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Gap Inc – ‘10-Q’ for 7/29/06

On:  Wednesday, 9/6/06, at 8:55pm ET   ·   As of:  9/7/06   ·   For:  7/29/06   ·   Accession #:  1193125-6-186227   ·   File #:  1-07562

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Document/Exhibit                   Description                      Pages   Size 

 1: 10-Q        Quarterly Report                                    HTML    429K 
 2: EX-10.2     Form of Stock Unit Agreement and Stock Unit         HTML     41K 
                          Deferral Election Form                                 
 3: EX-31.1     Certification of the CEO                            HTML     13K 
 4: EX-31.2     Certification of the CFO                            HTML     13K 
 5: EX-32.1     Certification of the CEO                            HTML      7K 
 6: EX-32.2     Certification of the CFO                            HTML      7K 

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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

or

Commission File Number 1-7562

THE GAP, INC.

(Exact name of registrant as specified in its charter)

Two Folsom Street

San Francisco, California 94105

(Address of principal executive offices)

Registrant’s telephone number, including area code: (650) 952-4400

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 by check mark whether Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer   x                Accelerated filer  ¨                Non-accelerated filer¨

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes   ¨    No  x

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, 828,504,127 shares as of August 26, 2006

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THE GAP, INC.

TABLE OF CONTENTS

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THE GAP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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THE GAP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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THE GAP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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THE GAP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The condensed consolidated balance sheets as of July 29, 2006, and July 30, 2005, the interim condensed consolidated statements of income and the condensed consolidated statements of cash flows for each of the thirteen and twenty-six week periods ended July 29, 2006 and July 30, 2005, have been prepared by The Gap, Inc. (the “company,” “we,” and “our”), without audit. In the opinion of management, such statements include all adjustments (which include only normal recurring adjustments) considered necessary to present fairly our financial position, results of operations and cash flows at July 29, 2006 and July 30, 2005 and for all periods presented. The condensed consolidated balance sheet as of January 28, 2006 has been derived from our audited consolidated financial statements.

Certain information and disclosures normally included in the notes to the annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted from these interim financial statements. We suggest that you read these condensed consolidated financial statements in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended January 28, 2006.

Certain prior period amounts have been reclassified to conform to the current period presentation. We reclassified $16 million of cash used for operating activities to cash used for investing activities representing the non-cash portion of property and equipment purchases for the twenty-six week period ended July 30, 2005 in our condensed consolidated statements of cash flows. This reclassification had no effect on the net decrease in cash and equivalents or on net earnings, as previously reported.

In fiscal 2005, the company implemented a new inventory system and effective January 29, 2006 (the beginning of fiscal 2006), the company changed its inventory flow assumption from the first-in, first-out (“FIFO”) method to the weighted average cost method (“WAC”). The company determined that WAC is a preferable method because the new inventory system and method improves the overall accuracy of the company’s accounting for inventory. The change in inventory accounting method did not have a material impact on the fiscal 2006 financial statements and because the effect on prior periods presented is not material, they have not been restated as would be required by Statement of Financial Accounting Standards No. (“SFAS”) 154, “Accounting Changes and Error Corrections - a Replacement of APB Opinion No. 20 and FASB Statement No. 3.”

The results of operations for the thirteen and twenty-six weeks ended July 29, 2006 are not necessarily indicative of the operating results that may be expected for the fifty-three week period ending February 3, 2007.

Our comprehensive earnings are comprised of net earnings, adjusted for foreign currency translation and fluctuations in fair market value of financial instruments related to foreign currency hedging activities, net of tax. Other comprehensive earnings are excluded from net earnings and reported as a separate component of shareholders’ equity.

Comprehensive earnings, net of taxes, is comprised of:

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On January 29, 2006, we adopted the provisions of SFAS 123 (Revised 2004), “Share-Based Payment” (“123(R)”) using the modified prospective transition method. Prior to the adoption of SFAS 123(R), stock-based compensation expense related to stock options was not recognized in the results of operations if the exercise price was equal to the market value of the common stock on the grant date, in accordance with Accounting Principles Board Opinion No. (“APB”) 25, “Accounting for Stock Issued to Employees.” As a result, the recognition of stock-based compensation expense was generally limited to the expense attributed to discounted stock options, performance units and stock option modifications. Under the modified prospective transition method, compensation cost recognized in the first twenty-six weeks of fiscal 2006 included: a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 28, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS 123, “Accounting for Stock-Based Compensation” and b) compensation cost for all share-based payments granted subsequent to January 28, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). The impact of forfeitures that may occur prior to vesting is also estimated and considered in the amount recognized.

See Note 8 for further information regarding our stock-based compensation assumptions and expenses, including pro forma disclosures for prior periods as if we had recorded the stock-based compensation expense.

In November 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS 151, “Inventory Costs, an Amendment of ARB No. 43, Chapter 4.” SFAS 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material and requires that these items be recognized as current period charges. SFAS 151 applies only to inventory costs incurred during periods beginning after the effective date and also requires that the allocation of fixed production overhead to conversion costs be based on the normal capacity of the production facilities. SFAS 151 is effective for fiscal 2006. The adoption of SFAS 151 did not have a material impact on our financial position, cash flows or results of operations.

In May 2005, the FASB issued SFAS 154 which changes the requirements for the accounting for, and reporting of, a change in accounting principle. Previously, voluntary changes in accounting principles were generally required to be recognized by way of a cumulative effect adjustment within net earnings during the period of the change. SFAS 154 requires retrospective application to prior period financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS 154 is effective for fiscal 2006; however, the statement does not change the transition provisions of any existing accounting pronouncements. The adoption of SFAS 154 did not have a material effect on our financial position, cash flows or results of operations.

In October 2005, the FASB issued FASB Staff Position (“FSP”) 13-1, “Accounting for Rental Costs Incurred During a Construction Period,” to clarify the proper accounting for rental costs incurred on building or ground operating leases during a construction period. The FSP requires that rental costs incurred during a construction period be expensed, not capitalized. FSP 13-1 is effective for fiscal 2006. The adoption of FSP 13-1 did not have a material effect on our financial position, cash flows or results of operations.

On November 10, 2005, the FASB issued FSP 123(R)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards,” that provides a practical transition election related to accounting for the tax effects of share-based payment awards to employees. The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee share-based compensation, and to determine the subsequent impact on the APIC pool and Consolidated Statements of Cash Flows of the tax effects of employee share-based compensation awards that are outstanding upon adoption of SFAS 123(R). The company is in the process of evaluating whether to adopt the provisions of FSP 123(R)-3.

In July 2006, the FASB issued FASB Interpretation No. (“FIN”) 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109,” which clarifies the accounting for uncertainty in tax positions. This Interpretation requires that we recognize in our financial statements the impact of a tax position, if that position is

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more likely than not of being sustained on audit, based on the technical merits of the position. FIN 48 is effective for fiscal 2007, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We are currently evaluating the impact of adopting FIN 48 on our financial statements.

As of July 29, 2006, we had $284 million in trade letters of credit issued under our letter of credit agreements totaling $500 million. There were no drawings under our $750 million revolving credit facility at July 29, 2006.

On May 6, 2005, we entered into four separate $125 million, 3-year letter of credit agreements and four separate $100 million, 364-day letter of credit agreements for a total aggregate availability of $900 million, which collectively replaced our prior letter of credit agreements. Unlike the previous letter of credit agreements, the current letter of credit agreements are unsecured. Consequently, the $900 million of restricted cash that collateralized the prior letter of credit agreements was fully released in May 2005. As of May 5, 2006, the four $100 million 364-day letter of credit agreements expired and the total letter of credit capacity was reduced to $500 million. This reduction in the letter of credit capacity reflects our transition to open account payment terms as well as the available capacity under our $750 million revolving credit facility to issue trade letters of credit.

On March 11, 2005, we called for the full redemption of our outstanding $1.4 billion, 5.75 percent senior convertible notes (the “Notes”) due March 15, 2009. The redemption was complete by March 31, 2005. Note holders had the option to receive cash at a redemption price equal to 102.46 percent of the principal amount of the Notes, plus accrued interest, for a total of approximately $1,027 per $1,000 principal amount of Notes. Alternatively, note holders could elect to convert their Notes into approximately 62.03 shares of Gap Inc. common stock per $1,000 principal amount. As of March 31, 2005, $1.4 billion of principal was converted into 85,143,950 shares of Gap Inc. common stock and approximately $0.5 million was paid in cash redemption.

The decrease in the effective tax rate during the second quarter of fiscal 2006 compared to the second quarter of fiscal 2005 primarily reflects the reassessment of foreign tax exposures and the effect of a favorable audit settlement.

We have excess facility space as of July 29, 2006 as a result of our 2001 decision to consolidate and downsize corporate facilities in our San Francisco and San Bruno campuses. We record a sublease loss reserve for the net present value of the difference between the contractual rent obligations and the rate at which we expect to be able to sublease the properties. These estimates and assumptions are monitored on at least a quarterly basis for changes in circumstances. We estimate the reserve based on the status of our efforts to lease vacant office space, including a review of real estate market conditions, our projections for sublease income and sublease commencement assumptions. Sublease loss charges are reflected in operating expenses in our condensed consolidated statements of income.

The following table provides the liability balances and activities of our sublease loss reserve:

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Remaining cash expenditures associated with the headquarters facilities sublease loss reserve are expected to be paid over the various remaining lease terms through 2012. Based on our assumptions as of July 29, 2006, we expected our lease payments, net of sublease income, to result in a total net cash outlay of approximately $18 million for future rent.

During the quarter ended July 30, 2005 we completed our assessment of available space and future office facility needs and in mid-May 2005 decided that we would occupy one of our vacant leased properties in San Francisco. As a result, the sublease loss reserve of $58 million associated with this space at April 30, 2005 was reversed.

In June 2006, a Sale and Purchase agreement was executed with a buyer for our distribution center located in Brampton, Ontario, Canada. In accordance with SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the facility is classified as held for sale and the total carrying value of $19 million for the land and building is included in other current assets in the condensed consolidated balance sheet as of July 29, 2006.

Stock Repurchase Program

On February 23, 2006, we announced the authorization of an additional $500 million for our share repurchase program all of which has been used. During the second fiscal quarter of 2006, we repurchased approximately 6 million shares of our common stock at a total cost of approximately $111 million, at an average price per share of $17.95 including commissions. During the first twenty-six weeks of 2006, we repurchased approximately 28 million shares of our common stock at a total cost of approximately $500 million, at an average price per share of $17.92 including commissions. On August 3, 2006, we announced the authorization of an additional $750 million for our ongoing share repurchase program. Under this authorization, shares may be repurchased over 12 months.

Dividends

In February 2006, we announced our intention to increase our annual dividend per share from $0.18 to $0.32 for fiscal 2006. Pursuant to this plan, a first quarter dividend of $0.08 per share was paid in April 2006 and a second quarter dividend of $0.08 per share was paid on July 25, 2006. The remaining dividends are expected to be paid quarterly in October and January.

Stock Award Plans

The 1996 Stock Option and Award Plan (the “1996 Plan”) was established on March 26, 1996, and amended and restated on January 28, 2003. The Board authorized 123,341,342 shares for issuance under the 1996 Plan, which includes shares available under the Management Incentive Restricted Stock Plan and an earlier stock option plan established in 1981, both of which were superseded by the 1996 Plan. The 1996 Plan was most recently amended and restated on January 24, 2006 and renamed the 2006 Long-Term Incentive Plan (the “2006 Plan”). On May 9, 2006, the shareholders approved an increase in the number of shares available for grant under the 2006 Plan by the sum of (a) the number of shares that remained available for grant under the 2002 Stock Option Plan (the “2002 Plan”) as of January 24, 2006, the date of board approval of the 2006 Plan, and (b) any shares that otherwise would have been returned to the 2002 Plan after January 24, 2006, on account of the expiration, cancellation, or forfeiture of awards granted thereunder. The 2006 Plan empowers the Compensation and Management Development Committee of the Board of Directors (the “Committee”) to award compensation primarily in the form of nonqualified stock options, restricted stock, or performance units to key employees.

The 2002 Plan, formerly known as Stock Up On Success, was established on January 1, 1999. The Board originally authorized 52,500,000 shares for issuance under the 2002 Plan, which includes shares available under an earlier stock option plan established in 1999 that was merged with the 2002 Plan. On May 9, 2006, the 2002 Plan was discontinued and only those awards then outstanding continue to be subject to the terms of the 2002 Plan under which they were granted. The 2002 Plan empowered the Committee to award nonqualified stock options to non-officer employees.

At July 29, 2006, we had reserved 153,636,052 shares of our common stock, including 477,359 treasury shares, for the issuance of common stock under our stock award plans. Stock options generally expire 10 years from the grant date, three months after employee termination, or one year after the date of an employees’ retirement or death, if earlier. In addition, stock options generally vest over a four-year period, with shares becoming exercisable in equal

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annual installments of 25 percent. Performance units generally vest over a four year period, and one share of common stock is issued for each performance unit upon vesting.

Employee Stock Purchase Plan

We have an Employee Stock Purchase Plan (“ESPP”) under which eligible U.S. employees may purchase our common stock at 85 percent of the lower of the closing price on the New York Stock Exchange on the first or last day of the six-month purchase period. Employees pay for their stock purchases through payroll deductions at a rate equal to any whole percentage from 1 percent to 15 percent. There were 860,183 and 801,404 shares issued under the plan during the first half of fiscal 2006 and 2005, respectively. At July 29, 2006, there were 6,041,776 shares reserved for future issuances.

Stock Compensation

On January 26, 2006, we accelerated the vesting of all stock options with an exercise price equal to or greater than $21 per share except options held by non-employee directors and performance-based options to purchase 1,000,000 shares granted to our Chief Executive Officer. Options to purchase approximately 15 million shares of common stock that were scheduled to vest from fiscal 2006 to 2009 were impacted by this action. Although these options became immediately exercisable, the exercise price did not change. The primary purpose of the accelerated vesting was to reduce compensation expense after the adoption of SFAS 123(R) by approximately $45 million in the first quarter of fiscal 2006. There was no impact to our Consolidated Statement of Income in fiscal 2005.

In the first quarter of 2006, we adopted SFAS 123(R). See Note 3 for a description of our adoption of SFAS 123(R). We use the Black-Scholes-Merton option-pricing model to determine the fair value of stock awards and employee stock purchase plan (“ESPP”) shares. This model requires the input of subjective assumptions that have a significant impact on the fair value estimate. The assumptions for the current period grants were developed based on SFAS 123(R) and SEC guidance contained in Staff Accounting Bulletin No. (“SAB”) 107, “Share-Based Payment.” The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, the expected term based on projected employee stock option exercise behaviors, risk-free interest rate and expected dividends. Changes in the subjective assumptions can materially affect the estimate of fair value of stock-based compensation and consequently, the related amount recognized on the consolidated statements of income.

The expected term represents the estimated time until exercise and is based on historical exercise patterns, which we believe are representative of future behavior. The expected term of employee stock purchase rights is the purchase period under each offering period. The expected volatility of our common stock is based on a combination of historical volatility of our stock for a period approximating the expected term and the implied volatility based on traded options of our stock. Prior to fiscal 2006, only historical volatility was considered. The expected dividend yield is based on our expected annual dividend payout for the current fiscal year. The risk-free interest rate is based on zero-coupon U.S. Treasury instruments with a remaining term equal to the expected term of the share options.

We are required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are expected to vest. With the adoption of SFAS 123(R) at the beginning of our first fiscal quarter of 2006, we added “Stock-Based Compensation” as a critical accounting policy and estimate.

The weighted average assumptions used to value option grants are as follows:

The weighted-average fair value of stock options granted during the thirteen weeks ended July 29, 2006 and July 30, 2005 was $5.44 and $7.10 per share, respectively. The weighted-average fair value of stock options granted during the twenty-six weeks ended July 29, 2006 and July 30, 2005 was $4.98 and $7.67 per share, respectively. The fair value of stock options that vested during the thirteen weeks ended July 29, 2006 and July 30, 2005 was $3 million

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and $9 million, respectively. The fair value of stock options that vested during the twenty-six weeks ended July 29, 2006 and July 30, 2005 was $28 million and $66 million, respectively.

The assumptions used to value employee stock purchase rights are as follows:

Beginning in fiscal 2005, the Committee began granting stock awards in the form of performance units. One share of common stock is issued for each performance unit where vesting is subject to continued service by the employee (“stock awards”) and, in some cases, vesting is subject to the achievement of certain performance metrics (“performance stock awards”).

In accordance with SFAS 123(R), we recognize the estimated compensation cost of stock awards, net of estimated forfeitures, and performance stock awards based on the value of our traded stock price on the date of grant, with an offsetting increase to shareholder’s equity. We evaluate the probability that the performance stock awards will vest at the end of each reporting period and adjust compensation cost accordingly. Prior to the adoption of SFAS 123(R), we recognized the compensation expense related to stock awards based on actual forfeitures. As such we evaluated the need to record a cumulative effect adjustment for estimated forfeitures upon the adoption of SFAS 123(R). Because the adjustment was not material, it was recognized as a credit to operating expenses.

When the granting of the stock award is subject to the achievement of certain performance metrics, we evaluate the probability that the stock awards will be granted. In addition, we revalue compensation cost at the end of each reporting period, based on the value of our traded stock price and the probability that the performance metrics will be achieved, with an offsetting increase to current liabilities. Upon achievement of the performance metrics, the stock award is granted, accounted for as fixed equity award and valued using our traded stock price on the date of grant, and the associated liability is reclassified to shareholder’s equity.

The weighted-average fair value of stock awards and performance stock awards granted during the thirteen weeks ended July 29, 2006 and July 30, 2005 was $17.49 and $20.87 per share, respectively. The weighted-average fair value of stock awards and performance stock awards granted during the twenty-six weeks ended July 29, 2006 and July 30, 2005 was $17.84 and $22.24 per share, respectively. The fair value of stock awards that vested during the thirteen weeks ended July 29, 2006 and twenty-six weeks ended July 29, 2006 was $1 million and $9 million, respectively. No performance units vested during fiscal 2005.

As required by SFAS 123(R), the estimated fair value of our stock-based awards granted prior to the adoption of SFAS 123(R), less expected forfeitures, will continue to be amortized based on an accelerated recognition method. The estimated fair value of our stock-based awards granted after the adoption of SFAS 123(R), less expected forfeitures, with time-based service conditions are being amortized on a straight-line basis, while those with performance conditions are being amortized on an accelerated basis.

At July 29, 2006, there was $84 million (before any related tax benefit) of unrecognized compensation cost, adjusted for estimated forfeitures, related to nonvested share-based compensation that is expected to be recognized over a weighted-average period of 3 years. Total unrecognized compensation may be adjusted for future changes in estimated forfeitures. There was no share-based compensation capitalized as of or during the thirteen weeks and twenty-six weeks ended July 29, 2006.

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The following table shows the effect on net earnings and earnings per share had compensation cost been recognized based upon the estimated fair value on the grant date of stock options, and employee stock purchase rights during the comparable period last year.

There were no material modifications made to our outstanding stock options, stock awards or performance stock awards in fiscal 2006.

General Stock Information

Under our stock option plans, nonqualified options to purchase common stock are granted to officers, directors, eligible employees and consultants at exercise prices equal to the fair market value of the stock at the date of grant or as determined by the Compensation and Management Development Committee of the Board of Directors.

The following table summarizes stock option activity for our stock option plans:

The aggregate intrinsic value of options exercised during the thirteen weeks ended July 29, 2006 and July 30, 2005 was $7 million and $29 million, respectively. The aggregate intrinsic value of options exercised during the twenty-six weeks ended July 29, 2006 and July 30, 2005 was $26 million and $42 million, respectively.

The following table summarizes additional information about stock options outstanding and exercisable at July 29, 2006:

The aggregate intrinsic value of options outstanding and options exercisable at July 29, 2006 was $95 million and $73 million, respectively. Options exercisable at July 29, 2006 had a weighted-average remaining contractual life of 5.72 years.

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The following table summarizes non-vested stock award and performance stock award activity:

The aggregate intrinsic value of non-vested stock awards and performance stock awards at July 29, 2006 was $74 million. Stock awards and performance stock awards at July 29, 2006 had a weighted-average remaining contractual life of 3.24 years.

Basic earnings per share are computed using the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share includes the additional dilutive effect of our potentially dilutive securities, which include certain stock options and unvested performance units, calculated using the treasury stock method, and convertible notes which are potentially dilutive at certain earnings levels calculated using the if-converted method. The following summarizes the incremental shares from the potentially dilutive securities:

Excluded from the above computations of weighted-average shares for diluted earnings per share (in thousands) were options to purchase 45,368 and 44,889 shares of common stock during the thirteen and twenty-six weeks ended July 29, 2006, respectively. Excluded from the above computations of weighted-average shares for diluted earnings per share (in thousands) were options to purchase 39,033 and 36,782 shares of common stock during the thirteen and twenty-six weeks ended July 30, 2005, respectively. The calculated amounts have been excluded because the exercise price was greater than the average market price of the company’s common stock during the period and, therefore, the effect is antidilutive.

We are a party to a variety of contractual agreements under which we may be obligated to indemnify the other party for certain matters. These contracts primarily relate to our commercial contracts, operating leases, intellectual property, financial agreements and various other agreements. Under these contracts we may provide certain indemnifications relating to representations and warranties (e.g., ownership of assets, environmental or tax indemnifications), or personal injury matters or other matters. The terms of these indemnifications range in duration and may not be explicitly defined.

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Generally, the maximum obligation under such indemnifications is not explicitly stated and as a result, the overall amount of these obligations cannot be reasonably estimated. Historically we have not made significant payments for these indemnifications. We believe that if we were to incur a loss in any of these matters, the loss would not have a material effect on our financial condition or results of operations.

As party to a reinsurance pool for workers’ compensation, general liability and automobile liability, we have guarantees with a maximum exposure of $75 million, of which $8 million has been cash collateralized.

As a multinational company, we are subject to various proceedings, lawsuits, disputes and claims (“Actions”) arising in the ordinary course of our business. Many of these Actions raise complex factual and legal issues and are subject to uncertainties. Actions filed against us include commercial, intellectual property, customer, and labor and employment related claims, including class action lawsuits in which plaintiffs allege that we violated federal and state wage and hour and other laws. The plaintiffs in some Actions seek unspecified damages or injunctive relief, or both. Actions are in various procedural stages, and some are covered in part by insurance. If the outcome of an action is expected to result in a loss that is considered probable and reasonably estimatable, we will record a liability for the estimated loss.

We cannot predict with assurance the outcome of Actions brought against us. Accordingly, adverse developments, settlements or resolutions may occur and negatively impact earnings in the quarter of such development, settlement or resolution. However, we do not believe that the outcome of any current Action would have a material adverse effect on our results of operations, liquidity or financial position taken as a whole.

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Our Business

We are a global specialty retailer operating retail and outlet stores selling casual apparel, accessories, and personal care products for men, women and children under the Gap, Banana Republic, Old Navy and Forth & Towne brand names. We operate stores in the United States, Canada, the United Kingdom, France and Japan. In addition, our U.S. customers may shop online at gap.com, bananarepublic.com and oldnavy.com. We design virtually all of our products, which are manufactured by independent sources, and sell them under our brands.

Overview

The second quarter continued to be challenging due to weak traffic and disappointing product acceptance, driving a negative 5 percent comparable store sales compared to last year. Gross margins were negatively impacted as we aggressively cleared through summer product to prepare for fall merchandise. Further, we experienced higher operating expenses associated with driving both our turnaround and long term growth. As a result, net earnings were 53 percent lower than second quarter last year and earnings per share was $0.15, which was $0.15 lower than last year.

While we are not satisfied with our operating results, our cash flow remains strong. For the twenty-six weeks ended July 29, 2006, we generated free cash flow of $300 million, an increase of $279 million compared to prior year driven by improvements in our working capital. For a reconciliation of free cash flow, a non-GAAP measure, to a GAAP measure, see the Financial Condition section of this Management’s Discussion and Analysis.

We made progress against our strategic priorities. During the second quarter, we returned excess cash to shareholders by repurchasing approximately 6 million shares of our common stock for $111 million and declared and paid a quarterly dividend of $0.08 per share. Cash distribution to shareholders will continue to play an important role in delivering shareholder returns; however, our first priority for excess cash is investing in our business in a way that meets or exceeds our return criteria.

Even though the second quarter was challenging, we continue to make progress in each of our brands and remain committed to the strategies underway to turnaround our business performance. We are focused on creating stronger product assortments, improving the store experience for our customers, and delivering marketing with compelling messages. We remain confident in our growth strategies, which we believe will create and deliver value to our shareholders over the long-term. These strategies include: building our existing lifestyle brands and creating new ones, growing those brands internationally, becoming the best online apparel retailer, and leveraging our scale and operating discipline to yield superior shareholder returns. Our online shoe concept is scheduled to launch in time for holiday shopping and our first franchise stores will open this fall.

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. All statements other than those that are purely historical are forward-looking statements. Words such as “expect,” “anticipate,” “believe,” “estimate,” “plan,” “project,” and similar expressions also identify forward-looking statements. Forward-looking statements include, but are not limited to, statements regarding: (i) amount of future lease payments net of sublease income; (ii) timing and amount of dividends in fiscal 2006; (iii) expected stock price volatility; (iv) impact of losses under contractual indemnifications; (v) impact of various proceedings, lawsuits, disputes and claims; (vi) gross interest expense for fiscal 2006; (vii) effective tax rate for fiscal 2006; (viii) free cash flow in fiscal 2006; (ix) minimum net cash provided from operating activities in fiscal 2006; (x) year over year change in inventory per square foot at the end of the third and fourth quarters of fiscal 2006; (xi) capital expenditures (net purchases of property and equipment) in fiscal 2006; (xii) number of new store openings and store closings in fiscal 2006 and weightings by brand; (xiii) net square footage change in fiscal 2006; (xiv) funding of capital expenditures in fiscal 2006; (xv) dividend policy and increases in future periods; (xvi) maximum exposure and cash collateralized balance for reinsurance pool in future periods; and (xvii) estimate of unrecorded compensation expense over the 10-year period ended June 2006.

Because these forward-looking statements involve risks and uncertainties, there are important factors that could cause our actual results to differ materially from those in the forward-looking statements. These factors include, without limitation, the following: the risk that we will be unsuccessful in gauging fashion trends and changing

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consumer preferences; the highly competitive nature of our business in the U.S. and internationally and our dependence on consumer spending patterns, which are influenced by numerous other factors; the risk that we will be unsuccessful in identifying and negotiating new store locations effectively; the risk that comparable store sales and margins will experience fluctuations; the risk that we will be unsuccessful in implementing our strategic, operating and people initiatives; the risk that adverse changes in our credit ratings may have a negative impact on our financing costs and capital structure in future periods; the risk that trade matters, events causing disruptions in product shipments from China and other foreign countries, or IT systems changes may disrupt our supply chain or operations; and the risk that we will not be successful in defending various proceedings, lawsuits, disputes, claims, and audits; any of which could impact net sales, costs and expenses, and/or planned strategies. Additional information regarding factors that could cause results to differ can be found in our Annual Report on Form 10-K for the fiscal year ended January 28, 2006.

Future economic and industry trends that could potentially impact net sales and profitability are difficult to predict. These forward-looking statements are based on information as of August 30, 2006 and we assume no obligation to publicly update or revise our forward-looking statements even if experience or future changes make it clear that any projected results expressed or implied therein will not be realized.

We suggest that this document be read in conjunction with the Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the fiscal year ended January 28, 2006.

RESULTS OF OPERATIONS

Business in the second quarter continued to be challenging due to disappointing sales performance coupled with higher operating expenses. For the thirteen weeks ended July 29, 2006, net earnings decreased 53% percent to $128 million or $0.15 per diluted share, compared to net earnings of $272 million or $0.30 per diluted share for the thirteen weeks ended July 30, 2005. For the twenty-six weeks ended July 29, 2006, net earnings decreased 34% percent to $370 million or $0.43 per diluted share, compared to net earnings of $563 million or $0.61 per diluted share for the twenty-six weeks ended July 30, 2005.

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Net Sales by Brand, Region and Channel

Net sales consist of retail sales and online sales, which include shipping fees received from customers for delivery of merchandise. Outlet retail sales are reflected within the respective results of each brand.

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Net Sales

A store is included in comparable store sales (“Comp”) when all three of the following requirements have been met: the store has been open at least one year, square footage has not changed 15 percent or more within the past year, and the store has not been permanently repositioned within the past year. A store is included in Comp on the first day it has comparable prior year sales. Stores in which square footage has changed by 15 percent or more as a result of remodel, expansion, or reduction are excluded from Comp until the first day they have comparable prior year sales. Current year foreign exchange rates are applied to both current year and prior year Comp store sales to achieve a consistent basis for comparison.

A store is considered non-comparable (“Non-comp”) when, in general, the store has no comparable prior year sales. For example, a store that has been open for less than one year, a store that has changed its square footage by 15 percent or more within the past year, or the store has been permanently repositioned within the past year is considered Non-comp. Non-store sales such as online operations are also considered Non-comp.

A store is considered “Closed” if it is temporarily closed for three or more full consecutive days or is permanently closed. When a temporarily closed store reopens, the store will be placed in the Comp/Non-comp status it was in prior to its closure. If a store was in “Closed” status for three or more days in the prior year then the store will be in “Non-comp” status for the same days in the following year.