The Gap, Inc. Q2 FY2025 earnings call

Management Statement and Operational Highlights

• Financial and Operational Rigor: Maintaining financial and operational rigor has driven significant gross margin expansion of 360 basis points to 41.2% in the second quarter versus the same period 2 years ago. Delivered EPS of $2.20 in fiscal 2024 and ended the year with cash balances of $2.6 billion.
• Reinvigorating Brands:
  • Old Navy: Sixth consecutive quarter of positive comp sales. Strong in key customer metrics like brand consideration and Net Promoter Scores. Denim posted the highest-volume second quarter in 10 years, and active business is growing with relevant marketing campaigns.
  • Gap: Seventh consecutive quarter of positive comp sales. Performance led by women's and improving men's trends. Strategic pursuit of denim and successful brand activations like 'Better in Denim' campaign.
  • Banana Republic: 4% comp sales. Progress in tightening assortment, refining product aesthetic, enhancing marketing, and improving service levels. Notable traction in women's bottoms.
  • Athleta: Disappointing second quarter performance. Appointed new President and CEO, with a disciplined approach to resetting the brand underway.
• Strengthening Platform: Restructured fixed cost base, strengthened supply chain, modernized media mix model, and invested in technology to drive efficiency and effectiveness.
• Energizing Culture: Conducted global engagement survey showing progress, optimism for the future, and industry-leading employee Net Promoter Scores, with focus on creating best employee experience.

Segment Performance

• Old Navy: Net sales were $2.2 billion, up 1% versus last year, with comparable sales up 2%. It delivered strong results with consistent growth in key categories like denim and active.
• Gap brand: Net sales of $772 million were up 1% versus last year, and comparable sales were up 4%. It has shown continuous momentum with its reinvigoration playbook.
• Banana Republic: Net sales of $475 million were down 1% year-over-year with comparable sales up 4%. The brand is making progress in reestablishing itself in the premium lifestyle space.
• Athleta: Net sales of $300 million decreased 11% versus last year, and comparable sales were down 9%. It is in a reset phase with a new leadership appointment, and efforts are underway to align with customer expectations.

Guidance

• Net Sales: Reiterates fiscal 2025 net sales outlook of up 1% to 2% year-over-year.
• Operating Margin: Updates operating margin for 2025 to 6.7% to 7%, which includes an estimated net tariff impact of approximately 100 to 110 basis points. Excluding tariffs, underlying operating margin expansion is expected.
• Third Quarter Outlook: Expect third quarter net sales to be up 1.5% to 2.5% year-over-year. Gross margin expected to deleverage by approximately 150 to 170 basis points year-over-year with estimated net tariff impact of approximately 200 basis points. Slight SG&A deleverage year-over-year due to timing shift of investments.

Risks

• Tariff Impact: Trade policy changes and tariffs have a material impact on the financial outlook. The latest trade policies have led to an estimated net tariff impact of approximately 100 to 110 basis points on operating margin for fiscal 2025, affecting gross margin and overall financial performance.

Question and Answer

• **Q: Congrats on a nice quarter. Maybe for Katrina, you're lowering the full year EBIT and EPS guidance despite the 2Q outperformance, obviously implying a worse back half outlook. Is that just mostly worse tariffs? Or has anything else really changed for you all? And then related to that, many peers seem pretty optimistic on their ability to offset incremental tariffs with very few actually trimming guidance. I'm just wondering if there's anything different for you all as you think about the tariff dynamics.

A: Thanks, Alex. I really appreciate the question. I think as you say, we did deliver a very solid second quarter. We really see that our strategy is working, and it's showing up in our results. The outlook we provided today reflects that strength of execution and our brand momentum but it also updates based on the headwinds from the latest trade policies you just said. So because our playbook is working, our brands are resonating, really gives us the confidence to reaffirm the net sales outlook of up 1% to 2% year-over-year. So that has not changed. We also remain committed to the cost discipline that we've been demonstrating, and that's also reflected in the outlook of slight leverage in SG&A, which is also not different. As you say, the biggest update today is that we are now putting in $150 million to $175 million worth of tariff impact which equates to about 100 to 110 basis points of operating margin. I noted on the call that without the tariffs, we would actually be expanding both gross margin and operating margin for the full year, in line with our original expectations, which I think is notable. I'm proud that the team has made really good progress in their mitigation efforts to date. We're remaining focused on sustaining the momentum and the market share gains that we've gotten through our reinvigoration playbook while we pursue our mitigation plans. I'd also say what's notable is that we don't currently expect that the annualization of tariffs in 2026 will cause further operating income declines year-over-year. And we expect to mitigate the full impact of tariffs over time, which we believe represents actual opportunity for operating margin improvement over the longer term.

• **Q: On Old Navy, the stores have never looked better. And I know the product has improved, but really, a lot of it to me feels like the merchandising and the marketing has changed. I guess have you been spending in stores? And I'm assuming -- that's assumed in the guidance in the back half. But is it more costly what you're doing in the stores these days? Or is it really just the merchandising? And then I have a quick Gap question after that.

A: Okay. Yes. Thank you, Marni. And we agree. Look, Old Navy delivered another strong quarter, comps up 2%, and that's on top of last year's 5% comp. And these results are really reflecting that our operating teams are just functioning with greater discipline and delivering sustainable growth, and this is quarter after quarter. As you've seen in our stores, which we appreciate you going into and recognizing the progress, what you'll also see is category shops and emphasis on categories like denim and active where we've been strategically focused and are executing really well, and it's clearly showing up in the results. As you see in the denim shops, it's been a standout category for us. We posted the highest-volume second quarter in brand history. In active, it continues to be fueled by our marketing campaign that we initiated with Lindsay Lohan, the first one we've done in years, driving innovation in product with StudioSmooth and Bounce Fleece. And so overall, what you see is our playbook is being executed incredibly well. We are not spending more in stores or in marketing. In fact, we're getting much more efficient and effective. So the merchandising and the edit and the way that we've executed our playbook is really starting to show up in multiple places in stores, online and in our storytelling. And as we continue to execute, we continue to believe there's great value creation ahead.

• **Q: So Richard, if you break down the portfolio, could you elaborate on drivers of the revenue acceleration to 2% growth that's embedded in the third quarter forecast relative to flat this quarter? Maybe just speak to trends that you've seen in August for early back-to-school. And then Katrina, just to clarify your comments on tariffs not causing further operating income declines next year. So relative to the roughly 7% operating margin outlook this year, are there any constraints to annual operating margin expansion at low single-digit revenues as we think about next year?

A: Okay. Thanks, Matthew. I'll address the first one and then Katrina can come back and address the second one. So we really rooted our brands with a singular focus. And so if I look at each brand, the objective of Gap has been to reignite Gap. And Gap is furthest along in our playbook, but I think everybody could agree Gap is getting its vibe back. There was a moment in time a couple of years ago where we were looking at it more as a clothing retailer, highly promotional, lost, to some extent, it's merchandising conviction. And today, you're looking at a very different platform brand that is much more of a pop culture brand that tells relevant stories with trend-right product and is shaping culture. And the performance, again, fourth quarter comp in Q2 -- sorry, 4% comp in Q2 is another proof point that this is actually working in our favor. And again, 7 consecutive quarters of growth. As we move forward, it gives me the confidence that we can continue that. On Old Navy, we talk about reasserting. This brand has delivered, again, consistently in terms of its productivity. But we've been refreshing the way we show up in everything that we do from product to experience, online and in our stores. We've shared that we've been pursuing category leadership in categories such as denim, active, kids and baby. And you see the continued accelerated growth in those categories, resulting in plus 2% comp in the second quarter. And that also is consistent in the context of its deliverable. So moving into the back half, knowing that, that playbook is starting to really show up, I'm very confident in the Old Navy's team to execute against that plan. Banana Republic. We used the word reestablish. And I think this quarter, reporting a 4% comp really proves that we're starting to find our footing in the next chapter of what we believe is growth for Banana Republic. It's been a big undertaking to reinterpret the brand for today and make it newly relevant. But again, you look at the product, the storytelling, our stores, the way that we're navigating the omnichannel experience, and you get really excited about the potential that this brand has. And of course, with the comp performance, you could see the progress being made. The last brand, of course, is Athleta. Athleta is a powerful brand in the active space, B Corp, the #5 women's active brand in the market. That said, we've talked about the brand being in reset mode. And we continue to believe that this brand has great potential. We moved away, if you will, from distinctive performance roots, which the brand was sort of known for. We're now going to get back into that spirit with Maggie Gauger, who we hired from Nike, 20-year veteran. She has hit the ground running, only been there for 3 weeks, but I can tell you the energy is palatable. And as we look to the future, we really believe that these 4 brands, iconic American brands that shape culture, have enormous opportunity for growth. Katrina O'Connell: And then I think, Matt, as it relates to back-to-school, third quarter is off to a strong start. In Q2, May and June were sort of slow because of the weather being so cool. But we really did start to see July accelerate with more seasonal weather and the drop of our back-to-school product. And August has really continued that momentum as we head into third quarter with customers responding well to our back-to-school assortments, I would say, especially at Gap and Old Navy. So that's the back-to-school piece. As it relates to any constraints on operating margin for 2026, I think the simple answer is we'll give you a more holistic view of 2026 when we provide guidance. But for tariffs, while we did have an impact this year that we're previewing of 100 to 110 basis points that, as you say, sets us up for about a 6.7% to 7% operating margin this year. The teams have worked quickly and aggressively to come up with mitigation efforts that we think are balanced across the variety of things that we've previewed that now will keep us from seeing further degradation related to tariffs next year.