Earnings Call Transcript - GAP Q1 2021

Operator (Justin), Conference Operator

Please standby. Good afternoon, ladies and gentlemen. My name is Justin, and I will be your conference operator today. At this time, I'd like to welcome everyone to The Gap, Inc., First Quarter 2021 Conference Call. Operator instructions were provided. I'd now like to introduce your host, Steve Austenfeld. Please go ahead.

Steve Austenfeld, Head of Investor Relations

Thanks, Justin. Good afternoon, everyone, and thanks for joining us today. Welcome to Gap, Inc.’s first quarter 2021 earnings conference call. Before we begin, I'd just 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 provided today on the Investors section of our website, gapinc.com, which supplement today's remarks as well as today's earnings release. The company's annual report on Form 10-K filed with the SEC on March 16, 2021, and any subsequent filings with the SEC all of which are available on gapinc.com. These forward-looking statements are based on information as of today May 27, 2021, and we assume no obligation to publicly update or revise our forward-looking statements. So joining me on the call today are Chief Executive Officer, Sonia Syngal and Chief Financial Officer, Katrina O'Connell. So with that, I’ll turn it over to Katrina.

Katrina O'Connell, Chief Financial Officer

Thank you, Steve and thank you everyone for joining us today. We're very pleased with our first quarter results and especially pleased that our performance is giving us confidence to raise our full year outlook on sales, operating margin and earnings per share. Our four purpose-led billion dollar lifestyle brands are competing well, gaining share and expanding gross margins driven by strong product and creative execution and digital dominance. And we're making progress on our transformation initiatives that are critical to our goal of growing sales profitably and expanding operating margins. We're optimistic that the consumer will remain strong particularly in the U.S., and that our iconic brands, well-located stores and digital advantage will remain relevant as consumers transition back to work and school. And while our business did benefit from stimulus spending in Q1, as well as a faster recovery due to accelerated vaccine deployment, we're very pleased with the way we leveraged our competitive advantages—our brands, our portfolio and our platform—to win this quarter. With that, let me share a few highlights from the quarter that demonstrate our continued progress against our Power Plan 2023 strategy. Starting with delivering sales growth. First, our revenue grew 8% versus 2019. We're pleased with this strong performance, recognizing it includes nearly five points of impact from our strategic North America store closure plan over that time period, as well as roughly two points of impact from COVID-related store closures outside of the U.S. Our U.S. market share is the highest we've seen in recent years at 5.5%, up 90 basis points versus last year. At nearly $4 billion, this was the largest Q1 revenue in the company's history. We're happy with the standout performance of Old Navy and Athleta, which grew net sales 27% and 56% respectively in Q1 versus 2019. Combined Old Navy and Athleta represented 66% of the company's sales in Q1, moving closer to our target of 70% by the end of 2023. Sonia will talk more about how they compete to win a little bit later. There's also meaningful progress to the Gap brand. Gap North America delivered a 9% comp versus 2019, underscoring the progress the brand is making in the product and operations of its core business. The brand has become more digitally led and is realizing the margin benefit of closing unprofitable stores while also reinvigorating the brand with great creative and product execution. And lastly, we're excited about the changes occurring at Banana Republic. Its updated product design, realigned pricing architecture, in-store experience and updated brand creative are all steps in the right direction. While we aren't yet seeing growth at Banana Republic, the team is focused on regaining relevance and repositioning Banana Republic for a post-COVID world. Our commitment to becoming a digitally led company is paying off—at over $6 billion in sales in fiscal 2020 our online channel was 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 an omni-channel lens. And in Q1 online momentum continued with sales growth up 82% versus 2019, ending the quarter at 40% of total sales compared to 25% in 2019. Next, we're strategically driving down fixed costs and reallocating a portion to demand generation in support of our sales growth. Several expense levers—strategic store closures and productivity in operating expenses, especially in stores—have helped us weather pandemic-related costs in the quarter and allowed us to lean into demand-generating investments, such as marketing and digital enhancements. Our strategic investment in marketing over the last several quarters has helped us gain market share in the dislocated apparel market and we're leveraging that share consolidation to drive growth now. We've driven improvement in product margins over the last few quarters as customers have responded to our brand building marketing. In addition, we've delivered creative execution and relevant product supporting higher regular-price selling and reduced discounts. While freight and shipping costs as well as pandemic-related supply chain headwinds persist, this margin expansion provided an offset against these rising costs. Our fleet rationalization is on track and driving significant economic value. I'll share more details in a moment, but we remain on track to closing 350 Gap and Banana Republic stores in North America by the end of 2023. Higher online sales, store closures both in the quarter and last year, along with lease negotiations and abatement settlements contributed 430 basis points of ROD leverage in Q1 versus 2019. We're making progress on leveraging partnerships as a capital efficient way to amplify our iconic brands and drive profitable sales, particularly at Gap brand. Yesterday, the brand announced an exclusive deal with Walmart.com to deliver Gap Home. Sonia will speak more about this later. But this is an example of how through partnerships, we can extend the reach of our brands to customers across product categories, markets and channels. Our strategic review of our European market presence is underway. We're evaluating options across France, Italy, the U.K. and Ireland. Gap brand has strong brand recognition in Europe and whether it's through a franchise model or online, we look forward to providing Gap products to our European customers. We'll share more progress in our evaluation as we move through the year. As part of our Power Plan 2023, we committed to profitably growing our $4 billion lifestyle brands. In support of this strategic initiative we completed the sale of our Janie & Jack business in the first quarter and completed the sale of the Intermix business early in the second quarter. While these transactions won't materially affect EBIT the brands together contributed approximately 2% of sales on an annual basis. This change further enables management to focus on the core brands and remove fixed costs in the portfolio. And finally, we've generated meaningful free cash flow, ending the quarter with $2.5 billion of cash, cash equivalents and short-term investments on the balance sheet. Our reliable cash generation and strong balance sheet supports our investment for growth in 2021 through capital expenditures, while also resuming our long standing practice of returning cash to shareholders. We initiated a new dividend in the second quarter and are returning to our program of share repurchases intended to offset dilution. We're also closely monitoring our debt position. Based on current market prices of our notes, we don't believe it's in the best interest of shareholders to repurchase or restructure at this time. While we're not planning any near-term actions related to our debt, we are actively watching the markets and interest rates so we can take action at the appropriate time. Before I move on to our revised 2021 outlook, I want to say I'm proud of how the team leaned into our competitive advantages, maximizing our strategies to drive long-term shareholder value. As we look to the balance of 2021, despite the remaining uncertainty related to the COVID pandemic, our first quarter performance gives us confidence to raise our 2021 outlook today. On a reported basis, the company now anticipates full year diluted earnings per share to be in the range of $1.55 to $1.70. On an adjusted basis, we're raising our full year earnings per share to be in the range of $1.60 to $1.75. So let me turn to our Q1 financials and starting with sales, net sales for the quarter were $4 billion up 8% versus 2019. Comp sales were up 28% versus a year ago and up 13% versus 2019. While overall performance was quite good Q1 sales were negatively impacted by the continued resurgence in the COVID pandemic that resulted in unplanned mandated store closures and restrictions across Canada, Japan, China and Europe. As noted, the pandemic-related impact on first quarter sales versus 2019 is estimated to be approximately two percentage points. In addition, the sales decline related to strategically planned permanent store closures had an estimated impact of about five percentage points versus 2019. Overall, store sales in Q1 were down 16% versus 2019. The decline in store sales is attributable to an estimated seven points of sales impact from permanent closures and an estimated three points of sales impact from international market COVID-mandated closures. Our online sales grew 82% versus 2019 and contributed 40% of sales in the quarter. For details on sales by brand, please refer to our earnings release. Turning to gross margin, first quarter gross margin rate was 40.8% leveraging 450 basis points versus 2019. Our margin expansion is as follows: ROD leveraged 430 basis points versus 2019 due to the increase in online sales, coupled with savings from store closures and rent negotiations. Merchandise margins expanded 20 basis points versus 2019, reflecting higher product margin due to lower promotional activities, offsetting approximately 200 basis points of higher shipping costs associated with increased online sales. Turning to SG&A, first quarter reported operating expenses were $1.4 billion and 34.8% of sales. Excluding $56 million in charges related to divestiture activity in the quarter, adjusted operating expenses were $1.3 billion or 33.4% of sales, deleveraging 60 basis points versus Q1 2019 adjusted SG&A. The 60 basis points of deleverage is due to the following dynamics: deleverage of 120 basis points due to elevated compensation costs as part of the company's performance philosophy; higher distribution center costs of 40 basis points in support of the company's online expansion; and importantly, productivity in store expenses of 230 basis points were partially redeployed into demand generation, as marketing investment was higher and deleveraged 140 basis points. The greater investment in demand generation resulted in nine tenths of a point of market share gain for Gap Inc. in Q1 versus a year ago, ending the quarter at 5.5% of total U.S. apparel market share. Turning to operating margin, on a reported basis, first quarter total operating income was $240 million, or 6% of sales. On an adjusted basis, first quarter operating income totaled $296 million, with operating margin of 7.4% expanding 390 basis points versus adjusted 2019 operating margin. Moving to taxes and interest, the reported effective tax rate was 11.2% for the first quarter. The lower first quarter effective tax rate primarily reflects the one-time income tax benefit related to divestiture activity in the quarter. Excluding this impact, the adjusted effective tax rate was 23.5%. And first quarter net interest expense was $53 million. Turning to EPS, our first quarter reported earnings per share was $0.43. Excluding charges related to divestiture activity adjusted earnings per share was $0.48. To provide some perspective on inventory, total inventory was up 6% versus the first quarter of 2019 and up 7% versus the year ago quarter. The increase is primarily due to COVID-related U.S. port congestion and the impact on shipping lanes resulting in higher in-transit inventory levels. Importantly, we remain pleased with the content of our inventory with markdowns below 2020 and 2019 and are confident in our ability to deliver product margins above last year's levels in Q2. We now expect Q2 inventory growth versus 2020 to be in the range of high single digits to mid teens acknowledging the volatility regarding COVID-related supply chain disruptions impacting in-transit inventory levels. Moving to real estate and store closures, in the first quarter we closed six Gap and Banana Republic stores in North America consistent with our strategy of improving the profitability of our store fleet. We still anticipate closing approximately 75 stores in 2021, which will bring us to approximately 75% of our goal of closing 350 stores in North America by the end of 2023. We anticipate the store closures in 2021 will be weighted towards the back half of the year based on the timing of lease expirations. In addition on a net basis, we opened 25 Old Navy and Athleta stores consistent with our plans to expand their customer reach. During the quarter, we incurred store related cash outlays of about $6 million for North America. In 2021, we continued to estimate cash outlays of about $135 million related to store closures. As noted previously, as of the end of 2023, we expect that the full store rationalization program will yield annualized pre-tax savings of about $100 million. This estimate does not include the strategic review of our Europe market which remains in progress. Regarding the balance sheet and cash flow, free cash flow was $216 million in the quarter. As a result of the company's strong cash flow performance, we ended the quarter with $2.5 billion of cash, cash equivalents and short-term investments. The company ended the quarter with 377 million shares outstanding. Before I turn it over to Sonia, let me touch on our financial outlook for 2021, which we are raising across all key measures. We believe the biggest domestic impact from the pandemic is largely behind us with the U.S. market showing signs of strength driven by stimulus in Q1 and a faster recovery from the accelerated vaccine rollout. While we are seeing a healthier macro environment in the U.S., we expect the lingering impact to continue globally as seen in market closures and stay-at-home restrictions in Canada, China, Japan and Europe. In addition, while our strategies are working and showing good results, we're also watching the evolving pressures on our supply chain from both COVID outbreaks in India and Southeast Asia, as well as the ongoing raw material supply pressures. With that in mind, I'd like to provide the following revised guidance for fiscal year 2021. On a reported basis, we now expect earnings per share to be in the range of $1.55 to $1.70. On an adjusted basis, excluding the Q1 charges associated with the divestiture activity, we now expect our adjusted earnings per share to be in the range of $1.60 to $1.75, a $0.40 increase versus prior year outlook. Both our reported and adjusted outlooks exclude the potential impact associated with ongoing strategic reviews in Europe. Now, let me provide you with some additional guidance metrics for 2021. We are raising our sales outlook and now anticipate full year net sales growth to be in the range of low to mid 20% versus fiscal year 2020. Notably, this revised outlook reflects the lost revenue attributable to the recent sale of Janie & Jack and Intermix which combined on an annual basis represented approximately 2% of the company's sales. Our reported and adjusted operating margin guidance is now approximately 6%, an increase from our previous guidance of about 5%. This reflects an acceleration of our progress towards reaching a 10% operating margin by the end of 2023. We anticipate a modestly higher level of SG&A spending as a percentage of sales in Q2 versus Q1. With a disproportionate advantage in back-to-school primarily at Gap and Old Navy, we plan to invest more heavily in marketing and digital assets to drive market share during this important time. Additionally, the integrated launch of our loyalty program in the fall is supported by elevated investments in customer-facing technology. This modest increase in SG&A spend in Q2 is fully contemplated in the higher operating margin guidance for fiscal year 2021 of about 6%. And lastly, I want to note the company's focus on returning cash to shareholders. First, we announced earlier this month that the company will pay a Q2 dividend of $0.12 a share, recognizing the strength of our balance sheet and continuing a long history of paying regular dividends to shareholders. In addition, we'll resume share repurchases with the intent to offset dilution, subject to market conditions and other considerations. The company expects to repurchase up to $200 million of shares under the program for the remainder of fiscal year 2021. In closing, our first quarter performance reflects a strong start to 2021 with profitable sales growth and operating margin expansion versus 2019. This strong start is giving us confidence to raise our full year outlook, putting us on an accelerated path to our long-term goals. And with that, I will turn the call over to Sonia.

Sonia Syngal, Chief Executive Officer

Thank you, Katrina and good afternoon, everyone. I'm happy to be here today to share our first quarter results and as Katrina mentioned, our sales were up significantly year-over-year and exceeded our 2019 results. Our strong performance in Q1 can be attributed to two things. First, and most importantly, our Power Plan 2023 is taking hold. And second, the macro tailwinds which included a third round of stimulus checks and increased vaccine distribution created an inflection point. Our teams are maniacally focused on growing our purpose-led billion dollar lifestyle brands and our customers are responding. The marketing investments we've made over the last several quarters to fuel demand, coupled with the macro tailwinds, are supercharging our business. The share we strategically took in 2020, during the consolidation in the apparel market, drove outsized momentum in Q1, especially in Old Navy and Athleta. And we're feeling great about the health of our business in North America. According to NPD, our market share gains outpaced the industry average and as Katrina shared, it's the highest we've seen in recent years. Customers are emerging from the pandemic with a newfound appreciation for social connections and a chance to express their style. At the same time, customers are holding on to the comfort they found in the spaces and rituals created over the last year. As store traffic rebounded, we sustained our digital dominance, with online growth up 61% year-over-year, and 82% when compared to 2019. Growth in Active and Fleece continue to rise, showing customers' hesitance to let go of the cozy mentality. We also saw a resurgence in dresses and summer fashion as customers welcome a spring awakening. While these trends benefited the entire industry, we are uniquely positioned to take advantage of the end-state blend of joggers and dresses, digital and in-store, stepping out and staying in. Customers are embracing their own blend which allows us to play to our strengths. While we're pleased with Q1 and we are seeing great progress in our U.S. market, we understand that the pandemic is far from over on a global scale. With the resurgence in cases in Canada, Europe, China and Japan, COVID impact on demand in international markets is still meaningful. And more critically due to rising cases in countries we sourced from, like India, we are facing supply chain and raw material challenges. Still, agility and flexibility and scale have become a strong muscle across the team. And as we monitor and mitigate these headwinds, I'm confident we have the right levers to pull. We're on track and feel positive about the progress we're making against our Power Plan 2023. We are taking swift action as needed, while shifting investments to grow our iconic brands in new and profitable ways for the long-term. Let me elaborate on some of Katrina's remarks and walk you through how that showed up this quarter. Starting with the power of our brands. I'm particularly energized by how each of our brands are demonstrating brand power to compete and take profitable share. I attribute this to having trend-right product, purpose-led marketing and brand-amplifying creative partnerships resulting in improved brand health and stronger customer relevance. Across our brands we are harnessing our pricing power, reducing promotions and directly investing to drive demand. Let me first talk about Old Navy. While the overall market has strengthened, Old Navy is taking share, outpacing the industry. The brand maintains its position as the number two apparel brand in the U.S. and now sits as the sixth apparel retailer on a rolling three-month basis according to NPD. The stimulus, consumer optimism, strong product acceptance and full-funnel marketing drove a remarkable quarter. Stores delivered profitable growth even with COVID closures, and at the same time our online growth continued to accelerate. Newly acquired customers are spending more, thanks to marketing investments in brand-building storytelling, like their vintage vibes campaign which taps into today's TikTok generation. In our most recent campaign, Old Navy teamed up with NBA Hall of Famer Magic Johnson to share the success stories of three inspiring graduates from our career skills and mentoring program—this is a way to show onward momentum and community impact. Growth in key categories like Active and Fleece remains strong, while seasonal categories like dresses, shorts and denim are coming back. Strength in stores and the shift in product mix signal a new stage in pandemic recovery as vaccines roll out, enabling the return of family vacations and in-person learning, and anticipates the store-led share acquisition in kids and baby from distressed retailers. When paired with customer exuberance this sets us up for a strong back-to-school performance. Building a successful sleepwear business, Old Navy extended into intimates in April to further deliver on the needs of our customers' full lives. And since the launch it has picked up five tenths of a point of market share, and moved into the top 20 intimates retailers. We are also looking forward to the brand expansion of inclusive sizing to all stores later this year. With one of the broadest size ranges in the industry, but largely limited to online, this serves to further its commitment to the democracy of style and better serve our existing plus customers with a physical space to shop and engage with us. Next, Gap momentum accelerated in Q1 with modern American optimism coming to life through improved product, evolving and clear creative direction and overall sharper execution. While COVID-related closures in Asia and Europe impacted sales meaningfully in the quarter, Gap North America is growing healthy and cool, delivering a positive 9% two-year comp with margin expansion. The team is focused on building relevance in the U.S., which in turn gives us the power to export that relevance globally. The 'Generation Good' campaign featuring passionate teen activists and self-defined creators who are forging a positive and inclusive path forward resonated deeply with customers. They're responding to Gap's effortless style, driving lower discounting and giving the brand pricing power. Priority categories—active, sleep and fleece—accelerated resulting in double-digit sales growth versus Q1 2019. And like Old Navy, kids and baby sales were strong as many kids returned to the classroom, which bodes well for a strong back-to-school season later this summer. Work is underway on the Yeezy Gap collaboration with Kanye West. We're approaching this launch with deep intention and we expect to share more with you in the next few months. And as we announced today, we're optimistic about our venture into home with the launch of Gap Home at Walmart.com this summer. Home is a large category in the U.S. and a natural extension of apparel where storytelling drives sales—it's a natural fit as we build lifestyle brands. Leveraging our model of partnering to amplify the brand via the Gap and Walmart partnership is a capital-efficient alternative to acquiring capabilities in-house. The assortment is sustainably made, beautifully curated, incredibly priced and we cannot wait to see Gap's modern American optimism translated to home and kids' dorm rooms later this year. Turning to Banana Republic, the new team at Banana Republic is making progress laying the foundation for its transformation. Over the quarter they've made strides in realigning their pricing architecture and yield management, improving the physical in-store experience and updating brand creative. To restore brand relevance, the team has identified target customer groups and the core cultural trends to inform new brand positioning, product design and customer engagement approach. Banana Republic showed off floral windows to welcome spring ahead of the launch of a capsule collection by emerging designer Preppy Curry, who makes streetwear with bold florals and gender-fluid style. This collection largely sold out in under a week showing the demand we can create through limited-edition partnerships. Laying the past for the future will take time and we are steadfast in our mission to reestablish Banana Republic's marketplace position as a leading affordable luxury lifestyle brand. Now, what a quarter for Athleta. Athleta drove outsized digital growth while achieving record full-price sales through gains in performance lifestyle products, particularly warm weather shorts, dresses, swim and tanks which really differentiate us from the competition. Performance of inclusive sizing has grown steadily since its January launch with 70% of the Athleta collection now available in 1X to 3X. Athleta had some really major wins in its effort to raise brand awareness by amplifying its values. The 'Power of She' campaign drove overwhelmingly positive engagement at two times the industry benchmark with impressions across print and digital totaling over 160 million. And Athleta will have two gold medal athletes on the world stage in Tokyo this summer who amplify the brand's mission to empower women and girls. Simone Biles joins Allyson Felix as the brand's newest ambassador, and will bring her personal story of unparalleled career achievement, along with her journey of pushing through pain and adversity. These value-led partnerships are driving awareness for Athleta. In fact, when we announced our partnership with Simone Biles, Athleta had the highest non-holiday search result in our history. Investments in digital are paying off with app performance exceeding expectation and success in digital marketing is driving new customer growth to historic highs, pushing Athleta's total customer file to 4.5 million in Q1. Athleta also announced plans to open stores in Canada later this year, joining Old Navy, Gap and Banana Republic. An online site will launch later this summer and two stores are planned for fall; this move is a proof point in our strategy to extend customers' access through new entry points. Our vision to grow purpose-led billion dollar lifestyle brands is taking hold and as Katrina mentioned earlier, we're transforming our brand portfolio to align with our Power Plan 2023. We successfully wound down Hill City and divested Janie & Jack and Intermix. These moves allow us to focus and prioritize our strategic intent and put resources behind the brands with the most potential and that generate the most sales. Next, the power of our platform. Our digitally led mindset is paying off with our dominant omni-channel strength and scaled operation. Online sales grew nearly 60% versus the first quarter of last year and represented approximately 40% of the total business even as sales rebounded in stores. Our omni teams delivered the largest March on record shipping 13 million packages to customers in North America. As I shared last quarter, one of our main priorities in 2021 is optimizing our mobile experience. We launched our Android native app in March and we're excited to be engaging with our Android customers. Strong contribution from our alternative payments providers, PayPal and Afterpay, represented 20% of online spend in Q1. We are leading omni platform efforts, whether in stores or on mobile to curbside pickup or our self-checkout pilot coming later this year. We're pushing for convenience and engaging experiences across the entire customer journey. We are laser focused on our SG&A transformation through increased productivity, organizational capacity and demand-generating investments. We are on track to close North America stores across Gap and Banana Republic in line with our strategy of releasing unproductive real estate. The strategic review of our European business is still underway. Finally, the power of our portfolio. We're using our brands' collective power to grow our customer file and extend brand reach. I've shared several ways our brands are doing this through store growth, market expansion and product extensions. We had 62 million active customers globally. We acquired over 60% more online customers than this time last year and that is a really big deal. We're on a mission to create loyalists. We enrolled more than 5 million customers in our multi-tender loyalty program in Q1. And on average, they're spending far more than customers not in our program. This gives us confidence ahead of our integrated loyalty program launch this summer. We also announced a new credit card agreement with Barclays and Mastercard that will begin in May 2022. We feel that the level of technology and personalization capabilities that Barclays brings to the partnership fit perfectly with our strategy to use new and more effective ways to speak to our customers. The power of our portfolio also means our brands can drive sustainable change at scale. Old Navy's move to eliminate plastic shopping bags in the U.S. and Canada by 2023 is a meaningful step in our waste reduction efforts. Gap Brand's latest Generation Good collection has the most sustainable tees and denim to-date. More than 60% of Banana Republic's 2021 spring collection was manufactured using more sustainable fibers. And through its solar power purchase agreement, Athleta brought additional renewable energy to the grid that is helping offset more than 100% of the electricity it uses to power its stores. Finally, our freshly branded company mailer will be made with 50% recycled content, leaving an optimistic first impression on our customer and further reducing our use of virgin plastic. We tie sustainability to an inclusion lens. And these efforts demonstrate our deep belief in empowering women, enabling opportunity and enriching communities, all part of our purpose to be inclusive by design. Now, before I turn it over to Q&A, I want to touch on our talented team because this is a team effort. We are creating a performance and owner culture for all with shared accountability in our business results. And I want to take a moment to acknowledge and honor a job well done over the last year and quarter—one that was particularly challenging for frontline team members, 96% of whom maintained loyalty through furloughs and served as a lifeblood of our business through the acute COVID impacts. On business performance, we believe vehemently that this is the time to push ourselves harder to strive for continuous improvement and to reach even further for growth across our brands. Momentum is on our side and we intend to capitalize. History suggests a spurt of innovation comes out of every crisis and the strength of our brands, platform and portfolio, coupled with our creative audacity suggests an exciting road ahead. So with that, we'll open it up for questions.

Operator (Justin), Conference Operator

Thank you. Operator instructions were provided. Our first question comes from Adrienne Yih with Barclays.

Adrienne Yih, Analyst, Barclays

Good afternoon, congratulations. It's been a tough road but well done. Sonia, couple questions. I guess my first question is on advertising spend. I know that you're moving from non-customer-facing SG&A shifting into demand creation. Should we think about that as probably being in the 6% of sales range? And I'm just wondering how you think about that number relative to other companies that have brands; they tend to be a little bit higher than that. And then of that spend, how are you thinking about proportioning it among the different brands? And then, for Katrina, can you give us either a line of sight of where Gap and Banana Republic are trending now for operating margin or alternatively, when you get to the 10% margin, what is the target for those two pieces of the business? Thank you very much.

Sonia Syngal, Chief Executive Officer

Thank you. So we are pleased with our top investments, which are technology and marketing, and the marketing investments have allowed us to expand our product margins, reduce discounting, etc. So we're learning as we go. Yes, you're correct that 6% is roughly where we're planning, but we're learning and we'll continue to see what we hear back from customers and some of those investments. Right now we're seeing a really great virtuous cycle, with the investments in marketing allowing us to improve our price realization across all of our brands.

Katrina O'Connell, Chief Financial Officer

Yes. And I'm glad you brought up the 6% because that is in fact roughly where we still expect the year to land. I mean, we'll see where revenue is. But it'll be sort of lumpy by quarter. And as we said on this call, we are going to lean a little bit more into Q2. We actually didn't hit the 6% marketing in Q1, and so we did reserve some of that money for Q2 to invest in back-to-school, as we said, and in the loyalty launch. So it's going to be lumpy, but I think six is about what we're thinking and we'll see. Sonia may or may not have said a lot of our marketing is digital; we can read it week-to-week, it's very flexible, and so we'll lean in as appropriate. With regards to operating margin, we haven't broken those out by brand. I think we've acknowledged that Old Navy and Athleta are the highest operating margins. But certainly the restructuring of Gap and Banana Republic is intended to really take out the lack of profitability at those brands and bring them back up. All of that's contemplated in various scenarios in the 10% operating margin goal. And we haven't really said more than that.

Operator (Justin), Conference Operator

Our next question comes from Matthew Boss with JPMorgan.

Matthew Boss, Analyst, J.P. Morgan

Thanks and congrats on the performance. So maybe Sonia or Katrina, at Old Navy, maybe just help us to break down the drivers of the improvement to the 27% top-line this quarter versus 5% in the fourth quarter. Have you seen the momentum sustained post stimulus? If so, what do you think is driving it? And on the bottom-line, I guess help us to think about product margin expansion drivers, as we think about the second quarter against pretty healthy expansion a year ago?

Sonia Syngal, Chief Executive Officer

We've got multiple strategies at play, Matt. Specifically to Old Navy, they're really seeing strength from the shift in product and the acceleration of comfort and cozy whether it's fleece and active dominance that they've seen. There's been very strong growth in those categories, and at the same time, seasonal categories such as dresses and shorts are reemerging. The family is wanting all of these choices from Old Navy and the product acceleration across those end uses, coupled with the kids and baby strength that Old Navy has as a leading brand in that space, yields really strong execution on product. They also deployed excellent new pricing strategies this quarter that you'll see in stores and online with everyday value pricing, which allows day-in, day-out pricing for a meaningful portion of the assortment. We see this as growing, customers are responding to it, and it's enabled margin expansion on top of strong product acceptance. Innovation in the site has really maintained our e-commerce momentum. As you know, technology investment is a big deal for us; that's manifesting in stronger momentum in the e-commerce business and loyalty enablement. We know how much more customers spend with loyalty, so those technology and loyalty investments are paying off and building. And then lastly, the stores' recovery from the COVID period has been fantastic. Customers are loving the experience; they want a physical shopping space where the family can come and have a human-centered experience. That desire is showing up in our stores.

Matthew Boss, Analyst, J.P. Morgan

Great. And then maybe just a follow up for Katrina, could you speak to gross margin progression, as we think about the first quarter being 400 to 500 basis points above 2019. I think you previously attributed half of the Analyst Day margin expansion to ROD and the other half to SG&A. I just wanted to confirm that these two pieces are at or ahead of the plan in order to get to the 10%?

Katrina O'Connell, Chief Financial Officer

Yes. So when I think about margin for the year, what I would say is the rent and occupancy leverage that we're seeing is largely on track based on the work we've done to close North America stores and get the lease renegotiations that we worked so hard on last year. I would say about 75% to 80% of that 430 basis points we saw in Q1 would continue for the year and continue to add significant value to our margin expansion. On the product margin side, as Sonia said, we're really pleased with the way our brands are competing. Whether that's the right product, the right creative, the right brand values, the right marketing, all of that is giving us the power to pull back on discounting. In Q1 that allowed us to offset shipping. We'll see how that plays out for the rest of the year, but certainly we expect product margins should continue to be higher on a year-over-year basis. What we're watching honestly on the margin side is what everyone has talked about, which is supply chain issues that could require air freight to continue to get inventory here, and potential commodity pressures in the back half. We'll see how all that plays out. We've been navigating that closely and using our advantaged supply chain to help us mitigate what we can. But certainly all of that's on our minds as we think about the back half of the year. All those scenarios are reflected in the 6% operating margin guidance. As we said on the call, we had originally expected 5% this year; we're now guiding to 6% and so all of that feels like we're accelerating towards our 10% plan and we're proud of that.

Operator (Justin), Conference Operator

The next question comes from Lorraine Hutchinson with Bank of America.

Lorraine Hutchinson, Analyst, Bank of America

I was hoping to just get your thoughts on the progression of the Gap brand as the year moves forward. Any timing on the Yeezy Gap collaboration and then how you're thinking about planning inventory for the brand through the collaboration and as sales continue to improve?

Sonia Syngal, Chief Executive Officer

So as you know, we've been doing the heavy work with building our creative competence and creative audacity with Gap while at the same time restructuring the business by shedding unproductive stores and reviewing our international markets. Easy-to-amplify partnerships are an important part of the strategy and an important partner, as we've announced, is the Yeezy Gap collaboration. We love the enthusiasm. It's the number one question we get every day from customers and across social media; we see the hype building and speculation around the product and launch dates. Yeezy Gap is a work in progress and remains a significant opportunity for us. It may be Q2 or Q3—we'll see—but I can tell you the creativity is through the roof and it's spurring energy across the brand. We're planning for a multi-year effect here, multi-year business. So we're confident in the potential. As we think about Gap for the rest of the year, continuing to drive for health and margin expansion is something that we are committed to. The inventory will be commensurate with that.

Katrina O'Connell, Chief Financial Officer

I think that's right. We were really pleased with the health of the North America core; I think you saw the 9% comp in North America which is a really good indicator that the brand is on track. They're becoming digitally dominant. We're making progress on shuttering unproductive stores. And as Sonia said, we're continuing to make progress on negotiating in our international markets and exploring partnership options. We have a lot of flexibility in inventory, so we'll keep managing that appropriately. For now, I don't think there's anything specific to report as it relates to the Gap versus the rest of the brands.

Sonia Syngal, Chief Executive Officer

Even though we gained a lot of speed and agility in our inventory management through COVID, that capability is being applied to all of our brands to respond as needed to customer demand. It's a new day in inventory and the Gap brand, like all of our brands, is focused on the inventory transformation so there's more ubiquity across channels. That's another lever we can apply.

Operator (Justin), Conference Operator

Next question comes from Kimberly Greenberger with Morgan Stanley.

Kimberly Greenberger, Analyst, Morgan Stanley

Katrina, my question is on gross margin. You got really nice leverage here in ROD; I wanted to know if you could break down the 430 basis points of leverage between any permanent and more lasting items compared to temporary items. Were there any rent abatements or other assistance that benefited in the quarter? And then, if you could provide some insight on how you're thinking about shipping costs? I don't know how much advance visibility you get on that. But are you expecting shipping costs to remain elevated through the year? Thanks so much.

Katrina O'Connell, Chief Financial Officer

Thanks, Kimberly. So on rent and occupancy, we actually didn't have a lot of totally unusual items happen in the quarter. I would say it's safe to assume about 75% of that 430 basis points of leverage will continue for the year. We'll see, the negotiations can be lumpy so we'll update you as we go. But if you think about the year, that's a good way to think about that leverage amount. As far as shipping costs, we disclosed that we experienced about 200 basis points of shipping headwinds in the quarter. I think that's a reasonable amount to assume for the rest of the year. Honestly, what we don't know is, as vendors are more impacted by COVID outbreaks in India and Southeast Asia and as those orders transpire, and we start to see what happens, we don't yet know how much we will or won't have to air-freight in order to get that here or if there will be broader freight implications. So I can't say definitively, but again we're looking closely at all of that and working hard to do what we've been doing, which is use our pricing power to offset what we can. But that 200 basis points is a reasonable estimate for planning at this point.

Operator (Justin), Conference Operator

We have a question from Mark Altschwager with Baird; that question will be presented by Sarah Goldberg, who is on for Mark.

Sarah Goldberg, Analyst (on behalf of Mark Altschwager), Baird

Thanks for taking our question. Was the intimate launch at Old Navy—there looks like some early signs there. I was just wondering, has this been capturing a new customer or has it largely been an add-on purchase at this stage? And then, how do you see scaling over time?

Sonia Syngal, Chief Executive Officer

We're excited. Between the Old Navy launch, Gap sleep and intimates as well as Banana Republic, all four of our brands have permission under their lifestyle positioning to lean into the intimate space. If you add them all up, it's a fairly sizable business now. Old Navy has seen some great success, particularly with their unique aesthetic. They've introduced colorful undergarments that really stand out in the market and we're seeing customer response. The average transaction value at Old Navy has really grown, which implies we're expanding the basket for existing customers and also attracting new customers. So it's both—add-on purchases and new customer acquisition—and intimates is one of the drivers.

Steve Austenfeld, Head of Investor Relations

And Justin, why don't we take one more question and then we have to break.

Operator (Justin), Conference Operator

Our last question will come from the line of Marni Shapiro with The Retail Tracker.

Marni Shapiro, Analyst, The Retail Tracker

Hey, guys, congratulations. Great improvement. I think the stores look fantastic and to your point, very optimistic. Could you touch a little bit about Old Navy's mix—because the intimate line was something—but I've also noticed the active line looks different in the stores, broader in the stores. How should we think about the balance of active into lounge into intimate in the stores? And are there other segments that you feel are missing in Old Navy that the customer is interested in buying from Old Navy?

Sonia Syngal, Chief Executive Officer

Thanks, Marni. Old Navy has a lot of permission to play across categories and they have leaned into intimates as their latest foray. Another example of expansion is extended sizing which launched online in the fall and will roll into stores. Active has been one of the biggest growth categories for Old Navy—it's been a major growth driver. We've given active more space in the store and online, and it's attracting a much younger customer. We're seeing moms and teenagers join the brand for the first time through the active business. So we are seeing new and younger customers and natural growth because active is one of the fastest-growing segments within apparel. All of this is converging to benefit Old Navy.

Marni Shapiro, Analyst, The Retail Tracker

Well, fantastic. Best of luck for the summer season, stores look great.

Sonia Syngal, Chief Executive Officer

Thank you, Marni. And thank you all for joining us today. We look forward to speaking with you at the end of the second quarter.

Operator (Justin), Conference Operator

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