Good afternoon, ladies and gentlemen. My name is Kevin, and I will be your conference operator today. At this time, I would like to welcome everyone to the Gap Inc. First Quarter 2015 Conference Call. At this time, all participants are in a listen-only mode. For those analysts who wish to participate in the question and answer session after the presentation, you may now press star one to enter the Q&A queue. As a reminder, please limit your questions to one per participant. If anyone should require assistance during the call, please press the star key followed by the zero key on your touchtone phone. I would now like to introduce your host, Jack Calandra, Senior Vice President of Investor Relations.
Good afternoon, everyone. Welcome to Gap Inc.'s First Quarter 2015 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 or descriptions of measures we are required to reconcile to GAAP financial measures, please refer to today's earnings press release, as well as our most recent annual report on Form 10-K 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 May 21st, 2015, we assume no obligation to publicly update or revise our forward-looking statements. Joining us on the call today are CEO Art Peck and Executive Vice President and CFO Sabrina Simmons.
Sabrina will be using slides to supplement her remarks, which you can view by going to the investor relations section at gapinc.com. With that, I'd like to turn the call over to Art.
Thanks, Jack, and good afternoon, everyone. I'm pleased to be here speaking to you now in my second earnings call as CEO. The most important thing I want to do today is reemphasize our earnings guidance for the year. You have, I'm sure, our press release in front of you. You have the details underneath that. After I am done, I'll hand it over to Sabrina Simmons, who will take you through the specific detail. Obviously, we'll have Q&A at the end of this call. We'll talk about our first quarter results, and I'll go a little bit deeper into what's been going on over the last three months. There are three issues that really impacted the first quarter. Two of those are macro factors, which we've spoken to you about before, in terms of foreign exchange and the West Coast port situation.
Sabrina Simmons will spend a little bit more time on that. I really want to dive in on the underlying results of our three global brands and specifically the performance of our women's businesses. As we've said, and we continue to see, we've had an exceptionally well-performing women's business at Old Navy, which has driven great profitable growth. Product acceptance at Gap in the women's business has been tough, and we're focused on making it happen. At Banana Republic, it's a work in process, and we have work to do there as well. Let me start first by spending a few minutes on Old Navy. Obviously, it's a very good story, a story that we're very pleased with, and a story that we have confidence in is going to continue to repeat itself on a going-forward basis.
Three years of excellent performance, and most importantly, underneath the covers, growth that is being driven in a very high-quality way with a very nice margin story underneath it. Q1 comp was a women's story. I'm saying that in particular because as we have struggled with our women's business in Gap, as an example, Old Navy is an excellent example where we continue to get women's right season after season, and we're very pleased with the performance that we're seeing with on-brand, on-trend product in our stores. I need to point out that this is a combination of factors. It is clearly a team working well together, led by Stefan, that is delivering this performance.
It's also underlying process changes that we have made in the way that we're running the business and the way that we're bringing product to market that is delivering the consistency that we're seeing. I mentioned this before, but I need to mention it again, which is we are taking these changes and, in some cases, largely transplanting them into our other businesses in that they are proven inside of Old Navy, and they have been delivering this kind of performance. Again, we have a strong women's business there, but it's been followed by a pretty strong business inside the rest of the box as well across men's, kids, and baby. It's a thing of beauty when Old Navy is firing on all cylinders and has now for several seasons running. On the flip side, I continue to be disappointed but not surprised by Gap's performance.
We have had a women's business challenge now for several seasons running. I believe we have diagnosed it correctly, having to do with being off-brand, in some cases off-trend, and I can promise you that the team is all over it. In the last call that we had, I mentioned the hiring of Wendi Goldman. Wendi has hit the ground running. She is a highly collaborative, skilled leader working with the team, and I've been really pleased so far the results the whole team is producing as they have focused on holiday and obviously on spring. Jeff really has three priorities right now, and I want to underline and emphasize those to you. We are in season every day, and we're managing the business as aggressively as we can to get every penny out of the business.
In relative terms, kids and baby is performing better, and men's is performing better. To be clear, I am not happy, and Jeff is not happy with the entire performance of the brand, and we're committed to turning it around. On top of managing in season, we're obviously working extremely hard to make every improvement that we can to the outlying seasons, including holiday and most importantly, spring. On top of that, I said I was impatient. We are working very hard to change the product processes a la what we're doing in Old Navy, in order to get Gap to a more consistent on-trend, on-brand footing. I have to say, much of the work that the team has done there to realign the team on the aesthetic of the brand is very encouraging. Banana Republic is a mixed bag.
This was Marissa's first collection showing up later in the quarter. It's had a couple of very positive impacts in terms of reestablishing some fashion credibility for the brand and the relevance of the brand. We didn't get it 100% right, and this is not to be excused, but perhaps expected as you're bringing a new designer and a new leadership team together. The color palette was pretty stark between black and white, not enough color and print and pattern for the season that we're in. We're still working to buy an assortment that is both commercial and fashion oriented. Relatively speaking, the men's business is stronger. It's not that the women's business is weak, but we have not hit the stride nor delivered the commercial results, while at the same time we have established some fashion credibility.
That's our job, and we're focused on making it happen. In a moment, I'll turn it over to Sabrina. What I wanted to do was offer a few comments in advance about how Sabrina and I are working together and the commitment that we very much share together. Obviously, a big part of our story over the last several years has been the fact that we are committed to a responsible capital structure, as this company continues to generate a significant amount of cash, we are committed to distributing net excess cash to the benefit of our shareholders. It's important for me to emphasize that Sabrina and I are highly aligned on continuing that going forward, while at the same time responsibly reinvesting in the business. Sabrina, let me pass it to you.
Thank you, Art. Good afternoon, everyone. As anticipated, our first quarter results were impacted by foreign exchange headwinds and delayed receipts due to the West Coast port issues. Despite these dynamics, we're pleased that Old Navy delivered another strong quarter on top of 3 years of growth. As Art mentioned, we're focused on taking the steps necessary to drive improvements and greater consistency in our other brands, while continuing to make progress on our long-term objectives. Operating income for the first quarter was $386 million versus $443 million last year. Net earnings were $239 million. On a reported basis, earnings per share were $0.56, down about 3% versus $0.58 last year. It's important to note that our reported earnings per share were negatively impacted by foreign exchange. We estimate that foreign exchange reduced our reported earnings per share growth rate by about 3 percentage points.
Sales for the first quarter were also impacted by foreign exchange and the port issues. As reported, first quarter sales were $3.7 billion, down 3% versus last year. The translation of foreign revenues into dollars negatively impacted our reported net sales by about $90 million in the first quarter. On a constant currency basis, net sales were down about 1%. Regarding the port impact, there's no meaningful change to our first half estimate of $0.13. As a reminder, first quarter sales were impacted by having fewer units available for sale. We expect that second quarter will be impacted by late units that will likely be sold at lower margins. Total sales and comps by division are listed in our press release. Moving to gross margin. First quarter gross margin was down 100 basis points to 37.8%.
Merchandise margins were about flat, driven by strong performance at Old Navy, offset by the impact of foreign exchange, as well as disappointing performance at Gap brand. Rent and occupancy de-leveraged 100 basis points. In the face of challenging sales performance, we managed SG&A tightly. First quarter total operating expenses were $996 million, down $27 million from the prior year, driven by foreign exchange favorability. Marketing expenses were down about $7 million versus last year to $136 million. As a percent of sales, total operating expenses were 27.2% and de-leveraged about 10 basis points versus last year. As a reminder, in Q2, we will lap last year's gain on sale of nearly $40 million. Therefore, we expect greater de-leverage in Q2 versus Q1. Regarding the balance sheet and cash flow. Inventory dollars per store were up about 4% at the end of the first quarter.
As anticipated, delayed receipts due to the West Coast port situation resulted in higher in-transit inventory levels at the end of the first quarter. We expect year-over-year inventory dollars per store at the end of the second quarter to be up slightly versus last year, as we focus on selling through these late receipts while trying to maximize margin. As a reminder, last year's inventory per store was up only 2% in Q2 versus up 7% at the end of Q1. For the quarter, free cash flow was an inflow of $61 million. Underscoring our commitment to distribute excess cash to shareholders, we distributed more than five times our free cash flow, or $329 million this quarter. This includes $230 million to repurchase 5.6 million shares, resulting in a quarter-end share count of 419 million. Regarding capital expenditures and store count, first quarter capital expenditures were $150 million.
We opened 29 company-operated stores on a net basis and ended the quarter with 3,309 stores. Store count and square footage are listed in our press release. Now I'd like to share our outlook for the rest of the year. Our first quarter performance was broadly in line with our expectations at the time we provided our full year guidance in February. Therefore, we are reaffirming our full year earnings per share guidance range of $2.75-$2.80. For the full year, all other guidance metrics remain substantially unchanged. In closing, as we enter the second quarter, we will continue to focus on levers that we can control while we work to deliver compelling product assortments across all of our brands. 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 one per person.
Thank you. We will take our first question from Randal Konik with Jefferies. Again, Mr. Konik, your line is open. Please check your mute button at this time. Due to no response, we'll be moving on.
Oh.
Please go ahead.
Hello? Hello?
Your line is open. Please go ahead.
Oh, sorry about that. I had a little phone issues here.
Hi, Randy.
Hey, guys. How are you?
Good.
I guess just, Art, first, I guess let's dive right into it, right on the Gap. You kind of talked a little bit about the relative better performance around Kid and Baby and Men's. Relative to the traffic of what you're seeing at, I guess, Banana and the Mall, is it truly a traffic issue, conversion issue? Is the mom going in there for the baby but just saying, "These clothes, I can't buy this." Just trying to get a perspective on what is truly the problem there. As it relates to your perspective on the Women's side, it sounds like it's a combination of inconsistent fit, lack of color, bad marketing or not the best marketing, what have you. Just want to get your perspective on which of these things are most important to improve, which can be turned the fastest, et cetera.
Thanks.
Yeah. Randy, it's the same thing I think, I've been pretty consistent in talking about, which is, we know we have problems in the Women's business. We've diagnosed it. We've diagnosed it because you can go in there and look at it. I spend time in stores. I talk to customers. I watch what customers buy, and we look at our product acceptance. The issues are clear and have been clear for several seasons. It is a combination of all of the above, which is we're off trend and in some cases, way off the brand. We have some quality and fit issues where we've made some choices.
The issue is that when the Women's business, which is why I'm focused on the Women's business, when the Women's business isn't working, it does in a brand like Gap, which is obviously dual gender and then whole family, have a negative halo on the rest of the box. We're actually getting very good customer feedback on our Kids and Baby business. The Men's business continues to be relatively strong. It's why when I have been working with Jeff and the team, it's been prioritize the Women's business because as it halos negatively when it's not working, it has the same halo effect positively when it is working. I'm pretty encouraged by what I see going forward. I can even look at the holiday assortment, which has largely landed now.
Some of the sort of obvious mistakes that we've made, they're gone from the line. We've actually taken the step of canceling some styles that we had that we knew were just not sellable, which is an appropriate thing to do as well, and which we've been able to do. From that standpoint, again, same thing I was saying before, team heads down working on the Women's assortment and getting it back on track as much as we can do in holiday, acknowledging it was mostly bought, then spring being a no excuses moment.
Thanks, guys.
Yeah. Okay.
We go next to John Morris with BMO Capital Markets.
Thanks. Good afternoon, everybody. Art, maybe if you could give us a little bit about your philosophy on handling the marketing spend go forward. I'm sure we'll hear from Sabrina as well in terms of the thoughts about the numbers, but I wanted to get a little bit on the philosophy. We saw you guys pulled back a little bit in the quarter, and what can we expect, and where are you thinking about allocating it by brand and your philosophy around that. Thanks.
The simplest philosophical statement that's easiest to make is that when you're not proud of your product, you're not going to be out there putting a lot of marketing behind the business. It's exactly the strategy that I followed back in 2011 when we looked forward down the pipeline, didn't feel good about the product, and consequently pulled back on a lot of the working media spend that we had in place, and we're doing some of that now as well. The other side of that is I'm feeling like we're really getting our returns in the marketing spend that we have at Old Navy. When I can see the returns, and it can help drive the business, I'm happy to put money into the business as well. It's really about placing smart bets, not just sticking with a marketing plan or anything like that.
Expect us to be tight, and as the product gets better, expect us to then start putting a little bit of pressure on the business. You correctly have seen that we've pulled back, and we'll continue to do that until we feel like there's an opportunity to really tell the story. Then the second issue is, and this is a topic broadly separate from the current performance of the business that both Sabrina and I are very focused on right now. We have, over a long period of time, generally spent more than many of the competitors out there in terms of marketing. I think we should be getting more out of our marketing dollar than we are at the end of the day. Sabrina, do you want to add anything to that?
Yeah, I was just going to add to be helpful, which underscores what Art said is, in the quarter, as you might imagine, with Old Navy positive comping, they're not down at all in marketing dollars. In fact, they're up. The improvement comes a little bit from everywhere else where we're not as happy. It also includes, by the way, I should say, Piperlime, because we closed that in the quarter. So we're not marketing behind that. Then with regard to the second quarter, I would just say there's not going to be any radical change because it's likely to follow the same pattern as Q1. I would look at last year as a good starting point to the second quarter.
Okay, good. Thanks. Good luck.
Thanks.
We'll take our next question from Oliver Chen with Cowen and Company. Please go ahead.
Hi. Thank you. I had a broader question about how you're feeling about supply chain and test, read and react and vendor manage inventories and how this will work in terms of your strategic planning. I do think we're observing some newness on the trend front in the marketplace from our perspective. I'm just wondering what vehicles might be best for you to try to capitalize upon that newness factor that seems to be happening in some bottoms and tops.
The story on supply chain is, as we've been telling it, that we're continuing to push on it on a number of the elements on platform fabric, which enables us to get back into season very quickly on some of the test and respond that we've been doing. Old Navy is farthest ahead in realizing this. With the changes that have taken place, obviously, and the challenges in the business at Gap, changes in leadership, challenges in the business, those two businesses lag. Banana's probably in the middle, and Gap is farthest behind. What I can say quite confidently is that as we have implemented it's very clear that it's having a positive impact, and it's the right thing to do. The question really is scaling it and continuing to scale it as fast as we can.
We are using this in some cases to do exactly what you talked about with respect to a trend out there that we see or something like that. We'll put a set of silhouettes in in bottoms, and we'll see which sells, and it allows us to go cut more aggressively and respond more quickly into the silhouettes that are selling right now. Obviously, in denim, as an example, there's a lot of variation out there in terms of rise, in terms of the leg silhouette, the novelty, and we can be more responsive there. Knits is an easy one where we've also used that, and particularly inside of Old Navy to be more responsive to where the knits business has really shown some real strength and put some volume behind it. It's a clear capability.
As I've said pretty publicly, we're in a business that we guess a lot, anything that we can do to minimize the guesses and guess better and inform it with data has a real positive impact on the business.
Okay, Art, just for expectations, it's more about Spring versus Holiday, but you've made some tweaks for Holiday. I just wanted to understand how we should think about the catalyst and timing.
In Gap brand specifically, you mean?
Yes.
Yeah. I'm going to stick to my same story there, which is that I don't want to make any promises about Holiday because as the team got in place, Holiday had a pretty good head of steam behind it, and so much of it was developed. What I can say is that the team didn't not do anything, and they've put their shoulder against it and made some changes there. I'm certainly hoping it will be better. From what I've seen, I've seen some encouraging elements of the assortment that I think are in a much better place. I'm really putting my big expectation on Spring.
Thank you. Best regards.
Sure.
Ladies and gentlemen, as a reminder, please limit your questions to one per participant. Your next question comes from the line of Matthew Boss with J.P. Morgan. Please go ahead.
Hey, good afternoon, guys. Expense control remains pretty impressive over this year and the last couple, actually. What type of flexibility do you think remains on a go-forward basis? Particularly if a top-line turn were not to materialize at the end of this year or even in the spring, just what kind of room do you have to continue to cut some expenses?
Yeah. Well, a big part of our expense base is related to our stores, and that varies in large part. About half of that varies with sales. We do have the benefit that if sales are not realized to the extent we'd like them to be, we have the natural variable component that comes down. That's one piece that will always be in the works. With regard to how we deliver the expense savings this quarter to help you think about how we would do it in future quarters, a chunk of it came from foreign exchange. We call that out, and we benefited probably between the translation and balance sheet remeasurement, about $30 million of benefit. Even after that, though, expenses were pretty close to last year, so very tight.
That comes primarily from this variable component I talked about, as well as we brought that marketing down a little bit by $7 million. We would continue to use those levers that are variable or discretionary, like marketing. Q2, I just want to call out again, it's a very different dynamic because we leveraged last year in Q2 by 190 basis points. Just from a sheer optic perspective, that includes the gain on sale of $40 million last year. We're going to be lapping that, and then we layer on really kicking in June, the wage increase. The deleverage we would expect to be higher in Q2 just because of what we're anniversarying such high leverage.
We will, behind the scenes, continue to work all the levers we have at our disposal to manage our expenses very tightly, especially if we're not realizing the sales we would expect.
Great. Just a quick follow-up. Online posted the first year-over-year contraction that I can remember maybe ever. Can you just talk about initiatives in place to stabilize this channel as well?
Yeah. Online's number really was driven and impacted by the ports as well. Number one is sort of at a high level. It's important to remember that they too were impacted by that. The second piece is the Piperlime closure. Again, we wound down and actually finished closing Piperlime in the first quarter, so that's going to be another chunk of it. You just have the effect of Gap brand product acceptance being fairly weak. You put those three together and you come up with, we're not happy with that number at all, but we would expect it to improve once we're out of this port situation, certainly, and get back to a more normalized level.
Okay, great. That's really helpful.
We'll go next to Matt McClintock from Barclays. Please go ahead.
Yeah. Good afternoon, everybody. Art, I was wondering if we could focus on Old Navy for a bit. Three consecutive years of solid comp store sales performance, it would appear that that performance should just be now gaining steam from some of your supply chain initiatives. Can you talk about the evolution of Old Navy's comps of the performance there from the beginning three years ago, we put up a solid 6% increase to the most recent result, how should we think about this evolution as those supply chain improvements continue to accelerate your ability to deliver fresh fashion to that business? Thanks.
Yeah. No, I'm glad you're seeing that, you can probably read the article that was in the newspaper earlier this week as well. There's some information in there. I think, and I hope what you're seeing and what you're believing is that you put that much consistency in place, three years, multiple quarters back-to-back, there's a reason behind that. There is a reason behind that. It starts with, obviously, Stefan and his team, which is a really good team working well together. The much more important thing behind the scenes is that team living inside of a very disciplined process and a set of process changes that is allowing for the consistency. Again, I say this often publicly, that it's relatively easy to have a great quarter.
What is superlatively hard in this industry is to put quarter after quarter together and then year after year. We have a lot of confidence there in the processes and capabilities that we've built. It starts with what we think is a really great process right at the beginning, which filters trend really systematically across a wide variety of sources. Filters trend down to the right ones that we feel are brand right and appropriately commercial for Old Navy. It's allowed us to be in trends that are happening at the same time in the designer and the premium contemporary space. It's allowed us to be into those trends in Old Navy almost in a simultaneous way, which really is the way the world is working right now. That ability to be right and to respond very quickly is powerful.
If you just go down into the system, there's a really, I think, a really disciplined and structured management of the assortment that we're running as well right now, which allows us to maintain the proper amount of newness entering the portfolio, but also have a super solid set of styles that are proven that we can invest in over several seasons to help us really drive the commercial plan of the business. I guess the way I think about it is that a healthy business is a business that's gaining market share, and Old Navy has now demonstrated its ability to hunt and win at market share pretty consistently for a number of quarters running.
You know I won't say that this is going to be perfect every time because it's tough in this industry with fashion, but I do have a great deal of confidence in the system and process that we've built there. It's obviously why we are working very aggressively with Jeff and his team, and Andi and her team to almost do turnkey installation of some of these components into the other businesses as well. We'll see the results there on a going forward basis, but I've been really pleased with what we've seen with Old Navy and really confident with what we see going forward.
Thanks a lot, Art.
Yep.
We'll go next to Susan Anderson with FBR Capital Markets. Please go ahead.
Hi. Good evening. Thanks for taking my question. I was wanting to ask just about expectations for gross margin as we go throughout the year. I assume in the second quarter it should be worse because of the port situation. Should we expect it to inflect positively in the back half, or should we expect continued SG&A to help to offset that to get to your EBIT margin guidance? Thanks.
That is a tough question because we do not guide to gross margin, Susan. To try and be helpful, we have given a perspective on operating margins. The gross margin, what I'll tell you just to keep in mind, you're absolutely correct with your view that there's going to be pressure that we expect in the second quarter because of the port, for sure. As a reminder, we're also dealing with this year headwinds within the gross margin line due to foreign exchange. That's just part of what we laid out at the early part of the year for everyone to understand because we have that very large Japan and Canada business.
Other than that, I will tell you once we're past the first half port impact, of course, we'll be heads down on trying to deliver the healthiest margin we can, and we will ultimately continue to use all of our levers to try and put up the best value that we can every quarter. We'll see how that works out.
Got it. That's helpful. Thank you.
We'll take our next question from Kimberly Greenberger with Morgan Stanley. Please go ahead.
Great. Thank you so much. Art, you talked about some of the improvements and changes in processes at Old Navy that have been implemented there over the last couple of years, and that you felt like those processes and that those improvements could be transported, I think, to Gap and Banana. Could you just talk to us about just help us understand exactly what those process improvements are if the transportation process from one division to the other has already started to happen, or the knowledge sharing has already started to happen. When do you think we might see the early results of that in terms of the merchandise in store? Thanks so much.
Yeah. Again, let me reiterate what I said in my comments. The three lanes of work that Jeff and his team are focused on right now, specifically at Gap. Obviously, you have to run the business aggressively in season, and we're doing that. The team is heads down on the business on a global basis. The second issue is fix as much of the product as we can that is in the pipeline and deliver spring women's product in a brand appropriate, trend appropriate way. Then the third is rebuilding the product processes. There are a lot of plates spinning right now inside of Jeff's world, but he and I both feel very strongly that we can't wait. We're working these things simultaneously.
If you think about some of the key elements of the process, one is very simply the length of the pipeline. Old Navy has been running on a shorter pipeline for a while, and Gap is developing on that pipeline now as we speak. There's the trend process, the assortment architecture, the supply chain capabilities, a number of other things as well, which we're layering in. Quite honestly, Jeff and I are sitting here saying, "How much can we throw at the organization? And how fast can we push?" We are pushing pretty hard and pretty fast. Spring will come to market with a shorter pipeline, but it's going to be a hybrid, really, of the way they've traditionally brought it to market and the new processes that we're building.
We'll get more and more up to speed on the new platform as we go through product development for 2016 and the outlying seasons. I can't tell you exactly when there's going to be a lights-on moment of this revealing itself because it was at Old Navy, and it is in both Banana and Gap, more of a progressive rebuild. Some of the key elements are already in place right now.
We'll take our next question from Lindsay Drucker Mann with Goldman Sachs. Please go ahead.
Yeah. To me, AUR is one of those things that if you have confidence you can achieve it's a thing of beauty. Our issue with AUR as a company has been our inconsistency in our ability to achieve AUR. Again, inside of Stefan's business, there's been an opportunity that they've had, and they have demonstrated their ability to mostly out of mix, really not out of make at the end of the day. One of the things that's really cool about what's going on in Old Navy is that they are able, in many cases, to achieve cost reductions, an elevated sense of quality, and a mix-up all at the same time in some AUR. It's in selective categories.
This is one where Sabrina and I are absolutely in lockstep, which is to put AUR and look for AUR on the basis of mix and track record because it's proved to be way too elusive at times, not just for us but for other people in this industry. The other side of AUR, having nothing to do really with the make of the product or AUC, is just getting off of the depth of the promotions that we've had in some parts of the company. Frankly, in my view, that's probably a much bigger AUR opportunity in the near to medium term than any fundamental changes in product mix or product make. We've been very heavily discounted, as you know, and in some cases, overbought in areas where the product is not registering, and that's a tough spot to be.
A second part of Gap is to really make sure that we are buying holiday and spring in exactly the right way. Again, I've said publicly that I have a pretty strong bias towards always modestly under-buying a season and looking for upside in AUR, versus trying to force a lot of units through the system.
Great. If I could just ask one follow-up. Art, when we met with you last, you had talked about thinking about some different ways you might conceptualize a store format and different things that you were thinking about. Have any of those experimental or newer evolved store formats come into clearer focus? Thank you.
We're still working on it on the inside. Old Navy has something that they'll be testing. I'm not quite sure of the timing yet, but certainly within the course of this calendar year. I'm focused on our international expansion as well, and in particular for both Old Navy and Gap. The store size is a big opportunity for us in terms of opening up smaller, more productive real estate spaces where we otherwise wouldn't actually necessarily even be able to open a store. I'm not ready to make a pronouncement on this one, but it hasn't lost any of its importance, and it certainly is being backed across the company with a high degree of urgency.
Great. Thank you.
We go next to Adrienne Yih with Janney Capital Markets.
Good afternoon. Quick question on the inventory. I know that Old Navy has been in a position of chase throughout fourth quarter and into the first quarter. You were able to cut some inventories at Gap going into late spring, summer. I'm wondering, are you comfortable with your inventory levels now? Really quickly, if you could just talk about AUC opportunity in the back half. Thank you very much.
Sure. The inventory increase, Adrienne, is really mostly due to the in-transit issue related to the port. We told you guys we wanted to goal ourselves at the beginning of the year, excluding the port, something like slightly down to flattish. I would say we're pretty much there, excluding this port issue that puts us up four. You see that we try and get back with the guidance at Q2 of getting back to tighter inventories slightly up. The reason we're giving ourselves a little bit of wiggle room is with those late inventories coming in, we don't want to do anything unnatural if goods aren't really liable to just force the sell-through to get to an EOQ.
It's still fairly tight when you think about it to be slightly up when last year we're lapping only in up two.
Okay.
Overall, I would say we're comfortable with our inventory levels, and we'll continue to manage them quite tightly. Your second question was?
On AUC opportunity with cotton deflation.
Right. That opportunity really begins with summer flows because we told you when we bought our spring flows, cotton really wasn't down yet. Yes, we hope to capture, and we feel confident that in the second half, we should get some tailwind. The magnitude of that, we've also talked about, it's a low single digit, certainly. Because the simple math that we try to help you all with to be illustrative is that if cotton prices were down 20% when we place those orders, broadly, you would expect with nothing else changing, you would expect AUC down about 2%. Of course, there's always some mix and a little bit of reinvestment here and there.
That's sort of directionally what we're trying to capture in the back half.
Okay, great. Thank you so much.
We will take our last question from Lorraine Hutchinson with Bank of America Merrill Lynch. Please go ahead.
Thank you. Good afternoon. Art, could you share your updated thoughts on square footage and points of distribution for both the Gap and Banana brands?
Yeah, it's a pretty simple conversation, I would say right now, which is that we are always looking at real estate opportunities, whether it's a store that we should be in because the center is no longer relevant, whether it's an opportunity to downsize or reposition. That's part of the normal ongoing part of how we think of this. That's really the work that the team is doing all the time, and it's obviously here in North America where we have the most mature business, but we're obviously doing that all around the world across all of our fleets. Not really ready to say anything more about it right now in any form other than it's part of how we view running the business in a responsible way. Sabrina, I don't know if you want to add anything more to that.
No, that's right. Reviews on the fleet are done on an ongoing basis, and obviously, we look even more deeply when brands are underperforming. Overall, historically, Banana Republic has had very high returns, and they have a pretty tight fleet size. Work underway, more to come, I would say. Yes, it's always on our radar, and it's an ongoing initiative.
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 first 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.
Ladies and gentlemen, this does conclude today's conference. We thank you for your participation.