See accompanying notesNotes to condensed consolidated financial statements.the Condensed Consolidated Financial Statements.

THE GAP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The condensed consolidated balance sheets as of October 28,May 5, 2007 and April 29, 2006, and October 29, 2005, the condensed consolidated statements of income for the thirteen and thirty-nine weeks ended October 28, 2006 and October 29, 2005, and the condensed consolidated statements of cash flows for the thirty-ninethirteen weeks ended October 28,May 5, 2007 and April 29, 2006 and October 29, 2005, have been prepared by The Gap, Inc. (the “company,“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, statementstatements of income and cash flows at October 28,May 5, 2007 and April 29, 2006 and October 29, 2005 and for all periods presented. The condensed consolidated balance sheet as of January 28, 2006February 3, 2007 has been derived from our audited consolidated financial statements.

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 January 28, 2006.

During the third fiscal quarter of 2005, approximately $30 million of sourcing expenses were reclassified from operating expenses to cost of goods sold and occupancy expenses. While we had been classifying the majority of sourcing expenses in cost of goods sold and occupancy expenses, some operating costs related to certain wholly owned agent offices that source our product had been classified in operating expenses. As a result, approximately $30 million of year to date sourcing expenses were reclassified at the end of the third fiscal quarter of 2005. This reclassification had no effect on net earnings.

In fiscal 2005, the company implemented a new inventory system and effective January 29, 2006 (the beginning of fiscal 2006), the company changed its inventory flow assumption from the first-in, first-out (“FIFO”) method to the weighted average cost method (“WAC”). The company determined that WAC is a preferable method because the new inventory system and method improves the overall accuracy of the company’s accounting for inventory. The change in inventory accounting method did not have a material impact on prior periods presented and, accordingly, they have not been restated as would be required by Statement of Financial Accounting Standards No. (“SFAS”) 154, “Accounting Changes and Error Corrections - a Replacement of APB Opinion No. 20 and FASB Statement No. 3.”February 3, 2007.

The results of operations for the thirteen and thirty-nine weeks ended October 28, 2006May 5, 2007 are not necessarily indicative of the operating results that may be expected for the fifty-threefifty-two week period ending February 3, 2007.2, 2008.

Our comprehensive earnings are comprised of net earnings, adjusted for foreign currency translation and fluctuations in fair market value of financial instruments related to foreign currency hedging activities, net of tax. Other comprehensive earnings are excluded from net earnings and reported as a separate component of shareholders’stockholders’ equity.

Comprehensive earnings, net of taxes, is comprised of:

3.	RECENT ACCOUNTING PRONOUNCEMENTS

In November 2004,September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS 151, “Inventory Costs, an AmendmentStatement of ARBFinancial Accounting Standards No. 43, Chapter 4.” SFAS 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material and requires that these items be recognized as current period charges. SFAS 151 applies only to inventory costs incurred during periods beginning after the effective date and also requires that the allocation of fixed production overhead to conversion costs be based on the normal capacity of the production facilities. SFAS 151 is effective for fiscal 2006. The adoption of SFAS 151 did not have a material impact on our financial position, cash flows or results of operations.

In May 2005, the FASB issued SFAS 154 which changes the requirements for the accounting for, and reporting of, a change in accounting principle. Previously, voluntary changes in accounting principles were generally required to be recognized by way of a cumulative effect adjustment within net earnings during the period of the change. SFAS 154 requires retrospective application to prior period financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS 154 is effective for fiscal 2006; however, the statement does not change the transition provisions of any existing accounting pronouncements. The adoption of SFAS 154 did not have a material effect on our financial position, cash flows or results of operations.

In October 2005, the FASB issued FASB Staff Position (“FSP”SFAS”) 13-1, “Accounting for Rental Costs Incurred During a Construction Period,” to clarify the proper accounting for rental costs incurred on building or ground operating leases during a construction period. The FSP requires that rental costs incurred during a construction period be expensed, not capitalized. FSP 13-1 is effective for fiscal 2006. The adoption of FSP 13-1 did not have a material effect on our financial position, cash flows or results of operations.

In November 2005, the FASB issued FSP 123(R)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards,” that provides a practical transition election related to accounting for the tax effects of share-based payment awards to employees. The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee share-based compensation, and to determine the subsequent impact on the APIC pool and consolidated statements of cash flows of the tax effects of employee share-based payment awards that are outstanding upon adoption of SFAS 123 (Revised 2004), “Share-Based Payment” (“123(R)”). The company is in the process of evaluating whether to adopt the provisions of FSP 123(R)-3.

In June 2006, the FASB ratified the consensuses reached by the Emerging Issues Task Force (“EITF”) in Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should be Presented in the Income Statement (That is, Gross Versus Net Presentation)”. Issue No. 06-3 requires disclosure of an entity’s accounting policy regarding the presentation of taxes assessed by a governmental authority that are directly imposed on a revenue-producing transaction between a seller and a customer including sales, use, value added and some excise taxes. We present such taxes on a net basis (excluded from net sales). We do not expect the adoption of Issue No. 06-3, which is effective for interim and annual reporting periods beginning after December 15, 2006, to have a material effect on our financial position, cash flows or results of operations.

In July 2006, the FASB issued FASB Interpretation No. (“FIN”) 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109,” which clarifies the accounting for uncertainty in tax positions. This Interpretation requires that we recognize in our financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. FIN 48 is effective for fiscal 2007, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We are currently evaluating the impact of adopting FIN 48 on our financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin No. (“SAB”) 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements”. SAB 108 provides interpretive guidance on how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in the current year financial statements. SAB 108 requires registrants to quantify misstatements using both an income statement (“rollover”) and balance sheet (“iron curtain”) approach and evaluate whether either approach results in a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. If prior year errors that had been previously considered immaterial now are considered material based on either approach, no restatement is required so long as management properly applied its previous approach and all relevant facts and circumstances were considered. If prior years are not restated, the cumulative effect adjustment is recorded in opening accumulated earnings as of the beginning of the fiscal year of adoption. SAB 108 is effective for fiscal 2006. We do not expect the adoption of SAB 108 to have a material impact on our financial position, cash flows or results of operations.

In September 2006, the FASB issued SFAS 157, “Fair Value Measurements”.Measurements.” SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. SFAS 157 applieswill be applied under other accounting pronouncements that require or permit fair value measurements and, accordingly, doeswill not require any new fair value measurements. SFAS 157 iswill be effective for fiscal 2008. We are currently in the process of assessing the impact the adoption of SFAS 157 will have on our financial statements.position, cash flows and results of operations.

In February 2007, the FASB issued SFAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115.” SFAS 159 will permit entities to choose to measure eligible items at fair value at specified election dates and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. SFAS 159 will be effective for fiscal 2008. We are currently in the process of assessing the impact the adoption of SFAS 159 will have on our financial position, cash flows and results of operations.

4.	DEBT AND CREDIT FACILITY

As of October 28, 2006, the remaining balance of ourOur 6.90 percent notes payable of $325$326 million are due September 2007 wasand have been classified as current maturities of long-term debt in our condensed consolidated balance sheet. In addition, the remaining balance of our 8.80 percent notes payable of $138 million due December 2008 (“2008 Notes”) is subject to an increasing or decreasing rate of interest based on certain credit rating fluctuations.

On November 17, 2006, Standard & Poor’s downgraded our senior unsecured debt rating to BB+ from BBB-. As a result of this downgrade by Standard & Poor’s,prior fiscal year changes to our long-term senior unsecured credit ratings, the interest rate payable by us on ourthe 2008 Notes will increase by 25 basis points from 9.55 percent towas 9.80 percent per annum, as ofeffective December 15, 2006. In the first quarter of fiscal year 2007, our credit rating was further downgraded which will increase the interest payable by us on the 2008 Notes to 10.05 percent per annum effective June 15, 2007. Our 6.25 percent notes payable of $50 million are due March 2009.

As of October 28, 2006,May 5, 2007, we had $221$150 million in trade letters of credit issued under our letter of credit agreements totaling $500 million. There were no drawings under our $750 million revolving credit facility at October 28, 2006.as of May 5, 2007.

On May 6, 2005,18, 2007, we entered intoreduced our $750 million revolving credit facility to $500 million and extended the facility through August 2012. We also canceled two of our four separate $125 million, 3-year letter of credit agreements, subject to our satisfaction of any remaining letters of credit issued thereunder, and four separate $100 million, 364-dayextended the remaining facilities through May 2010, effectively reducing our dedicated letter of credit agreements for a total aggregate availability of $900 million, which collectively replaced our prior letter of credit agreements. Unlike the previous letter of credit agreements, the current letter of credit agreements are unsecured. Consequently, the $900 million of restricted cash that collateralized the prior letter of credit agreements was fully released in May 2005. As of May 5, 2006, the four $100 million 364-day letter of credit agreements expired and the total letter of credit capacity was reducedlines to $500$250 million. This reduction in the letter of credit capacity was driven by the transition to open account payment terms as well as the available capacity under our $750 million revolving credit facility to issue trade letters of credit.

On March 11, 2005, we called for the full redemption of our outstanding $1.4 billion, 5.75 percent senior convertible notes (the “Notes”) due March 15, 2009. The redemption was complete by March 31, 2005. Note holders had the option to receive cash at a redemption price equal to 102.46 percent of the principal amount of the Notes, plus accrued interest, for a total of approximately $1,027 per $1,000 principal amount of Notes. Alternatively, note holders could elect to convert their Notes into approximately 62.03 shares of Gap Inc. common stock per $1,000 principal amount. As of March 31, 2005, $1.4 billion of principal was converted into 85 million shares of Gap Inc. common stock and approximately $0.5 million was paid in cash redemption.

Closure of Forth & Towne

On February 26, 2007, we announced that we will close our Forth & Towne store locations. The decision to take this action resulted from a thorough analysis of the concept, which revealed that it was not demonstrating enough potential to deliver an acceptable long-term return on investment. We notified affected employees of this decision on February 26, 2007 and we plan to close all 19 stores by the end of June 2007. For the thirteen weeks ended May 5, 2007, we recognized $37 million of charges related to the future closure of Forth & Towne, consisting of $29 million related to the impairment of long-lived assets, $4 million of employee severance, $3 million of administrative and other costs, and $1 million of inventory write-offs. The closure of Forth & Towne will result in a reduction in our workforce of approximately 550 employees. We expect to incur an additional $5-10 million of closure charges in the second and third quarters of fiscal year 2007, primarily consisting of lease related expenses. We anticipate that most cash payments for these charges will be made by the third quarter of fiscal year 2007 except for those cash payments associated with certain leases, which will be paid over the various remaining lease terms through 2017 unless we are successful in negotiating settlements with the respective landlords, or we are able to assign these leases or sublease these locations to third parties. Inventory write-offs have been recorded in cost of goods sold and occupancy expenses and all other charges related to the closure of Forth & Towne have been recorded in operating expenses in our condensed consolidated statement of income.

Other Operating Charges

As part of our ongoing assessment of our network capacity, we made the decision in February 2007 to close a distribution facility in Hebron, Kentucky. We expect the closure to be completed by December 2007. In addition, in order to drive improved returns and to leverage our existing retail channel, in March 2007 we announced that we intend to convert approximately 45 Old Navy Outlet stores into Old Navy stores. We expect the conversion to be completed by October 2007. For the thirteen weeks ended May 5, 2007, the charges recognized related to converting the Old Navy Outlet stores and closing the distribution facility were not material and we do not expect future expenses to be material.

We have excess facility space as of October 28, 2006 as a result of our 2001 decision to consolidateMay 5, 2007 and downsize corporate facilities in our San Francisco and San Bruno campuses. We recordhave recorded a sublease loss reserve for the net present value of the difference between the contractual rent obligations and the rate at which we expect to be able to sublease the properties. These estimates and assumptions are monitored on at least a quarterly basis for changes in circumstances. We estimate the reserve based on the status of our efforts to lease vacant office space and stores, including a review of real estate market conditions, our projections for sublease income and sublease commencement assumptions. Sublease loss chargeslosses (reversals) are reflected in operating expenses in our condensed consolidated statements of income.

The following table providesFor the liability balances and activities of ourthirteen weeks ended May 5, 2007, we recorded a net sublease loss reserve:

During the quarter ended July 30, 2005 we completed our assessment of available$2 million primarily related to excess headquarter space and future office facility needs and in mid-May 2005 decided that we would occupy one of our vacant leased properties in San Francisco. As a result, the sublease loss reserve of $58 million associated with this space at April 30, 2005 was reversed.

In June 2006, an Agreement of Purchase and Sale was executed with a buyer for our distribution center located in Brampton, Ontario, Canada. Upon completion of the sale in the third fiscal quarter of 2006, we recorded a gain of $3 million associated with the sale, which is included in operating expenses in the condensed consolidated statements of income.

Remaining cash expenditures associated with the headquarters facilitiesour sublease loss reserve are expected to be paid over the various remaining lease terms through 2012.2018. Based on our current assumptions as of October 28, 2006,May 5, 2007, we expect our lease payments, net of sublease income, to result in a total net cash outlay of approximately $17$21 million for future rent.

In addition to the $4 million of employee severance related to Forth & Towne, for the thirteen weeks ended May 5, 2007, we recorded $5 million of employee severance related to other organizational changes. Subsequent to the end of the first quarter, we recorded an additional $8 million of employee severance related to organizational changes.

Sublease Loss and Accrued Severance Costs

The balances and activity for our sublease loss reserve and accrued severance are as follows:

On February 4, 2007, we adopted FASB Interpretation No. (“FIN”) 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. (“SFAS”) 109.” FIN 48 prescribes a recognition threshold that a tax position is required to meet before being recognized in the financial statements and provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition issues.

The cumulative effects of applying this interpretation have been recorded as a decrease of $4 million to opening retained earnings, an increase of $85 million to short-term and long-term income tax assets and an increase of $89 million to short-term and long-term income tax liabilities as of February 4, 2007. Included in the cumulative effect decrease at the beginning of fiscal year 2007, we had $135 million of total gross unrecognized tax benefits. Of this total, $50 million, net of the federal benefit on state issues, represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in future periods. Also, as of the adoption date, we had accrued interest expense of $27 million related to the unrecognized tax benefits. We recognize interest related to unrecognized tax benefits in interest expense and penalties in operating expenses in our condensed consolidated statements of income.

During the thirteen weeks ended May 5, 2007, the total gross unrecognized tax benefits did not change materially.

We conduct business globally and, as a result, file income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. In the normal course of business, we are subject to examination by taxing authorities throughout the world, including such major jurisdictions as Canada, France, Hong Kong, Japan, the U.K. and the United States. With few exceptions, we are no longer subject to U.S. federal, state, local, or non-U.S. income tax examinations for fiscal years before 1997. We do not anticipate that total gross unrecognized tax benefits will significantly change as a result of the settlement of audits or the expiration of statutes of limitations within the next 12 months.

Pursuant to the guidance provided in Accounting Principles Board Opinion No. (“APB”) 23 and SFAS 109, except where required by U.S. tax law, we have historically elected not to provide for U.S. income taxes with respect to the undistributed earnings of our foreign subsidiaries as we have intended to utilize those earnings in the foreign operations for an indefinite period of time or repatriate such earnings only when tax effective to do so. In April 2007, we assessed the anticipated cash needs and overall financial position of our Canadian subsidiaries. As a result, we have determined that we no longer intend to utilize $88 million of the undistributed earnings of our Canadian subsidiaries in foreign operations indefinitely. Accordingly, we have established a deferred tax asset for U.S. income taxes with respect to this portion of the undistributed earnings of our Canadian subsidiaries as of May 5, 2007 and have recorded a related tax benefit of $3 million. We intend to utilize the remainder of the undistributed earnings of our foreign subsidiaries in the foreign operations for an indefinite period of time or repatriate such earnings only when tax effective to do so.

Stock Repurchase Program

On February 23,During fiscal year 2006, we announced the authorization of an additional $500 million for our share repurchase program allauthorizations totaling $1.25 billion, of which has been used. On August 3, 2006, we announced$200 million remains available as of May 5, 2007. For the authorization of an additional $750 million for our ongoingthirteen weeks ended May 5, 2007 there were no share repurchase program. Under this authorization, shares may be repurchased over 12 months. Duringrepurchases. For the third fiscal quarter ofthirteen weeks ended April 29, 2006, we repurchased approximately 1622 million shares for approximately $389 million, of our common stock at a total costwhich $382 million was paid by the end of approximately $271 million, at an average price per share of $16.86 including commissions. During the first thirty-nine weeks of 2006, we repurchased approximately 44 million shares of our common stock for a total cost of approximately $771 million, resulting in an average price per share of $17.53 including commissions.quarter.

Dividends

In FebruaryDuring fiscal year 2006, we announced our intention to increaseincreased our annual dividenddividends, which had been $0.18 per share from $0.18for fiscal year 2005, to $0.32 per share for fiscal year 2006. Pursuant to this plan,We paid a dividend of $0.08 per share was paid in April 2006, July 2006,the first quarter of fiscal year 2007 and Octoberthe first quarter of fiscal year 2006. The remaining quarterly dividend is expected to be paid in January 2007.

Stock Award Plans

The 1996 Stock Option and Award Plan (the “1996 Plan”) was established on March 26, 1996, and amended and restated on January 28, 2003. The Board authorized 123 million shares for issuance under the 1996 Plan, which includes shares available under the Management Incentive Restricted Stock Plan and an earlier stock option plan established in 1981, both of which were superseded by the 1996 Plan. The 1996 Plan was further amended and restated on January 24, 2006 and renamed the 2006 Long-Term Incentive Plan (the “2006 Plan”). On May 9, 2006, the shareholders approved an increase in the number of shares available for grant under the 2006 Plan by the sum of (a) the number of shares that remained available for grant under the 2002 Stock Option Plan (the “2002 Plan”) as of January 24, 2006, the date of board approval of the 2006 Plan, and (b) any shares that otherwise would have been returned to the 2002 Plan after January 24, 2006, on account of the expiration, cancellation, or forfeiture of awards granted thereunder. The 2006 Plan empowers the Compensation and Management Development Committee of the Board of Directors (the “Committee”) to award compensation primarily in the form of nonqualified stock options, restricted stock, or performance units to key employees.

The 2002 Plan, formerly known as Stock Up On Success, was established on January 1, 1999. The Board originally authorized 53 million shares for issuance under the 2002 Plan, which includes shares available under an earlier stock option plan established in 1999 that was merged with the 2002 Plan. On May 9, 2006, the 2002 Plan was discontinued and only those awards then outstanding continue to be subject to the terms of the 2002 Plan under which they were granted. The 2002 Plan empowered the Committee to award nonqualified stock options to non-officer employees.

At October 28, 2006, we had reserved 150 million shares of our common stock for the issuance of common stock under our stock award plans. Stock options generally expire 10 years from the grant date, three months after employee termination, or one year after the date of an employees’ retirement or death, if earlier. In addition, stock options generally vest over a four-year period, with shares becoming exercisable in equal annual installments of 25 percent. Performance units generally vest over a four year period, and one share of common stock is issued for each performance unit upon vesting.

Employee Stock Purchase Plan

Prior to December 1, 2006, under our Employee Stock Purchase Plan (“ESPP”), eligible U.S. employees could purchase our common stock at 85 percent of the lower of the closing price on the New York Stock Exchange on the first or last day of the six-month purchase period. After December 1, 2006, eligible U.S. employees will be able to purchase our common stock at 85 percent of the closing price on New York Stock Exchange on the last day of three-month purchase periods. Employees pay for their stock purchases through payroll deductions at a rate equal to any whole percentage from 1 percent to 15 percent. There were 0.9 million and 0.8 million shares issued under the plan during the thirty-nine weeks ended October 28, 2006 and October 29, 2005, respectively. At October 28, 2006, there were 6 million shares reserved for future issuances.

Stock Compensation

On January 26, 2006, we accelerated the vesting of all stock options with an exercise price equal to or greater than $21 per share except options held by non-employee directors and performance-based options to purchase 1 million shares granted to our Chief Executive Officer. Options to purchase approximately 15 million shares of common stock that were scheduled to vest from fiscal 2006 to 2009 were impacted by this action. Although these options became immediately exercisable, the exercise price did not change. The primary purpose of the accelerated vesting was to reduce total compensation expense after the adoption of SFAS 123(R). There was no impact to our consolidated statement of income in fiscal 2005.

On January 29, 2006, we adopted the provisions of SFAS 123(R) using the modified prospective transition method. Prior to the adoption of SFAS 123(R), stock-basedmethod and, accordingly, recorded share-based compensation expense related toof $11 million and $8 million for the thirteen weeks ended May 5, 2007 and April 29, 2006, respectively. Share-based compensation expense is classified as operating expenses in our condensed consolidated statements of income.

The following table summarizes stock option activity for our stock option plans:

The weighted-average fair value of stock options granted during the thirteen weeks ended May 5, 2007 and April 29, 2006 was not recognized in the results of operations if the exercise price was equal to the market value of the common stock on the grant date, in accordance with Accounting Principles Board Opinion No. (“APB”) 25, “Accounting for Stock Issued to Employees.” As a result, the recognition of stock-based compensation expense was generally limited to the expense attributed to discounted stock options, performance units$5.64 and stock option modifications. Under the modified prospective transition method, compensation cost recognized in the first thirty-nine weeks of fiscal 2006 included: a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 28, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS 123, “Accounting for Stock-Based Compensation” and b) compensation cost for all share-based payments granted subsequent to January 28, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). The impact of forfeitures that may occur prior to vesting is also estimated and considered in the amount recognized.$4.96 per share, respectively.

We use the Black-Scholes-Merton option-pricing model to determine the fair value of stock awards and ESPP shares.options. This model requires the input of subjective assumptions that have a significant impact on the fair value estimate. The assumptions for the current period grants were developed based on SFAS 123(R) and SEC guidance contained in SAB 107, “Share-Based Payment.” The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of subjective variables. These variables include our expected stock price volatility over the term of the awards, the expected term based on projected employee stock option exercise behaviors, risk-free interest rate and expected dividends. Changes in these subjective assumptions can materially affect the estimate of fair value of stock-based compensation and consequently, the related amount recognized on the consolidated statements of income.

The expected term represents the estimated time until exercise and is based on historical exercise patterns, which we believe are representative of future behavior. The expected term of employee stock purchase rights is the purchase period under each offering period. The expected volatility of our common stock is based on a combination of historical volatility of our stock for a period approximating the expected term and the implied volatility based on traded options of our stock. Prior to fiscal 2006, only historical volatility was considered. The expected dividend yield is based on our expected annual dividend payout for the current fiscal year. The risk-free interest rate is based on zero-coupon U.S. Treasury instruments with a remaining term equal to the expected term of the share options.

We are required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are expected to vest. With the adoption of SFAS 123(R) at the beginning of our first fiscal quarter of 2006, we added “Share-Based Payment” as a critical accounting policy and estimate.

The weighted average assumptions used to value option grants are as follows:

The weighted-average fair value ofIn addition to stock options, granted during the thirteen weeks ended October 28, 2006 and October 29, 2005 was $5.27 and $5.36 per share, respectively. The weighted-average fair value of stock options granted during the thirty-nine weeks ended October 28, 2006 and October 29, 2005 was $4.99 and $7.64 per share, respectively. The fair value of stock options that vested during the thirteen weeks ended October 28, 2006 and October 29, 2005 was $6 million and $28 million, respectively. The fair value of stock options that vested during the thirty-nine weeks ended October 28, 2006 and October 29, 2005 was $36 million and $93 million, respectively.

The assumptions used to value employee stock purchase rights are as follows:

Beginning in fiscal 2005, the Committee began grantingwe also grant stock awards in the form of performance units. One share of common stock is issued for each performance unit where vesting is subject to continued service by the employee, or earned for each unit where vesting is immediate in the case of members of the Board of Directors (“StockService Awards”). In some cases, Service Awards are granted after the achievement of certain performance metrics (“Performance Liability Awards”) and in someother cases, a grant is made, whereby the vesting is subject to the achievement of certain performance metrics (“Performance StockEquity Awards”).

In accordance with SFAS 123(R), we recognize the estimated compensation cost of Stock Awards, net of estimated forfeitures, and Performance Stock Awards based on the value of our traded stock price on the date of grant, with an offsetting increase to shareholder’s equity. We evaluate the probability that the Performance Stock Awards will vest at the end of each reporting period and adjust compensation cost accordingly. Prior to the adoption of SFAS 123(R), we recognized the compensation expense related to Stock Awards based on actual forfeitures. As such we evaluated the need to record a cumulative effect adjustment for estimated forfeitures upon the adoption of SFAS 123(R). Because the adjustment was not material, it was recognized as a credit to operating expenses in the first quarter of fiscal 2006.

For Performance Stock Awards, we evaluate the probability that they will be granted. In addition, we revalue compensation cost at the end of each reporting period, based on the value of our traded stock price and the probability that the performance metrics will be achieved, with an offsetting increase to current liabilities. Upon achievement of the performance metrics, the stock award is granted, accounted for as a fixed equity award and valued using our traded stock price on the date of grant, and the associated liability is reclassified to shareholders’ equity.

The weighted-average fair value of Stock Awards and Performance Stock Awards granted during the thirteen weeks ended October 28, 2006 and October 29, 2005 was $17.86 and $18.73 per share, respectively. The weighted-average fair value of Stock Awards and Performance Stock Awards granted during the thirty-nine weeks ended October 28, 2006 and October 29, 2005 was $17.84 and $22.02 per share, respectively. The fair value of Stock Awards that vested during the thirteen weeks ended October 28, 2006 and thirty-nine weeks ended October 29, 2006 was $1 million and $9 million, respectively. Through the third quarter of fiscal 2006 and all of fiscal 2005, no Performance Stock Awards vested.

As required by SFAS 123(R), the estimated fair value of our stock-based awards granted prior to the adoption of SFAS 123(R), less expected forfeitures, will continue to be amortized based on an accelerated recognition method. The estimated fair value of our stock-based awards granted after the adoption of SFAS 123(R), less expected forfeitures, with time-based service conditions are being amortized on a straight-line basis, while those with performance conditions are being amortized on an accelerated basis.

Total stock-based compensation expense recognized in the condensed consolidated statements of income for the thirteen and thirty-nine weeks ended October 28, 2006 was $11 million, net of related tax effects of $6 million, and $25 million, net of related tax effects of $14 million, respectively. Total cash paid related to liability awards for the thirteen and thirty-nine weeks ended October 28, 2006 was $1 million and $3 million, respectively. At October 28, 2006, there was $58 million (before any related tax benefit) of unrecognized compensation cost, adjusted for estimated forfeitures, related to unvested share-based compensation that is expected to be recognized over a weighted-average period of 3 years. Total unrecognized compensation may be adjusted for future changes in estimated forfeitures. There was no share-based compensation capitalized as of or during the thirteen weeks and thirty-nine weeks ended October 28, 2006.

The following table shows the effect on net earnings and earnings per share had compensation cost been recognized based upon the estimated fair value on the grant date of stock options, and employee stock purchase rights during the comparable period last year.

There were no material modifications made to our outstanding stock options, Stock Awards or Performance Stock Awards in fiscal 2006.

General Stock Option Information

Under our stock option plans, nonqualified options to purchase common stock are granted to officers, directors, eligible employees and consultants at exercise prices equal to the fair market value of the stock at the date of grant or as determined by the Compensation and Management Development Committee of the Board of Directors.

The following table summarizes stock option activity for our stock option plans:

The aggregate intrinsic value of options exercised during the thirteen weeks ended October 28, 2006 and October 29, 2005 was $19.3 million and $6.6 million, respectively. The aggregate intrinsic value of options exercised during the thirty-nine weeks ended October 28, 2006 and October 29, 2005 was $45.5 million and $49.0 million, respectively.

The following table summarizes additional information about stock options outstanding and exercisable at October 28, 2006:

The aggregate intrinsic value of options outstanding and options exercisable at October 28, 2006 was $179 million and $124 million, respectively. Options exercisable at October 28, 2006 had a weighted-average remaining contractual life of 5.61 years.

The following table summarizes unvested StockService Award and Performance StockEquity Award activity:

The aggregate intrinsic value of unvested Stock Awards and Performance Stock Awards at October 28, 2006 was $73 million. Stock Awards and Performance Stock Awards at October 28, 2006 had a weighted-average remaining contractual life of 3 years.

		Shares			Weighted-Average Grant-Date Fair Value Price
Balance at February 3, 2007		4,916,773			$	19.23
Granted		3,302,573				18.15
Vested		(682,187	)			19.72
Forfeited		(449,482	)			18.46
Balance at May 5, 2007		7,087,677				18.50

Basic earnings per share is 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 performance units,Service Awards, calculated using the treasury stock method, and convertible notes which are potentially dilutive at certain earnings levels calculated using the if-converted method. The following table summarizes the incremental earnings and shares from the potentially dilutive securities:

Excluded from theThe above computations of weighted-average shares for diluted earnings per share wereexclude options to purchase 4134 million and 4445 million shares of common stock duringfor the thirteen and thirty-nine weeks ended October 28,May 5, 2007 and April 29, 2006, respectively. Excluded from the above computations of weighted-average shares for diluted earnings per share were options to purchase 47 million and 41 million shares of common stock during the thirteen and thirty-nine weeks ended October 29, 2005, respectively. The calculated amounts have been excluded because the exercise price was greater than the average market price of the company’sCompany’s common stock during the period and, therefore, the effect is antidilutive.

We are a party to a variety of contractual agreements under which we may be obligated to indemnify the other party for certain matters. These contracts primarily relate to our commercial contracts, operating leases, trademarks, intellectual property, financial agreements and various other agreements. Under these contracts we may provide certain routine indemnifications relating to representations and warranties (e.g., ownership of assets, environmental or tax indemnifications), or personal injury matters or other matters. The terms of these indemnifications range in duration and may not be explicitly defined.

Generally, the maximum obligation under such indemnifications is not explicitly stated and, as a result, the overall amount of these obligations cannot be reasonably estimated. Historically, we have not made significant payments for these indemnifications. We believe that if we were to incur a loss in any of these matters, the loss would not have a material effect on our financial condition or results of operations.

As a party to a reinsurance pool for workers’ compensation, general liability and automobile liability, we have guarantees with a maximum exposure of $74$58 million as of May 5, 2007, of which $6$5 million has been cash collateralized. We are currently in the process of winding down our participation in the reinsurance pool. Our maximum exposure and cash collateralized balance are expected to decrease in the future as our participation in the reinsurance pool diminishes.

As a multinational company, we are subject to various proceedings, lawsuits, disputes and claims (“Actions”) arising in the ordinary course of our business. Many of these Actions raise complex factual and legal issues and are subject to uncertainties. Actions filed against us include commercial, intellectual property, customer, employment and labor and employmentsecurities related claims, including class action lawsuits in which plaintiffs allege that we violated federal and state wage and hour and other laws. The plaintiffs in some Actions seek unspecified damages or injunctive relief, or both. Actions are in various procedural stages, and some are covered in part by insurance. If the outcome of an Action is expected to result in a loss that is considered probable and reasonably estimable, we will record a liability for the estimated loss.

We cannot predict with assurance the outcome of Actions brought against us. Accordingly, adverse developments, settlements or resolutions may occur and negatively impact earnings in the quarter of such development, settlement or resolution. However, we do not believe that the outcome of any current Action would have a material adverse effect on our results of operations, liquidity or financial position taken as a whole.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Our BusinessITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

We are a global specialty retailer operating retail and outlet stores selling casual apparel, accessories, and personal care products for women, men and children under the Gap, Banana Republic, Old Navy and Forth & Towne brand names. We operate stores in the United States, Canada, Ireland, the United Kingdom, France and Japan, while our independent third party franchisees own and operate stores in Asia under the Gap brand name. Our U.S. customers may shop online at gap.com, bananarepublic.com, and oldnavy.com. Beginning in October 2006, we launched Piperlime.com, an online shoe store selling an assortment of third party brands for women, men and children.

OverviewRESULTS OF OPERATIONS

The third quarter remained challenging due to weak traffic and disappointing product acceptance. Comparable store sales were negative 5 percent compared to last year, and we experienced higher operating expenses associated with investing in marketing and stores to improve performance. As a result, net earnings were 11 percent lower than third quarter last year and earnings per share was $0.23 compared to $0.24 in the third quarter of fiscal 2005.

Our cash flows continue to be strong. For the thirty-nine weeks ended October 28, 2006, we generated free cash flow of $214 million, an increase of $334 million compared to the prior year primarily driven by an increase in our accounts payable balance as a result of timing differences in our payment terms and additional accruals associated with increased marketing activities and other initiatives. For a reconciliation of free cash flow, a non-GAAP measure, to a GAAP measure, see the Financial Condition section of this Management’s Discussion and Analysis.

We continue to make progress against our strategic priorities. During the third quarter, we returned excess cash to shareholders by repurchasing approximately 16 million shares of our common stock for $271 million and declared and paid a quarterly dividend of $0.08 per share. Cash distribution to shareholders will continue to play an important role in delivering shareholder returns; however, our first priority for excess cash is investing in our business in a way that meets or exceeds our return criteria.

Even though the third quarter was challenging, we remain committed to the strategies underway to turnaround our business performance. We are focused on creating stronger product assortments, improving the store experience for our customers, and delivering marketing with compelling messages. We remain confident in our growth strategies, which we believe will create and deliver value to our shareholders over the long-term. These strategies include: extending our existing lifestyle brands and creating new brands, growing brands internationally, becoming the best online apparel retailer, and leveraging our scale and operating discipline to yield superior shareholder returns. Examples of these growth initiatives in the third quarter of fiscal 2006 are:

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,” “plan,” “project,” and similar expressions also identify forward-looking statements. Forward-looking statements include, but are not limited to, statements regarding: (i) the impacttiming and expenses related to the Forth & Towne closure, the closure of new accounting pronouncements;a distribution facility in Kentucky, and the conversion of Old Navy Outlet stores into Old Navy stores; (ii) the total net loss for Forth & Towne for fiscal year 2007; (iii) the amount of future lease payments net of sublease income; (iii)(iv) changes in total gross unrecognized tax benefits within the timingnext 12 months; (v) the utilization or repatriation of undistributed earnings of foreign subsidiaries; (vi) expected term and amount of dividends in fiscal 2006; (iii) expected stock price volatility; (iv)volatility for share-based compensation; (vii) the impact of losses under contractual indemnifications; (v)(viii) the maximum exposure and cash collateralized balance for reinsurance pool in future periods; (ix) the impact of various proceedings, lawsuits, disputes and claims; (vi) confidence in our growth strategies; (vii)(x) interest expense for fiscal 2006; (viii)year 2007; (xi) effective tax rate for fiscal 2006; (ix) free cash flow in fiscal 2006; (x) minimum net cash provided by operating activities in fiscal 2006; (xi)year 2007; (xii) year over year change in inventory per square foot at the end of the fourth quartersecond and third quarters of fiscal 2006; (xii)year 2007; (xiii) capital expenditures (net purchases of property and equipment) in fiscal 2006; (xiii)year 2007; (xiv) number of new store openings and store closings in fiscal 2006; (xiv)year 2007; (xv) net square footage change in fiscal 2006; (xv) funding of capital expendituresyear 2007; (xvi) net cash provided by operating activities in fiscal 2006; (xvi)year 2007; (xvii) free cash flow in fiscal year 2007; (xviii) the amount of cash to be kept on our balance sheet; and (xix) the amount of our annual dividend policyfor fiscal year 2007 and increases in future periods; (xvii) maximum exposure and cash collateralized balance for reinsurance pool in future periods, and (xviii) the impact of changes in our rating by credit rating agencies.over time.

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 subsequent events may occur that require adjustments to our unaudited financial statements; the risk that the adoption of new accounting pronouncements will impact future results; the risk that we will be unsuccessful in gauging fashion trends and changing consumer preferences; the highly competitive nature of our business in the U.S. and internationally and our dependence on consumer spending patterns, which are influenced by numerous other factors; the risk that we will be unsuccessful in identifying and negotiating new store locations effectively; the risk that comparable store sales and margins will experience fluctuations; the risk that we will be unsuccessful in implementing our strategic, operating and people initiatives; the risk that adverse changes in the our credit ratings may have a negative impact on our financing costs and structure in future periods; the risk that trade matters, events causing disruptions in product shipments from China and other foreign countries, or IT systems changes may disrupt our supply chain or operations; and the risk that we will not be successful in defending various proceedings, lawsuits, disputes, claims, and audits; any of which could impact net sales, costs and expenses, and/or planned strategies. 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, 2006.February 3, 2007.

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 November 30, 2006June 12, 2007 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 you read 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 January 28, 2006.February 3, 2007.

RESULTS OF OPERATIONSOur Business

BusinessWe are a global specialty retailer operating retail, outlet and online stores selling casual apparel, accessories, and personal care products for men, women and children under the Gap, Old Navy, Banana Republic, Piperlime, and Forth & Towne brands. We operate stores in the United States, Canada, the United Kingdom, France, Ireland, and Japan. We also have announced franchise agreements with unaffiliated franchisees to operate Gap or Gap and Banana Republic stores in Bahrain, Indonesia, Kuwait, Malaysia, Oman, Qatar, Saudi Arabia, Singapore, South Korea, Turkey and United Arab Emirates. Under these agreements, third parties operate or will operate stores that sell apparel, purchased from us, under our brand names. In addition, our U.S. customers may shop online at www.gap.com, www.bananarepublic.com, www.oldnavy.com, and www.piperlime.com.

Overview

Net sales were $3.6 billion for the first quarter continuedof 2007 compared with $3.4 billion for the first quarter of 2006, and comparable store sales decreased 4 percent and 9 percent, respectively. Note that due to be challengingthe 53rd week in fiscal year 2006, first quarter 2007 comparable store sales are compared with the thirteen-week period ended May 6, 2006. While we saw progress in certain product categories such as dresses and shorts, overall response to our Spring products was

mixed. Gross margin decreased 2.1 percentage points for the first quarter of fiscal year 2007 from the prior year comparable period due to lower merchandise margins, primarily driven by Gap brand, combined with higher occupancy costs as a percent of sales. Our online net sales for the first quarter of fiscal year 2007 were $195 million compared with $159 million in the prior year. Net earnings were $178 million for the first quarter of fiscal year 2007, 26 percent lower than the prior year comparable period. Earnings per diluted share was $0.22, which was $0.06 lower than the prior year comparable period.

We generated free cash flow of $159 million, defined as net cash provided by operating activities less the purchase of property and equipment (for a reconciliation of free cash flow, a non-GAAP measure, to a GAAP measure, see the Liquidity section in this Management’s Discussion and Analysis). We also paid a dividend of $0.08 per share in the first quarter of fiscal year 2007.

In fiscal year 2007, we experienced a decreaseare focusing on three priorities: fixing our core business by creating the right product and store experience; retaining and developing the best talent in salesthe industry; and examining our organizational structure to ensure that we enable our brands to make decisions and effect change more efficiently. In the first quarter of fiscal year 2007, we strengthened the teams at Gap and Old Navy brands, offset by an increaseand set certain product and operational strategies. We are refining our target customers for those two brands.

We took the following actions in sales at Banana Republic and online for overall flat sales comparedthe first quarter of fiscal year 2007:

RESULTS OF OPERATIONS

Net Sales

Net sales consist of retail sales, online sales and shipping fees received from customers for delivery of merchandise. Outlet retail sales are reflected within the respective results of each brand. The following tables disclose net sales by brand, region and channel for the thirteen and thirty-nine weeks ended October 28, 2006May 5, 2007 and OctoberApril 29, 2005:2006:

(3)	Other includes Forth & Towne beginning August 2005, Business Direct, International Sales Program,our franchise business beginning September 2006, and Piperlime.com beginning October 2006, and Business Direct which ended in July 2006.

A store is included in comparable store sales (“Comp”) when all three of the following requirements have been met: the store has been open at least one year, square footage has not changed 15 percent or more within the past year, and the store has not been permanently repositioned within the past year. A store is included in Comp on the first day it has comparable prior year sales. Stores in which square footage has changed by 15 percent or more as a result of remodel, expansion, or reduction are excluded from Comp until the first day they have comparable prior year sales. Current year foreign exchange rates are applied to both current year and prior year Comp store sales to achieve a consistent basis for comparison.

A store is considered non-comparable (“Non-comp”) when, in general, the store has no comparable prior year sales. For example, a store that has been open for less than one year, a store that has changed its square footage by 15 percent or more within the past year, or a store that has been permanently repositioned within the past year is considered Non-comp. Non-store sales such as online operations are also considered Non-comp.

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

The difference between first quarter 2006 and first quarter 2007 net sales is classified as follows:

Our thirdfirst quarter 2007 net sales increased $117 million, or 3 percent, from the prior year comparable period. Note that due to the 53rd week in fiscal 2006, sales of $3.9 billion were flat compared to thirdfirst quarter 2005 sales of $3.9 billion and our2007 comparable store sales declined 5are compared with the thirteen-week period ended May 6, 2006. Our comparable store sales decreased 4 percent compared to last year. Sales productivity infor the thirdfirst quarter of fiscal 2006 decreasedyear 2007, primarily due to $95the overall mixed response to Spring product. The 7 percentage point difference between net sales and comparable store sales was primarily due to new stores and a 23 percent increase in online sales in the first quarter of fiscal year 2007 from the prior year comparable period. Overall, our net square footage increased 3 percent in the first quarter of fiscal year 2007 from the prior year comparable period and sales productivity was $86 per average square foot for the first quarter of fiscal year 2007 compared with $99$87 per average square foot infor the thirdprior year comparable period. During the first quarter of fiscal 2005. During the third quarter of fiscal 2006,year 2007, we closed 13 under-performingopened 41 new stores and opened 85 newclosed 20 stores.

Comparable store sales percentage change by brand for the thirdfirst quarter 2006of 2007 over 20052006 were as follows: