Jennifer Fall - VP, Corporate Finance & IR Arthur Peck - CEO, President and Director Teri List-Stoll - CFO and EVP

Lorraine Hutchinson - Bank of Ameri Matthew Boss - JPMorgan Chase & Co. Adrienne Yih - Wolfe Research Anna Andreeva - Oppenheimer Simeon Siegel - Nomura Securities Mark Altschwager - Robert W. Baird & Co. Brian Tunick - RBC Capital Markets Oliver Chen - Cowen and Company Edward Yruma - KeyBanc Capital Markets Dana Telsey - Telsey Advisory Groupca Merrill Lynch

Good afternoon, ladies and gentlemen. My name is Melissa, and I will be your conference operator today. At this time, I'd like to welcome everyone to the Gap Incorporated Second Quarter 2017 Conference Call. [Operator Instructions]. I would now like to introduce your host, Jen Fall, Senior Vice President of Corporate Finance and Investor Relations. Please go ahead.

Good afternoon, everyone. Welcome to Gap Inc.'s Second Quarter 2017 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 on factors that could cause our actual results to differ materially from our forward-looking statements as well as descriptions and reconciliations of non-GAAP financial measures, as noted on Page 2 of the slides supplementing Teri's remarks, please refer to today's earnings press release as well as our most recent annual report on Form 10-K and our subsequent filing with the SEC, all of which are available on gapinc.com. These forward-looking statements are based on information as of August 17, 2017, and we assume no obligation to publicly update or revise our forward-looking statements. Joining me on the call today are President and CEO, Art Peck; and Executive Vice President and CFO, Teri List-Stoll. As mentioned, we will be using slides to supplement our remarks, which you can view by going to the Investors section at gapinc.com. With that, I'd like to turn the call over to Art.

Good afternoon, everybody, and thanks for joining us. I will turn the call over to Teri in a few moments, and she'll share more details on our Q2 results. But before we do that, I really want to zoom out for a moment and talk pretty specifically about what separates Gap Inc. from the retail apparel pack. I often see us referred to as a "mall-based apparel retailer". And I think that's one dimensional probably at best, but really, it's just flat out wrong. We have clear points of advantage that are intrinsic to our business and set us apart, first, our portfolio of iconic and I would underline, profitable brands; We're using our product capabilities to lead in loyalty driving categories to drive our business; We have a very robust, very profitable online and mobile business that meet our customers exactly where they are; and we have scale, and we're using that scale to drive advantage growth and profitability. Let me spend a moment on each of these. First, our brands. Again, we'll talk more about each brand's Q2 performance later in the call, but no other apparel retailer has a better, more diversified collection of profitable brands. Individually, they have unique strengths and unique opportunities for value creation. In Athleta and Old Navy, we have 2 growth brands, both have significant runway in front of them. Gap and Banana, they're more mature but also profitable and where we're focused on driving improved performance and cash flow generation and at the same time, responsibly and aggressively managing our exposure to struggling mall real estate. We also have a very strong value position in our portfolio. Over 60% of our total business is in the value segment across Old Navy and our outlet and factory expressions. I think people sometimes miss the fact that value for Gap Inc. isn't limited to Old Navy. It extends to Gap Outlet and Gap Factory store and Banana Republic Factory store, and we are in many non-outlet mall locations with profitable stores in both of those businesses. Underpinning our strong profitable portfolio brands is a financially healthy company with ample capacity for investment in growth. Teri will spend more time on this. But just to reiterate, we remain conservative on our leverage levels, and we ended the quarter with $1.6 billion in cash, all while maintaining a healthy level of investment in the business and returning cash to our shareholders. Last thing here I want to point out is that, yes, we operate a lot of stores. The bulk of our business is in stores. But we have taken an aggressive and strategic approach to our real estate footprint and have proactively shed more than 5 million square feet in North America over the last 10 years. It's also important to point out that our real estate portfolio is very diversified. We have stores in strip centers, lifestyle centers, street locations, et cetera, and our stores are in places largely where customers are living their lives today. Our approach to real estate is disciplined and it's balanced. We also see opportunities to responsibly invest here particularly in the value space. Second, because we're not a single brand company, we are able to leverage multiple capabilities, including product creation, innovation, vendor relationships and others across the portfolio to take the lead in key categories that drive loyalty. I'll talk about loyal categories -- loyalty categories as we continue to talk going forward. But these are categories that drive repeat customer visits and a long-term relationship, categories like denim and bottoms, active and kids and baby. And we can build the best, most innovative and differentiated products in these categories because of our scale and our portfolio. Let me give you one small but important example. Stretch denim is the rage across men's and women's. The issue with stretch denim is sometimes it doesn't stretch back, and so recovery is just as important as stretch. Acknowledging this -- that this is a consumer satisfaction, we work with our vendors to develop several fabrics across all of our brands that offer excellent stretch, excellent compression and excellent recovery. And almost simultaneously, we expressed a new jean inside of our business from $108 price point inside of Athleta to a $50 price point in our value expressions. It's a product that customers have responded to, and it's a product that meets a real consumer need that has been enabled by our scale and by our portfolio. And we're also seeing it move the needle. We closed the quarter with an almost 8% market share in denim and 40 bps increase over the past 6 months in the denim space. Active is another key area. The U.S. active market is $40 billion with an 8% annual growth rate, 1 of the highest growing segments in the industry. We have a business in this space, over $1 billion across the enterprise, and at the end of the quarter, we ended with a 3.5% market share and a 20 bps increase in our market share. So again, bringing innovation, scale in our portfolio to bear, we are seeing the needle move in these loyalty categories from a market share standpoint. We've established a center for innovation in our headquarters in San Francisco and is focused on technical and sustainable innovation across the portfolio, where we're bringing technical fabrications as well as embedding new and differentiating performance attributes into our ready-to-wear collections across our portfolio brands. Another simple example, we introduced Rapid Movement Chino in Banana Republic a few weeks ago. It delivers everything you want in a work-appropriate, classic, clean chino pant. It also has amazing stretch for comfort. It has stain resistance and is out of the box, we believe, this is a winner, that we have a winner on our hands here, again, by driving innovation across the portfolio. Kids and baby, another category where we have unique credibility with parents. Between Gap and Old Navy, we have almost 10% market share in the $30 billion U.S. kids and baby market, and we see significant incremental opportunity to drive loyalty with parents. To date, we've made great progress in Old Navy, growing to almost 6% share in the category. Honestly, we still have work to do in Gap, but we know we have very strong equity in that brand as well. Third, we're meeting our customers exactly where they are, which today means having a robust, easy-to-use, fast, online and mobile business and a multi-channel, multi-brand presence. We were early movers in the digital space, launching e-commerce more than 2 decades ago. More than a decade ago, we saw the power of our brands together and quickly migrated to one platform where our customers could cross shop all of our brands with one easy checkout. This scaled platform allows us to add innovation easily and also brands as we did with Athleta, as we continue to grow the company. I'm not aware of, maybe you can point out, any company -- any of our competitive companies that have multiple brands that offer a single cart shopping experience, and we know that this matters for our customers. Today, we're one of the largest retail apparel e-commerce businesses in the world, and this year, we expect double-digit online growth with strong performance from Intermix to outlet. As we've grown the business to its current size, the economics also have remained very attractive. And we take a world-class e-commerce approach to this business. We iterate, we A/B test. We run dozens of tests each month, things like new online product recommendations where we have just inserted a world-class product engine into our -- into the mix of our capabilities. We've also expanded mobile POS functionality. We've added new capabilities with our native mobile apps. On the mobile POS, we've deployed mobile point-of-sale devices in more than 900 North American stores so far, and we've accelerated the mobile point of sale. We're seeing higher conversion rates, larger basket sizes and higher overall satisfaction scores and loyalty increases. This is because it offers both convenience as well as a different way of engaging our sales associates on the floor of our stores. And most importantly, a cross-brand, cross-channel customer is extraordinarily valuable to us as a company. Underneath all of this is data, and this is another place where the scale of our business comes to bear. We're in the early days of turning this data into dollars, which allows us to build meaningful experiences with our customers. The highest portion of our revenue is driven by customers who shop with us across multiple channels and multiple brands. We're focused on testing new capabilities that will encourage repeat visits across all channels and all brands. And to grow our known customer base and build more meaningful relationships, we are piloting as we speak in multi-tender loyalty program in Old Navy, which will provide customers with benefits to shop with us, a more personalized experience even if they're not currently a credit card holder with one of our credit cards, which is where our current loyalty program resides. Continuing to power our omni transformation, we've added capabilities such as Reserve in Store, Find in Store, Ship from Store, Order in Store, some as much as 5 years ago, and we'll be testing a new buy online, pick up in store program this next quarter. We aren't behind. We're ahead, and we are accelerating. Finally, our portfolio allows us to play at scale in a way that we are taking advantage of we have a lot of runway in front of us. You've heard me talk about this before. Our scale drives efficiency. Our scale drives speed, and our scale drives profitability. For example, scale has been a critical advantage as we continue to leverage our responsive capabilities. We aren't asking suppliers to change processes for one small brand. And as we built these responsive capabilities, it is important for our suppliers to be deeply integrated into our own processes. We're doing this on behalf of a broad portfolio. And this is showing up in our numbers. For example, Athleta now has more than half of its bottoms business on responsive. And by responsive, I mean back in the styles in 8 weeks or less. And with that capability, they're driving double-digit growth year-to-date on top of double-digit growth in 2016. Another example is vendor-managed inventory, which is a capability that we have had for several years. We've reduced the time to get back in the goods that are managed by our vendors. When we first moved to VMI, it took 12 weeks to get back in stock. Now the average is 7, and we will continue to get this number down even further. And of course, as it does in most businesses, our scale gives us cost advantages. With strategic relationships with mills, we're able to platform more than half of our fabrics which enables higher-quality fabrications with significant cost savings and has also helped us dramatically reduce our product lead times. Our multi-year commitments in our production capacity, we also achieved significant savings based on our scale and volume purchases. The remaining opportunity in front of us is to ensure that we fully leverage our portfolio scale to yield even more efficiency, modifying processes to be better and faster and cheaper. These strengths I just talked about, our portfolio brands, our online and mobile business, winning categories and scale differentiate us. Teri will go over the numbers in detail. But let's talk about what's working for us and driving our results, and I'll start with Athleta. We continue to go from strength to strength in Athleta, outpacing overall industry growth, and through the strength of brand positioning, unique product offering and a compelling storytelling, we are very confident about the future runway in front of this business. We continue to drive growth in our customer base. We're responding to customer demand for our Athleta Girl business, which just launched in spring of 2016, and we'll now have an expression of the Girl collection in every store this fall just as our competition is closing all of their girl stores. I could say a lot more about Athleta. Let me end on Athleta by saying I'm very pleased with the results and very confident and bullish about their long-term potential. Next, Old Navy. Old Navy's pillars are consistently fashion, fun, family and value, and they continue to work. Among major retailers, Old Navy is now the fastest growing apparel brand in the U.S. In addition to strengthening our loyalty categories that I mentioned, we've seen exceptional performance in dresses, pants, knit tops and shorts, which have helped fuel the Old Navy business. And innovation matters here as well. Our phrase forward in Old Navy is frugal innovation. It matters to our valued customers, and we're constantly improving product quality at accessible price points across the assortment. We're also continuing to feed the funnel and engage new customers. The Hi, Fashion platform, which was our brand voice pivot from celebrity content, combined with the Say Hi social campaign has brought the brand personality to life across all customer touch points and has driven higher engagement, content sharing as well as a 3 point beat to industry traffic pretty consistently during the quarter. We're going to continue to focus on unleashing the potential of this brand, and we also believe that it has a long runway for growth in front of it. Turning to Gap and Banana Republic. They are, of course, our more mature but also profitable brands where we're focused on performance, cash flow generation and growing the value expression of Gap Outlet and Gap Factory store and Banana Republic Factory store. At the same time, as we have demonstrated for years, we will continue to responsibly manage our exposure to real estate in the specialty channel. Banana Republic specifically, as a reminder, I just put a new leader in place in May. We continue to see challenges but overall, feel that the brand is well positioned and is servicing a customer base with desirable demographics. For the back half, the team is entirely focused on stabilizing the business, fixing fashion misses, improving storytelling and continuing to focus on execution. On Gap, Gap continues to improve its performance quarter-over-quarter versus last year with stable and steady, but I will not say yet, satisfying results. Q2 is an improvement over Q1 in both 1- and 2-year sales comps as well as excellent traffic trends compared to the industry. And I would underline that, excellent traffic trends compared to the industry. Gap's strong emotive global brand awareness continues to come alive, and the response we're seeing against our customer engagement efforts, our newest campaign, Meet me in the Gap, which builds through the course of the year, is resonating with the brand's core customer base as well as a new generation of customers. There is still work to do. As you know, we've been prudent in rebalancing our fleet according to where our customers shop, and online continues to grow at rates faster than the market. And quickly, Intermix, which we don't talk about very much. As I mentioned before, while small, Intermix has had an exceptional quarter with respect to the growth in digital sales year-to-date. I want to turn the conversation over to Teri in just a moment, but before I do, I want to tie a bow around my comments today. The work that we've been doing over the past few years has been critically important to position us to where we are today, which is to deliver consistent balanced growth. When I say balanced growth, it's a very straightforward construct, number one, to continue to gain market share in key loyalty categories that drive the business; number two, to continue to invest in what is already a large, fast growing and profitable online and mobile business; and number three, to appropriately, responsibly and selectively add stores, starting with Athleta, following with Old Navy and selectively in the factory and outlet expressions of Gap and Banana Republic while at the same time continuing our decade-long track record of responsibly and aggressively managing our exposure to mall-based real estate. Below the top line, we've demonstrated our ability to expand margins and we will continue to be aggressive and disciplined cost managers. Do the math. It's a very compelling value creation story that we are confident we can deliver. Over to you, Teri. Teri List-Stoll: Thanks, Art, and good afternoon, everyone. We're pleased to deliver another quarter of positive results. And as we entered the second half of the year, I'd just like to take a minute and reiterate our financial priorities for 2017, first, to capitalize on our initiative to improve product quality in order to grow sales with healthy merchandise margins; also, investing strategically in the business to strengthen our brand equity and our customer experience and to support growth; maintaining operating discipline to drive efficiencies and leverage scale; and of course, returning excess cash to shareholders. So let's turn to the second quarter results. Continuing the trend of solid first quarter performance, we're pleased to have delivered another quarter of positive comps and to end the first half ahead of our original expectations. I'll walk you through the quarterly results and then talk about our expectations for the remainder of the year. As we noted in our press release, our second quarter reported results include a $64 million benefit from insurance proceeds primarily related to a gain on fixed assets destroyed in the fire at our Fishkill DC. We're excluding that impact in our comparisons to provide a better assessment of the base business. So starting with sales. Our comp sales were up 1%, and we're pleased to have delivered our third consecutive quarter of positive comp sales. Net sales for the quarter were $3.8 billion, a slight decrease from last year. The spread between net sales and comp sales is largely due to our international closures last year. Our Old Navy delivered a record net sales quarter with positive 5% comp. This is against a flat comp last year and is driven by positive AUR and conversion. In addition, the brand traffic trends meaningfully outpaced industry metrics throughout the quarter. Improving sequentially from first quarter, Gap comp was negative 1% against the negative 3% last year, largely driven by improved product acceptance resulting in positive AUR. Banana Republic remained challenged as it's still too early to see the benefits of the leadership change Art mentioned. Comp sales were down 5% against the negative 9% last year. Moving to gross margin. As we continue to capitalize on our initiative to improve product quality, we are pleased to deliver another quarter of gross margin expansion. When excluding the 2016 restructuring costs, our second quarter gross margin was up 120 basis points from last year to 38.9%. Again, excluding 2016 restructuring costs, merchandise margin was up 110 basis points from last year driven by positive AUR at Gap and Old Navy. Similar to Q1, our rents and occupancy leveraged 10 basis points, primarily driven by lower rents and occupancy expenses as a result of our international store closures last year partially offset by the preopening costs associated with our Times Square flagship location scheduled to open in the back half of 2017. Moving to SG&A. Our second quarter total operating expenses were about $1 billion, which includes $64 million benefit from insurance proceeds. Excluding that benefit, operating expenses were up about $70 million when compared to the 2016 adjusted operating expenses. Similar to last quarter, the increase was primarily driven by an increase in payroll largely due to bonus accruals as well as resources added to support our customer and digital efforts that support our growth. Together, this represents over half of the increase. Additionally, there was a modest increase in advertising. The increase was lower than in Q1 and lower than our original plan as we decided to shift more of our marketing efforts into Q3 to support the important back-to-school season. Our second quarter effective tax rate was 38.3%, while we continue to expect a full year effective tax rate of about 39%. So turning to earnings. Our second quarter earnings per share were $0.68, including about a $0.10 benefit from insurance proceeds primarily related to fixed assets. The adjusted $0.58 compared to an adjusted $0.60 in the second quarter of 2016. Now you'll recall, our previous guidance for the first half was down mid-single digits. Excluding the insurance proceeds, our first half adjusted earnings per share growth was plus 3% relative to adjusted EPS for the same period last year. So we're very pleased with the earnings progress, which mostly reflects the gross margin expansions we have mentioned and slightly lower SG&A versus our original plan due to strategic decision to shift that advertising into Q3. As expected, FX negatively impacted our second quarter EPS by an estimated $0.02 and the first half by $0.05. Finally, as we discussed in our last call, we had expected to book about half of the $0.08 to $0.09 of expected business interrupted -- interruption insurance proceeds during the second quarter. We had indicated there was some uncertainty about the timing of the receipt of the recovery. We did not receive those in the second quarter, and our current view is that the full $0.08 to $0.09 recovery will occur in the second half. As a reminder, this expected recovery largely offsets expected elevated full year logistics costs resulting from the fire. Moving to cash flow. Year-to-date, our free cash flow was $270 million, which includes about $59 million of insurance proceeds related to property and equipment. The lower free cash flow is primarily driven by timing of lease payments and the increase in inventory since the end of last fiscal year. We ended the quarter with $1.6 billion of cash. Consistent with our commitment to returning cash to shareholders, we completed an additional $100 million of share repurchases in Q2. So looking to our strength during the first half, we plan to purchase an additional $100 million in shares in the third quarter. We ended the quarter with 392 million shares outstanding. Year-to-date, we paid dividends of $182 million and currently have a dividend yield of about 4%. Regarding inventory, we ended the second quarter with inventory up 5% to last year. Now to understand why we're comfortable with this level of increase, you have to deconstruct the drivers. About half of the increase was driven by an increase in in-transit inventory. You'll remember, we talked about that variability when we provided guidance on inventory levels. Another factor of the increased cost is related to increased cost of inventory on relatively flat unit growth. We've increased our investment in higher AUC loyalty categories that I referred to such as denim as well as active and lifestyle. These are categories where we see margin expansion opportunity. On the unit side, the composition has changed with an increase in basics being offset by a reduction in fashional and seasonal basics. Given the risk level associated with basics is much lower, we feel good about the composition of the inventory overall, and it's worth noting that our liable inventory is down year-over-year. And finally, there is a negative FX impact that's driving inventories up at the end of the quarter. Regarding capital and store count. Our year-to-date capital expenditures were $275 million, consistent with our expectations. We ended the quarter with 3,179 stores, reflecting the closure of 7 company-operated stores on a net basis. And with regard to our earnings outlook for the remainder of the year, as we've said previously, we believe we're uniquely positioned to turn the challenges the industry is facing into opportunities. Our first half results begin to demonstrate the strength of our brands and the initial benefits of our investments in product capabilities, omni-channel customer experience and brand equity. We feel we have more work to do there, but the proof points are there. There's market share progress in this environment, and we're focused on providing customers a reason to continue to choose to shop our brands, categories and channels. Based on the strength of the first half, we are raising our full year guidance and now expect adjusted earnings per share for fiscal 2017 should be in the range of $2.02 to $2.10. This is excluding $0.10 of the insurance proceeds that we received in Q2. Now a few things to note about the assumptions around our EPS guidance. Regarding SG&A, in the current year, we have incremental investments that we're making in the brands, largely marketing but also investments in the store environment and the digital and customer capabilities we mentioned. These have a disproportionate effect on the Q3 compares, and for the quarter, we expect a year-over-year increase in SG&A that will be slightly above the first half trend. The drivers in the third quarter are as follows. First, we began to increase our investments in the fourth quarter of last year, so we are comparing against a lower base of spend in Q3. And as I said, we've shifted some of our Q2 marketing spend into Q3 to support the important back-to-school season. Beyond this, we will continue to lap minimal incentive-based comp accruals last year that will pressure SG&A in the second half. In addition to these factors, we expect continued investments around omni-channel capabilities and expenses related to the work we are doing around our global inventory assortment tools and our logistics network. So to conclude, overall, we're very pleased with our first half results. They support our conviction and the priorities we have set and the strategies we continue to follow to differentiate ourselves as a company with a strong portfolio of iconic brands that can deliver balanced growth and create sustainable shareholder value. Thank you, and I'll turn it back over to Jen.

Thanks, Teri. That concludes our prepared remarks. We will now open up the call to questions. [Operator Instructions].

[Operator Instructions]. Our first question will come from the line of Lorraine Hutchinson with Bank of America.

As you look to the back half gross margin, how should we think about the impacts that the fire had by taking some of the inventory out of the picture? And what are your expectations for gross margin in 3Q and 4Q based on that? Teri List-Stoll: Yes. So we're not going to provide specific guidance under the gross margin line. But as we said, we did learn something that we worked through the inventory reductions we experienced following Fishkill. And you've see us play that through this year as we've really driven the AUR and the margin expansion. The fundamentals of what we experienced in the first half will stay about the same. So we'll be pursuing the same strategies. And so from there, you can kind of draw your conclusions. But we generally feel good about the way the business has been approaching that margin expansion throughout the year.

And our next question comes from the line of Matthew Boss with JPMorgan.

Art, at the Gap brand, I guess, how would you rank assortment opportunities in the back half of the year? And then as you dissect the store, can you just elaborate on trends in some of your more loyal categories that you talked to and just how best to think about your ability to increase the mix towards some of these categories over time?

Yes. If I look at the assortment, and thank you, we're pleased with the improvement. We know we have more to do. If I look at the assortment, frankly, across the company but then focusing on Gap versus where we were a couple of years ago with the exception of a couple of categories inside of Banana, we didn't -- we are not experienced product -- we are not experiencing product acceptance issues either because of trend, fit, quality, whatever. And that would absolutely apply to Gap. We've had a little bit of softness in the Gap girls business, which we've been focused on correcting, rebalancing the assortment there. The bigger issue that I see, and I spend a lot of time in stores and talk to stores, is to continue to buy into some of the big ideas with more confidence. And that's where we've probably been leaving some money and some comp on the table. And you'll see that happen where we will come out with a new flow. And again, these are not seasonal, typically, these will be more monthly in nature. We'll get some cute women's woven top or something like that into the store, and then we sell down very rapidly. Now we're able to get back in oftentimes much more quickly. But we still need to put more confidence and depth behind some of these buys. And I do believe that it represents an opportunity for us for incremental comp.

As a follow-up on the expense front, how are you assessing some of the investments that you're making, particularly in marketing? And then just longer term, potential buckets of cost savings over time as we think about just the 4 concepts and the change that's taking place larger picture in retail?

Well, let me take the first one, and maybe I can talk the -- toss the second one to Teri. Marketing, obviously, traditionally was pretty traditional with print and TV. We still do some TV. But a lot of it is digital. And when we're doing digital marketing, we have a much more direct line of sight to returns, whether it's customer acquisition or driving conversion or whatever it is. And so I actually feel like we have continued opportunity in front of us given the returns that we're seeing from much of our marketing mix to feel very comfortable that we continue to support the brands. And then you have -- and I'm not signaling a large increase in marketing but to continue to support the brands. And then you have in both Gap and Old Navy very convincing traffic beats that give us confidence that our customers are responding and we're seeing the footsteps into the stores. And so we're very focused on seeing where the returns are. In the same way, that if we're putting any incremental payroll, we're looking for that to show up in the P&L, et cetera. Teri, I don't know if you want to field the second one. Teri List-Stoll: Sure. So on the productivity front, as you know, we've got a long history of being pretty disciplined in delivering productivity savings year-after-year. We've largely done it at the brand level with each brand optimizing its own operations, and we've started to move toward more scale. But there's a lot more opportunity for us as we think about productivity on a sustaining basis and an enterprise level for us to really continue to tap into that scale, whether it's scaling the actual activities or whether it's really just reapplying best practices faster and creating more standard processes that can be better, faster and cheaper. So as we've started to look at this, we do see a tremendous opportunity, as I said, on a sustaining basis to be able to deliver additional productivity that can help us fund some of the investments that we think will drive growth.

[Operator Instructions]. Your next question comes from the line of Adrienne Yih with Wolfe Research.

Art, I wanted to ask about Gap brand. The second quarter Gap brand comp notably accelerated on a stacked basis. So can you talk about the product improvement, where you are relative to your expectation? And was the negative 1% hampered by lack of inventory units? And then very quickly, Teri, if you can just -- the ROD leverage has been at about a flat comp breakeven for the past 3 quarters. So is that something that we should expect going forward?

Yes. Let me talk with the first one, and I'll again hand the second one. I think that was 2 questions over to Teri, proving that I can count through the numbers. I'm not going to quantify the comp that we've left on the table, but my gut tells me in being out and talking to the stores that I've seen enough smoke where the stores feel like they haven't had the inventory to really support the business where I know that we have an opportunity in not so much more inventory but continuing to balance the inventory and get it more behind and confidently behind some of our big ideas. And again, our responsive capabilities allow us to get back in more quickly, but we still have times when we go flat because we've sold through some of the items that are moving the business. Where we are right now as Teri mentioned, I feel like we're in a very solid inventory position. I think we have very little inventory in Gap brand that we're going to be disappointed about its productivity. We were pretty light in some parts of kids and baby around the world. And we've gotten back in there as well. So again, I've learned my lesson in calling a comp turn, but as you noted, we are getting convincingly better season over season and on a stacked basis. And I'm really pleased with the progress that we're seeing, and I just want more faster. Teri? Teri List-Stoll: So on the ROD question, we've been pretty consistent and nothing's really fundamentally changed relative to what it takes to leverage ROD. It's kind of likely in the low to mid-single digits, which reflects the fact that some of our store openings are in higher-end markets. We have the Times Square opening, so some of that's putting upward pressure. But in these last couple of periods, what we've had is the benefit of international closures that have offset it and brought us down to a lower leverage point. But on a sustaining basis, nothing fundamentally has changed. So it's still likely low to mid-single-digit comp to drive that.

Our next question will come from the line of Anna Andreeva with Oppenheimer.

We had a question about the comp metrics during the quarter. I guess, did traffic conversion and AUR all improve sequentially across the portfolio? And I think you mentioned focus on value at outlets. Just curious, could you talk about what kind of trends did you see in outlet versus various mall types?

Yes. So on the levers, without going into a lot of detail there, as I mentioned, Gap and Old Navy have seen nice traffic beats relative to the industry. And again, that's validation of what we're doing in product. It's also validation obviously of the marketing and the effectiveness of the marketing. What I can say is that we've seen across all the brands a positive sales less traffic, and so that would tell you we're also seeing excellent execution inside the boxes for the most part. We're monetizing the footsteps that are coming into the stores more effectively. And sales less traffic or sales over traffic has always been an important leading-edge metric to me because what it does is it equalizes for any product differences across the stores and talks about store execution and see that consistently across the portfolio. It's quite encouraging. As to the differences across outlet versus other types of real estate, I'll be very honest with you. We continue to disaggregate the data. I'm very big about the averages hiding the truth and look at different types of real estate, look at first quartile versus fourth quartile, and we really -- I really can't say and paint a very convincing picture for you that there is a -- there are big differences other than as you get into the C type malls, I think, we and other people pretty consistently see the fact that traffic is tougher there. That all said, those are the types of malls where we have continued to reduce our exposure over time, and we will continue to do that on a going forward basis.

Our next question will come from the line of Simeon Siegel with Nomura.

Art, what's your view on the right long-term margin just given your points on the advantages of gaining share and the benefits from scale? And then, Teri, if I can, to follow up, I think it was Lorraine's question. Just to clarify, with the fire impacting last year's comp and margins, is there any shift in 3Q trends that we should keep in mind just versus what's been happening in the first half?

Yes. And let me give you a specific non-specific answer to the first question, which is I'm -- I like margin dollars because, at the end of the day, margin dollars is what we put in the bank. So we're very focused in a relatively new way with analytically based functions on understanding elasticity and therefore, where our products points drive share maximization and most importantly, margin dollar maximization. And that's a metric that starts on the first 20 feet of the store with understanding what margin dollar output is per square foot on a table, and it goes all the way up to thinking about our stores and our brands at the end of the day. So this is work in process. But rather than focus on a rate, I would say that we really truly do understand and are thinking about everyday elasticity and yield management and about maximizing margin dollars to the system. Obviously, we've demonstrated our ability to open up some rate expansion, which we're pleased with, but we also don't want to get greedy at the end of the day. We want to make sure that we are focused on market share and margin dollar maximization. Teri List-Stoll: So on the Q3 specifics, I'll give you a little bit of perspective that you will come to yourself as you do your modeling. If you think about it, on the gross margin line, in the -- in last year with the Fishkill and other things, our gross margin for Q3 '16 was up pretty substantially from Q3 '15. And so if you compare the magnitude of expansion you might see in Q3 versus what we've experienced in Q2 and Q1, it's probably not going to be as great. But we don't have anything that we would say in particular that would change the fundamentals of what we're doing on the business. We're still continuing to be focusing on AUR on these higher loyalty categories that drive higher margins. On the SG&A line, as I said, you're going to get a little bit more increase in Q3 versus what we've seen in Q1 and Q2, same fundamental drivers, just a higher magnitude as we've reallocated some of that advertising expense into the back-to-school season and also to see some of the engagement we want as we head into the holiday season.

Our next question comes from the line of Mark Altschwager with Robert W. Baird.

I wanted to follow up on inventory. You talked about more basics versus fashion or seasonal basics in the inventory mix. Maybe just talk about the decision to shift the balance of the assortment. Wondering if that's concentrated in one particular brand or across-the-board. And maybe contrast that trend with the opportunity you mentioned on buying bigger into some of the big ideas with more confidence in depth. And then just also on inventory, with the investments in the loyalty category, just curious how that's impacting your AUR outlook for the back half.

Yes. That was a complicated question. So I'll do my best to first remember it and then try to answer it. Yes, if you think about the comments on basics, so again, the traditional way of buying a season, you're buying preseason and you're going to be buying it against your traffic trend. And with traffic overall tending to be negative, although, again, we've seen some positives in our business, you're going to be buying your units very tight, particularly in Banana as an example. We had pivoted more of that open to buy, which is a finite pool of open to buy. It is supporting some of the fashion. Some of that fashion's been working, and some hasn't. So it's less about really adjusting the architecture of the assortment than about rebalancing the buy inside of it and taking some pressure off of those fashion categories and frankly, putting some basics inventory in to just get our service levels back up. It's an important part of the business. And we have places where we were running service levels that were unacceptably low, and we felt like if we took a little bit of pressure off of some of the fashion in particular that wasn't working and put the inventory back in responsibly to support the basics business, that would be good. The second thing to think about is where our responsive pipeline really kicks in is in supporting trend and fashion, and so that gives us the ability to invest later and put pressure into those categories if we see an opportunity. On the AUR -- or AUC, AUR, et cetera, I would say we're going to continue to look for opportunities from both mix. So I referenced the sculpt denim that we have across. That's our highest price point denim with the exception of selvedge in our business. And as we see that product and customer response to it, we're going to put investment behind it. That's going to pull our AUR up. The other driver of AUR is to continue to manage our yields through less promotional depth and less promotional breadth on an ongoing basis. And appropriately, we've been pleased that some of the notes that had been written have actually noticed the fact that we have been backing off of some of the promotional intensity versus a year or 2 years ago. And that is correct. That's been very intentional, and that will also be a contributor to AUR expansion as well. Teri List-Stoll: I guess, I would just add, this is -- I mentioned this, but I know there's a lot to deconstruct in inventory and I'm sure the increase strikes you. And we, like you, are very cognizant of the need to remain very disciplined in our inventory levels. And so we are very thoughtful and very controlled at how we execute that growth. But just keep in mind, in addition to the in-transit timing piece, there is an FX piece, which is probably close to 1 point, I think, of negative impact. So when you net those 2 pieces out, you get down to a bit of a build, which is explained by the things we talked about but isn't so far ahead of our comp sales that when we look at the liable percentages being improved that we feel uncomfortable with where we are.

Our next question comes from the line of Brian Tunick with Royal Bank of Canada.

I was curious if you guys can talk a little more about Old Navy, maybe the second half expectations from a bigger picture perspective. But are there changes that you're making regarding marketing spend at Old Navy in addition to Gap brand? And maybe talk about either categories or processes that you think are the best opportunities as you look at the back half of last year.

Yes. Just let me throw a few things at you. We're always tuning our commercial plan and our marketing mix. And a simple example of that would be as we've seen back-to-school become less of a defined moment in time and more of an event that starts somewhere in later July and can oftentimes go through September week 1 or week 2, we've managed and tuned the marketing mix to also put some media in place to support the later back-to-school this year. So as an example, on the East Coast, a lot of the schools aren't starting until after Labor Day versus schools in the South -- in the Southeast that have started 1 week or 2 ago. So we're bouncing that regionally to support that. For the most part, the back half otherwise is, based on our learnings, tuned and tweaked but not necessarily any fundamental changes in terms of what we're doing. The only other thing I would just talk about is that we saw particular success and continue to, even recently, with key price point item promotions in Old Navy. We did a $3 dollar polo for back-to-school couple of weeks ago, and it was a blowout event. And so customers do respond to that. We find it's a very effective way to generate traffic and then build a basket around that. And we're, of course, looking at anything that works in saying how do we mix it up and how do we build some of that into our commercial plan in the back half. Largely with Old Navy, it has stayed the course with what's working and continue to support with inventory investment in the categories that are driving the business, which goes back to those that I mentioned at the end of the day. Kids and baby business is continuing to pull the train, and bottoms and denim business is continuing to pull. And we mentioned many times that we have an active business that we think has significant runway in front of us in that business as well.

Our next question comes from the line of Oliver Chen from Cowen and Company.

We were curious about your prioritization of different digital initiatives in the back half. What would you say are the more versus more significant factors? And any comments on what you want to do with mobile and what kind of opportunities you have? And also, as you have such stellar brands, would you look to partner with Amazon? Like, how would you think about a framework for considering that as an option?

On digital, it's -- digital and running a great digital e-commerce business and mobile business is about many things. And the wonderful thing about it is that because it's clean, you can put things into work, whether it's product recommendations, whether it's site speed, et cetera, A/B test, A/B placement test, A/B test video, et cetera, et cetera, and be very rapid and innovate very rapidly. And so it's hard for me to really look at it and say it's any particular thing at the end of the day because there's a whole bunch of things in work right now. I mentioned some of the customer facing capabilities, which have continued to be important for us. But the bulk of it is really about making sure that you've got an easy shopping experience that the customer can click through cleanly, where it's easy to check out, et cetera. If I go to mobile, everybody on mobile needs to continue to figure out how to effectively monetize that traffic, and that's what we continue to work on. Getting to a native app experience on our apps has been a big step forward. It's faster. It's easier. It's cleaner. It's more intuitive for our consumer. But there's going to continue to be work as to how do we build big baskets around our mobile shoppers, and we believe that it will continue to be a place where our customers go to at the end of the day. So we're excited about both. We're seeing traffic grow. We're seeing our e-mail acquisitions grow. We're seeing our SMS list grow, et cetera, to be able to feed that business, and then it's about really delivering a low-friction, high-touch experience in the digital world.

On Amazon, could you just speak to your thoughts there about a potential partnership? Or what distinguishes you most in terms of being -- having unique core competencies? I think you talked a lot about that in the beginning of your remarks as well.

Yes. And that really starts with brands at the end of the day, and we feel like very strongly that expressing our brands and controlling that expression of the brand and delivering an experience around that, whether it's an experience in e-commerce or mobile or experience in our stores, is really important. I've been open in saying that we will always be where our customer is, and so we are not close minded in making sure that because, first and foremost, we are a fashion apparel company, and people come to us to buy clothing. As to something on Amazon, I just really don't want to comment right now. I've commented where we have had effective third-party relationships like Tmall, which has been a wonderful relationship for us in China. We've done business with Zalando. At the moment, we're staying the course, and we're focused on delivering an exceptional brand experience, whether it's digital, in our stores or the combination of the 2.

Our next question will come from Ed Yruma from KeyBanc Capital Markets.

I know you guys have made significant investments in responsive and in speed. I guess, can you link at all the gross margin performance in the quarter or maybe kind of how we think about gross margin longer term with some of these initiatives and maybe how they're helping to drive gross margin?

Yes. So there's a bunch of things that are packed in the gross margin, and what I'm not going to do is I'm not going to assign a coefficient to each of them. I mentioned product acceptance. Start there. We believe that we are largely on trend with appropriate fit and quality and pricing on our products, and that matters. Responsive certainly plays into the equation, and I cited the numbers from Athleta, which is one example but representative of the kinds of things we're seeing in a number of categories right now where Athleta has the great majority of its bottoms complex on responsive, less than 8 weeks, oftentimes faster than that and has been driving double-digit comps now in a 2-year stack. And that has been, in that case, largely enabled by both great product but also able to feed units into the business close to demand. A third piece is I mentioned that we're focused on yield management, which is really continuing to be as selective as we can about the breadth and the depth of promotions. I'm not going to signal the fact that magically we're going to get back to a right price business. That's not the nature of this business. But there is a lot of money to be had through really being focused on yield management and continuing to back off of the promotional depth and breadth. And so it's a number of things that come together, also including being responsible on our inventories and not over broaden our inventories, which we are quite confident that we're not right now. So it's hard to break all of those out. We feel they all matter and they're all important, and we have to work all of them equally hard everyday.

Our last question will come from the line of Dana Telsey with Telsey Advisory Group.

Given your real estate outlook, Art, how do you envision the pace of store closings? Any change by division in terms of how you're seeing the base? And as you think about the online business and the profitability there, has it been improving? And with the initiatives in omnichannel, will that drive operating margins the same level or higher than physical? How do you think about it?

Thanks, Dana. And you are both consistent and persistent I would say. If I think about real estate, so let me just start with Gap. Gap's got the oldest fleet. We've had the greatest number of store closures in Gap, and yet almost by definition, Gap will continue to have the highest level of exposure into older centers. Some of those centers are fantastic, and some of those centers, at some point, are going to go away. So without giving you a store count because I don't want to do that right now but I will reassure you that we are working that everyday. We are, like I said, going to really aggressively and responsibly manage our exposure to real estate that is struggling, and we'll continue to do that. And we'll do that across all the brands, but it really starts with Gap and then Banana Republic. We had very little of that inside of our portfolio at Old Navy. We have very little of that, to be clear, inside the value businesses of Gap and Banana Republic, whether they're in traditional outlets or in non-traditional value locations. And of course, Athleta's fleet is very fresh. So we'll continue to work it. I'm -- like I said, I'm big about the averages hiding the insight. And so we're always looking at the trailing edge of our fleet and the leading edge of our fleet and understanding what the differences are in performance and really trying to identify places where we just shouldn't be at the end of the day and frankly, identify places where maybe the consumer has moved on and we could reposition the store as well. And you know all those tools have been in our toolkit over the course of the many years that we've taken a lot of square footage out of the space -- or out of the fleets.

All right. I'd like to thank everyone for joining us on the call today. As a reminder, the press release, which is available on gapinc.com, contains a full recap of our second 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.

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