SECURITIES AND EXCHANGE COMMISSION 	Washington, D.C. 20549 	FORM 10-Q (Mark One) [ X ]		Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended August 1, 1998 or [ ]		Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from __________ to __________ Commission File Number 1-7562 	THE GAP, INC. 	(Exact name of registrant as specified in its charter) Delaware 94-1697231 (State of Incorporation) (I.R.S. Employer Identification No.) 	One Harrison 	San Francisco, California 94105 	(Address of principal executive offices) 	Registrant's telephone number, including area code: (415) 952-4400 	_______________________ 	Securities registered pursuant to Section 12(b) of the Act: Common Stock, $0.05 par value 		 New York Stock Exchange, Inc. (Title of class) Pacific Stock Exchange, Inc. (Name of each exchange where registered) 	Securities registered pursuant to Section 12(g) of the Act: None 	_______________________ 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 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, 386,317,796 shares as of August 28, 1998 GAP INC. PART 1 CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited) (in thousands, except par value) August 1, January 31, August 2, 1998 1998 1997 ASSETS Current Assets: Cash and equivalents $ 515,207 $ 913,169 $ 220,148 Short-term investments 29,532 - 37,454 Merchandise inventory 1,102,693 733,174 791,925 Prepaid expenses and other current asset 186,589 184,604 151,562 Total Current Assets 1,834,021 1,830,947 1,201,089 Property and equipment, net 1,576,440 1,365,246 1,234,384 Long-term investments - - 5,465 Lease rights and other assets 172,688 141,309 135,811 Total Assets $ 3,583,149 $ 3,337,502 $ 2,576,749 LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities: Notes payable $ 93,006 $ 84,794 $ 90,245 Accounts payable 530,275 416,976 384,464 Accrued expenses 585,159 389,412 264,499 Income taxes payable 43,955 83,597 31,402 Deferred lease credits and 12,585 16,769 11,905 and other current liabilities Total Current Liabilities 1,264,980 991,548 782,515 Long-term Liabilities: Long-term debt 496,250 496,044 - Deferred lease credits and 292,620 265,924 234,273 other liabilities Total Long-Term Liabilities 788,870 761,968 234,273 Shareholders' Equity: Common stock $.05 par value Authorized 1,500,000 shares Issued 441,701, 439,923 and 477,842 shares Outstanding 388,270, 393,133 and 402,068 shares 22,085 21,996 23,892 Additional paid-in capital 406,656 317,674 469,089 Retained earnings 2,626,800 2,392,750 2,051,955 Foreign currency translation adjustment (16,980) (15,230) (6,490) Deferred compensation (34,365) (38,167) (38,068) Treasury stock, at cost (1,474,897) (1,095,037) (940,417) Total Shareholders' Equity 1,529,299 1,583,986 1,559,961 Total Liabilities and $ 3,583,149 $ 3,337,502 $ 2,576,749 Shareholders' Equity See accompanying notes to condensed consolidated financial statements. GAP INC. CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS Unaudited Thirteen Weeks Ended Twenty-six Weeks Ended ($000 except per share amounts) August 1, August 2, August 1, August 2, 1998 1997 1998 1997 Net sales $1,904,970 $ 1,345,221 $ 3,624,682 $ 2,576,407 Costs and expenses Cost of goods sold and 1,135,165 883,086 2,166,169 1,672,212 occupancy expenses Operating expenses 550,128 352,462 1,022,272 664,373 Net interest (income)/expense 678 (1,459) (463) (6,197) Earnings before income taxes 218,999 111,132 436,704 246,019 Income taxes 82,125 41,674 163,764 92,257 Net earnings $ 136,874 $ 69,458 $ 272,940 $ 153,762 Weighted average number of 388,632,895 398,414,470 388,641,885 400,613,268 shares - basic Weighted average number of 406,472,605 410,092,007 405,811,066 411,872,378 shares - diluted Earnings per share - basic $ 0.35 $ 0.17 $ 0.70 $ 0.38 Earnings per share - diluted $ 0.34 $ 0.17 $ 0.67 $ 0.37 Cash dividends per share $ 0.05 $ 0.05 $ 0.10 $ 0.10 See accompanying notes to condensed consolidated financial statements. GAP INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Unaudited ($000) Twenty-six Weeks Ended August 1, 1998 August 2, 1997 Cash Flows from Operating Activities: Net earnings $ 272,940 $ 153,762 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization (a) 152,524 126,540 Tax benefit from exercise of stock options by employees and from vesting of restricted stock 56,012 12,707 Change in operating assets and liabilities: Merchandise inventory (371,397) (213,821) Prepaid expenses and other (5,858) (25,251) Accounts payable 115,212 36,366 Accrued expenses 196,461 (17,525) Income taxes payable (39,708) (60,321) Deferred lease credits and other long-term liabilities 18,248 36,310 Net cash provided by operating activities 394,434 48,767 Cash Flows from Investing Activities: Net (purchase)/proceeds from maturity of (29,532) 137,263 short-term investments Net purchase of long-term investments - (8,378) Net purchase of property and equipment (349,025) (211,383) Acquisition of lease rights and other assets (31,420) (10,681) Net cash used for investing activities (409,977) (93,179) Cash Flows from Financing Activities: Net increase in notes payable 10,761 50,279 Issuance of common stock 26,766 20,782 Net purchase of treasury stock (379,860) (251,616) Cash dividends paid (38,890) (40,160) Net cash used for financing activities (381,223) (220,715) Effect of exchange rate changes on cash (1,196) (369) Net decrease in cash and equivalents (397,962) (265,496) Cash and equivalents at beginning of year 913,169 485,644 Cash and equivalents at end of quarter $ 515,207 $ 220,148 See accompanying notes to condensed consolidated financial statements. (a) Includes amortization of restricted stock, discounted stock options and discount on long-term debt. GAP INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. BASIS OF PRESENTATION The condensed consolidated balance sheets as of August 1, 1998 and August 2, 1997 and the interim condensed consolidated statements of earnings for the thirteen and twenty-six weeks ended August 1, 1998 and August 2, 1997 and cash flows for the twenty-six week periods ended August 1, 1998 and August 2, 1997 have been prepared by the Company, without audit. In the opinion of management, such statements include all adjustments (which include only normal recurring adjustments) considered necessary to present fairly the financial position, results of operations and cash flows of the Company at August 1, 1998 and August 2, 1997, and for all periods presented. Certain information and footnote disclosures normally included in the annual financial statements prepared in accordance with generally accepted accounting principles have been omitted from these interim financial statements. It is suggested that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended January 31, 1998. The condensed consolidated balance sheet as of January 31, 1998 was derived from the Company's January 31, 1998 balance sheet included in the 1997 Annual Report. The results of operations for the twenty-six weeks ended August 1, 1998 are not necessarily indicative of the operating results that may be expected for the year ending January 30, 1999. 2. COMPREHENSIVE EARNINGS During the first quarter of fiscal 1998, the Company adopted Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income. This Statement requires that all components of comprehensive earnings be reported prominently in the financial statements. For the Company, other comprehensive earnings includes only foreign currency translation adjustments. Total comprehensive earnings for the thirteen and twenty-six weeks ended August 1, 1998 and August 2, 1997 were as follows (in thousands): Thirteen Thirteen Twenty-six Twenty-six Weeks Ended Weeks Ended Weeks Ended Weeks Ended August 1, August 2, August 1, August 2, 1998 1997 1998 1997 Net earnings $136,874 $69,458 $272,940 $153,762 Foreign currency translation adjustments (4,258) 826 (1,750) (1,303) Total comprehensive earnings $132,616 $70,284 $271,190 $152,459 3. FINANCIAL INSTRUMENTS The Company enters into foreign exchange contracts to reduce exposure to foreign currency exchange risk. These contracts are primarily designated and effective as hedges of commitments to purchase merchandise. The market value gains and losses on these contracts are deferred and recognized as part of the underlying cost to purchase the merchandise. At the end of the second quarter, the Company held various put option contracts to repurchase up to 1,800,000 shares of Gap stock. The contracts have exercise prices ranging from $38.37 to $60.00, with expiration dates ranging from August 1998 through December 1998. 4. EARNINGS PER SHARE Under SFAS No. 128, the Company provides dual presentation of EPS on a basic and diluted basis. The Company's granting of certain stock options and restricted stock resulted in potential dilution of basic EPS. The following summarizes the effects of the assumed issuance of dilutive securities on weighted-average shares for basic EPS. Thirteen Thirteen Twenty-six Twenty-six Weeks Ended Weeks Ended Weeks Ended Weeks Ended August 1, August 2, August 1, August 2, 1998 1997 1998 1997 Weighted-average number of shares - basic 388,632,895 398,414,470 388,641,885 400,613,268 Incremental shares from assumed issuance of: Stock options 15,765,710 7,771,360 14,411,689 6,933,917 Restricted stock 2,074,000 3,906,177 2,757,492 4,325,193 Weighted-average number of shares - diluted 406,472,605 410,092,007 405,811,066 411,872,378 The number of incremental shares from the assumed issuance of stock options and restricted stock is calculated applying the treasury stock method. Excluded from the above computation of weighted-average shares for diluted EPS were options to purchase 752,396 and 1,337,356 shares of common stock during the thirteen and twenty-six weeks ended August 1, 1998 respectively, and 7,912 and 89,995 shares during the thirteen and twenty-six weeks ended August 2, 1997, respectively. Issuance of these securities would have resulted in an antidilutive effect on EPS. Deloitte & Touche Deloitte & Touche LLP Telephone: (415)247-4000 50 Fremont Street Facsimile: (415)247-4329 San Francisco, California 94105-2230 INDEPENDENT ACCOUNTANTS' REPORT To the Board of Directors and Stockholders of The Gap, Inc.: We have reviewed the accompanying condensed consolidated balance sheets of The Gap, Inc. and subsidiaries as of August 1, 1998 and August 2, 1997 and the related condensed consolidated statements of earnings for the thirteen and twenty-six week periods ended August 1, 1998 and August 2, 1997 and condensed consolidated statements of cash flows for the twenty-six week periods ended August 1, 1998 and August 2, 1997. These financial statements are the responsibility of the Company's management. We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and of making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to such consolidated financial statements for them to be in conformity with generally accepted accounting principles. We have previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheet of The Gap, Inc. and subsidiaries as of January 31, 1998, and the related consolidated statements of earnings, stockholders' equity and cash flows for the year then ended (not presented herein); and in our report dated February 27, 1998, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of January 31, 1998 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it was derived. /s/ Deloitte & Touche LLP August 11, 1998 GAP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The information below contains certain forward-looking statements which reflect the current view of Gap Inc. (the "Company") with respect to future events and financial performance. Wherever used, the words "expect," "plan," "anticipate," "believe," and similar expressions identify forward-looking statements. Any such forward-looking statements are subject to risks and uncertainties that could cause the Company's actual results of operations to differ materially from historical results or current expectations. Some of these risks include, without limitation, ongoing competitive pressures in the apparel industry, risks associated with challenging international retail environments, changes in the level of consumer spending or preferences in apparel, trade restrictions and political or financial instability in countries where the Company's goods are manufactured and/or disruption to operations from Year 2000 issues, and other factors that may be described in the Company's Annual Report on Form 10-K and/or other filings with the Securities and Exchange Commission. Future economic and industry trends that could potentially impact revenues and profitability remain difficult to predict. It is suggested that this document be read in conjunction with the Management's Discussion and Analysis included in the Company's 1997 Annual Report on Form 10-K and in subsequent Forms 10-Q. The Company does not undertake to publicly update or revise its forward- looking statements even if experience or future changes make it clear that any projected results expressed or implied therein will not be realized. RESULTS OF OPERATIONS Net Sales Thirteen Weeks Ended Twenty-six Weeks Ended August 1, August 2, August 1, August 2, 1998 1997 1998 1997 Net sales ($000) 1,904,970 1,345,221 3,624,682 2,576,407 Total net sales growth percentage 42 20 41 15 Comparable store sales growth percentage 19 4 18 0 Net sales per average square foot ($) 116 99 225 194 Square footage of gross store space at period end (000) 16,799 13,750 N/A N/A Fifty-two Fifty-two Weeks Ended Weeks Ended August 1, 1998 August 2, 1997 Number of New stores 304 254 Expanded stores 135 56 Closed stores 16 27 The increases in net sales for the second quarter and the first half of 1998 over the same periods last year were primarily attributable to the increase in retail selling space, both through the opening of new stores (net of stores closed) and the expansion of existing stores, as well as to the increase in comparable store sales. The increases in net sales per average square foot were primarily attributable to the increases in comparable store sales. Cost of Goods Sold and Occupancy Expenses Cost of goods sold and occupancy expenses as a percentage of net sales decreased 6.0 and 5.1 percentage points in the second quarter and first half of 1998, respectively, from the same periods in 1997. The decreases were driven by increased merchandise margins and decreased occupancy expenses as a percentage of sales. Merchandise margins improved due to increased regular price selling and greater margins achieved on marked down goods. For both the second quarter and first half of 1998, the decreases in occupancy expenses as a percentage of net sales were primarily driven by leverage achieved through the growth in comparable store sales and total sales growth. As a general business practice, the Company reviews its inventory levels in order to identify slow-moving merchandise and broken assortments (items no longer in stock in a sufficient range of sizes) and uses markdowns to clear merchandise. Such markdowns may have an adverse impact on earnings depending upon the extent of the markdowns and amount of inventory affected. Operating Expenses Operating expenses as a percentage of net sales increased 2.7 and 2.4 percentage points for the second quarter and the first half of 1998, respectively, from the comparable periods in 1997. The increases were driven by significantly higher advertising/marketing costs as part of the Company's brand development efforts. These were partially offset by leverage from comparable store sales growth and total sales growth. Net Interest Income/Expense Net interest expense increased in the second quarter from the same period last year, and net interest income decreased in the first half of 1998 from the same period last year, primarily due to the interest expense related to the long-term debt securities issued in the third quarter of fiscal 1997. The interest expense was offset partially by greater interest income resulting from an increase in both average investments and the average investment interest rate. Income Taxes The effective tax rate was 37.5 percent for the first half of 1998 and 1997. LIQUIDITY AND CAPITAL RESOURCES The following sets forth certain measures of the Company's liquidity: Twenty-six Weeks Ended August 1, 1998 August 2, 1997 Cash provided by operating activities ($000) 394,434 48,767 Working capital ($000) 569,041 418,574 Current ratio 1.45:1 1.53:1 For the twenty-six weeks ended August 1, 1998, the increase in cash flows provided by operating activities was primarily attributable to the timing of certain payables and an increase in net earnings, partially offset by purchases of merchandise inventory. The Company funds inventory expenditures during normal and peak periods through a combination of cash flows provided by operations and normal trade credit arrangements. The Company's business follows a seasonal pattern, peaking over a total of about ten to twelve weeks during the Back-to-School and Holiday periods. The Company has committed credit facilities totaling $950 million, consisting of an $800 million, 364-day revolving credit facility, and a $150 million, 5-year revolving credit facility through June 30, 2002. These credit facilities provide for the issuance of up to $450 million in letters of credit. The Company has additional uncommitted credit facilities of $400 million for the issuance of letters of credit. At August 1, 1998, the Company had outstanding letters of credit of approximately $764 million. To provide financial flexibility, the Company issued $500 million of 6.9 percent, 10-year debt securities in fiscal 1997. The proceeds from this issuance are being used for general corporate purposes, including store expansion, brand investment, development of additional distribution channels and repurchases of the Company's common stock pursuant to its ongoing repurchase program. For the twenty-six weeks ended August 1, 1998, capital expenditures, net of construction allowances and dispositions, totaled approximately $343 million. These expenditures resulted in a net increase in store space of approximately 1.5 million square feet or 10 percent due to the addition of 147 new stores, the expansion of 73 stores, and the remodeling of certain stores. For 1998, the Company expects capital expenditures to exceed $700 million, net of construction allowances. This represents the addition of 300 to 350 new stores, the expansion of approximately 100 stores, the remodeling of certain stores, as well as amounts for headquarters facilities, distribution centers, equipment, and a catalog facility for the Banana Republic division. The Company expects to fund these capital expenditures with cash flow from operations and other sources of financing. New stores are generally expected to be leased. To further support its growth, the Company acquired land in San Francisco and additional land in San Bruno on which to construct additional headquarter facilities. During 1997 the Company commenced construction on a distribution center for an estimated cost at completion of $60 million. The majority of the expenditures for this facility will be incurred this fiscal year and is thus included in the projected capital expenditures above. The facility is expected to begin operations in early 1999. Under the Company's 45 million share repurchase program, the Company acquired 7 million shares for approximately $391 million during the first half of 1998. To date under this program, 35.2 million shares have been repurchased for approximately $1.1 billion. During the first half of 1998, the Company entered into various put option contracts in connection with the share repurchase program to hedge against stock price fluctuations. The Company also continued to enter into foreign exchange forward contracts to reduce exposure to foreign currency exchange risk involved in its commitments to purchase merchandise for foreign operations. Additional information on these contracts and agreements is presented in the Notes to Condensed Consolidated Financial Statements (Note 3). YEAR 2000 ISSUE The Year 2000 issue is primarily the result of computer programs using a two-digit format, as opposed to four digits, to indicate the year. Such computer systems will be unable to interpret dates beyond the year 1999, which could cause a system failure or other computer errors, leading to a disruption in the operation of such systems. In 1996, the Company established a project team to coordinate existing Year 2000 activities and address remaining Year 2000 issues. The team has focused its efforts on three areas: (1) information systems software and hardware; (2) facilities and distribution equipment; and (3) third-party relationships. The Program. The Company has adopted a five-phase Year 2000 program consisting of: Phase I -- identification and ranking of the components of the Company's systems, equipment and suppliers that may be vulnerable to Year 2000 problems; Phase II -- assessment of items identified in Phase I; Phase III -- remediation or replacement of non-compliant systems and components and determination of solutions for non-compliant suppliers; Phase IV -- testing of systems and components following remediation; and Phase V -- developing contingency plans to address the most reasonably likely worst case Year 2000 scenarios. The Company has completed Phase I, has made substantial progress on Phases II, III and IV, and is beginning Phase V. Information Systems Software and Hardware. The Company has completed Phase II and has made substantial progress in Phase III. Phase IV testing is being conducted concurrently with Phase III activities. The Company is on track to complete remediation, testing and implementation of its individual information systems by mid-1999. Facilities and Distribution Equipment. The Company has made substantial progress on Phase II scheduled for completion by the end of 1998. Third-Party Relationships. The Company has substantially completed Phase II and is actively working on Phase III. Risks / Contingency Plans. Based on the assessment efforts to date, the Company does not believe that the Year 2000 issue will have a material adverse effect on its financial condition or results of operations. The Company operates a large number of geographically dispersed stores and has a large supplier base and believes that this will mitigate any adverse impact. The Company's beliefs and expectations, however, are based on certain assumptions and expectations that ultimately may prove to be inaccurate. The Company believes that by the end of 1998, it will be able to fully determine its most reasonably likely worst case scenarios. Potential sources of risk include (a) the inability of principal suppliers to be Year 2000 ready, which could result in delays in product deliveries from such suppliers, and (b) disruption of the distribution channel, including ports, transportation vendors, and the Company's own distribution centers as a result of a general failure of systems and necessary infrastructure such as electricity supply. Phase V contingency plan development is in process. The Company does not expect the costs associated with its Year 2000 efforts to be substantial. Less than $30 million has been allocated to address the Year 2000 issue, of which $8.5 million has been incurred through August 1, 1998. The Company's aggregate cost estimate does not include time and costs that may be incurred by the Company as a result of the failure of any third parties, including suppliers, to become Year 2000 ready or costs to implement any contingency plans. Item 3. Quantitative and Qualitative Disclosures About Market Risk The market risk of the Company's financial instruments as of August 1, 1998 has not significantly changed since January 31, 1998. The market risk profile on January 31, 1998 is disclosed in the Company's 1997 Annual Report. PART II OTHER INFORMATION Item 5. Other Information In accordance with Rule 14a-4(c)(1) promulgated by the Securities and Exchange Commission, management proxies intend to use their discretionary voting authority with respect to any shareholder proposal raised at the Company's annual meeting as to which the proponent fails to notify the Company on or before February 20, 1999 (45 days prior to the date on which the proxy statement for the Company's prior year's annual meeting was mailed to shareholders). Item 6. Exhibits and Reports on Form 8-K a) Exhibits (15) Letter re: Unaudited Interim Financial Information (27) Financial Data Schedule b) The Company did not file any reports on Form 8-K during the three months ended August 1, 1998. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. THE GAP, INC. Date: September 4, 1998 By /s/ Warren R. Hashagen Warren R. Hashagen Chief Financial Officer (Principal financial officer of the registrant) Date: September 4, 1998 By /s/ Millard S. Drexler Millard S. Drexler President and Chief Executive Officer EXHIBIT INDEX (15) Letter re: Unaudited Interim Financial Information (27) Financial Data Schedule