By  on August 24, 2007

Glenn Murphy is getting off on the right foot.

While the new Gap Inc. chairman and chief executive officer, who started at the beginning of August, can't take any of the credit, on Thursday the company he's charged with turning around revealed its first quarterly earnings increase in two years — even as the group continues to struggle on the sales side.

And as Gap upped its forecast for the year, Murphy promised to "unleash and reward creativity" and said he's been telling employees "the size of the challenge we have before us is easily surpassed by the opportunities we have ahead of us."

Helped by cost reductions and better inventory management, Gap Inc. reported a 19 percent increase in second-quarter net profits to $152 million, or 19 cents a diluted share. That compares to $128 million, or 15 cents a diluted share, in the year-ago quarter.

The last time Gap reported an earnings increase was in the second quarter of fiscal 2005, when the net rose 39 percent. Gross margins in the second quarter ended Aug. 4 increased 34.3 percent, up 130 basis points.

But Murphy clearly has his work cut out for him as sales remained difficult at the group amid concerns about product acceptance. Gap said summer merchandise got a "mixed response in all divisions," though with inventories down 2 percent, the company said it feels comfortable with current fall levels.

Comparable-store sales were down 5 percent, while total sales fell 1 percent to $3.69 billion, compared with $3.71 billion for the year-go quarter. The difference between comps and total sales was mostly due to online sales, which increased 26 percent to $172 million, from $136 million.

By division, Gap division sales were down 6 percent; Banana Republic was up 4 percent, and Old Navy was down 9 percent.

The company, which has been cutting staff and other expenses, upped its forecast of earnings per share on a Generally Accepted Accounting Principles basis for the year to 83 cents to 88 cents from its previous guidance of 76 cents to 86 cents. On a non-GAAP basis, which would exclude expenses associated with the discontinued Forth & Towne division and other cuts, Gap forecasts 90 cents to 95 cents, compared to previous guidance of 80 cents to 90 cents.Gap shares closed at $17.40 down 8 cents, or 0.46 percent, but in after-hours trading rose 44 cents, or 2.53 percent, to $17.84.

In his first Gap conference call since joining the $16 billion retailer, Murphy, a veteran retailer from Canada with a track record for turnarounds, spelled out priorities and addressed concerns over his lack of experience in fashion, assuring analysts that he would be sensitive to design and creative teams at Gap Inc. "The creative merchandising component will continue to be unleashed and unfettered when it comes to bureaucracy," he said.

He said he will be close to the merchandising and design organizations, would learn more about the fashion product development cycle, and insure that creativity is rewarded.

Creating "a more brand-centric structure," he said, is "the first step in a long journey toward getting the business back to sustained improvement in earnings, which is the goal we all have."

Murphy added that he's "getting grounded in the business," having conducted 50 town hall meetings from San Francisco to Miami and New York to Columbus, Ohio, and participating in 50 store tours in the last three and a half weeks.

"We also had a number of deep dive sessions and meetings, with a real focus on the merchandising and design component of the business," Murphy disclosed. "Performance depends on the quality of product and how on target it is....It's been a good beginning."

The ceo stressed continuing to simplify the Gap businesses so the company is swifter to react to trends, reaches the right talent level, and even more important retains "talented people who have innovative approaches to our business." In recent years, Gap has been a revolving door of talent.

"I will be spending a lot of time with people on the merchandising and design side, making sure the team knows we reward and appreciate them based on their creative skill. We won't shackle them," he said. "We want to make sure they have all the tools and freedom to do what is right for the brand."

Murphy said it was too soon to list specific objectives, but added, "I am going to continue to reinforce near-term priorities — the simplification of the business, allow people the freedom to make decisions and be accountable for those decisions."Bob Fisher, a member of the board, son of Gap founder Don Fisher and the former ceo who deserves the most credit for the profit improvement, said the second quarter was marked by "solid progress stabilizing our business, streamlining our organization and importantly, hiring our new chairman and chief executive officer."

He said the company has completed the majority of workforce reductions, which occurred primarily at headquarters, the former Forth & Towne division, and by not filling open positions. In total, the company eliminated about 2,200 positions during the first half of 2007, of which about one-third were open positions. Annualized cost savings from filled positions eliminated are expected to be about $100 million on a pre-tax basis. Jobs axed ranged from entry to senior levels, with roughly two thirds in areas unrelated to stores and individuals that touch most directly customer service, Gap said. The retailer is cutting costs in other ways, including reducing corporate office space by 16 percent.

"We've seen a lot of change," Fisher said. "We made solid progress on what we believe is necessary to get our business on track. The majority of job reductions are behind us and we continue to find ways to simplify our business.

"We are comfortable with inventory levels."

Fisher said that at Gap Adult, woven tops and clean pants performed well in the second quarter, and felt that was a sign that the brand was starting to resonate on the new target customer, which is the 24-to-34 age range, with a sweet spot in the late 20s.

At Old Navy, 'the ongoing priority is to stabilize the business and improve merchandise margins," said Fisher, while Banana Republic continues to perform well, with 4 percent comp-store sales in the quarter.

Executives on the call acknowledged some past disappointments, including in 2006 making significant incremental investments in marketing that did not get a return, mostly at Gap brand, and lacking color and "letting competitors get take that space," as Fisher said, and having "confusing over-assortments" of khaki pants and denim, and targeting audiences that were too broad. Fisher said Gap will still be essentially a key item business.Fisher said that in terms of ease of shopping and styling, "We're 50 percent of the way there," and added that "We are not going to know whether we have the proper flow and strategy until we get into spring."

In the quarter, the company repurchased 11 million shares for $200 million, completing a $750 million share repurchase plan.

An additional $1.5 billion share repurchase program was announced. Part of the plan includes purchasing $250 million in stock from members of the Fisher family whose ownership represents approximately 34 percent of the company's outstanding shares.

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