The Gap, Inc. (NYSE:GPS) Q2 2023 Earnings Call Transcript

The Gap, Inc. (NYSE:GPS) Q2 2023 Earnings Call Transcript August 24, 2023

The Gap, Inc. beats earnings expectations. Reported EPS is $0.34, expectations were $0.09.

Operator: Good afternoon, ladies and gentlemen. My name is Brianna, and I will be your conference operator today. I would like to welcome everyone to the Gap Inc. Second Quarter 2023 Earnings Conference Call. [Operator Instructions] I would now like to turn your call over and introduce your host, Emily Gacka, Director of Investor Relations.

Emily Gacka: Good afternoon, everyone. Welcome to Gap Inc.’s second quarter fiscal 2023 earnings conference call. Before we begin, I’d like to remind you that the information made available on this conference call contains forward-looking statements that are subject to risks that could cause our actual results to be materially different. For information on factors that could cause our actual results to differ materially from any forward-looking statements as well as the description and reconciliation of any financial measures not consistent with generally accepted accounting principles, please refer to the cautionary statements contained in our latest earnings release. The risk factors described in the company’s annual report on Form 10-K filed with the Securities and Exchange Commission on March 14, 2023 and any subsequent filings with the Securities and Exchange Commission, all of which are available on gapinc.com.

These forward-looking statements are based on information as of today, August 24, 2023, and we assume no obligation to publicly update or revise our forward-looking statements. Joining me on the call today are Executive Chair, Bob Martin; Chief Executive Officer, Richard Dickson; and Chief Financial Officer, Katrina O’Connell. With that, I’ll turn the call over to Bob.

Bobby Martin: Thank you, Emily, and good afternoon, everyone. Before Katrina shares our second quarter results, I have the pleasure of welcoming our new CEO, Richard Dickson, to the call. There’s no denying that Richard was destined for this role at this moment. His experience as a transformational brand builder makes him a perfect fit for this great company. He is uniquely qualified to lead and carry out the transformative work already underway and more importantly, he is the right leader for tomorrow, defining the future of Gap Inc. Appointed to our Board of Directors in November of 2022, he’s had a view into how we are changing the way we work and the results we deliver. But what energizes him most is building a new legacy for our renowned portfolio of brands, one that matters to our customers, employees and shareholders.

And before I hand off, I want to say thank you to our entire Gap Inc. team for their commitment to the success of this company and their tenacity and care for our brands, for embracing operational rigor and regaining the product and customer obsession with an eye on modernizing the way we work, all of which becomes a strong foundation for what’s ahead under Richard’s leadership. I have great belief that Richard and this team will define a very bright future for this company. So, with that, I want to welcome Richard Dickson, the new CEO of Gap Inc. Richard?

Richard Dickson: Well, good afternoon. This is my third official day as CEO of Gap Inc. So first, let me begin by thanking Bobby, the Board and the entire Gap Inc. organization for the opportunity to lead this incredible company. And thank you, everyone, for joining us today on our second quarter 2023 earnings call. Now many have asked me, why Gap Inc. and why now? So, let me start by saying that I have admired Gap Inc. and its brands Old Navy, Gap, Banana Republic and Athleta for decades as a customer, a brand builder, and most recently, as a Board member. Those of you who know a bit about my career know that I’ve always been drawn to companies and brands with storied legacies and powerful purposes. And in apparel, there’s no equal to Gap Inc.

When Don and Doris Fisher opened the very first Gap store in San Francisco in 1969, little did they know, that they had tapped into the zeitgeist in a way that would democratize and define American style. Suddenly, great clothes were accessible, stores were experiential, self-expression could be an everyday pursuit, open to all. Talk about a game changer, Gap did that. Creating an opportunity from the currents of culture has been a hallmark of Gap Inc. for more than 5 decades. Over the years, our brands made jeans, khakis, kidswear, suits, yoga pants, you name it, into massive trends through great design, great marketing and an all-out obsession with our customer. Fast forward to today. The apparel and retail landscape has changed dramatically, evolving at an even quicker pace now it requires that great brands run at the speed of culture to maintain relevance.

What has not changed is the customer’s desire for fashion they can make their own. We will take that one step further, making what we do, what we stand for, and what we sell, relevant. As anyone in this industry will tell you, clothing is a rational need, while fashion is an emotional want. Our brands will balance both. Going forward, I’m confident that we have the scale, talent, and determination to spark huge, defining trends again. Think about it, Gap Inc. is the largest specialty apparel company in America. An empowered community of more than ninety thousand people who apply their talents to Gap Inc. and our brands producing about nine hundred million units a year. Our brands draw 600 million visits to stores, and 1.4 billion to our sites online each year, making Gap Inc.

the #2 player in US apparel ecommerce. These customers, across multiple generations, turn to Old Navy, Gap, Banana Republic and Athleta to help them step out everywhere from schools and studios to offices and date nights. So, our brands matter. But they can matter even more. In my previous role in toys and entertainment, we always strived to make consumers fans and to grow those fandoms. And I want to apply that approach to our portfolio of brands. A virtuous cycle where our products and experiences motivate belief and loyalty that fans then badge and amplify in culture, growing the fandom, validating, and inspiring us to even greater creativity and monetization. It works because everyone wins. Gap Inc. brands already have incredible fans. Our job now will be to excite and delight them even more, growing their numbers and the value of our brands.

The comprehensive transformation effort that Bobby initiated has been an important step in that direction, streamlining operations so that we can focus on growth-driving initiatives. And Katrina will take you through that progress, in addition to the quarterly performance, in detail. But before she does, I want to acknowledge that restructuring is challenging. And that change of this magnitude doesn’t come fast. Transformation is difficult. Still, our people, at every level of the organization, have stepped up, made tough calls, and championed the progress we’ve made so far. And we’re going to keep going. As we continue to focus on strengthening our financial footing, we’re now going to build on that progress, accelerating our efforts to drive profitable growth by unlocking the value in our brands.

This time, we’ll do it differently with a clear focus on brand revitalization, redefining our brands meaning to consumers, focusing on creativity designing for relevance as a pursuit rather than a goal, building to quality and leveraging our remarkable legacy to shape an exciting new future. That’s my passion. It’s why I’m here and why I’m here now. And I know that our teams are just as passionate and committed to making it happen. In the quarters to come, I’ll share specific priorities and plans. What I can tell you today is that I’m intent on reigniting a creative culture at Gap Inc. that is a magnet for the industry’s best talent, including the great creative talent we already have, recommitting each of our brands to a distinctive brand purpose that aligns with customer values and sets them apart, reorienting our brands around both the art and science of design-centric thinking informed by consumer insights in an absolute obsession with our customer, reengaging in the cultural conversation with hyper-relevant products and ideas that inspire constructive dialogues and rethinking how our brands show up in store and online with customer experiences that excite and delight.

Most of all, mattering to our people, our investors, our communities, and the world. In the coming weeks, I look forward to spending time in every part of the organization. Our headquarters offices, stores, customer support centers, DCs, and with partners in key regions of the US, and globally. Meeting the people behind our brands, the customers who shop us, and you, our shareholders. Listening, learning, experiencing it all first-hand in order to get grounded and even more defined about where we’re going. I’ll wrap up by saying that my start date was deliberate. Just as August 22, 1969, was the milestone that created this remarkable company, I want August 22, 2023, to mark the start of an exciting new chapter for Gap Inc. One that celebrates our past as we pioneer an extraordinary future.

Thank you. And I’ll now hand-off the call to Katrina.

Katrina O’Connell: Thank you, Richard. It has been a pleasure working with you in your role as a Board member over the past 9 months, and I am thrilled to partner with you in your new role as CEO. Let me start with some reflections on our financial performance before I dive into more detail. Notably, we continued to strengthen our balance sheet and improve cash flows, reducing inventory 29% year-over-year, generating over $300 million of free cash flow, further paying down our ABL balance, and ending the quarter with cash and equivalents of $1.4 billion, nearly twice as much as last year. Even in a choppy consumer market, each of our brands maintained or gained share during the quarter, fueled particularly by strength in our women’s business through great style and relevant fashion.

We delivered net sales within our previously communicated guidance range despite a weak apparel environment. We substantially completed the organizational changes that we previewed earlier this year which we continue to expect will drive about $300 million in cost savings annually but more importantly will change how we work, allowing teams to be more consumer-centric. We continued to successfully recoup the excess air costs we incurred during the pandemic. That combined with improved unit sell-through rates driving AURs enabled meaningful gross margin expansion despite the inflationary cost headwinds we have faced. We believe the actions to improve our operations and shore up the foundation of Gap Inc. continue to position us well as we enter the second half of fiscal 2023 and beyond.

While we are pleased with this progress, we are mindful of the mixed economic and consumer environment in which we are operating. With that backdrop, we continue to plan the business prudently. And the outlook we are providing today for both the third quarter and fiscal 2023 does contemplate the headwinds we continue to navigate in the second half of the year while also taking on new challenges like the resumption of student loan payments. Let me start now with our second quarter results. Net sales of $3.5 billion decreased 8% versus last year in the range of our expectations for second quarter sales to be down mid- to high single digits. Store sales decreased 7% from the prior year. Online sales decreased 11% versus last year and represented 33% of total net sales in the quarter.

As a reminder, the sale of Gap China completed at the beginning of the first quarter of fiscal 2023 had about a $60 million or 2-point negative impact to net sales growth. There was also a 1 point foreign exchange headwind. Excluding these factors, total company net sales would have been down about 5%. Comparable sales were down 6% in the quarter. In spite of the sales declines, we’re pleased to report that all 4 of our brands gained or maintained market share during the second quarter, with particular strength in women’s. We know that regardless of market conditions, strong brands, brands that matter, win. So we remain focused on the levers and opportunities in our control to deliver on behalf of our customers, employees and shareholders.

Let me now provide some sales color and highlights by brand. Starting with Old Navy. Net sales in the second quarter were $1.96 billion. Both net sales and comparable sales declined 6% versus last year. We’re pleased that Old Navy again modestly gained share in the quarter despite increased softness in the active category as well as continued slower demand from the lower-income consumer. We believe that Old Navy remains well positioned given its value orientation in the marketplace. The Old Navy team has lined up great marketing, product and value to compete in the important back-to-school season. Turning to Gap brand. Gap brand total sales of $755 million were down 14% versus last year and comparable sales were down 1%. Excluding the negative impacts to sales of 7 points related to the sale of Gap China, 2 points due to the shutdown of Yeezy Gap and the estimated 1 point from foreign exchange, net sales were down 4% versus last year, predominantly driven by store closures in North America.

Women’s was the standout segment in the quarter, outpacing the market as the brand’s reinvented icons are resonating with consumers. Gap continues to make great strides with exciting collaborations and partnerships as the brand executes against its strategy to reimagine its product icons in new and exciting ways. Earlier this month, Gap brand partnered with LoveShackFancy on a limited-edition, multi-category capsule for every generation. The collaboration merges Gap’s iconic styles with LoveShackFancy’s vintage-inspired florals and feminine silhouettes. This most recent collaboration is a prime example of how Gap’s strategy of partnering with relevant brands and individuals can create buzz and marketing for the brand, reaching new consumers and garnering more premium pricing.

Turning to Banana Republic. Second quarter sales of $480 million declined 11% year-over-year. Comparable sales were down 8%. Revenue remains impacted in the short-term as the brand laps an outsized benefit last year driven by the dramatic shift in customer preferences. BR continues to make impressive strides in its evolution to a premium lifestyle brand. Fine fabrics, like linen, cashmere, and leather showed signs of strength in the quarter and the brand expects to maximize them in the back half of the year. Banana Republic’s transformation towards a more evolved lifestyle position is coming to life through an elevated fashion aesthetic and more full price selling. As we look to the future, we are excited to see the brand extend its vision and refined aesthetic to other addressable markets with BR Home, including the launch of premium bedding, rugs, pillows, and décor in March, and the upcoming debut of a broader home offering this fall.

Athleta sales of $341 million declined 1% from the prior year. Comparable sales were down 7%, an improvement in trend from Q1. Sales in core performance bottoms, the critical backbone of Athleta’s assortment, accelerated throughout the quarter and outperformed total brand sales. Athleta’s positioning, empowering a community of active women and girls to reach their true potential through the Power of She is as relevant and impactful as ever. The work the team has been doing to improve product presentation, customer experience, and creative in the short term, optimizing online marketing, site merchandising, and resetting store floors in key markets emphasizes the performance DNA that Athleta is known for. We are excited to welcome Chris Blakeslee to the team.

As a proven leader in driving growth and innovation in the active apparel and wellness sector, most recently at Alo Yoga, we look forward to the work he and the team will drive to bring the Athleta brand to its full potential over the long-term. Now to gross margin in the quarter. Gross margin was 37.6%, an increase of 310 basis points versus last year’s reported gross margin. Compared to last year’s adjusted rate, gross margin expanded 160 basis points due to merchandise margin expansion of approximately 260 basis points, which was slightly ahead of our expectations, partially offset by ROD deleverage of 100 basis points. Drivers of the margin rate expansion were as follows: approximately 200 basis points of leverage as we lapped last year’s elevated air freight and drove our normalized air expense down; approximately 200 basis points of leverage driven primarily from improved promotional activity relative to last year; approximately 140 basis points of deleverage related to inflationary cost headwinds, which was better than our prior expectations of approximately 200 basis points as we realized improved ocean freight rates; and ROD was flat on a nominal basis compared to last year but deleveraged 100 basis points due to the lower sales volume.

Now let me turn to SG&A. Reported SG&A in the second quarter was $1.2 billion and included $13 million in restructuring charges related to our headcount actions. On an adjusted basis, second quarter SG&A declined 8% and leveraged 10 basis points versus last year, driven mainly by lower advertising expense, payroll and technology investments. Reported operating income was $106 million. Adjusted operating income, which excludes restructuring charges, was $119 million in the second quarter. Adjusted operating margin improved 170 basis points from last year to 3.4% in the quarter, driven by the 160 basis point improvement in adjusted gross margin and 10 basis points of adjusted SG&A leverage. During the second quarter, we recorded a benefit to both tax and net interest as a result of a transfer pricing settlement related to our sourcing activities.

Reported EPS was $0.32, adjusted EPS, which excludes restructuring charges, was $0.34. Share count ended at 369 million. Turning to balance sheet and cash flow, starting with inventory. Ending inventories declined 29% in second quarter versus last year. This includes a 9 percentage point decline related to in-transit as we lap the prior year supply chain challenges and 6 points of decline related to releasing the majority of our pack and hold inventory balance. The remaining 14-point decline was driven by more efficient inventory management. As you know, we made significant progress on reducing inventories as we exited fiscal 2022. We remain focused in fiscal 2023 on moderating buys and utilizing our responsive levers. As a result, we are planning for year-over-year inventory to be down generally in line with year-to-date trends at the end of third quarter.

Quarter-end cash and equivalents were $1.4 billion, an increase of 91% from the prior year. Year-to-date net cash from operating activities was $528 million, driven primarily by lower inventory levels. Capital expenditures were $199 million. We are pleased to have generated free cash flow of $329 million year-to-date. As we told you last quarter, we expect to be positioned to pay down the $350 million draw on our asset-backed line of credit this year. During the quarter, we paid down $200 million and intend to pay down the remaining $150 million balance by the end of the year. We remain committed to delivering an attractive quarterly dividend as a core component of total shareholder returns. During the quarter, we paid a dividend of $0.15 per share.

And on August 16, our Board approved maintaining that $0.15 dividend for the third quarter of fiscal 2023. Now turning to our outlook. We are all well aware of the mixed economic data and uncertain consumer trends in the marketplace, including the new dynamic regarding student loan repayments beginning in the third quarter. As a result, we continue to be prudent in our approach to planning in light of what remains an uncertain macro environment and choppy consumer backdrop. We now anticipate fiscal 2023 net sales inclusive of the 53rd week to be down generally in the mid-single-digit range compared to $15.6 billion in net sales last year and similar to our first half 2023 sales performance. The extra week is estimated to add approximately $150 million to fourth quarter and fiscal 2023 net sales.

Specific to Q3 sales, we’re encouraged by trend improvements as we exit second quarter and into August. However, we remain mindful of two important dynamics for the quarter: First, we are lapping tougher sales comparisons from last year; and second, as mentioned, we remain measured in our outlook. With these dynamics in mind, we are estimating third quarter net sales to be down in the low double-digit range compared to the $4.04 billion in net sales last year. Turning to gross margin. Starting with the full year compared to the 35% adjusted gross margin in fiscal 2022, gross margin expansion in fiscal 2023 is expected to be driven by the following factors: an estimated 200 basis points of leverage as we lap last year’s elevated air freight and continued to drive down normalized air expense; at least 100 basis points of margin benefit as a result of our better inventory position and expected improved promotional activity compared to last year; approximately 10 basis points of inflationary cost deleverage versus last year.

As we look to the second half, we expect the inflationary deleverage in the first half of the year will shift to leverage in the back half as we benefit from both improved commodity costs and ocean freight rates; and ROD as a percentage of sales is now planned to deleverage roughly 70 basis points compared to last year. For the third quarter, we expect gross margin to be generally in line with last year’s adjusted gross margin of 38.7%. We anticipate lower inflation and air costs slightly below normalized levels are expected to offset approximately 150 basis points of ROD deleverage, and we expect that promotional activity will be largely in line with last year. Turning to SG&A. We now expect fiscal 2023 SG&A of approximately $5.15 billion, below our prior outlook of $5.2 billion, primarily driven by variable expense flow through on our narrow to fiscal 2023 sales.

SG&A in the third quarter is expected to be approximately $1.3 billion. We continue to expect capital expenditures of approximately $500 million to $525 million for the year. In closing, we were pleased to drive meaningful margin expansion and strong cash flow generation in the quarter and remain focused on delivering our fiscal 2023 outlook despite what continues to be a choppy consumer environment. I am looking forward to working with Richard and the team as we unlock the value of our important and iconic brands and position Gap Inc. back on its path towards sustainable, profitable growth and delivering value for our shareholders over the long term. With that, we’ll open up the call for questions. Operator?

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Q&A Session

Operator: [Operator Instructions] Our first question will come from Matthew Boss with JPMorgan.

Matthew Boss : Great. So maybe a two-part question. Richard, could you elaborate on the encouraging signs of progress that you see across the organization and maybe just as we think about opportunity for your concepts to take market share over time. And then Katrina, maybe just any way to elaborate on trends that you saw progress as the second quarter move forward? And maybe what you’re seeing today in terms of consumer behavior in August and into back-to-school?

Richard Dickson: Well, first off, thank you, Matthew, for the question. And I’ll start with saying again how excited I am to be here on my third day. What I can tell you in the context of where we are, first and foremost, is that these brands are incredible assets, Gap, Navy, Banana Republic, Athleta, these are truly some of the most iconic brands in the fashion industry. We serve such a broad-based consumer, which is such a strength as well, generations and backgrounds. We’ve got incredible story legacies, 54-year-old history. We created massive trends. When I look at the strength across the portfolio, as I mentioned in my opening remarks, we’re the #1 specialty apparel company in America, the scale that we operate with 600 million store visits, 1.4 billion online visits.

The scaled operations we have from our DC network and logistics, our vendor partnerships, which can provide us incredible favorable rates and service, our production, we produced over 900 million units annually, the stats and strength of the fundamentals of this business are pretty incredible. Clearly, the transformation work that the team has done has put us on incredibly better financial footing. As Katrina mentioned, again, $1.4 billion in cash on hand in the balance sheet, $300 million of cash flow, 30% less inventory. These are metrics that matter and ultimately, metrics that are incredibly encouraging in the context of our ability to build upon it and continue it and go forward. As I also mentioned, part 2 to the question in terms of where are the opportunities.

These are brands that truly matter. Now as I also said, they can matter more. And how to do that? I talked about reigniting the creative culture at Gap. We have extraordinary talent here. We are going to not only encourage the great talent to be unlocked in new and innovative ways, but we’re also going to become a magnet for the industry’s best talent. We are going to work very specifically with intent on creating distinctive brand purposes and ultimately really driving a consumer proposition that sets us apart from the competition and really leveraging, if you will, the art and science of this business, informed by consumer insights, but ultimately really obsessing over the consumer. There’s a lot of work ahead, but I’m incredibly encouraged with 3 days in around what we can offer and where we’re going ahead.

And obviously, in the days ahead, quarters ahead as well, we’ll get more details and look forward to sharing that with you.

Katrina O’Connell : Thanks, Richard, and Matthew. I think on your other part of your question, we saw sequential improvement throughout the quarter in where in July, we definitely saw more improvement than we had seen sort of in May and June. I think that mirrored a lot of what apparel showed overall and we’ve seen that improvement continue into August, which we’re encouraged by. Overall, what we’re seeing is that the women’s business, particularly at Gap and Old Navy has shown momentum shift and kids and baby as we’re in the important back-to-school period has also started off fairly well. So all of that is encouraging to see. And then as I said in my prepared remarks, we’re mindful, though, of the fact that we’ve seen the consumer still be pressured, especially at the low income range.

And we’re watchful of what I think is widely reported as the student loan repayment coming in the end of the quarter, which does primarily impact our Old Navy consumer.

Operator: Our next question comes from Paul Lejuez with Citi.

Paul Lejuez : Richard, you’ve been on the Board, so obviously in touch with what’s been going on operationally to some extent. So I’m curious what you think might be the lowest hanging fruit as you think about each of the brands. Also curious, big organization, you talked about scale. Profitability doesn’t quite match the efficiencies you would expect with such scale. So I’m curious what you think are the biggest inefficiencies of the company.

Richard Dickson: Yes. Thanks, Paul. Look, broadly speaking, it’s about really reigniting Gap Inc.’s culture to really empower creativity in my experience on the Board and certainly on the ground for 3 days running fast. Our teams are incredibly creative and they’re all in on this. They’re differentiating and strengthening our brands, being design-centric, being customer-obsessed and ultimately being culturally relevant. These are not necessarily new phrases and their common language, but these are the areas that we need to work upon and reignite and ultimately, really think about how our brands show up in-store, online with consumer experiences that really excite and attract drive demand and all of the variables that go into kind of balancing wants and needs that ultimately is kind of where fashion lies.