I would now like to introduce your host, Katrina O'Connell, Vice President of Investor Relations.
Good afternoon, everyone. Welcome to Gap Inc. Q3 2014 earnings conference call. Today's call is intended to cover both our Q3 earnings results and the company's organizational announcements issued today in separate press releases. Before we begin, I'd like to remind you that the information made available on this webcast and conference call contains certain 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're 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 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 November 20, 20 14, and we assume no obligation to publicly update or revise our forward looking statements. I also want to mention that Sabrina will be using slides to supplement her remarks, which you can view by going to the Investor Relations section at gapincdot com. Joining us on the call today are current Chairman and CEO, Glenn Murphy Art Peck, current President, Growth Innovation and Digital and Future CEO and Executive Vice President and CFO, Sabrina Simmons. As usual, Glenn and Sabrina will share the earnings results for the quarter.
In addition, both Glenn and Art will also share their respective views on the announced leadership transitions. Please note that Art is joining us on the call from New York today, so he will make his comments and then turn his attention to the teams in New York. Therefore, he will not join for Q and A. However, after our prepared remarks, we will open up the call and Glenn and Sabrina will be available for questions. Now I'd like to turn the call over to Sabrina.
Thank you, Katrina. Good afternoon, everyone. As usual, I'll begin today by reviewing 3rd quarter performance and then provide an update on our full year guidance. While we're not proud of our 3rd quarter sales performance driven by a particularly tough result at Gap Brand, we are pleased that the team demonstrated strong discipline on both expense and inventory. Net income for the Q3 was $351,000,000 and we delivered earnings per share of $0.80 up 11% to last year.
As a reminder, our Q3 earnings per share of $0.80 includes a non recurring benefit of about $0.06 from a lower effective tax rate of 34.5% in the quarter. Regarding sales for the Q3, total net sales were flat at $4,000,000,000 and comp sales were down 2%. For the quarter, the translation of foreign revenues into dollars negatively impacted our reported sales by $31,000,000 primarily due to the weakening yen and Canadian dollar. On a constant currency basis, therefore, our revenues were up 1%. Moving to gross margin.
3rd quarter gross margins were up 20 basis points to 40.2% with the favorability versus our prior outlook being driven by non merchandise items like shrink in shipping.
Merchandise margins were up 90 basis points
for the quarter with Old Navy delivering Merchandise margins were up 90 basis points for the quarter with Old Navy delivering the strongest margin performance. Rent and occupancy deleveraged 70 basis points. Regarding SG and A, 3rd quarter total operating expenses card income reclass of about $40,000,000 operating expense dollars would actually have been below last year. Regarding the balance sheet, at the end of the 3rd quarter, quarter, we're pleased that inventory ended down 2% per store, below our previous guidance. We ended the quarter with about $1,000,000,000 in cash.
Given our opportunistic approach to share buybacks, we're pleased we repurchased 11,400,000 shares in the quarter with the vast majority of those shares bought at a price of about $36.50 Year to date, we've used over $1,000,000,000 to repurchase 26,000,000 shares. We've also distributed nearly $300,000,000 in dividends, resulting in total cash distributions through October of more than 1,300,000,000 dollars We ended the quarter with 424,000,000 shares outstanding. Regarding capital expenditures and store count, year to date CapEx was 508000000. Dollars We ended the quarter with 3,266 company operated stores and square footage was up about 2% compared with Q3, 2013. Store count and square footage details are listed in our press release.
And now I'd like to share our outlook for the rest of the year. Overall, our expectation is that the holiday season will remain highly promotional and competitive. We're revising our full year earnings per share outlook to 2.7 $3 to $2.78 which includes the Q2 gain on asset sale of about $39,000,000 The new range also includes a lower full year effective tax rate of about 38%, reflecting the 3rd quarter tax benefit. In addition, we now expect operating margins to be about 12.5%. Our guidance range assumes current foreign exchange rates hold for the remainder of Q4.
Given that some major currencies weakened meaningfully against the dollar in October, foreign exchange is likely to have a bigger negative impact on our Q4 earnings than we experienced in Q3. For the full year, we continue to estimate that foreign exchange will negatively impact our EPS growth rate by about 5 percentage points. Regarding other full year guidance metrics, we've reduced our expected capital expenditures in response to a more challenging operating performance. We now expect CapEx to be about $700,000,000 down from our previous guidance of about $750,000,000 and we now expect depreciation and amortization to be about $500,000,000 Our net square footage guidance is unchanged at up about 2.5%. To be helpful, here are some other things to keep in mind.
Clearly, we plan to remain diligent in our expense management. As a reminder, we delivered a full point of leverage in the first half of the year. However, similar to the Q3, we expect expenses to deleverage in the Q4. At the end of the Q4, we expect year over year inventory dollars per store to be down slightly. It's important to note that this guidance on inventory excludes any impact from the West Coast port issues.
If we trigger any contingency plans that could impact inventory levels such as pulling forward receipts, we'll give you an update on our monthly sales call. Finally, the guidance assumes we see no meaningful improvement in the trend for Gap brand. Speaking of which, as Katrina mentioned, today we also announced some important organizational changes at both Gap and Banana Republic. So now that I've taken you through earnings, I'll turn it over to Glenn to discuss those announcements in greater detail.
Thank you, Sabrina, and good afternoon, everybody. Earlier today, we put out 2 press releases. The first one that Sabrina just covered off are results for the Q3 2014. And the second press release that we put out is about 2 presidents who will be leaving our business. So Art Peck, our new CEO who will be taking over from May on February 1st can put the team he wants to put together going forward that gives Gap Inc.
The best chance to have innovation to win more customers to grow internationally and to be a top global retail apparel company around the world. So at the end of the day, I'm very supportive of what Art is doing. Conversations I've had with him have always been around, look you have to put together the winning combination of existing executives, new executives that you think are right in order for Gap Inc. To achieve what I just said earlier to be the leading global retail apparel company around the world. Steve Sonnich will be leaving us before the end of the calendar year.
I've known Steve now for 8 years. He's worked for me that whole time. He's gone from running Europe to running franchise to running Asia. And we put Gap Global together in New York City and Steve's overseen that now for 2 years. A lot of the structural work to bring Gap together have been done under Steve's leadership, but there's more work to do.
It's not quite complete. And certainly as Art and Jeff Kerwin, our new President for Gap Global start working together, there's work to be done at Gap. Our performance has been a little less consistent we want it to be and there's definitely room for improvement. Under Art's leadership with Jeff at the helm, I believe Gap brand have a very strong opportunity to drive their business forward in 2015 and beyond. Jack Calhoun, who I appointed to become President of Banana Republic a few months after I started in 2007 has really done a very good job for the company.
I think Jack did a great job integrating Outlet into the specialty business, integrating online to create this new Banana Republic global team and have one view of the brand across all customer touch points. And recently the addition of Marissa Webb, who Jack recruited and hired to become our Creative Director, I really feel strongly that's going to position Banana Republic very well for the future. Now Art made 2 very good decisions in appointing Andy Owen and Jeff Kirwan to become future presidents. I've known both these executives for the better part of 8 years. I've worked side by side with them.
I've seen them grow. I've seen them tested. Andy has got great experience between grew up in the field, but has always had this incredible merchant skill and eye for product. And Jeff, who was running Canada for Old Navy when I started in 2007, but the last three years has worked directly for me in driving the China business forward. The future of the company in terms of growth is really going to be very much focused on the China business.
So from my perspective, Art's made 2 very good decisions. He's putting the team together he wants to move forward with. So with that said, why don't I pass it over to Art and give him a couple of minutes to talk about the choices of Andy Owen and Jeff Kerwin. Art?
Thanks, Glenn. I really appreciate it. And let me echo Glenn's comments and his thanks to both Jack and Steve for their time with the company and service and commitment to the company. I want to spend a moment just talking about really why now, why I initiated these changes now. First I would point out that while I've had the benefit now of several weeks since we announced the transition to get to know more about parts of the company and the situation in the company that I've not been close to and familiar with.
Being at the company for the last 10 years and having multiple roles around the company has really given me very broad and oftentimes very deep exposure to the executives in our senior roles. And that applies obviously both to Jeff in his role in China and to Andy in multiple roles where we worked very closely together. So I really appreciated the time to get to know things, but this is a change that is really based upon my deeper experience and knowledge of the company as well as knowledge of the talent that we have across the company. I also will just communicate to you that I have inherited an extraordinarily strong and deep bench. And it's something I'm proud of for us as an organization and it's a reason why I have confidence that even with two changes like this, we will not miss our stride as an organization as we go into next year with this senior team in place.
The why now is very simple, which is I'm impatient to get the team in place for 2015 and ready to drive business results as we go into the new fiscal year. Let me spend a moment first then about Jeff. Obviously, Jeff until now has been building our China business. I would describe Jeff as number 1, a great leader number 2, a very balanced executive number 3, somebody who really gets our brands and really gets brand building. There is a word that I will use with both Andy and Jeff, which is consistency.
Jeff has been a consistent deliverer of exceptional performance across all of the assignments that he's been in. I'll say
the same thing about Andy, but
I just want you to note that consistency for me and both of these executives and their track records is a critical issue. Jeff and I have a high degree of urgency about the situation at Gap and I'm very anxious to get him in there with the team working with me to get the business back on track. We owe that to our customers, to our employees and certainly to our investors. We need to get the aesthetic righted for the brand. And I would note that this is something that I've done before.
So when I went to Gap in 2011, we also had an aesthetic issue there and it was highest priority in terms of writing the business. We worked on it during the course of that year and we made some improvements in the product during the year. And in 2012, we delivered with the team an exceptional performance. And so I've been there worked on these issues before and I have a high degree of confidence that Jeff with my partnership working with the team can lead that team to getting the brand righted quickly. With Andi, again I would say a very balanced executive.
She's been in a number of different functions in the company. She's worked across many of our brands. She's been in the online space. She's been in the specialty space. She's been in the outlet space.
So she's really seen the bulk of what we do as a company and again delivered consistent performance across all of the key roles that we've put her in. She is really an unusual executive for us. She grew up in the field organization then transitioned into merchandising. She's demonstrated that she has an exceptional taste level, but she's also an exceptional leader. And that's what I get excited about Andy as well as she is balanced, she's fluid across multiple disciplines in the business, she has great taste and I think she will do very well in building on the work that Jack and Marissa and the team have done in terms of delivering more consistent performance and realizing the potential of Banana Republic.
So I've talked about both Jeff and Andy and I've used the word consistency. It's a very important word for me and it starts with exceptional product that we deliver consistently season after season. This is the focus that I have right now. It's the focus that Jeff will have going into that building with the team and I know it's the focus that Andy has building on Jack's work as well. Let me just wrap then.
I could talk about this for a long time. Hopefully, you can hear in my comments the confidence that I have in both Jeff and Andy and the teams that they will be leading in these new roles. I also want to say that I am extraordinarily confident in the broader team here. The individuals running our P and Ls across Old Navy and Piper Lime, Athleta and Intermix as well as my functional partners, I think it's a very strong team. We're going to use December January to really align our priorities and be ready to stand up in front of the company and in front of you with very clear priorities and a renewed focus as we go into next year.
With that, let me hand it back to Glenn.
Thank you, Art. Art has to leave the call now because he has to attend to a number of other matters. But Sabrina and I will be here to answer any questions related to the changes with our brand presidents. But before we get to that, I'd like to talk a little bit about Q3 and Q4 then for sure we look forward to answering any questions you have. When I think about the Q3, my observation is we weren't as successful commercially as I wanted the business to be.
We had a minus 2 comp on a 2 year basis that was minus 1. Now inside of that Old Navy certainly was stronger than the other brands. And I think Stephane is doing some very good work at Old Navy that hopefully can build every single quarter as we go forward. So commercially, we learned a lot of lessons. The team continues to commit to making our business stronger and stronger every single season.
But a company like Gap Inc. With our 6 brands inside of our portfolio, I don't think anybody here ever thinks that we should negative comp. It just makes no sense. So when it does happen to us, I think the team gets more invigorated, more focused, tenacity, which is such an important part of being a successful retailer comes through. And I think we're turning that tenacity into positive energy as we look at the Q4.
But I would then look at that and say we had a much better quarter when it comes to the work done by our finance team. The one time tax benefit and the cash that we now have inside the company to buy back more shares or to give us flexibility to buy back more shares. And also the work that was done in the share buyback in the quarter buying over $400,000,000 of shares. So I definitely tip my hat to Sabrina and her team and I've told everybody else on the commercial revenue side of the business, we need to do better. Now we had some accomplishments in the quarter.
In China, we opened our 100th store for Gap brand. I think that's exciting. That's great progress. And you heard me talk about Jeff Kerwin earlier. And Old Navy continues to do very well inside of China.
So I think that combination, we feel very good about as we look at China becoming the 2nd most important country to Gap Inc. As we go forward. We did a lot of good work on omnichannel and how is the company going to differentiate itself with our competitive advantages. We have over 1,000 stores with Wi Fi. We will have a lot more of those done in the Q1 of next year.
We have 1,000 stores that we do order in store. And so I think you'll see the omnichannel part of our business, the unique parts of that really drive sales for us in the Q4. I think the work on the margin rate, while I wasn't happy and really nobody in this company is happy with a minus 2 comp, the work done on the margin rate was actually pretty strong. So I'm pleased with that. One change we made, which we haven't talked about a lot is now our biggest distribution center, which is in New York State.
We've now put an online pop up inside of a store distribution center. So that's the beginning of our vision of seamless inventory. But what does it mean for 2014 holiday is we can extend the last date to ship to customers and it gives us a lot of flexibility on the East Coast, which is our biggest market, allows us to save a little bit of money when it comes to shipping expense. So I think that's a very good step will help us in the P and L in the Q4, but is a cornerstone of what seamless inventory will look like in Gap Inc. And of course, the quarter was about succession, less than the announcements we made today, but a lot about a month ago when I announced that I'd be leaving the company as Chairman and CEO on January 31, and we had this incredible internal executive who's going to step up in Art Peck.
That's probably the biggest news inside of the quarter. Right now, we're a couple of weeks inside of Q4. We're very excited about our opportunity to compete and to win. You heard in our recent sales announcement I put out, I do believe we have improved assortment in terms of the mix of our assortment. I think the team has done a very good job on product for the Q4.
Our customer communications are the best I've seen from us put forward in the holiday season. We've been planning this for the last 9 months, putting them in place and now it's up to the teams in our mobile business, our e commerce business, our store teams and everybody around the world to go out and execute. This is all about execution. I'm here right till the end of Q4 working with the teams in stores, pushing execution aggressively because we are committed to one another to finish the year strong. So that said, I'm going to hand it over now back to Katrina and we'll take any questions we have the analyst.
Thank you, everybody.
Great. That concludes our prepared remarks. And we'll now open up the call to questions. As a reminder, I have Glenn and Sabrina here to take Q and A. And we'd appreciate limiting your questions to 1 per person.
Thank you. And we will go first to Ed Yruma with KeyBanc Capital Markets.
Thanks very much for taking my question. And Glenn congratulations on a very successful tenure. I think when you last spoke you were looking for some signs of hope within product within Gap banner. Obviously you're not guiding to any kind of financial improvement. But are you starting to see either signs of greater customer acceptance?
Are you seeing some of this more optimistic color palette work? Any insight there would be helpful. Thank you.
Well, first of all, thank you for the kind comment. We're not going to talk about because the optimistic color you're referring to is the collection and the flow we just dropped about 2 weeks ago, which is anchored in Crazy Stripes, which is something we did 7 years ago with fresh marketing. Look, we're pretty honest, I think, recently on the sales call that we really thought that we would see some signs of improvement in our September October flow from GAAP. I mean, there's a few green shoots here and there in certain categories, which I guess when you look at where we're going to be investing our inventory going forward, they're in going forward, they're in categories that showed a little bit of improvement in the Q3. So I think that's a good sign.
I think now it's a combination of the aesthetic we know has to continue to evolve and evolve quickly. And I believe some of that improvement will be in place either in the store today or in separate flows we have coming on the Monday after Thanksgiving, I think on December 15 and again in the 1st week of January with an extra flow this year for Gap, which will provide more newness to the business. I think that improvement is in place on the flows I just talked about, but it's not enough to take us to a place where we're even satisfied. There has been some better work done similar to Old Navy on the actual assortment and the investment of inventory in the parts of the business which we do feel good. So Gap brand, we feel good about our baby business.
We feel good about our fit, Gap Fit business. We feel good about our outerwear business. There are certain parts we have put the inventory to match where we had evidence that we were starting to get the product to resonate much better than you've seen the 1st 9 months of this year. So a little early on Q4, I think the extra flow is going to help. But we look forward to talking to people every single month because that's our commitment and giving you updates on our performance and trying to answer more specifically the question about signs of positive acceptance by customers at Gap brand.
Great. Thanks so much.
We will go next to Anna Andreeva with Oppenheimer and Company. Great. Thanks so much. Afternoon and thank you for taking my question. I guess on guidance for implied down earnings for the Q4.
Can you talk about if this is based on what you're seeing so far in November? Or is this a more conservative stance ahead of the holiday? And on the gross margin, the implied decline, I guess, in the range of 100 basis points, give or take, you guys have an easier comparison. Just trying to understand what's driving that degradation given inventories are clean? And Glenn, you sound more encouraged about the product at the GAAP division.
Thanks so much.
Yes. With regard to guidance, I
would say we just thought it prudent given performance year to date to be grounded in that performance. So the basis for the guidance is really our year to date performance on sales and comp. And then as I said, it also assumes Gap brand doesn't have any meaningful change in trend from what we've seen year to date. I would add to that comment as I said in my remarks the fact that in Q4 we really expect more foreign exchange headwinds than we did in Q3 as well. If you think about the yen alone, the average rate was about 105 in Q3 And as of today, it's about 118, which is a 12% depreciation.
So that's an important piece to keep in mind as well.
And we will go next to Betty Chen with Mizuho Securities.
Thank you. I was wondering if you can talk a little bit more about the potential shipping benefit, Glenn, I think you alluded to earlier. We've also noticed that the brand started to test a lot more of the 2 day shipping, which we expect shoppers to probably welcome. Can you talk to us about any initial learnings on the receptivity of the 2 day shipping program? And any quantification on what the potential savings could be for 2015?
Thanks.
I think this is all part of a, what I would call, a longer term plan under this definition. It's not a well marketed theme, but it's called seamless inventory for us. So how we've learned to get to this point, so the inventory for online customers and for stores are in the same building. As a matter of fact, the real step to purity on this front is on the same shelf in the same building. Athleta runs this way.
Japan runs right now not on the same shelf, but in the same building. And we just changed our situation in Europe about 6 months ago, where we had a separate online building and we consolidated that into the store distribution center. So I think we've been thoughtful about going around the U. S. And trying to get some learnings and so far it's what you want to get from this.
Can you save money over time? The answer should be yes. But the real benefit here is the benefit on gross margin dollars, basically sending a unit to let's call it for now the highest bidder, who will pay the highest AUR that could be an online customer or could be a store that's exhibiting stronger AUR performance and I think that's what seamless inventory eventually gets at. What we did in the distribution center in New York, we had some excess capacity. Right now, we ship to our online customers from Columbus and from Phoenix.
As delivery time has become more of a table stakes, we decided to use some of that capacity in New York, but it's all part of the strategic direction on Seamless and we popped up about 300,000 square feet of online inventory in that distribution, physical distribution building. We own the land, so it's an easy it wasn't that costly. I put the IT system in and now starting last week, we're actually shipping to Eastern on the Eastern side of the country from New York down to Florida. We're shipping out of the New York DC. So could we get some benefit in terms of expense?
We hope so. Is it really more about expediting and trying to do some of the 2 day events you're talking about? That's the answer because coming into Q4, we're trying to find a better balance between our value proposition also known as promotions and our service proposition driven by delivery opportunities and also driven by omnichannel. So how was the 2 day free gone? I think we're pleased with it.
I think we're pleased with it as long as the incremental cost of the expense of doing that is more than made up by the benefit of gross margin. Because if we're going to continue to the same depth of discount and then go to 2 days, well, that's not a smart decision. So, so far, I think customers and we're obviously excited about it, we'd rather as a company that owns brands, we'd rather have a better balance of our value proposition to our service offering. And you're seeing us putting some of that forward and even more of that will happen in Q4.
Okay. Thank you.
We will go next to Kimberly Greenberger with Morgan Stanley.
Great. Thank you. My question is
on e commerce, but Sabrina, I just wanted to clarify, is does your guidance imply that the negative one comp that we saw here in the Q3 continues into Q4? Or were you not that specific? That's the clarification. And Glenn, I just wanted to ask about e commerce. The e commerce strategies and the digital strategies of this company have been really compelling here for a number of years.
We're seeing a pretty big slowdown in e commerce sales growth here in 2014, and I think the growth rate here in the Q3 was only about 5%. So is it simply product that is holding back the growth rate in e commerce or is there something else going on that's making it more difficult to grow that business over time?
Yes. I'll just start with a clarification, Kimberly. It is a range. So I would say that the range is kind of grounded on this year to date trend that, yes, we have seen a negative one year to date comp and a plus one sale, but you can get to numbers within that range with different configurations. But I would say, yes, it's grounded in that notion.
And on the 5% growth in the 3rd quarter, look, part of my opening comments was we had some accomplishments in the quarter and we had some areas we're disappointed. That was clearly a disappointment. It's a little bit about product. It's a little bit about last year we had a 20 comp, which I think is in a pretty strong growth, but market leading, but what something we should be doing given the investments we're making. So a 2 year 2025, we were not happy with that at all.
And the team is very focused and omni channel initiatives are not all about driving online sales. As a matter of fact, in some cases reserve in store and order in store to drive more productivity inside our physical assets. But I completely agree with you Kimberly and I know that the brand presidents supported by Art have had lots of conversations about that particular 5% growth, but about that particular 5% growth. We gained share in Q3 of 2013 and we gave up some of it in Q3 of 2014 and we're not into the borrowing share business, we're into the gaining share and keeping it. So I think that we're not happy about it, but I'm not I think it's a quarter.
I agree with you this year has kind of slowed down as well, but this was a particular quarter where we're not happy and I think we're on it and some changes we've made to make sure we get back to gaining share online.
Great. Thank you.
We'll go next to Matt McClintock with Barclays.
Hi. Yes. Good afternoon, everyone. One quick clarification question, Sabrina. Is the one time tax benefit and the asset sale in the second quarter both included in guidance for the full year?
Yes, they absolutely are. That's GAAP guidance. And the full year tax rate rate, as I said, Matt, has come down slightly from 38.5 percent to 38% to reflect the benefit of the Q3 non recurring issue.
Okay. And then if may ask a longer term question. Just Glenn, as we look into the holiday season, it sounds like there's optimism for some of the e commerce initiatives order in store, etcetera, to potentially benefit and drive holiday sales. Are you planning for any benefit from these initiatives as you set your plans for holiday? And then now that you're rolling out order in store to over 1,000 locations, could you maybe give us some update on what you're seeing in terms of what you've seen in the benefit?
How that's impacting sales in those stores?
I'd say, Matt, that we didn't plan for any of it because we just turned the switch on to the 1,000 stores on the I guess it was in the 1st day of the new quarter. So we worked our way from 10 stores to 50 stores to a couple of 100 and then we made the big leap, Art's team did from just around 250 to 1000 almost overnight because we had everything set up and the technology was working. So our stores are actually have been trained well before that. They were ready to go. They're excited about it.
Here are the benefits as far as I can tell. Numbers that I've given internally and I think externally before is are something like this. On average in the apparel business conversion is around 30%, which means that 70% of your customers that do not convert. In that 70%, there's about 10 points of people who come in and can't there's about 10 points of people who come in and can't find what they want. Purchase intent high, but unable to find it.
Now that could be in somebody else's hands. It could be in the fitting room. It could be in something in the retail business called the go backs product that people did not decide to go within the fitting room and put back onto the shelf. Or it could be the highest percent of that is that we just don't have that item and that size or color in the store. So order in store is intended to change the paradigm of the conversation that's been going on for multiple generations, which is can I get this in a Size 8 and our natural answer is I'm sorry?
Or we could go to the phone and that takes about 8 minutes to do a charge send from another store. So what's been developed by Art's team is this amazing way to instantaneously change the conversation from we don't have it, but I can get it for you. And our teams really, you'll see through the holiday season have been retrained and thinking about that is the conversation, close the sale. So I'm actually I'm pretty excited about it. I'm still excited about reserve in store, but I think order in store has always on our road map looked like it had more potential than reserve in store.
So I think going forward, not for this holiday season, but in the New Year the real opportunity of that also is if you look at a fleet of Old Navy of 1,000 stores, there's about 25 what I would call flagship and signature stores. They have the full assortment. Well, now the other 1,000 stores can actually customers in those locations can see the full assortment because our team will continue to be trained to say, I know you saw that or you read about it. It's not available in the store, but I can get it for you. The first order comes to the DC, 90% of the product is going to come from our online distribution channel, but some could come from another store.
But exposing the full assortment to a customer at a physical location, I think, is a huge opportunity for this business in the
New Year. And I know Art believes in that fully, seeing as how
the innovation, the development came from his team that he runs now the digital area.
Thank you very much, Lynn.
We will go next to Nealey Tamminga with Piper Jaffray.
Great. Good afternoon. Sabrina, can we get a little bit more color on the reduction in CapEx, either in terms of what the projects that might be canceled and or delayed or reevaluated? And are these delayed would you say if there are delays, are they delayed more kind of indefinitely? Or just will we see kind of another bump up in next year's CapEx to kind of make for that reduction?
Thanks.
Yes. No, that's great question. I mean, I think zooming out philosophically, it's just important to say because we're strong believers in managing to ROIC. We just feel it's very important that if our outlook in earnings is coming down that we should be revisiting the amount of capital spend we have in any year. And so at the highest level, we felt like with the earnings guidance coming down, it was important to relook at capital.
And that's why we're cropping it back a bit. With regard to where it's coming from, it is primarily coming from GAAP, because we also want to reward the businesses that are delivering return. And we look to crop back those where we are not getting return in the short run. Obviously, we never want to do anything that damages our long term strategies. So all of our growth areas, our growth initiatives, growth in China, our omnichannel, all of that is moving forward and as planned.
But we did crop back primarily Gap brand and primarily in the area of stores. Store remodels is where we've cropped it back and we'll be revisiting the importance of that in 2015 in terms of whether it becomes any incremental spend or whether it's just out. Thank you.
We'll go next to Dorothy Lachner with Topeka Capital Markets.
Thanks and good afternoon everyone. I wondered, Glenn, you gave some thoughts I think about what categories kind of in a larger sense are working at Gap brand. I wondered if you could drill down a little bit in terms of 3rd quarter tops and bottoms, men's and women's? Are there things within those categories that are working outside of the kind of big buckets that you mentioned earlier?
Look, I'd say the theme is pretty much the same as we've said in the first half of the year as we went to the Q3. Still not happy with our women's business and that's the work that continues to that we continue to try to improve upon especially when it comes to the aesthetic. But the point I was making earlier is even though everything starts with design aesthetic, if the product is assorted properly in categories that have natural growth, then that's also the job of a great merchant team beyond just what the design team provides to them. But we've had a tough year like so many others on just indigo 5 pocket denim. So back to we reward people quite a bit here in the merchant side and the inventory management side to turn that inventory down and to change the assortment we have.
So thank God, we went to one tool in our toolset that helps us with response to supply chain and that's vendor managed inventory. If we didn't have that, which we should have had to be honest with you a number of years ago, we've had it fully working for 12 months, that allowed us very quickly to turn off the tap of inventory on 5 pocket denim and switch into not other denim, although we are seeing some performance across the total business on some of our fashion denim, especially in distressed, but we just switched that into pants. So I think that when you're invested in bottoms the way we are across our entire businesses, when you're particularly invested in Gap in denim and indigo denim, the ability to be faster than we've been before, we're not going to set any land speed records today, although we are getting faster. And I know under Art's leadership, the plan is to get even faster in 2015. But you can use some of these tools to adjust your assortment.
What I was trying to say, it's a Gap brand for sure, but definitely there's a Gap brand component to this in the Gap Inc. I think we've done some much better work this year beyond the aesthetic to really understand where the growth is. And a lot of this, Dorothy, gets validated when we look at the department store results, which we always study about what's working because that's our best chance besides our market data we have and the customer research we do is to get a sense of what's working at Macy's, what's working at Nordstrom. So the fact that we have put more inventory into active, outerwear, accessories at Gap and Old Navy and Baby and we find a better balance between our definition of fashion product or what I could call unexpected styles at Gap in particular, you'll see that in the December flow versus what people just expect from us year in, year out. I think all of those shifts have been well executed.
We have a ton of work to do with GAAP, right, in particular. But I think Gold Navy is further ahead of curve and Republic is further ahead of curve. And some of these categories that in the macro environment are doing better. I'm glad that we've shifted some inventory, especially starting next week with some of the flow we get in before Black Friday, shifting some of the inventory to what we know is actually growing in the total market.
Great. Thanks so much for all that color.
And we will go next to John Moores with BMO Capital Markets.
Thanks. Glenn, first of all, thank you for all your hard work and congratulations. And we look forward to working with Art if he's still listening in. A question for Sabrina. Just rewinding on SG and A, I know we know that you had sort of walked that increase down a little bit partway through the quarter, quite a big move.
Just refresh for us why it was going from about an 8% increase down to where you came in nicely at 3%, but more so the implications for Q4. Could there be also a little bit of wiggle room there as well beyond what you had implied with the guidance? I'm wondering if it has to do with maybe pulling back on marketing spend and maybe if Glenn can talk a little bit about whether or not this was a decision to pull back evenly across the brands? Thank you.
Sure, sure. Yes. No, that's a great question. So you might recall, we've often said that a large part of our expense base, so about 50% of our expense base is related to stores and over half of that is variable to sales. So part of the reason the expense came down, John, is one that we're not happy about, which is just as sales came down to flat, we actually gained more expense savings given we have a variable chunk of expense to sales.
So that's one component. The second component was really or the rest of the components were really a combination of old fashioned belt tightening, including savings in areas like bonus and areas like favorability in credit card income. And additionally, we got a little bit of foreign exchange favorability. So just as foreign exchange hurts your sales and hurts your earnings, it actually when you translate the SG and A dollars, it helps your SG and A. So I'd say those were the biggest reasons that Q3 came in better.
We have many of the same factors at work in Q4. We're going to continue to manage expenses tightly. But I think the important thing to remember about Q4 is it is our toughest quarter in terms of comparison, because now we are lapping the fact that we saved over $100,000,000 in Q4 of 2013 versus Q4 of 2012. And we leveraged 150 basis points. It actually was our lowest percent of sales clearly in the last 5 years and maybe even beyond that.
So it's an extremely low base we're lapping on, which is why again we say clearly we expect to deleverage even as we do our best to manage expenses as we always do, very disciplined.
And I don't know if Glenn wanted to comment on the marketing, if there was a pullback there.
Well, John, I would say that some of our marketing is booked and planned and some it's not like our store expenses, has a some it's not like our store expenses has a variable component to it. But no, I think we're kind of coming into the year taking flat to last year as a starting point. And the way Sabrina categorized return on invested capital and the decision to reconsider remodels for GAAP, I think we look at marketing the same way. We have to invest where we think we're going to get the best return. So while GAAP is going to have marketing, I mean, I think they have a new gift guide out, which is doing really well.
We feel very good about that, but it's electronic. So those are trade offs we do. We could have had a gift guide distributed to our best customers, call it 3,000,000, 4000000 people and that would have cost X per copy. So thoughtfully, we actually put a little bit more money into the digital side of it. It's so far so good.
The money we put into is when you're on the digital gift guide, which changes every day on GAAP, you can actually click on to something you love, it'll take you right to our site. So we felt it was more prudent to put a little bit of money behind that choice as opposed to mailing out 4,000,000 copies. So those kinds of choices we're making. We're especially bullish on the marketing quality we're seeing coming out of Old Navy. I think that I'm not translating that to commercial success for anybody on the phone.
I'm just saying we're really feeling good about the work that they're doing and the quality of the content they're putting together, which you'll see some of the new content coming out next Wednesday before Thanksgiving. I was lucky enough to spend time with Stephane last night and saw the full December slate of content and he was excited, I was excited. So they're going to get their fair share of investment because their business is stronger and their content is very good.
Thanks. Very helpful.
We will take our final question from Jennifer Davis with Buckingham Research Group.
Hey, guys, and congratulations on navigating through a tough Q3. Sabrina, I was hoping maybe for a little more color, I guess, or clarification around 4th quarter guidance. Can you at least maybe help us in terms of how much gross margin pressure you expect versus SG and A? And then on the Q3 gross margin or merchandise margins, is the credit card income in merchandise margins? And how much did that impact merchandise margins, please?
Thanks.
Just a reminder, Jennifer, we do have that reclass going on all year in credit card income. So just like previous quarters, we have about $40,000,000 that last year had all been in SG and A of credit card income going up into margin. So that's definitely happened in the 3rd quarter, will happen again in the Q4. I would say most of the favorability I talked about previously was really that hit mostly SG and A, a small amount also of favorability went into margin, but mostly SG and A. And then with regard to guidance, I mean, we really are trying to keep it high level.
I gave you some points on my prepared remarks to be helpful about some of the underlying assumptions. But again, I mean, we just believe in this environment that we've been operating in all year that it's important to be prudent and grounded in what we've experienced year to date. So just to refresh a little bit on what I said, because I don't want to get into every single line item of the P and L, but we definitely that range is grounded in year to date trends in sales and comps and no meaningful improvement in GAAP. And I think the big change versus previous quarters, especially as compared to Q3 is the foreign exchange, because the dollar has strengthened considerably against currencies that matter to us, not only the yen, but also the pound and also the Canadian dollar. So I think those factors taken together against the backdrop this year that's been not a bullish backdrop for our company or apparel retailing, we thought that was an appropriate range to set for now.
Okay. All right. Thanks and best of luck.
Thank you.
Great. I'd like to thank everyone for joining us on the call today. And as a reminder, both press releases, which are available on gapinc.com, one contains a full recap of our Q3 results and the other contains a recap of today's leadership announcements as well as the forward looking guidance included in our prepared remarks. And as always, the Investor Relations team is available after the call for further questions. Thank you.
Thank you. That does conclude our conference. You may now disconnect.