Katrina O' Connell
Chief Financial Officer at GAP
Thank you, Richard. It's been a pleasure working with you in your role as a board member over the past nine months, and I'm thrilled to partner with you in your new role as CEO.
Let me start with some reflections on our financial performance before I dive into more detail. Notably, we continued to strengthen our balance sheet and improve cash flows, reducing inventory 29% year-over-year, generating over $300 million of free cash flow, further paying down our ABL balance and ending the quarter with cash and equivalents of $1.4 billion, nearly twice as much as last year. Even in a choppy consumer market, each of our brands maintained or gained share during the quarter, fueled particularly by strength in our women's business through great style and relevant fashion.
We delivered net sales within our previously communicated guidance range despite a weak apparel environment. We substantially completed the organizational changes that we previewed earlier this year, which we continue to expect will drive about $300 million in cost savings annually, but more importantly, will change how we work, allowing teams to be more consumer-centric. We continue to successfully recoup the excess air costs we incurred during the pandemic. That, combined with improved unit sell-through rates driving AURs enabled meaningful gross margin expansion despite the inflationary cost headwinds we have faced.
And we believe the actions to improve our operations and shore up the foundation of Gap Inc. continue to position us well as we enter the second half of fiscal 2023 and beyond. While we're pleased with this progress, we're mindful of the mixed economic and consumer environment in which we are operating. With that backdrop, we continue to plan the business prudently. And the outlook we're providing today for both the third quarter and fiscal 2023 does contemplate the headwinds we continue to navigate in the second half of the year while also taking on new challenges like the resumption of student loan payments.
Let me start now with our second quarter results. Net sales of $3.5 billion decreased 8% versus last year in the range of our expectations for second quarter sales to be down mid- to high single digits. Store sales decreased 7% from the prior year. Online sales decreased 11% versus last year and represented 33% of total net sales in the quarter.
As a reminder, the sale of Gap China completed at the beginning of the first quarter of fiscal 2023 had about a $60 million or 2-point negative impact to net sales growth. There was also a 1 point foreign exchange headwind. Excluding these factors, total company net sales would have been down about 5%. Comparable sales were down 6% in the quarter. In spite of the sales declines, we're pleased to report that all four of our brands gained or maintained market share during the second quarter, with particular strength in women's. We know that regardless of market conditions, strong brands, brands that matter, win. So, we remain focused on the levers and opportunities in our control to deliver on behalf of our customers, employees and shareholders.
Let me now provide some sales color and highlights by brand. Starting with Old Navy. Net sales in the second quarter were $1.96 billion. Both net sales and comparable sales declined 6% versus last year. We're pleased that Old Navy again modestly gained share in the quarter despite increased softness in the active category as well as continued slower demand from the lower-income consumer. We believe that Old Navy remains well positioned given its value orientation in the marketplace. The Old Navy team has lined up great marketing, product and value to compete in the important back-to-school season.
Turning to Gap brand. Gap brand total sales of $755 million were down 14% versus last year and comparable sales were down 1%. Excluding the negative impacts to sales of 7 points related to the sale of Gap China, 2 points due to the shutdown of Yeezy Gap and the estimated 1 point from foreign exchange, net sales were down 4% versus last year, predominantly driven by store closures in North America.
Women's was the standout segment in the quarter, outpacing the market as the brand's reinvented icons are resonating with consumers. Gap continues to make great strides with exciting collaborations and partnerships as the brand executes against its strategy to reimagine its product icons in new and exciting ways.
Earlier this month, Gap brand partnered with Love Shock fancy on a limited edition multi-category capsule for every generation. The collaboration merges Gap's iconic styles with Love shock fancies vintage-inspired florals and feminine silhouettes. This most recent collaboration is a prime example of how Gap strategy of partnering with relevant brands and individuals can create buzz and marketing for the brand, reaching new consumers and garnering more premium pricing.
Turning to Banana Republic. Second quarter sales of $480 million declined 11% year-over-year. Comparable sales were down 8%. Revenue remains impacted in the short term as the brand laps an outsized benefit last year, driven by the dramatic shift in customer preferences. BR continues to make impressive strides in its evolution to a premium lifestyle brand. Fine fabrics like linen, Kashmir [Phonetic] and leather showed signs of strength in the quarter, and the brand expects to maximize them in the back half of the year.
Banana Republic's transformation towards a more evolved lifestyle position is coming to life through an elevated fashion aesthetic and more full-price selling. As we look to the future, we're excited to see the brand extend its vision and refined aesthetic to other addressable markets with BR Home, including the launch of premium bedding, rugs, pillows and decor in March and the upcoming debut of a broader home offering this fall.
Athleta sales of $341 million declined 1% from the prior year. Comparable sales were down 7%, an improvement in trend from Q1. Sales and core performance bottoms, the critical backbone of Athleta's assortment accelerated throughout the quarter and outperformed total brand sales. Athleta positioning, empowering a community of active women and girls to reach their true potential through the power of she is as relevant and impactful as ever. The work the team has been doing to improve product presentation customer experience and creative in the short term, optimizing online marketing, site merchandising and resetting store floors in key markets, emphasizes the performance DNA that Athleta is known for.
We're really excited to welcome Chris Blakeley to the team. As a proven leader in driving growth and innovation in the active apparel and wellness sector, most recently at Allo Yoga, we look forward to the work he and the team will drive to bring the Athleta brand to its full potential over the long term.
Now turning to gross margin in the quarter. Gross margin was 37.6%, an increase of 310 basis points versus last year's reported gross margin. Compared to last year's adjusted rate, gross margin expanded 160 basis points due to merchandise margin expansion of approximately 260 basis points, which was slightly ahead of our expectations, partially offset by raw deleverage of 100 basis points.
Drivers of the margin rate expansion were as follows: approximately 200 basis points of leverage as we lap last year's elevated airfreight and drove our normalized air expense down. Approximately 200 basis points of leverage driven primarily from improved promotional activity relative to last year. Approximately 140 basis points of deleverage related to inflationary cost headwinds, which was better than our prior expectations of approximately 200 basis points as we realized improved ocean freight rates, and ROD was flat on a nominal basis compared to last year, but deleveraged 100 basis points due to the lower sales volume.
Now let me turn to SG&A. Reported SG&A in the second quarter was $1.2 billion and included $13 million in restructuring charges related to our headcount actions. On an adjusted basis, second quarter SG&A declined 8% and leveraged 10 basis points versus last year, driven mainly by lower advertising expense, payroll and technology investments.
Reported operating income was $106 million. Adjusted operating income, which excludes restructuring charges, was $119 million in the second quarter. Adjusted operating margin improved 170 basis points from last year to 3.4% in the quarter, driven by the 160 basis point improvement in adjusted gross margin and 10 basis points of adjusted SG&A leverage. During the second quarter, we recorded a benefit to both tax and net interest as a result of a transfer pricing settlement related to our sourcing activities. Reported EPS was $0.32, adjusted EPS, which excludes restructuring charges, was $0.34. Share count ended at $369 million.
Turning to balance sheet and cash flow, starting with inventory. Ending inventories declined 29% in second quarter versus last year. This includes a 9 percentage point decline related to in-transit as we lap the prior year supply chain challenges and 6 points of decline related to releasing the majority of our pack and hold inventory balance. The remaining 14-point decline was driven by more efficient inventory management.
As you know, we made significant progress on reducing inventories as we exited fiscal 2022. We remain focused in fiscal 2023 on moderating buys and utilizing our responsive levers. As a result, we are planning for year-over-year inventory to be down generally in line with year-to-date trends at the end of third quarter. Quarter-end cash and equivalents were $1.4 billion, an increase of 91% from the prior year.
Year-to-date net cash from operating activities was $528 million, driven primarily by lower inventory levels. Capital expenditures were $199 million. We are pleased to have generated free cash flow of $329 million year-to-date. As we told you last quarter, we expect to be positioned to pay down the $350 million draw on our asset-backed line of credit this year. During the quarter, we paid down $200 million and intend to pay down the remaining $150 million balance by the end of the year. We remain committed to delivering an attractive quarterly dividend as a core component of total shareholder returns. During the quarter, we paid a dividend of $0.15 per share. And on August 16, our Board approved maintaining that $0.15 dividend for the third quarter of fiscal 2023.
Now turning to our outlook. We are all well aware of the mixed economic data and uncertain consumer trends in the marketplace, including the new dynamic regarding student loan repayments beginning in the third quarter. As a result, we continue to be prudent in our approach to planning in light of what remains an uncertain macro environment and choppy consumer backdrop. We now anticipate fiscal 2023 net sales inclusive of the 53rd week to be down generally in the mid-single-digit range compared to $15.6 billion in net sales last year and similar to our first half 2023 sales performance. The extra week is estimated to add approximately $150 million to fourth quarter and fiscal 2023 net sales.
Specific to Q3 sales, we're encouraged by trend improvements as we exit second quarter and into August. However, we remain mindful of two important dynamics for the quarter: First, we are lapping tougher sales comparisons from last year; and second, as mentioned, we remain measured in our outlook. With these dynamics in mind, we are estimating third quarter net sales to be down in the low double-digit range compared to the $4.04 billion in net sales last year.
Turning to gross margin. Starting with the full year compared to the 35% adjusted gross margin in fiscal 2022, gross margin expansion in fiscal 2023 is expected to be driven by the following factors: an estimated 200 basis points of leverage as we lap last year's elevated air freight and continued to drive down normalized air expense, at least 100 basis points of margin benefit as a result of our better inventory position and expected improved promotional activity compared to last year. Approximately 10 basis points of inflationary cost deleverage versus last year.
As we look to the second half, we expect the inflationary deleverage in the first half of the year will shift to leverage in the back half as we benefit from both improved commodity costs and ocean freight rates. And ROD as a percentage of sales is now planned to deleverage roughly 70 basis points compared to last year.
For the third quarter, we expect gross margin to be generally in line with last year's adjusted gross margin of 38.7%. We anticipate lower inflation and air costs slightly below normalized levels are expected to offset approximately 150 basis points of ROD deleverage, and we expect that promotional activity will be largely in line with last year.
Turning to SG&A. We now expect fiscal 2023 SG&A of approximately $5.15 billion, below our prior outlook of $5.2 billion, primarily driven by variable expense flow through on our narrow to fiscal 2023 sales. SG&A in the third quarter is expected to be approximately $1.3 billion. We continue to expect capital expenditures of approximately $500 million to $525 million for the year.
In closing, we're pleased to drive meaningful margin expansion and strong cash flow generation in the quarter and remain focused on delivering our fiscal 2023 outlook despite what continues to be a choppy consumer environment. I'm looking forward to working with Richard and the team as we unlock the value of our important and iconic brands and position Gap Inc. back on its path towards sustainable, profitable growth and delivering value for our shareholders over the long term.
With that, we'll open up the call for questions. Operator?
