Old Navy's sales rise, lifting Gap's 3Q profit up 25% to best results this decade

Sales of kid's clothing and jeans helped a slimmer Gap (GPS) deliver its best third-quarter results in this decade. Now, management says it's going after market share, even in this tough market.

The parent of The Gap, Old Navy and Banana Republic posted net income of $307 million, up 25% over a year ago with the 44 cents per share in earnings hitting analysts' target for the period. Executives said the company reaped its best third-quarter operating profit in 10 years by increasing its profit margins through tweaking its merchandise mix and controlling costs.Gap managed to increase its gross profit by 11%, despite spending more on marketing heading towards the holidays. Gap and Old Navy spent an extra $40 million in fall marketing, including the kickoff of the first Gap TV ads since 2006, said Chief Financial Officer Sabrina Simmons. Gap is expecting marketing expenses will rise another $45 million in the fourth quarter.

Inventories were down 10% below last year, and the company is shrinking overall. Gap plans to end the year with 50 fewer stores; most of the closings so far have been Gap stores. But Gap plans to increase inventory in areas that are showing popularity with customers, such as Old Navy, so inventories are expected to be flat in the fourth quarter, Simmons said.

Sales were up 1%, but comparable sales -- for stores open at least a year -- were flat. The sales figures got a push from a 10% increase in comparable sales at Old Navy, which offset drops of 7% at The Gap and 6% at Banana Republic stores. Old Navy got a strong push from sales of kids and baby clothes, while going back to basics with the introduction of the 1969 denim line at The Gap gave that chain a traffic boost, said Gap CEO Glenn Murphy.

Denim is a heritage for The Gap, which started out as a jeans store. But Murphy noted it's also a good repeat business, if The Gap can hook back those customers it had lost. Jeans are a need for shoppers, not a discretionary purchase like other apparel, he noted.

"If we can be a dominant player again...the upside for us is getting people on a regular basis," said Murphy.

Gap has been working on generating traffic for the last six months, said Murphy. It has retooled stores and merchandise in all three chains, launched new prototype stores for Old Navy meant to make them easier to shop. It is also revamping Banana Republic's store layout. The first three new Banana Republic prototypes -- featuring an arrangement of products boutiques, rather than mens and womens departments -- opened in the last month in Las Vegas, Scottsdale, Ariz. and New York's Soho; 50 new Old Navy prototype stores have opened nationwide, with more coming.

"We still have a lot of work to do," said Murphy. "But it's good to see the work we've done."

Specialty apparel retailers are looking nervously at the holiday stakes, after last year's debacle. Apparel sales have only recently begun to recover from the low's of last winter.

Murphy noted that while the fourth quarter always shows stronger sales than the third, last year that dynamic was reversed when retailers were forced into wholesale markdowns. And while this holiday is looking better, he warned it is still going to be very competitive. Sales are still very volatile and any gains show "not much traction," he said.

That volatility is a challenge to merchandisers, Murphy said. Both he and Simmons said the Gap units have "contingency plans" to react to consumer demand.

"We know the customer is really looking for value, so we're going to play hard," said Simmons. "You're going to see us compete on Black Friday."

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