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Gap Profits Up on Cost-Cutting

Comp sales continue to lag as second-quarter net earnings increase 51 percent.

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In its slow and laborious turnaround efforts, Gap Inc. showed progress on Thursday, reporting second-quarter net earnings up 51 percent due to improved margins and wide cost reductions.

Still, comparable-store sales dropped 10 percent, indicating the $16 billion San Francisco-based chain continues to face serious issues with product acceptance, drawing customers into the stores, and operating locations that are too large for the offering.

For the quarter ended Aug. 2, Gap’s net earnings were $229 million, or 32 cents a share on a diluted basis, compared with $152 million, or 19 cents, for the second quarter last year. The 2007 second-quarter diluted earnings per share included 2 cents of expenses related to the company’s cost-reduction initiatives.

Excluding the 2 cents a share of expenses, second-quarter diluted earnings per share last year on a non-Generally Accepted Accounting Principles basis were 21 cents.

Second-quarter net sales were $3.5 billion, compared with $3.69 billion in the year-ago period. Gross margins rose to 38.2 percent from around 34 percent a year ago. In the call, executives said they were pleased with current inventory levels.

Full-year earnings per share guidance has been upped to $1.30 to $1.35, from $1.20 to $1.27. Capital expenditures for the year are down to $450 million from $500 million.

“External conditions aside, we continue to deliver improved earnings with healthy margins and I am pleased with our second-quarter results,” said Glenn Murphy, chairman and chief executive officer of Gap. “While we continue to pursue our 2008 financial strategy, we are very focused on bringing more customers into our stores.”

Downsizing will be significant in the years ahead. Murphy said the company plans a 10 to 15 percent reduction of square footage over the next three to five years.

“We have never had a clear real estate strategy for our 3,100-plus stores,” involving what the role is and the right size for each store, Murphy said during a conference call. “That work is now completed.” He said the objective is to operate a chain with a simpler structure. “It’s much easier to operate a 10,000-square-foot store than a 17,000-square-foot store.”

Old Navy, the most troubled division, announced top-level changes on Thursday, including the promotion of Tom Wyatt from interim president to president, and the departure of merchandising executive vice president Sheryl Clark, which underscores the concern about product. The company is searching for a new top merchant and could select from the field of candidates reviewed while considering who should run Old Navy. As an insider already running Old Navy since February, Wyatt was hardly a surprise choice. He joined Gap in 2006 and most recently ran the Gap’s outlet division.

On the cost reduction side, Gap has been cutting back on everything from inventory to capital expenses for store openings and remodelings, to marketing.

Murphy stressed the company won’t go back to historical levels of marketing spend until it gets the product, store presentations and messages right. Of the three retail divisions, Murphy said Gap is more advanced in that journey and closer to unleashing marketing that’s robust again. The division is doing more print advertising this year compared with last year.

Murphy said that as the specialty retailer moves deeper into the second half, Gap remains focused on cost and inventory management and returning excess cash to shareholders.

“The environment is still challenging. I don’t see any reason for any optimism in the back half of the year,” Murphy said, adding the company is focused on four key pillars. Number one is driving improving margin dollars. Second is driving down costs. “The base inside the business was too high. More work needs to be done on reducing real dollar costs inside the company.” The third priority is improving the return on capital investment.

The fourth component is reversing the traffic trajectory. “Traffic is unacceptable. The Gap has been on that trajectory for a number of years,” he admitted.

It’s even an issue at Banana Republic, which Murphy said has been pressured by the promotional character of competitors.

As far as merchandise and operating margins, there’s been good progress at the Gap and Banana Republic divisions, but not Old Navy, Murphy said.

Contributing to the lack of traffic generally, Murphy said divisions have been out of stock at an unnecessary level. “We have suffered from that, definitely at Old Navy and to a smaller degree at the other two brands.” He also said pricing has not been a core competency, so he sees room for improvement there.

The company has been successful in shortening the product development cycle for Old Navy, enabling the division to bring in less inventory. Last year, designer and reality show celebrity Todd Oldham became Old Navy’s creative director. According to Murphy, October’s assortment will be “the first shot of Todd’s involvement.”

Old Navy has refocused on women ages 25 to 35, on a budget and shopping for the family and herself. Gone is the marketing that for years injected a quirky and fun personality into the business and gave it some soul. But Murphy said Old Navy will return to that. In addition, remodeling will kick in again next year. The program at Old Navy has been on hold, pending product improvements and staff changes.�

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