I would now like to introduce your host, Katrina O'Connell, Vice President of Investor Relations.
Good afternoon, everyone. Welcome to Gap Inc.'s third quarter 2014 earnings conference call. Today's call is intended to cover both our third quarter 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-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 November 20, 2014, 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 gapinc.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&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 third quarter performance and then provide an update on our full year guidance. While we're not proud of our third quarter sales performance, driven by a particularly tough result at Gap brand, we are pleased that the teams demonstrated strong discipline on both expense and inventory. Net income for the third quarter was $351 million, 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 third quarter, total net sales were flat at $4 billion, and comp sales were down 2%.
For the quarter, the translation of foreign revenues into dollars negatively impacted our reported sales by $31 million, primarily due to the weakening JPY and CAD. On a constant currency basis, our revenues were up 1%. Moving to gross margin. Third quarter gross margins were up 20 basis points to 40.2%, with a favorability versus our prior outlook being driven by non-merchandise items like shrink and shipping. Merchandise margins were up 90 basis points for the quarter, with Old Navy delivering the strongest margin performance. Rent and occupancy de-leveraged 70 basis points. Regarding SG&A, third quarter total operating expenses were $1 billion, up $29 million from the prior year. Marketing expenses were up $14 million to last year at $176 million. Excluding the credit card income reclass of about $40 million, operating expense dollars would actually have been below last year. Regarding the balance sheet.
At the end of the third quarter, we're pleased that inventory ended down 2% per store, below our previous guidance. We ended the quarter with about $1 billion in cash. Given our opportunistic approach to share buybacks, we're pleased we repurchased 11.4 million 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 billion to repurchase 26 million shares. We've also distributed nearly $300 million in dividends, resulting in total cash distributions through October of more than $1.3 billion. We ended the quarter with 424 million shares outstanding. Regarding capital expenditures and store count. Year to date, CapEx was $508 million. 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.
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 $2.73-$2.78, which includes the Q2 gain on asset sale of about $39 million. The new range also includes a lower full-year effective tax rate of about 38%, reflecting the third 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 five 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 million, down from our previous guidance of about $750 million, and we now expect depreciation and amortization to be about $500 million. 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 third quarter, we expect expenses to deleverage in the fourth quarter.
At the end of the fourth quarter, 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. 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 two press releases. The first one that Sabrina just covered off are Gap Inc.'s financial results for the third quarter 2014. The second press release that we put out is about two presidents who will be leaving our business. Art Peck, our new CEO, who will be taking over from me 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. At the end of the day, I'm very supportive of what Art's 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 Sunnucks will be leaving us before the end of the calendar year. I've known Steve now for eight years. He's worked for me that whole time. He's gone from running Europe to running franchise to running Asia. We put Gap Global together in New York City, and Steve's overseen that now for two 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, certainly as Art and Jeff Kirwan, 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.
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 two very good decisions in appointing Andi Owen and Jeff Kirwan to become future presidents. I've known both these executives for the better part of eight years. I've worked side by side with them. I've seen them grow. I've seen them tested. Andi's got great experience between grew up in the field, but has always had this incredible merchant skill and eye for product. 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.
From my perspective, Art's made two very good decisions. He's putting the team together he wants to move forward with. 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 Andi Owen and Jeff Kirwan. Art?
Thanks, Glenn. I really appreciate it. 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.
That applies obviously both to Jeff in his role in China and to Andi in multiple roles where we've worked very closely together. I've 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 one, a great leader. Number two, a very balanced executive. Number three, somebody who really gets our brands and really gets brand building. There is a word that I will use with both Andi 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 Andi, but I just want you to note that consistency for me in 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. When I went to Gap in 2011, we also had an aesthetic issue there, and it was highest priority, in terms of righting the business. We worked on it during the course of that year, and we made some improvements in the product during the year. In 2012, we delivered, with the team, exceptional performance.
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. 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.
That's what I get excited about Andi as well, she is balanced. She's fluent 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. I've talked about both Jeff and Andi, 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 Andi has building on Jack's work as well. Let me just wrap up. 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 Andi 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&Ls across Old Navy and Piperlime, Athleta, and Intermix, as well as my functional partners. I think it's a very strong team. We're going to use December and January to really align on 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. Sabrina and I will be here to answer any questions related to the changes with our brand presidents. Before we get to that, I'd like to talk a little bit about Q3 and Q4, for sure, we look forward to answering any questions you have. When I think about the third quarter, my observation is we weren't as successful commercially as I wanted the business to be. We had a minus two comp. On a two-year basis, that was minus one. Inside of that, Old Navy certainly was stronger than the other brands. I think Stefan's doing some very good work at Old Navy that hopefully can build every single quarter as we go forward. Commercially, we learned a lot of lessons.
The team continues to commit to making our business stronger and stronger every single season. A company like Gap Inc, with our six brands inside of our portfolio, I don't think anybody here ever thinks that we should negative comp. It just makes no sense. 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 fourth quarter. I would 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.
The work that was done, the share buyback in the quarter, buying over $400 million of shares. 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. 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. You heard me talk about Jeff Kirwan earlier. Old Navy continues to do very well inside of China. I think that combination, we feel very good about as we look at China becoming the second most important country to Gap Inc., as we go forward. We did a lot of good work on omni-channel and how's the company going to differentiate itself, what are our competitive advantages. We have over 1,000 stores with Wi-Fi.
We will have a lot more of those done in the first quarter of next year. We have 1,000 stores that can do order in store. I think you'll see the omni-channel part of our business, the unique parts of that, really drive sales for us in the fourth quarter. I think the work on the margin rate, while I wasn't happy, and really, nobody in this company's happy with the minus 2 comp, the work on the margin rate was actually pretty strong. 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 N.Y. State. We've now put an online pop-up inside of a store distribution center. That's the beginning of our vision of seamless inventory. What does it mean for 2014 holiday?
It means 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, and allows us to save a little bit of money when it comes to shipping expense. I think that's a very good step, will help us in the P&L in the fourth quarter, but is a cornerstone of what seamless inventory will look like in Gap Inc. 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 31st, and we had this incredible internal executive who was 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 a 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's done a very good job on product for the fourth quarter. Our customer communications are the best I've seen from us put forward in a holiday season. We've been planning this for the last nine 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 to the end of the fourth quarter, working with the teams in stores, pushing execution aggressively, because we are committed to one another to finish the year strong.
That said, I'm going to hand it over now back to Katrina, and we'll take any questions we have from the analysts. 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&A. We'd appreciate limiting your questions to one per person.
Thank you. If you would like to ask a question, please signal by pressing *1 on your telephone keypad. If you're using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Once again, please press *1 to ask a question, and we will go first to Edward Yruma with KeyBanc Capital Markets.
Thanks very much for taking my question. 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 brand. 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 about the kind comment. 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 were pretty honest, I think, recently on the sales call that we really thought that we would see some signs of improvement in our September and October flow from Gap. 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 categories that showed a little bit of improvement in the third quarter. 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. 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 15th, and again, in the first week in January. We have an extra flow this year for Gap, which will provide more newness in 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 into parts of the business which we do feel good. Gap brand, we feel good about our baby business.
We feel good about our GapFit business. We feel good about our outerwear business. There's 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 first 9 months of this year. A little early on Q4, I think the extra flow is going to help. 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 & Co. Inc.
Great. Thanks so much. Good afternoon, and thank you for taking my question. I guess on guidance for implied down earnings for the fourth quarter, 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?
On the gross margin, the implied decline, I guess in the range of 100 basis points, give or take. You guys have the easier comparison. Just trying to understand what's driving that degradation given inventories are clean. Glenn, you sound more encouraged about the product at the Gap division. Thanks so much.
Yeah. With regard to guidance, I would say we just thought it prudent given performance year to date to be grounded in that performance. The basis for the guidance is really our year-to-date performance on sales and comp. 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. That's an important piece to keep in mind as well.
We will go next to Betty Chen with Mizuho Securities.
Oh, 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 two-day shipping, which we expect shoppers to probably welcome. Can you talk to us about any initial learnings on the receptivity of the two-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. How we've learned to get to this point, to the decision we've made in our New York store distribution facility, is China today runs in a seamless inventory way, where 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. We just changed our situation in Europe about six months ago, where we had a separate online building, and we consolidated that into the store distribution center.
I think we've been thoughtful about going around the U.S. and trying to get some learnings. So far it's what you want to get from this. Can you save money over time? The answer should be yes. The real benefit here is the benefit on gross margin dollars of 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. It's all part of the strategic direction on Seamless. We popped up about 300,000 sq ft of online inventory in that physical distribution building. We own the land, it wasn't that costly. Just had to put the IT system in. Now, starting last week, we're actually shipping on the eastern side of the country, from New York down to Florida. We're shipping out of the New York DC. 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 two-day events you're talking about?
That's the answer. 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 omni-channel. How has the two-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. If we're going to continue the same depth of discount and then go to two days, well, that's not a smart decision. So far, I think customers, and we're obviously excited about it. We'd rather, as a company that owns brands, have a better balance of our value proposition to our service offering. You're seeing us putting some of that forward.
Even more of that will happen in Q4.
Great. Thank you.
We will go next to Kimberly Greenberger with Morgan Stanley.
Great. Thank you. My question's on e-commerce, Sabrina, I just wanted to clarify. Does your guidance imply that the negative one comp that we saw here in the third quarter continues into Q4, or were you not that specific? That's the clarification. 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 third quarter was only about 5%. 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?
I'll just start with a clarification, Kimberly. It is a range. 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. You can get to numbers within that range with different configurations. I would say yes, it's grounded in that notion.
On the 5% growth in the third quarter. Part of my opening comments was we had some accomplishments in the quarter, and some areas were 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 a pretty strong growth, market leading, but something we should be doing given the investments we're making. A two-year 25, we were not happy with that at all, and the team is very focused. Omni-channel initiatives are not all about driving online sales. Matter of fact, in some cases, Reserve in Store and order in store to drive more productivity inside our physical assets. 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.
We gained share in Q3 2013. We gave up some of it in Q3 2014. We're not into the borrowing share business. We're into the gaining share and keeping it. I think that we're not happy about it. I think it's a quarter. I agree with you, this year's kind of slowed down as well, but this was a particular quarter where we're not happy. I think we're on it. 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?
Yeah, they absolutely are. That's GAAP guidance. The full year tax rate, as I said, Matt, has come down slightly from 38.5 to 38 to reflect the benefit of the Q3 non-recurring issue.
Okay. If I may ask a longer-term question. Glenn, as we look into the holiday season, sounds like there's optimism for some of the e-commerce initiatives, order in store, et cetera, to potentially benefit and drive holiday sales. Are you planning for any benefit from these initiatives as you set your plans for holiday? 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 first day of the new quarter. We worked our way from 10 stores to 50 stores to a couple of hundred, and then we made the big leap, Art's team did, from just around 250 to 1,000 almost overnight because we had everything set up and the technology was working. Our stores 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 are something like this. On average, in the apparel business, conversion's 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 find what they want. Purchase intent high, but unable to find it. 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 with in the fitting room, but they put back onto the shelf. It could be, and the highest % of that is that we just don't have that item in that size or color in the store.
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?" 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. 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." Our teams really, you'll see through the holiday season, have been retrained and thinking about that is the conversation. Close the sale. 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 roadmap, looked like it had more potential than reserve in store.
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. 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 this store, but I can get it for you." The first order comes to the DC. 90% of the product's going to come from our online distribution channel, but some could come from another store.
Exposing the full assortment to a customer in a physical location, I think, is a huge opportunity for this business in the new year. 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, Glenn.
We will go next to Neely 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? 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.
Yeah, no. That's a great question. 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 and earnings is coming down, that we should be revisiting the amount of capital spend we have in any year. 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 Gap, 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. All of our growth areas, our growth initiatives, growth in China, our omni-channel, all of that is moving forward and as planned.
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 Lakner with Topeka Capital Markets.
Thanks. Good afternoon, everyone. 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 third quarter tops and bottoms, men's and women's. Are there things within those categories that are working outside of the big buckets that you mentioned earlier?
Dorothy, I'd say the theme is pretty much the same as we've said in the first half of the year as we went into the third quarter. Still not happy with our women's business, and that's the work that we continue to try to improve upon, especially when it comes to the aesthetic. 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, that's also the job of a great merchant team beyond just what the design team provides for them. We've had a tough year, like so many others, on just indigo five-pocket denim. 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.
Thank God we went to one tool in our tool set that helps us with responsive 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 five-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, we just switched that into pants.
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, we've been before, we're not going to set any land speed records today, although we are getting faster, I know under Art's leadership, the plan is to get even faster in 2015. 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.
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. The fact that we have put more inventory into active, outerwear, accessories at Gap and Old Navy and Baby, 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 at Gap Brand in particular, I think Old Navy is further ahead of the curve.
Banana Republic is further ahead of curve. 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.
We will go next to John Morris with BMO Capital Markets.
Thanks. Glenn, first of all, thank you for all your hard work, and congratulations. We look forward to working with Art if he's still listening in. A question for Sabrina. Just rewinding on SG&A, 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%. More so the implications for fourth quarter. 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.
No, that's a great question.
You might recall, we've often said that a large part of our expense base, about 50% of our expense base, is related to stores, and over half of that is variable to sales. 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. That's one component. 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. Additionally, we got a little bit of foreign exchange favorability. Just as foreign exchange hurts your sales and hurts your earnings, it actually, when you translate the SG&A dollars, it helps your SG&A.
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 million in Q4 of 2013 versus Q4 of 2012. We leveraged 150 basis points. It actually was our lowest percent of sales, clearly in the last five years and maybe even beyond that. 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.
I didn't know if Glenn wanted to comment on the marketing, if there was a pullback there.
John, I would say that some of our marketing is booked and planned, and some, it's not like our store expenses, has a variable component to it. No, I think we're kind of coming into the year thinking flat to last year as a starting point. The way Sabrina categorized return on invested capital and the decision to reconsider remodels for Gap, I think we look at marketing the same way. We have to invest where we think we're going to get the best return. While Gap's going to have marketing, I think they have a new gift guide out, which is doing really well. We feel very good about that. It's electronic. Those are trade-offs we do. We could have had a gift guide distributed to our best customers, call it three, four million people, and that would've cost X per copy.
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 Gap, you can actually click onto something you love. It'll take you right to our site. We felt it was more prudent to put a little bit of money behind that choice as opposed to mailing out 4 million copies. It's those kinds of choices we're making. We're especially bullish on the marketing quality we're seeing coming out of Old Navy. 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 Stefan last night and saw the full December slate of content. He was excited, I was excited. They're going to get their fair share of investment because their business is stronger and their content's very good.
Thanks. Very helpful.
Pascal.
We will take our final question from Jennifer Davis with Buckingham Research Group.
Hey, guys, congratulations in navigating through a tough third quarter. Sabrina, I was hoping maybe for a little more color, I guess, or clarification around fourth quarter guidance. Can you at least maybe help us in terms of how much gross margin pressure you expect versus SG&A? On this third quarter 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.
Right.
Just like previous quarters, we have about $40 million that last year had all been in SG&A of credit card income going up into margin. That's definitely happened in the third quarter, will happen again in the fourth quarter. I would say most of the favorability I talked about previously was really that hit mostly SG&A. A small amount also of favorability went into margin, but mostly SG&A. With regard to guidance, 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. Again, 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.
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&L, but we definitely, that range is grounded in year-to-date trends in sales and comp, and no meaningful improvement in Gap. 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. 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. As a reminder, both press releases, which are available on gapinc.com, one contains a full recap of our third quarter results, and the other contains a recap of today's leadership announcements as well as the forward-looking guidance, including our prepared remarks. 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.