Gap : Fourth Quarter 2023 Transcript

Gap Inc. Fourth Quarter Fiscal 2023 Conference Call Prepared Remarks

March 7th, 2024

Emily Gacka - Director of Investor Relations, Gap Inc.

Good afternoon, everyone. Welcome to Gap Inc.'s Fourth Quarter Fiscal 2023 Earnings Conference Call. Before we begin, I'd like to remind you that the information made available on this conference call contains forward-looking statements that are subject to risks that could cause our actual results to be materially different.

For information on factors that could cause our actual results to differ materially from any forward- looking statements, as well as a description and reconciliation of any financial measures not consistent with Generally Accepted Accounting Principles, please refer to the cautionary statements contained in our latest earnings release, the risk factors described in the company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 14, 2023, and any subsequent filings with the Securities and Exchange Commission, all of which are available on gapinc.com.

These forward-looking statements are based on information as of today, March 7th, 2024, and we assume no obligation to publicly update or revise our forward-looking statements.

Joining me on the call today are Chief Executive Officer Richard Dickson and Chief Financial Officer Katrina O'Connell.

With that, I'll turn the call over to Richard…

Richard Dickson - Chief Executive Officer, Gap Inc.

Thank you for joining our call today where I will provide an update on our performance and progress in the context of our four strategic priorities. Then I'll pass the call to Katrina to walk you through our detailed financial results as well as our 2024 outlook before we take questions.

As a reminder, our four strategic priorities are: first, maintaining and delivering financial and operational rigor; second, the reinvigoration of our brands; third, strengthening our platform; and fourth, energizing our culture.

Before I start, I'd like to highlight three recent additions to our leadership team, each of whom will contribute meaningfully to the ongoing execution of our strategic priorities:

• Eric Chan has joined us as Chief Business and Strategy Officer
• Amy Thompson as Chief People Officer
• And Zac Posen as Creative Director of Gap Inc. and Chief Creative Officer of Old Navy

I've been purposeful in thinking about the talent and skills these executives bring and how they complement our existing institutional knowledge. These new leaders will play critical roles in unlocking our full potential and solidifying our foundation as we redefine Gap Inc. for a new era - one where financial and operational rigor is a cornerstone of strength, bolstered by best-in-class talent and a culture of creativity - all paving the way for brand reinvigoration and greater cultural relevance.

We are pleased with the results of the quarter as we exceeded expectations on several key metrics, driven by our strategic priorities.

Maintaining and delivering financial and operational rigor strengthened our financial footing in 2023 - showing that we can drive more efficiency and productivity - enabling us to focus on brand reinvigoration.

We've made a lot of progress, delivering cost savings and gross margin expansion, and this work helped us deliver meaningful improvement in adjusted operating margin of 410 basis points for 2023.

Our focus on controlling the controllables also resulted in better working capital and a stronger balance sheet at year-end. This includes reducing our inventory levels by 16% year over year, building a strong cash balance of $1.9 billion, and generating over $1.1 billion in free cash flow. These proof points put us on strong financial footing as we begin 2024.

Our results in the 4th quarter demonstrate strong progress, not only in terms of improved margins and well-controlled expenses but also with more stability in net sales.

Net Sales grew by 1%, and comps were flat, with Gap Inc. gaining market share. The sequential improvement, which is noteworthy in a declining apparel market, reflects the team's responsiveness and nimbleness as we begin our brand reinvigoration work.

Old Navy comps increased 2%. We were pleased to gain share in Women's for the fourth quarter, building on the success we saw in the third quarter. We are also encouraged that we increased our foothold in two key categories, active and bottoms. As the #5 player in the Active space, we are excited for Old Navy to accelerate in this leading category. The all-important Bottoms category creates additional opportunities because it's the gateway to the full wardrobe.

Gap brand's comps were up 4%, driven by strength in women's where we delivered our fifth consecutive quarter of market share gains. This result was amplified by good performances in denim and sweaters, supported by new marketing campaigns.

Banana Republic comps were down 4% as we conduct deliberate and ongoing work to re-establish the brand.

And Athleta's comps were down 10% as we lapped a period of heavy discounting that we previewed last quarter, but improved sequentially driven by new holiday product, updated marketing, and improved in- store presentation.

We expanded our company gross margin by 530 basis points, ahead of expectations, driven by more effective sourcing strategies and lower commodity costs combined with improved promotional activity, leaner inventories, and better assortments.

We also increased our operating margin by 570 basis points to 5.0%.

Our team is demonstrating the ability to do what we say we are going to do, and in some cases, even more. However, we're not where we need to be. Our ongoing focus on financial and operational rigor will allow us to continue to elevate our performance, improve execution consistency and set the foundation for our exciting brand reinvigoration work.

Turning to our next priority, brand reinvigoration is about driving both relevance and revenue, inspired by our brands' incredible heritage. As a reminder, this strategic priority begins with strengthening the identities and purpose of each of our brands. We are striving for each brand to have trend-right product assortments - rooted in customer centric design thinking - and a clear point of view that delivers on both wants and needs.

From there, we need to execute several key ingredients. We must consistently deliver product storytelling that excites our customers, supported by compelling merchandising. We need to drive demand with innovative marketing to regain a powerful voice in the cultural conversation. And we must create better, more engaging omnichannel experiences with a clear and compelling pricing strategy. Most importantly, we must execute with excellence along every touchpoint and interaction. These elements form the basis of our brand reinvigoration playbook. While specific execution will differ by brand, we are working with each of our brand teams to implement this playbook holistically and consistently.

Now, I would like to provide an update on the progress of each brand.

Let's start with Old Navy. We are encouraged by the sales performance we saw in the back half of 2023 and the growth we delivered in the quarter.

We are reasserting Old Navy's authority as the #2 apparel brand in the U.S.

We delivered on-trend products - particularly in women's, active, bottoms, and knits, which performed well in the quarter. Supported by our campaign with Natasha Lyonne, we showcased and leveraged our authority in the Bottoms business and saw great response especially to the Taylor pant, the refreshed Pixie pant, and the Cargo.

We are celebrating "Fashion, Family and Fun" through more precise marketing and storytelling. Another example of reasserting our authority is "Jingle Jammies". We took our famous "Jingle Jammies" and created "Jingle Glammies," supporting it through a compelling social media campaign where influencers paired jammies with going-out wear. This demonstrates how we take a product and make it a trend by dialing it up in a relevant way through storytelling.

Old Navy is reinforcing value by communicating to customers with more clarity on price and quality both in stores and online, highlighting the brand's value proposition.

We are seeing the strength of the brand identity evolving and coming alive through online and visual communications.

The progress we are making at Old Navy gives us confidence in our ability to build consistency while we deliver against our priorities.

Let's turn to Gap brand.

We are driving continuous improvement, and Gap has exciting potential as we focus on reigniting the brand dialogue. Gap was built on strong product narratives with brilliant marketing, expressed through big ideas. Gap, in its best days, was a storyteller who could take a product and create a trend using culturally relevant marketing.

During the fourth quarter, our team took Cashsoft, Gap's innovative, washable fabric that feels like cashmere, and turned it into a big idea through creative storytelling, supported by elevated marketing and in-store design and digital presentation. We amplified this innovative product idea, and it became a key contributor to the strength in sweaters we saw during the quarter. Its success is an important proof point that shows we can reignite Gap with big ideas and deliver improved results. And now, we are going to build on that example with relentless repetition.

Our Linen campaign, which launched in late February, is the big idea for spring. The campaign is running now, and I encourage you to take a look. This is a great example of the brand taking trend-right product and amplifying it, turning it into a big idea expressed through compelling in-store merchandising and strong digital execution, with an innovative and culturally relevant marketing campaign entitled "Linen Moves," featuring musical artists, Tyla and JUNGLE. We struck a cultural chord on Instagram and Tik Tok

• "Linen Moves" was Gap brand's highest performing video on both platforms EVER! And we're just getting started.

Regarding Banana Republic, we are focused on re-establishing this brand to thrive in the premium lifestyle space.

As I've dug in with the Banana Republic team, I've realized that we are behind on the fundamentals - having the right product, in the right place, with the right price. 2024 will be about getting back to the basics, both for product and execution. This includes a focus on go-to wardrobe pieces and BR Classics like sweaters, oxfords, suit separates and khakis - those products that Banana Republic has been known for and will be again.

We are encouraged by the brand aesthetic, but it will take some time to get this right and unlock the potential of this business.

Turning to Athleta, as we shared with you last quarter, the brand had missteps in prior years, and as a result, net sales for the brand remained muted in Q4 as we lapped markdowns, a challenge we will continue to face through the first half of 2024. Athleta is a brand with significant growth potential and a clear and distinct positioning rooted in the "Power of She."

Early holiday ideas like cold-weather train and our shine sets sold well. These great ideas were ultimately bought too small, but they are good proof points that we are on the right track at Athleta.

We are making progress in resetting this brand, returning to the core of Athleta's positioning. We started the new year with a cleaner palate, and we've seen early successes in new arrivals. Although the changes are small, we are learning and encouraged by the customer's early reaction.

We are focused on resetting the brand for success and putting Athleta back at the center of the cultural wellness conversation while reengaging the brand's performance roots.

Moving to the third strategic priority, strengthening our platform. We are focusing on building and sharpening our operational capabilities to improve effectiveness and efficiency, and in turn drive cost leverage and demand generation.

I recently returned from a two-week trip to Asia, during which I immersed myself in our supply chain infrastructure. I spent time listening, learning and understanding the facets of our supply chain network, and I have gained insight into the incredible long-standing partnerships we have built over the years.

I also spent time in our Hyderabad office in India, studying our technology tools and capabilities. While encouraging, this is an area we will be focused on elevating as part of our path to becoming a high- performing apparel company. We are still in the assessment phase, but my intent is to cultivate a digital-

first organization and mindset that uses technology to enable business strategy, enhance the customer experience, and capture future opportunities.

We are also beginning to evaluate how we can better leverage our media and marketing with the goal of developing more compelling creative and more innovative media, to support growth across the portfolio.

I believe our platform gives us meaningful differentiation and has the potential to unlock additional value creation, and we will work to further build out our capabilities to drive efficiency and effectiveness.

The fourth priority is culture. Energizing our culture will fuel creativity and connectivity while driving accountability across our organization.

As I mentioned earlier, the recent appointment of Amy Thompson has bolstered our leadership team and underscored our investment in building a culture where employees show up every day with purpose and a sense of belonging. Amy is a builder of highly effective cultures that integrate purpose, vision, mission, and values throughout an end-to-end employee experience - all dedicated to driving business success. This includes igniting a growth mindset with empowered leaders and aligned incentives. I'm confident she will help us build a winning culture at Gap Inc.

Today our company is on strong financial footing. In 2024, we will continue to strengthen our fundamentals as we focus on our four strategic priorities.

While there is a lot of work to do, I am energized by the progress we have made so far, and I am inspired by the team's commitment and talent. I want to take a moment to recognize our global team for their ongoing dedication and I look forward to continuing this work in partnership with them as we drive towards becoming a high performing apparel company.

And now I will turn the call to Katrina for a closer look at our financials and our outlook for 2024…

Katrina O'Connell - Chief Financial Officer, Gap Inc.

Thank you, Richard and thanks everyone for joining us this afternoon.

We are pleased to report fourth quarter and full year 2023 results ahead of our expectations, with market share gains. We remain focused on the discipline we have created around margin recovery, expense actions, inventory management, and maintaining a strong balance sheet. As Richard noted, our financial and operational rigor continues to be foundational as we turn our attention to the reinvigoration of our brands in 2024.

Before we begin, I'll note that all results reported today are inclusive of the 53rd week, except for comparable sales metrics.

Some of the key highlights from fourth quarter and fiscal 2023 include the following:

• Fourth quarter comparable sales were flat and net sales were up 1%, ahead of our expectations, driven by Old Navy and Gap Brand's sales results during the important holiday season. And, while full-year 2023 comparable sales were down 2% and net sales declined 5% year over year, this performance was in line with the outlook we provided at the beginning of the year, as our financial and operational rigor begins to deliver more consistent performance.
• Old Navy drove a positive 2% comparable sales in the quarter, building increased confidence in consistent delivery of net sales growth. For the year, Old Navy comparable sales were down 1%, with positive comp performance in the second half of the year, and market share gains in all four quarters.
• Gap Brand drove 4% quarterly comparable sales growth with a positive 1% comp for the year, outpacing the market.
• We delivered 530 bps of gross margin expansion in Q4 and 380 bps of expansion for the year versus last year's adjusted gross margin, resulting from trend-right product, which, when combined with well-managed inventories, led to improved promotional activity. Margins also benefited from lower commodity costs.
• We reduced fiscal 2023 SG&A by over $300M year-over-year on an adjusted basis as a result of our commitment to financial discipline.
• All of which resulted in an operating margin of 5.0% for Q4; and an adjusted operating margin of 4.1% for the year, a 410 basis point improvement versus last year's adjusted operating margin, demonstrating meaningful progress on our path toward profitable sales growth.
• Inventories ended down 16% year over year and remained well controlled, driving better profitability and working capital.
• And we ended the year with $1.9 billion of cash on the balance sheet, delivering $1.1 billion of free cash flow for the year.

While we enter fiscal 2024 encouraged by the financial progress we have made, we are taking a balanced view of 2024 while we shore up the foundation of our brands. I will discuss our outlook in more detail in a moment.

Let me start with fourth quarter results.

Net sales for the quarter were up 1% to last year at $4.3 billion, exceeding our previously communicated guidance range, and comparable sales were flat. The 53rd week added approximately 4 percentage points of sales growth in the quarter. Also, the sale of Gap China last year had an estimated 2-point negative impact to Gap Inc. total net sales growth.

Let me now provide fourth quarter sales results by brand.

Starting with Old Navy, net sales were $2.3 billion, up 6% versus last year, with comparable sales up 2%. This represented the second consecutive quarter of positive comps at the brand.

Turning to Gap brand. Gap brand net sales of $1.0 billion were down 5% versus last year. Excluding the estimated negative impact to sales of 8 percentage points related to the sale of Gap China, net sales would have been up 3% versus last year.

Comparable sales inflected positively, increasing 4%, driven by continued strength in Women's, which gained market share for the fifth quarter in a row.

Banana Republic net sales of $567 million declined 2% year over year, with comparable sales down 4%. Re-establishing Banana Republic will take time, and we know that there's work to be done to better execute many of the fundamentals in 2024.

Athleta net sales of $419 million declined 4% versus last year. Comparable sales were down 10%. While the sales trend improved versus the prior quarter, net sales performance was still challenged due to tougher comparisons as we anniversary a period of elevated discounting, a dynamic which we expect will continue through the first half of fiscal 2024.

While Athleta sales remain negative from the headwinds related to lapping last year's significant promotions, we are encouraged by the positive customer reaction to our new assortments, cleaner store presentations, improved online experiences, better marketing execution, and innovative new customer activations which give us confidence that the brand's efforts are driving underlying benefits.

Now turning to gross margin in the quarter.

Gross margin of 38.9% expanded 530 basis points versus last year.

Merchandise margin increased 500 basis points in the quarter compared to last year driven by:

• An estimated 300 basis points of leverage from lower commodity and air freight costs
• With the remaining leverage primarily driven by improved promotional activity, ahead of expectations, as strong Holiday assortments and well-controlled inventory enabled lower discounting during the season.

Rent, Occupancy, & Depreciation modestly declined on a nominal dollar basis versus last year. As a percentage of sales, ROD leveraged 30 basis points.

Now let me turn to SG&A.

SG&A was $1.46 billion in the quarter, largely in line with our prior outlook. As a percentage of sales, SG&A of 33.9% leveraged 40 basis points versus last year.

Operating income was $214 million, up $244 million versus last year. Fourth quarter operating margin of 5% improved 570 basis points versus last year, driven primarily by gross margin expansion.

Fourth quarter net interest income was $4 million as higher interest earned on cash balances offset interest expense.

Our fourth quarter tax rate was 15.1% and benefited from the release of certain reserves.

Earnings per share in the quarter were $0.49.

Now, turning to full year fiscal 2023 results.

Net sales were down 5% to last year at $14.9 billion, and comparable sales were down 2%. The addition of the 53rd week contributed approximately 1 point of sales growth to the full year, and the sale of Gap China in fiscal 2022 had an estimated 2-point negative impact to Gap Inc. total net sales growth.

Gross margin was 38.8%, expanding 450 basis points versus last year's reported gross margin and 380 basis points versus last year's adjusted gross margin.

Merchandise margin increased 420 basis points versus last year on an adjusted basis driven by:

• 200 basis points of benefit from lower air freight expense.
• With the remaining expansion primarily driven by improved promotional activity.
• Inflationary impacts from commodity costs were relatively neutral to the year

And ROD as a percentage of net sales deleveraged 40 basis points versus last year.

Reported SG&A was $5.22 billion for the year or 35.0% of sales. Excluding restructuring costs and a gain related to the sale of an office building, adjusted SG&A was $5.17 billion, down 6% versus last year primarily driven by cost savings as a result of strategic actions.

Reported operating margin was 3.8%. Excluding $93 million in restructuring costs and $47 million related to the gain on sale of an office building, adjusted operating margin of 4.1% expanded 410 basis points versus last year.

Fiscal year 2023 net interest expense was $4 million, as interest expense was largely offset by interest earned on cash balances.

The reported effective tax rate was 9.7% for the year and the adjusted effective tax rate was 11.0%. During the year, we received discrete tax benefits from the impact of foreign operations, a transfer pricing settlement related to sourcing activities, and the release of certain reserves.

Share count ended at 372 million.

Reported earnings per share was $1.34. Excluding the impact of restructuring and the gain on sale of an office building, adjusted earnings per share was $1.43. Adjusted earnings per share includes $0.29 of discrete tax benefits and a $0.05 benefit related to the 53rd week.

Now turning to the balance sheet and cash flow.

Inventory levels were meaningfully below last year in all quarters, with fiscal 2023 ending inventory declining 16% year-over-year.

We ended the year with cash and equivalents of $1.9 billion, an increase of 54% from last year.

Full year net cash from operating activities was $1.5 billion as a result of our improved operating profit and lower inventory buys. Free cash flow was an inflow of $1.1 billion.

We remain committed to delivering an attractive quarterly dividend as a core component of total shareholder returns. During the year, we returned $222 million to shareholders in the form of dividends, representing annual dividends of $0.60 per share. On February 27th our board approved maintaining a dividend of $0.15 per share for the first quarter of fiscal 2024.

In summary, as I reflect on 2023, I am proud of the discipline and rigor we have brought back into our foundation, which has resulted in meaningful recovery in profits as well as strong free cash flow. I am also encouraged by the progress we made in the second half of the year with sales stabilizing in the fourth quarter, led by progress at Old Navy and Gap, early proof points of brand reinvigoration. We remain committed in 2024 to delivering continued improved performance through maintaining our financial and operational rigor.

Now let me turn to our 2024 outlook.

Our attention in 2024 remains on controlling the controllables - gross margin recovery, expense discipline, inventory management, and maintaining a strong balance sheet - while we continue the foundational work related to our brands as we aspire to drive relevance and revenue. We expect this rigor to deliver roughly flat sales, excluding the 53rd week, while delivering low to mid-teens operating income growth.

Let me provide some details on our outlook.

Starting with full year 2024.

Our outlook of flat net sales year over year, excluding the 53rd week assumes continued performance at Old Navy and Gap, offset by challenging comparisons for Athleta in the first half of the year as the brand laps elevated discounting from 2023, and a longer recovery timeline at Banana Republic.

This net sales outlook also contemplates the following unique dynamics:

• First, as a reminder, 2024 is a 52-week year, but will be compared in total to a 53-week year in 2023. The loss of the 53rd week results in a detrimental impact of approximately $160 million to fiscal 2024 net sales. It's worth noting that timing shifts associated with the 53rd week are expected to be impactful to both Q1 and Q4 in 2024. In the first quarter, we expect to benefit from the timing shifts as we lose a low volume week in February and add a modestly larger week in May. Additionally, the fourth quarter is expected to be negatively impacted by the loss of the 53rd week.
• Second, we have embedded multiple scenarios that contemplate modest headwinds in the first half of the year related to late deliveries as a result of geopolitical issues in the Red Sea. We currently expect that impact will moderate in the second half of 2024, but we will monitor the situation closely as we move through the year.