Jack Calandra - SVP of Corporate Finance and IR Art Peck - Chief Executive Officer Sabrina Simmons - EVP and Chief Financial Officer

Randy Konik - Jefferies John Morris - BMO Capital Markets Oliver Chen - Cowen and Company Matthew Boss - JP Morgan Matt McClintock - Barclays Susan Anderson - FBR Capital Markets Kimberly Greenberger - Morgan Stanley Lindsay Drucker Mann - Goldman Sachs Adrianne Neve - Janney Capital Markets Lorraine Hutchinson - BofA Merrill Lynch

Good afternoon ladies and gentlemen, my name is Kevin and I will be your conference operator today. At this time, I would like to welcome everyone to the Gap Inc. First Quarter 2015 Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] I would now like to introduce your host, Jack Calandra, Senior Vice President of Investor Relations.

Good afternoon everyone. Welcome to Gap Inc.'s first quarter 2015 earnings conference call. Before we begin, I'd like to remind you that the information made available on this webcast and conference call contains forward-looking statements. For information factors that could cause our actual results to differ materially from the forward-looking statements, as well as reconciliations or descriptions of measures we are required to reconcile to GAAP financial measures, please refer to today's earnings press release as well as our most recent annual report on Form 10-K and our subsequent filings with the SEC, all of which are available on gapinc.com. These forward-looking statements are based on information as of May 21st, 2015, and we assume no obligation to publicly update or revise our forward-looking statements. Joining us on the call today are CEO, Art Peck; and Executive Vice President and CFO, Sabrina Simmons. Sabrina will be using slides to supplement her remarks which you can view by going to the Investor Relations section at gapinc.com. With that I'd like to turn the call over to Art.

Thanks, Jack, and good afternoon everyone. I'm pleased to be here speaking to now in my second earnings call as CEO. The most important thing I want to do today is reemphasize our earnings guidance for the year. You have I'm sure our press release in front of you. You have the details underneath that and after I'm done, I'll hand it over to Sabrina Simmons who will take you through the specific details and obviously, we'll have Q&A at the end of this call. We'll talk about our first quarter results and I'll go a little bit deeper into what's been going on over the last three months. There are three issues that really impacted the first quarter. Two of those are macro factors which we've spoken to you about before in terms of foreign exchange and the West Coast port situation. Sabrina will spend a little bit more time on that. I really want to dive in on the underlying results of our three global brands and specifically, the performance of our women's businesses. As we've said and we continue to see, we've had an exceptionally well performing women's business at Old Navy which has driven great profitable growth. Product acceptance at Gap in the women's business has been tough and we're focused on making it happen. At Banana Republic, it's a work-in-process and we have work to do there as well. Let me start first by spending a few minutes on Old Navy. Obviously, it's a very good story. A story that we're very pleased with it and a story that we have confidence and that's going to continue to repeat itself on a going forward basis. Three years of excellent performance and most importantly, underneath the covers, growth that is being driven in a very high quality way with a very nice margin story underneath it. Q1 comp was a women's story and I'm saying that in particular because as we have struggled with our women's business in Gap, as an example, Old Navy is an excellent example where we continue to get women's right season after season and we're very pleased with the performance that we're seeing with on-brand, on-trend product in our stores. I need to point out that this is a combination of factors. It is clearly a team working well together, led by Stefan that is delivering this performance. But it's also underlying process changes that we have made in the way that we're running the business and the way that we're bringing product to market that is delivering the consistency that we're seeing. I mentioned this before, but I need to mention it again, which is we're taking these changes and in some cases, largely transplanting them into our other businesses and that they are proven inside of Old Navy and they have been delivering this kind of performance. Again, we have a strong women's business there, but it's been followed by a pretty strong business inside the rest of the box as well across men's, kids, and baby. And it's a thing of beauty when Old Navy is firing on all cylinders and has now for several seasons running. On the flipside, I continue to be disappointed, but not surprised by Gap's performance. We have had a women's business challenge now for several seasons running, I believe we have diagnosed it correctly having to do with being off-brand, in some cases off-trend, and I can promise you that the team is all over it. In the last call that we had I mentioned the hiring of Wendy Goldman. Wendy has hit the ground running. She is a highly collaborative, skilled leader working with the team and I've been really pleased so far the results the whole team is producing as they are focused on holiday and obviously on spring. Jeff really has three priorities right now and I want to underline and emphasize those to you. We are in season every day and we're managing the business as aggressively as we can to get every penny out of the business. In relative terms, kids and baby is performing better, and men's is performing better, but to be clear, I am not happy and Jeff is not happy with the entire performance of the brand and we're committed to turning it around. On top of managing in season, we're obviously working extremely hard to make every improvement that we can to the outlying seasons including holiday and most importantly, spring. On top of that, I said I was impatient. We're working very hard to change the product processes all of what we're doing at Old Navy in order to get Gap to a more consistent on-trend, on-brand footing. And I have to say much of the work that the team has done there to realign the team on the aesthetic of the brand is very, very encouraging. Banana Republic is a mix bag. This was Marissa's first collection showing up later in the quarter. It's had a couple of very positive impacts in terms of reestablishing some fashion credibility for the brand and the relevance of the brand, but we didn't get it a 100% right and this is not to be excused, but perhaps expected as you're bringing a new designer and a new leadership team together. The color palette was pretty start between black and white, not enough color in print and pattern for the season that we're in and we're still working to buy an assortment that is both commercial and fashion-oriented. Relatively speaking, the men's business is stronger and it's not that the women's business is weak, but we have not hit the stride nor delivered the commercial results while at the same time, we have established some fashion credibility and that's our job and we're focused on making it happen. In a moment, I'll turn it over to Sabrina. What I wanted to do is offer a few comments in advance about how Sabrina and I are working together and the commitment that we very much share together. Obviously, a big part of our story over the last several years has been the fact that we're committed to a responsible capital structure and as this company continues to generate a significant amount of cash, we're committed to distributing that excess cash to the benefit of our shareholders. It's important for me to emphasize that Sabrina and I are highly aligned on continuing that going forward while at the same time, responsibly reinvesting in the business. Sabrina, let me pass it to you.

Thank you, Art. Good afternoon everyone. As anticipated, our first quarter results were impacted by foreign exchange headwinds and delayed receipts due to the West Coast port issues. Despite these dynamics, we're pleased that Old Navy delivered another strong quarter on top of three years of growth. As Art mentioned, we're focused on taking the steps necessary to drive improvements and greater consistency in our other brands while continuing to make progress on our long-term objectives. Operating income for the first quarter was $386 million versus $443 million last year. Net earnings were $239 million. On a reported basis, earnings per share were $0.56, down about 3% versus $0.58 last year. It's important to note that our reported earnings per share were negatively impacted by foreign exchange. We estimate that foreign exchange reduced our reported earnings per share growth rate by about three percentage points. Sales for the first quarter were also impacted by foreign exchange and the port issues. As reported, first quarter sales were $3.7 billion, down 3% versus last year. The translation of foreign revenues into dollars negatively impacted our reported net sales by about $90 million in the first quarter. On a constant currency basis, net sales were down about 1%. Regarding the port impact there is no meaningful change to our first half estimate of $0.13. As reminder, first quarter sales were impacted by having fewer units available for sale. We expect that second quarter will be impacted by late units that well likely be sold at lower margins. Total sales and comps by division are listed in our press release. Moving to gross margin, first quarter gross margin was down 100 basis points to 37.8%. Merchandise margins were about flat driven by strong performance at Old Navy, offset by the impact of foreign exchange as well as disappointing performance at Gap brand. Rent and occupancy deleveraged 100 basis points. In the face of challenging sales performance, we managed SG&A tightly. First quarter total operating expenses were $996 million, down $27 million from the prior year driven by foreign exchange favorability. Marketing expenses were down about $7 million versus last year to $136 million. As a percent of sales, total operating expenses were 27.2% and deleveraged about 10 basis points versus last year. As a reminder, in Q2, we will lap last year's gain on sale of nearly $40 million. Therefore, we expect greater deleverage in Q2 versus Q1. Regarding the balance sheet and cash flow, inventory dollars per store were up about 4% at the end of the first quarter. As anticipated, delayed receipts due to the West Coast port situation resulted in higher in-transit inventory levels at the end of the first quarter. We expect year-over-year inventory dollars per store at the end of the second quarter to be up slightly versus last year as we focus on selling through these late receipts while trying to maximize margin. As a reminder, last year’s inventory per store was up only 2% in Q2 versus up 7% at the end of Q1. For the quarter, free cash flow was an inflow of $61 million. Underscoring our commitment to distribute excess cash to shareholders, we distributed more than five times our free cash flow or $329 million this quarter. This includes $230 million to repurchase 5.6 million shares resulting in a quarter end share count of 419 million. Regarding capital expenditures and store count, first quarter capital expenditures were $150 million. We opened 29 company-operated stores on a net basis and ended the quarter with 3,309 stores. Store count and square footage are listed in our press release. And now I would like to share our outlook for the rest of the year. Our first quarter performance was broadly in line with our expectations at the time we provided our full year guidance in February. Therefore, we are reaffirming our full year earnings per share guidance range of 2.75 to 2.80. For the full year all other guidance metrics remains substantially unchanged. In closing, as we entered the second quarter we will continue to focus on levers that we can control, while we work to deliver compelling product assortments across all of our brands. Thank you. And now I will turn it back over to Jack.

That concludes our prepared remarks. We will now open up the call to questions. We would appreciate limiting your questions to one per person.

Thank you. We will take our firs question from Randy Konik with Jefferies. Again, Mr. Konik your line is open. Please check your mute button at this time. Due to no response we will be moving on --

Hello?

Please go ahead.

Hello.

Your line is open. Please go ahead.

Sorry about that. I had little phone issues here.

Hi, Randy.

Hey guys. How are you?

Good.

I guess, just -- Art first on the -- I guess we will just -- let’s dive right into it, right on the Gap. You kind of talked a little bit about the relative better performance around kid and baby and men’s. So relative to the traffic of what you are seeing at, I guess, Banana and the Mall, is it more -- is it truly a traffic issue, conversion issue. Is the mom going in there for the baby, but just saying that these clothes -- I can't buy this? And just trying to a perspective on what is truly the problem there? And then as it relates to your perspective on the women’s side, is it -- it sounds like a combination of consistent fit, lack of color, bad marketing or not the best marketing, what have you. Just want to your get perspective on which are these things are most important to improve, which can be turned the fastest et cetera? Thanks.

Yeah. I mean, Randy, it’s a same thing. I think we've been and I have been pretty consistent in talking about, which is, we know we have a problems in the women’s business. We've diagnosed it. We've diagnosed it because you can go in there and look at it. I spend time in stores. I talk to customers, I watch what customers buy. We look at our product acceptance. And the issues are clear and have been clear for several seasons. And it is a combination of all the above, which is we've got -- we are off trend and in some cases, way off the brand. We have some quality and fit issues, where we made some choices. And the issue is the one women’s business which is why I'm focused on women’s business, when the women’s business isn’t working it does in a brand like Gap, which is obviously dual gender and then whole family have a negative halo on the rest of the box. But we are actually getting very good customer feedback on our kids and baby business. Men’s business continues to be relatively strong. And so it’s why -- when I have been working with Jeff and the team, it’s been prioritize the women’s business, because as it halos negatively when it’s not working it has the same halo effect positively when it is working. And I'm actually -- I'm pretty encouraged by what I see going forward. I can even look at the holiday assortment which is largely landed now and some of the, sort of, obvious mistakes that we've made, we have -- they are gone from the line. We've actually taken the step of cancelling some styles that we had and we knew were just not saleable, which is an appropriate thing to do as well, and which we've been able to do. So from that standpoint, again, same thing I was saying before, team heads down working on the women’s assortment and getting it back on track as much as we can do in holiday, acknowledging it was mostly bought and then spring being a no excuses moment.

Thanks guys.

Okay.

We go next to John Morris with BMO Capital Markets.

Thanks. Good afternoon everybody. Art, maybe if you could give us a little bit about your philosophy on handling marketing, the marketing spend going forward. I mean, I’m sure we will hear from Sabrina as well in terms of the thoughts about the numbers. But I want to get little bit on the philosophy we saw you guys pulled back a little bit in the quarter and what can we expect and where are you thinking about allocating it by brand and your philosophy around that. Thanks.

I mean, the simplest philosophical statement that's easiest to make is that when you are not proud of our product you are not going to out there putting a lot of marketing behind the business and it’s exactly the strategy that I followed back in 2011 when we looked forward down the pipeline, didn’t feel good about the product and consequently pulled back on a lot of the working media spend that we had in place, and we are doing some of that now as well. The other side of that is, I am feeling like we are really getting our returns in the marketing spend that we have at Old Navy. And well I can see returns and it can help drive the business, I am happy to put money into the business as well. So it’s really about placing smart bets, not just sticking with the marketing plan or anything like that. So expect us to be tight and as product gets better, expect us to then start putting a little bit of pressure on the business. But you correctly have seen that we've pulled back and we will continue to do that until we feel like there is an opportunity to really tell the story. And then the second issue is, and this is a topic broadly separate from the current performance of the business, that both Sabrina and I are very focused on right now. We have, over a long period of time, generally spent more than many of the competitors out there in terms of marketing and I think we should be getting more out of our marketing dollar than we are at the end of the day. Sabrina, do you want to add anything to that?

Yeah, I was going to add to be helpful which underscores what Art said is, in the quarter, as you might imagine, with Old Navy positive comping, they are not down at all in marketing dollars, in fact they are up. And the improvement comes a little bit from everywhere else where we are not as happy. And it also includes, by the way, I should say, Piperlime, because we closed that in the quarter and so we are not marketing behind that. And then with regard to the second quarter, I would just say, there is not going to be any radical change, because it’s likely to follow the same pattern as Q1. So I would look at something sort of starting -- last year as a good starting point to the second quarter.

Okay, thanks. Good luck.

Thanks.

We'll take our next question from Oliver Chen with Cowen and Company. Please go ahead.

Hi, thank you. I had a broader question about how you are feeling about supply chain and test, read and react inventory - manage inventories and how this will work in terms of your strategic planning. And then I do think we are observing some newness on the trend front on the marketplace, from our perspective. I'm just wondering what vehicles might be best for you to try to capitalize upon that newness factor that seems to be happening in some bottoms and tops.

So the story on supply chain is, as we've been telling it that we’re continuing to push on it on a number of the elements, on platform fabric which enables us to get back into season very quickly on some of the test and respond that we've been doing. Old Navy is farthest ahead in realizing this with the changes that have taken place, obviously and the challenges in the business at Gap, changes in leadership, challenges in the business. Those two businesses lag. Banana is probably in the middle and Gap is farthest behind. What I can say quite confidently is that as we have implemented it it’s very clear that it’s having a positive impact and it’s the right thing to do. And then the question really is scaling it and continuing to scale it as fast as we can. And so -- and we are using this in some cases to do exactly what you talked about with respect to a trend out there that we see or something like that. We will put a set of silhouettes in bottoms and we'll see which sells and allows us to go -- cut more aggressively and respond more quickly into the silhouettes that are selling right now. And obviously in denim, as an example, there is lot of variation out there in terms of rise, in terms of leg silhouette, and the novelty and we can be more responsive there. Knits is an easy one where we've also used that and particularly inside of Old Navy to be more responsive to where the knits business has really shown some real strength and puts some volume behind it. So, it’s a clear capability. As I've said pretty publicly, we are in the business that we guess a lot and anything that we can do to minimize the guesses and guess better, and inform it with data, has a real positive impact on the business.

Okay, Art. And just your -- just for expectations, it's more about spring versus holiday, but you've made some tweaks for holiday. Just I wanted to understand, I mean, how we should think about the catalyst and timing?

So in Gap brands, specifically, you mean?

Yes.

Yeah. I mean, kind of, going to stick to my same story there, which is that, I don’t want to make any promises about holiday because as the team got in place holiday had a pretty good team behind it and so much of it was developed. What I can say is that the team did not do anything and they’ve put their shoulder against it and made some changes there. I'm certainly hoping it will be better and from what I have seen, I have seen some encouraging elements of the assortment that I think are in a much better place. But I'm really putting my big expectation on spring.

Thank you. Best regards.

Sure.

[Operator Instructions] Your next question comes from the line of Matthew Boss with JP Morgan. Please go ahead.

Hey, good afternoon guys. So expense control remains pretty impressive over this year and next couple actually. What type of flexibility do you think remains on a go forward basis, and particularly if a top-line turn where not to materialize at the end of this year or even in the spring. And then just what kind of room do you have to continue to cut some expenses?

Yeah, well this part of our expense phase is related to our stores and that varies in large part that -- half of that varies with sales. So we do have the benefit that if sales do not -- are not realized to the extent we’d like them to be, we have a natural variable component that comes down. So that's one piece that will always be in the work. With regard to sort of how we deliver the expense savings this quarter to help you think about how we would do it in future quarters. A chunk of it came from foreign exchange, so we call that out. And so we benefited, probably between the translation and balance sheet re-measurement about $30 million of benefit. Even after that the expenses were pretty close to last year. So very tight. And that comes primarily from this variable component I talked about, as well as we brought that marketing down a little bit by $7 million. And so we would continue to use those levers that are variable or discretionary like marketing. Q2, I just want to call out, again, it’s a very different dynamic, because we've leveraged last year on Q2 by 190 basis points. So just, I'm sure, optic perspective that includes the gain on sale of $40 million last year. So we are going to be lapping that. And then we layer on really kicking in June the wage increase. So the deleverage we would expect to be higher in Q2, just because of what we are anniversarying such high leverage, but we will behind the scenes continue to work all the levers we have at our disposal to manage our expenses very tightly, especially if we are not realizing the sales we would expect.

Great. And then just quick follow-up, online posted the first year-over-year contraction that I can remember maybe ever. Can you just talk about initiatives in place to stabilize this channel as well?

Yeah, online number really was driven and impacted by the ports as well. So number one is sort of at a high level, it’s important to remember that they too were impacted by that. The second piece is the Piperlime closure. So, again, we wound down and actually finished closing Piperlime in the first quarter. So that's going to be another chunk of it. And then you just have the effect of Gap product acceptance being fairly weak. So you put those three together, and you come up with, we are not happy with the number at all, but we would expect it to improve ones for out of the port situation, certainly and get that to a more normalized level.

Okay, great. That’s really helpful.

We'll go next to Matt McClintock from Barclays. Please go ahead.

Yeah. Good afternoon everybody. Art, I was wondering if we could focus on Old Navy for a bit. Three consecutive years of solid comp store sales performance and it would appear that that performance should just be now gaining steam from some of our supply chain initiatives. Can you talk about the evolution of Old Navy’s comps of the performance there from the beginning. Three years ago we put up a solid 6% increase to the most recent result. And how should we think about this evolution as those supply chain improvements continue to accelerate your ability to deliver fresh fashion to that business. Thanks.

Yeah. I'm glad you are saying that. And you can probably read the article that was in the newspaper earlier this week as well. There is some information in there. I think and I hope what you saying and what you are believing is that you put that much consistency in place, three years, multiple quarters back to back and there is a reason behind that and there is a reason behind it. And it is -- it starts with, obviously, Stefan and his team, which is a really good team, working together, but the much more important thing behind the scenes is that team living inside of a very disciplined process and as set of process change, it is allowing for the consistency. Again, I say this often publicly that it’s relatively easy to have a great quarter. What is superlatively hard in this industry is to put quarter after quarter together and then year after year. And so we have a lot of confidence there in the processes and capabilities that we've built. It starts with what we think is a really great process right at the beginning which filters trend, really systemically across a wide variety of sources, filters trend down to the right ones that we feel are brand right and appropriately commercial for Old Navy. And it’s allowed us to be in trends that are happening, at the same time in the designer and the premium contemporary space, it’s allowed us to be into those trends in Old Navy almost in the simultaneous way which really is the way the world is working right now. So that ability to be right and to respond very quickly is powerful. And then if you just go down into the system, there is really -- I think a really disciplined and structured management of the assortment that we are running as well right now, which allows to maintain the proper amount of newness at Arena portfolio, but also have a super solid set of styles that are proven that we can invest in over several seasons to help us really drive the -- really drive the commercial plan of the business. I guess, the way I think about it is, that a healthy business is a business that’s gaining market share and Old Navy has now demonstrated its ability to hunt and win at market share pretty consistently for a number of quarters running. So I won't say that this is going to be perfect every time, because it’s tough in this industry with fashion. But I do have a great deal of confidence in the system and process that we've built there. And it’s obviously why we are working very aggressively with Jeff and his team and Andi and her team to almost do turnkey installation of some of these components into the other businesses as well. And we will see the results on a going forward basis, but I have been really pleased with what we are seeing with Old Navy and really confident with what we see going forward.

Thanks a lot Art.

Yeah.

We'll go next to Susan Anderson with FBR Capital Markets. Please go ahead.

Hi, good evening. Thanks for taking my question. I was wanting to ask just about expectations for gross margin, kind of, as we go throughout the year. I assume in second quarter it should be worse because of the port situation. But then should we expect it to kind of impact positively in the back half or should we expect continued SG&A to kind of help to offset that to get to your EBIT margin guidance? Thanks.

That is a tough question, because we do not guide to gross margin season. But to try and be helpful, we do -- we have given a perspective on operating margin. The gross margin, what I will tell you just to keep in mind. And you are absolutely correct with your view that, there is going to be pressure that we expect in the second quarter because of the port for sure. As a reminder, we are also dealing with this year headwinds within the gross margin line due to foreign exchange, so that's just part of what we laid out as the early part of the year for everyone to understand because we have that very large Japan and Canada business. Then other than that I will tell you once we're passed the first half poor impact, of course, we'll be heads down on trying to deliver the healthiest margin we can. And we will ultimately continue to use all of our levers to try and put up the best value that we can every quarter. So, we'll see how that works out.

Got it, that's helpful. Thank you.

We'll take our next question from Kimberly Greenberger with Morgan Stanley. Please go ahead.

Great. Thank you so much. Art, you talked about some of the improvements in changes in processes at Old Navy that have been implemented there over the last couple of years, and that you felt like those processes -- and those improvements could be transported I think to Gap and Banana. Could you just talk to us about what -- just help us understand exactly what those process improvements are if the transportation process from one division to the other has already started to happen or the knowledge sharing already started to happen. When do think we might see the early results of that in terms of the merchandise in-store? Thanks so much.

Yeah. I mean again, I reiterate -- and let me reiterate what I said in my comments. The three lanes of work that Jeff and his team are focused on right now specifically in Gap. Obviously, you have to run the business aggressively in season and we're doing that. The team is heads down on the business on a global basis. The second issue is fixed as much of the product as we can that is in the pipeline and deliver spring -- spring women's product at a in a brand appropriate, trend appropriate way. And then the third is rebuilding the product processes. So, there are a lot of plate spinning right now inside of Jeff's world, but he and I both feel very strongly that we can't wait. So, we're working these things simultaneously. If you think about some of the key elements of the process, one is very simply the length of the pipeline and Old Navy has been running on a shorter pipeline for a while. And Gap is developing on that pipeline now as we speak. And then there is the trend process, the assortment architecture, the supply chain capabilities, a number of other things as well which we're layering in. Quite honestly Jeff and I are sitting your saying how much can we throw at the organization? And how fast can we push? But we are pushing pretty hard and pretty fast. Spring will come to market with a shorter pipeline. But it's going to be a hybrid really of the way they have traditionally brought it to market and the new process that we're building. Remember that more and more up to speed on the new platform as we go through product development for 2016 in the outlying seasons. I can't tell you exactly when there's going to be a lights on moment of this revealing itself, because it was at Old Navy and it is in both at Banana and Gap more of a progressive rebuild, but some of the key elements are ready of lease right now.

We'll take our next question from Lindsay Drucker Mann with Goldman Sachs. Please go ahead.

Thanks. Hi everyone. I wanted to ask about Old Navy and given the brand success whether you think there's opportunity to take a little bit of AUR and how you're thinking about AUR generally in light of the lower AUC environment for the back half? Thanks.

Yeah. I mean to me AUR is one of those things that if you have confidence, you can achieve it. It's a thing of beauty. And our issue with AUR as a company has been our inconsistency in our ability to achieve AUR. Again inside of Stefan's business, there has been opportunity that they have had and they have demonstrated their ability to mostly out of mix, really not out of make at the end of the day. I mean one of the things that's really cool about what's going on at Old Navy is that they are able in many cases to achieve cost reductions, an elevated sense of quality, and a mix up all at the same time from AUR. Now, it's in selective category. So, this is one where Sabrina and I are absolutely in locks-up which is to put AUR and look for AUR on the basis of mix and track record because it's proved to be way too elusive at times, not just for us, but for other people in this industry. And then the other side of AUR having nothing to do really with the make of the product or AUC is just getting off of the depth of the promotions that we've had in some parts of the company. And frankly in my view that's probably a much bigger AUR opportunity in the near to medium term than any fundamental changes in product mix or product make. We've been very heavily discounted as you know and in some cases, overbought in areas where the product is not registering, and that's a tough spot to be. So, a second part of Gap is to really make sure that we're buying holiday and spring in exactly the right way and again, I've said publicly that I have a pretty strong bias towards always modestly under buying a season and looking for upside in AUR versus trying to force a lot of units through the system.

Great. And if I could just ask one follow-up. Art when we met with you last, you had talked about -- thinking about some different ways you might conceptualize the store format and different things that you were thinking about. Have any of those experimental or new or evolved store formats come into clearer focus? Thank you.

We're still working on it on the inside. Old Navy has something that they will be testing, I'm not quite sure of the timing yet, but certainly within the course of this calendar year. And then I'm focused on our international expansion as well and in particular for both Old Navy and Gap. The store size is a big opportunity for us in terms of opening up smaller, more productive real estate spaces where we otherwise wouldn't actually necessarily even be able to open a store. So, it's -- not ready to make a pronouncement on this one, but it hasn't lost any of its importance and it certainly is being backed across the company with a high degree of urgency.

Okay. Thank you.

We go next to Adrianne Neve with Janney Capital Markets.

Good afternoon. Quick question on the inventory. I know that Old Navy has been in a position of Chase throughout fourth quarter and into the first quarter. You're able to cut some inventory at Gap going into late summer -- late spring summer. So, I'm wondering are you comfortable with your inventory levels now? And then really quickly if you could just talk about AUC opportunity in the back half? Thank you very much.

Sure. So, the inventory increase, Adrianne, is really mostly due to the in-transit issue related to the port. We told you guys we wanted to goal ourselves at the beginning of the year excluding the port something like slightly down to flattish and I would say we're pretty much there excluding this port issue that puts us up for. And then you see that we trying get back with the guidance at Q2 of getting back to tighter inventories slightly up. And the reason we're giving ourselves a little bit of wiggle room is with those late inventories coming in, we don't want to do anything unnatural of goods aren’t really liable to just force the sell-through to get to EOQ. But it's still fairly tight when you think about it to be slightly up when last year we're lapping only in EP2 [ph]. So, overall I would say we're comfortable with our inventory levels and will continue to manage them quite tightly. And your second question was --

On AUC opportunity with cotton deflation?

Right. Yeah. So, that opportunity really begins the summer flows because we told you when we bought our spring flow cotton really wasn't down yet and so yes, we hope to capture -- I mean -- and we feel confident that in the second half, we should get some tailwind. The magnitude of that we've also talked about isn't -- it's a low single-digit certainly because the simple math that we try to help you all with to be illustrative is that if cotton prices were down 20% when we placed of those orders, broadly you would expect -- with nothing else changing, you would expect AUC down about 2%. But, of course, there's always some mix and a little bit of reinvestment here and there. But that's sort of directionally what we're trying to capture in the back half.

Okay, great. Thank you so much.

We will take our last question from Lorraine Hutchinson with Bank of America Merrill Lynch. Please go ahead.

Thank you. Good afternoon. Art could you share your updated thoughts on square footage and points of distribution for both the Gap and Banana brands?

Yeah. I mean it's a pretty simple conversation I would say right now, which is that we are always looking at real estate opportunities, whether it's a store that we should be in, because the center has -- is no longer relevant, whether it's an opportunity to downsize or reposition and so that's part of the normal ongoing part of how we can downsize. And that's really the work that the team is doing all the time. And it's obviously here in North America where we have the most mature business, but we're obviously doing that all around the world across all of our fleets. So, not really ready to say anything more about it right now in any form other than it’s part of how we would be running the business in a responsible way. Sabrina I don't know if you want to add anything more to that.

No, that's right. I mean reviews on the fleet are done on an ongoing basis and obviously we look even more deeply when brands are underperforming. Overall, historically Banana Republic has had very high returns and they have a pretty tight fleet size. So, work underway more to come, I would say, but yes, it's always on our radar and it's an ongoing initiative.

Thank you. A - Art Peck: I'd like to thank everyone for joining us on the call today. As a reminder, the press release which is available on the gapinc.com contains a full recap of our first quarter results as well as the forward-looking guidance included in our prepared remarks. As always, the Investor Relations' team will be available after the call for further questions. Thank you.

Ladies and gentlemen this does conclude today's conference. We thank you for your participation.