Gap Inc (GPS) Q4 2020 Earnings Call Transcript

Gap Inc (GPS) Q4 2020 Earnings Call Transcript

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Gap Inc (NYSE: GPS) Q4 2020 earnings call dated Mar. 04, 2021.

Corporate Participants:

Steve Austenfeld — Head of Investor Relations

Katrina O’Connell — Chief Financial Officer

Sonia Syngal — Chief Executive Officer

Analysts:

Matt Boss — JPMorgan — Analyst

Oliver Chen — Cowen and Company — Analyst

Ike Boruchow — Wells Fargo — Analyst

Kimberly Greenberger — Morgan Stanley — Analyst

Adrienne Yih — Barclays — Analyst

Janine Stichter — Jefferies — Analyst

Kate Fitzsimons — RBC Capital Markets — Analyst

Presentation:

Operator

Good afternoon, ladies and gentlemen. My name is James and I’ll be your conference operator today. At this time I’d like to welcome everyone to The Gap Inc. Fourth Quarter 2020 Conference Call. [Operator Instructions]

I would like to introduce your host, Steve Austenfeld, Head of Investor Relations.

Steve Austenfeld — Head of Investor Relations

Thanks, James. Hey, good afternoon everyone and welcome to The Gap Inc’s fourth quarter 2020 earnings conference call.

Before we begin, I’d like to remind you that the information made available on this webcast and earnings call contains forward-looking statements. For information on factors that could cause our actual results to differ materially from any forward-looking statements as well as a description and reconciliation of any financial measures not consistent with Generally Accepted Accounting Principles, please refer to Page 2 of the slides shown on the Investors section of our website gapinc.com, which supplement today’s remarks as well as today’s earnings release, our quarterly report on Form 10-Q filed with the Securities and Exchange Commission on June 9, 2020 and any subsequent filings. Again, all of which are available on gapinc.com. These forward-looking statements are based on information as of today, March 4, 2021, and we assume no obligation to publicly update or revise our forward-looking statements.

Joining me on the call today are Chief Executive Officer, Sonia Syngal; and Chief Financial Officer, Katrina O’Connell.

With that, I’ll turn the call over to Katrina.

Katrina O’Connell — Chief Financial Officer

Thank you, Steve, and thank you everyone for joining us today. It’s nice to be with you as we wrap up 2020. I want to share comments regarding the fourth quarter of the year, but more importantly provide our 2021 financial outlook, as noted in our earnings release today. Following my comments Sonia will then share her perspective, followed by Q&A.

We’re very pleased with our progress on our path to our sustainable economic model which I outlined at our Investor Day in October. Let’s talk first about some key accomplishments from 2020 that put us well on our path to achieving our Power Plan 2023. First, we remain very pleased with the performance of Old Navy and Athleta, which grew 5% and 29% respectively in Q4. Old Navy gained share to become the number two apparel brand in the US, second to Nike. And that let us surpass a $1 billion in sales and grew 16% for the full year, despite the pandemic. Combined, they represented 63% of company sales in 2020, on the way to our target of 70% by the end of 2023. Their standout sales performance reflected gains in market share during the fourth quarter, led by their brand strength, omnichannel offerings in relevant product categories. Sonia will talk more about how they compete to win a bit later.

There is meaningful progress at Gap brand, while total sales for Gap brand global were down in Q4, significantly impacted by pandemic related market closures and restrictions in international markets. Gap North America delivered a 1% comp. This underscores the progress the brand is making in the product and operations of its core business. We’re pleased to have new leadership at Banana Republic. Sandra Stangl and her team will be focused on repositioning Banana Republic for a post COVID world with relevant marketing and product. We are becoming digitally dominant. Our online business grew 54% in 2020 and closed the year at about 45% of total company sales, up from 25% at the end of last year. At over $6 billion, our online channel is ranked number two in US apparel e-commerce sales and when leveraged with our well located fleet is a strategic advantage in serving our customers through the omnichannel lens.

Our fleet rationalization is on track and driving significant economic value. In 2020, we closed 228 net Gap and Banana Republic stores globally, ahead of our 225 store closure target. These closures along with lease negotiations and rent abatements settlements as well as higher online sales contributed to over 400 basis points of ROD leverage in Q4. We are progressing on our goal of improving the profitability of Gap brand as we partner to amplify through asset light models. The Yeezy partnership is on track for launch in the latter part of the first half of 2021 and we continue to be excited by the creativity that partnership will bring to the brand.

Our strategic review of Europe market is underway and we are in process on several licensing deals that we believe will provide great extensions to the brand. We have driven meaningful improvements in product margins with good pricing discipline. And while freight and shipping costs as well as pandemic headwinds have persisted, this margin expansion has provided a partial offset against these rising costs. Several expense levers, strategic store closures and a reduction in force early in the year, helped us weather pandemic related costs this year, such as meaningful health and safety costs and allowed us to lean into demand-generating investments such as marketing. Marketing has been a strategic investment this year as we leverage this dislocated apparel market to gain market share.

We’ve undertaken a strategic review of our intermix business as we continue to focus on our four billion dollar brands to drive a more profitable portfolio. And we have generated meaningful free cash flow in the quarter, ending the year with $2.4 billion of cash on the balance sheet. Our reliable cash generation and strong balance sheet will enable us to continue investing in growth in 2021 through capital expenditures while also returning to our long-standing practice of returning cash to shareholders through paying the previously approved dividend in the first quarter and initiating a new dividend in the second quarter. Recognizing the COVID related challenges faced during 2020, I am very proud of our team and how we remain focused on driving these strategic initiatives to drive long-term shareholder value.

As we look to 2021, despite the significant uncertainty that remains related to the COVID pandemic, we are pleased to provide a 2021 outlook today. For 2021, we expect to deliver earnings per share in the range of $1.20 to $1.35. I will provide more context regarding this range in a moment, but it’s important to note that the 2021 guidance range we are providing today was fully contemplated in our Power Plan 2023 and in the 2023 estimated 10% operating margin target we provided in October, Investor Event.

So let me move on to recap of fourth quarter results, starting with sales. Net sales for the quarter were $4.4 billion, down 5% to last year and below our previous outlook. Fourth quarter sales were impacted by a mid quarter resurgence in the COVID pandemic that resulted in unplanned mandated store closures and restrictions across Canada, Japan, China and Europe as well as new US stay-at-home orders in select densely populated regions, such as California in the Northeast, which impacted store traffic. The pandemic related impact of fourth quarter sales is estimated to be approximately 4 percentage points. In addition, the sales declined related to strategically planned permanent store closures, had an estimated impact of about 5 percentage points. Overall store sales in Q4 were down 28% as a result of slower traffic in select US markets, COVID related closures and the strategic closures related to the company’s store rationalization initiative. Online sales grew 49% and contributed 46% of the sales in the quarter. We leveraged our omnichannel capabilities such as BOPUS and ship from store to serve the customer even as the pandemic surged. Comparable sales were flat in the quarter. Comp sales by brand are in our earnings press release.

Turning to gross margin. On a reported basis, fourth quarter gross profit totaled $1.7 billion and gross margin rate was 37.7%, nearly 200 basis points ahead of both last year and the guidance we provided last quarter. Our year-over-year margin expansion is as follows: ROD leveraged 400 basis points from rent and occupancy savings as online sales increased and as we continue to close unprofitable stores, favorably settle lease liabilities and derive benefit from rent negotiations and rent abatement resolution. Merchandise margins deleveraged 210 basis points, driven by 300 basis points of higher shipping costs associated with increased online sales and carrier surcharges, offset by higher product margin due to lower promotional activities, despite increases in air freight costs. Air costs were incurred in the quarter to navigate the port delays that mounted because of COVID imposed restrictions.

Turning to SG&A. Fourth quarter operating expenses were $1.5 billion and 34.7% of sales, leveraging 640 basis points versus last year. Recall that last year had $501 million in one-time SG&A costs primarily related to Flagship impairments as well as costs for previously planned separation from Old Navy. We have initiated a strategic review of our intermix business as we reshape the profitability of our portfolio of brands. As a result, fourth quarter operating expenses include a $56 million trademark and long-term asset impairment charge related to the intermix business. Excluding this impairment charge on an adjusted basis, fourth quarter total operating expenses were 33.4% of sales in line with our previous guidance for SG&A for the quarter of 33% to 34% of sales. When normalizing for the intermix impairment this year and the Flagship impairment charges last year, fourth quarter SG&A dollars increased $60 million versus last year.

Notably, store expense savings largely offset the investment in demand generation with nominal increase in expenses over last year being mostly driven by real estate termination fees and higher distribution center costs. Consistent with our strategy we generated store expense savings of approximately $133 million related to store closures and productivity efforts, partially offset by $40 million in higher health and safety costs to keep our employees and customers safe. These safety costs are likely to stay with us for the first half of 2021, but we are closely monitoring vaccination progress and infection rates and we’ll continue to invest in the safety of our customers and employees as long as necessary.

We invested in marketing as we pursue market share growth during this highly disrupted time in the apparel market. Marketing dollars were up $66 million year-over-year and deleveraged 150 basis points. As a result, Gap Inc gained 0.7 point in market share in Q4, ending the quarter at 6% of total US market share for the company. And we grew our customer file to $183 million global known customers. We incurred $19 million of costs in the quarter associated with strategic store closures, although from an earnings standpoint these costs were essentially offset in gross margin through lower rent and occupancy.

Turning to EBIT. On a reported basis, fourth quarter operating income totaled $134 million. Operating margin of 3% leveraged 820 basis points versus last year’s reported operating margin, due to the material year ago Flagship store impairments and costs associated with the previously planned Old Navy separation. On an adjusted basis, fourth quarter operating income totaled $190 million with operating margin of 4.3%.

Moving to taxes and interest. The effective tax rate was negative 204% for the quarter. Taxes were highly favorable in the quarter reflecting changes in the estimated benefit associated with the enactment of the CARES Act and the impact of the non-recurring income tax benefit related to legal entity structure changes. These tax items in the quarter delivered an EPS benefit of approximately $0.45. For the year the effective tax rate was 40% and fourth quarter net interest expense was $57 million.

Turning to EPS for the fourth quarter. Our fourth quarter reported earnings per share was $0.61 versus a loss of $0.49 in the prior year, including a current year benefit of approximately $0.45 from non-recurring tax items and approximately $0.12 in charges related to the impairment of the intermix business as a result of the strategic review.

Now let me provide some perspective on inventory. Total inventory was up 14% versus fourth quarter of last year, despite the higher year-over-year inventory, markdown inventory is below last year and we’re pleased with the current inventory composition. We are confident that first half assortments and the quality of the inventory composition will enable product margins in the first half of 2021 to be above last year’s levels.

There were three main drivers of the year-over-year increase, with the first two associated with the timing of inventory ownership. First, about 10 percentage points of the increase resulted from inventory the company strategically held back in the first half of fiscal year 2020 due to COVID related store closures, that will be re-introduced for sale during the first half of fiscal year 2021. While this does drive a temporary increase in our inventory balance, it was contemplated in our first half receipt plans which were adjusted accordingly. Second, new COVID related US port congestion and impacts on shipping lanes were unforeseen, and contributed to higher year-over-year in-transit inventory levels. And third, we continued to sell COVID related safety products such as masks and hand sanitizers in the near term and owned this new category of inventory at year end. We also ended the year with inventory levels above our prior guidance.

In addition to the impact from port congestion, the second driver of this increase is from longer living seasonal styles and basics that we purposely held at shallow promotions within Q4 to improve product margins while we balanced deeper discounts on seasonally liable products. While this did increase our year-end inventory levels of non-liable and basic products, we will leverage our responsive of supply chain to adjust replenishment within the first half of fiscal year ’21 and believe this strategy will enable us to maximize gross margin over the life of these products.

Looking forward, we expect inventory levels to decrease as we reached the end of the first half and to end Q2 with inventory up high-single-digits. This inventory outlook includes the expectation of continued port delays causing higher in-transit balances as well as set up inventory to support the Q3 launch of Old Navy Plus product, a strategic growth initiative the brand is proud to launch.

Moving to real estate and store closures. Regarding our previously announced real estate restructure program, our discussions with landlords have progressed quite well, and we are making quick and effective progress on our real estate goal. During the year we closed 228 Gap and Banana stores globally in line with our guidance of 225. In fiscal 2020, we incurred cash outlays of about $75 million related to closures. In 2021, we expect to meet our closure target of 75 Gap and Banana Republic stores in North America and estimate net cash outlays of about $135 million. We are still targeting to close about 350 Gap and Banana Republic stores in North America by the end of 2023 and we continue to expect total cash outlays of the program as shared during our October Investor Meeting to be about $210 million. For the full program as of the end of 2023, we continue to expect annualized pre-tax savings of about $100 million. This estimate does not include our strategic review of our Europe market. Fiscal 2020 capital expenditures were $392 million below our normal levels of investment as we responded to the pandemic impact on cash flows.

Regarding the balance sheet and cash flow, fiscal year 2020 free cash flow was negative $155 million compared with positive $709 million last year. Notably, following the challenges of the COVID pandemic earlier in the year, free cash flow during the last three quarters of the year was approximately $900 million. We ended the quarter with $2.4 billion of cash. We are committed to the uses of cash we laid out at our Investor Day. Number one, invest in growth through capital expenditures. Number two, return cash to shareholders, largely through a competitive dividend. And number three evaluate how we use excess cash to delever over time. In light of the continued pandemic uncertainty, we remain prudent in our approach to cash management with a balance between return of capital to shareholders, while maintaining financial flexibility to invest in the business. And our ending share count was 374 million shares.

So before I turn it over to Sonia, let me touch on our financial outlook for 2021. While the biggest impacts on the pandemic is likely largely behind us, we expect the lingering impacts as seen in the fourth quarter of international market closures and stay-at-home restriction, including in Canada, China and Japan and Europe as well as US COVID case counts to persist, particularly in the first half of 2021. However, as vaccines rollout and stimulus checks begin, we currently view the second half of 2021 favorably, reflecting a likely return to a more normalized pre-pandemic level.

With that in mind, I would like to provide the following guidance for fiscal year 2021. Excluding costs associated with strategic reviews we are conducting in Europe or with our intermix business, we expect earnings per share to be in the range of $1.20 to $1.35. Now let me provide you with some additional guidance metrics for 2021. We anticipate full year net sales growth to be in the range of mid to high teens versus fiscal year 2020. We expect to deliver an operating margin of approximately 5% in 2021. The outlook for 2021 is consistent with the company’s Power Plan 2023 objective of achieving at least 10% EBIT margin by the end of 2023. We expect to open 30 to 40 Old Navy stores and 20 to 30 Athleta stores. And consistent with our strategy, we plan to close approximately 100 Gap and Banana Republic stores globally, including 75 closures in North America. This will put us at 75% of our targeted North America closures by the end of fiscal ’21. We expect the annual effective tax rate to be about 25%.

Our reliable cash generation and balance sheet remain strong. As we look to 2021, our capital allocation philosophy and priorities remain consistent. First and foremost, we plan to invest adequately but responsibility — responsibly in the business to drive growth. With that, we expect capital expenditures for the year to be about $800 million. We will shift our capital spend to higher ROIC projects as we distort our investments for its higher returning customer facing growth initiatives such as digital, customer acquisition programs like loyalty, DC capacity to accommodate online growth and store growth for Old Navy and Athleta. Second, we remain committed to returning to paying a dividend. With that, we will pay the previously declared and deferred Q1 fiscal ’20 dividend of just over $0.24 per share in Q1 of fiscal ’21. In addition, the company expects to initiate a new dividend in Q2 of 2021 at a level that balances the return of capital to shareholders with the financial flexibility to face continued uncertainty and invest in growth. In light of the current uncertainty related to the pandemic recovery, we do not anticipate share repurchases in the first half of 2021. We believe this outlook reflects the company’s progress even amidst a challenging 2020 and as we transition to a strong 2021. And most importantly is consistent with the strategic objectives and long-term goals we shared with you during our October Investor Meeting, including improving our cost structure, particularly through store fleet rationalization, strongly supporting the growth of our brands and returning cash to shareholders.

Looking forward, we remain on track to delivering our 2023 EBIT margin target of about 10%. Our progress in 2020 and our guidance for 2021 continue to provide important milestones and progress on our journey towards that goal. Continued improvements beyond 2021 will be accomplished by progressing the following initiatives. One, completing our North America store closure plan. Two, sunsetting COVID costs such as health and safety. Three, completing strategic reviews of select international markets and domestic businesses. Four, making meaningful progress on engineering fixed operating costs. Five, launching sourcing logic and inventory initiatives targeted at growing gross margins as we look to defray growing pressures from the continued shift into online and six leveraging increases in marketing from 2020 and 2021, we made to proactively gain share.

And so with that I will turn the call over to Sonia.

Sonia Syngal — Chief Executive Officer

Thank you, Katrina, and good afternoon everyone. Before we look ahead, I want to take a minute to reflect on 2020. COVID-19 presented the biggest crisis our company, our industry has ever faced, and alongside our employees, our customers, our communities and the rest of the world we faced challenges that defined a new path for every one of us. It’s also true that every crisis is an opportunity and this one met Gap Inc at a crucial pivot point. We used this opportunity to lead with our competitive advantages, while embracing the values of company was founded on to emerge in a place of strength and with a clear path forward. Our teams showed resiliency and the ability to try fast, learn fast and think big to meet customers’ needs.

First, we gained meaningful market share quarter-over-quarter by investing in growth across our purpose led brands during this period of market dislocation. We grew our global known customer file by 14% in 2020 to over 183 million and introduced communicating ways for them to shop with us by expanding our buy online pickup in store capabilities to curbside pickup and launching new payment methods like Afterpay and introducing our loyalty program. Our online business reached over $6 billion in sales and delivered 54% annual sales growth, leveraging our powerful omnichannel platform. Following the shutdown we reopened our fleet of more than 3,000 stores quickly, while permanently closing a group of over 20 — 200 unprofitable stores as part of our fleet rationalization strategy.

With the increased casualization of style we played into our product category strength with disproportionate sales coming from Active and Fleece, Sleep and Kids & Baby. We also quickly pivoted to produce masks, a new top category, which represented 3% of sales in 2020 and drove new customer growth. We met our customers e-commerce shipping expectations at scale with on-time delivery of approximately 130 million products well above the industry average. And finally we helped to develop the gold standard and health and safety practices allowing employees and customers to feel confident working and shopping in our stores.

Now as we turn the page to 2021, we’re pleased with the traction we’re seeing in the business. However, we understand retail is highly volatile and that we will continue to face challenges that we will remain agile and face that. I recently had the honor to speak with President, Biden; Vice President, Harris and other members of the new administration alongside several other CEOs. I represented our business in broader industry, discussing the urgent actions required to recover from this crisis and rebuild an equitable and inclusive economy. And while uncertainty remains, I’m confident in our agility in Gap Inc’s speed and flexibility and then all that will serve us well. Through it all, we understand this is a long game and are squarely focused on executing against our Power Plan 2003 and delivering profitable growth in 2021.

Let me walk you through how our strategy will show up this year, starting with the power of our brands. Each of our brands are poised to deliver growth to world-class branding, relevant product and unbeatable experiences that will inspire our customers to become loyalists, each with a distinct point of view deeply rooted in value. Let me first talk about Old Navy. Old Navy’s results were very strong in Q4, driving 5% sales growth year-over-year, while also delivering margin expansion. According to NPD Group, Old Navy has made continuous market share gains each quarter, year-to-date on a trailing 12-month basis. The brand’s strong value proposition, leadership in key categories like Active and Fleece and Kids & Baby, and commitment to leading with values has allowed Old Navy to win in today’s dislocated market and they will lean on these strengths moving forward. The future looks bright for Old Navy and we’re confident in their ability to grow to $10 billion over the next three years. This year Old Navy deliver on the democracy of style to its commitment to inclusivity and the rollout of Plus to the entire store fleet later this year. They will focus on the market rising service through a differentiated experience powered by new and highly scaled omni capabilities as well as their Navy at loyalty program that will accelerate value creation for both our customers and for our business.

Next, Gap. Gap stands for modern American optimism and we have seen customers respond well over the last year to a more consistent point of view as we leaned into relevant product and culture defining conversations and creative. We are positioning Gap to win for the long-term by creating a profitable store fleet, a shift to digital and by delivering effortless style and quality in market share gaining categories, and partnering to amplify brand reach. This transformation is well underway and we’re excited to build upon it this year. The number one question mark get asked and I as well is about our Yeezy Gap partnership. We are on track to launch in the first half of this year and I’m impressed with how the team is unleashing their creativity and innovation in both the development of the product and the experience for the customer. We cannot wait to share with you. Additionally, we’re excited about the licensing work underway with IMG and are set to deliver new categories like Gap Home and Baby Gap gear later this year.

Moving to Banana Republic. Since the appointment of Sandra Stangl, our head of Banana Republic in December, the team is moving fast to position the brand for health by redefining affordable luxury and building a roadmap for growth that meet customer needs today and in the future. We’re excited to see how this comes to life later this year. In January, we launched BR Standard, a collection of Luxe performance wear, an elevated essentials for everyday, more in line with current customer trends as well as creative repositioning in February that is beautiful and right for brand. The team is also highly focused on the store experience, from transforming allocation of inventory to better align with our customer, improving digital merchandising and transforming our field culture from operational to one of style and service.

And finally Athleta. With 29% sales growth in Q4, yes 29% we have never been more confident in that path forward and its ability to reach $2 billion by 2023. Athleta is our highest margin business and like Old Navy has made continuous market share gains each quarter year-to-date. The brand is positioned in the growing active category and a powerful mission to support confident women and girls, gives the team permission to grow in multiple directions, across product categories, digital and physical locations, internationally, and through distributed commerce by leveraging the power of our platform and portfolio.

Athleta had two exciting product launches in January. First, they brought sleepwear to the market using a rapid customer-centric product innovation approach that they will apply to other opportunities going forward. This will develop with the customer at the center. Next, to bring life to it’s mission of inclusivity, Athleta announced the expansion into inclusive sizing. For spring 2021, 70% of the Athleta collection will be available in sizes 1x to 3x now. As part of this Athleta launched a new holistic brand campaign entitled All Powerful. A multiplatform celebration of the beauty and power in all women. We believe both of these product expansions will be major growth drivers in 2021.

Our vision is to grow our purpose led billion dollar lifestyle brands and as Katrina mentioned earlier, in line with our strategy, we have performed a strategic review of our intermix business. This move allows us to prioritize our strategic focus and resources behind the brands of the most potential and that generate the most sales and profit.

Next, the power of our portfolio. Together, our brands have huge reach, targeting approximately 80% of the $200 billion addressable apparel market. The power of our portfolio is extending that reach to new customers. Each brand is playing their part to, to create differentiation, pricing segmentation and product expansions like Teen, Plus and Sleep. It’s also leveraging the brands collective power to make big products like we did last year with masks. We’re also using the collective power to grow our customer profile and so as said about this we welcomed new customers and are building stronger relationships with the ones we have. As I’ve said before, it is our goal to turn every customer into a loyalist.

We launched our Navyist, Gap Good, Banana Republic and Athleta rewards at the end of September, and in Q4 alone enrolled 6.4 million new loyalists across the company into the program. But the biggest value drivers for us in 2021 will be the full implementation and integration of our loyalty program across all of our brands this summer. We know members of our loyalty program outspend non- loyalty customers by more than 80%. This integrated program will offer our loyalists, benefits across our entire portfolio, while still providing unique and emotional brand connection. If we can get a customer from a single transaction to multiple transactions, to multiple channels and to multiple brands, we see value accretion at every step.

Another focus across the portfolio is the profitability of our store fleet. We are on track with our fleet restructuring efforts across Gap and Banana Republic, while we’re opening stores across Old Navy and Athleta to fuel growth. Additionally, we are moving forward with the strategic review of our Europe business and we’ll have more to share later this year.

Finally, the power of our platform. Powering our brands to the strength of our platform and capabilities at scale. At number two in the US apparel e-commerce sales of $6 billion, we believe Gap Inc is uniquely advantaged to win in digital. Our online business grew 54% in 2020 and closed the year at about 45% of total company sales. To meet the rising demand of online shopping and our target of increasing digital penetration to 50% by 2023, we’re focused on personalization at scale and enhancing capabilities across mobile, all supported by a highly automated fulfillment network.

Mobile has become our customers’ preferred way to shop with us online. And we know it can deliver further degrees of personalization and inspiration as well as enable the entire omni shopping journey. We now have over 50% of traffic and 75% of sales annually through mobile. With mobile as the primary engagement platform, we’re working quickly to create frictionless mobile shopping, as new digital experiences as devices, network and customer preferences evolve. Fueling the growth of our online business is our investment in distribution center capacity.

Last month, we announced plans to open a new state-of-the-art DC in Texas to support Old Navy’s growing online business. By delivering inventory faster and more efficiently to customers across the country, this new campus will allow us to meet the rising customer demand for online shopping. Key elements of our Power Plan will also take shape in our thousands of stores by making customer facing improvements that will also help us reduce store operating costs. We will apply automation to key customer touch points that will enable greater levels of service and engagement with our shoppers, including exploring the introduction of self checkout later this year. We will begin work on optimizing our store operating model starting with Old Navy by leaning on lessons and talent from our distribution centers. Through store closures, strategic reviews and our focus on reducing fixed operating costs, we are building a virtuous cycle where productivity can fuel demand generation, fundedly our investments in technology and marketing.

As Katrina mentioned we are making progress against SG&A and our effort to systemize and digitize our operations will be the rocket fuel for growth across our brands. As America’s largest clothing company with reach around the world and a collection of purpose led lifestyle brands, we’re proud to create product experiences our customers love while doing right by our employees, communities and planning. We are led by our purpose inclusive by design and in the coming year our steadfast in delivering on our commitments to racial equality and increasing representation at all levels of the company. We fundamentally believe the diversity of experience, thought and prospective increases creativity and innovation, promotes high quality decisions and enhances business growth, not to mention a deeper reflection of our customers.

Today, we announced that Salaam Coleman Smith has been elected to serve on the Gap Inc Board of Directors. Salaam is a proven creator and innovator bringing more than 20 years of leadership experience from top brands and entertainment, including Walt Disney Company, Comcast NBCUniversal and Viacom. She has the perfect blend of art and science, sounds and creative vision with strong business insight. Salaam connects deeply to Gap Inc’s value, having hard and led one of the most diverse and inclusive management teams in her industry. We look forward to her energy, guidance and leadership as we work to serve and represent the voice of the interest of millions of customers.

Now before I turn it over to Q&A, I want to thank the team. A year ago, I was asked to lead this incredible company and I could not be prouder of what our nearly 120,000 employees, along with the 2 million around the world in our value chain have accomplished together. This year allowed us to unleash our potential and we’re ready to deliver the next phase of work ahead. Through the power of our brands, our portfolio and our platform, we are ready to deliver profitable growth, value for our shareholders and a future we can all be proud of.

With that I will open it up for questions.

Questions and Answers:

Operator

[Operator Instructions] Our first question will come from Matt Boss with JPMorgan.

Matt Boss — JPMorgan — Analyst

Great, thanks. So at Old Navy 7% comps, despite significant improvement in the mark down rate for the third straight quarter I think now. So could you just speak to what you see driving the inflection at Old Navy? Any structural changes with inventory and the sustainability of top line growth in the mid-teens margins at this concept in your view?

Sonia Syngal — Chief Executive Officer

Thank you for the question. We’re really pleased with the trajectory of the Old Navy business and it has been a strong response to the product offering through 2020 and we think that we’ve distorted into the winning categories with excellent execution. And we’re investing in digital and traditional marketing with more to come. Strong active business, Old Navy has seen phenomenal growth there and we’re very well positioned to meet the rising demand for active and casual product over last year. And Kids & Baby, another very bright spot for the brand, as the Old Navy achieved the rank of number one with Kids & Baby brand in this segment, and this is a particularly distress sector outside of our business and so we are consolidating market share aggressively here. The brand has evolved the product offering and we expect to launch incentive sizing across the assortment later this year. The test results have been really positive. So proud of the work that the team is doing to give our customers what they are asking for and confident in the sustained momentum against our Power Plan 2023. I don’t know if you like to build on that.

Katrina O’Connell — Chief Financial Officer

Yes, I mean, what I would add is a couple of things. So as Sonia said, they are advantaged in their values basin with their democracy of style positioning and then their creative execution has been excellent and they offer the products customers want like Active and Kids & Baby. And then as we look forward, we are launching the Plus business in the back half of this year, which we think is really squarely appropriate for acquiring new customers and servicing better the existing customers and also the loyalty capability that we look to launch in the back half of the year, as we look forward to driving more lifetime value with a multi-center loyalty customer.

And then to add to your question about margins, I would say, the right products with a relevant brand and strong execution has allowed the team to really pull back on promotions and use the strength of the brand and marketing to drive the sell-through on the inventory and structurally we feel like there’s nothing really holding them back from continuing to deliver that. And then I think you heard Sonia say in her prepared remarks, we’re also looking at store productivity as it relates to self checkout and other mechanisms where we can start driving more productivity in stores. So I guess also say, we have great confidence in how Old Navy has executed and what the future holds for them this year and beyond.

Sonia Syngal — Chief Executive Officer

Yes, just to build on, we could talk about this forever. It is very exciting. Two of the main capabilities that we’re — that we know will help with driving consistency for us and the consistency is very, very important for this business, is the expansion of our loyalty program, which allows for repeat visits and a deeper relationship. And the personalization journey that our tech investments are fueling. And so when you think about the huge reach of Old Navy in a sheer customer file, and personalization continuing to progress in having the ability to optimize on products, on price, etc. The need for the historical discounting or methods in driving the business are fading as we move into these more sophisticated and consistent capability. The big part of our capital investment this coming year and we are suggesting what that’ll do to transform very this important measure that we’re holding ourselves to which is consistency of growth.

Matt Boss — JPMorgan — Analyst

Great color and best of luck.

Operator

Next we’ll hear from Oliver Chen with Cowen.

Oliver Chen — Cowen and Company — Analyst

Hi, thank you very much. Regarding the loyalty program and the innovation there, how did you decide to do it as a platform versus pursuing individual brands? And how would you speak to the intersection of speed agility and supply chain relative to interaction measurement and/or lower hanging fruit that you’re loyalty program can achieve? Thank you.

Sonia Syngal — Chief Executive Officer

A great question in why we spend a lot of time on this, we have these four amazing brands. We also know the power of our platform and portfolio. So we’re solving for the and not the or. What we’re doing with this — with our loyalty design is to have really intimate emotional brand level engagement and offerings, while at the same time, we know the customer value is cross-brand shopping. We know the customer values the benefit of the portfolio. So we’re doing both. And we’ve been very thoughtful about what offerings we give our customers depending on their preferences. Now as it links to supply chain and make sure I understand your question, one of the things we are using loyalty for and we’re designing it for is to tier fulfillment based on if you’re a bronze, silver, gold member for example. And so that will also allow us to optimize the speed of delivery, fulfillment, based on our best customers and manage fulfillment cost effectively whilst pleasing our most valuable customers.

Oliver Chen — Cowen and Company — Analyst

Thank you. And just a follow-up. Reintroduction of inventory, as you do that, how does that intersect with the trends that you’re seeing now and also the promotional environment in terms of optimizing — reintroducing inventory that you held back in a dynamic environment?

Sonia Syngal — Chief Executive Officer

Yes. No. Great question. Listen we love the inventory that we held back last year. We are very thoughtful about what we held back to make sure that it would be relevant now and we believe it is. It’s already coming to life in our stores as we speak and we’re seeing good acceptance. So that’s all contemplated and was contemplated in our inventory buys for Q1 in terms of seasonal relevance and integration.

Oliver Chen — Cowen and Company — Analyst

Thank you very much. Best regards.

Operator

Next we’ll hear from Ike Boruchow with Wells Fargo.

Ike Boruchow — Wells Fargo — Analyst

Hi, everyone. Katrina thanks for the details on the outlook. I was wondering if I could ask something there. The $1.20 to $1.35, I believe you mentioned that excludes any actions around intermix or the European business to Gap. Could you frame — could you let us know what the earnings drag is — those two businesses are currently on the P&L?

Katrina O’Connell — Chief Financial Officer

I’m glad you caught that, because it’s really important. We are still deep in the negotiations on a potential operating model change or outlook for Europe, and we just have initiatives strategic review for intermix. So more to come and the reason why we didn’t include it in our current outlook is we didn’t want our current outlook to be clouded by what we don’t yet know the outcome of those two things will be. But certainly as soon as those things start to take shape, we will provide as much detail as possible to be able to help you understand what the impact of those are. If you think about just at the highest level, a model change on Europe, if for instance we were to partner a franchise of that model, the revenue, which is about 2% of sales will go down, right, as our franchise business or partner business. But importantly, the SG&A, the rent and occupancy and really the cost of operating that business will be meaningfully less. And so they should have a profit impact that is favorable to the company. Now, more to come on exactly how that get structured when and how. But that’s conceptually how it could work. And again, we will update you as soon as we know more about how those things are progressing.

Ike Boruchow — Wells Fargo — Analyst

I guess just a follow-up, Katrina. I mean, is it possible to say, now we’re talking about penny for the P&L or we’re talking about nickels and dimes. I guess just some training that would be helpful if you can?

Sonia Syngal — Chief Executive Officer

I mean I think it’s premature, because again, we are not sure even what the change will look like. And so as you can imagine the model that we choose will have a wide range of outcomes. And so we’ll let you know. But again, we said that Europe is 2% of sales. We have about 120 wholly owned stores and we have an online business and so that can help you understand sort of quarter of magnitude. But again, it’s just too premature without having really gotten into any level of structure yet on what the future could be to be able to dimensionalize that. It could be such a wide range about comp. So, we promised as we’ve committed to transparency that as soon as we have line of sight of that we’ll provide more detail.

Ike Boruchow — Wells Fargo — Analyst

Understood. Thank you.

Operator

[Operator Instructions] Your next question will come from the line of Kimberly Greenberger with Morgan Stanley.

Kimberly Greenberger — Morgan Stanley — Analyst

Great, thank you so much. I wanted to just ask about the occupancy or the ROD leverage this quarter of 400 basis points. Katrina I think you said, how much of that was sort of temporary savings that might have been from rent abatements that you were able to settle and how much of that is permanent driven by the store closures?

Katrina O’Connell — Chief Financial Officer

Yes, good question. So really I would say Kimberly, about half of the ROD leverage is permanent as it relates to closures and so ongoing and the other half is really the temporary non-recurring benefits.

Kimberly Greenberger — Morgan Stanley — Analyst

Okay, that’s super helpful. And can I just ask one follow-up on the comp for the fourth quarter. Could you just help us understand a little bit the texture of the progress through the quarter? Did you see improvement in comp trend from month-to-month? Did you see any sort of pickup in January on the back of stimulus? And I’m not sure if you gave a comment and I missed it on sort of how Q1 has started. But if you have anything you’d like to share there? I’d certainly be curious about that as well.

Katrina O’Connell — Chief Financial Officer

Sure. Kimberly, I’ll give you a little bit of insight on the fourth quarter and then maybe Sonia can talk a little bit about how the quarter has started off. I would say, we continue to see the dynamic that we saw all year in the midst of this pandemic play out in the fourth quarter where the customer is just shopping differently. And so the peaks aren’t as peaky and there is — it is just sort of a flatter seasonality. And so overall, when you think about November, December, January, I would say, different flatter seasonality. Now of course December is also when we started to see the pandemic surge again. So that had an impact on December. And then I’ll let Sonia talk a little bit about how we’re feeling quarter-to-date.

Sonia Syngal — Chief Executive Officer

Yes, and let me just start by talking about the comp sales. Look I’m really very pleased to see three of our four brands deliver positive comps in Q4, including Gap brand. And I think that just shows the operating health. Overall what I would say is, we have — we grew our customer file by about 14% that’s meaningful, and those customers paid more. We saw higher pricing realization. And the reason we saw that was because our products resonating and our branding and marketing is more emotional and more connected, which then converted these customers into loyalists, right. So these are some of the underlying momentum trends that we’re pleased about. And we’re seeing that play into the start of Q1 with more momentum in February than we had in Q4. So we’re pleased with the start and with the new capabilities that we’re deploying and the response that we’re seeing from the customer through price and acceptance of our product.

Kimberly Greenberger — Morgan Stanley — Analyst

Great. Very encouraging. Thank you.

Operator

Our next question will come from Adrienne Yih with Barclays.

Adrienne Yih — Barclays — Analyst

Hey, from me and my colleagues. How pleased I am to see the progress and congratulations to everybody. Sonia, I guess my first question is on the incremental ad spend that started in the third quarter carried into the fourth quarter. Can you talk about how you felt about the return on that ad spend? Would it mean that you go into this year and what we should think about either in dollars or that I guess it’s pushing on 5.5%, 5.7% this year, but on very low sales to how we should think about total ad spend for 2021? And then Katrina, could you just remind us, did you, I just missed it in the prepared remarks, the lost sales during the fourth quarter, what percent was from store closures temporary versus permanent store closures? And how should we sort of shape the sales against fiscal ’19 Q1. Thank you very much.

Katrina O’Connell — Chief Financial Officer

Maybe, Adrienne, I’ll start with your last question and then Sonia can talk about marketing for a second. So in the fourth quarter, what I had said is that, we attribute about 4 points of sales loss in the quarter to the COVID related impacts to the quarter and about 5 percentage points of sales decline related to our strategic store closures that we’re closing permanently, because we are restructuring Gap and Banana. So that’s the store closures. As it relates to Q1, I think what Sonia said is true, which is quarter-to-date, we are pleased with the momentum we’re seeing and certainly seeing that the trends are better than what we saw in Q4. And I think I’ll leave it at that other than to say, you know, there is pluses and minuses as you can imagine. Right there is all the momentum that Sonia spoke to as far as the underlying health in our brands, the incremental growth that we’re getting from our file, the margin momentum we’re seeing, but we’re also still navigating COVID and we said in our prepared remarks that the front half of the year likely has some of that still in it, whereas the back half will return to the pre-pandemic levels. So I’ll let you sort of model Q1 and Q2 based on that, but overwhelmingly feeling like so far so good. And we certainly feel good about the mid to high teens sales growth guidance that we gave you overall for the year.

Adrienne Yih — Barclays — Analyst

Very helpful. Thank you.

Sonia Syngal — Chief Executive Officer

And let me add on to that and give you a little color on marketing. As we declared our strategy at our Investor Event last year, we led with the power of our brands and so for us that meant moving to offsets on branding, marketing and technology investments to unleash that power. And when we talk specifically about marketing and the investments, we do expect those investments to continue. We feel good about the effectiveness of those investments.

I can talk about at the high end of the funnel, top of the funnel and the bottom of funnel. Certainly at the bottom of the funnel, our digital marketing investments we managed by the hour, by the day, by the week and have a lot of fluidity in being able to turn that on and off, based on return on that investment. And at the top of the funnel in terms of brand affinity and brand building, we’ve been really pleased with accretive clarity that we’re seeing from our brands and the values based marketing has given us some of the highest ad spots that we’ve seen in the history of the company this past year. So that combination and the momentum that we’re building creatively, the talent that we’re adding to the teams and unleashing the full creative sense of our teams is giving me more and more confidence that leaning into market in this time of dislocated disruption is even more critical than ever, as we look to consolidate market share from a position of strength.

Adrienne Yih — Barclays — Analyst

Certainly great. Good luck. Thank you.

Operator

Our next question will come from Janine Stichter with Jefferies.

Janine Stichter — Jefferies — Analyst

Hi, thanks so much for taking my question and congrats on the momentum. I wanted to ask a bit about the ports. Is there any markdown risk associated with some of the product as may be arriving later than planned or is that mostly as smoothed out and accounted for? And then on the merchandise margins in the product margins, I think you said above last year in the first half, maybe you can help us contextualize where that would be versus pre-COVID levels? And then more broadly, just how you see the market opportunity. Thank you.

Sonia Syngal — Chief Executive Officer

Yes. As it relates to the port, I would say, it really is timing and certainly we wish everything could be here exactly on time, but fundamentally, the teams have developed an amount of agility around navigating the assortment timing and so they are watching closely the timing of when the receipts hit getting those into the stores. And then if there is lateness adjusting receipts on the back end. And so we feel quite good that there is no margin impact of the port issues. It’s really more about the timing of getting things offloaded and over here. So that’s that piece I think. As you said, we said our markdown inventory was below last year heading into this year. The teams did an incredible job of really balancing the choices that they made around pricing to get higher AURs, lower markdown inventory level and then are highly focused on maximizing the margin on the inventory we have in the front half of the year.

I’m not going to comment specifically as it relates to 2019, but certainly our aspiration as a company is to continue to build momentum through relevance in our brands and better product to drive incrementally better margins year-over-year, especially as we look to offset some of the structural changes that happened in the business where you shift into online. So anyway, we’re focused on AUR and as you said, we’re focused on driving higher margins in product space in the first half.

Janine Stichter — Jefferies — Analyst

Great. Thanks for the color.

Operator

Our last question will come from the line of Kate Fitzsimons with RBC Capital Markets.

Kate Fitzsimons — RBC Capital Markets — Analyst

Yes, hi. Thanks very much for squeezing me in. I guess one for Sonia and then one for Katrina. Sonia can you just elaborate a bit more about the inflection you saw in the Gap brand in North America. And I guess as you’re evaluating that brand into 2021 and in context with your plans, any indicators you see suggest maybe brand consideration is moving in the right direction relative to awareness? And then Katrina, I guess, I appreciate certainly the 5% EBIT margin target. I guess, just thinking about the puts and takes relative to where we were pre-pandemic that 6.4 margin, occupancy is certainly moving in the right direction. Sounds like you’re feeling good about the product improvement here in the markdown opportunity. I guess the offsets of COVID costs, I guess, just help us peak together pre-pandemic and now 2021? Thank you.

Sonia Syngal — Chief Executive Officer

Yes, happy to talk about Gap. So listen, a 1% North America comp in Q4 is reflect the positive momentum in the brand, and they’ve done so much hard work this year restructuring their unprofitable fleet segments of it, while investing in their stores. I mean we refreshed 70 of our go-forward stores. We intend to get to the rest by mid-year and I was in a store in New Jersey recently, and the customer stopped in her tracks and said this is light bright and happy and what’s the better statement than that for — to hear from our customers. We’re seeing a really nice pickup in that Promoter Score as a result of our refresh plan. So the restructure the stores, the improvement of the go-forward fleet, the leaning out of the SG&A and this is a lean mean effective team now that is wired and has a culture oriented to winning. They are attracting new customers, their team launch, for example, they are — is now representing about 17% of the kids business and they’re centered grounded in sustainable product offering. So really pleased to see their overall discounting reduced.

And then their partnership. Partnerships are important part of the future of the brand. We have a big launch coming up with Yeezy Gap and I spoke to Yeezy last night, he is very, very focused on this incredible opportunity. We are both very excited about it and he and Mark and the entire Gap team are heads down and believe this to be a very big potential for us and look forward to sharing more with you as we launch in the first half. And then our licensing program that plan that we signed last year, we expect some big launches in multi-categories across Lifestyle coming up here later part of this year. So lots of levers to drive the momentum in Gap while dealing with the structural issues that have plagued the brand.

And what makes me the happiest honestly is to see the fact that the brand is trending. It’s trending with the younger customers, it’s trending on TikTok. The new spring launch is incredibly relevant and we’re seeing massive impressions, whether it was Kornacki’s Khakis during the election or what we’re seeing today, the brand is back and the conversation at the zeitgeist of culture where it belongs. And it’s a comment upon us to continue to deliver excellent execution with discipline every day to live up to the promise of Gap brand potential.

Katrina O’Connell — Chief Financial Officer

And then Kate, as it relates to the operating margin. As you say that’s 5% operating margin guide for this year that we gave today is very much on the path to the 10% operating margin goal we put out for 2023. As we had said in our Investor Event 2020 with COVID, 2021 is a return to profitable sales growth, but we do — we have said that the first half contemplates some of the COVID related impacts. And so whether that’s a little bit of weight on the sales driven by store traffic or market closures, whether it’s health and safety costs [Technical Issues] getting out of the pandemic, one of the levers we’ll have is to trend set those as I talked about. And then as you said, some of the levers in our favor in the year are really reaping the benefits of the store closures as well as some of the productivity initiatives we’ve already put in place and some of the impact of moving towards the Old Navy and Athleta operating margin — higher operating margin brand.

And then to come, honestly, is a lot of the work we’re going to do around partnering markets as well as really leaning into, as I said in my prepared remarks, really re-engineering the fixed operating costs in the business more systematically through digitizing operations as well as some of the margin initiatives like inventory management and such that we think will start to help offset the impact of shifting to online. So more to come on that. But the 5% again is very much on the path that we expected and still unfortunately have some of the COVID related costs in it.

Kate Fitzsimons — RBC Capital Markets — Analyst

Thanks very much for the color. Best of luck.

Katrina O’Connell — Chief Financial Officer

Thank you.

Sonia Syngal — Chief Executive Officer

All right. Thank you for joining us today and we look forward to speaking with you at the end of the first quarter.

Credit: AlphaStreet

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