SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended May 3, 2003 or

For the transition period fromto

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

Securities registered pursuant to Section 12(b) of the Act:

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 by check mark whether Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    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, 890,601,385895,834,143 shares as of May 27,December 2, 2003

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 OPERATIONS

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

(c)	Includes a dividend of $0.02 per share declared in first quarter of fiscal 2003 but paid in second quarter of fiscal 2003.

(d)	Includes a dividend of $0.02 per share declared in second quarter of fiscal 2003 but paid in third quarter of fiscal 2003.

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THE GAP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

(a)	See Note 2 and Note 5.

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THE GAP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.BASIS OF PRESENTATION

The condensed consolidated balance sheets as of May 3,November 1, 2003 and May 4,November 2, 2002 and the interim condensed consolidated statements of operations for the thirteen and thirty-nine week periods ended November 1, 2003 and November 2, 2002 and cash flows for the thirteen weeksthirty-nine week periods ended May 3,November 1, 2003 and May 4,November 2, 2002 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 May 3,November 1, 2003 and May 4,November 2, 2002 and for all periods presented.

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 February 1, 2003.

Certain amounts from the prior periods have been reclassified to conform to the current period presentation. These reclassifications had no effect on net earnings as previously reported.

The results of operations for the thirteen weeksand thirty-nine week periods ended May 3,November 1, 2003 are not necessarily indicative of the operating results that may be expected for the year ending January 31, 2004.

2.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

For a description of our significant accounting policies, see Note A to the Consolidated Financial Statements included in Form 10-K for the year ended February 1, 2003. Additional information regarding our significant accounting policies is set forth below.

Restricted Cash

Restricted cash represents the restriction of cash that backs our letter of credit agreements and other cash which is restricted from withdrawal for use. As of November 1, 2003 restricted cash represents the restriction of $1.24 billion of cash that backs our letter of credit agreements and $118 million of other cash which is restricted from withdrawal for use. Restricted cash classified in Current Assets on the Condensed Consolidated Balance Sheet totaled $1.35 billion as of November 1, 2003.

Stock-based Awards

Statement of Financial Accounting Standards No. 148 (“SFAS 148”), “Accounting for Stock-Based Compensation — Transition and Disclosure an Amendment of FASB Statement No. 123”, amends the disclosure requirements of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), to require more prominent disclosures in both annual and interim financial statements regarding the method of accounting for stock-based employee compensation and the effect of the method used on reported results.

We account for stock-based awards to employees and directors using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees”. Under the intrinsic value method, when the exercise price of an employee stock option is equal to the market price of the underlying stock on the date of grant, no compensation expense is recognized in the Condensed Consolidated Statements of Operations. For restricted stock

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and discounted stock option awards, which are granted at a price less than fair market value, we recognize deferred compensation. Deferred compensation is shown as a reduction of shareholders’ equity and is amortized to operating expenses over the vesting period of the stock award. We amortize deferred compensation for each vesting layer of a stock award using the straight-line method.

We have adopted the disclosure provisions required under SFAS 148, to disclose pro forma information regarding the effect on net earnings and earnings per share as if we had applied the fair-value recognition provisions of SFAS 123. The following table illustrates the pro forma information required:

3.NEW ACCOUNTING PRONOUNCEMENTS

During January 2003, the Financial Accounting Standards Board (“FASB”) issued Financial Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities”. FIN 46 requires that if an entity has a controlling financial interest in a variable interest entity, the assets, liabilities and results of activities of the variable interest entity should be included in the consolidated financial statements of the entity. The provisions of FIN 46 requires that its provisions are effective immediately for all arrangements entered into after January 31, 2003. For anythose arrangements entered into prior to January 31,February 1, 2003, the provisions of FIN 46 provisions arewere required to be adopted at the beginning of the first interim or annual period beginning after June 15, 2003. However, in October 2003, the FASB deferred the effective date of FIN 46 to the end of the first interim or annual period ending after December 15, 2003 for those arrangements entered into prior to February 1, 2003. The adoption of FIN 46 did not have anany impact on our operating results or financial position as we do not have any variable interest entities.

During June 2001, the FASB issued Statement of Financial Accounting Standards No. 143 (“SFAS 143”), “Accounting for Asset Retirement Obligations,” which is effective for fiscal years beginning after June 2002. SFAS 143 addresses the financial accounting and reporting for obligations and retirement costs related to the retirement of tangible long-lived assets. The adoption of SFAS 143 did not have a significant impact on our operating results or financial position.

During December 2002, the FASB issued Statement of Financial Accounting Standards No. 148 (“SFAS 148”), “Accounting for Stock-Based Compensation—Transition and Disclosure an Amendment of FASB Statement No. 123”. SFAS 148 amends SFAS 123 to provide alternative methods of transition for a voluntary change to the fair value-based method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require more prominent disclosures in both annual and interim financial statements regarding the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The alternative methods of transition of SFAS 148 are effective for fiscal years ending after December 15, 2002. We adopted the disclosure provision of SFAS 148 and will continue to follow APB 25 in accounting for our employee stock options. See Note 3, “Stock-Based Awards,” for these expanded disclosures. The adoption of SFAS 148 didposition because we do not have any impact on our operating results or financial position.significant asset retirement obligations.

During April 2003, the FASB issued Statement of Financial Accounting Standards No. 149 (“SFAS 149”), “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”. SFAS 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133. SFAS 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The guidance should be applied prospectively. We do not expect theThe adoption of SFAS 149 todid not have a significantany impact on our operating results or financial position.position as we do not have any derivative instruments that are affected by FAS 149.

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During May 2003, the FASB issued Statement of Financial Accounting Standards No. 150 (“SFAS 150”), “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. SFAS 150 clarifies the accounting for certain financial instruments with characteristics of both liabilities and equity and requires that those instruments be classified as liabilities in statements of financial position. Previously, many of those financial instruments were classified as equity. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003 and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. We do not expect theThe adoption of SFAS 150 todid not have a significantany impact on our operating results or financial position.position as we do not have any financial instruments with characteristics of both liabilities and equity that are not already classified as liabilities.

We account for stock-based awards to employees and directors using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees”. Under the intrinsic value method, when the exercise price of employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized in the consolidated statements of operations. Restricted stock and discounted stock option awards, which are granted at less than fair market value, result in the recognition of deferred compensation. Deferred compensation is shown as a reduction of shareholders’ equity and is amortized to operating expenses over the vesting period of the stock award. We amortize deferred compensation for each vesting layer of a stock award using the straight-line method.4.COMPREHENSIVE EARNINGS

Based on the additional disclosure requirements under SFAS 148 the following table is a reconciliation of net earnings and earnings per share had we adopted the fair value recognition provisions of SFAS 123.

Comprehensive earnings include net earnings and other comprehensive earnings. Other comprehensive earnings include foreign currency translation adjustments and fluctuations in the fair market value of certain derivative financial instruments. Comprehensive earnings for the thirteen and thirty-nine weeks ended May 3,November 1, 2003 and May 4,November 2, 2002 were as follows:

On May 1,5.DEBT AND OTHER CREDIT ARRANGEMENTS

In June 2003, $500we replaced our existing $1.4 billion secured two-year credit facility scheduled to expire in March 2004 with a new three-year secured $750 million aggregate principalrevolving credit facility (the “new Facility”). In addition, we executed agreements securing $1.2 billion in letter of credit issuing capacity. The letter of credit agreements also have three-year terms and are secured by approximately $1.24 billion in cash, which is included in restricted cash on our Condensed Consolidated Balance Sheet. The new Facility is available for general corporate purposes. The fees related to the new Facility fluctuate based on our long-term senior unsecured credit ratings and our leverage ratio.

The new Facility contains financial and other covenants, including, but not limited to, limitations on capital expenditures, liens and cash dividends and maintenance of certain financial ratios, including a fixed charge coverage ratio and a leverage ratio. The letter of credit agreements contain a fixed charge coverage ratio, which is more lenient than the ratio in the new Facility. Violation of these covenants could result in a default under the new Facility and letter of credit agreements, which default would permit the participating banks to restrict our ability to further access the new Facility for letters of credit and advances, terminate our ability to request letters of credit pursuant to the letter of credit agreements and require the immediate repayment of any outstanding advances under the new Facility. In addition, such a default could, under certain circumstances, permit the holders of our outstanding unsecured debt to accelerate payment of such obligations.

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Letters of credit represent a payment undertaking guaranteed by a bank on our behalf to pay the vendor a given amount of debt securities with a fixed annual interest ratemoney upon presentation of 5.625 percent, was repaid.specific documents demonstrating that merchandise has shipped. Vendor payables are recorded in the balance sheet at the time of merchandise title transfer, although the letters of credit are generally issued prior to this.

As of May 3,November 1, 2003, we had $659$715 million in trade letters of credit issued under our $1.4 billion secured two-yearletter of credit agreements. There were no drawings under the $750 million revolving credit facility.

6.EARNINGS PER SHARE

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 shares of restricted stock, calculated using the treasury stock method, and convertible notes which are potentially dilutive at certain earnings levels, and are computed 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 were options to purchase 37,938,095 and 77,667,536 shares of common stock and 3,750 and 109,213 shares of unvested restricted stock during the thirteen weeks ended May 3, 2003 and May 4, 2002, respectively. The calculation above also excludes senior convertible notes which are convertible to 85,607,940 shares of common stock during the thirteen weeks ended May 4, 2002 because their inclusion would have an anti-dilutive effect on earnings per share.

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7.EXCESS FACILITIES AND SUBLEASE LOSS CHARGES

During 2001, as a result of the rationalization of our global distribution center network, we announced plans to close distribution facilities located in Erlanger, Kentucky (“Erlanger”), Basildon, England (“Basildon”), and Roosendaal, Holland (“Roosendaal”). We lease the Erlanger and Basildon facilities and we own the Roosendaal facility. The closure of the Basildon facility was completed byclosed during the first quarter of fiscal 2002, the Roosendaal facility was closed during the second quarter of fiscal 2002 and the Erlanger facility was closed during the third quarter of fiscal 2002. We lease the Erlanger and Basildon facilities, and we own the Roosendaal facility.

The Roosendaal facility, including land and building, is currently on the market for sale. The total carrying value of the remaining land and building as of November 1, 2003 was $3.0 million. Our lease associated with the Erlanger facility expired in February 2003, and the lease associated with the Basildon facility expired in October 2003.

Facilities-related charges associated with the Erlanger facility and the Basildon facilitydistribution center closures include costs associated with lease terminations, facilities restoration and equipment removal. Our lease associated with the Erlanger facility expired during February 2003 and the lease associated with the Basildon facility will expire in October 2003. Remaining cash expenditures of $1.3$0.2 million associated with facility closures as of May 3,November 1, 2003 are expected to be paid byin the fourth quarter of fiscal 2003.

The land and building of the distribution center in Roosendaal, Holland, is classified as held for sale in accordance with Statement of Financial Accounting Standards No. 144 (“SFAS 144”), “Accounting for the Impairment or Disposal of Long-Lived Assets”. In fiscal 2002, we recorded an impairment charge of $1.0 million to reduce the net book value of the facility to the estimated net selling price. During the first quarter of fiscal 2003 we sold a portion of the land adjacent to the Roosendaal facility. The total carrying value of the remaining land and building as of May 3, 2003 was $6.6 million.

During 2001, we consolidated and downsized headquarters facilities in our San Francisco and San Bruno campuses as part of our cost containment efforts. We identified 361,383 square feet of excess facility space and recorded charges of $47.3 million duringin fiscal 2001, which primarily related to the difference between our contract rent obligations and the rate at which we expected to be able to sublease the properties. In2001. During 2002, based on a review of real estate market conditions we revised our sublease income and sublease commencement projections and assumptions. Additionally, in 2002, we considered our corporate facilities space needs and identified additional excess facility space of 193,228 square feet. As a result of these actions, we recorded an additional sublease loss charge of $77.4 million in fiscal 2002.

Our sublease loss charges primarily relate to the net present value of the difference between the contract rent obligations and the rate at which we expected to be able to sublease the properties. In the third quarter of fiscal 2003, based on the status of our efforts to lease vacant office space including a review of real estate market conditions we revised our sublease projections and recorded an additional sublease loss charge of $8.5 million. In addition, for year-to-date fiscal 2003 we recorded accretion of $0.6 million of interest for total adjustments to our provision of $9.1 million. The additional sublease loss charge was recorded in operating expenses onin our condensed consolidated statement of operations. Remaining cash expenditures associated with the sublease loss reserve are expected to be paid over the remaining various lease terms through 2017. Based on theour current assumptions set forth above as of May 3,November 1, 2003, we expect the sublease of our excess facilities to result in a total reduction of approximately $284$112 million in future rent expense and $112 million in$273 millionin cash savings over the various remaining lease terms through 2017.

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The above excess facility and sublease loss charges and future rent and cash savings are based on estimates that are subject to change.

8.INCOME TAXES

The effective tax rate was 39.0 percent and 49.047.0 percent for the first quarterthirty-nine weeks of fiscal 2003 and 2002, respectively. The decrease in tax rate was primarily driven by an improvement in the mix of earnings infrom domestic and international operations and improved earnings performance.

As a result of our improved operating performance in the third quarter of fiscal 2002, we reduced our effective tax rate from 49 percent to 47 percent for the thirty-nine week period ended 2002. The adjusted tax rate was based on our assessment of estimated full year earnings and the mix of earnings. The impact of the reduction on third quarter 2002 results was $0.01 per share. This included $5.0 million for the two-percentage point rate change on third quarter earnings and a $3.7 million tax expense reduction to bring the first-half tax rate of 2002 from 49 percent to 47 percent.

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Deloitte & Touche LLP

50 Fremont Street

San Francisco, California 94105-2230

Tel: (415) 783-4000

Fax: (415) 783-4329

www.deloitte.com

INDEPENDENT ACCOUNTANTS’ REPORT

To the Board of Directors and Shareholders of

The Gap, Inc.:

We have reviewed the accompanying condensed consolidated balance sheets of The Gap, Inc. and subsidiaries as of May 3,November 1, 2003 and May 4,November 2, 2002, and the related condensed consolidated statements of operations for the thirteen and thirty-nine week periods ended November 1, 2003 and November 2, 2002, and the condensed consolidated statements of cash flows for the thirteenthirty-nine week periods ended May 3,November 1, 2003 and May 4,November 2, 2002. These interim 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 auditing standards generally accepted in the United States of America, 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 condensed consolidated financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

We have previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet of The Gap, Inc. and subsidiaries as of February 1, 2003, and the related consolidated statements of operations, shareholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated March 7, 2003, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of February 1, 2003 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ DELOITTEDeloitte & TOUCHETouche LLP

San Francisco, California

May 23,December 4, 2003

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THE GAP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The information in this quarterly report on Form 10-Q contains certain forward-looking statements whichthat reflect the current view of The Gap, Inc. (the “Company”, “we” and “our”) with respect to future events and financial performance. Wherever used, the words “expect,” “plan,” “anticipate,” “believe,” “may” and similar expressions identify forward-looking statements.

Any such forward-looking statements are subject to risks and uncertainties, and our future results of operations could 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 domestic and international retail environments, changes in the level of consumer spending or preferences in apparel, trade restrictions and political or financial instability in countries where our goods are manufactured, impact of legal proceedings, and/or other factors that may be described in our 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 are difficult to predict.

We suggest that this document is read in conjunction with the Management’s Discussion and Analysis included in our Annual Report on Form 10-K for the fiscal year ended February 1, 2003.

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 February 1, 2003.

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RESULTS OF OPERATIONS

Net Sales

Store count and square footage at third quarter end for fiscal 2003 and 2002 were as follows:

Gap Brand stores are reported based on concepts and locations. Any Gap Adult, GapKids, babyGap or GapBody concept that meets a certain square footage threshold has been counted as a store concept, even when residing within a single physical location that may have other concepts. In the table above, we present the number of store concepts and the number of locations.

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Net sales for the third quarter of fiscal 2003 increased $285 million compared with the same period last year. This increase is due to an increase in our comparable store sales of $211 million and an increase in our non-comparable sales of $74 million. Improved margins on our regular priced goods and an increase in regular price selling drove the increase in our comparable store sales.

Because we translate foreign currencies into U.S. dollars for reporting purposes, currency fluctuations can have an impact on our results. The impact of changes in foreign currency exchange rates during 2003 positively affected the translation of foreign currency sales into U.S. dollars. For the third quarter of fiscal 2003, currency fluctuations accounted for $48 million of the increase in net sales.

Net sales for the first quarter ofyear-to-date fiscal 2003 increased $462 million$1.2 billion compared towith the same period last year. Comparable store sales increased $341 million and non-comparable store sales increased $121 million. The non-comparable andThis increase is due to an increase in our comparable store sales of $861 million and an increase was primarily due to increasedin our non-comparable sales of $302 million. Increased regular price selling and higher markdown margins compared towith the first quarter of 2002.same periods last year drove the increase in our comparable store sales.

TheFor year-to-date fiscal 2003, currency fluctuations accounted for $135 million of the increase in net sales.

Non-comparable sales per average square foot for the first quarter was attributable to positive comparable store sales.include sales generated from our online business.

Comparable store sales by division for the firstthird quarter were as follows:

Old Navy reported a positive 16% versus a negative 18% last year

Gap U.S. reported a positive 12%5% versus a negative 20%2% last year

Gap International reported a positive 13%4% versus a negative 19%positive 2% last year

Banana Republic reported a positive 1%11% versus a negative 9%positive 1% last year

Old Navy reported a positive 6% versus a positive 6% last year

Total sales by division for the firstthird quarter were as follows:

Gap U.S. reported $1.3 billion versus $1.3 billion last year

Gap International reported $476 million versus $420 million last year

Banana Republic reported $512 million versus $456 million last year

Old Navy reported $1.6 billion versus $1.5 billion last year

Comparable store sales by division for year-to-date were as follows:

Gap U.S. reported a positive 9% versus a negative 11% last year

Gap International reported a positive 10% versus a negative 9% last year

Banana Republic reported a positive 6% versus a negative 4% last year

Old Navy reported a positive 11% versus a negative 4% last year

Total sales by division for year-to-date were as follows:

Gap U.S. reported $3.7 billion versus $3.4 billion last year

Gap International reported $1.4 billion versus $1.1 billion last year

Gap U.S.Banana Republic reported $1.2$1.4 billion versus $1.0$1.3 billion last year

Gap InternationalOld Navy reported $412 million$4.5 billion versus $319 million last year

Banana Republic reported $411 million versus $398 million$3.9 billion last year

Cost of Goods Sold and Occupancy Expenses

Cost of goods sold and occupancy expenses as a percentage of net sales decreased 7.72.8 percentage points from 69.663.9 percent to 61.961.1 percent in the firstthird quarter of fiscal 2003 and decreased 4.2 percentage points from 66.5 percent to 62.3 percent for year-to-date fiscal 2003 compared towith the same periodperiods in fiscal 2002. The decrease in the firstthird quarter of fiscal 2003 was primarily driven by higher merchandise margins of 5.81.7 percentage points and by lower occupancy expenses as aof 1.1 percentage points.The decrease for year-to-date fiscal 2003 was primarily driven by higher merchandise margins of net sales2.7 percentage points and lower occupancy expenses of 1.91.5 percentage points.

Merchandise15

The improvement in merchandise margins increased 5.8of 1.7 percentage points in the firstthird quarter of fiscal 2003, compared with the same period in fiscal 2002 was primarily due to improved margins on our regular-priced goods and an increase in regular price selling. The improvement in merchandise margins of 2.7 percentage points for year-to-date fiscal 2003, compared to the same period in fiscal 2002 as a result of improved product acceptance and focused assortments that drove increasedwas due to an increase in regular price selling and higher markdown margins. In addition, we experienced improved shortage results based on annual counts in the first quarter offor year-to-date fiscal 2003 compared to the first quarter ofsame period in fiscal 2002.

The decrease in occupancy expenses as a percentage of net sales for the firstthird quarter ofand year-to-date fiscal 2003 compared towith the same periodperiods in fiscal 2002 was due to improved sales leverage.

Operating Expenses

Operating expenses increased $44 million in the third quarter of fiscal 2003, but decreased 0.9 percentage points as a percentage of net sales remained consistent at 26.5from 27.7 percent to 26.8 percent compared with the same period in fiscal 2002 primarily due to sales leverage. Operating expenses increased $174 million for the first quarter ofyear-to-date fiscal 2003, but decreased 1.3 percentage points as a percentage of net sales from 27.5 percent to 26.2 percent compared towith the same period in fiscal 2002. Operating expenses increased $123 millionThe increase in total operating expense dollars for the firstthird quarter of fiscal 2003 to $889 million compared to $766 million in the first quarter of fiscal 2002. This increase iswas primarily due to higher repairs and maintenance expenses, higher store payroll to support increased advertising expensessales and higher bonus expenseconsulting fees compared towith the same period in fiscal 2002 offset by our improved store payroll efficiency2002. The increase in the first quarter of fiscal 2003.

For the first half of fiscal 2003, we expect total operating expense dollars for year-to-date fiscal 2003 was primarily due to increase 9 percenthigher repairs and maintenance expenses, higher store payroll to 11 percent comparedsupport increased sales, higher bonus expense and higher consulting fees, partially offset by insurance recovery proceeds received in the second quarter of fiscal 2003 which were primarily related to the samelosses at the World Trade Center stores.

The aggregate amount of insurance recovery proceeds received for year-to-date fiscal 2003 was $21.6 million, almost all of which were received during the second quarter. This compares with $6.5 million of insurance recovery proceeds received during the thirty-nine week period of fiscal 2002, almost all which were received during the first quarter.

The decrease in operating expenses as a percentage of net sales for year-to-date fiscal 2002.2003 was primarily due to improved sales leverage and insurance recovery proceeds.

In the third quarter of fiscal 2003, based on the status of our efforts to lease vacant office space including a review of real estate market conditions we revised our sublease projections and recorded an additional sublease loss charge of $8.5 million.

Interest Expense

The increasedecrease of $15.8 million in interest expense in the firstthird quarter, compared with the same period in fiscal 2002, was primarily due to lower fees related to the new Facility and letter of credit agreements and the maturity of our $500 million two-year bond in May 2003.

The decrease of $2.6 million in interest expense for year-to-date fiscal 2003, compared with the same period in fiscal 2002, was primarily due to lower fees related to the new Facility and letter of credit agreements and to the maturity of our $500 million two-year bond in May 2003. This decrease was partially offset by a full three quarters of interest expense in fiscal 2003 on our senior convertible notes issued in March 2002 plus a full three quarters of higher coupon interest rates on $700 million of our outstanding notes in fiscal 2003. The higher coupon interest rates on our $700 million of outstanding notes, which took effect June 15, 2002, is a result of downgrades in our long -term senior unsecured credit ratings in early 2002.

For fiscal 2003, we expect interest expense to be approximately $235 million compared with $249 million in fiscal 2002.

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Interest Income

The decrease of $1.2 million in interest income in the third quarter, compared with the same period in fiscal 2002, was primarily due to a full quarter of interest expense on our senior convertible notes issueddecrease in March 2002 plus higher interest rates, payablepartially offset by us on $700 million of our outstanding notesincreases in average cash available for investment as a result of downgrades in our long-term credit ratings, effective June 15, 2002.

Interest Incomeimproved cash flow from operations.

The increase of $0.5 million in interest income in the first quarter offor year-to-date fiscal 2003, compared towith the same period in fiscal 2002, was primarily due to increases in average cash available for investment as a result of improved cash flow from operations and the issuance of our senior convertible notes in March 2002.2002, partially offset by a decrease in interest rates.

Income Taxes

The effective tax rate was 39.0 percent and 49.047.0 percent for the first quarterthirty-nine weeks of fiscal 2003 and 2002, respectively. The decrease in tax rate compared with the prior year was driven primarily driven by an improvement in the mix of earnings from domestic and international operations and improved earnings performance. While we expect the effective tax rate for fiscal 2003 to be 39 percent, the actual rate could fluctuate higher or lower depending on several variables, including the mix of earnings from domestic and international operations, the overall level of earnings, and the potential resolution of outstanding tax controversies. We anticipate that any fluctuation would result in an effective tax rate in the range of 38 percent to 40 percent.

LIQUIDITY AND CAPITAL RESOURCES

The following sets forth certain measures of our liquidity:

At November 1, 2003 our working capital and current ratio calculation included $1.35 billion of restricted cash.

For the thirteenthirty-nine weeks ended May 3,November 1, 2003, the decreaseincrease in cash flows provided by operating activities, compared towith the same period in the prior year, was primarily attributable to an increaseimprovement in merchandise inventoryour net earnings, exclusive of depreciation and amortization, and a decrease in the relative changegrowth of merchandise inventory, offset by changes in accounts payableother operating assets and accrued expensesliabilities, which were primarily driven by timing of certain payments.

For the thirty-nine weeks ended November 1, 2003, the decrease in cash flows provided by financing activities, compared towith the same period in the prior year. Thisyear, was partially offset by an increaseprimarily due to the restriction of cash that backs our letter of credit agreements. Additionally, in net earnings exclusivethe third quarter of depreciationfiscal 2003 we repurchased the equivalent of $27 million of Eurobonds in the open market.

We plan to utilize our cash to provide adequate liquidity for business operations, capital expenditures, growth opportunities, debt reduction and amortization.dividend payments.

We fund inventory expenditures during normal and peak periods through a combination of cash flows from operations as well as long-term financing arrangements. Our business follows a seasonal pattern, peaking over a total of about 13 weeks during the back-to-school and holiday periods. The seasonality of

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our operations may lead to significant fluctuations in certain asset and liability accounts between fiscal year-end and subsequent interim periods. Consequently, we believe the most meaningful analysis of operating cash flows is one that compares the current interim period to the comparable period in the prior year.

Credit Facility and Trade Obligations

In June 2003, we replaced our existing $1.4 billion secured two-year credit facility scheduled to expire in March 2004 with a new three-year secured $750 million revolving credit facility (the “new Facility”). In addition, we executed agreements securing $1.2 billion in letter of credit issuing capacity. The letter of credit agreements also have three-year terms and are secured by approximately $1.24 billion in cash which is included in restricted cash on our Condensed Consolidated Balance Sheet. The new Facility is available for general corporate purposes. The fees related to the new Facility fluctuate based on our long-term senior unsecured credit ratings and our leverage ratio.

The new Facility contains financial and other covenants, including, but not limited to, limitations on capital expenditures, liens and cash dividends and maintenance of certain financial ratios, including a fixed charge coverage ratio and a leverage ratio. The letter of credit agreements contain a fixed charge coverage ratio, which is more lenient than the ratio in the new Facility. Violation of these covenants could result in a default under the new Facility and letter of credit agreements, which default would permit the participating banks to restrict our ability to further access the new Facility for letters of credit and advances, terminate our ability to request letters of credit pursuant to the letter of credit agreements and require the immediate repayment of any outstanding advances under the new Facility. In addition, such a default could, under certain circumstances, permit the holders of our outstanding unsecured debt to accelerate payment of such obligations.

Letters of credit represent a payment undertaking guaranteed by a bank on our behalf to pay the vendor a given amount of money upon presentation of specific documents demonstrating that merchandise has shipped. Vendor payables are recorded in the balance sheet at the time of merchandise title transfer, although the letters of credit are generally issued prior to this.

As of May 3,November 1, 2003, we had $659$715 million in trade letters of credit issued under our $1.4 billion secured two-yearletter of credit agreements. There were no drawings under the $750 million revolving credit facility.

Summary Disclosures about Contractual Obligations and Commercial Commitments

We also have standby letters of credit, surety bonds and bank guarantees outstanding at May 3,November 1, 2003, amounting to $30$64 million, $21$23 million and $6$7 million, respectively.

On MayAugust 12, 2003, Moody’s Investor Services changed our long-term ratings outlook from negative to stable and raised our speculative grade liquidity (SGL) rating from SGL-2 to SGL-1. The SGL rating is intended to give bondholders a short-term (12-18 month) view of a company’s ability to meet operating and financing obligations. The rating is based on a scale of 1 2003, $500 million aggregate principal amount of debt securitiesto 4 with a fixed annual interest rate of 5.625 percent, was repaid.

For1 being the thirteen weeks ended May 3, 2003, capital expenditures totaled approximately $56 million. The majority of these expenditures was used for information technology and the remodeling of certain stores.highest.

Rent expense for all operating leases was $246$746 million and $241$727 million, for the thirteenthirty-nine weeks ended May 3,November 1, 2003 and May 4,November 2, 2002, respectively.

Our current outlook forFor the thirty-nine weeks ended November 1, 2003, capital expenditures totaled approximately $181 million. The majority of these expenditures were for information technology and store remodels.

Updated 2003 Outlook

We are planning inventory per square footage to be down on a percentage basis at the end of the fourth quarter of fiscal 2003 compared with the fourth quarter of fiscal 2002; the decrease is expected to be between $300 million and $325 million. Also, we anticipate full year depreciation and amortization expensein the mid- to high-teens compared with a 13 percent increase in the fourth of fiscal 2002 compared with the fourth quarter of fiscal 2001.

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We expect capital spending to be in the mid to high $600about $ 275 million range.for fiscal year 2003.

For fiscal 2003, we continue to expect a 2 percent decline in net square footage of approximately 2%.footage. We anticipate concept closuresexpect about 35 location openings weighted toward Old Navy and storeabout 135 location closures to be higher than compared to fiscal 2002.

Ourweighted toward Gap U.S. for a net reduction of about 100 store plans for fiscal 2003 are as follows:locations.