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," "intend," "plan," "project," and similar expressions also identify forward-looking statements. Forward-looking statements include, but are not limited to, statements regarding the following:

• repaying the remaining balance on the term loan;

• income recognition of unrealized gains and losses from designated cash flow hedges;

• changes in total gross unrecognized tax benefits within the next 12 months;

• the outcome of proceedings, lawsuits, disputes, and claims;

• the impact of losses due to indemnification obligations;

• earnings per share for fiscal 2012;

• improving sales with healthy merchandise margins;

• investing in our business while maintaining discipline;

• returning excess cash to shareholders;

• improving comparable store sales;

• growing revenues;

• opening additional stores, including outlets, in Asia, Canada, and Europe;

• continuing to open franchise stores worldwide;

• opening additional Athleta stores;

• the number of new store openings and store closings in fiscal 2012, including franchise stores;

• square footage change in fiscal 2012;

• operating margin and leveraging operating expenses in fiscal 2012;

• the effective tax rate in fiscal 2012;

• current cash balances and cash flows being sufficient to support our business operations, including growth initiatives and planned capital expenditures;

• ability to supplement near-term liquidity, if necessary, with our $500 million revolving credit facility;

• the impact of the seasonality of our operations on certain asset and liability accounts;

• depreciation and amortization expense in fiscal 2012;

• capital expenditures in fiscal 2012;

• dividend payments in fiscal 2012; and

• the impact of changes in internal controls.

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 adoption of new accounting pronouncements will impact future results;

• the risk that changes in general economic conditions or consumer spending patterns could adversely impact our results of operations;

• the highly competitive nature of our business in the United States and internationally;

• the risk that we or our franchisees will be unsuccessful in gauging apparel trends and changing consumer preferences;

• the risk to our business associated with global sourcing and manufacturing, including sourcing costs, events causing disruptions in product shipment, or an inability to secure sufficient manufacturing capacity;

• the risk that our efforts to expand internationally may not be successful;

• the risk that our franchisees will be unable to successfully open, operate, and grow their franchised stores in a manner consistent with our requirements regarding our brand identities and customer experience standards;

• the risk that we or our franchisees will be unsuccessful in identifying, negotiating, and securing new store locations and renewing, modifying or terminating leases for existing store locations effectively;

• the risk that changes in our credit profile or deterioration in market conditions may limit our access to the capital markets and adversely impact our financial results and our ability to service our debt while maintaining other initiatives;

• the risk that trade matters could increase the cost or reduce the supply of apparel available to us and adversely affect our business, financial condition, and results of operations;

• the risk that updates or changes to our information technology systems may disrupt our operations;

• the risk that actual or anticipated cyber attacks, and other cybersecurity risks, may cause us to incur increasing costs;

• the risk that natural disasters, public health crises, political crises, or other catastrophic events could adversely affect our operations and financial results;

• the risk that acts or omissions by our third-party vendors, including a failure to comply with our code of vendor conduct, could have a negative impact on our reputation or operations;

• the risk that we do not repurchase some or all of the shares we anticipate purchasing pursuant to our share repurchase program;

• the risk that we will not be successful in defending various proceedings, lawsuits, disputes, claims, and audits; and

• the risk that changes in the regulatory or administrative landscape could adversely affect our financial condition, strategies, and results of operations.

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, 2012 and our other filings with the U.S. Securities and Exchange Commission.

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 31, 2012, 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 Management's Discussion and Analysis included in our Annual Report on Form 10-K for the fiscal year ended January 28, 2012.

OUR BUSINESS

We are a leading global specialty apparel company. We offer apparel, accessories, and personal care products for men, women, children, and babies under the Gap, Old Navy, Banana Republic, Piperlime, and Athleta brands. We have Company-operated stores in the United States, Canada, the United Kingdom, France, Ireland, Japan, China, and Italy. We also have franchise agreements with unaffiliated franchisees to operate Gap and Banana Republic stores in many other countries around the world. Under these agreements, third parties operate, or will operate, stores that sell apparel and related products under our brand names. Our products are also available to customers online in about 90 countries through Company-owned websites and using third parties that provide logistics and fulfillment services. Most of the products sold under our brand names are designed by us and manufactured by independent sources. We also sell products that are designed and manufactured by branded third parties.

We identify our operating segments based on the way we manage and evaluate our business activities. We have two reportable segments: Stores and Direct.

OVERVIEW

Financial highlights for the second quarter of fiscal 2012 are as follows:

• Net sales for the second quarter of fiscal 2012 increased 6 percent to $3.6 billion compared with $3.4 billion for the second quarter of fiscal 2011. Comparable sales for the second quarter of fiscal 2012, which include the associated comparable online sales, increased 4 percent compared with a 2 percent decrease for the second quarter of fiscal 2011.

• Direct net sales for the second quarter of fiscal 2012 increased 24 percent to $384 million compared with $309 million for the second quarter of fiscal 2011. Our Direct reportable segment includes sales for each of our online brands, including Piperlime and Athleta.

• Net sales outside of the U.S. and Canada (including Direct and franchise) increased 7 percent to $551 million for the second quarter of fiscal 2012 compared with $515 million for the second quarter of fiscal 2011.

• Operating expenses for the second quarter of fiscal 2012 were $1.0 billion compared with $917 million for the second quarter of fiscal 2011 and increased 0.9 percent as a percentage of net sales.

• Net income for the second quarter of fiscal 2012 increased 29 percent to $243 million compared with $189 million for the second quarter of fiscal 2011, and diluted earnings per share increased 40 percent to $0.49 for the second quarter of fiscal 2012 compared with $0.35 for the second quarter of fiscal 2011. For fiscal 2012, we expect diluted earnings per share to be in the range of $1.95 to $2.00.

• During the first half of fiscal 2012, we generated free cash flow of $673 million compared with free cash flow of $298 million during the first half of fiscal 2011. Free cash flow is defined as net cash provided by operating activities less purchases of property and equipment. For a reconciliation of free cash flow, a non-GAAP measure, from a GAAP financial measure, see the Liquidity and Capital Resources section.

Our full-year business and financial priorities for fiscal 2012 remain as follows:

• improve sales with healthy merchandise margins;

• invest in our business while maintaining discipline; and

• return excess cash to shareholders.

As we focus on improving comparable store sales in fiscal 2012, we also plan to grow revenues through the following:

• opening additional stores, many of which will be outlets, in Asia, Canada, and Europe;

• continuing to open franchise stores worldwide; and

• opening additional Athleta stores.

RESULTS OF OPERATIONS

Net Sales

Net sales primarily consist of retail sales, online sales, and franchise revenues.

See Item 1, Financial Statements, Note 12 of Notes to Condensed Consolidated Financial Statements for net sales by brand, region, and reportable segment.

Comparable Sales

The percentage change in comparable ("Comp") sales by brand and region and for
total Company, including the associated comparable online sales, as compared
with the preceding year, is as follows:



                                                    13 Weeks Ended                           26 Weeks Ended
                                            July 28,              July 30,           July 28,              July 30,
                                              2012                  2011               2012                  2011
Gap North America                                    7 %                 (3 )%                6 %                 (3 )%
Old Navy North America                               3 %                 -  %                 4 %                 (1 )%
Banana Republic North America                        7 %                 (2 )%                6 %                 (1 )%
International                                       (5 )%                (4 )%               (4 )%                (5 )%
The Gap, Inc.                                        4 %                 (2 )%                4 %                 (2 )%

The percentage change in Comp store sales by brand and region and for total Company, excluding the associated comparable online sales, as compared with the preceding year, is as follows:

                                                    13 Weeks Ended                           26 Weeks Ended
                                            July 28,              July 30,           July 28,              July 30,
                                              2012                  2011               2012                  2011
Gap North America                                    5 %                 (5 )%                5 %                 (5 )%
Old Navy North America                               2 %                 (2 )%                2 %                 (3 )%
Banana Republic North America                        5 %                 (3 )%                4 %                 (3 )%
International                                       (5 )%                (6 )%               (5 )%                (7 )%
The Gap, Inc.                                        2 %                 (4 )%                2 %                 (4 )%

Only Company-operated stores are included in the calculations of Comp sales. Gap and Banana Republic outlet Comp sales are reflected within the respective results of each brand. The results for Athleta are excluded from the calculations of total Company Comp sales due to its small number of Comp stores compared to our other brands. The results for Piperlime are excluded from the calculations of total Company Comp sales, as Piperlime is an online-only brand.

A store is included in the Comp sales calculations when it has been open for at least one year and the selling square footage has not changed by 15 percent or more within the past year. A store is included in the Comp sales calculations on the first day it has comparable prior year sales. Stores in which the selling square footage has changed by 15 percent or more as a result of a remodel, expansion, or reduction are excluded from the Comp sales calculations until the first day they have comparable prior year sales.

A store is considered non-comparable ("Non-comp") when it has been open for less than one year or has changed its selling square footage by 15 percent or more within the past year.

A store is considered "Closed" if it is temporarily closed for three or more full consecutive days or it 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, the store will be in Non-comp status for the same days the following year.

Comparable online sales include sales through online channels and are reported based on the location of the distribution center.

Current year foreign exchange rates are applied to both current year and prior year Comp sales to achieve a consistent basis for comparison.

Store Count and Square Footage Information

Net sales per average square foot is as follows:



                                                     13 Weeks Ended                     26 Weeks Ended
                                               July 28,          July 30,          July 28,         July 30,
                                                 2012              2011              2012             2011
Net sales per average square foot (1)         $       85        $        80       $      166        $     156

(1) Excludes net sales associated with our online, catalog, and franchise businesses.

Store count, openings, closings, and square footage for our stores are as follows:

                                      January 28, 2012                 26 Weeks Ended July 28, 2012                               July 28, 2012
                                         Number of                 Number of                  Number of                Number of               Square Footage
                                      Store Locations            Stores Opened              Stores Closed           Store Locations            (in millions)
Gap North America                                 1,043                       9                         38                     1,014                      10.4
Gap Europe                                          193                       2                          1                       194                       1.7
Gap Asia                                            152                      15                          2                       165                       1.6
Old Navy North America                            1,016                       8                         14                     1,010                      17.8
Old Navy Asia                                        -                        1                         -                          1                        -
Banana Republic North America                       581                      10                          5                       586                       4.9
Banana Republic Asia                                 31                       4                          2                        33                       0.2
Banana Republic Europe                               10                      -                          -                         10                       0.1
Athleta North America                                10                      12                         -                         22                       0.1

Company-operated stores total                     3,036                      61                         62                     3,035                      36.8
Franchise                                           227                      30                          7                       250                       N/A

Total                                             3,263                      91                         69                     3,285                      36.8

Increase (decrease) over prior year                                                                                              1.1 %                    (2.4 )%

                                      January 29, 2011                 26 Weeks Ended July 30, 2011                               July 30, 2011
                                         Number of                 Number of                  Number of                Number of               Square Footage
                                      Store Locations            Stores Opened              Stores Closed           Store Locations            (in millions)
Gap North America                                 1,111                       8                         28                     1,091                      11.1
Gap Europe                                          184                       7                          5                       186                       1.6
Gap Asia                                            135                       6                          1                       140                       1.3
Old Navy North America                            1,027                      12                         17                     1,022                      18.5
Banana Republic North America                       576                       3                          1                       578                       4.9
Banana Republic Asia                                 29                      -                           1                        28                       0.2
Banana Republic Europe                                5                       2                         -                          7                       0.1
Athleta North America                                 1                      -                          -                          1                        -

Company-operated stores total                     3,068                      38                         53                     3,053                      37.7
Franchise                                           178                      18                          1                       195                       N/A

Total                                             3,246                      56                         54                     3,248                      37.7

Increase (decrease) over prior year                                                                                              0.7 %                    (2.1 )%

Gap and Banana Republic outlet stores are reflected in each of the respective brands. We have franchise agreements with unaffiliated franchisees to operate Gap and Banana Republic stores throughout Asia, Australia, Eastern Europe, Latin America, the Middle East, and Africa.

In fiscal 2012, we expect to open about 160 new Company-operated store locations and close about 145 Company-operated store locations. We expect square footage for Company-operated stores to decrease about 1 percent at the end of fiscal 2012 compared with the end of fiscal 2011. We expect our franchisees to open about 50 to 75 new franchise stores in fiscal 2012.

Net Sales

Our net sales for the second quarter of fiscal 2012 increased $189 million, or 6 percent, compared with the prior year comparable period due to an increase in net sales of $114 million related to our Stores reportable segment and an increase in net sales of $75 million related to our Direct reportable segment.

• For the Stores reportable segment, our net sales for the second quarter of fiscal 2012 increased $114 million, or 4 percent, compared with the prior year comparable period. The increase was primarily due to an increase in Comp store sales, excluding the associated comparable online sales, for the U.S. and Canada, incremental sales for new international stores, and higher franchise net sales; partially offset by the unfavorable impact of foreign exchange of $18 million. The foreign exchange impact is the translation impact if net sales for the second quarter of fiscal 2011 were translated at exchange rates applicable during the second quarter of fiscal 2012.

In the second quarter of fiscal 2012, our net sales for the U.S. and Canada (including Direct) were $3.0 billion, an increase of $153 million or 5 percent compared with $2.9 billion for the prior year comparable period. In the second quarter of fiscal 2012, our net sales outside of the U.S. and Canada (including Direct and franchise) were $551 million, an increase of $36 million or 7 percent compared with $515 million for the prior year comparable period.

Our net sales for the first half of fiscal 2012 increased $381 million, or 6 percent, compared with the prior year comparable period due to an increase in net sales of $244 million related to our Stores reportable segment and an increase in net sales of $137 million related to our Direct reportable segment.

• For the Stores reportable segment, our net sales for the first half of fiscal 2012 increased $244 million, or 4 percent, compared with the prior year comparable period. The increase was primarily due to an increase in Comp store sales, excluding the associated comparable online sales, for the U.S. and Canada, incremental sales for new international stores, and higher franchise net sales.

• For the Direct reportable segment, our net sales for the first half of fiscal 2012 increased $137 million, or 21 percent, compared with the prior year comparable period. The increase was due to growth in our online business across all brands and the incremental sales related to new Athleta stores.

In the first half of fiscal 2012, our net sales for the U.S. and Canada (including Direct) were $6.0 billion, an increase of $288 million or 5 percent compared with $5.7 billion for the prior year comparable period. In the first half of fiscal 2012, our net sales outside of the U.S. and Canada (including Direct and franchise) were $1.1 billion, an increase of $93 million or 10 percent compared with $969 million for the prior year comparable period.

Cost of Goods Sold and Occupancy Expenses



                                                    13 Weeks Ended                  26 Weeks Ended
                                               July 28,        July 30,        July 28,        July 30,
($ in millions)                                  2012            2011            2012            2011
Cost of goods sold and occupancy expenses     $    2,148      $    2,135      $    4,260      $    4,126
Gross profit                                  $    1,427      $    1,251      $    2,802      $    2,555
Cost of goods sold and occupancy expenses
as a percentage of net sales                        60.1 %          63.1 %          60.3 %          61.8 %
Gross margin                                        39.9 %          36.9 %          39.7 %          38.2 %

Cost of goods sold and occupancy expenses as a percentage of net sales decreased 3.0 percent in the second quarter of fiscal 2012 compared with the prior year comparable period.

• Cost of goods sold decreased 2.1 percent as a percentage of net sales in the second quarter of fiscal 2012 compared with the prior year comparable period. The decrease in cost of goods sold as a percentage of net sales was primarily due to improved product acceptance resulting in improved average unit selling price.

• Occupancy expenses decreased 0.9 percent as a percentage of net sales in the second quarter of fiscal 2012 compared with the prior year comparable period. The decrease in occupancy expenses as a percentage of net sales was primarily driven by higher net sales without a corresponding increase in occupancy expenses.

Cost of goods sold and occupancy expenses as a percentage of net sales decreased 1.5 percent in the first half of fiscal 2012 compared with the prior year comparable period.

• Cost of goods sold decreased 0.4 percent as a percentage of net sales in the first half of fiscal 2012 compared with the prior year comparable period. The decrease in cost of goods sold as a percentage of net sales was primarily driven by improved product acceptance resulting in improved average unit selling price partially offset by increased cost of merchandise primarily due to higher cotton prices.

• Occupancy expenses decreased 1.1 percent as a percentage of net sales in the first half of fiscal 2012 compared with the prior year comparable period. The decrease in occupancy expenses as a percentage of net sales was primarily driven by higher net sales and a decrease in occupancy expenses.

Operating Expenses




                                                  13 Weeks Ended                      26 Weeks Ended
                                            July 28,          July 30,          July 28,          July 30,
($ in millions)                               2012              2011              2012              2011
Operating expenses                         $    1,002        $      917        $    1,982        $    1,835
Operating expenses as a percentage of
net sales                                        28.0 %            27.1 %            28.1 %            27.5 %
Operating margin                                 11.9 %             9.9 %            11.6 %            10.8 %

. . .