SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [ X ] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended November 1, 1997 or [ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from ________ to _________ Commission File Number 1-7562 THE GAP, INC. (Exact name of registrant as specified in its charter) Delaware 94-1697231 (State of Incorporation) (I.R.S. Employer Identification No.) One Harrison San Francisco, California 94105 (Address of principal executive offices) Registrant's telephone number, including area code: (415)427-2000 _______________________ Securities registered pursuant to Section 12(b) of the Act: Common Stock, $0.05 par value New York Stock Exchange, Inc. (Title of class) Pacific Stock Exchange, Inc. (Name of each exchange where registered) Securities registered pursuant to Section 12(g) of the Act: None _______________________ Indicate by check mark whether Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate the number of shares outstanding of each of the issuer's classes of Common Stock, as of the latest practicable date. Common Stock, $0.05 par value, 263,791,121 shares as of December 8, 1997 <TABLE> <CAPTION> PART 1 THE GAP, INC. AND SUBSIDIARIES ITEM 1 CONDENSED CONSOLIDATED BALANCE SHEETS ($000) November 1, February 1, November 2, 1997 1997 1996 (Unaudited) (See Note 1) (Unaudited) ASSETS <S> <C> <C> <C> <C> Current Assets: Cash and equivalents $ 627,760 $ 485,644 $ 477,272 Short-term investments - 135,632 109,340 Merchandise inventory 980,531 578,765 711,934 Prepaid expenses and other 154,670 129,214 140,033 Total Current Assets 1,762,961 1,329,255 1,438,579 Property and equipment, net 1,319,462 1,135,720 1,067,607 Long-term investments - 36,138 37,966 Lease rights and other assets 142,653 125,814 84,004 Total Assets $ 3,225,076 $ 2,626,927 $ 2,628,156 LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Notes payable $ 115,245 $ 40,050 $ 86,333 Accounts payable 433,313 351,754 390,206 Accrued expenses 349,999 282,494 271,418 Income taxes payable 93,395 91,806 61,432 Deferred lease credits and other current liabilities 15,170 8,792 9,829 Total Current Liabilities 1,007,122 774,896 819,218 Long-term Liabilities: Long-term debt 495,941 - - Deferred lease credits and other liabilities 249,151 197,561 176,712 745,092 197,561 176,712 Stockholders' Equity: Common stock $.05 par value: Authorized 500,000,000 shares Issued 318,761,298, 317,864,090 and 317,515,944 shares Outstanding 263,441,719, 274,517,331 and 278,743,066 shares 15,938 15,895 15,877 Additional paid-in capital 495,063 442,049 420,271 Retained earnings 2,196,647 1,938,352 1,787,708 Foreign currency translation adjustments (7,790) (5,187) (3,036) Restricted stock plan deferred compensation (43,908) (47,838) (42,132) Treasury stock, at cost (1,183,088) (688,801) (546,462) 1,472,862 1,654,470 1,632,226 Total Liabilities and Stockholders' Equity $ 3,225,076 $ 2,626,927 $ 2,628,156 See accompanying notes to condensed consolidated financial statements. </TABLE> <TABLE> <CAPTION> THE GAP, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS Thirteen Weeks Ended Thirty-nine Weeks Ended <S> <C> <C> <C> <C> Unaudited November 1, November 2, November 1, November 2, ($000 except per share amounts) 1997 1996 1997 1996 Net sales $ 1,765,939 $ 1,382,996 $ 4,342,346 $ 3,616,485 Costs and expenses Cost of goods sold and 1,044,673 837,775 2,716,885 2,257,254 occupancy expenses Operating expenses 453,977 328,434 1,118,350 906,442 Net interest (income)/expense 4,052 (5,213) (2,145) (12,787) Earnings before income taxes 263,237 222,000 509,256 465,576 Income taxes 98,714 87,690 190,971 183,903 Net earnings $ 164,523 $ 134,310 $ 318,285 $ 281,673 Weighted average number of shares 266,784,436 281,746,335 269,982,251 285,302,456 Earnings per share $ 0.62 $ 0.48 $ 1.18 $ 0.99 Cash dividends per share $ 0.075 $ 0.075 $ 0.225 $ 0.225 See accompanying notes to condensed consolidated financial statements </TABLE> <TABLE> <CAPTION> THE GAP, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Unaudited ($000) Thirty-nine Weeks Ended November 1, 1997 November 2, 1996 <S> <C> <C> Cash Flows from Operating Activities: Net earnings $ 318,285 $ 281,673 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization (a) 194,571 156,699 Tax benefit from exercise of stock options by employees and from vesting of restricted stock 16,047 45,559 Change in operating assets and liabilities: Merchandise inventory (401,827) (226,535) Prepaid expenses and other (32,789) (13,274) Accounts payable 81,647 124,472 Accrued expenses 67,138 76,493 Income taxes payable 1,598 (4,893) Deferred lease credits and other long-term liabilities 52,462 33,973 Net cash provided by operating activities 297,132 474,167 Cash Flows from Investing Activities: Net maturity of short-term investments 174,709 4,181 Purchase of long-term investments (2,939) (31,611) Purchases of property and equipment (352,745) (246,831) Acquisition of lease rights and other assets (13,223) (9,880) Net cash used for investing activities (194,198) (284,141) Cash Flows from Financing Activities: Net increase in notes payable 73,031 63,291 Issuance of long-term debt 495,890 Issuance of common stock 23,838 28,853 Purchase of treasury stock (494,287) (324,402) Cash dividends paid (59,990) (63,312) Net cash provided by/(used) for financing activities 38,482 (295,570) Effect of exchange rate changes on cash 700 3,250 Net increase/(decrease) in cash and equivalents 142,116 (102,294) Cash and equivalents at beginning of year 485,644 579,566 Cash and equivalents at end of quarter $ 627,760 $ 477,272 See accompanying notes to condensed consolidated financial statements. (a) Includes amortization of restricted stock, discounted stock options, and discount on long-term debt. </TABLE> THE GAP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. BASIS OF PRESENTATION The condensed consolidated balance sheets as of November 1, 1997 and November 2, 1996, and the interim condensed consolidated statements of earnings and the interim condensed consolidated statements of cash flows for the thirteen and thirty-nine weeks ended November 1, 1997 and November 2, 1996 have been prepared by the Company, without audit. In the opinion of management, such statements include all adjustments (which include only normal recurring adjustments) considered necessary to present fairly the financial position, results of operations and cash flows of the Company at November 1, 1997 and November 2, 1996, and for all periods presented. Certain information and footnote disclosures normally included in the annual financial statements prepared in accordance with generally accepted accounting principles have been omitted from these interim financial statements. It is suggested that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Company's annual report on Form 10-K for the year ended February 1, 1997. The results of operations for the thirty-nine weeks ended November 1, 1997 are not necessarily indicative of the operating results that may be expected for the year ending January 31, 1998. 2. SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Year-to-date 1997 and 1996 gross interest payments were $4.6 million and $4.0 million respectively; income tax payments were $174.2 million and $142.7 million respectively. 3. DERIVATIVES The Company enters into foreign exchange contracts to reduce exposure to foreign currency exchange risk. These contracts are primarily designated and effective as hedges of commitments to purchase merchandise. The market value gains and losses on these contracts are deferred and recognized as part of the underlying cost to purchase the merchandise. At the end of the third quarter, the Company had various put option contracts to repurchase up to 2,000,000 shares of Gap stock. The contracts have exercise prices ranging from $38.74 to $52.03, with expiration dates ranging from November 1997 through April 1998. In the second quarter, the Company entered into interest rate swaps in order to reduce interest rate risk on a substantial portion of its issuance of its long-term debt. The swap agreements, which were issued at an aggregate notional amount of $400 million, settled in the third quarter at an interest rate of 6.7 percent. The Company is amortizing net gains associated with these swaps of approximately $2.9 million over the life of the debt securities. 4. RECLASSIFICATION OF INVESTMENTS Prior to the second quarter, investments were classified as held to maturity and were carried at amortized cost. During the second quarter the Company sold short- and long-term debt securities prior to their maturity. The Company used the proceeds for general corporate purposes. Consequently, any investments held subsequent to the second quarter are classified as available for sale and are reported at fair market value. The gains and losses on investments are deferred and recorded in equity. 5. DEBT OBLIGATIONS On September 17, 1997, the Company issued $500 million of 6.9 percent unsecured notes, due September 15, 2007. Interest on the notes is payable semi-annually. The balance of the debt obligations at November 1, 1997 is net of unamortized discount. 6. SUBSEQUENT EVENT On November 24, 1997, the Company's Board of Directors authorized a three-for-two split of its common stock effective December 22, 1997, in the form of a stock dividend for stockholders of record at the close of business on December 8, 1997. 7. NEW ACCOUNTING PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards (SFAS) No. 130, Reporting Comprehensive Income, which requires that an enterprise report, by major components and as a single total, the change in its net assets during the period from non-owner sources; and SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, which establishes annual and interim reporting standards for an enterprise's operating segments and related disclosures about its products, services, geographic areas and major customers. Adoption of these standards will not impact the Company's consolidated financial position, results of operations or cash flows, and any effect will be limited to the form and content of its disclosures. Both statements are effective for fiscal years beginning after December 15, 1997, with earlier application permitted. Deloitte & Touche LLP 50 Fremont Street Telephone:(415) 247-4000 San Francisco, California 94105-2230 Facsimile:(415) 247-4329 INDEPENDENT ACCOUNTANTS' REPORT To the Board of Directors and Stockholders of The Gap, Inc.: We have reviewed the accompanying condensed consolidated balance sheets of The Gap, Inc. and subsidiaries as of November 1, 1997 and November 2, 1996 and the related condensed consolidated statements of earnings for the thirteen week and thirty-nine week periods ended and consolidated statements of cash flows for the thirty-nine week periods ended November 1, 1997 and November 2, 1996. These financial statements are the responsibility of the Company's management. We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and of making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to such condensed consolidated financial statements for them to be in conformity with generally accepted accounting principles. We have previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheet of The Gap, Inc. and subsidiaries as of February 1, 1997, and the related consolidated statements of earnings, stockholders' equity and cash flows for the year then ended (not presented herein); and in our report dated February 27, 1997, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of February 1, 1997 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it was derived. /s/ Deloitte & Touche LLP December 4, 1997 THE GAP, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The information below contains certain forward-looking statements which reflect the Company's current view with respect to future events and financial performance. Wherever used, the words "expect," "plan," "anticipate," "believe," and similar expressions identify forward-looking statements. Any such forward-looking statements are subject to risks and uncertainties that could cause the Company's actual results of operations to differ materially from historical results or current expectations. Some of these risks include, without limitation, ongoing competitive pressures in the apparel industry, a continuation or exacerbation of the current over-capacity problem affecting the industry, and/or changes in the level of consumer spending or preferences in apparel, and other factors that may be described in the Company's filings with the Securities and Exchange Commission. Future economic and industry trends that could potentially impact revenues and profitability remain difficult to predict. The Company does not undertake to publicly update or revise its forward-looking statements even if experience or future changes make it clear that any projected results expressed or implied therein will not be realized. RESULTS OF OPERATIONS Net Sales Thirteen Weeks Ended Thirty-nine Weeks Ended November 1, November 2, November 1, November 2, 1997 1996 1997 1996 Net sales ($000) 1,765,939 1,382,996 4,342,346 3,616,485 Total net sales growth 28 20 20 26 Comparable store sales 9 1 4 6 growth percentage Net sales per average 123 114 319 308 square foot ($) Square footage of gross store 14,679 12,348 space at period end (000) Fifty-two Fifty-three weeks ended weeks ended November 1, 1997 November 2, 1996 Number of: New stores 281 220 Expanded stores 76 43 Closed stores 27 43 The increases in third quarter and year-to-date 1997 net sales over the same periods last year were attributable to the increase in retail selling space, both through the opening of new stores (net of stores closed) and the expansion of existing stores. Growth in comparable store sales also contributed to the increase. Cost of Goods Sold and Occupancy Expenses Cost of goods sold and occupancy expenses as a percentage of net sales decreased to 59.2 percent for the third quarter of 1997 from 60.6 percent for the same period in 1996. The 1.4 percentage point increase in gross margin net of occupancy expenses was primarily attributable to a decrease in occupancy expenses as a percentage of net sales. Merchandise margin for the quarter was essentially flat compared to that for the same period last year. Decreases in initial merchandise margins were offset by increases in the percentage of merchandise sold at regular prices. For the year-to-date period of 1997, cost of goods sold and occupancy expenses as a percentage of net sales increased to 62.6 percent from 62.4 percent for the same period in 1996. The .2 percentage point decrease in gross margin net of occupancy expenses was attributable to a .9 percentage point decrease in merchandise margins as a percentage of net sales offset by a .7 percentage point decrease in occupancy expenses as a percentage of net sales. For the year-to-date period, the decreases in merchandise margins as a percentage of net sales resulted from decreases in both initial margins and margins achieved on marked-down goods. The Company reviews its inventory levels in order to identify slow-moving merchandise and broken assortments (items no longer in stock in a sufficient range of sizes) and uses markdowns to clear merchandise. Such markdowns may have an adverse impact on earnings depending upon the extent of the markdowns and amount of inventory affected. For the third quarter and year-to-date period of 1997, occupancy expenses decreased as a percentage of net sales when compared to the same periods last year. The decrease in occupancy expenses as a percentage of net sales for both periods was primarily attributable to leverage achieved through increases in comparable store sales. The growth of the Old Navy division with lower occupancy expenses when compared to other divisions also contributed to the decrease. Operating Expenses Operating expenses as a percentage of net sales increased to 25.7 percent for the third quarter of 1997 from 23.7 percent for the same period in 1996. The 2.0 percentage point increase was primarily attributable to a .8 percentage point increase in advertising/marketing costs and a 1.0 percentage point increase in the write-off of leasehold improvements and fixtures associated with the remodeling, relocation and closing of certain stores planned for the next fiscal year. For the year-to-date period, operating expenses as a percentage of net sales increased to 25.7 percent from 25.1 percent when compared to the same period in 1996. The .6 percentage point increase was attributable to a .7 percentage point increase in advertising/marketing costs and a .5 percentage point increase in the write-off of leasehold improvements and fixtures. These expenses were partially offset by decreases in payroll expense as a percentage of sales due to leverage from increased sales. Net Interest Income/Expense Net interest expense was approximately $4.1 million for the third quarter compared to net interest income of $5.2 million for the same period in 1996. For the year-to-date period, net interest income was $2.1 million compared to $12.8 million for the same period in 1996. The change in 1997 from 1996 was due to the issuance of long-term debt securities during the quarter, as well as to a decrease in average net investments for the quarter and year-to-date periods. Income Taxes The effective tax rate was 37.5 percent for year-to-date 1997 compared to 39.5 percent for the same period of 1996. The decrease in the effective tax rate was a result of the impact from tax planning initiatives to support changing business needs. LIQUIDITY AND CAPITAL RESOURCES The following sets forth certain measures of the Company's liquidity: Thirty-nine weeks ended November 1, 1997 November 2, 1996 Cash provided by operating activities ($000) $297,132 $474,167 Working capital ($000) $755,839 $619,361 Current ratio 1.75:1 1.76:1 For the thirty-nine weeks ended November 1, 1997, the decrease in cash flows provided by operating activities was attributable to an increased investment in inventory and the timing of certain payables, offset in part by an increase in net earnings and depreciation. The Company funds inventory expenditures during normal and peak periods through a combination of cash flows provided by operations and normal trade credit arrangements. The Company's business follows a seasonal pattern, peaking over a total of about ten to twelve weeks during the late summer and holiday periods. The Company has committed credit facilities totaling $950 million, consisting of an $800 million, 364-day revolving credit facility, and a $150 million, 5- year revolving credit facility through June 30, 2002. These credit facilities provide for the issuance of up to $450 million in letters of credit. The Company has additional uncommitted credit facilities of $300 million for the issuance of letters of credit. At November 1, 1997, the Company had outstanding letters of credit of approximately $450 million. To provide financial flexibility, management issued $500 million of 6.9 percent, 10-year debt securities in the third quarter. The proceeds from this issuance are intended to be used for general corporate purposes, including store expansion, brand investment, development of additional distribution channels and repurchases of the Company's common stock pursuant to its ongoing repurchase program. For the thirty-nine weeks ended November 1, 1997, capital expenditures net of construction allowances and dispositions, totaled approximately $344 million. These expenditures included the addition of 237 new stores, the expansion of 67 stores and the remodeling of certain stores, resulting in a net increase in store space of approximately 2.0 million square feet or 16 percent since February 1, 1997. For 1997, the Company expects capital expenditures to total at least $450 million, net of construction allowances, representing the addition of at least 275 new stores, the expansion of at least 75 stores, and the remodeling of certain stores. Planned expenditures also include amounts for corporate offices, distribution centers, and equipment. The Company expects to fund such capital expenditures through a combination of cash flow from operations and other sources of financing. Square footage growth is expected to be approximately 20 percent before store closings. New stores are generally expected to be leased. During the quarter, the Company completed construction of a corporate office facility in San Bruno, California. The estimated cost of completion is included above in the capital expenditures expected for 1997. The Company continues to explore alternatives for additional corporate office facilities in San Francisco and San Bruno, California. During the quarter, the Company commenced construction on a distribution center in Fresno, California for an estimated cost at completion of $60 million. The majority of the expenditures for this facility will be incurred in 1998. The facility is expected to begin operations in early 1999. In October 1996, the Board of Directors approved a program under which the Company may repurchase up to 30 million shares of its outstanding common stock in the open market over a three-year period. During the third quarter, the Company acquired 4.8 million shares for approximately $243 million. To date under this program, 16.8 million shares have been repurchased for approximately $635 million. During the year, the Company entered into various put option contracts, foreign exchange contracts, and interest rate swaps to hedge against stock price fluctuations, foreign currency exchange risk, and interest rate risk, respectively. Additional information on these contracts and agreements is presented in the Notes to Condensed Consolidated Financial Statements (Note 4). PART II OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K a) Exhibits (4) Indenture, dated September 1, 1997, between the Registrant and Harris Trust Company of California (10.1) Amendment No. 5 to GapShare (10.2) The Gap, Inc. Nonemployee Director Deferred Compensation Plan, filed as exhibit 4.1 to Registrant's Registration Statement on Form S-8, Commission File No. 333-36265 (10.3) Form of Discounted Stock Option Agreement under the Nonemployee Director Deferred Compensation Plan, filed as exhibit 4.5 to Registrant's Registration Statement on Form S-8, Commission File No. 333-36265 (11) Computation of Earnings per Share (15) Letter re: Unaudited Interim Financial Information (27) Financial Data Schedule b) The Company did not file any reports on Form 8-K during the three months ended November 1, 1997. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. THE GAP, INC. Date: December 12, 1997 By /s/ Warren R. Hashagen Warren R. Hashagen Chief Financial Officer (Principal financial officer of the registrant) Date: December 12, 1997 By /s/ Millard S. Drexler Millard S. Drexler President and Chief Executive Officer EXHIBIT INDEX (4) Indenture, dated September 1, 1997, between the Registrant and Harris Trust Company of California (10.1) Amendment No. 5 to GapShare (10.2) The Gap, Inc. Nonemployee Director Deferred Compensation Plan, filed as exhibit 4.1 to Registrant's Registration Statement on Form S-8, Commission File No. 333-36265 (10.3) Form of Discounted Stock Option Agreement under the Nonemployee Director Deferred Compensation Plan, filed as exhibit 4.5 to Registrant's Registration Statement on Form S-8, Commission File No. 333-36265 (11) Computation of Earnings per Share (15) Letter re: Unaudited Interim Financial Information (27) Financial Data Schedule