections in out-seasons for the business. I never like to play the macro factor, but it's a legitimate play in this case. Whatever article you read on weather, we saw unprecedented levels and I won't go into it because, Dana, and all the rest of you - you've seen it, you've tracked it here, of moisture, of temperature, obviously the violent weather we're seeing in parts of the country, et cetera. It's clearly an issue and Old Navy given its locational strategy, which is you have to work to get there. Number two, the fact that Kids/ Baby business, which is an important part of the Old Navy business tends to be more of a wear-now business. Both of those factors kicked in at Old Navy. I'm not going to say it was entirely as I've said all along the way, and I will continue to say we are never going to be perfect. There are couple of trends that we probably went with a little bit too long, especially in terms of the dress business. That all said, we're playing well in the bottoms business right now, across all of our brands where we're seeing the proper silhouettes in Denim, the proper rise, et cetera. So to me, I'm not going to give you a split, but the great majority of this I think as we've seen again with other people reporting was really a factor that the - it was just a very tough environment for apparel, the independent data shows that that was the case. And we've planned for a better month and move the units. We obviously, in Old Navy in particular, put some pressure on margins to move the units through the business. Teri, do you want to add more on that?

No.

And we'll go next to Susan Anderson with B. Riley FBR.

You talked about - I guess the baby business being little weak at Old Navy, I guess, I was kind of curious, and maybe it's more kids related too across your format. Did you see any impact potentially from the Gymboree liquidation?

Absolutely. Hard to quantify it, but there was a ton of inventory that got pushed through the system in a short period of time. And if you were in those stores, what you would have seen is that it was kind of three seasons that moved through simultaneously. There was some fall and certainly holiday merchandise, there was spring merchandise, and then there were longer lead time buys that they already had in the pipeline, in terms of some summer product as well. I can't tell you what the exact quantification of it is, but as we looked at it, when it was happening acutely. We saw it clearly in the business and we saw it in the traffic numbers as well. There was a distortion, we believe in industry traffic associated with that liquidation. So, the good news is that's behind us. We don't know if the consumer is going to sit on the sidelines, having just eaten a big meal, if you will, in participating in the liquidation. We're not really seeing evidence of that right now. But we have somebody like that with that many stores and that much products in the system pushing it out at very, very deep discounts in a short-period of time, it is going to have an impact on anybody playing in the same space.

And maybe just one follow-up, if I could. If you could maybe just give some color, I was curious how the active wear category performed both that Gap and Old Navy versus fashion apparel? Thanks.

Yes, I'm not going to go into specific numbers. We don't obviously give those out. I would say that what we really saw in active is the same proportional performance that we've been saying there which is active as a category has for a while, been growing above the rate of the overall ready-to-wear category. We have experienced pretty consistently performance that has matched that. And while even active as you know, looking at us and others has come down over that quarter because of it. We did see positive comps at Old Navy in that category and we are continuing to be bullish across the entire space where we play in active. It's a segment that is lifestyle based, is above average growth and we're going to continue to put our shoulder against it.

We'll go next to Paul Trussell with Deutsche Bank.

I know there is only so much commentary at this juncture to share around the split. But just curious around why we are waiting to the split - to maybe take some of the more aggressive and dramatic actions around structural - around the structure of the business and some of the operational changes. That seem to be coming once you all actually get to that point.

Well, let me just highlight where we are on the split, is maybe the best way to do this. Because it's actually - Teri is sitting here with a smile on her face, because we're pushing in many respects harder than the comfort level is of the organization to move forward. And I want to post as many points as I can, as we're going through the split. We're only a matter of a couple of months into it right now. Since we announced it, we did make it clear that we needed to announce before we could begin the real work. We have - what I'd describe as a bit of a luxury that you really get, to really think deeply and do the analysis in the face of this catalytic events to drive very, very aggressive change. And that is the work that is underway right now. I am concerned around obviously delivering performance quarter-over-quarter-over-quarter, but I am at least equally concerned about making sure that we're making the right structural decisions for both of these businesses, in light of the environment we're in, the evolving environment, the changing customers to set these companies up for success. And everything that we have heard and seen and talked with companies that have been through this, is the caution to make sure that we are keeping our eye on the long game here that is going to be played out at both of these companies separate and become two separate operating companies. So, I would then also then caution you, which is just because it isn't necessarily public right now, don't assume that we're not doing very, very aggressive work under the covers. And then the last thing I would say is, respect the fact obviously that this has - it's kind of the split and the work that we're intending to do with respect to the operating model, the overhead structure, it has pretty profound impact on lots of people in this organization, and we are going to manage our way through that, respectfully in terms of communication and making sure that the impact is managed appropriately as we work our way through this. So we are certainly not throttling our ambition or throttling our work, but I want to manage through this in a - yeah, it's a very complicated thing, and I want to make sure that we get through it in a way where all the parts work when we come out the other side.

Absolutely. And then just a follow-up, maybe just quickly update us on the store closures and what you're seeing from new store productivity with Old Navy? Thank you.

Yes, so on the Gap fleet restructuring, we said we expect to close about 230 specialty stores over the next two years. Most of those - many of those 150 or so will occur with natural lease expiration and the remainder will be ones that we actively negotiate to close. The closures for 2019 will largely happen in the fourth quarter. So I would overall just call the program on track to deliver what we said that it would, and we definitely we'll keep you posted as we move through the year. On the Old Navy new store productivity, as Art referred to earlier, they have a very attractive four wall model and that shows in the new stores, we are opening, which is a part of what gives us such great confidence as we think about the growth prospects ahead for the brand. So we are seeing the new stores performed at or above our pro forma expectations. We're also seeing that as we invest in remodeling, which we've done initially, quite thoughtfully as we tested the power of the remodels, but then did enough a larger scale last year and are continuing this year. And even there, we're seeing a meaningful lift in the sales as we invest in our stores. So just confirms that stores remain a very important part of the overall operating model, not just for Old Navy, but for all of our brands. And so we're really pleased with what we're seeing there.

I would just pile on this one because it's super important, and obviously as we get to the September meeting that Sonia, and I will host, and then go into the spring of next year, as we're talking more detail about both companies. One of the most important foundational cornerstones of Old Navy as a business is an exceptional four-wall model. And I'm a big believer that we are still the bricks-and-mortar retailer with an incredibly successful fast growing complementary online business, but it all starts inside the four walls. And nothing, and I would just underline, nothing has done anything other than give us confidence about the growth opportunity, as we've continued to roll out stores in smaller markets and infill opportunities. And as Teri mentioned, even very low scope remodels, which are largely a can of paint and a paintbrush, have yielded really good returns in terms of the lift in the business and the return on investment that we're making. So, and this is pretty foundational, obviously to the growth thesis in front of the business.

We'll go next to Simeon Siegel with Nomura Instinet.

This is Dan Stroller on for Simeon, thanks for taking our questions. On the DTC channel, I guess is there anything you could parse out with trends within that channel, our expectations for the year, and how should we think about margin dynamics in store versus online? Thank you.

There is no meaningful change there. We did, we continue to post strong results in online - the margin dynamics there as we've said before, it's profitable business and incrementally profitable, an incremental sale in the online channel is accretive to us. So really nothing new to report there, in general, this is a large attractive business. As Art said, very complementary to how we think of our overall approach to the customer, which is, she is using the online channel, even if she is not shopping in the online channel. And so we continue to learn from the customer journey to be able to tailor our response and provide an experience that - that is satisfying for her or she makes her final purchase.

And I would just add to that and say, we are, where she wants us to be, which is, if she is moving and shopping more on her phone, we're definitely there with her. We're seeing pretty encouraging metrics coming out of that mobile customer, BOPIS which as you know we lit up in Old Navy first, we're continuing to see the penetration go up there. As you know again, I'll just reiterate it right now, Old Navy has kind of - focus in Old Navy and focus in any of our brands is a win-win-win-win. It's getting a customer into our store, who is highly qualified, it's eliminating the below the line expense, gives us an opportunity to sell the customer immediate gratification. And as we continue to increase penetration there, we're really seeing how to tailor that capability for her, how to market it to her et cetera. So nothing but big bullish on continuing progress and stay the course aggressively on the DTC overall business that we have for all of our brands.

Also, if I could just get one more, given the Gap brand marketing shift, how should we think about SG&A growth for the year? Thanks a lot.

Yes. So we deleverage this quarter. As we look forward over the remainder of the year, obviously we'll be continuing to drive operating cost discipline. But inevitably, we will probably see some deleverage on the year, which is contrary to the trends we had been driving and really the objective of our productivity program. So we'll be doing everything we can to bring that number down. But at the moment, I think it's safe as to expect some amount of deleverage, as we really continue to invest in the marketing, that we do think is important, particularly as the product assortment strengthens in Old Navy and Gap.

And we'll go next to Ike Boruchow with Wells Fargo.

This is Lauren Frasch on for Ike. I wanted to ask about Athleta, sales growth in the other segments slowed pretty persistently to mid-single digits in the quarter. Could you provide a little more color around Athleta's performance and how that reconciles with the accelerated openings this year. Thank you.

Well, the accelerated openings are in front of us. We did note the fact that this quarter and the weather trends in the quarter as broadly impacted the apparel sector. I have zero concerns about the health of Athleta, zero concerns about the health of the brand, zero concerns about customer engagement. If I had to call something negative out of the macro factors is swim, partly also by weather, but swim was a tougher category this year. And it's something that we'll continue to look at. I made some changes to the swim business when I was running Gap brand, and it can be challenging, but that's really the place where I'd have to put my finger. I think overall, again, we think Athleta is well-positioned in the space that it's in, its got an incredibly loyal customer, it is truly omni. When you're dealing with some unprecedented, unusual weather and she is standing on the sidelines for a moment, it is going to impact people. and I think you've seen that more broadly. But zero concerns about Athleta and nothing but absolutely bullish in the same way we had been about what their brand has in front of us.

And we'll go next to Randy Konik with Jefferies.

Sorry, real quick, can you just re-clarify the gross margin impact from Old Navy versus Gap in the quarter. And then as we think about the annual guide change, we are expecting most of the disruption in the earnings per share for the year to come out of most of the second quarter or the gross margin, the primary culprit and deleverage from this lower sales. I just want to kind of think through or maybe versus Gap on the margin impact, and then how we should think about the flow of the year on the earnings front to the annual. Thanks.

That's a pretty complicated question Randy. Do you want me to send my model over for you?

It's a little bit complicated quarter.

Sure, it's.

It's indeed.

So let kind of walk through how we see the quarter. We didn't get down to the specific margin delineation between the brands. But as I said, the Old Navy inventory situation did drive a level promotion that significantly affected the margin. And as we've said before, and this given the size and mix of the portfolio, as goes Old Navy, so goes the company. And in this case, if you excluded Navy, it would probably actually would have had some gross margin progress on the quarter. So you can sort of take that for what it is. As we move through, I see Q2 being our next most challenging quarter given the start to May coming in with a little bit heavier inventory, and still having some of the lingering product challenges in some of those key brands. Then as we move through the second half, and I realize the second half, definitely looks like a bit of a hockey stick, but you have to keep in mind we're comping a second half of 2018 that was not our strongest and so we're effectively when you model all the way through it, saying we're going to do about the same as last year in the back half. So not a particularly aspirational goal at this point, certainly what we're sitting here doing is figure out how we can do better than that. But that is kind of the construct that we see with the back half showing the benefits of improved product, tighter inventory, better marketing plans, some specific programs in Gap, for example as we really drive changes we've been making in the denim program there. So really driving those loyalty categories that have higher margin potential. So the back half should be, you know us getting back to better operation of the business model we know can win and that's really sort of how the construct comes together on the year.

Understood. Any other nuances, that we should be knowing about regarding the annual outlook? Or is it just plainly, the $0.40 reduction, whatever it is, is purely just a lower sales and just all mostly gross margin impact item?

I think that's largely what you're seeing, we'll continue to work on the expense discipline of it, but it's always a challenge, right. How aggressive do you want to be on short-term decisions that hurt long-term health, and we just fundamentally believe, particularly as we go into the separation, and we want these brands to be strong and healthy, that we're going to cut back, but not do things that hurt the long-term health of the brands.

And we'll go next to Jay Sole with UBS.

I just want to follow-up on the margin question. For the full-year EBIT margin, it sounds like that the - what was implied in the guide before was around the - so an EBIT margin is around 8% range, maybe now we're talking about something in the high 6% range. If we look at the impact by brand, based on the commentary you're making about Old Navy. Is it fair to say that that brand will have a bigger EBIT margin decline for the year than the other brands?

Well, I mean, you're asking me to get down to a level of detail, we wouldn't normally do. What I would say is that, given what we saw in the first quarter for Old Navy, and how we would expect with the start of the second quarter for that to transpire, even though we will continue to get sharper on how we handle the inventory movement, we'll continue to have that pressure. And just given the size of the business as we do that, you're likely to have a disproportionate impact on Old Navy versus what we expect to see in the other brands.

The Navy part, if I could follow up on just some of the opportunities created by the separation, what will it mean for the type of opportunities and things you can do with real estate by having Gap sort of an imminent unencumbered from Old Navy and vice versa to give you some flexibility to maybe drive profitability or different improvement?

Yes, I mean I would go less to real estate because I think we're pursuing the real estate objective quite aggressively right now. And again, a big part of that is reducing our exposure to specialty, while continuing to grow the channels that we believe are the future, obviously including the direct to consumer, our franchise business, et cetera. I would go a little bit farther upstream and just talk about our tech and logistics investment portfolio, where we see pretty significant divergent needs between the business. And we're already looking at those decisions that we're making right now, whether it's systems or capabilities, and thinking about how do we start mapping those decisions against the needs of the business as we separate the two companies. Another place that again we'll talk about and I don't want to get out ahead of where we are right now, is to really rebase the operating structure of what will be the remainder of Gap, Inc. And this is something that I know Teri is passionate, I am passionate about it, we put it out there before. There will be, as we've communicated some level of dis-synergies, but at the same time, we're really going to use this as an opportunity to run the portfolio of brands differently to lighten up on corporate overhead, and brand overhead as much as possible, as quickly as possible. So stay tuned on this one, we'll obviously have more specifics. Again, I would caution everybody that as impatient as you are, we're couple months into the work. We want to do this work thoughtfully, we want to do this work well, but I can assure you that we are also doing this work very, very aggressively. And I've used internally the expression that we're going to break some things, and I feel really strongly about that. I do think when you're 50 years old as we are, this year, that there are some things you accumulate over time, that become very comfortable. And if you don't bring some things, therefore, the organization can't go back too, you aren't going to achieve the kind of enduring change that we need and that this opportunity of the separation presents to us.

And we'll go next to Matthew Boss with JPMorgan.

This is Steve Zaccone on for Matt today. Thanks for taking our question. So we just had a follow-up on gross margin. Is your expectation for similar merchandise margin performance in 2Q, relative to the first quarter and are you embedding merchandise margin expansion in the back half or until maybe it's on better inventory footing? And then outside of your own inventory actions, what is your view on the current promotional activity in the mall, right now?

Yes, I'll start with that one. Nobody is in a different position quite honestly than we are. Maybe somebody got lucky and bought the quarter tighter or happen to have extraordinary marketing. But we've clearly seen promotional pressure as people have worked hard to get through the units that they had for Q1, against the lower consumer demand. And then on top of that, the Gymboree liquidation and other liquidations that are going on so promotional pressure is going to be out there. We've been watching very carefully as people have come out with their numbers to see where they are in inventory levels to get calibrated on Q2. And then as Teri had said, we're taking a pretty aggressive approach towards our inventory levels in Q3 and Q4. I would expect that other people would be doing that as well. The good news from our standpoint is that we can take those units out, but again as we've referenced before leverage our response capabilities, if we start to see places in the business where we can put units profitably back in, closer to the time that those units need to be in the store. But it was clearly a promotional environment and that is, if you really want to wrap a bow around Q1, you would say depress demand due to weather and aggressive promotions to move units to the system, and that's really the story of where Q1 came in at.

And unfortunately that is kind of how Q2 starts as well. So to your direct question of do we expect Q2 margins to look like Q1? No. We do get smarter with each iteration of this and so we would expect to be able to handle it with building on the learnings from Q1, in terms of how best to optimize margin, while we move through those units. So, that's really what we're very much focused on. And we'll take that through the whole year, as I said we're very much focused on right-sizing our inventory buy and we were able to affect that to some degree for Q3 and certainly for Q4 to reflect the revised expectations we're seeing in the market. And so that should play through on the margin delivery as we move through the year.

We'll go next to Paul Lejuez with Citi.

Your guidance already assumes some declines in EBIT margin, I think operating cash flow as well. And so I guess I'm curious as you think about the synergies that are yet to come or if you don't see that hockey stick in the second half, does it make you rethink the ability of the organization with declining EBIT margins to the ability to absorb the synergies that might come what's putting things up, if you rethink things little bit, if the second half doesn't work out as planned?

Yes, so maybe a couple of ways to think about that - and Art, feel free to chime in. As we thought about the separation, we modeled the likely implications of the synergies and the cost actually affects the execution vis-à-vis the value creation opportunities that it presented. Nothing has changed with respect to our assumptions there as we've started the planning work, there's nothing to indicate that what we thought we could achieve by virtue of launching these two companies with the ability to more effectively compete in their respective spaces within the industry, and that all remains intact. So I don't see anything about our performance over the course of this year, that indicates that fundamentally the decision we've taken should be changed or reconsidered. We do have obviously the luxury of a very strong balance sheet, the choices we've been making to invest are all investments that we feel good about the ability to deliver a return on over time, and that's exactly how we view the cost to execute the separation as well. If it moved forward and for some reason something changed with regard to our expectation for value creation or the cost separate, we obviously would be responsible and look at that and we consider, but we're just nowhere near that at this stage with everything we know about the potential for the business on a combined basis, and on a standalone basis and the ability that's the expectation for cost to separate.

Yes, obviously, I would actually start this with looking at the consumer, and I think that you can largely explain what happened, both to us and to others in Q1 by the consumer rationally slowing down her apparel purchases because of volatile and unusual weather. There are some other factors out there as well, which is we are in an environment, it's bit of a flat spot relative to a compelling trend, especially in bottoms that is causing her to get out and go shop with urgency. We've seen those things before, they come along once in a while. Inevitably, they're overtaken by the fact that a compelling trend does come along and she wants to refresh her wardrobe. I think it would be profoundly shortsighted to question the wisdom of the separation of the Company, which we've looked at from upside down and center at every place else around the business logic of doing this, on the basis of a very, very unusual quarter. If I thought, that somehow that quarter represented a fundamental overnight step function change in the structural profitability of this industry, that would be a different consideration. But consumers don't change their spending patterns overnight, this is evidently explainable and we are staying the course, because we are absolutely convinced that this is the right thing to do for long-term value creation.

I guess, Art, the context is that - because I think this will be the sixth year of EBIT margin contraction. And so I guess, is there anything that you're seeing, if things were to accelerate in the back half that would make you take that longer-term view of what happen to the business, and think that you just don't have the cushion to absorb the synergies to take margin down further?

We're not going to do something that imperils the company, that would be irresponsible. And Teri will nod her head when I say that people that hearing the words cash flow coming out of my mouth, a lot right now, because that is my starting point for looking at the launch point for these two companies, and to make sure that we have strong cash flow and forward-looking cash flow out of both organizations. Of course, if there was something that caused significant deterioration that imperiled the viability - the cash flow production, the operating profit of these businesses, we would take a second look at it. I don't anticipate it. To me in a way, as again, as I said in my comments, that you're noting of the continued divergence and the impact on operating profit, which as we've indicated over time has been significantly driven, not out of Old Navy, which has been largely healthy, but out of Gap brand, increases the urgency to get this done, because it allows us to maneuver differently and to operate differently. And if anything it's overdue.

Our last question will come from the line of Janet Kloppenburg with JJK Research.

Teri and Art, I heard a different strategy about the Gap brand in the first quarter, maybe profitability improved, comps fairly depressed. I'm wondering if this is something we should expect going forward that you want to lower the promotional profile of the brand or if we should expect a pivot in comps, as we move forward, perhaps you could talk a little bit about the strategy that you engaged in the first quarter, and what we should expect for the brand as we go through the remainder of the year? Thank you.

Yes, I don't - thanks for asking the question. I actually don't think it's a different strategy at all. I mean taking the decision to closed stores, stores were unprofitable and in many cases stores, the reason that they were unprofitable was a combination of the productivity of the store, but also the promotional intensity of the store. A lot of these stores are in places where the center that they're has become more of a value oriented customer, more of a promotional customer. So our willingness to take unprofitable top line out of the business to restore the health of the brand, that is what we are committed to right now. We do need to lower the promotional intensity of the business. I don't know that that necessarily means that we have to take the kind of negative comps that we've been looking at over time. But we are going to continue to push to restore profitability in the business, probably because we want the brand to be profitable and partly because profitability of that business and seeing a positive margin comp relative to the sales comp is an extraordinarily important leading edge indicator of the health of the business. So I'm not going to signal what our comp objectives are going forward, obviously I'll be the first one to say I want positive comp. But more importantly, I want a positive foundational core to the business, where we're establishing pricing authority, and customers are paying us for what our product is worth.

So are you confident that the new team that's operating Gap will be able to make progress on the merchandising front, so that the brand resonates better at a full price level going forward?

Yes, used a bit of a loaded word there, which is full price. The great majority of the industry is what they call blended, which is a combination of full price and promotional. Do I think we're going back to a what somebody tells me existed somewhere back in the dawn of time, a full price business. I don't think that's the reality of these categories that we play right now given the competitive environment that we're in. And I'm confident that the team in New York through the merchandising strategies that they have through the tools we put in place through the operating discipline, the marketing, store presentation, all the pieces that have to come together that we can increase our yields. I am absolutely confident you saw a proof of that happening, what we're moving through units in Q1.

Thank you. That does conclude our conference. You may now disconnect.