Gap Inc (GAP) Q3 2022 Earnings Call Transcript

Good afternoon, ladies and gentlemen. My name is Brent, and I will be your conference operator today. I would like to welcome everyone to the Gap, Inc. Third Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. I would now like to introduce your host, Cammeron McLaughlin, Head of Investor Relations. Cammeron, you may proceed.

Good afternoon, everyone. Welcome to Gap, Inc.’s third quarter fiscal 2022 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 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 information included on page two of the slides shown on the Investors section of our website, gapinc.com, which supplement today’s remarks, the risk factors described in the company’s annual report on Form 10-K filed with the Securities and Exchange Commission on March 15th, 2022, and any subsequent filings with the Securities and Exchange Commission, all of which are available on gapinc.com. These forward-looking statements are based on information as of today, November 17th, 2022 and we assume no obligation to publicly update or revise our forward-looking statements. Joining me on the call today are Interim Chief Executive Officer, Bobby Martin; and Chief Financial Officer, Katrina O’Connell. With that, I’ll turn the call over to Bobby.

Thank you, Cammeron, and good afternoon, everyone. After four months as Interim President and CEO, I have even deeper conviction that we have a portfolio of iconic brands that our customers love, an increased confidence in our platform to drive leverage and economies of scale, and belief in this team's ability to deliver. We know where we've gotten things wrong and the team and I are at work to correct them. As I told you last quarter, we can and we should win in any environment and the management team and I continue to hold the company accountable to deliver on that. We've taken action to optimize profitability and cash flow, while rebalancing and reducing inventory to drive near and long-term improvements across our entire business. We've sharpened our focus on execution and are bringing more rigor to our operations and are responding to what our customers are telling us with respect to trend. While our efforts drove sequential improvement during the quarter, our expectations are set on the consistency of execution quarter-after-quarter, year-after-year that we know is crucial to delivering the sustainable profitable growth and value that our people and shareholders expect. Let me provide an update on our progress during the quarter, starting with actions taken on cost. As I last shared, we are aggressively managing costs and have taken decisive actions in this quarter alone, resulting in roughly $250 million in estimated annualized savings. These actions include: the elimination of approximately 500 existing and open roles in our corporate offices and a pause on hiring and contractor spend for the remainder of the year, resulting in $125 million in estimated annualized savings; the renegotiation of our advertising agency contracts, resulting in approximately $75 million in annualized savings; and a reduction in technology operating costs and rationalized investments, resulting in estimated $50 million of annualized savings beginning in fiscal 2023. We are early in our work here and yet already these savings are expected to help offset higher incentive compensation and increasing labor costs in fiscal 2023. However, there is still work to be done to transform our cost structure and improve overall efficiency, so that we are fit for the future. Next, let me share more on our inventory actions and assortment rebalancing efforts. We continue to rely heavily on markdowns and discounting to sell-through certain styles this quarter and have reduced receipts in Q4. These actions will allow us to enter fiscal 2023 in an improved inventory position, and beginning in Q1, our brands will benefit from our reinstated responsive capabilities to chase into product demand. We're seeing an improved balance in the assortment across the portfolio compared to the first half of the year. Each of our brands was better positioned in the categories that resonate with base consumer preferences, and our customers rewarded us for that. We saw consistent category strength in dresses, sweaters, pants and woven tops across the portfolio, with activewear underperforming across the board, as consumers continue to shift away from the cozy at-home lifestyle. While Athleta isn't immune to the change in consumer preference, despite moderation of growth in the women's active market, the brand is showing strength in lifestyle categories like dresses and accessories that are demonstrating disproportionate growth in today's current environment. Now, let me take a moment and speak to each of our brands, starting with Old Navy. Old Navy delivered net sales growth of 2% over last year, showing early signs of improvement as the brand continues its efforts to right-size inventory, balance assortment, relevance and sizing across its channels. The brand saw strength in its women's business in categories including pants, outerwear, sweaters and woven tops. All this was offset, however, by softness in active, kids and baby, as we lapped last year's strong demand, which we believe was driven in part by the U.S. Child Tax Credit and, of course, the heightened post-COVID back-to-school spending. Old Navy customers still have a propensity to buy. That being said, it continues to experience softness in spending and shopping frequency from its lowest-income consumers. As we continue to attract a wide range of consumers, we still believe Old Navy is well positioned in the marketplace, particularly as consumers become more value-conscious. Next, Gap brand. Gap delivered net sales flat to last year and is seeing signs of strength in its core, with a significant shift in trend performance across its women's business. Iconic Gap product and categories in trend-right fabrics like faux leather and occasion-based categories like dresses, woven tops, sweaters and pants all drove comparable sales growth. Similar to Old Navy, Gap brand experienced softness in kids and baby and activewear overall. Over the last 18 months, Gap brand has successfully transitioned its France, Italy and UK businesses to franchise partners as part of our Partner to Amplify strategy. And last week, we signed an agreement to transition the Gap Greater China business to Baozun Inc., who will operate our e-commerce sites and stores under a franchise agreement, pending closing conditions and regulatory approval early next year. This strategy allows Gap brand to operate its businesses through a more asset-light, cost-effective model and to benefit from the local expertise of our partners. Moving to Banana Republic, we saw net sales growth of 8% compared to last year. September marked the one-year anniversary of the brand relaunch. Shifting from a highly promotional workwear brand catering to everybody, Banana Republic spent the last year reimagining every element of the customer journey, with a special focus on quality products, differentiated experiences, and relevant branding, positioning it as a premier lifestyle brand that enhances people's lives wherever they are. This accessible luxury differentiates Banana Republic from others at this price point and has brought in a more premium consumer. During the quarter, Banana Republic experienced strong demand for suiting and its finer fabrics, including silk and cashmere. As post-pandemic consumer preferences began to balance from the current trend of occasion and workwear, it will be important that Banana Republic continues to use its unique customer proposition as a lifestyle brand to differentiate itself for years to come. Finally, Athleta. Athleta delivered net sales growth of 6% compared to last year. While the women's activewear market has continued to be soft against the growth trajectory of the past few years, Athleta is holding share. As I mentioned last quarter, Athleta has made quick pivots to print and pattern as well as with their performance-lifestyle product to better meet customer preferences. The new fall and holiday product is resonating well with the customer and Athleta saw growth in both bottoms and tops, the largest categories in the women's apparel market and key to the brand's long-term strategy. Before I pass it off to Katrina to share more details on our financials, let me end with how I began on the state of the business. I have no doubt we have world-class brands that our customers love, and we drive value and scale through the synergy of our platform. But I'm also very clear that there is work to be done to right-size our cost structure, streamline inventory, and capitalize on our creative strengths to deliver the products and experience our customers deserve and employees and shareholders expect. Lastly, the Board remains active in its search for a permanent Chief Executive Officer. We're focused on a hands-on leader who can greatly increase our operating rigor, moving us past our deficiencies, while in parallel enabling strong creative direction and brand architecture as they develop the vision for how our portfolio should evolve over time to create a sustainable business model. This is a great company with strong assets and one that demands a leader who can hold to its value and ensure it remains fit and capable of scaling its omni-platform and market leadership. And with that, I'll turn the call over to Katrina.

Thank you, Bobby and thanks, everyone, for joining us this afternoon. Let me start with our third quarter results. Third quarter net sales of $4.04 billion increased 2% versus last year or 3% on a constant currency basis, driven by an improvement in trend relative to the first half of the year and in part due to the timing of franchise sales. Sales in the third quarter were 1% above pre-pandemic levels in 2019. Comparable sales were up 1% on top of negative 1% comp last year and a significant sequential improvement from the negative 10% comp last quarter, primarily as our assortment rebalancing efforts at Old Navy and Gap are starting to take hold and resonating with our customers as well as the benefit of an early holiday promotional event at Old Navy in October. Store sales increased 1% from the prior year. Year-to-date, we have closed a net total of 29 Gap and Banana Republic stores in North America and now anticipate closing approximately 30 additional stores this year, bringing us to close to 90% of our goal of closing 350 stores in North America by the end of fiscal 2023. As we look to the remainder of fiscal 2022, we remain on track to open a net 30 Athleta stores and now expect to open a net 10 Old Navy stores this year. Online sales increased 5% versus last year and represented 39% of total sales in the quarter. Compared to pre-pandemic levels in 2019, online sales increased 55%. Turning to sales by brand. Starting with Old Navy, sales in the third quarter of $2.1 billion were up 2% versus last year and increased 10% relative to pre-pandemic levels in 2019. Old Navy comparable sales were down 1%, representing a sequential improvement from the negative 15% comp last quarter, driven by improvements in category mix and a more balanced assortment that now includes more of the product that our customers have been looking for, as preferences have shifted from cozy casual to work and occasion this year. However, we do believe that Old Navy did benefit from a slight pull-forward of sales from the fourth quarter into October, as a result of its efforts to get out earlier than typical with its first holiday promotional event. Gap brand global sales of $1.04 billion were flat versus last year, with global comparable sales up 4%, driven by improved category mix and a more balanced assortment, including more occasion-based and faster-moving categories, as well as comp growth in Asia as a result of lapping the outsized negative impact of COVID-related restrictions last year. North America comparable sales were flat, a sequential improvement from negative 10% last quarter. Banana Republic sales grew 8% from last year to $517 million, with comparable sales up 10%, as the brand continued to capitalize on the shift in consumer preference and the relaunch and elevated positioning of the brand last year. Athleta sales grew 6% to $340 million, or an increase of 57% compared to 2019 pre-pandemic levels. Comparable sales improved sequentially to a flat comp in the third quarter, compared to negative 8% comp last quarter and negative 7% in the first quarter. As we look to sales in the fourth quarter, we continue to take a prudent approach, given the uncertain macro and consumer environment, as well as the competitive promotional environment. Also, as stated earlier, third quarter net sales benefited in part by the timing of franchise sales as well as the October holiday event at Old Navy. In addition, Gap brands will be up against an approximate 1 point headwind as we anniversaryed Yeezy Gap sales last year that will not be in the base this year. As a result of these factors and the continued uncertain environment, we anticipate that total company sales in the fourth quarter could be down mid-single digits year-over-year. Now, to gross margin. Gross margin in the third quarter was 37.4%, deleveraging 470 basis points versus last year, inclusive of 130 basis points of deleverage related to a $53 million Yeezy Gap impairment charge. On an adjusted basis, gross margin was 38.7%, deleveraging 320 basis points versus last year as we continue to experience higher levels of markdowns in order to better position our inventory. Excluding the impairment related to Yeezy Gap, merch margin deleveraged 370 basis points as a result of higher discounting due to the previously communicated assortment imbalances as well as a more aggressive focus on better positioning and clearing excess inventory as we exit fiscal 2022. Airfreight contributed approximately 200 basis points of leverage as spend levels normalized during the quarter and we lapped the $70 million of incremental air freight expense last year. Equally offsetting this was approximately 200 basis points of deleverage due to inflationary and commodity cost-related headwinds. Turning to ROD. We continue to benefit from our fleet restructuring efforts through lower ROD costs, which were relatively in line with last year on a nominal basis. Excluding a Yeezy Gap impairment charge, ROD as a percentage of sales leveraged approximately 50 basis points. As we look to gross margin in the fourth quarter, we will lap last year's $245 million of incremental airfreight, which is expected to add approximately 540 basis points to gross margin versus last year. We continue to anticipate an approximate 200 basis point inflationary and commodity cost headwind and that ROD will likely be about flat as a percentage of sales versus last year. As we communicated last quarter, while we are taking actions to right-size inventory in an increasingly promotional environment, we continue to expect significant variability in discount rate. As a reminder, gross margin in the second and third quarters were impacted by approximately 370 basis points of deleverage stemming from higher discounting. Turning to SG&A. Reported SG&A was $1.3 billion or 32.8% of sales, leveraging 540 basis points from the prior year and includes an $83 million net benefit from the sale of our UK DC now that our European partnership model transition is complete. In addition, we recorded an immaterial amount of severance related to the overhead reductions taken in the third quarter. Adjusted SG&A, excluding the UK DC benefit, decreased 5% versus last year to $1.4 billion. As a percentage of sales, adjusted SG&A leveraged 280 basis points from the prior year's adjusted rate, primarily as a result of higher sales volumes, lower bonus accrual, and lower marketing expense compared to last year. As Bobby discussed, we've begun to take actions to right-size our cost structure and improve profitability, focusing acutely on areas where we may have invested without commensurate returns in recent years as it relates to overhead, marketing, and technology. We've already acted on approximately $250 million in annualized savings stemming from the reduction of approximately 500 existing and open corporate roles in the quarter, the renegotiation of advertising agency contracts and the reduction of technology operating costs and rationalization of digital investments. These actions will not have a material impact on SG&A as we look to the fourth quarter as a result of timing and severance offsets, in addition to headwinds in the quarter related to higher seasonal labor costs relative to last year. However, these actions will provide a significant offset to the higher incentive compensation and wage inflation headwinds we anticipate in fiscal 2023. Reported operating income increased 22% to $186 million or 4.6% as a percentage of sales. Adjusted operating income decreased 8% from the prior year to $156 million. Adjusted operating margin of 3.9% was 40 basis points lower than last year's adjusted rate, reflecting the elevated promotional activity and higher inflationary costs, offset by the air freight leverage and the SG&A leverage relative to last year. Moving to interest and taxes. We recognized $18 million in net interest expense, a $25 million savings versus last year due to the refinancing of our long-term debt last fall. During the quarter, we recorded an income tax benefit of $114 million on pre-tax income of $168 million, which resulted in a negative effective tax rate of 68%. This income tax benefit was related to the cumulative impact of a change in the estimated annual tax rate as a result of quarterly earnings variability. This year-to-date tax benefit is expected to reverse and result in at least $200 million of tax expense in the fourth quarter, offsetting the tax benefit on a fiscal year basis. Reported EPS was $0.77. Adjusted EPS, which excludes an approximate $0.18 net benefit related to the UK DC sale and a $0.12 negative impact due to the Yeezy Gap impairment charge was $0.71. Adjusted EPS includes $0.33 related to the tax benefit in the quarter. Share count ended at 365 million. Turning to balance sheet and cash flow, starting with inventory. We are making initial progress on our plan to right-size inventories and move to levels below last year by the end of the fiscal year. Our more aggressive markdowns combined with moderated holiday receipts drove a sequential improvement in the inventory growth during the quarter. Total ending inventory was up 12% versus last year, a sequential improvement from 37% inventory growth in the second quarter. The 12% year-over-year growth in the third quarter includes a 13 percentage point benefit related to in-transit, as we lapped last year's supply chain challenges, 9 percentage points of growth related to pack and hold, and close to two-thirds of the remaining increase is attributable to elevated levels of slow-turning basics and the remainder seasonal products. Compared to pre-pandemic levels in the third quarter of 2019, ending inventory was up 12%. While an improvement in trend versus the first half as we expected, we are entering the fourth quarter with overall elevated inventory levels and some carryover of fall product, despite the increased markdown activity in the third quarter. Although we did take action earlier this year to reduce holiday receipts, we continue to anticipate a competitive promotional environment, given the increased inventory levels industry-wide and plan to continue to take aggressive action to clear inventory in order to enter fiscal 2023 better positioned. As we look to fiscal 2023, we continue to moderate buys and expect to begin to lean into our responsive levers this spring, which will provide further flexibility to better align inventory levels with demand trends next year. In addition, we are releasing some of last year's holiday pack and hold inventory, and we'll continue to integrate our pack and hold inventory into future assortments. As you know, while pack and hold is the use of cash in the short term, we are able to optimize our margin in the near term and benefit working capital next year, as we buy lower receipts and sell through the pack and hold inventory. Quarter-end cash and equivalents were $679 million. Net cash from operating activities was an inflow of $95 million in the quarter, driven by a moderation in working capital usage as a result of our progress on improving inventory levels and composition coupled with our receipt cuts and leaner buys. As we stated last quarter, we anticipated beginning to see more normalized cash flow in the back half of the year and we are seeing that play out. We continue to focus on fortifying our balance sheet and cash position. As discussed last quarter, we've cut or deferred some capital spending and reduced the number of Old Navy stores slated for back half of the year and continue to expect CapEx of approximately $650 million for 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 November 8th, our Board approved a $0.15 dividend for the fourth quarter of fiscal 2022. We repurchased 1.2 million shares early in the quarter. As discussed last quarter, we have completed our goal of offsetting dilution in fiscal 2022 and do not anticipate repurchasing additional shares this year. We continue to have $476 million available under our current share repurchase program authorization. Before closing, we understand that there has been increased focus on freight and commodity-related tailwinds in fiscal 2023 across the industry as we've all begun to see favorability in rates. As a reminder, we have experienced a more modest freight headwind throughout fiscal 2022 as compared to many other retailers as a result of our long-term ocean contracts, which were locked in at favorable rates. These negotiated rates remain below current ocean container rates. As a result, as ocean container rates come down, this will not represent a significant tailwind to our margin as it may for other retailers as we look to fiscal 2023. In addition, as it relates to cotton and commodity costs, we have already made purchases through the first half of fiscal 2023, and therefore will not begin to benefit from advantaged pricing until we enter the back half of next year. In closing, while we continue to navigate an uncertain consumer environment and promotionally competitive environment, we are confident in the actions we're taking and believe we are taking the right steps to position Gap Inc. back on its path towards sustainable, profitable growth and delivering value to our shareholders over the long-term. With that, we'll open the line for questions. Operator?

Thank you. Our first question comes from Lorraine Hutchinson with Bank of America. Your line is open.

Thank you. Good afternoon. Katrina, thanks for the gross margin puts and takes. I just had a question about the promotional piece of that. You mentioned the 370 in the past two quarters. Just given where your inventories are, where your receipts are and the macro environment, would you expect the promotional pressure to be in line with that or better? Maybe if you could give us some guide rails there? Thank you.

Yes. Sure, Lorraine, and thanks for the question. I think that's the real open part of the margin that we sort of left for you to model, giving you guys the known things, which are the airfreight benefit in the quarter for fourth quarter of 540 basis points, partially offset by the inflationary pressure of 200 basis points. We're prepared to keep promoting to get ourselves clean of both fall and holiday inventories as we enter into next year. And so, there's a wide range of possibilities as to what that discount amount could be. I think, if you see Q2 at 370 basis points and Q3 at 370 basis points, it's rational to think that's a possibility, but we're not guiding to that number, given there's such a wide range of possible outcomes. So we'll let you guys take a look at what you think that will look like, knowing that we will be committed to getting our inventories cleaned up so that we don't continue to carry the excess inventory into next year.

Thank you. And then related to that, as you look into the first half of next year, what proportion of your inventory will be able to take advantage of some of the responsive capabilities?

We haven't said and we'll certainly consider if we'll say more on a future call. But I think what's important to know about responsive capabilities, as we've said, is that it can take many different formats. So whether it's getting our basics loaded on to vendor-managed inventory, which allows us to take advantage of their replenishment capabilities, or whether it's leaving overall inventory open to chase in-season, or just give us an ability to range up or range down total inventory based on demand, it really is a capability that we're looking forward to having back. With the manufacturing disruption that we saw starting with India closing and then Vietnam closing and many of the other jurisdictions closing down during COVID, we really lost those capabilities, which caused us to have to lean too far forward into total inventory as well as category inventory. And so, having those levers back will give us so much more flexibility. But we haven't said it's different by brand, and certainly, we're happy to talk more about it as we get closer in, if appropriate.

Thank you.

Your next question is from the line of Bob Drbul with Guggenheim. Your line is open.

Hi. Good afternoon. I guess, the first question I have is on Old Navy. Can you maybe just talk to some of the operational improvements? And where do you think any of the early reads are on Old Navy under Haio, as he's taking over? And then, Bobby, I'm just curious if are you thinking of staying on as CEO, given the delay in naming a permanent CEO? Thanks.

Maybe I’ll start—do you want to go ahead, Bobby? Go ahead. I'll go ahead and start with Old Navy. I think we're really pleased to see playing out at Old Navy what we have been talking about, which is sequentially improving the inventory, which has finally been cleaned up and more rationalized in stores, back towards what is an appropriate level of inventory for that customer, while still having that inventory fully available online to serve that customer, but really getting that markdown inventory out of stores. Then on top of that, being able to finally pivot the inventories towards the categories that are selling. And then on top of that, starting to really get back to pulling down inventory more in line with demand. And all of that sequentially has started to show real improvement. Bobby, I know you also have a view on some of the executional work, so I'll let you talk to that.

Yes. Look, I think looking at Haio, although he's only been in a little over 100 days, he's taken decisive steps, particularly around the store inventory. If you get in our stores right now, they're full. We brought a lot of that inventory forward but it's being merchandised well. His focus has been very, very strong that we don't lose sight of good merchandising, so we've got good product that is resonating with the customer and we should never get confused even in the excess of inventory to not merchandise that well. So that as a customer comes in, right now, we've really tightened up under his leadership, particularly in Old Navy, but it's across the other brands to really know when the customer is in. We know she's there from the time she comes in until she leaves. So the engagement with the customers is really high. And being able to, again, capitalize on some of the current trends. Old Navy, clearly, even in the given assortment, we serve a wide range of customer. We commented on it during our opening remarks that even with the lower-income customer, we're seeing some transition there, but that's just meaning that they're really moving to opening price point and denim a little bit more. But on the other side, we've got big strengths that are showing up in categories like back-to-office and even in some of our basic fashion where she's really responding well. So Haio's strengths right now through the team—and I'd say that we're really pleased with what we're seeing happen—is really getting the inventory right-sized and cleaned up. Operationally, we're executing to get the maximum conversion and then driving units per transaction up, knowing as soon as we can get her committed to the checkout, we have a greater opportunity to see additional transactions hit the basket. And that's the work of the team. Right now, we're pretty pleased with what we're seeing, and again, a lot more to come. I will address your second question and I'm flattered, I guess, that you would ask, but there's really only two messages that you really should hear. The strong focus is around operational improvements, getting things right, knowing where we've got it wrong and stepping up to those things. So the message you really have to hang on to there is we're not in timeout. It's very clear to me what the Board's asked me to do in terms of stepping in and assessing where we are, capitalizing on our strengths, improving, and responding quickly to make things move in the direction we want them to go. But the Board is very diligent around getting a CEO in place and so we're very active at that. The Board's also very determined to make sure we take the time to get it right. As I said in my closing remarks earlier, not just casually, this is a great company. My confidence has gone way up being inside, seeing the strength of these brands. They are iconic. We're seeing right now in our results customers are responding, that when we get it right, they return to exactly what they trust us for. We will find the right leader who can do the kind of job that I described relative to being strong operationally and getting us past some of the deficiencies, whether they're costs or execution or right-sizing. More than anything, also being able to double down on what you know and expect of us: returning ourselves to really strong creative strengths and brand architecture because I believe in the portfolio strategy. I'm not sure exactly when we will finish there, but we will land the CEO for the future of this company.

Thank you very much.

Your next question comes from the line of Alex Straton with Morgan Stanley. Your line is open.

Great. Thanks so much for taking my question and congrats on a good quarter. I just wanted to drill down on the traffic or sales trends that you saw throughout the quarter. How did things develop by month? We have been hearing some October and November weakness at select retailers, just wondering if you saw a similar exit rate as they did. Thanks.

Thanks, Alex. In line with other commentary in the industry, we did see strong volume in October slow a bit toward the end and a little bit of a slow start to November. But that trend is fully contemplated in the outlook that we described today and is part of why we remain prudent on the outlook for fourth quarter revenue. That said, it's early days and we know that some of that was weather and potentially some other disruption happening out there. So we'll see what plays out, but certainly we did see a similar trend.

Great. That's helpful. Maybe I could also ask about your outlook on holiday. I know last year customers had a call to action to shop earlier. It seems like maybe shopping could be later this year, and our surveys are also saying customers could be waiting for deals. What are your thoughts on that as we head into the holiday selling period?

I've heard those various points of view as well. We're just prepared to compete when the customer is ready to shop. We know we have to get out ahead to ensure that we're early enough, that we're promoting at a time when she's willing to buy, and we're not waiting too late to clear merchandise. On the flip side, if customers are not going to shop until later, we don't want to be too far out ahead of it. So we're remaining vigilant in our view on what's happening competitively, as well as taking a prudent approach to understanding where our inventory movement is and where our customer is shopping. We're watching it carefully day-to-day.

Your next question is from the line of Paul Lejuez with Citi. Your line is open.

Hey. Thanks, guys. You mentioned seeing commodity costs higher in the first half of 2023. Any quantification of that relative to what you've been seeing as a drag in the second half of 2022? And then also, you've pulled back this year a bit on store openings. Curious how you're thinking about store growth for next year, specifically Athleta and Old Navy? Thanks.

Paul, we'll provide a lot more color on 2023 as we get closer to the year. What we wanted to make sure you understood is we do see the cotton movement happening. Of course, it takes a while for the raw materials to move through the full average unit cost of a garment. So more to come on the timing of the benefit on cotton flowing through our COGS. Importantly, we've bought for the first half, so any raw material movement won't be flowing through COGS materially in Q1 and Q2. We'll be focused on figuring out how much of that we can realize through our back-half average unit cost. More to come on that dynamic. As for store openings, Athleta we're going to open about 30 stores and we feel good about that pace of growth. That's a reasonable pace. For Old Navy, the 10 stores we're opening this year was a pullback; that was partially based on wanting to be prudent given performance. We did have some slip into next year, but likely we'll have a more moderated pace on Old Navy store openings as we move forward. More to come as we fully land that pipeline of stores.

Your next question comes from the line of Mark Altschwager with Baird. Your line is open.

Good afternoon. Thanks for taking my question. Standing back on margin and EBIT margin, there are a lot of moving pieces this year and many temporary factors as you right-size inventory and prepare for additional clearance and promotions over the holiday. As we look forward to next year and your path to clearance, you annualize some of the SG&A savings that you're seeing. Is there a baseline level of EBIT margin that you think the business can achieve regardless of the revenue backdrop?

There are many moving pieces, Mark, and we haven't issued forward-looking guidance beyond where we are now, so more to come on that. Overall, we feel good about store closure activity that has given us ROD leverage. We feel good about transitioning many of our international markets to partners, which should reduce losses in those markets. We're committed to closely evaluating operating costs that we've added in recent years in the form of marketing, overhead and technology. That said, we are still in a very inflationary environment, with headwinds on labor and other costs we are working through. Lots of moving pieces—we'll provide more of an outlook as we put 2023 together. We're focused on the long-term goal of getting the company back to a better operating margin with profitable sales growth.

Your next question is from the line of Brooke Roach with Goldman Sachs. Your line is open.

Good afternoon and thank you so much for taking the question. I wanted to focus on Athleta, which had a nice comp improvement this quarter on both a sequential and a three-year stack. Can you reflect a little more on the drivers of the sequential improvement? Do you think that the three-year stack trend is sustainable? If so, what is the segment profit margin you expect for this brand ending the year, and how does that compare with your view of long-term segment operating margins for the business?

Brooke, we were pleased to see Athleta return to positive 6% growth and a flat comp, which was a meaningful improvement. NPD reported the women's active market was down about 7% for the quarter, so Athleta's growth shows that they are taking market share even as the category slows after several years of strong growth. We are seeing a rebound in performance product and, as Bobby noted, success in lifestyle pieces that balance performance and lifestyle. The new product is resonating and they're winning in both bottoms and tops. As for the three-year stack going forward, we'll see, but our aspiration is to continue to drive profitable sales growth at Athleta. We don't report segment operating margins by brand, so we won't comment on that at this point.

Thank you. One more question: as you contemplate the mid-single-digit sales decline that you forecast for Q4, can you help us with any quantification about the franchise impact and the holiday event pull-forward impact within that?

We haven't quantified that, Brooke. The dynamics are such that Old Navy saw a slight pull-forward from the October promotion, and there was a modest timing impact from franchise sales. Gap also faces a roughly one-point headwind from anniversarying Yeezy Gap sales last year. All those factors together, plus our prudence about the consumer environment heading into holiday, add up to the view we provided. It's not one single driver; it's the combination of many.

Your next question is from the line of Oliver Chen with Cowen. Your line is open.

Hi, Katrina and Bobby. Thank you. Regarding the carryover fall product, what's the nature of the product that you still need to work through at this time? And then, as we zoom out on Old Navy, what's your hypothesis for a few strategic items that need to be done to drive more consistent comps and margins? You mentioned balancing the assortment as one, and I'm sure speed and agility and fabric platforming are opportunities too. Thanks.

Sure, Oliver. On the content side, it's different by brand. Fundamentally, as we think about summer inventory that carried into fall, that was a margin drain in Q2 and Q3, and then we had fall inventory we were clearing that now is carrying into holiday. We do feel like with holiday buys being down, we will stop that from continuing, but we need to focus on the fall product that's carried over. There's nothing isolated to one category—it's more about overall inventory being higher than relative demand and our ability to actually clear through that, given current customer dynamics. We're focused on clearing through that now, and that is part of why we believe margins will be pressured in Q4. We have a lot less holiday merchandise into next year, so we expect the cycle to stop as we head into Q1 of next year.

You put your finger on the things that challenge us. We let assortment breadth get broader than necessary and in some cases we were missing depth. The course correction is getting back to fundamentals and putting the right lens on inventory. There's a much greater focus on sell-through expectations, a lifecycle mindset around product so we can keep freshness and newness. Haio and the team have been engaging closely with mills and partners for greater collaboration. The responsive capabilities that have helped Gap brand will enable Old Navy to chase in-season and be more agile. We're also focused on better merchandising—ensuring product is presented well in stores so customers can easily find and buy it. Localizing inventory more effectively will increase sell-through. This is a big opportunity for the brand and is why we feel optimistic about Old Navy's potential.

Thank you. Happy holidays.

Your next question is from the line of Ike Boruchow with Wells Fargo. Your line is open.

Hi everyone. This is Jesse Sobelson on for Ike. Thanks for taking our questions. First, the $53 million write-down of the Yeezy product—can you confirm that that was all of the product you held and that it's fully written down? Second, looking longer term at real estate in your business, I'm curious on your views of ownership. Should we expect any more sales in the future?

Thanks, Jesse. Yes, we took the appropriate impairment on the Yeezy inventory as we wind down that business and that $53 million is reflected appropriately. Regarding corporate-owned real estate, we will always look to monetize underutilized assets. To the degree assets are being fully utilized, we are proud of them and feel good about them. We're continually evaluating how we utilize our assets to make sure they're adding the value they need to add. At this point, we feel good about where we are today.

Wonderful. Thank you.

Your next question is from the line of Matthew Boss with JPMorgan. Your line is open.

Thanks. Katrina, could you help rank the assortment changes that you made at Gap which drove sequential improvement this quarter? Two, at Old Navy, is there a reasonable timeline for achieving optimal inventory balance across categories? And three, on the $250 million of annualized expense savings, what percent do you see flowing through to the bottom line next year versus opportunities for reinvestment?

For Gap, they've done a nice job interpreting trend-right fashion into modern essentials. Whether it's faux leather pants, occasion-based pieces, or reinvented basics like a denim jacket with a modern sleeve, they've driven interest by making basics more current. On Old Navy, we're making progressive improvement every quarter. We're excited to have responsive inventory back in spring, which gives much more ability to align inventory to demand. Gap has been able to chase successful styles more quickly once they identified demand, and Old Navy should see similar benefits from responsive inventory. On the $250 million in annualized savings, our preliminary view is that this will largely offset the reset in incentive bonuses for next year and some wage inflation. We're not stopping at $250 million—this is an early step and we expect to continue looking for additional opportunities to right-size the company's expense structure and make it fit for purpose.

I'll just double down on the cost point—we're very early in the work and we're questioning everything we do. This will be a continued focus into 2023. On Gap's product, we've been pleased to see strong women's specialty turn across wovens and bottoms, sweaters, and fashion items. The team has geared up and we're seeing positive traction.

Your next question is from the line of Corey Tarlowe with Jefferies. Your line is open.

Hi. I wanted to touch on Gap brand. It seems strategically the business has focused on driving capital-efficient growth via franchising international, selling the China business, and launching on new e-commerce platforms. Could you talk about the overarching strategy at the Gap brand, how it's progressing, and how you see that playing out into Q4 and next year?

Corey, that's consistent with our stated strategy for Gap brand. Over the last couple of years we've right-sized the business model to a more modern, asset-light model: closing North America specialty stores that were overexpanded, pivoting to digital, and pursuing international growth with partners so we can be in important markets without sustaining operating losses. We're focused on a healthier core and the creative health of the brand—product relevance and partnerships are the recipe for Gap brand. That's what's playing out in the third quarter and what we're committed to heading into next year.

Your last question comes from the line of Janet Kloppenburg with JJK Research. Your line is open.

Hi everybody. Congratulations on the progress. Katrina, I wanted to flesh out the merchandise margin direction for the fourth quarter where it seems like you have some caution. I appreciate the inventory breakdown; you did a great job bringing inventories down. So I'm wondering, with better-balanced product—not where you want it to be but better—does that indicate promotional levels could be less severe, even though overall inventories are still elevated? And on SG&A, it seems like you saved a lot on marketing in the third quarter. Will you start to uptick marketing spend in the fourth quarter and into 2023?

Janet, we're glad to have started to see inventory levels improve. When you adjust for in-transit, pack and hold, and the basics we're carrying, we still have fashion heading into the fourth quarter. That's part of the reason for our cautious revenue outlook and why we remain mindful of the margin. Others are also working hard to get inventory levels down, and we'll see where margins land. We did have discounts impacting the margin by about 370 basis points for Q2 and Q3, and while we hope it's better in Q4, it's on our mind that it could be similar, so we'll let you model that. On SG&A, we did save on marketing in Q3. I wouldn't expect marketing to go up in Q4. We continue to focus on marketing effectiveness and being prudent with marketing spend after a couple of years of heavier investment.

Okay. Great. Thanks so much and best of luck for a good holiday.

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