Gap (GPS)

Operating Expenses, Excluding Loss on Early Retirement of Debt

Operating expenses include payroll and related benefits (for our store operations, field management, distribution centers, and corporate functions), advertising, and general and administrative expenses. Also included are costs to design and develop our products, merchandise handling and receiving in distribution centers and stores, distribution center general and administrative expenses, and rent, occupancy, and depreciation for headquarter facilities.

Operating expenses as a percentage of net sales increased 2.4 percentage points, or $351 million, in fiscal 2006 compared with fiscal 2005. Our operating expenses were higher than last year because of $91 million in increased marketing and store related activities, $169 million in increased payroll and related expenses for more employees and merit, $32 million in increased share-based compensation as a result of the adoption of Statement of Financial Accounting Standards No. (“SFAS”) 123(R), “Share-Based Payment”, in the first quarter of fiscal 2006, $61 million as a result of the effect of the sublease loss reserve reversal in fiscal 2005, $29 million in

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increased impairment of long-lived assets offset by $31 million in income relating to the change in our estimate of the elapsed time for recording income associated with unredeemed gift cards in the second quarter of fiscal 2006.

Operating expenses as a percentage of net sales decreased 0.7 percentage points, or $172 million, in fiscal 2005 compared with fiscal 2004. The decrease was primarily driven by a $61 million net reversal of sublease loss reserve in the second quarter of fiscal 2005 and the reclassification of certain sourcing expenses. While we have been classifying the majority of sourcing expenses in cost of goods sold and occupancy expenses, some operating costs related to certain wholly owned agent offices that source our product had been classified in operating expenses. As a result, approximately $42 million of year to date sourcing expenses were reclassified in fiscal 2005. This reclassification had no effect on net earnings. Lower advertising expenses primarily driven by our decision not to run a holiday television campaign at Gap brand and lower bonus expense related to fiscal 2005 performance also contributed to the decrease in operating expenses.

Operating margin excluding loss on early retirement of debt, was 7.4 percent, 10.9 percent, and 12.8 percent in fiscal 2006, 2005 and 2004, respectively. For fiscal 2007, we expect operating margin to be in the high single-digits.

Included in operating expenses are costs related to store closures and sublease loss reserves. The following discussion should be read in conjunction with Note 5 of Notes to the Consolidated Financial Statements.

During the second fiscal quarter of 2005, we completed our assessment of available space and future office facility needs and 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 was reversed in the second fiscal quarter of 2005 and we occupied the space in fiscal 2006. We further reduced the reserve by $3 million based on our decision to occupy certain additional office space.

Operating Expenses, Excluding Loss on Early Retirement of Debt

Operating expenses include payroll and related benefits (for our store operations, field management, distribution centers, and corporate functions), advertising, and general and administrative expenses. Also included are costs to design and develop our products, merchandise handling and receiving in distribution centers and stores, distribution center general and administrative expenses, and rent, occupancy, and depreciation for headquarter facilities.

Operating expenses as a percentage of net sales decreased 0.7 percentage points, or $172 million, in fiscal 2005 compared with fiscal 2004. The decrease was primarily driven by a $61 million net reversal of sublease loss reserve in the second quarter of fiscal 2005 and the reclassification of certain sourcing expenses. While we have been classifying the majority of sourcing expenses in cost of goods sold and occupancy expenses, some operating costs related to certain wholly owned agent offices that source our product had been classified in operating expenses. As a result, approximately $42 million of year to date sourcing expenses were reclassified in fiscal 2005. This reclassification had no effect on net earnings. Lower advertising expenses primarily driven by our decision not to run a holiday television campaign at Gap brand and lower bonus expense related to fiscal 2005 performance also contributed to the decrease in operating expenses.

Operating expenses as a percentage of net sales increased 0.7 percentage points, or $228 million, in fiscal 2004 compared with fiscal 2003. The increase was primarily due to higher store payroll and benefits to support increased sales, planned increases for new growth initiatives and increased advertising expenses. Gap North America ran incremental television campaigns compared to the prior year and Old Navy increased its circulars to promote sales.

Operating margin, excluding loss on early retirement of debt, was 10.9 percent, 12.8 percent, and 12.0 percent in fiscal 2005, 2004 and 2003, respectively. For fiscal 2006, we expect operating margin to be about 10.0 to 10.5 percent, including the impact of the adoption of SFAS 123(R).

Included in operating expenses are costs related to store closures and sublease loss reserves. The following discussion should be read in conjunction with Note E to the Consolidated Financial Statements.

During the second fiscal quarter of 2005 we completed our assessment of available space and future office facility needs and decided that we would occupy one of our vacant leased properties in San Francisco. As a result, in the same quarter the sublease loss reserve of $58 million associated with this space at April 30, 2005 was reversed and planning efforts to design and construct leasehold improvements for occupation in 2006 began. We further reduced the reserve by $3 million based on our decision to occupy certain additional office space.

In prior years, we considered our headquarter facilities’ space needs and identified and abandoned excess facility space. As a result of these actions, we recorded sublease loss charges of $77 million in fiscal 2002. During fiscal 2004 and 2003, due to continued weakness in the commercial real estate market, we revised our sublease income and sublease commencement projections and assumptions related to headquarter facilities in our San Francisco and San Bruno campuses and recorded additional sublease loss charges of $5 million and $9 million, respectively.

In August 2004, we sold our stores and exited the market in Germany. In fiscal 2003, we recognized a charge to operating expense of $14 million for asset write-downs. The actual net selling price approximated our initial estimate. This decision represented a strategic move toward re-allocating our international resources to optimize growth in our other existing markets and focusing our attention on more attractive, longer-term growth opportunities in new markets.

Operating Expenses, Excluding Loss on Early Retirement of Debt

Operating expenses include payroll and related benefits (for our stores, distribution network and corporate functions), advertising, and general and administrative expenses. Also included are costs to design and develop our products, pre-opening expenses related to new store openings, and the costs of maintenance and minor enhancement, which are expensed as incurred.

Operating expenses as a percentage of net sales increased 0.7 percentage points, or $228 million, in fiscal 2004 compared with fiscal 2003. The increase was primarily due to higher store payroll and benefits to support increased sales, planned increases for new growth initiatives and increased advertising expenses. Gap North America ran incremental television campaigns compared to the prior year and Old Navy increased its circulars to promote sales.

Operating expenses as a percentage of net sales decreased 1.3 percentage points in fiscal 2003 compared with fiscal 2002. While operating expenses increased, the decrease in operating expenses as a percentage of net sales was due primarily to the higher rate of increase in sales compared to store payroll, benefit costs and operating expenses. The increase in total operating expenses compared with fiscal 2002 was primarily due to higher repair and maintenance expenses to support our store fleet and higher store payroll to support increased sales.

Operating margin, excluding loss on early retirement of debt, was 12.8 percent, 12.0 percent and 7.0 percent in fiscal 2004, 2003 and 2002, respectively. For fiscal 2005, we expect operating margin to be about 13 percent, excluding loss on early retirement of debt and the impact of the adoption of SFAS 123(R).

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GAP INC. FINANCIALS 2004

Included in operating expenses are costs related to store closures and sublease loss reserves. The following discussion should be read in conjunction with Note F to the accompanying consolidated financial statements.

In August 2004, we sold our stores and exited the market in Germany. In fiscal 2003, we recognized a charge to operating expense of $14 million for asset write-downs. The actual net selling price approximated our initial estimate. This decision represents a strategic move toward re-allocating our international resources to optimize growth in our other existing markets and focusing our attention on more attractive, longer-term growth opportunities in new markets.

In prior years, we considered our headquarter facilities’ space needs and identified and abandoned excess facility space. As a result of these actions, we recorded sublease loss charges of $77.4 million in fiscal 2002. During fiscal 2004 and 2003, due to continued weakness in the commercial real estate market, we revised our sublease income and sublease commencement projections and assumptions related to headquarter facilities in our San Francisco and San Bruno campuses and recorded additional sublease loss charges of $4.8 million and $8.6 million, respectively.

As a result of improved business performance, new business initiatives and opportunities for future growth, and continued levels of high vacancy in the San Francisco Bay Area market, we have recently completed an assessment of our available space and future needs. We are in the process of analyzing our options and the results of this analysis could positively or negatively impact the level of our sublease reserves.

In addition, during fiscal 2004, we announced that we would be closing our Edgewood, Maryland distribution facility and consolidating its operations into several of our other facilities in the summer of 2005. There were no material charges in fiscal 2004 as a result of this decision.