Gap Inc
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GAP : Management's Discussion and Analysis of Financial Condition and Results of Operations. (form 10-K)

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03/20/2017 | 07:35 pm

Overview



We are a global retailer offering apparel, accessories, and personal care
products for men, women, and children under the Gap, Banana Republic, Old Navy,
Athleta, and Intermix brands. We have Company-operated stores in the United
States
, Canada, the United Kingdom, France, Ireland, Japan, Italy, China, Hong
Kong
, Taiwan, and beginning in October 2015, Mexico. We have franchise
agreements with unaffiliated franchisees to operate Gap, Banana Republic, and
Old Navy stores throughout Asia, Australia, Europe, Latin America, the Middle
East
, and Africa. Under these agreements, third parties operate, or will
operate, stores that sell apparel and related products under our brand names.
Our products are also available to customers online through Company-owned
websites and through the use of third parties that provide logistics and
fulfillment services. In addition to operating in the specialty, outlet, online,
and franchise channels, we also use our omni-channel capabilities to bridge the
digital world and physical stores to further enhance our shopping experience for
our customers. Our omni-channel services, including order-in-store,
reserve-in-store, find-in-store, and ship-from-store, as well as enhanced mobile
experiences, are tailored uniquely across our portfolio of brands. Most of the
products sold under our brand names are designed by us and manufactured by
independent sources. We also sell products that are designed and manufactured by
branded third parties, primarily at our Intermix brand.
We identify our operating segments according to how our business activities are
managed and evaluated. As of January 28, 2017, our operating segments included
Gap Global, Old Navy Global, Banana Republic Global, Athleta, and Intermix. We
have determined that each of our operating segments share similar economic and
other qualitative characteristics, and therefore the results of our operating
segments are aggregated into one reportable segment.
In May 2016, we announced measures to better align talent and financial
resources against our most important priorities to position the Company for
improved business performance and long-term success. Our aim is to capture
additional market share in our home market, North America, where we have our
largest structural advantages, and to focus on international regions with the
greatest potential. As part of this effort, we closed the entire fleet of 53 Old
Navy
stores in Japan during fiscal 2016. Japan remains an important market for
the Company's portfolio, with a continued strong presence of more than 200 Gap
and Banana Republic stores. Including the Old Navy closures in Japan, the
Company closed 67 stores in total related to these measures in fiscal 2016.
We also created a more efficient operating model, enabling us to more fully
leverage our scale. For example, we centralized or consolidated several brand
and corporate functions, allowing us to simplify the organization and operate
more efficiently.
The Company estimates that its actions will result in annualized pre-tax savings
of about $275 million. In connection with the decision to close stores and
streamline the Company's operations, the Company incurred $197 million in
restructuring costs during fiscal 2016 on a pre-tax basis. The charges primarily
include lease termination fees, employee-related costs, and store asset
impairment. Certain of these costs incurred in foreign subsidiaries did not
result in a tax benefit.

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On August 29, 2016, a fire occurred in one of the buildings at a Company-owned
distribution center campus in Fishkill, New York. Following the fire, the
Company immediately activated contingency plans to help mitigate the overall
impact to the business. In October 2016, the Company completed construction of a
temporary fulfillment site at the Fishkill campus, which was in place to process
orders by peak holiday season, and plans to rebuild a permanent building are
currently underway. For fiscal 2016, the Company incurred fire-related costs
which included $86 million in inventory at cost, $12 million in property, plant,
and equipment at net book value, and $35 million in other fire-related costs. In
January of fiscal 2016, the Company agreed upon a partial settlement of $159
million
related to the inventory and recorded a gain of $73 million,
representing the excess over the loss on inventory. Based on the provisions of
the Company's insurance policies, the Company has determined that recovery of
certain remaining fire-related costs incurred during fiscal 2016 is probable,
and an insurance receivable, net of advance insurance proceeds received, has
been recorded as of January 28, 2017 to offset the fire-related costs. The
company expects to continue to record additional costs and recoveries until the
insurance claim is fully settled.

Fiscal 2015 results were impacted by a series of strategic actions to position
Gap brand for improved business performance in the future, including rightsizing
the Gap brand store fleet primarily in North America, streamlining the brand's
headquarter workforce, and developing a clear, on-brand product aesthetic
framework to strengthen the Gap brand to compete more successfully on the global
stage. During fiscal 2015, the Company completed the closure of about 150 Gap
global specialty stores related to the strategic actions. During fiscal 2015,
the Company incurred $132 million of charges in connection with the strategic
actions, primarily consisting of impairment of store assets related to
underperforming stores, lease termination fees and lease losses, employee
related expenses, and impairment of inventory that did not meet brand standards.
Financial results for fiscal 2016 are as follows:
• Net sales for fiscal 2016 decreased 2 percent to $15.5 billion compared with


$15.8 billion for fiscal 2015.



• Comparable sales ("Comp Sales") for fiscal 2016 decreased 2 percent.



• Gross profit for fiscal 2016 was $5.6 billion compared with $5.7 billion for



fiscal 2015. Gross margin for fiscal 2016 was 36.3 percent compared with 36.2



percent for fiscal 2015.



• Operating margin for fiscal 2016 was 7.7 percent compared with 9.6 percent for



fiscal 2015. Operating margin is defined as operating income as a percentage of



net sales.



• Net income for fiscal 2016 was $676 million compared with $920 million for



fiscal 2015, and diluted earnings per share was $1.69 for fiscal 2016 compared



with $2.23 for fiscal 2015. Diluted earnings per share for fiscal 2016 included



about a $0.41 impact of restructuring costs incurred during fiscal 2016, a



non-cash goodwill impairment charge of $0.18 related to Intermix, an $0.11



benefit from the gain from insurance proceeds related to the fire which



occurred at the Company's Fishkill distribution center campus, and a favorable



income tax impact of a legal structure realignment of about $0.15. Diluted



earnings per share for fiscal 2015 included a $0.20 impact of costs related to



strategic actions incurred during fiscal 2015.



• During fiscal 2016, we distributed $367 million to shareholders through



dividends.



Our business priorities in 2017 include:
• offering product that is consistently brand-appropriate and on-trend with high



customer acceptance, with a focus on expanding our advantage in the most



promising categories;



• delivering meaningful product innovation;



• creating a unique and differentiated customer experience that builds loyalty,



with focus on both the physical and digital expressions of our brands; and



• attracting and retaining great talent in our businesses and functions.



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In fiscal 2017, we are focused on investing strategically in the business while
also maintaining operating expense discipline. One of our primary objectives is
to continue transforming our product to market process, with the development of
an advantaged operating platform. To enable this, we have several product,
supply chain, and IT initiatives underway. Further, we expect to continue our
investment in customer experience, both in stores and online, to drive higher
customer engagement and loyalty, resulting in market share gains. Finally, we
will continue to invest in strengthening brand awareness and customer
acquisition.
Fiscal 2017 will consist of 53 weeks versus 52 weeks in fiscal 2016.
Results of Operations
Net Sales
See Item 8, Financial Statements and Supplementary Data, Note 17 of Notes to
Consolidated Financial Statements for net sales by brand and region.

Comparable Sales
The percentage change in Comp Sales by global brand and for total Company, as
compared with the preceding year, is as follows:
Fiscal Year
2016 2015 2014
Gap Global (3 )% (6 )% (5 )%
Old Navy Global 1 % - % 5 %
Banana Republic Global (7 )% (10 )% - %
The Gap, Inc. (2 )% (4 )% - %


Comp Sales include the results of Company-operated stores and sales through
online channels in those countries where we have existing comparable store
sales. The calculation of The Gap, Inc. Comp Sales includes the results of
Athleta and Intermix but excludes the results of our franchise business.
A store is included in the Comp Sales calculations when it has been open and
operated by the Company for at least one year and the selling square footage has
not changed by 15 percent or more within the past year. A store is included in
the Comp Sales calculations on the first day it has comparable prior year sales.
Stores in which the selling square footage has changed by 15 percent or more as
a result of a remodel, expansion, or reduction are excluded from the Comp Sales
calculations until the first day they have comparable prior year sales.
A store is considered non-comparable ("Non-comp") when it has been open and
operated by the Company for less than one year or has changed its selling square
footage by 15 percent or more within the past year.
A store is considered "Closed" if it is temporarily closed for three or more
full consecutive days or it is permanently closed. When a temporarily closed
store reopens, the store will be placed in the Comp/Non-comp status it was in
prior to its closure. If a store was in Closed status for three or more days in
the prior year, the store will be in Non-comp status for the same days the
following year.
Current year foreign exchange rates are applied to both current year and prior
year Comp Sales to achieve a consistent basis for comparison.

Store Count and Square Footage Information
Net sales per average square foot is as follows:
Fiscal Year
2016 2015 2014


Net sales per average square foot (1) $ 334 $ 337 $ 361



__________



(1) Excludes net sales associated with our online and franchise businesses.



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Store count, openings, closings, and square footage for our stores are as
follows:
January 30, 2016 Fiscal 2016 January 28, 2017
Number of Number of Number of Number of Square Footage
Store Locations Stores Opened Stores Closed Store Locations (in millions)
Gap North America 866 14 36 844 8.8
Gap Asia 305 27 21 311 3.0
Gap Europe 175 2 13 164 1.4
Old Navy North America 1,030 27 14 1,043 17.4
Old Navy Asia 65 5 57 13 0.2
Banana Republic North
America 612 9 20 601 5.0
Banana Republic Asia 51 - 3 48 0.2
Banana Republic Europe 10 - 9 1 -
Athleta North America 120 12 - 132 0.6
Intermix North America 41 3 1 43 0.1
Company-operated stores
total 3,275 99 174 3,200 36.7
Franchise 446 56 43 459 N/A
Total 3,721 155 217 3,659 36.7
Decrease over prior year



(1.7 )% (3.2 )%

January 31, 2015 Fiscal 2015 January 30, 2016
Number of Number of Number of Number of Square Footage
Store Locations Stores Opened Stores Closed Store Locations (in millions)
Gap North America 960 34 128 866 9.1
Gap Asia 266 48 9 305 3.0
Gap Europe 189 4 18 175 1.5
Old Navy North America 1,013 36 19 1,030 17.3
Old Navy Asia 43 22 - 65 1.0
Banana Republic North
America 610 24 22 612 5.1
Banana Republic Asia 44 7 - 51 0.2
Banana Republic Europe 11 1 2 10 0.1
Athleta North America 101 19 - 120 0.5
Piperlime North America 1 - 1 - -
Intermix North America 42 2 3 41 0.1
Company-operated stores
total 3,280 197 202 3,275 37.9
Franchise 429 52 35 446 N/A
Total 3,709 249 237 3,721 37.9
Increase (decrease) over
prior year 0.3 % (0.5 )%


Gap and Banana Republic outlet and factory stores are reflected in each of the
respective brands.
In fiscal 2017, we expect net openings of about 40 Company-operated store
locations, primarily for Athleta and Old Navy.


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Net Sales Discussion
Our net sales for fiscal 2016 decreased $281 million, or 2 percent, compared
with fiscal 2015 primarily due to a decrease in net sales at Gap and Banana
Republic
, partially offset by an increase in net sales at Old Navy and Athleta.
The translation of net sales in foreign currencies to U.S. dollars had an
unfavorable impact of about $20 million for fiscal 2016 and is calculated by
translating net sales for fiscal 2015 at exchange rates applicable during fiscal
2016.
Our net sales for fiscal 2015 decreased $638 million, or 4 percent, compared
with fiscal 2014 primarily due to the unfavorable impact of foreign exchange of
about $363 million and a decrease in net sales primarily at Gap and Banana
Republic
; partially offset by an increase in net sales at Old Navy. The
unfavorable impact of foreign exchange was primarily driven by the weakening of
the Canadian dollar and Japanese yen against the U.S. dollar. The foreign
exchange impact is the translation impact if net sales for fiscal 2014 were
translated at exchange rates applicable during fiscal 2015.


Cost of Goods Sold and Occupancy Expenses



Fiscal


Year



($ in millions) 2016 2015


2014



Cost of goods sold and occupancy expenses $ 9,876 $ 10,077 $ 10,146
Gross profit $ 5,640 $ 5,720 $ 6,289
Cost of goods sold and occupancy expenses as a
percentage of net sales 63.7 % 63.8 % 61.7 %
Gross margin 36.3 % 36.2 % 38.3 %


Cost of goods sold and occupancy expenses decreased 0.1 percentage points in
fiscal 2016 compared with fiscal 2015.
• Cost of goods sold decreased 0.3 percentage points as a percentage of net sales


in fiscal 2016 compared with fiscal 2015, primarily driven by higher selling at



regular prices at all global brands and improved product acceptance resulting



in improved margins at Old Navy. This was offset by a negative foreign exchange



impact for our foreign subsidiaries as our merchandise purchases are primarily



in U.S. dollars.



• Occupancy expenses increased 0.2 percentage points in fiscal 2016 compared with



fiscal 2015, primarily driven by the decrease in net sales without a



corresponding decrease in occupancy expenses.





Cost of goods sold and occupancy expenses increased 2.1 percentage points in
fiscal 2015 compared with fiscal 2014.
• Cost of goods sold increased 1.3 percent as a percentage of net sales in fiscal


2015 compared with fiscal 2014, primarily driven by increased markdown



activities, inventory impairment charges primarily at Gap brand related to the



strategic actions, and incremental shipping costs partially due to the U.S.



West Coast port congestion. Cost of goods sold as a percentage of net sales in



fiscal 2015 for our foreign subsidiaries was also negatively impacted by



foreign exchange as our merchandise purchases are primarily in U.S. dollars.



• Occupancy expenses increased 0.8 percentage points in fiscal 2015 compared with



fiscal 2014, primarily driven by the decrease in net sales without a



corresponding decrease in occupancy expenses.





In fiscal 2017, we expect that gross margins for our foreign subsidiaries will
continue to be negatively impacted by the continuing depreciation of certain
foreign currencies as our merchandise purchases are primarily in U.S. dollars.

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Operating Expenses and Operating Margin



Fiscal Year
($ in millions) 2016 2015 2014
Operating expenses $ 4,449 $ 4,196 $ 4,206



Operating expenses as a percentage of net sales 28.7 % 26.6 %



25.6 %
Operating margin 7.7 % 9.6 % 12.7 %


Operating expenses increased $253 million or 2.1 percent as a percentage of net
sales in fiscal 2016 compared with fiscal 2015 primarily due to the following:
• restructuring costs of $197 million in fiscal 2016 compared with the costs


related to strategic actions of $98 million in fiscal 2015;



• store asset impairment charges of $53 million unrelated to restructuring



activities in fiscal 2016 compared with store asset impairment charges of $16



million unrelated to the strategic actions in fiscal 2015;



• a goodwill impairment charge related to Intermix in fiscal 2016 of $71 million;



and



• an increase in bonus and marketing expense; partially offset by



• a gain from insurance proceeds of $73 million related to the fire that occurred



in one of the buildings at a Company-owned distribution center campus in



Fishkill, New York, representing the excess over the loss on inventory; and



• higher income from revenue sharing payments from Synchrony.





Operating expenses decreased $10 million, but increased 1.0 percent as a
percentage of net sales, in fiscal 2015 compared with fiscal 2014 primarily due
to the following:
• a favorable foreign exchange translation impact of about $85 million,


calculated as if operating expenses for fiscal 2014 were translated at exchange



rates applicable during fiscal 2015; and



• a decrease in bonus and marketing expense; partially offset by



• costs related to the strategic actions of $98 million; and





• the gain on sale of a building of $39 million recognized in fiscal 2014.



Interest Expense
Fiscal Year
($ in millions) 2016 2015 2014
Interest expense $ 75 $ 59 $ 75


Interest expense for fiscal 2016 and 2014 primarily includes interest on overall
borrowings and obligations mainly related to our $1.25 billion long-term debt.
Interest expense for fiscal 2015 includes $74 million of interest on overall
borrowings and obligations mainly related to our $1.25 billion long-term debt,
offset by a reversal of $15 million of interest expense primarily resulting from
a favorable foreign tax ruling and actions of foreign tax authorities related to
transfer pricing matters in fiscal 2015.

Income Taxes
Fiscal Year
($ in millions) 2016 2015 2014
Income taxes $ 448 $ 551 $ 751
Effective tax rate 39.9 % 37.5 % 37.3 %



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The increase in the effective tax rate for fiscal 2016 compared with fiscal 2015
was primarily due to the impact of restructuring costs incurred in certain
foreign subsidiaries for which the Company was not able to recognize any tax
benefit and the impact of a non-deductible goodwill impairment charge related to
Intermix. The increase was partially offset by the recognition of certain
foreign tax benefits associated with a legal structure realignment.
The increase in the effective tax rate for fiscal 2015 compared with fiscal 2014
was primarily due to the recognition of foreign tax credits upon a distribution
of certain foreign earnings that occurred during the third quarter of fiscal
2014, partially offset by the impact of the indefinite reinvestment of certain
fiscal 2015 foreign earnings, which will be used to fund our international
businesses and their growth.
Liquidity and Capital Resources
Our largest source of cash flows is cash collections from the sale of our
merchandise. Our primary uses of cash include merchandise inventory purchases,
occupancy costs, personnel-related expenses, purchases of property and
equipment, and payment of taxes. In addition, we may have dividend payments,
debt repayments, and share repurchases.
We consider the following to be measures of our liquidity and capital resources:
January 28, January 30, January 31,
($ in millions) 2017 2016 2015
Cash and cash equivalents $ 1,783 $ 1,370 $ 1,515
Debt $ 1,313 $ 1,731 $ 1,353
Working capital $ 1,862 $ 1,450 $ 2,083
Current ratio 1.76:1 1.57:1 1.93:1


As of January 28, 2017, the majority of our cash and cash equivalents was held
in the United States and is generally accessible without any limitations.
In October 2015, the Company entered into a $400 million unsecured term loan
(the "Term Loan"), which was fully repaid in January 2017.
In January 2014, the Company entered into a 15 billion Japanese yen, four-year,
unsecured term loan ("Japan Term Loan") due January 2018. A final repayment of
7.5 billion Japanese yen ($65 million as of January 28, 2017) is payable on
January 15, 2018 and is classified as current maturities of debt in the
Consolidated Balance Sheet.
We believe that current cash balances and cash flows from our operations will be
sufficient to support our business operations, including growth initiatives,
planned capital expenditures, and repayment of debt, for the next 12 months and
beyond. We are also able to supplement near-term liquidity, if necessary, with
our $500 million revolving credit facility or other available market
instruments.

Cash Flows from Operating Activities
Net cash provided by operating activities during fiscal 2016 increased $125
million
compared with fiscal 2015, primarily due to the following:
Net income
• a decrease of $244 million in net income.



Non-cash items
• an increase of $246 million related to non-cash and other items primarily



due to the lower gain reclassified into income related to our derivative



financial instruments in fiscal 2016 compared with fiscal 2015, a



goodwill impairment charge related to Intermix of $71 million during



fiscal 2016, and an increase of $53 million related to store asset
impairment; partially offset by



• a decrease of $155 million related to deferred income taxes driven by



fluctuations in book versus tax temporary differences for bonus accruals,



depreciation, and share-based compensation.




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Changes in operating assets and liabilities
• an increase of $193 million related to accounts payable primarily due to



the timing of merchandise and lease payments;



• an increase of $117 million related to accrued expenses and other current



liabilities primarily due to bonus accruals; and



• an increase of $52 million related to merchandise inventory primarily due



to the volume and timing of receipts; partially offset by


• a decrease of $79 million related to other current assets and other
long-term assets in part due to the insurance claim receivable from the
fire of the company-owned distribution center in Fishkill, New York on
August 29, 2016.



Net cash provided by operating activities during fiscal 2015 decreased $535
million
compared with fiscal 2014, primarily due to the following:
Net income
• a decrease of $342 million in net income.



Changes in operating assets and liabilities
• a decrease of $107 million related to other current assets and other



long-term assets primarily due to the change in timing of payments



received related to our credit card programs, which resulted in increased



cash inflow in fiscal 2014; and


• a decrease of $150 million related to lease incentives and other



long-term liabilities primarily due to the receipt of an upfront payment



in fiscal 2014 related to the amendment of our credit card program
agreement with Synchrony, which is being amortized into income over the
term of the contract; partially offset by


• an increase of $63 million related to income taxes payable, net of



prepaid and other tax-related items, primarily due to timing of payments.





We fund inventory expenditures during normal and peak periods through cash flows
from operating activities and available cash. Our business follows a seasonal
pattern, with sales peaking during the end-of-year holiday period. The
seasonality of our operations may lead to significant fluctuations in certain
asset and liability accounts between fiscal year-end and subsequent interim
periods.

Cash Flows from Investing Activities
Net cash used for investing activities during fiscal 2016 decreased $201 million
compared with fiscal 2015, primarily due to less property and equipment
purchases.
Net cash used for investing activities during fiscal 2015 increased $134 million
compared with fiscal 2014, primarily due to $121 million of proceeds from the
sale of a building owned but no longer occupied by the Company in fiscal 2014
and $12 million more property and equipment purchases in fiscal 2015.
In fiscal 2016, cash used for purchases of property and equipment was $524
million
primarily related to investments in stores, information technology, and
supply chain. In fiscal 2017, we expect cash spending for purchases of property
and equipment to be about $825 million which includes an estimated $200 million
related to rebuilding of the Company's Fishkill, New York distribution center
campus, which the Company expects will be covered by insurance proceeds.

Cash Flows from Financing Activities
Net cash used for financing activities during fiscal 2016 decreased $213 million
compared with fiscal 2015, primarily due to the following:
• no repurchases of common stock in fiscal 2016 compared with $1 billion cash


outflow related to repurchases of common stock in fiscal 2015; partially offset



by



• no debt issuances in fiscal 2016 compared with the issuance of $400 million in



short-term debt in fiscal 2015; and



• the repayment of the $400 million short-term debt in fiscal 2016.



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Net cash used for financing activities during fiscal 2015 decreased $517 million
compared with fiscal 2014, primarily due to the following:
$400 million proceeds from the issuance of short-term debt in fiscal 2015; and



$164 million less repurchases of common stock; partially offset by



$4 million net cash out flows for fiscal 2015 compared with $38 million net



cash inflows for fiscal 2014 related to issuance under share-based compensation



plans and withholding tax payments related to vesting of stock units.






Free Cash Flow
Free cash flow is a non-GAAP financial measure. We believe free cash flow is an
important metric because it represents a measure of how much cash a company has
available for discretionary and non-discretionary items after the deduction of
capital expenditures, as we require regular capital expenditures to build and
maintain stores and purchase new equipment and invest in technology to improve
our business. We use this metric internally, as we believe our sustained ability
to generate free cash flow is an important driver of value creation. However,
this non-GAAP financial measure is not intended to supersede or replace
our GAAP result.
The following table reconciles free cash flow, a non-GAAP financial measure,
from net cash provided by operating activities, a GAAP financial measure.
Fiscal Year
($ in millions) 2016 2015 2014


Net cash provided by operating activities $ 1,719 $ 1,594 $ 2,129
Less: Purchases of property and equipment (524 ) (726 ) (714 )
Free cash flow


$ 1,195 $ 868 $ 1,415



Debt and Credit Facilities
Certain financial information about the Company's debt and credit facilities is
set forth under the headings "Debt" and "Credit Facilities" in Notes 5 and 6,
respectively, of Notes to Consolidated Financial Statements included in Item 8
of this Form 10-K.

Dividend Policy
In determining whether and at what level to declare a dividend, we consider a
number of factors including sustainability, operating performance, liquidity,
and market conditions.
We paid an annual dividend of $0.92 per share in fiscal 2016 and fiscal 2015. We
plan to pay an annual dividend of $0.92 per share in fiscal 2017.

Share Repurchases
Certain financial information about the Company's share repurchases is set forth
under the heading "Share Repurchases" in Note 9 of Notes to Consolidated
Financial Statements included in Item 8 of this Form 10-K.
In fiscal 2017, the Company intends to re-initiate share repurchases under its
existing $1 billion share repurchase authorization.

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Contractual Cash Obligations
We are party to many contractual obligations involving commitments to make
payments to third parties. The following table provides summary information
concerning our future contractual obligations as of January 28, 2017. These
obligations impact our short-term and long-term liquidity and capital resource
needs. Certain of these contractual obligations are reflected in the
Consolidated Balance Sheet as of January 28, 2017, while others are disclosed as
future obligations.
Payments Due by Period
Less than 1 More Than 5
($ in millions) Year 1-3 Years 3-5 Years Years Total
Debt (1) $ 65 $ - $ 1,250 $ - $ 1,315
Interest payments on debt 75 149 112 - 336
Operating leases (2) 1,128 2,091 1,449 1,874 6,542
Purchase obligations and
commitments (3) 4,098 89 56 5 4,248
Total contractual cash
obligations $ 5,366 $ 2,329 $ 2,867 $ 1,879 $ 12,441


__________



(1) Represents principal maturities, excluding interest. See Note 5 of Notes to



Consolidated Financial Statements for discussion on debt.



(2) Excludes maintenance, insurance, taxes, and contingent rent obligations. See



Note 12 of Notes to Consolidated Financial Statements for discussion of our



operating leases.



(3) Represents estimated open purchase orders to purchase inventory as well as



commitments for products and services used in the normal course of business.





There is $70 million of long-term liabilities recorded in lease incentives and
other long-term liabilities in the Consolidated Balance Sheet as of January 28,
2017
that is excluded from the table above as the amount relates to uncertain
tax positions and deferred compensation, and we are not able to reasonably
estimate the timing of the payments or the amount by which the liability will
increase or decrease over time.

Commercial Commitments
We have commercial commitments, not reflected in the table above, that were
incurred in the normal course of business to support our operations, including
standby letters of credit of $16 million, surety bonds of $44 million, and bank
guarantees of $18 million outstanding (of which $12 million was issued under the
unsecured revolving credit facilities for our operations in foreign locations)
as of January 28, 2017.

Other Cash Obligations Not Reflected in the Consolidated Balance Sheet
(Off-Balance Sheet Arrangements)
The majority of our contractual obligations relate to operating leases for our
stores. Future minimum lease payments represent commitments under non-cancelable
operating leases and are disclosed in the table above with additional
information provided under the heading "Leases" in Note 12 of Notes to
Consolidated Financial Statements included in Item 8 of this Form 10-K.
Critical Accounting Policies and Estimates
The preparation of financial statements in accordance with accounting principles
generally accepted in the United States of America ("U.S. GAAP") requires
management to adopt accounting policies and make significant judgments
and estimates to develop amounts reflected and disclosed in the financial
statements. In many cases, there are alternative policies or estimation
techniques that could be used. We maintain a thorough process to review the
application of our accounting policies and to evaluate the appropriateness of
the many estimates that are required to prepare the financial statements of a
large, global corporation. However, even under optimal circumstances, estimates
routinely require adjustment based on changing circumstances and the receipt of
new or better information.

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Our significant accounting policies can be found under the heading "Organization
and Summary of Significant Accounting Policies" in Note 1 of Notes to
Consolidated Financial Statements included in Item 8 of this Form 10-K.
The policies and estimates discussed below include the financial statement
elements that are either judgmental or involve the selection or application of
alternative accounting policies and are material to our financial statements.
Management has discussed the development and selection of these critical
accounting policies and estimates with the Audit and Finance Committee of our
Board of Directors, which has reviewed our disclosure relating to critical
accounting policies and estimates in this annual report on Form 10-K.

Merchandise Inventory
We value inventory at the lower of cost or market ("LCM"), with cost determined
using the weighted-average cost method and market value determined based on the
estimated net realizable value. We review our inventory levels in order to
identify slow-moving merchandise and broken assortments (items no longer in
stock in a sufficient range of sizes or colors), and we primarily use promotions
and markdowns to clear merchandise. We record an adjustment to inventory when
future estimated selling price is less than cost. Our LCM adjustment calculation
requires management to make assumptions to estimate the selling price and amount
of slow-moving merchandise and broken assortments subject to markdowns, which is
dependent upon factors such as historical trends with similar merchandise,
inventory aging, forecasted consumer demand, and the promotional environment. In
addition, we estimate and accrue shortage for the period between the last
physical count and the balance sheet date. Our shortage estimate can be affected
by changes in merchandise mix and changes in actual shortage trends.
Historically, actual shortage has not differed materially from our estimates.
We do not believe there is a reasonable likelihood that there will be a material
change in the future estimates or assumptions we use to calculate our LCM or
inventory shortage adjustments. However, if estimates regarding consumer demand
are inaccurate or actual physical inventory shortage differs significantly from
our estimate, our operating results could be affected. We have not made any
material changes in the accounting methodology used to calculate our LCM or
inventory shortage adjustments in the past three fiscal years.

Impairment of Long-Lived Assets, Goodwill, and Intangible Assets
We review the carrying amount of long-lived assets for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
or asset group may not be recoverable. Events that result in an impairment
review include a significant decrease in the operating performance of the
long-lived asset, or the decision to close a store, corporate facility, or
distribution center. Long-lived assets are considered impaired if the carrying
amount exceeds the estimated undiscounted future cash flows of the asset or
asset group. For impaired assets, we recognize a loss equal to the difference
between the carrying amount of the asset or asset group and its estimated fair
value. The estimated fair value of the asset or asset group is based on
estimated discounted future cash flows of the asset or asset group using a
discount rate commensurate with the related risk. The asset group is defined as
the lowest level for which identifiable cash flows are available and largely
independent of the cash flows of other groups of assets. The asset group for our
retail stores is reviewed for impairment primarily at the store level. Our
estimate of future cash flows requires management to make assumptions and to
apply judgment, including forecasting future sales and expenses and estimating
useful lives of the assets. These estimates can be affected by factors such as
future store results, real estate demand, and economic conditions that can be
difficult to predict. We have not made any material changes in the methodology
to assess and calculate impairment of long-lived assets in the past three fiscal
years. We recorded a charge for the impairment of long-lived assets of $107
million
, $54 million, and $10 million for fiscal 2016, 2015, and 2014,
respectively.
We also review the carrying amount of goodwill and other indefinite-lived
intangible assets for impairment annually in the fourth quarter of the fiscal
year and whenever events or changes in circumstances indicate that it is more
likely than not that the carrying amount may not be recoverable. Events that
result in an impairment review include significant changes in the business
climate, declines in our operating results, or an expectation that the carrying
amount may not be recoverable.

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In connection with the acquisitions of Athleta in September 2008 and Intermix in
December 2012, we allocated $99 million and $81 million of the respective
purchase prices to goodwill. Goodwill is reviewed for impairment using the
applicable reporting unit, which is an operating segment or a business unit one
level below that operating segment for which discrete financial information is
prepared and regularly reviewed by segment management. We have deemed Athleta
and Intermix to be the reporting units at which goodwill is tested for Athleta
and Intermix, respectively.
We review goodwill for impairment by first assessing qualitative factors to
determine whether it is more likely than not that the fair value of the
reporting unit is less than its carrying amount, including goodwill, as a basis
for determining whether it is necessary to perform the two-step goodwill
impairment test. If it is determined that it is more likely than not that the
fair value of the reporting unit is less than its carrying amount, the two-step
test is performed to identify potential goodwill impairment. If it is determined
that it is not more likely than not that the fair value of the reporting unit is
less than its carrying amount, it is unnecessary to perform the two-step
goodwill impairment test. During the fourth quarter of fiscal 2016, we
determined that the fair value of the reporting unit for Athleta significantly
exceeded its carrying amount as of the date of our annual impairment review and
therefore, we did not recognize any impairment charges for Athleta.
Based on certain circumstances, we may elect to bypass the qualitative
assessment and proceed directly to performing the first step of the two-step
goodwill impairment test. The first step of the two-step goodwill impairment
test compares the fair value of the reporting unit to its carrying amount,
including goodwill. The second step includes hypothetically valuing all of the
assets and liabilities of the reporting unit as if the reporting unit had been
acquired in a business combination. Then, the implied fair value of the
reporting unit's goodwill is compared to the carrying amount of that goodwill.
If the carrying amount of the reporting unit's goodwill exceeds the implied fair
value of the goodwill, we recognize an impairment loss in an amount equal to the
excess, not to exceed the carrying amount.
At the end of each of the first three quarters of fiscal 2016, given the
information available at the time of those assessments, we determined that there
were no events or circumstances that indicated any impairment for goodwill
related to Intermix. During the fourth quarter of fiscal 2016, management
updated the fiscal 2017 budget and financial projections beyond fiscal 2017 for
Intermix. There were several factors that caused the financial projections and
estimates to significantly decrease from the previous estimates, which included:
poor fourth quarter of fiscal 2016 holiday performance at Intermix stores, the
decision to reduce expected future store openings, the approval of additional
store closures in fiscal 2017, and the budgeting of additional headcount
required to support increased focus on the online business. These factors
arising during the fourth quarter of fiscal 2016 had a significant and negative
impact on the estimated fair value of the Intermix reporting unit, and we have
determined that the Intermix reporting unit's carrying value exceeded its fair
value as of the date of our annual impairment review. As such, we performed the
second step of the goodwill impairment test which resulted in an impairment
charge of $71 million for goodwill related to Intermix in fiscal 2016. This
impairment charge reduced the $81 million of purchase price allocated to
goodwill in connection with the acquisition of Intermix in December 2012 to $10
million
as of January 28, 2017.
We did not recognize any impairment charges for goodwill in fiscal 2015.
As of January 28, 2017, the aggregate carrying value of trade names was $95
million
, which primarily consisted of $54 million and $38 million related to
Athleta and Intermix, respectively. A trade name is considered impaired if the
carrying amount exceeds its estimated fair value. If a trade name is considered
impaired, we recognize a loss equal to the difference between the carrying
amount and the estimated fair value of the trade name. The fair value of the
trade names is determined using the relief from royalty method. During the
fourth quarter of fiscal 2016, we completed our annual impairment review of the
trade names and we did not recognize any impairment charges. We determined that
the fair value of the Athleta trade name significantly exceeded its carrying
amount as of the date of our annual impairment review. The fair value of the
Intermix trade name exceeded its carrying amount by less than 10 percent as of
the date of our annual impairment review.
These analyses require management to make assumptions and to apply judgment,
including forecasting future sales and expenses, and selecting appropriate
discount rates and royalty rates, which can be affected by economic conditions
and other factors that can be difficult to predict.

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If actual store and online results and brand performance, real estate market
conditions, and economic conditions including interest rates are not consistent
with our estimates and assumptions used in our calculations, we may be exposed
to additional impairment losses that could be material.

Revenue Recognition
While revenue recognition for the Company does not involve significant judgment,
it represents an important accounting policy. We recognize revenue and the
related cost of goods sold at the time the products are received by the
customers. For sales transacted at stores, revenue is recognized when the
customer receives and pays for the merchandise at the register. For sales where
we ship the merchandise to the customer from a distribution center or store,
revenue is recognized at the time we estimate the customer receives the
merchandise.
We sell merchandise to franchisees under multi-year franchise agreements. We
recognize revenue from sales to franchisees at the time merchandise ownership is
transferred to the franchisee, which generally occurs when the merchandise
reaches the franchisee's predesignated turnover point. We also receive royalties
from franchisees primarily based on a percentage of the total merchandise
purchased by the franchisee, net of any refunds or credits due them. Royalty
revenue is recognized primarily when merchandise ownership is transferred to the
franchisee.
We record an allowance for estimated returns based on our historical return
patterns and various other assumptions that management believes to be
reasonable. We do not believe there is a reasonable likelihood that there will
be a material change in the future estimates or assumptions we use to calculate
our sales return allowance. However, if the actual rate of sales returns
increases significantly, our operating results could be adversely affected. We
have not made any material changes in the accounting methodology used to
estimate future sales returns in the past three fiscal years.
See Note 1 of Notes to Consolidated Financial Statements included in Item 8 of
this Form 10-K for recent accounting pronouncements related to revenue
recognition and expected impact from the adoption of new standards.

Unredeemed Gift Cards, Gift Certificates, and Credit Vouchers
Upon issuance of a gift card, gift certificate, or credit voucher, a liability
is established for its cash value. The liability is relieved and net sales are
recorded upon redemption by the customer. Over time, some portion of these
instruments is not redeemed ("breakage"). Based on historical redemption
patterns, we determine breakage income for gift cards, gift certificates, and
credit vouchers when we can determine the portion of the liability where
redemption is remote, which is three years after issuance. Breakage income,
which has been historically immaterial, is recorded in other income which is a
component of operating expenses in the Consolidated Statements of Income. When
breakage income is recorded, a liability is recognized for any legal obligation
to remit the unredeemed portion to relevant jurisdictions. Substantially all of
our gift cards, gift certificates, and credit vouchers have no expiration dates.
We do not believe there is a reasonable likelihood that there will be a material
change in the future estimates or assumptions we use to calculate our breakage
income. However, if the actual pattern of redemption for gift cards, gift
certificates, and credit vouchers changes significantly, our operating results
could be adversely affected. We have not made any material changes in the
accounting methodology used to estimate breakage in the past three fiscal years.
See Note 1 of Notes to Consolidated Financial Statements included in Item 8 of
this Form 10-K for recent accounting pronouncements related to revenue
recognition and expected impact on recognition of breakage income from the
adoption of new standards.


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Income Taxes
We record a valuation allowance against our deferred tax assets when it is more
likely than not that some portion or all of such deferred tax assets will not be
realized. In determining the need for a valuation allowance, management is
required to make assumptions and to apply judgment, including forecasting future
income, taxable income, and the mix of income or losses in the jurisdictions in
which we operate. Our effective tax rate in a given financial statement period
may also be materially impacted by changes in the mix and level of income or
losses, changes in the expected outcome of audits, or changes in the deferred
tax valuation allowance.
At any point in time, many tax years are subject to or in the process of being
audited by various taxing authorities. To the extent our estimates of
settlements change or the final tax outcome of these matters is different from
the amounts recorded, such differences will impact the income tax provision in
the period in which such determinations are made. Our income tax expense
includes changes in our estimated liability for exposures associated with our
various tax filing positions. Determining the income tax expense for these
potential assessments requires management to make assumptions that are subject
to factors such as proposed assessments by tax authorities, changes in facts and
circumstances, issuance of new regulations, and resolution of tax audits.
We believe the judgments and estimates discussed above are reasonable. However,
if actual results are not consistent with our estimates or assumptions, we may
be exposed to losses or gains that could be material.
Recent Accounting Pronouncements
See "Organization and Summary of Significant Accounting Policies" in Note 1 of
Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K
for recent accounting pronouncements, including the expected dates of adoption
and estimated effects on our Consolidated Financial Statements.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Derivative Financial Instruments
Certain financial information about the Company's derivative financial
instruments is set forth under the heading "Derivative Financial Instruments" in
Note 8 of Notes to Consolidated Financial Statements included in Item 8 of this
Form 10-K.
We have performed a sensitivity analysis as of January 28, 2017 based on a model
that measures the impact of a hypothetical 10 percent adverse change in foreign
currency exchange rates to U.S. dollars (with all other variables held constant)
on our underlying estimated major foreign currency exposures, net of derivative
financial instruments. The foreign currency exchange rates used in the model
were based on the spot rates in effect as of January 28, 2017. The sensitivity
analysis indicated that a hypothetical 10 percent adverse movement in foreign
currency exchange rates would have an unfavorable impact on the underlying cash
flow, net of our foreign exchange derivative financial instruments, of $35
million
as of January 28, 2017.


Debt



Certain financial information about the Company's debt is set forth under the
heading "Debt" in Note 5 of Notes to Consolidated Financial Statements included
in Item 8 of this Form 10-K.
Our $1.25 billion aggregate principal amount of 5.95 percent notes due April
2021
are not subject to interest rate risk as they have a fixed interest rate.
A final repayment of 7.5 billion Japanese yen ($65 million as of January 28,
2017
) for the 15 billion Japanese yen, four-year, unsecured Japan Term Loan is
payable on January 15, 2018. The average interest rate associated with the Japan
Term Loan for fiscal 2016 was 1 percent. Due to the maturity of the Japan Term
Loan in fiscal 2017, we believe we have no material exposure to interest rate
risk.


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Cash Equivalents
We have highly liquid fixed and variable income investments classified as cash
equivalents, which are placed primarily in time deposits, money market funds,
and commercial paper. We value these investments at their original purchase
prices plus interest that has accrued at the stated rate. The value of our
investments is not subject to material interest rate risk. However, changes in
interest rates would impact the interest income derived from our investments. We
earned interest income of $8 million in fiscal 2016.

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