The Gap, Inc. (GAP) Q1 2020 Earnings Report, Transcript and Summary

Good afternoon, ladies and gentlemen. My name is Jenny, and I will be your conference operator today. At this time, I would like to welcome everyone to the Gap, Inc. First Quarter 2020 Conference Call. [Operator Instructions] I would now like to introduce your host, Tina Romani, Head of Investor Relations.

Good afternoon, everyone. Welcome to Gap, Inc.'s first 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 non-GAAP financial measures, as noted on Page 2 of the slide supplementing our remarks. Please refer to today's earnings press release as well as our current report on Form 8-K filed on April 23, 2020 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 June 4, 2020, and we assume no obligation to publicly update or revise our forward-looking statements. Joining me on the call today are President and CEO, Sonia Syngal; and Executive Vice President and CFO, Katrina O'Connell. As mentioned, we will be using slides to supplement our remarks, which you can view by going to the Investors Section of gapinc.com. With that, I'd like to turn the call over to Sonia.

Thank you, Tina, and good afternoon, everyone. I hope you're joining us today in good health and that you're taking care during these challenging times. Before we jump into the results of our first quarter, I would be remiss to not address the situation that is top of mind for everyone across the United States with people of all backgrounds and beliefs coming together to drive social change. As a company, we have an opportunity to create a world that is more inclusive, ensuring our brand serve as a force for good by being open to all, listening and giving back to our community. While many peaceful protests have taken place across the country, in some cities, our stores have been taken advantage of and 20 stores have sustained extensive damage. We're fortunate that all of our teams are safe and we are working to reopen the impacted stores quickly and safely so we can serve our customers again. Now, turning to Q1. As I transitioned into the CEO role, we were making good progress with momentum entering the quarter led by Old Navy and Athleta, only to be met almost immediately with a shelter-in-place orders that resulted in the closure of all of our North American stores. As we monitor the situation in China and then Europe, we moved quickly to respond to the looming spread of the virus across geographies, its implications on our business and the industry. While there's no playbook to manage the fallout, the situation required a radical shift in our priorities. Starting first and foremost with protecting the health and safety of our employees and customers. While our online business continued to thrive, the store closure resulted in approximately 75% of our demand being disrupted. To help mitigate these impacts, we took swift action to preserve liquidity and strengthen our financial flexibility, including having to furlough store team and reduce headcount across all of our global offices. Katrina will speak to you shortly about the full breadth of actions we've taken, which while difficult, have enabled us to focus on leveraging our inherent advantages to win in the post-COVID environment. Throughout we have moved more quickly and more united than we have in years. Our teams have been oriented to action and have delivered for the business and our customers in the face of unprecedented change and challenges. I could not be more proud of the team. To-date, over 1,500 stores are opened in North America, almost doubling our previously announced plan to reopen 800 by the end of May. Our team's ability to pivot quickly and lean into our strong online business resulted in an encouraging 40% online sales growth in April. While net sales and store sales continue to reflect material declines in May due to the store closures and demand shock, we saw over 100% growth in online sales during this past month of May. It's still early days, but we're encouraged by the trends we're seeing, specifically the strong recovery at Old Navy, America's second largest apparel brand. We attribute this to Old Navy's advantaged value proposition for the entire family and strength in relevant categories such as active, fleet and denim. We're now operating over 2,100 stores as mini fulfillment hubs through ship-from-store and over 500 stores as curbside pickup locations, a capability we launched during the COVID crisis. We have welcomed tens of thousands of our employees back to work and expect to have the vast majority of our North American stores opened by the end of June. As COVID-19 has accelerated a shift in consumer behavior, we're playing to our strength. First, starting with our trusted brand. In a time of crisis, brands matters. Customers want to spend their hard-earned money on brands and products they trust and not with the bad customer experience with one that's not familiar. We don't talk about this enough, but Gap, Inc. has three multi-billion dollar brand in Old Navy, Gap and Banana Republic who have led us closely on the horizon. And Old Navy, Banana Republic and Gap brands rank among only nine specialty brands that exceed $2 billion of sales in the U.S. Our brands are among the most well-known constructive in retail apparel with Old Navy, Banana Republic and Gap, all exceeding 75% brand awareness. And there are numerous examples, particularly during this pandemic of how that matters and how this is true. Old Navy provide access to critical category and much needed liberty in the crisis with digital sunshine as a unique asset in a social and web marketing, resulting in meaningful online acceleration. As well as achieved all-time high engagement metric through wondrous storytelling and virtual community activations with a focus on at-home workout and cozy product content. Banana Republic served the styling sessions on its digital channel, offering customers new ways to wear their favorite style while working from home. And Gap launched Gap Teen with positive results. This brand new, highly-additive and sustainably designed assortment is the first new age segment to the brand since 1990. Simply put, as the largest U.S. specialty clothing company is measured by revenue, each of our brands has a unique opportunity to meet customers' needs now and as we reopen the stores. Our brands matters. Second, our direct customer relationships. Our brands are leveraging their direct connection with 60 million customers to make customer fuel decisions and deliver must-have product with attributes that matter most to them. We're in daily communication with our customers about how we're taking care of our teams and communities and we're providing clarity and confidence in the shopping experience they're returning to, however they choose to safely interact with us. Importantly, our stores remained integral to the experience we offer. With approximately 70% of our stores located in stressed outlet and off-mall real estate locations, we expect customers to gravitate toward these locations as they consider health and safety, an opportunity for us going forward. Third, our expansive e-commerce business and omni capabilities. During the widespread shelter-in-place orders, we leaned on the strength of our online presence, which is the second largest apparel e-commerce site in North America at $4 billion in annual revenue pre-COVID. During the crisis, we doubled the way customers can shop with us, by expanding our buy online pick-up in store capability to include curbside pick-up, as well as a new virtual concierge that Athleta has begun testing, offering customers the chance to have one-on-one interactions with the store associates in the comfort of their own home. Before the pandemic hit the U.S., 25% of sales came from e-commerce. We've seen a meaningful acceleration online as customer choose our suites of omni capabilities as a preferred way to shop. The interaction between stores and online continues to grow. During the quarter, we saw a 40% increase in customers migrating from retail-only to multi-channel versus last year and we all know how valuable the multi-channel customer is. Fourth, product that is relevant and resilient. The casualization of American style, particularly accelerated during COVID and have played to our product strength with our scaled active and lounge business, which generated $2.7 billion in sales last year, and the kid and baby business at nearly $4 billion. Gap stays as a leader in branded children's apparel, a staple like category that is largely insulated from volatility in retail. In Q1, we saw a disproportionate sales coming from active, fleet in kids and baby categories. Fifth, our advantaged supply chain and agile operations. Our extensive supply chain and deep relationships with suppliers enables us to affect well over $2 billion of inventory purchases as we look to quickly match our inventory supply with uncertain demand outlook. Our supply chain responsive capabilities, particularly developed at Old Navy, will help us change into the recovery we hope to see as stores open and as the customer demands become fair. We were also able to deliver millions of PPE to frontline healthcare workers when they needed at the most at the early onset of the virus as well as the charity organizations like the Boys & Girls Clubs of America. We've since pivoted factory capacity in a sub-fabric to produce million more washable fabric masks for customers. In May, we sold more than 3 million masks on pre-order across our brands. We completed the expansion of our Ohio Distribution Center, worked up again in 2019. The new facility is designed to be the company's highest capacity fulfillment facility with integrated automation and robotics. This launch was fortuitously timed as we expect online penetration to continue to climb and this provides capacity with improved labor productivity. And lastly, and certainly not least, our competitive team that leads with our values. Our brands and teams are a force for good as we relentlessly strive to better serve our customers' communities and to set the gold standard for safe shopping in this current environment. We have seen many examples of our brand acting as a force for good over the past 10 weeks. Starting with the small cross-functional team that, with audacity, chased into mass production to deliver PPE to frontline healthcare workers and now for customers to our dedicated store teams who have weathered through the highs and lows with us. And has served in a rapid responsible reopening of our stores, demonstrating tremendous care for our customers and each other. We've donated over $50 million of new clothing to needy American families via Old Navy and to help underprivileged get back to work via Banana Republic. And most recently, our brand came together to donate more than a $0.25 million to the NAACP and EmbraceRace Organization to stand with our customers and employees in the fight against racial injustice. I want to take this moment to thank the teams that are listening. This Gap, Inc. community of employees has just risen to the challenge, witnessed the occasion of leading with heart. A very big thank you from me to all of you that are listening. Really, it was a massive team effort. As much as we expected to drive value for our strength, our future success is dependent on addressing areas of significant opportunities. For example, in our specialty brands where past performance has not met expectations. We believe each brand must earn its right for investment and are focused on doing this through two key actions. For our brands to break through the noise in the marketplace, we must be resolute about delivering brand clarity, quality, product and consistent execution with every expression. Frankly, we have not done this well at Gap or Banana Republic. Creative confidence is something we are focused on promotion. We will also continue to rational – the rationalization of our fleet as well as identify asset-light ways to amplify and expand the reach of our brands. And we've made progress in just a few short months even among the crisis. Some examples. We began a systemic change for structure for success. To begin, we actioned a 15% headcount reduction across the company, indexing toward Gap brand with a 25% reduction. This is a first step in driving the organization focused on value creation to profitable growth. We are acutely focused on delivering consistent on brand products and marketing. We believe the Gap brand is better than recent business results. During the crisis, Gap has benefited from its high brand awareness and deep emotional customer connection. However, years of inconsistent execution have depleted brand health, which we're actively working to correct by defining clear brand positioning and product filters that translate to a narrower and deeper assortment that delivers to the customer. At Banana Republic, the leadership team is taking aggressive actions to adjust its product, offering them a pivot in the brand positioning to address the evolving customer needs. In this crisis, with the unforeseen shift to consumers working from home, Banana Republic was disadvantaged in its product mix as customers opted for casual style. Banana Republic's workwear categories such as soothing and dresses underperformed, which coincided with less available inventory of casual categories like knits and shorts. This affected online demand resulting in less benefits than our other brands. With respect to extending the power of our brands, we recently announced a licensing deal with IMG, allowing us to increase consumer access to Gap, Banana Republic and Janie and Jack through brand partnership and collaborations, including global opportunities within kids and baby gear, furniture home textile and decor. This is a great example of an asset-light, capital-light opportunity that delivers value for the customer and plays to the power of our brands. Additionally, we believe we can further amplify our brands. We're optimistic about the opportunity for creative partnerships to increase Gap's relevance and tapping to the cultural zeitgeist. Lastly, we remain committed to our prior fleet rationalization target, as our goal is to operate smaller healthier Gap brand positioned to compete. Katrina will share more on how we're thinking about this as well as the important progress we've made in strategically reevaluating our real estate and rent structures. So with that, I'm going to pass it on to Katrina to provide details on our financial performance for the quarter, and I'll then come back to share additional thoughts and how we're looking at Q2. Katrina?

Thank you, Sonia, and good afternoon, everyone. As Sonia mentioned, while the first two months as CFO has certainly been unique, I've been both impressed and energized by how the organization has responded to this unprecedented crisis. I'd like to echo Sonia in thanking our teams for their tremendous work, an unwavering dedication to operating the business during an extraordinarily challenging period. It's at a time like this that I am truly grateful to be a part of an organization like Gap, Inc. As we continue to build toward our longer term growth opportunities, our near-term priorities in navigating the crisis are clear. First, strengthening our financial foundation to ensure sufficient liquidity and financial flexibility to navigate the evolving landscape and emerge positioned to gain share. Second, leveraging our distinct competitive advantages, a collection of $1 billion plus brands, highly engaged customer base, a nimble supply chain and an advantaged omnichannel platform. And third, thoughtfully preparing for the future as we will emerge one of the winners by pursuing a balanced approach to driving profitable growth by investing in capabilities that amplify our advantages, while streamlining our operations and repositioning our fleet. As the crisis hit, we pivoted to the first and most important priority, preserving cash and accessing liquidity to provide us the flexibility to navigate our worst case scenario for this tumultuous year. In response, we did the following. We deferred our previously declared first quarter dividend, suspended dividends and share repurchases for the remainder of the fiscal year, cut capital expenditures in half to recession level lows, furloughed a majority of store employees, implemented temporary executive and board pay cuts, reduced expenses across all aspects of the organization, including a 15% headcount reduction, worked with our vendors to move from 45 days to 60-day to 90-day payment terms, developed a detailed inventory plans, including tightening purchases to demand and utilization of pack and hold inventory to preserve margin, suspended rent payments and raised capital through the issuance of two – of new $2.25 billion senior secured notes and secured a new nearly $1.9 billion asset-backed revolving credit facility to replace our prior unsecured revolving credit facility. Of note, the new debt issuance will be partially used to redeem our existing $1.25 billion notes that were due in 2021. We also paid off the $500 million drawn on our prior revolving credit facility and have not made any draws under the new ABL facility. It was an incredible amount of work done in a very short period and a real display of commitment by the Gap, Inc. team. Taking these actions put Gap, Inc. in a strong financial position and will improve the structural economics of the business. With this behind us, Gap, Inc. is in a position to pivot to our second and third priorities, leveraging our competitive advantages and accelerating initiatives to improve profitability, namely reopening our stores quickly, but safely, driving outside sales growth in our strong online channel, especially leveraging new omni capabilities that the customer is asking for, such as buy online, pickup in-store and curbside pickup. Renegotiating our existing leases, while simultaneously optimizing our fleet with emphasis on Gap brand and Banana Republic, and maintaining inventory flexibility and responsiveness as we navigate through an uncertain retail environment. I'll touch on each of these as I review first quarter business performance. The temporary closure of all of our North American stores midway through the quarter combined with slow global sales as our international operations reopened, catastrophically impacted nearly every area of our financials from sales to margins including two significant non-cash impairments taken for inventory and certain store assets. Let me start with sales, which declined 43% in the quarter, as the impact of store closures midway through the quarter led to store sales decline of 61%, which overshadowed the 13% growth in our online business. As a reminder, online represented approximately 25% of the company's sales last year. Beginning in April, our online growth sequentially improved week-over-week. We delivered 40% online sales growth in April, followed by over 100% growth in online in May. First quarter gross margin was 12.7%, down 23.6 percentage points compared to last year. Merchandise margin accounted for more than half of the overall decline and was down 13.7 percentage points, primarily driven by a $235 million inventory impairment charge in the quarter or about 11 percentage points of deleverage. The remaining merchandise margin deleverage was primarily related to increased promotional activity across all brands. Rent and occupancy deleveraged 9.9 percentage points, driven by a decrease in net sales, largely due to store closures as a result of COVID-19. It's also worth noting that while we suspended rent payments beginning in April, for accounting purposes, we have accrued our full rent expense, which is reflected in the first quarter's gross margin results. Let me address both starting with inventory. Inventory is the foundation of our business, we need the right items in the right locations to support demand or we will not win in the market. So we need to plan much tighter inventory levels to protect margin. My bias is to operate leaner than we have been and leverage our responsive capabilities to meet demand as it becomes clearer. In Q1, we took three primary actions to address excess inventory. One was the writedown, I just mentioned. This inventory was primarily spring inventories that were trapped in closed stores and are now seasonally irrelevant. We were pleased to donate a portion of this inventory to charities in need at the time. Another was an expanded effort to leverage ship from store and buy online pickup in store capabilities to meet demand even when stores were closed. This helps to service strong online demand while also clearing stores' inventory that was trapped during closures. And third, we implemented a flexible pack and hold inventory approach, whereby summer, feel like summer and fall inventory that we will be unable to sell due to store closures and potentially lower demand will be held until next year selling season. While there is a cost to storing this product, the economics are more advantaged than flowing the goods into what is likely to be a highly promotional environment. Taking this into account, our quarter-end inventory balance was down 1% year-over-year. Looking forward, depending on demand, pack and hold inventory will remain in our reported inventory numbers until the same time next year. While our reported inventory levels would fluctuate throughout the year, our underlying inventory levels, excluding pack and hold, are expected to be down for the remainder of the year, with Q2 down low- to mid-single digits. With regards to rent, as I noted upfront, beginning in April, we suspended rent payments for the period stores were closed. However, for accounting purposes, we have accrued the full amount of Q1 rent expense. So the expense continued to impact gross margin even though cash payment was not made. We are in active and ongoing negotiations with our landlords to work through this crisis together. We value these relationships and are committed to finding mutually agreeable solutions that will enable both of us to benefit from an aligned strategic plan. If we are successful in reaching a resolution with our landlords to abate a portion or all of the suspended rent, this could result in a benefit to gross margin in a future quarter as we reverse some or all of the rent expense accrual. It may also require a cash outlay for any agreed upon rent that is currently suspended. From a strategic standpoint, we consider a well positioned and productive store at a fair rent to be a huge asset, supporting brand awareness and relevance and playing an important part in our customer shopping journey. Although online consumer spending is advancing rapidly, that customer preference is enhanced by store locations, which can support ship from store and buy online, pickup in store options. We believe a robust suite of omnichannel tools, including curbside pickup will enable us to leverage our fleet and e-commerce site to best serve our customers' desire for convenience. That said, while our economics and our Old Navy and Athleta fleets are strong, our specialty store fleet has not been as profitable as we need it to be. So we're seeking rent concessions for those stores that are well positioned, but cannot support the current rent structures and prioritizing closing those stores that simply have no role in our fleet portfolio with the majority being in the Gap brand. In short, our specialty store closure plans remain on track. We also will continue to consider new store openings largely for Athleta and Old Navy. Of course, we'll do that quite thoughtfully and after considering the change in market conditions that result from the crisis. Turning to SG&A. SG&A in the quarter was $1.5 billion, or 71.8% of sales. The vast majority of the increase was due to the $484 million non-cash impairment charge related to our stores, reducing the carrying amount of the store assets and the corresponding operating lease assets to their fair value. Of note, with this writedown, we do expect to benefit to gross margin from lower depreciation and amortization expense of approximately $60 million in fiscal 2020 and approximately $80 million on an annualized basis. During the quarter, we also recorded a $35 million charge primarily related to our previously announced corporate headquarter reductions, as part of our commitment to creating a more efficient and streamlined operating structure. Looking ahead, we expect net savings of approximately $180 million for fiscal 2020 and approximately $240 million on an annualized basis from these actions. Year-over-year SG&A changes also reflected lower store operating costs due to closures. Looking forward, store operating costs, as you would expect, will continue to rise as our stores reopen. In addition, the operating cost of each store will be higher due to safe shopping protocols being implemented across the fleet. Looking at cash flow, there were two notable items. First, we deferred our previously declared first quarter dividend and suspended dividend and share repurchases for the remainder of the fiscal year, resulting in no cash outflows in the quarter. Second, capital expenditures were $122 million during the quarter. As previously disclosed, we've reduced planned capital spend by about half to $300 million. Most of the reduction comes from investment in stores with an eye toward the minimum level of capital necessary to operate the business. Of the remaining capital spending in fiscal year 2020, the majority is oriented toward technology and supply chain investments that support changing customer shopping habits, including the expansion of our Ohio distribution center, critical work that began last year to double the capacity supporting e-commerce demand, a valuable benefit with a dramatic rise in online shopping. So, let me return to cash and liquidity and start with a reminder. Fundamentally, Gap, Inc. is a strong cash flow generator with over 10 consecutive years of at least $1 billion of operating cash flow. Following six weeks of nearly full fleet store closures, as well as the benefit of a $500 million draw under our revolver, we ended the quarter with $1.1 billion in cash, a decrease of $600 million from fiscal year-end. While the reduction in cash in the first quarter is significant, it's important to recognize two key factors beyond the reduction in sales caused by the pandemic. The first is seasonality. Q1 and Q3 are traditionally smaller quarters from a sales and cash generation standpoint with Q1 following the holiday season. Second, several of the actions we took, including expense and headcount reductions, payment term renegotiations were only implemented midway through the quarter. For both of these reasons, normal seasonality and the timing of execution, our cash burn in the quarter appeared outsized. As stores begin to reopen in Q2 and as our expense, capital and inventory actions begin to take effect, we expect to see our cash burn slow meaningfully in the second quarter. Looking to the back half of the year, we expect to see continued benefits from our capital expense actions, Additionally, as traffic continues to recover, we would expect sales trends to improve sequentially as we move throughout the year. Further, we have dramatically reduced our inventory purchases in the back half as we were just placing fall orders as the crisis escalated. I'd also like to note the traditional seasonal pattern of cash flow, particularly as it relates to the build of inventory in Q3 for holidays. Although our new ABL facility is currently undrawn, it does provide flexibility to support operating liquidity and leave Gap, Inc. with ample liquidity to execute its plans. Now, turning to the remainder of the year, given the current macro volatility and uncertainty, we're not providing an outlook on the year at this time. That said, I do you think it's helpful to provide our general view on some important factors impacting our business that we're closely monitoring. With the reopening of stores, many items impacting Q1 will be meaningfully approved. Specifically, sales, operating leverage and the expected absence of impairments of the magnitude seen in the first quarter, especially related to inventory. While we expect total net sales to remain lower year-over-year, we expect sequential improvement from Q1 trends with continued improvement as we move through the year. With regard to North America store openings in May, while results have varied by brand and location, we're pleased with reopened stores already generating sales at nearly 70% of their performance last year, with particular strength at Old Navy, where our customer base is strong and our store fleet is advantaged given its off-mall positioning. Online is expected to continue to grow strongly with some lumpiness as customers adjust back to having an in-store option. Additional factors we're monitoring include customers' willingness to resume shopping in-store, pent-up demand, recessionary impact from the pandemic once the benefit of stimulus money dissipates, the success of recent new items, in particular masks and other distressed retailers who are aggressively trying to liquidate inventory. Well, it's unknown whether another wave of COVID-19 will have later in the year, we are modeling and preparing for it if it occurs. Gross and operating margins should be higher sequentially as we move through the year, but still impacted by lower year-over-year sales and higher cost to serve expenses for both online shipping and in-store safety measures. Of note, we expect fulfillment costs to be elevated in the second quarter driven by two important factors. First, with a subset of our stores still closed, online sales growth is expected to be outsized; and second, we continue to fulfill a meaningful portion of online demand through our stores, which is generally a more expensive fulfillment option. As we look to the back half, we expect to largely mitigate these acute near-term pressures as our stores reopen and we right-size inventory against demand in our online channel. With regard to expenses, we remain committed to prudently managing expenses, particularly in light of the current environment. Hopefully, that color on key business attributes will be helpful as you model the remainder of the year. Before I turning it back to Sonia, I want to emphasize that while we are clear on our near-term priorities that will enable Gap, Inc. to weather the crisis, we also remain committed to building toward our future. The unprecedented disruption experienced in the retail sector presents a very acute and unique opportunity. While everyone is adapting to a rapidly changing environment, we intend to lean into and apply our strategic advantages in order to gain customer loyalty and market share over time. As we continue to navigate the rapidly evolving marketplace, we remain steadfast and ensuring sufficient liquidity and financial flexibility to navigate the ever-changing landscape and emerge positioned to gain share, as well as amplifying our distinct advantages and scale to capture demand as it recovers, inclusive of share growth opportunities where our brands have an authority to win, and continuing execution of our initiatives to drive profitable growth through streamlining our operating model and fleet optimization. With that, I'll turn it back over to Sonia for a few closing remarks.

Thank you, Katrina. So you've heard from both of us and you know that we are focused on refashioning this company for growth. As we know that the retail landscape is changing rapidly and will undoubtedly look different in the future. From the competitive set to how customer shop for us with our products and engage with our brands. This is a really unique moment. The industry and everything is changing and we intend to lead that change by being a progressive leader in this transformation. We will do this by deeply listening to our customers and working alongside our partners and other industry leaders, to set the course for the next 50 years on the back of our last 50 years of a strong, growing company. We believe our brands will be poised to take share based on momentum we're seeing with stores reopening and a sustained online acceleration, coupled with our dominant market position and growing categories, I'm excited by Gap, Inc.'s ability to win. And so, with that, we will open it to Q&A.

Thank you. [Operator Instructions] And we will go first to Dana Telsey of Telsey Group.

Hi. Good afternoon, everyone, and hope everyone is safe and healthy. As you think about the complexion of the business on the margin side and the attributes going into it, whether it's rent, whether it's wages, what kind of differential do you need going forward in order to operate the business, smaller and stronger and what are you looking for in rents besides abatements? Is there cotenancies? Or what do you think the occupancy structure needs to be? Thank you.

Thanks, Dana. It's Katrina. And I appreciate you asking the question. As we think about rents, I think as I said in my remarks, we still believe that a small healthy fleet with good rent economics is incredibly important to our business model as we look to maximize both our strongly located fleet combined with our strong omnichannel and e-commerce – our omnichannel capabilities and e-commerce platform. That said, we do have some stores that need to be renegotiated from a rent structure standpoint. And so, that's where we are today is using this unique opportunity to go back in and leverage, as you say, whether it's co-tenancy abilities to renegotiate lease terms or whether it's just partnering with our landlords in these acute time to try and get some rent relief in our long-term structure so that we end up with a portfolio of stores that we think meet our profitability objectives. We haven't put a number out there. We're deep in those negotiations right now, but we do look forward to emerging from this with a profitable fleet that we think well complements our online business.

So let me just add to that, too, Katrina. We're pleased with the progress we've made with hundreds of landlords as we're reopening across the country as the right progressive partners are recognizing as we do that the world has changed. And that means that our customers have changed. And so, we want to create a mutually beneficial win-win structures with our rents and that's what we're seeing happen with our partners, which is quite good.

Got it. Just a quick follow-up on inventory. As you think about inventory by brand or by channel and the pack-and-hold that you have, how much of it is pack-and-hold? And have you ever had pack-and-hold levels like this before?

So, we're not quantifying the pack-and-hold. I will say, we've not had levels of pack-and-hold like this before. We feel quite good that the pack-and-hold consists of either ongoing basics or summer product that was not ever delivered to stores that we can keep on hand. We can either access it to deliver to stores or we can hold that and assort it into next year. And so, I think we feel quite good about the pack-and-hold. I'm not sure, Dana, if you can remind me the balance of your question?

And in terms of the inventory levels, how you think about inventories throughout the year? And does it differ by brand? Is Gap the brand that's the most over-inventoried as you'd like – from what you'd like to see?

No. I wouldn't say that at all. I think all of the brands have been very prudent in managing their inventory and we've taken care of the spring inventory glut that we had through the inventory impairment that we told you about today and we feel quite good as we think about inventory for the back half. As we – as the crisis hit, we were able to impact our back half inventory levels to lower demand and we're using our responsive capabilities to chase into the categories that are working and the brands that are working and fundamentally, as we've said, we're seeing good traction, particularly at Old Navy, where we have lots of flexibility to get back into demand.

Thank you.

And we'll go next to Mark Altschwager of Baird.

Good afternoon. Thanks for taking my question. So clearly a lot of important items on the agenda right now and I have to imagine certain items on your transformation agenda were put on hold during the crisis as well. Others, perhaps like store closures, were maybe accelerated. So, my question is, what do you think is a reasonable timeline to get from where the business is today to the optimal operating structure and store footprint of the future? Sonia, I think you talked about refashioning the company. I guess the question is, do you think the company could be refashioned by 2021, or is this more likely a 2022 story? Thanks.

Yes. Mark, it's a question, and I'll let Sonia add anything. We're not yet guiding to what we think the exit rate on store closures will look like. But we still do feel like we will make good progress, similar to the progress we had put out at the beginning of the year as far as Gap brand closure. So that work is all largely on track. That said, because of the current environment, we're actually using this opportunity to talk through really virtually almost every property and lease with every landlord to see if we can get after whether it's rent, the lease term or whether we would actually just close the store. So, we're just knee-deep with all the landlords today. It's very hard to say how long it will take, but do know that it is one of our primary objectives is to use this opportunity to partner with our landlords to come out with a better profitability for the company.

Yes. Let me just add that – some thoughts on that. Thanks, Katrina. One of the things, as we studied past crises, and we have done that deeply, the most important thing on strategy is not to set the strategy too early. It's to stay flexible and to very clearly and acutely listen to what is happening, what our customers are doing, and that's what we're intending – that's where we intend to operate right now. What we know is our omni capabilities, stores, online working together is critical for us and we know that we will be invested in that capability holistically, that ecosystem around the customer, that fuel our powerful brands. And 60 million customers and growing with growing frequency, it's an enviable customer file that we intend to capitalize on. Those are really the top three assets we see, our powerful brands, our customer file and our omni capabilities. Those three together, enabled through our lean operations and our values, which values matter today more than ever are going to be the elements that shape and refashion this company and how that plays out. I don't know that we're ever done on that front. It's an evolution. It's a daily work to move toward those aspects.

Thank you. That's helpful. And if I could just ask a quick follow-up on digital, it looks like trends accelerated nicely in April and into May. Just any color on the various drivers there? Whether it's pent-up demand, stimulus or some of the markdown activity? And what do you think is a reasonable expectation for kind of a normalized digital run rate in the months ahead?

Listen, I think that if we could offer the customer, it would be a great thing. But what I will say is this, we – as soon as we turned our shift from store and as we started to fully activate and lean into our online business we saw sequential week-over-week, month-over-month growth. And how that normalizes as our stores fully open is something we're actively looking at. We do expect being such a large e-com business, $4 billion last year, and that's significantly growing, that gives us advantage in share of voice out there in the marketplace against smaller players that we fully intend to capitalize on.

Great. Thanks for all the detail and best of luck.

And we'll hear next from Matthew Boss of J.P. Morgan.

Great, thanks. Maybe to dig a little deeper into recent trends, what level of productivity are your Old Navy stores in particular reopening at relative to that 70% total company metric that you gave? And then maybe just on the 100% e-commerce growth in May, what are you seeing at Old Navy and Athleta relative to the Gap brand?

Yes. Those are great questions. So, as it relates to productivity, I think it's fair to say that Old Navy, given the strength of the brand, as well as the fact that Old Navy is positioned in off-mall locations where the customer is likely more confident shopping, as well as the curbside pickup capability is easier to activate, we're seeing a meaningfully better trend in productivity at our Old Navy stores. As you can imagine stores that are in malls are harder to get people to shop at. And so, you would imagine that maybe Gap and Banana are lower productivity, that averages out at that 70% – about 70% mark that we're out today. But it's early days, we are just in the process of reopening. We're pleased to be at 1,600 stores today open, but that's 55% of our fleet. And so, we have a ways to go. And then as it relates to online, I would say, similarly, whether it's Old Navy, who has the advantage of being a family brand servicing kids and baby, as well as in the value space, you can imagine that seeing strong trends. And then Athleta with strong brand health and the athleisure trends being so strong is also seeing great performance. But I think we're also pleased that we – Sonia can potentially talk about it, we made some changes at Gap brand and we are seeing some meaningful improvement in our Gap brand online business as well.

Yes. Gap brand's online strength has built and we're quite happy with it. We don't break it up separately, but we're quite happy with it for May. And as you know, Gap has been a challenge for us and we're focused on five elements there really the first is leveraging our online growth; the second is store fleet rationalization; third is rightsizing our resources with the 25% headcount reduction, I mentioned; the fourth is new products and segments like Gap team; and the fifth is cost-effective, our asset-light opportunities like the IMG licensing. We think this coupled with proven leaders in place in design merchandising and online are going to fuel this business as we rightsize it and build it for health.

Great. And then maybe just to follow-up on gross margin, what are you seeing broadly from a pricing and promotion standpoint on reopening in the mall? Maybe just help us to think about mark downs in the second quarter versus back half of the year as you see it right now?

Yes. I mean, interestingly, it seems as though, I don't know. But it feels like a lot of people got many of the inventory issues behind them. And so, while there will be promotions in the second quarter, I'm not sure that they will be meaningfully different than the first quarter. I think the commentary we put into our script was just to ensure that the fact that we are growing our online business so high in the second quarter, but that the inventory is being serviced from stores, we did nod to the fact that we do have an unusual amount of fulfillment costs to consider, but beyond that, from a promotional environment, largely the same likely.

Great. Best of luck.

And we'll hear next from Kimberly Greenberger, Morgan Stanley.

Great. Thank you so much. I wanted to just follow-up on the productivity of stores as they're reopening. Are you seeing any geographical variance as you're opening in terms of the productivity of the new stores across the United States? Are you seeing any sort of differences? And then maybe if you could talk about globally what you're seeing, that would be helpful as well?

We've seen – I'll start with global, since the pandemic hit China first, as we – we've seen a nice recovery in our China business month-over-month, and the omni business there now is really pivoting toward managing in a more normalized fashion as we look into Q2, which is nice to see. As Japan's reopen, we've seen a better than expected rebound in our stores demand and pent-up demand. And then as our stores have opened across the U.S., really the factor of a combination of the few things, one is real estate type, the second is weather, the third is consumer sentiment as it relates to safety. And so, we've seen some early on good performance in the south and the west with the weather signaling the need for summer clothing. East and the Northeast in particular is little bit lagging. And yet, we expect that as those stores open up and as the consumer wants the seasonal shift and as kids grow and need clothes that's all – that's going to play out.

Great. Thanks so much. And I just wanted to follow up, Sonia, with your – the sort of vision you laid out with regard to the responsive capabilities that you have built and continue to build in your supply chain. And I wanted to ask, if you could sort of wave a magic wand and get to your destination on how much inventory you would be ordering upfront on more standard kind of lead times versus what percentage of inventory you ultimately expect to be able to use that responsive capability for? Is it like a 70-30 split or if you could just help us understand what the end goal looks like? And then where are you now? What sort of that split now? Thank you so much.

Yeah. Thank you for the question. The inventory is complicated space right now, especially as we try to match supply/demand across our multiple brands. But what I will say is this; we have really leaned into accelerating our responsive expectations in each of our products – in each of our brands and moving as fast as we can to – faster and more quicker order placements so that we are agile in matching those two in terms of matching supply and demand. And as quickly as we went after masks, it's the great example of our fast and responsive supply chain across all of our brands, when we saw that as both a need for healthcare workers and as a customer need, we activated our responsive supply chain very, very quickly. So, I think we are pleased with the acceleration that we're seeing. As far as the end state, like I said earlier, I'm not sure there is an end state. We want faster and faster and more and more responsive and that's what we will be aiming for.

Thank you.

And we will go next to Jay Sole, UBS.

Thank you so much. And so, my question is, does the consumer gets acclimated to all the great deals that they're seeing out there? How do you think fiscal 2021 will look in terms of your ability to return to normal pricing that you're used to and get the gross margin back, specifically the merchandise margin back to where it was in fiscal 2019? Thank you.

Yeah. Thanks, Jay. I mean, I think as Sonia said, we believe we have a lot of assets as they relate to strong brands, as it relates to very strong and growing customer base that we intend to speak to, not through pricing and promotion as much as through experience, brand stories, loyalty, the other things we have in our arsenal to be able to drive our business. And so, I don't think we're as concerned about the long-term promotional aspect of the business and expect that – It seems like so far the consumer is snapping back fairly quickly. And so, really our role is in continuing to drive healthy brands with great capabilities and the appropriate ways to be speaking to that consumer about why to shop with us more frequently as we look to drive lifetime value with those customers. So I don't think we're as concerned about the promotional environment, but we'll see how it plays out.

Got it. And then maybe can you also just talk about SG&A in the second quarter, because in the first quarter you called that $484 million? If we take that out, plus the actions that you took, you've already talked about it quite a bit. Can you give us a color – give us an idea of how much SG&A will be down in Q2 relative to where it was ex the one-time items in Q1?

Yes. So we're not quantifying that. I think in the speech we tried to give you some of the puts and takes, right? We've made some pretty meaningful decisions around headquarters reductions and we quantified that for you. We also are closely monitoring marketing, but we haven't quantified. We've been pivoting our marketing expense from store traffic driving marketing into digital marketing. And so, we've been cutting as appropriate, but also ensuring that we're driving our digital channels. So we're watching that prudently and certainly, by brand it will differ, but we're looking at marketing closely. And then the other big line item is stores expenses. And as we reopen stores, we will see expenses coming back into the business. And as we said, those are likely to be a little higher. We are all being very careful about metering and extra people at the doors and in the sitting rooms. And, in fact, we're getting great customer response from them feeling safe shopping in our stores, but that will result in higher operating expenses. So there's lots of puts and takes and we'll see how the quarter plays out. But what we have said sort of more broadly is, we understand in this uncertain time that we are committed to really watching every dollar of SG&A to ensure that we are prudently investing in growth, but also being careful as we watch the uncertain environment play out.

And I would just add that one of the things we did – one of the things I did in terms of organizational structure, as I stepped into the role, the first week, in fact, is, we structured the leadership team and the priorities against some of these priorities that I've talked about, powerful brand, focus on customer, and omni capabilities and then the lean and mean operations that are going to be essential to continuously managing down SG&A. So we have consolidated many of our large operation to – and stood up a value office in order to continuously improve on the SG&A front. And while the quarters might be lumpy, we're setting a new standard and expectation around SG&A as we move forward with this company.

Got it. Thank you so much.

And we'll hear next from Paul Lejuez of Citi.

Hey. Thanks, guys. I'm curious if you could talk about Gap and Banana, and the stores that have been reopened. Any big differences that you're seeing between outlets and closed malls, street locations? Also, one follow-up on the pack-and-hold, is that across brands? Just curious if that's kind of in proportion with the percent of sales that each brand represents. Sorry if I missed that. And then, just curious on the $484 million charge, how many stores did that touch? Thanks.

Thanks, Paul. So, as it relates to the store reopenings for Gap and Banana Republic, as you can imagine, similar to the Old Navy discussion, the outlet and the outdoor malls are performing better than indoor malls. Your second question, I'm not remembering but your third question, we haven't quantified the number of stores that are related to the store asset impairment. So, it's just the number that we've given you, not the number of stores.

Yeah. The second question was pack-and-hold across brands.

Yes. Sorry. And so, as it relates to pack-and-hold, it's different by brand, it's not proportional to brand. And honestly, it's just – it's hard to quantify by brand, because it's sort of moving around, as you can imagine, as demands unfold, we could go use the pack-and-hold. So, we haven't quantified it by brand.

Okay. Thank you. Good luck.

And we'll move to our next question from Kate Fitzsimons of RBC Capital Markets.

Yes, hi. Thanks very much for taking my question. I guess, Sonia, you had alluded to earlier, approaching, I believe, Gap brand into the back half with more narrow and deeper assortment. Just kind of curious how you are thinking about the merchandise strategy, ideas or flashes of newness that maybe we could potentially see into the back half just maybe to reengage the customer? And then just as we approach back to school, denim is obviously a very important category for you guys. Just how are you thinking about the denim business approaching that for the back half, just given some of the category commentary we've heard here in Q1 about an emphasis on lounge and casual, et cetera?

Yes. Thank you. So, Mark Breitbard is leading the brand is hands on actively looking at all those opportunities around the merchandise direction. I know he believe that Gap stands for modern American optimism and focusing on the core items that the brand's all been famous for, as you say, playing into the kids and baby business, the denim business, those essentials that are modern and available and American and classic. Those are the aspects that will shape the assortment. And the assortment is going to get more and more focused and deeper. And so, that is the strategic direction. And the specifics, we'll follow up and I know Mark will share more at the right time.

Great. And just on denim, just higher level views on the category?

We think we're well poised to drive denim share across the company. And we're one of the largest players. And so, as it relates to denim and Gap, I think that it's a very important category for the brand and will continue to have an important role.

And that will conclude the question-and-answer session. I'll turn the call back to our presenters.

Thank you. You can disconnect.

And thank you. That does conclude our conference. We would like to thank everyone for your participation. You may now disconnect.