Gap Inc Q4 FY2020 Earnings Call

Please standby. Good afternoon, ladies and gentlemen. My name is James, and I will be your conference operator today. At this time, I’d like to welcome everyone to The Gap, Inc. Fourth Quarter 2020 Conference Call. I’d now like to introduce your host, Steve Austenfeld, Head of Investor Relations.

Thanks, James. Good afternoon, everyone, and welcome to Gap, Inc.’s fourth quarter 2020 earnings conference call. Before we begin, I’d like to remind you that the information made available on this webcast and earnings call contains forward-looking statements. For information on factors that could cause our actual results to differ materially from any forward-looking statements as well as a description and reconciliation of any financial measures not consistent with generally accepted accounting principles, please refer to Page 2 of the slides shown on the Investors section of our website, gapinc.com, which supplement today’s remarks as well as today’s earnings release, our quarterly report on Form 10-Q filed with the Securities and Exchange Commission on June 9, 2020, and any subsequent filings, again, all which are available on gapinc.com. These forward-looking statements are based on information as of today March, 04, 2021, and we assume no obligation to publicly update or revise our forward-looking statements. Joining me on the call today are Chief Executive Officer, Sonia Syngal and Chief Financial Officer, Katrina O’Connell. With that, I’ll turn the call over to Katrina.

Thank you, Steve and thank you everyone for joining us today. It’s nice to be with you as we wrap up 2020. I want to share comments regarding the fourth quarter of the year, but more importantly, provide our 2021 financial outlook as noted in our earnings release today. Following my comments, Sonia will then share her perspective followed by Q&A. We’re very pleased with our progress on our path to our sustainable economic model, which I outlined at our Investor Day in October. Let’s talk first about some key accomplishments from 2020 that put us well on our path to achieving our Power Plan 2023. First, we remained very pleased with the performance of Old Navy and Athleta, which grew 5% and 29% respectively in Q4. Old Navy gained share to become the number two apparel brand in the U.S., second to Nike, and Athleta surpassed $1 billion in sales and grew 16% for the full year despite the pandemic. Combined, they represented 63% of company sales in 2020 on the way to our target of 70% by the end of 2023. Their standout sales performance reflected gains in market share during the fourth quarter led by their brand strength, omnichannel offerings and relevant product categories. Sonia will talk more about how they compete to win a bit later. There’s meaningful progress at Gap brand. While total sales for Gap brand global were down in Q4, significantly impacted by pandemic-related market closures and restrictions in international markets, Gap North America delivered a 1% comp. This underscores the progress the brand is making in the product and operations of its core business. We’re pleased to have new leadership at Banana Republic. Sandra Stangl and her team will be focused on repositioning Banana Republic for a post-COVID world with relevant marketing and product. We are becoming digitally dominant. Our online business grew 54% in 2020 and closed the year at about 45% of total company sales up from 25% at the end of last year. At over $6 billion, our online channel is ranked number two in U.S. apparel e-commerce sales and when leveraged with our well located fleet is a strategic advantage in serving our customers through the omnichannel lens. Our fleet rationalization is on track and driving significant economic value. In 2020, we closed 228 net Gap and Banana Republic stores globally ahead of our 225 store closure target. These closures along with lease negotiations and rent abatement settlements, as well as higher online sales contributed to over 400 basis points of ROD leverage in Q4. We are progressing on our goal of improving the profitability of Gap brand as we partner to amplify through asset-light models. The Yeezy partnership is on track for launch in the latter part of the first half of 2021 and we continue to be excited by the creativity that partnership will bring to the brand. Our strategic review of Europe market is underway and we are in process on several licensing deals that we believe will provide great extensions to the brand. We have driven meaningful improvements in product margins with good pricing discipline and while freight and shipping costs, as well as pandemic headwinds have persisted, this margin expansion has provided a partial offset against these rising costs. Several expense levers, strategic store closures and a reduction in force early in the year helped us weather pandemic related costs this year, such as meaningful health and safety costs and allowed us to lean into demand generating investments such as marketing. Marketing has been a strategic investment this year, as we leverage this dislocated apparel market to gain market share. We’ve undertaken a strategic review of our Intermix business as we continue to focus on our $4 billion brands to drive a more profitable portfolio. And we have generated meaningful free cash flow in the quarter ending the year with $2.4 billion of cash on the balance sheet. Our reliable cash generation and strong balance sheet will enable us to continue investing in growth in 2021 through capital expenditures, while also returning to our longstanding practice of returning cash to shareholders through paying the previously approved dividends in the first quarter and initiating a new dividend in the second quarter. Recognizing the COVID-related challenges faced during 2020, I am very proud of our team and how we remain focused on driving these strategic initiatives to drive long-term shareholder value. As we look to 2021, despite the significant uncertainty that remains related to the COVID pandemic, we are pleased to provide a 2021 outlook today. For 2021, we expect to deliver earnings per share in the range of $1.20 to $1.35. I will provide more context regarding this range in a moment, but it’s important to note that the 2021 guidance range we are providing today was fully contemplated in our Power Plan 2023, and in the 2023 estimated 10% operating margin target we provided in October investor event. So let me move on to a recap of fourth quarter results starting with sales. Net sales for the quarter were $4.4 billion down 5% to last year and below our previous outlook. Fourth quarter sales were impacted by a mid-quarter resurgence in the COVID pandemic that resulted in unplanned mandated store closures and restrictions across Canada, Japan, China, and Europe, as well as new U.S. stay at home orders in select densely populated regions such as California and the Northeast, which impacted store traffic. The pandemic related impact to fourth quarter sales is estimated to be approximately 4 percentage points. In addition, the sales decline related to strategically planned permanent store closures had an estimated impact of about 5 percentage points. Overall store sales in Q4 were down 28% as a result of slower traffic in select U.S. markets, COVID-related closures and the strategic closures related to the company’s store rationalization initiative. Online sales grew 49% and contributed 46% of the sales in the quarter. We leveraged our omnichannel capabilities such as BOPIS and ship from store to serve the customer even as the pandemic surged. Comparable sales were flat in the quarter. Comp sales by brand are in our earnings press release. Turning to gross margin. On a reported basis fourth quarter gross profit totaled $1.7 billion and gross margin rate was 37.7%, nearly 200 basis points ahead of both last year and the guidance we provided last quarter. Our year-over-year margin expansion is as follows; ROD leveraged 400 basis points from rent and occupancy savings as online sales increased and as we continue to close unprofitable stores, favorably settled lease liabilities and derive benefit from rent negotiations and rent abatement resolutions. Merchandise margins deleveraged 210 basis points driven by 300 basis points of higher shipping costs associated with increased online sales and carrier surcharges offset by higher product margin due to lower promotional activities despite increases in air freight costs. Air costs were incurred in the quarter to navigate the port delays that mounted because of COVID imposed restrictions. Turning to SG&A. Fourth quarter operating expenses were $1.5 billion and 34.7% of sales, leveraging 640 basis points versus last year. Recall that last year had $501 million in one-time SG&A costs primarily related to flagship impairments as well as costs for previously planned separations from Old Navy. We have initiated a strategic review of our Intermix business as we reshape the profitability of our portfolio of brands. As a result, fourth quarter operating expenses include a $56 million trademark and long-term asset impairment charge related to the Intermix business. Excluding this impairment charge on an adjusted basis fourth quarter total operating expenses were 33.4% of sales in line with our previous guidance for SG&A for the quarter of 33% to 34% of sales. When normalizing for the Intermix impairment this year and the flagship impairment charges last year, fourth quarter SG&A dollars increased $60 million versus last year. Notably, store expense savings largely offset the investment in demand generation with nominal increase in expenses over last year, being mostly driven by real estate termination fees and higher distribution center cost. Consistent with our strategy, we generated store expense savings of approximately $133 million related to store closures and productivity efforts, partially offset by $40 million in higher health and safety costs to keep our employees and customers safe. These safety costs are likely to stay with us for the first half of 2021, but we are closely monitoring vaccination progress and infection rates, and we’ll continue to invest in the safety of our customers and employees as long as necessary. We invested in marketing as we pursue market share growth during this highly disruptive time in the apparel market. Marketing dollars were up $66 million year-over-year, and deleveraged 150 basis points. As a result, Gap, Inc. gained 0.7 point in market share in Q4 ending the quarter at 6% of total U.S. market share for the company. And we grew our customer file to 183 million global known customers. We incurred $19 million of costs in the quarter associated with strategic store closures, although from an earnings standpoint, these costs were essentially offset in gross margin through lower rent and occupancy. Turning to EBIT. On a reported basis, fourth quarter operating income totaled $134 million, operating margin of 3% leveraged 820 basis points versus last year’s reported operating margin due to the material year ago flagship store impairments and costs associated with the previously planned Old Navy separation. On an adjusted basis, fourth quarter operating income totaled $190 million with operating margin of 4.3%. Moving to taxes and interest. The effective tax rate was negative 204% for the quarter. Taxes were highly favorable in the quarter, reflecting changes in the estimated benefit associated with the enactment of the CARES Act and the impact of the non-recurring income tax benefit related to legal entity structure changes. These tax items in the quarter delivered an EPS benefit of approximately $0.45. For the year the effective tax rate was 40% and fourth quarter net interest expense was $57 million. Turning to EPS for the fourth quarter. Our fourth quarter reported earnings per share was $0.61 versus a loss of $0.49 in the prior year, including a current year benefit of approximately $0.45 from non-recurring tax items and approximately $0.12 in charges related to the impairment of the Intermix business as a result of a strategic review. Now, let me provide some perspective on inventory. Total inventory was up 14% versus fourth quarter of last year, despite the higher year-over-year inventory markdown; inventory is below last year, and we’re pleased with the current inventory composition. We are confident that first half assortments and the quality of the inventory composition will enable product margins in the first half of 2021 to be above last year’s levels. There were three main drivers of the year-over-year increase with the first two associated with the timing of inventory ownership. First about 10 percentage points of the increase resulted from inventory the company strategically held back in the first half of fiscal year 2020 due to COVID related store closures that will be reintroduced for sale during the first half of fiscal year 2021. While this does drive a temporary increase in our inventory balance, it was contemplated in our first half receipt plans, which were adjusted accordingly. Second, new COVID related U.S. port congestion and impacts on shipping lanes were unforeseen and contributed to higher year-over-year in transit inventory levels. And third, we continue to sell COVID related safety products, such as masks and hand sanitizers in the near term and owned this new category of inventory at year end. We also ended the year with inventory levels above our prior guidance. In addition to the impact from port congestion, the second driver of this increase is from longer living seasonless styles and basics that we purposely held at shallow promotions within Q4 to improve product margins, while we balanced deeper discounts on seasonally liable products. While this did increase our year-end inventory levels of non-liable and basic products, we will leverage our responsive supply chain to adjust replenishment within the first half of fiscal year 2021 and believe this strategy will enable us to maximize gross margin over the life of these products. Looking forward, we expect inventory levels to decrease as we reach the end of the first half and to end Q2 with inventory up high single digits. This inventory outlook includes the expectation of continued port delays causing higher in transit balances, as well as set-up inventory to support the Q3 launch of Old Navy plus product, a strategic growth initiative the brand is proud to launch. Moving to real estate and store closures. Regarding our previously announced real estate restructure program, our discussions with landlords have progressed quite well, and we are making quick and effective progress on our real estate goals. During the year we closed 228 Gap and Banana stores globally in line with our guidance of 225. In fiscal 2020, we incurred cash outlays of about $75 million related to closures. In 2021, we expect to meet our closure target of 75 Gap and Banana Republic stores in North America and estimate net cash outlays of about $135 million. We are still targeting to close about 350 Gap and Banana Republic stores in North America by the end of 2023. And we continue to expect total cash outlays of the program as shared during our October investor meeting to be about $210 million. For the full program as of the end of 2023, we continue to expect annualized pretax savings of about $100 million. This estimate does not include our strategic review of our Europe market. Fiscal 2020 capital expenditures were $392 million below our normal levels of investment as we responded to the pandemic impact on cash flows. Regarding the balance sheet and cash flow fiscal year 2020 cash flow was negative $155 million compared with positive $709 million last year. Notably following the challenges of the COVID pandemic earlier in the year, free cash flow during the last three quarters of the year was approximately $900 million. We ended the quarter with $2.4 billion of cash. We are committed to the uses of cash we laid out at our Investor Day. Number one, invest in growth through capital expenditures. Number two, return cash to shareholders, largely through a competitive dividend and number three, evaluate how we use excess cash to delever over time. In light of the continued pandemic uncertainty, we remain prudent in our approach to cash management with a balance between return of capital to shareholders, while maintaining financial flexibility to invest in the business. And our ending share count was 374 million shares. So before I turn it over to Sonia, let me touch on our financial outlook for 2021. While the biggest impact from a pandemic is likely largely behind us, we expect the lingering impacts as seen in the fourth quarter of international market closures and stay at home restrictions, including in Canada, China, Japan, and Europe, as well as U.S. COVID case counts persist, particularly in the first half of 2021. However, as vaccines rollout and stimulus checks begin, we currently view the second half of 2021 favorably reflecting a likely return to a more normalized pre-pandemic level. With that in mind, I would like to provide the following guidance for fiscal year 2021. Excluding costs associated with strategic reviews we are conducting in Europe or with our Intermix business, we expect earnings per share to be in the range of $1.20 to $1.35. Now let me provide you with some additional guidance metrics for 2021. We anticipate full year net sales growth to be in the range of mid to high-teens versus fiscal year 2020. We expect to deliver an operating margin of approximately 5% in 2021. The outlook for 2021 is consistent with the Company's Power Plan 2023 objective of achieving at least 10% EBIT margin by the end of 2023. We expect to open 30 to 40 Old Navy stores and 20 to 30 Athleta stores. And consistent with our strategy, we plan to close approximately 100 Gap and Banana Republic stores globally, including 75 closures in North America. This will put us at 75% of our targeted North America closures by the end of fiscal 2021. We expect the annual effective tax rate to be about 25%. Our reliable cash generation and balance sheet remains strong. As we look to 2021, our capital allocation philosophy and priorities remain consistent. First and foremost, we plan to invest adequately, but responsibly, in the business to drive growth. With that, we expect capital expenditures for the year to be about $800 million. We shift our capital spend to higher ROIC projects as we adjust our investments for higher returning customer facing growth initiatives, such as digital, customer acquisition programs like loyalty, DC capacity to accommodate online growth and store growth for Old Navy and Athleta. Second, we remain committed to returning to paying a dividend. With that, we will pay the previously declared and deferred Q1 fiscal 2020 dividend of just over $0.24 per share in Q1 of fiscal 2021. In addition, the company expects to initiate a new dividend in Q2 of 2021 at a level that balances the return of capital to shareholders with the financial flexibility to face continued uncertainty and investing growth. In light of the current uncertainty related to the pandemic recovery, we do not anticipate share repurchases in the first half of 2021. We believe this outlook reflects the company's progress, even amidst the challenging 2020, and as we transitioned to a strong 2021. And most importantly, it’s consistent with the strategic objectives and long-term goals we shared with you during our October investor meeting, including improving our cost structure, particularly through store fleet rationalization, strongly supporting the growth of our brand and returning cash to shareholders. Looking forward, we remain on track to delivering our 2023 EBIT margin target of about 10%. Our progress in 2020 and our guidance for 2021 continue to provide important milestones of progress on our journey towards that goal. Continued improvements beyond 2021 will be accomplished by progressing the following initiatives. One, completing our North America store closure plan. Two, funding and setting COVID costs such as health and safety. Three, completing strategic reviews of select international markets and domestic businesses. Four, making meaningful progress on reengineering fixed operating costs. Five, launching sourcing logic and inventory initiatives targeted at growing gross margins. As we look to defray growing pressures from the continued shift into online and fixed leveraging increases in marketing from 2020 and 2021, we made to proactively gain share. And so with that, I will turn the call over to Sonia.

Thank you, Katrina, and good afternoon, everyone. Before we look ahead, I want to take a minute to reflect on 2020. COVID-19 presented the biggest crisis to our company and our industry has ever faced. And alongside our employees, our customers, our communities, and the rest of the world, we faced challenges that defined a new path for everyone. It's also true that every crisis is an opportunity. And this one met Gap Inc. at a crucial pivot point. We used this opportunity to lead with our competitive advantages while embracing the values the company was founded on, to emerge in a place of strength and with a clear path forward. Our teams showed resiliency and the ability to try fast, learn fast and think big to meet customers’ needs. First, we gained meaningful market share quarter-over-quarter by investing in growth across our purpose-led brands, during this period of market dislocation. We grew our global known customer file by 14% in 2020 to over 183 million and introduced convenient new ways for them to shop with us by expanding our buy online, pickup in store capabilities, to curbside pickup and launching new payment methods like Afterpay and introducing our loyalty program. Our online business reached over $6 billion in sales and delivered 54% annual sales growth leveraging our powerful omnichannel platform. Following the shutdown, we reopened our fleet of more than 3,000 stores quickly while permanently closing a group of over 200 unprofitable stores as part of our fleet rationalization strategy. With the increased casualization of style, we played into our product category strength with disproportionate sales coming from active and fleece and kids and baby. We also quickly pivoted to produce masks, a new top category, which represented 3% of sales in 2020 and drove new customer growth. We've met our customer's e-commerce shipping expectations at scale with on-time delivery of approximately 130 million products well above the industry average. And finally, we helped develop the gold standard in health and safety practices, allowing employees and customers to feel confident working and shopping in our stores. Now, as we turn the page to 2021, we're pleased with the traction we're seeing in the business. However, we understand retail is highly volatile, and that we will continue to face challenges and that we will remain agile. I recently had the honor to speak with President Biden, Vice President Harris, and other members of the new administration alongside several other CEOs. I represented our business and broader industry discussing the urgent actions required to recover from this crisis and rebuild an equitable and inclusive economy. And while uncertainty remains, I'm confident in our agility and speed and flexibility, and I believe all that will serve us well. Through it all we understand this is a long game and are squarely focused on executing the Power Plan 2023 and delivering profitable growth in 2021. Let me walk you through how our brand strategy will show up this year, starting with the power of our brands. Each of our brands are poised to deliver growth to world-class branding, relevant product and unbeatable experiences that will inspire our customers to become loyalists, each with a distinct point of view deeply rooted in value. Let me first talk about Old Navy. Old Navy’s results were very strong in Q4, driving 5% sales growth year-over-year, while also delivering margin expansion. According to NPD Group, Old Navy has made continuous market share gains each quarter on a trailing 12-month basis. The brand's strong value proposition, leadership in key categories like active and fleece and kids and baby, and commitment to leading with values allowed Old Navy to win in today's dislocated market, and they will lean on these strengths moving forward. The future looks bright for Old Navy and we're confident in their ability to grow to $10 billion over the next three years. This year Old Navy will deliver on the democracy of style and its commitment to inclusivity with the rollout of plus to the entire store fleet later this year. We will focus on democratizing service to a differentiated experience powered by new and highly scaled omni capabilities, as well as their Navyist loyalty program that will accelerate value creation for both our customers and for our business. Next, Gap. Gap stands for Modern American Optimism, and we have seen customers respond well over the last year to a more consistent point of view, as we've leaned into relevant product and culture-defining conversations and creative. We are positioning Gap to win for the long-term by creating a profitable store fleet, a shift to digital and by delivering effortless style and quality in market share gaining categories and partnering to amplify brand reach. This transformation is well underway and we're excited to build upon it this year. The number one question Mark gets asked, and I as well, is about our YEEZY Gap partnership. We're on track to launch it in the first half of this year. And I'm impressed with how the team is unleashing their creativity and innovation in both the development of the product and the experience for the customer. We cannot wait to share with you. Additionally, we're excited about the licensing work underway with IMG and are set to deliver new categories like Gap Home and Baby Gap gear later this year. Moving to Banana Republic. Since the appointment of Sandra Stangl, Head of Banana Republic in December, the team is moving fast to position the brand for health by redefining affordable luxury and building a roadmap for growth that meets customer needs today and in the future. We're excited to see how this comes to life later this year. In January, we launched BR Standard, a collection of luxe performance wear, an elevated essential for everyday, more in line with current customer trends, as well as creative repositioning in February. That is beautiful and right for the brand. The team is also highly focused on the store experience, from transforming allocation of inventory to better align with our customer, improving digital merchandising and transforming our field culture from operational to one of style and service. And finally, Athleta with 29% sales growth in Q4 — we have never been more confident in Athleta’s path forward and its ability to reach $2 billion by 2023. Athleta is our highest margin business and like Old Navy has made continuous market share gains each quarter year-to-date. The brand's position in the growing active category and its powerful mission to support confident women and girls gives the team permission to grow in multiple directions, across product categories, digital and physical locations, internationally, and through distributed commerce by leveraging the power of our platform and portfolio. Athleta had two exciting product launches in January. First, they brought Freeport to the market using a rapid customer-centric product innovation approach that they will apply to other opportunities going forward. This was developed with a customer at the center. Next, to bring life to its mission of inclusivity, Athleta announced the expansion into inclusive sizing. For spring 2021, 70% of the Athleta collection will be available in sizes 1X to 3X. As part of this Athleta launched a new holistic brand campaign entitled "All Powerful," a multi-platform celebration of the beauty and power in all women. We believe both of these product expansions will be major growth drivers in 2021. Our vision is to grow our purpose-led billion-dollar lifestyle brands. And as Katrina mentioned earlier, in line with our strategy, we have performed a strategic review of the Intermix business. This move allows us to prioritize our strategic focus and resources behind the brands with the more potential and that generate the most sales and profits. Next, the power of our portfolio. Together our brands had huge reach, targeting approximately 80% of the $200 billion addressable apparel market. The power of our portfolio is extending that reach to new customers with each brand playing its part through creative differentiation, pricing segmentation and product expansion like teen, plus and sleep. It's also leveraging the brands’ collective power to make big product bets like we did last year with masks. We're also using that collective power to grow our customer file. I'm so excited about this—we've welcomed new customers and are building stronger relationships with the ones we have. As I've said before, it is our goal to turn every customer into a loyalist. We launched our Navyist, Gap Good, Banana Republic and Athleta rewards at the end of September, and in Q4 alone, enrolled 6.4 million new loyalists across the company into the program. One of the biggest value drivers for us in 2021 will be the full implementation and integration of our loyalty program across all of our brands this summer. We know members of our loyalty program outspend non-loyalty customers by more than 88%. This integrated program will offer our loyalists benefits across our entire portfolio while still providing unique and emotional brand connections. If we can get a customer from a single transaction to multiple transactions, to multiple channels, to multiple brands, we see value accretion at every step. Another focus across the portfolio is the profitability of our store fleet. We are on track with our fleet rationalization efforts across Gap and Banana Republic, while we're opening stores across Old Navy and Athleta to fuel growth. Additionally, we are moving forward with the strategic review of our Europe business, and we'll have more to share later this year. Finally, the power of our platform, powering our brands is the strength of our platform and capabilities at scale. Being number two in U.S. apparel e-commerce sales at $6 billion, we believe Gap Inc. is uniquely advantaged to win in digital. Our online business grew 54% in 2020 and closed the year at about 45% of total company sales. To meet the rising demand of online shopping and our target of increasing digital penetration to 50% by 2023, we're focused on personalization at scale and enhancing capabilities across mobile—all supported by a highly automated fulfillment network. Mobile has become our customer's preferred way to shop with us online, and we know it can deliver further degrees of personalization and inspiration as well as enable the entire omni shopping journey. We now have over 50% of traffic and 75% of sales annually through mobile. With mobile as the primary engagement platform, we're working quickly to create frictionless mobile shopping and new digital experiences as devices, networks, and customer preferences evolve. Fueling the growth of our online business is our investment in distribution center capacity. Last month, we announced plans to open a new state-of-the-art DC in Texas to support Old Navy's growing online business by delivering inventory faster and more efficiently to customers across the country. This new campus will allow us to meet the rising customer demand for online shopping. Key elements of our Power Plan will also take shape in our thousands of stores by making customer-facing improvements that will also help us reduce store operating costs. We will apply automation to key customer touch points that will enable greater levels of service and engagement with our shoppers, including exploring the introduction of self-checkout later this year. We will begin to work on optimizing our store operating model, starting with Old Navy, by leaning on lessons and talent from our distribution centers. Through store closures, strategic reviews, and our focus on reducing fixed operating costs, we are building a virtuous cycle where productivity can fuel demand generation and our investments in technology and marketing. As Katrina mentioned, we are making progress against our G&A and our efforts to systemize and digitize our operations will be the rocket fuel for growth across our brands. As America's largest clothing company with reach around the world and a collection of purpose-led lifestyle brands we're proud to create product experiences our customers love, while doing right by our employees, communities and the planet. We are led by our purpose, inclusive by design. And in the coming year are steadfast in delivering on our commitments to racial equality and increasing representation at all levels of the company. We fundamentally believe that diversity of experience, thoughts and perspective increases creativity and innovation, promotes high quality decisions and enhances business growth. Not to mention a deeper reflection of our customers. Today we announced that Salaam Coleman Smith has been elected to serve on the Gap Inc. Board of Directors. Salaam is a proven creator and innovator bringing more than 20 years of leadership experience from top brands and entertainment, including The Walt Disney Company, Comcast NBCUniversal and Viacom. She has the perfect blend of art and science, balancing creative vision with strong business insight. Salaam connects deeply to Gap Inc. values, having led one of the most diverse and inclusive management teams in her industry. We look forward to her energy, guidance and leadership as we work to serve and represent the voices and interests of millions of customers. Now, before I turn it over to Q&A, I want to thank the team. A year ago, I was asked to lead this incredible company and I could not be prouder of what our nearly 120,000 employees along with 2 million people around the world in our value chain have accomplished together. This year allowed us to unleash our potential and we're ready to deliver the next phase of work ahead. To the power of our brands, our portfolio, and our platform, we are ready to deliver profitable growth, value for shareholders and a future we can all be proud of. With that, I will open it up for questions.

Thank you. Our first question will come from Matt Boss with JP Morgan.

Great, thanks. So at Old Navy 7% comps, despite significant improvement in the markdown rate for the third straight quarter, I think now. So could you just speak to what you see driving the inflection at Old Navy, any structural changes with inventory and the sustainability of top line growth and the mid-teens margins at this concept in your view?

Yes. Thank you for the question. We're really pleased with the trajectory of the Old Navy business and the strong response to the product offering through 2020, and we think we've doubled down into the winning categories with excellent execution and we're investing in digital and traditional marketing with more to come. The strong active business saw phenomenal growth and is very well positioned to meet the rising demand for active and casual product. Kids and baby is another very bright spot for the brand, as Old Navy achieved the rank of the number one kids and baby brand in the segment. We are consolidating market share aggressively here. The brand has evolved the product offering, and we expect the launch of plus across the assortment later this year. The test results have been really positive. So proud of the work that the team is doing to give our customers what they're asking for and confident in the sustained momentum against our Power Plan 2023. Katrina, would you like to build on that?

What I would add is a couple of things. As Sonia said, they're advantaged in their value space with their democracy of style positioning, their creative execution has been excellent and they offer the products customers want like active, kids and baby. Looking forward, we're launching the Plus business in the back half of this year, which we think is really appropriate for acquiring new customers and servicing existing customers better, and also the loyalty capability we plan to launch in the back half of the year, which will help drive lifetime value with multi-tender loyalty customers. Regarding margins, the right product with a relevant brand and strong execution has allowed the team to pull back on promotions and use the strength of the brand and the marketing to drive sell-through on inventory. Structurally, we feel like there's nothing holding them back from continuing to deliver that. We're also looking at store productivity initiatives such as self-checkout and other mechanisms to drive more productivity in store. So we have great confidence in Old Navy's execution and what the future holds for them this year and beyond.

Just to build onto it: there are two main capabilities that will help drive consistency, which is very important for this business. One is the expansion of our loyalty program, which allows for repeat visits and a deeper relationship, and the other is the personalization journey that our tech investments are fueling. When you think about the huge reach of Old Navy and the sheer customer file and personalization continuing to progress, and having the ability to optimize product and price, the need for historical discounting methods is fading as we move into these more sophisticated and consistent capabilities. This is a big part of our capital investment this coming year, and we're excited to see how it transforms consistency of growth.

Great color. Best of luck.

Next we'll hear from Oliver Chen with Cowen.

Thank you very much. Regarding the loyalty program and the innovation there, how did you decide to do it as a platform versus pursuing individual brands and how would you speak to the intersection of speed, agility and supply chain relative to interaction measurement and/or lower hanging fruit that your loyalty program can achieve? Thank you.

Great question. We spent a lot of time on this. We have four major brands and we also know the power of our platform and portfolio. We're solving for the 'and,' not the 'or.' Our loyalty design creates intimate, emotional brand-level engagement and offerings, while also enabling customers to get benefits across brands. We've been thoughtful about what offerings we give customers depending on their preferences. As it links to supply chain, one of the things we are using loyalty for is to tier fulfillment based on membership level—if you're a bronze, silver, gold member, for example. That will allow us to optimize the speed of delivery and fulfillment based on our best customers and manage fulfillment costs effectively while pleasing our most valuable lifetime value customers.

Thank you. And just a follow-up, reintroduction of inventory as you do that, how does that intersect with the trends that you're seeing now? And also the promotional environment in terms of optimizing reintroducing of inventory that you held back in a dynamic environment?

We love the inventory that we held back last year. We were very thoughtful about what we held back to make sure that it would be relevant now, and we believe it is. It's already coming to life in our stores as we speak and we're seeing good acceptance. That's been contemplated in our inventory buys for Q1 in terms of seasonal relevance and integration.

Thank you very much. Best regards.

Next we'll hear from Ike Boruchow with Wells Fargo.

Sonia thanks for the details on the outlook. I was wondering if I could ask something there. So the $1.20 to $1.35 I believe you mentioned that it excludes any actions around Intermix or the European business of Gap. Could you frame it up for us, if you could let us know what those two businesses currently drive on the P&L?

Yes, I'm glad you caught that, because it's really important. We are still deep in the negotiations on a potential operating model change for Europe, and we just have initiated a strategic review for Intermix, so more to come and the reason why we didn't include it in our current outlook is we didn't want our current outlook to be clouded by what we don't yet know the outcome of those two things will be. But certainly, as soon as those things start to take shape, we will provide as much detail as possible. At a high level, a model change in Europe, if for instance we were to partner or franchise that model, the revenue, which is about 2% of sales, would go down as a franchise business, but importantly the SG&A, the rent and occupancy, and really the cost of operating that business would be meaningfully less. So that should have a favorable operating impact to the company. Again, we'll update you as soon as we know more about how those things are progressing.

I guess, just a follow-up, Katrina, I mean, is it possible just to say, are we talking about $0.01 to the P&L? Are we talking about nickels and dimes? So I guess just some trending that up would be helpful if you can?

It's premature, because we are not sure even what the change will look like. As you can imagine, the model that we choose will have a wide range of outcomes. We'll let you know, but conceptually Europe is about 2% of sales. We have about 120 wholly owned stores and we have an online business, and so that can help you understand order of magnitude. But it's too premature without having a structured plan to provide precise impact. As soon as we have line of sight, we'll provide more details.

Our next question will come from the line of Kimberly Greenberger with Morgan Stanley.

Thank you so much. I wanted to just ask about the occupancy or the ROD leverage this quarter, 400 basis points, Katrina, I think you said. How much of that was sort of temporary savings that might've been from rent abatements that you were able to settle and how much of that is permanent driven by the store closures?

Excellent question. I would say about half of the ROD leverage is permanent as it relates to closures and ongoing, and the other half is really temporary non-recurring benefit such as abatements and settlements.

That is super helpful. And can I just ask one follow-up on the comp for the fourth quarter? Could you help us understand a little bit the texture of the progress through the quarter? Did you see improvement in comp trend from month-to-month? Did you see any sort of pickup in January on the back of stimulus? And if you have anything you'd like to share there, I'd certainly be curious about that as well.

I'll give you a little insight on the fourth quarter and then Sonia can talk a little bit about how the quarter has started off. We continue to see the dynamic that we saw all year where the customer is shopping differently and seasonality is flatter—peaks aren't as peaky. November, December, January had a different, flatter seasonality. December of course is when we started to see the pandemic surge again, and that had an impact on December. I'll let Sonia talk a bit about how we're feeling into the quarter today.

I'm really pleased to see three of our four brands deliver positive comps in Q4, including Gap brand. That shows operating health. We grew our customer file by about 14%, and those customers paid more. We saw higher pricing utilization because our products resonated and our branding and marketing is more emotional and connected, which converted customers into loyalists. Those are underlying momentum trends that we're pleased about and we're seeing that play into Q1 with more momentum in February than we had in Q4. So we're pleased with the start and with these new capabilities that we're deploying and the customer response through price and product acceptance.

Our next question will come from Adrienne Yih with Barclays.

Let me add my congratulations on the progress. I guess my first question is on the incremental ad spend that started in the third quarter and carried into the fourth quarter. Can you talk about how you felt about the return on that ad spend? What it means as you go this year? And what we should think about either in dollars or as a percent of sales for total ad spend for 2021? And then Katrina, could you just remind us the lost sales during the fourth quarter, what percent was from temporary versus permanent store closures? And how should we shape the sales against fiscal 2019 Q1? Thank you very much.

I'll start with your last question and then Sonia can talk about marketing. In the fourth quarter, we attributed about 4 points of sales loss to COVID-related impacts and about 5 percentage points of sales decline related to our strategic permanent store closures. As it relates to Q1, quarter-to-date we are pleased with the momentum and seeing trends better than Q4. There are positives—underlying health, growth from our file, margin momentum—but we are still navigating COVID. We said the front half of the year likely has some of that still in it, whereas the back half should return to pre-pandemic levels. We're feeling good about mid-to-high teens sales growth guidance for the year.

On marketing: as we declared our strategy at our investor event last year, we led with the power of our brands. That meant moving to invest in brand marketing and technology. We expect those investments to continue and we feel good about their effectiveness. At the bottom of the funnel, our digital marketing investments are managed very closely and we can turn them on and off based on return. At the top of the funnel, the brand affinity and brand building work has delivered very strong creative clarity and some of the highest ad spots we've seen in the company's history. The combination of strong creative, talent additions, and leaning into brand-led marketing during a dislocated market is driving the consolidation of market share and giving us confidence in continuing to invest in marketing.

Totally agree. Best of luck. Thank you.

Our next question will come from Janine Stichter with Jefferies.

Hi. Thanks so much for taking my question and congrats on the momentum. I want to ask a bit about the ports. Is there any markdown risk associated with some of the products that may be arriving later than planned, or is that mostly smoothed out and accounted for? And then on merchandise margins, you said product margins would be above last year in the first half—could you help us contextualize where that would be versus pre-COVID levels and then more broadly how you see the markdown opportunity taking hold? Thank you.

As it relates to the port issues, it's really about timing. The teams have developed agility around navigating assortment timing, watching when receipts hit, getting those into stores, and if there is lateness adjusting receipts on the back end. We feel good that there's no margin impact from the port issues—it's timing of receipt. We set our market inventory below last year heading into the year. The teams balanced pricing to get higher AUR, lower markdown inventory levels, and are highly focused on maximizing margin on the inventory we have in the front half of the year. Our aspiration is to continue to build momentum through relevance in our brands and better product to drive incrementally better margin year-over-year, especially as we look to offset structural changes when shifting to online. We're focused on AUR and driving higher product margins in the first half.

Great. Thanks for the color.

Our last question will come from the line of Kate Fitzsimons with RBC Capital Markets.

Hi. Thanks very much for squeezing me in. I guess, one for Sonia and then one for Katrina. Sonia, can you just elaborate a bit more about the inflection you saw on the Gap brand in North America? And as you’re evaluating Gap brand into 2021 and in the context of your plan, any indicators you see suggesting brand consideration is moving in the right direction relative to awareness? And Katrina, I appreciate the 5% EBIT margin target, but just thinking about puts and takes relative to where we were pre-pandemic, that 6.4% margin, occupancy is moving in the right direction. Sounds like you’re feeling good about the product improvements and the markdown opportunity. I guess the offsets with COVID costs—could you just help us keep together pre-pandemic and now 2021?

Regarding Gap: a 1% North America comp in Q4 reflects positive momentum in the brand. They've done a lot of hard work this year, restructuring unprofitable fleet segments while investing in their go-forward stores. We refreshed 70 go-forward stores and expect more by mid-year. We are seeing a pickup in net promoter score as a result of the refresh plan. The restructure of the stores, the improvement of the go-forward fleet, leaner SG&A, and a team oriented to winning are all contributing. They are attracting new customers; for example, Teen now represents about 17% of our kids business and they're grounded in sustainable product offerings. Discounting has reduced. The Yeezy Gap partnership is an important potential for the brand—I'm in active conversations with Kanye and the team is heads down. We also have licensing programs launching later this year across lifestyle categories. Lots of levers to drive momentum while addressing structural issues. Importantly, the brand is trending with younger customers and on social platforms; the new spring launch is resonating. The brand is back in cultural conversation where it belongs and we must continue disciplined execution.

As it relates to the operating margin: the 5% operating margin guide for this year is very much on the path to the 10% operating margin goal we put out for 2023. 2020 was COVID-impacted; 2021 is a return to profitable sales growth. The first half still contemplates some COVID-related impacts—impacts to sales from traffic, health and safety costs, higher fulfillment costs from air freight to navigate ports. Those incremental costs are in the 5% guide. As we pivot out of the pandemic, we can sunset some of those costs. Levers in our favor include benefits from store closures, productivity initiatives, a shift toward higher operating margin brands like Old Navy, partnering markets, reengineering fixed operating cost through digitization, and margin initiatives like inventory management. The 5% guide is on the path we expected but does include some pandemic-related costs.

Thanks very much for the color. Best of luck.

All right. Thank you for joining us today. We look forward to speaking with you at the end of the first quarter.

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