I would now like to introduce your host, Jack Calandra, Senior Vice President of Corporate Finance and Investor Relations.
Good afternoon, everyone. Welcome to Gap Inc. 2nd quarter 2016 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 the forward looking statements as well as reconciliations and descriptions of non GAAP financial measures, as noted on Page 2 of the slides supplementing Sabrina's remarks, please refer to today's earnings press release as well as our most recent annual report on Form 10 ks 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 August 18, 2016, and we assume no obligation to publicly update or revise our forward looking statements. Joining me on the call today are CEO, Art Peck and Executive Vice President and CFO, Sabrina Simmons. As I mentioned, Sabrina will be using slides to supplement her 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.
Thanks, Jack, and good afternoon. I have a number of things on my mind today that I want to share with you and really they're reflections about the first half of this year and certainly about Q2. So number 1 on my mind is the consumer environment. And let me really tease it apart. There's obviously some strength out there in different parts of retail.
In apparel specifically, the environment remains challenging. And quite frankly, it remains most challenging in the higher end of the market. And just to remind everybody, we have a very robust value portfolio with our outlet channels and the Old Navy business. Number 2, the restructuring work that we announced several months ago. I'm very pleased that we've been decisive and we've taken action.
And as you know, that includes some expense reduction and trimming some parts of the portfolio where we had businesses that we felt did not have the potential for long term returns. We're not all the way through this and we've taken action in Japan with the Old Navy fleet there. And as we mentioned, are making progress on tuning in the BR international fleet as well. The third thing on my mind is the product operating model, and we've obviously been talking to you quite a bit about this over the last several calls that we've had. If you think about the work that we're doing, we've been very aggressively focused now for some time on the back end of our model on really building responsive supply chain capabilities.
And that's through all of the things that we've discussed, fabric platforming, more test and respond, shorter lead times or shorter calendar. The front end of that model is demand driven buying. And so we're doing work in both of those right now. I want to be clear that this is about continuous improvement, continuously building and speeding up our capabilities. We have work to do still in the front end or demand driven buying, and both of these things will continue to evolve and advance in parallel.
The last thing that's on my mind is Old Navy. We obviously diagnosed some of the issues that we had in the business in Q4. I think I said at the time that Old Navy would hit a bump in the road, but the bump was going to be less deep and less long. I think the return to improved performance that we've seen in Old Navy is validation. It's validation that we can once again move the brand to a market share gaining position, validation of the operating model that has allowed us to respond quite quickly and improve the business quite quickly, validation in the fact that we have a solid team in place and frankly validation of the value proposition that our consumer sees in Old Navy.
But again, those four things have been on my mind and I wanted to share them with you. Let me move to a brand by brand conversation for Q2 and I want to start with Banana Republic. Clearly, nowhere close to the performance that the brand is capable of nor what we expect and want to hold us accountable for. The team and I are relentlessly focused on continuing to make improvement in the business. And under the covers, there are some proof points that the work that we're doing is the right work, where we've restored quality, customers have responded to that, Where we bought deeper into key categories, customers have responded to that.
But the results of that obviously are not significant enough to manifest themselves on the top line or the bottom line. So we have urgency and we have a lot more work to do. Now let me turn to the Gap Specialty business. Extremely aggressive work that we're doing there where Gap is following Old Navy's lead on demand driven buying and also some pretty aggressive work on the restructuring as well to get the cost structure of that business in line. The work is deep and it centers around core processes in the business that is work underway.
Again, many points of validation for the work, but nowhere close to the results that we need to see. We have and I am encouraged by this, some very good product acceptance going on inside the Gap Women's Business as we have reestablished the aesthetic of the brand. We have a great kids and baby business, continues to be a franchise category. And again, I'll talk about this a bit later. We have a fit business, which we believe is very well connected to the active lifestyle that we think has significant growth and upside potential.
So when Gap gets it right and has quality, on trend, on brand merchandise, we have the authority to price and deliver value in a way that I'm confident the brand has, but we haven't seen the brand be able to do for a while. I want to turn to Old Navy. Very pleased with the recovery of performance from Q4. We diagnosed it. The team has come together around the fix.
But again, we started to see the business pull out in Q2 as we made the changes through the product pipeline and the assortment. And I would like to believe and I'm actually pretty confident that we will see Old Navy deliver a very solid back half this year. The other thing that makes me very confident about it is the opportunity for growth in front of us. And we have opportunities to put Old Navy into markets that are underserved today. We have an opportunity for a small store format and the first one of those that will really test it will be coming online in the next several months.
If you can deliver a holistic fully assorted Old Navy brand experience in a box 8,000 square feet. It opens up a significant opportunity for us with that brand globally. Last, it just plays in the sweet spot of where the consumer is. The value sweet spot today, Old Navy is extraordinarily competitive for the price out the door and has incredible quality, which is a killer proposition for the consumer. And then let me close with Athleta.
There's a lot talked about with respect to the active space, the athleisure space. We continue to be really excited about the opportunity not just for Athleta, but for the company. We are one of the few, if not the only large apparel company that has a very material enterprise wide active business and obviously a very large ready to wear portfolio. So first, excited about the growth prospects in Athleta and continue to be very pleased with its performance. Secondly, excited about the opportunity for active growth inside of Gap and Old Navy.
It continues to be something that our customer responds to. She has made it part of the way she leads her life and now really the way her family leads their life. And so we have an excellent position in 3 brands in one of the highest growth segments of the apparel industry that shows continued and very good growth. 3rd, excited about the prospect to begin or accelerate technical innovation from the active space into ready to wear. One of the things that I was really pleased about this last weekend was as I looked across our 3 brands in men's denim, we now have a compelling and amazing stretch offering in all three brands.
That's a direct lift from the active space and we're not stopping at denim. There's applicability of that fabrication plus other technical features in Twill, in shorts and those are just the beginning here. We see significant opportunity for accelerating technical innovation in ready to wear, whether it's stain repellent, stretch, moisture management, etcetera. And it's something that we're moving to both embrace in our businesses as well as organizationally put some muscle behind. So let me close with where I started.
I'm very pleased with the decisiveness and the action on the restructuring work that we've taken on. I'm pleased with the direction and the validation that we're starting to see of our operating model work, again, both the back end of the supply chain and the demand based buying work that we're doing. And I want to call out Old Navy for quickly returning to improved performance, which again was absolutely positioned to do. We've seen that show up now in Q2. This is a company that is incredibly well positioned for long term success.
You've heard my strong conviction to make some very material changes to how we do business and come out the other side as a very strong retailer and very strong apparel company. Thanks and Sabrina over to you.
Thank you, Art. Good afternoon, everyone. While we have more work to do to deliver the performance we expect of ourselves, it's important to acknowledge there were signs of improvement in the business in Q2. For example, comp and adjusted earnings trends improved quarter over quarter. Merchandise margins in the quarter were up versus last year with positive average unit retail.
And Old Navy, our largest brand, began to see signs of stabilization with a 6 point improvement in comp versus Q1. Additionally, we maintained our operating discipline. Specifically, we managed inventories tightly, delivered strong free cash flow and continued to manage expenses prudently. With regard to second quarter performance, as anticipated, our reported results were negatively impacted by the costs associated with our previously announced restructuring plan. These costs totaled about $0.29 in earnings per share, of which about $0.07 related to a higher effective tax rate.
The non tax related restructuring costs were about $150,000,000 with about $15,000,000 hitting gross margin and about $135,000,000 in SG and A. On a reported basis, earnings per share were $0.31 Excluding the impact of restructuring costs, our adjusted earnings per share were 0 point 6 exchange negatively impacted the quarter by about $0.05 or about 8 percentage points of EPS growth on an adjusted basis. Excluding restructuring costs in both periods and the impact from foreign exchange, our adjusted earnings per share year over year were up slightly. Regarding other key metrics, sales totaled $3,850,000,000 comp sales were down 2% and total sales were down 1%. Total sales and comps by division are in our press release.
Excluding restructuring costs from both periods, adjusted gross margin rate was about flat. It's worth noting that our merchandise margins were up 20 basis points year over year or up about 90 basis points excluding foreign exchange. Additionally, both marketing expenses and adjusted total operating expense dollars were about flat year over year. Regarding taxes, our reported effective tax rate was 52.5%. The higher rate was driven by non cash valuation allowances related to our restructuring.
Our adjusted effective tax rate was over 10 points lower. Regarding the balance sheet and cash flow, total inventory was down about 3% at the end of the second quarter, in line with our previous guidance. We expect total inventory dollars at the end of the 3rd quarter to be down low single digits year over year. Year to date free cash flow was an inflow of over $460,000,000 and we ended the quarter with $1,700,000,000 of cash. As a reminder, we currently intend to repay our $400,000,000 term loan this year.
Regarding capital expenditures and store count, year to date capital expenditures were $270,000,000 Square footage was down 1% compared with last year. Store count and square footage are listed in our press release. With regard to our earnings outlook for the remainder of the year, on our Q1 earnings call, we stated that full year earnings per share excluding restructuring costs of $1.92 fell within a reasonable range of outcomes assuming trends improved. While we acknowledge that trends did improve, as we said on our sales call 2 weeks ago, performance was uneven throughout the quarter. Therefore, we think it's prudent to provide a guidance range that incorporates the likelihood of inconsistent traffic.
Excluding restructuring costs, we now expect our full year earnings per share to be in the range of $1.87 to $1.92 and operating margin to be about 8.5%. Regarding tax rate, we expect the rate for the full year will be about 44% or about 40% excluding restructuring costs in line with our guidance last quarter. All other full year guidance metrics remain substantially unchanged. Thank you. And now I'll turn it back over to Jack.
That concludes our prepared remarks. We will now open up the call to questions. We'd appreciate limiting your questions to 1 per person.
Thank you. We'll go to John Morris with BMO Capital Markets.
Thanks. My congratulations to everybody on the great progress you're making. I think the question would be for Art. You mentioned a couple of things that were interesting in your prepared remarks and I'm wondering if you can give us a little bit more color around the Gap division, particularly when you talked about very good product acceptance. Where are you seeing that?
And in what ways would you look to get the cost structure in line on a go forward basis? Thanks.
Yes, let me just I'll just skate on this, John, a little bit. And obviously, if you have further questions, we're happy to process them. We've seen good product acceptance, in particular, on our key fashion buys that we haven't bought deep enough. So if you were in our stores in July, you would have seen some really beautiful, well made, feminine, brand right tops with eyelet and lace. They were in the stores, gone in a heartbeat, very much on trend, off the shoulder as well, some of those things.
We were over assorted in some of our basics programs, which is why in summer clearance, I called it a just a sort of an array of color that was left, particularly in knits, where we were over assorted. And so it's about rebalancing the buys and having more confidence in some of the fashion places where we're now starting to see some of that validation. And we're also seeing really the authority of the brand. I was in our flagship store in New York a few weeks ago and in San Francisco here yesterday. There's a suede program, which is the flagship program, which has prices from $200 to $4.50 and it's sold down to the piece.
And it shows where when we get it right, what the authority the brand is from a pricing aperture standpoint as well. And again, I'd like a lot more depth behind those buys. And so we're learning here to get that confidence. On the cost structure, Gap's been our most complicated business in terms of geographies and channels and multiple locations. And so as we're rebuilding business processes, we're also further rationalizing some of the complexity and getting some more leverage out of the cost structure as well.
We've had essentially 2 headquarters locations between San Francisco and New York, and then different teams in different parts of the business. And we're just looking for efficiency every place we can in the overall cost structure.
Great. Thanks. Good luck for Paul. Thanks.
Thank you. Our next question comes from Matthew Boss with JPMorgan.
Thanks. So with traffic at the Gap brand in Banana, I know materially down exiting the quarter, have you seen any signs of improvement in August? And just your comfort with inventory if traffic did not bounce back from what you saw in July? Yes. I'd rather not talk about August right now because we'll talk about that when we get into sales and especially with volatility before we have the whole month in.
Depending on the day you look at it with traffic patterns right now, you can call any of a number of different directions. And we're also seeing back to school now really kicking in earnest across the country. And so I think it's a month that's still got to fill itself out before we're really ready to say what it looks like. With respect to inventories, we are and always, I think, have been for a while, very, very responsible on inventories and being very careful about how we buy to the traffic trend. And so we were aggressive on carry on our carryover in terms of summer clearance.
We wanted to make sure that we moved as quickly as possible to get clean there. I'll let Sabrina jump in here as well, but I don't have acute concerns about our inventory levels right now.
Yes. No, I agree. I think we're trying to strike the right balance of being tight and lean on inventory, but not cutting off the opportunity to positive comp, mostly using better average unit retail. So that's the balance we're trying to strike. And obviously, our inventories are in line with our overall total sales right now, which is not a bad place to begin a new quarter.
Then Matthew, I'd just add one more thing here because as we've talked now again about building responsive supply capabilities, back to those fashion tops that we had in the women's assortment, we blew through them. We felt we had a selling opportunity as we went into August September. And in working differently with our vendors, we actually executed several new styles in a 24 hour period, including approving samples, put the PO out and we're able to book several 100,000 units with a just a multi week, several weeks lead time to have them back in stores. And so as we continue to scale those very responsive in season fashion capabilities, it gives us the ability to feed the upside when we see it. Great.
Good luck.
We'll now hear from Lorraine Hutchinson with Bank of America.
Thank you. Good afternoon. Sabrina, could you talk a little bit about, which of the brands saw the most dramatic change from the Q1 in terms of gross margin and what the drivers of that were?
Yes. So I'll start with Gap. We've been saying all year, Lorraine, that Gap been managing their actual margin rate pretty well, that they've delivered their performance with a pretty healthy comp. So that continued throughout the quarter. I would say they weren't a big driver to the upside, but they certainly continue to deliver healthily.
On the flip side, I will tell you again not new news to you, but Banana Republic experienced the most margin pressure. And offsetting all of that, of course, was Old Navy, who, we've talked about had a quite a strong June. It led with, very nice healthy margins and that really helped deliver the higher AUR that we mentioned on my remarks.
Thank you. Thank you. We'll now go to Ike Boruchow with Wells Fargo.
Hi, good afternoon. Thanks for taking my question. Sabrina, it sounds like the merchant margin had a 70 bps drag from FX from your prepared remarks. I'm just curious, how does that drag look as we move into Q3 and Q4 on the merch margin line? And then given the lean inventory position, do you think you could continue to see merch margin improvement in the back half even in a negative comp environment?
Yes. So starting with the foreign exchange impact, we lock our rates in like 12 to 18 months in advance of the year. So a lot of that headwind we're feeling is really from a while back when we locked in the rates, the year over year rates, especially for Canadian dollar and for yen had declined significantly. And that's the headwind we're feeling. So for the portion of our cost of sales that we have hedged, which is a majority, let's just call it round numbers 80%, we will continue to have that kind of headwind.
Now offsetting that opportunity is, for example, yen has strengthened a lot, which is great. And so for the piece that's unhedged, you have opportunity and on translation, you have opportunity. So certainly translation is not as big of a headwind in terms of sales. So that's part 1 of your question. And then part 2 was, sorry, I didn't write it down.
I was just basically saying, can you continue to see merch margin improvement like you did in Q2 if you get an indicative comp back half?
Yes. We haven't guided to, merch margins or gross margins. Obviously, what we're striving for is that kind of improvement. A lot of it depends on where the traffic comes out. So you've seen when we bring traffic into a low single digit negative, we've done much, much better on both top line and delivering it in a healthy way.
And it's tougher if that traffic doesn't show up. So again, I think a lot of it will turn out, or will be dependent upon whether we can bring and sustain traffic levels that are not deeply negative, but are reasonable, like in the low single digit range.
Got it. Thanks. That's helpful.
Our next question comes from Simeon Siegel with Nomura Securities.
Thanks. Good afternoon. Art, to your comments about the technical innovation, the ready to wear and I guess the growing a lot of business. Can you just talk to your approach around R and D, maybe any thoughts around the cost associated there versus any potential AUR you might expect to recognize from improved product? Then just to the comment about inconsistent traffic, do you guys tend to see any meaningful deviations between e comm and brick and mortar when you see that inconsistency?
Thanks.
Yes. Let me talk just about this technical thing and see if I can answer your question. It's a very it's a deep and large question, so I may not give you all the way to satisfaction. If I just use an example of beginning to build and stretch into men's woven fabrications, That is something that is really partly our vendors and partly a direct port from some of our fabric R and D work and fabric and technical knowledge that we have inside of Athleta. And then some of the work that we're doing in our businesses as well working with our vendors.
And so I don't see it as I mean, we are taking some organizational steps in order to concentrate our strength there and our knowledge in fabric R and D. I don't see this as driving any significant deviations from the standpoint of the cost of our products. And one of the advantage that we have is when we put our businesses together, we do have scale. We're buying very large quantities. We're working with our vendors as a large purchaser.
And so if I look at Old Navy as an example, we've rebuilt a great deal of stretch into the men's denim complex. It was a modest impact on product cost, but not a huge impact on product cost. And I'm really pleased that as we've continued to feather it into the assortment, the incremental product cost has been overwhelmed by price realization. And so we've seen that he's actually willing to pay for it and willing to pay more for it. So to me, this is being careful.
But so far, the validation that customers are willing to pay for technical innovation and ready to wear is very clear across all of our brands and across the entire family. On traffic, Sabrina, I don't
know if
you want
to jump in.
Yes. I would say, web traffic is much more consistent than brick and mortar traffic. There's some volatility, but overall definitely more consistent.
Yes. Great. Thanks a lot guys. Best of luck for the rest of
the year.
Thank you. Our next question comes from Paul Lejuez with Citi.
Hey, thanks guys. It seems like AUC maybe wasn't much of a help in the second quarter. If Bob can confirm whether or not that's true and I'm curious if you do expect to see some AUC improvement in the back half of this year and even into next year? Thanks.
Yes. I would say, Paul, that from a commodity perspective, average unit cost has some tailwind for all of 2016. Now what we've been saying all along is it's no headline because our brands always make decisions around mix choices and investment choices. And once you take that all into account, there's just not any significant change in average unit cost. And we're not talking yet about 2017, so more to come on that.
Got you.
And then just one follow-up. We can't really see into your hedging so much. So I'm just curious if FX rates kind of stay where they are today, what are the P and L impacts for next year, if you might be able to shed any light there?
We're partially hedged already for next year because again hedging 12 to 18 months in advance would have us partially hedged. So for example, a lot of the first half would be done, but we'd have much more opportunity in the second half. And then we have quite a bit open. So there should be for the yen, for example, there should certainly be some opportunity.
Okay. Thanks. Good luck.
Our next question will come from Lindsey Druckerman with Goldman Sachs.
Thanks. Good afternoon, everyone. Art, I wanted to ask about on Gap brand, now that you have a lot of the pieces in place that you need for the turnaround, what with comps still negative, what are some of the indicators you're looking at that give you confidence that it is working? And as we think about over the next 2 to 3 quarters, what signs we'll see to show continued progress? And ultimately, when do you think we can get back to positive comps?
Yes. I mean, I sort of work through a chain in my mind, and this is the conversation we've been having, which is, first, to get the product dialed back in to the aesthetic of the brand and to restore the quality and the fit. And we have very encouraging metrics on all three of those that we our customers see us as expressing the brand appropriately and that they are responding to quality that they understand, recognize and value. And our fit consistency has continued to improve, and it's been a real focus on bottoms. And that's a big deal for us.
And when we're at our best, we really kill it on fit, and she really appreciates that. But we've done too much wandering around the landscape over the last couple of years, as we've tuned and tweaked fit and not had a consistent fit. It also, as you probably know, has an economic drag on the company, particularly in the online business because when you're inconsistent on fit, she quickly learns that she's going to order a 2, a 4 and a 6, knowing the 4 is her size. And then obviously figuring out which one fits and then sending the other 2 back or returning them to a store. And that has a drag of cost and devalued merchandise associated with it as well.
So fit has been a big issue for me and we're seeing some progress in response there. Next really is to bring the voice of the brand back and start telling the story because we have we increased marketing a little bit. We really pivoted it towards traffic and digital, but we've not been telling the story about the product and about the quality of the fit, etcetera, all the elements of the story to the extent that we need to. And so as we look at the back half, that's something that's very much on my mind. As you can imagine, I mean, that's part of the story at Old Navy is that we've continued to put marketing against business and we've seen the consumer respond to it, but we've been relatively quiet at both Banana and Gap.
Yes. And further to Art's point, I stated in my remarks that marketing was flat in the second quarter, but we are planning on investing in marketing in the Q3. Still working out our plans for the Q4, but we will be investing in marketing in the Q3.
So what would you say Art, you talked about you're seeing some encouraging metrics that she's responding. Are you able to share any of those with us? And then maybe when do you think the brand is in a position to comp positively?
I came out pretty provocatively on this earlier in the year, and it has taken longer with this consumer environment and frankly rebuilding our trust with the customer. And so this is a period over period improvement, and we're seeing those. I don't want to go into a lot of specific metrics right now, but I am very confident we're doing the right work and I am very confident that we're seeing the customer respond to it. It just isn't happening, as significantly and as fast as it needs to.
Okay. Thank you.
Thank you. Our next question comes from the line of Brian Tunig with Royal Bank of Canada.
Thanks. Good afternoon and congrats on the progress. I guess curious in hindsight, it seemed like July was the strongest month for a lot of companies. So I was just curious as you hindsight the quarter or look at maybe there was a calendar shift, but any reason why July was called out as weaker and traffic, I think, from you guys? And the second question is, it sounds like additional mall anchors are announcing store closings.
Can you maybe talk about how you feel about your portfolio between your value channel versus what you see in the mall and how often and what we could hear about an additional store closings viewpoint? Thanks very much.
Hey, Brian, I'll start with those. So with regard to July, the difference really between June July was the traffic dropped off significantly again for Banana and for Gap. We actually held traffic pretty well in July for Old Navy and that's why they have the better results of the 3 brands. Why it dropped off? We are still trying to work through.
That's part of the reason that we are investing in marketing in Q3, because we're really focused on trying to change that inconsistency and trajectory. So that's the July deal. With regard to the portfolio and the state of the fleet, we are, as you know, been very proactive in trying to stay ahead and take action on optimizing the fleet with big announcements last year on the Gap fleet and then another announcement in Q1 of this year closing another 75 stores in addition to those 175. So we are always open to looking to opportunities to optimize the fleet, but also I think Art mentioned in his remarks to look for opportunities to grow the fleet where appropriate. Now any growth in our future will certainly be focused around much tighter, smaller boxes.
That is something we're very sensitive and hyper aware about is we just think we need to get much more productive within smaller boxes in our future.
The other thing I'd say is you mentioned obviously closures right now. We certainly have our eye on if we're in a center and there's an anchor tenant that announces a closure, that's going to be something that we're going to process and deal with. So some of these companies have come out and announced significant closures. We're waiting to know what the specifics are in order to figure out whether we need to do something there.
Thanks very much.
Thank you. We'll continue on to Adrienne Yih with Wolfe Research.
Good afternoon. Congrats on the progress at Old Navy. Art, can you talk a little bit about the more about the responsive supply chain and then a part that comes with the test and reorder. How much do you hold back at the beginning of a season? How much can you chase into intra season?
And then Sabrina really quickly, just helping us with the timing of the 200 basis points gross op margin opportunity that you announced last quarter? Thank you.
Yes. Again, very long conversations. So let me try to be quick and maybe not fully satisfy you. But there's really 2 components to the responsive supply chain. The back end, which is vendor facing, length of our calendar, our fabric being platformed, strategic vendor relationships where they have capacity reserved and they can cut into us on release of a PO.
I'm really pleased with the extent to which we built that capacity out. The reality right now is that we are constrained in fully utilizing the back end by our front end processes, which is why I also threw in the work that we're doing on demand based buying. And that's really if you really want to think about what that is, it's disaggregating what was a 4 season brand reveal buy all at once into a much more disaggregated deaveraged buying process. And so we're working our way through that one right now. It is the constraint to scaling this at an enterprise level.
And Gap brand is doing the heavy lifting on the front end right now on behalf of other parts of the company. And so we have a ways to go there, and it's really step by step. We're a long way advanced from where we were a year ago, and we have a lot of room in front of us to continue to hold more open, be more in season, etcetera. Okay.
Thank you. Yes. And with regard to the operating margin opportunity, Adrienne, as a reminder, that opportunity was outlined as going with the restructuring announcement that will provide us with $275,000,000 of annualized savings. So the way you get the 2 points is really just take out that annualized cost holding the other variables. Now we said that because the actions we are taking are happening throughout the year and many of them at the end of the year, like a lot of the store closures for Old Navy Japan, that opportunity will mostly be viewed in 2017.
Okay, great. Thank you very much. Good luck.
Thank you. Our next question comes from Mark Altschwager with Robert W. Baird.
Hi, good afternoon. Thanks for taking the question and congrats on the nice progress with margin and inventory. Art, I was also intrigued by your comments about the accelerating technical innovation in ready wear. Just beyond stretch denim, what's the timeline for introducing some of these additional innovations into the assortment in a more significant way? And are there areas where you think the Gap Inc.
Brands will have some differentiated fabrications versus the competition? And then finally, what would the strategy be to communicate these technical innovations to the consumer? I think marketing has traditionally been focused on style and a value message, not necessarily technical attributes. So just curious how you might be thinking about that? Thank you.
Mark, you really pushed the button on you really pushed several of my hot buttons on this question. So congratulations. Again, if you just start with where can we see this start to roll out, we're really pushing stretch in men's, which we're finding the men's customer really responds to across multiple fabrications and multiple wearing occasions. So if you're in Old Navy today, there's a stretch Oxford shirt in there that is super comfortable. It really it's like this precision fit.
We're pushing stretch across really in men's, our 2 key bottoms fabrications in terms of denim and twill and both shorts and long bottoms. And really testing where else we can go with it, because we believe that it's actually really revolutionizing in many respects. That's a big word, but how men dress and the comfort and fit that they have in both tops and bottoms. So that's a step. We have nanotechnology in a pant and banana that we have basically not marketed at all, which is highly stain resistant.
If you pour a cup of coffee on the pants, it beads up and runs off. And we find that he has responded to that. Right now, to be honest, we are more using pre existing fiber and fabric innovation from our vendors, but we're also reorganizing in order to be able to work with some of our key vendors and be more proactive about driving innovation, which then we believe can unlock potentially some proprietary benefits. And I don't want to get into that right now. It's a much longer conversation and it's early days.
But we feel that our scale and our size working as a $16,000,000,000 enterprise for the company has the potential to not just benefit from pre existing innovation, but drive innovation. And so that's exciting for us as well. And it's across a number of different dimensions, whether it's, as I said, whether it's heat management, whether it's stain resistance, whether it's stretch and comfort, just to name a few right now that are out there.
Thanks again and best of
luck. Yes.
Thank you. We'll now hear from Janet Kloppenburg with JJK Research.
Good afternoon and thanks for taking my questions. Art, I was wondering if you could comment on what the outlook is for the fashion versus basic inventory to get in better balance at GAAP. You talked about shortening some of the lead times and betting bigger on some of the fashion. Maybe you could give us a timeline on when that inventory may content may balance out. And I was also wondering about your denim positioning.
It feels like we're going through a resurgence of denim right now and Gap has always been very well known for the denim. And I wondered if you were hopeful on that front. And lastly, Sabrina, on the 8.5% operating margin guide, does that assume a big uptick in operating expenses, not big, but a step up from where we were in the Q2? I appreciate some help there. Thank you.
Let me try to quickly hit the 2. On rebalancing fashion versus basics, it's kind of an old term, but I'll go with it for a second. We needed to reestablish authority in some of our key item programs because we had moved away from that. And so you saw that happen in spring summer, big multi CC knit programs, etcetera. We were over assorted there, so we're learning season over season, and we've made some changes even after we've booked in order to tighten some of our programs up.
So season over season, getting rebalanced for, again, key item programs, but also making sure that we have depth in some of these fashion buys. That's something that is going to get better every season. I was just again in stores yesterday, and I saw a gap show up again with the 1st full fall, and you'll see that again with more depth in fashion as we get into September. So it's a season over season process and one where we're actively learning and managing our buys as aggressively as we can. On denim, I've obviously been tracking and reading all of the comments that have come out across the industry over the last several days.
And there's a bit of optimism about denim out there. We're obviously extraordinarily well positioned in the denim business across all of our businesses. Banana has a great denim business now as well. It's front of store. I'm not ready to say I'm always hopeful about denim and it's been in a trough for a long time.
We are absolutely positioned to rise of denim,
but I
don't want to get frothy about talking about the fact that denim is now on a massive upturn and everything else. I want to I'm much more in the mode of under promising and trying to over deliver here. And I'm confident denim is going to come back because it has been in kind of a malaise. But we are well positioned across all the bottoms' fabrications, whether it's from an active fabrication, a by stretch in a pant for a woman, a twill fabrication or denim, we're well positioned to play wherever the market goes.
Yes. And on the operating margin guidance, Janet, we don't guide specifically to expenses, as you know. But to try and be helpful, what I'll just remind is that we will continue for certain to be very disciplined with regard to our expense management. We delivered not only in Q2, but I think for the entire first half on an adjusted basis, flat expenses. And that isn't easy to get to because we're on many years now of managing these expenses pretty much flat and it gets harder in the second half.
The other reminder I'll just point to is that, I've mentioned a couple of times that because we are focused on improving the traffic, we are making some investments in marketing in Q3.
Thank you. Our last question will come from the line of Betty Chen with Mizuho Securities.
Thank you and thanks for taking
my question. Congrats on the progress. I was
hoping to maybe shift the conversation a little bit
to the international business for a moment.
Can you talk a little bit about what you're seeing
in each of the major geographies, Canada, Japan, Europe and especially China, and some of the progress maybe by brand if possible? Thanks.
You want me to start the 1st?
Yes. Well, Spreen will jump in and I'll jump in behind her.
Yes. So I would say, broadly speaking, North America is stronger than international. It was interesting to see the, I think, U. K. Retail sales come out this morning that were fairly strong.
So maybe that's European tourists going into the U. K. But broadly speaking, there have been more challenges versus North America. And I would say that is probably somewhat attributable to global geopolitical uncertainties, but it does vary by geography and it actually varies quarter by quarter.
Yes. I just we're still bullish on our international business, obviously, and committed to it. But it's honestly, you have to look country by country at the end of the day. Old Navy as an example in North America and Canada has continued to be a very strong business. If you look at what is, I think, a very interesting environment in China right now, in the space that we're in, we're seeing the value business there, particularly with our Gap Factory stores continue to be very good, but the customer is somewhat standing on the guidelines, which has resulted in a lot of very aggressive and early sale activity across the whole specialty channel.
So it's hard to really generalize overall, but I would agree with Sabrina. North America, better and international, more challenging.
Thank you.
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 2nd 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. Ladies and gentlemen, that does conclude our conference. You may now disconnect.