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 May 2, 1998 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) 952-4400 _______________________ 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, 392,842,829 shares as of May 30, 1998 <TABLE> <CAPTION> PART 1 GAP INC. ITEM 1 CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited) (in thousands, except par value) May 2, January 31, May 3, 1998 1998 1997 ASSETS <S> <C> <C> <C> Current Assets: Cash and equivalents $ 836,314 $ 913,169 $ 244,643 Short-term investments - - 112,268 Merchandise inventory 823,305 733,174 628,693 Prepaid expenses and other current assets 184,815 184,604 151,132 Total Current Assets 1,844,434 1,830,947 1,136,736 Property and equipment, net 1,475,099 1,365,246 1,174,003 Long-term investments - - 64,623 Lease rights and other assets 162,193 141,309 127,053 Total Assets $ 3,481,726 $ 3,337,502 $ 2,502,415 LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities: Notes payable $ 97,264 $ 84,794 $ 86,241 Accounts payable 376,413 416,976 296,089 Accrued expenses 438,514 389,412 213,698 Income taxes payable 71,009 83,597 58,927 Deferred lease credits and other 15,824 16,769 8,845 current liabilities Total Current Liabilities 999,024 991,548 663,800 Long-term Liabilities: Long-term debt 496,147 496,044 - Deferred lease credits and other liabilities 291,999 265,924 219,973 Total Long-Term Liabilities 788,146 761,968 219,973 Shareholders' Equity: Common stock $.05 par value Authorized 1,500,000 shares Issued 441,074, 439,923 and 477,831 shares Outstanding 392,721, 393,133 and 407,086 shares 22,054 21,996 23,892 Additional paid-in capital 376,050 317,674 452,358 Retained earnings 2,509,420 2,392,750 2,002,458 Foreign currency translation adjustments (12,722) (15,230) (7,316) Deferred compensation (36,965) (38,167) (42,897) Treasury stock, at cost (1,163,281) (1,095,037) (809,853) Total Shareholders' Equity 1,694,556 1,583,986 1,618,642 Total Liabilities and Shareholders' Equity $ 3,481,726 $ 3,337,502 $ 2,502,415 See accompanying notes to condensed consolidated financial statements. </TABLE> <TABLE> <CAPTION> GAP INC. CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS Unaudited Thirteen Weeks Ended ($000 except per share amounts) May 2, 1998 May 3, 1997 <S> <C> <C> Net sales $ 1,719,712 $ 1,231,186 Costs and expenses Cost of goods sold and occupancy expenses 1,031,004 789,126 Operating expenses 472,144 311,911 Net interest income (1,141) (4,738) Earnings before income taxes 217,705 134,887 Income taxes 81,639 50,583 Net earnings $ 136,066 $ 84,304 Weighted average number of shares - basic 388,650,880 402,803,539 Weighted average number of shares - diluted 405,000,437 413,316,480 Earnings per share - basic $.35 $.21 Earnings per share - diluted $.34 $.20 Cash dividends per share $.05 $.05 See accompanying notes to condensed consolidated financial statements. </TABLE> <TABLE> <CAPTION> GAP INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Unaudited ($000) Thirteen Weeks Ended <S> <C> <C> May 2, 1998 May 3, 1997 Cash Flows from Operating Activities: Net earnings $ 136,066 $ 84,304 Adjustments to reconcile net earnings to net provided by operating activities: Depreciation and amortization (a) 74,801 56,659 Tax benefit from exercise of stock options by employees and from vesting of restricted stock 42,624 7,095 Change in operating assets and liabilities: Merchandise inventory (90,016) (51,018) Prepaid expenses and other (2,966) (24,970) Accounts payable (38,685) (53,912) Accrued expenses 49,019 (68,504) Income taxes payable (12,587) (32,800) Deferred lease credits and other long-term liabilities 22,440 25,218 Net cash provided by (used for) operating activities 180,696 (57,928) Cash Flows from Investing Activities: Net proceeds from maturity of short-term investments 0 43,747 Net purchase of long-term investments 0 (48,868) Net purchase of property and equipment (174,156) (93,787) Acquisition of lease rights and other assets (19,700) (378) Net cash used for investing activities (193,856) (99,286) Cash Flows from Financing Activities: Net increase in notes payable 12,677 46,874 Issuance of common stock 11,191 10,870 Net purchase of treasury stock (68,244) (121,052) Cash dividends paid (19,396) (20,198) Net cash used for financing activities (63,772) (83,506) Effect of exchange rate changes on cash 77 (281) Net decrease in cash and equivalents (76,855) (241,001) Cash and equivalents at beginning of year 913,169 485,644 Cash and equivalents at end of quarter $ 836,314 $ 244,643 See accompanying notes to condensed consolidated financial statements. (a) Includes amortization of restricted stock, discounted stock options and discount on long-term debt. </TABLE> GAP INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. BASIS OF PRESENTATION The condensed consolidated balance sheets as of May 2, 1998 and May 3, 1997 and the interim condensed consolidated statements of earnings and cash flows for the thirteen weeks ended May 2, 1998 and May 3, 1997 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 May 2, 1998 and May 3, 1997, 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 January 31, 1998. The condensed consolidated balance sheet as of January 31, 1998 was derived from the Company's January 31, 1998 balance sheet included in the 1997 Annual Report. The results of operations for the thirteen weeks ended May 2, 1998 are not necessarily indicative of the operating results that may be expected for the year ending January 30, 1999. 2. COMPREHENSIVE EARNINGS During the first quarter of fiscal 1998, the Company adopted Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income. This Statement requires that all components of comprehensive earnings be reported prominently in the financial statements. For the Company, other comprehensive earnings includes only the foreign currency translation adjustments. Total comprehensive earnings for the first quarter of 1998 and 1997 were as follows (in thousands): Thirteen Thirteen Weeks Ended Weeks Ended May 2, 1998 May 3, 1997 Net earnings $136,066 $84,304 Foreign currency translation adjustments 2,508 (2,129) Total comprehensive earnings $138,574 $82,175 3. FINANCIAL INSTRUMENTS 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 first quarter, the Company had various put option contracts to repurchase up to 1,550,000 shares of Gap stock. The contracts have exercise prices ranging from $34.67 to $38.37, with expiration dates ranging from May 1998 through August 1998. 4. EARNINGS PER SHARE Under SFAS No. 128, the Company provides dual presentation of EPS on a basic and diluted basis. The Company's granting of certain stock options and restricted stock resulted in potential dilution of basic EPS. The following summarizes the effects of the assumed issuance of dilutive securities on weighted-average shares for basic EPS. Thirteen Thirteen Weeks Weeks Ended Ended May 2, 1998 May 3, 1997 Weighted-average number of shares - basic 388,650,880 402,803,539 Incremental shares from assumed issuance of: Stock options 13,119,936 5,863,800 Restricted stock 3,229,621 4,649,141 Weighted-average number of shares - diluted 405,000,437 413,316,480 The number of incremental shares from the assumed issuance of stock options and restricted stock is calculated applying the treasury stock method. Excluded from the above computation of weighted-average shares for diluted EPS were options to purchase 3,401,193 shares of common stock during the first quarter of fiscal 1998 and 6,921,979 during the first quarter of fiscal 1997. Issuance of these securities would have resulted in an antidilutive effect on EPS. Deloitte & 50 Fremont Street Telephone (415)247-4000 Touche LLP 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 May 2, 1998 and May 3, 1997 and the related condensed consolidated statements of earnings and cash flows for the thirteen- week periods ended May 2, 1998 and May 3, 1997. 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 January 31, 1998, 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, 1998, 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 January 31, 1998 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it was derived. /s/ Deloitte & Touche LLP May 12, 1998 GAP INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The information below contains certain forward-looking statements which reflect the current view of Gap Inc. (the "Company") 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, risks associated with challenging international retail environments, changes in the level of consumer spending or preferences in apparel, and/or trade restrictions and political or financial instability in countries where the Company's goods are manufactured and other factors that may be described in the Company's Annual Report on Form 10-K and/or other 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 May 2, 1998 May 3, 1997 Net sales ($000) $1,719,712 $1,231,186 Total net sales growth percentage 40 11 Comparable store sales growth percentage 17 <3> Net sales per average square foot $109 $95 Square footage of gross store space (000) 15,975 13,163 Fifty-two Fifty-two weeks ended weeks ended May 2, 1998 May 3, 1997 Number of New stores 298 230 Expanded stores 112 49 Closed stores 18 33 The total net sales growth in the first quarter of 1998 over the same period last year was attributable primarily to the increase in retail selling space, both through the opening of new stores (net of stores closed) and the expansion of existing stores, as well as to the increase in comparable store sales. The increase in net sales per average square foot for the first quarter of 1998 was primarily attributable to increases in comparable store sales. Cost of Goods Sold and Occupancy Expenses Cost of goods sold and occupancy expenses as a percentage of net sales decreased to 60.0 percent for the first quarter of 1998 from 64.1 percent for the same period in 1997. The resulting 4.1 percentage point increase in gross margin net of occupancy expenses was attributable to a 2.7 percentage point increase in merchandise margin as a percentage of net sales and a 1.4 percentage point decrease in occupancy expenses as a percentage of net sales. The increase in merchandise margin as a percentage of net sales was primarily attributable to a greater percentage of merchandise sold at regular prices when compared to the same period last year. Margin achieved on marked-down goods was also higher than that of last year. The decrease in occupancy expense as a percentage of net sales was primarily attributable to leverage achieved from the increase in comparable store sales. The Company continually 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. Operating Expenses Operating expenses as a percentage of net sales were 27.4 percent for the first quarter of 1998 compared to 25.3 percent in 1997. The 2.1 percentage point increase was primarily attributable to a 1.1 percentage point increase in advertising/marketing costs as part of the Company's brand development efforts. An increase in incentive bonus expense of 1.3 percentage points also contributed to the increase. The Company increased its rate of accrual for bonus due to the stronger earnings performance measured against the annual target. The increase in operating expense from advertising and bonus was partially offset by the leverage from comparable store sales growth. Net Interest Income/Expense Net interest income was approximately $1.1 million for the first quarter of 1998 compared to $4.7 million for the same period last year. The decrease in 1998 was due to the interest expense related to the long-term debt securities issued during the third quarter of 1997, a decrease in gross average investments and a decrease in investment interest rates. Income Taxes The effective tax rate was 37.5 percent for both of the thirteen weeks ended May 2, 1998 and May 3, 1997. LIQUIDITY AND CAPITAL RESOURCES The following sets forth certain measures of the Company's liquidity: Thirteen weeks ended May 2, 1998 May 3, 1997 Cash provided by (used for) operating activities ($000) $180,696 ($57,928) Working capital ($000) $845,410 $472,936 Current ratio 1.85:1 1.71:1 For the thirteen weeks ended May 2, 1998, the increase in cash flows provided by operating activities was attributable to the timing of certain payables, an increase in net earnings, and an increase in tax benefit from the vesting of restricted stock. 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 Back-to-School 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 May 2, 1998, the Company had outstanding letters of credit of approximately $582 million. To provide financial flexibility, the Company issued $500 million of 6.9 percent, 10-year debt securities in fiscal 1997. The proceeds from this issuance are being 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 thirteen weeks ended May 2, 1998, capital expenditures, net of construction allowances and dispositions, totaled approximately $173 million. These expenditures resulted in a net increase in store space of approximately 662,000 square feet or 4 percent due to the addition of 69 new stores, the expansion of 31 stores and the remodeling of certain stores. For 1998, the Company expects capital expenditures to total approximately $700 million, net of construction allowances. This represents the addition of 300 to 350 new stores, the expansion of approximately 80 to 90 stores, the remodeling of certain stores, as well as amounts for headquarters facilities, a distribution center, equipment and a catalogue facility for the Banana Republic division. The Company expects to fund such capital expenditures with cash flow from operations and other sources of financing. Square footage growth is expected to be 18 to 20 percent before store closings. New stores are generally expected to be leased. To further support its growth, the Company continues to explore alternatives for additional headquarters facilities in San Francisco and San Bruno, California. The Company acquired the rights to purchase land in San Francisco and acquired additional land in San Bruno. During 1997 the Company commenced construction on a distribution center for an estimated cost at completion of $60 million. The majority of the expenditures for this facility will be incurred this fiscal year and is thus included in the projected capital expenditures above. 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 45 million shares of its outstanding common stock in the open market over a three-year period. During the first quarter, the Company acquired 1.6 million shares for approximately $72 million. To date under this program, 29.7 million shares have been repurchased for approximately $816 million. During the first quarter of 1998, the Company held various put option contracts in connection with the share repurchase program to hedge against stock price fluctuations. The Company also continued to enter into foreign exchange forward contracts to reduce exposure to foreign currency exchange risk involved in its commitments to purchase merchandise for foreign operations. Additional information on these contracts and agreements is presented in the Notes to Condensed Consolidated Financial Statements (Note 3). The Company is addressing the need to ensure that its operations will not be adversely impacted by software or other system failures related to year 2000. A program office was established in 1997 to coordinate the identification, evaluation and implementation of any necessary changes to computer systems, applications, and business processes. The costs associated with this effort are expected to be incurred through 1999 and are not expected to have a material impact on the results of operations, cash flows or financial condition in any given year. However, no assurances can be given that the Company will be able to completely identify or address all year 2000 compliance issues, or that third parties with whom the Company does business will not experience system failures as a result of the year 2000 issues, nor can the Company fully predict the consequences of noncompliance. Item 3. Quantitative and Qualitative Disclosures About Market Risk The market risk of the Company's financial instruments as of May 2, 1998 has not significantly changed since January 31, 1998. The market risk profile on January 31, 1998 is disclosed in the Company's 1997 Annual Report. PART II OTHER INFORMATION Item 4. Submissions of Matters to a Vote of Security Holders a) On April 28, 1998 the Annual Meeting of Stockholders of the Company was held in San Francisco, California. There were 393,500,175 shares of common stock outstanding on the record date and entitled to vote at the Annual Meeting. b) The following directors were elected: Vote For Vote Withheld Adrian D.P. Bellamy 348,053,603 570,254 John G. Bowes 348,052,103 571,754 Millard S. Drexler 348,053,780 570,077 Donald G. Fisher 348,035,560 588,297 Doris F. Fisher 348,052,403 571,454 Robert J. Fisher 348,053,903 569,954 John M. Lillie 348,053,903 569,954 Charles R. Schwab 322,738,625 25,885,232 Brooks Walker, Jr. 348,051,953 571,904 Sergio Zyman 348,053,303 570,554 There were no abstentions and no broker non-votes. c) The amendment to the Amended and Restated Certificate of Incorporation to increase the authorized number of shares of Common Stock was approved with 284,038,802 votes in favor and 64,309,322 against. There were 213,938 abstentions and 61,794 broker non-votes. d) The selection of Deloitte & Touche, LLP as independent auditors for the fiscal year ending January 30, 1999 was ratified with 347,622,959 votes in favor and 796,099 against. There were 204,799 abstentions. Item 6. Exhibits and Reports on Form 8-K a) Exhibits (3) Certificate of Amendment of Amended and Restated Certificate of Incorporation (10) Amended and Restated GapShare Plan (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 May 2, 1998. 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: June 10, 1998 By /s/ Warren R. Hashagen Warren R. Hashagen Chief Financial Officer (Principal financial officer of the registrant) Date: June 10, 1998 By /s/ Millard S. Drexler Millard S. Drexler President and Chief Executive Officer EXHIBIT INDEX (3) Certificate of Amendment of Amended and Restated Certificate of Incorporation (10) Amended and Restated GapShare Plan (15) Letter re: Unaudited Interim Financial Information (27) Financial Data Schedule