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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

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, 902,105,234 shares as of May 28, 2005

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THE GAP, INC.

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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.

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THE GAP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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THE GAP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The condensed consolidated balance sheets as of April 30, 2005, January 29, 2005 and May 1, 2004, the interim condensed consolidated statements of operations and the condensed consolidated statements of cash flows for each of the thirteen week periods ended April 30, 2005 and May 1, 2004, 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 April 30, 2005 and May 1, 2004 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 January 29, 2005.

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 weeks ended April 30, 2005 are not necessarily indicative of the operating results that may be expected for the year ending January 28, 2006.

During fiscal 2004, we re-evaluated our lease accounting practices and corrected the way we account for our leases, specifically the accounting for operating leases with scheduled rent and tenant allowances.

Under the requirements of FASB Technical Bulletin 85-3, “Accounting for Operating Leases with Scheduled Rent Increases,” rent expense should be amortized on a straight-line basis over the term of the lease. In prior periods, we had determined that the term of the lease begins on the commencement date of the lease, which generally coincides with the store opening date, instead of at the time we take physical possession of the property to start construction on leasehold improvements. This had the effect of excluding the construction period of the stores from the calculation of the period over which rent is expensed. We have restated our previously reported financial statements to correct our accounting for scheduled rent increases.

In addition, under FASB Technical Bulletin 88-1, “Issues Relating to Accounting for Leases,” lease incentives such as tenant allowances received from the landlord to cover construction costs incurred by us should be reflected as a deferred liability, amortized over the term of the lease and reflected as a reduction to rent expense. We had previously classified a portion of tenant allowances as a reduction to store build out costs instead of as a deferred lease credit on the consolidated balance sheet to reflect construction costs incurred on behalf of the landlord. As a result, we also amortized the deferred lease credit over the asset life instead of over the lease term and reflected the amortization as a reduction to depreciation expense instead of as a reduction to rent expense. We reassessed this accounting policy in 2003 and effective February 1, 2004, prospectively changed our accounting policy to treat lease incentives received as deferred lease incentives. We have also corrected the prior years consolidated financial statements to properly account for tenant allowances.

In addition, we have restated our first quarter 2004 condensed consolidated statements of cash flows to reflect changes in restricted cash balances as an investing activity rather than a financing activity.

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The following is a summary of the effects of these adjustments on our condensed consolidated financial statements.

In December 2004, the FASB issued Statement No. 123 (revised 2004) (“SFAS 123(R)”), “Share-Based Payment,” which was initially proposed to be effective for reporting periods beginning after June 15, 2005. In April 2005, the Securities and Exchange Commission amended the compliance date to the first interim reporting period of the registrant’s next fiscal year. SFAS 123(R) requires an entity to recognize compensation expense in an amount equal to the fair value of share-based payments granted to employees. We will adopt SFAS 123(R) in the first quarter of fiscal 2006 and apply the standard using the modified prospective method, which requires compensation expense to be recorded for new and modified awards. For any unvested portion of previously issued and outstanding awards, compensation expense is required to be recorded based on the previously disclosed SFAS 123 methodology and amounts. Prior periods presented are not required to be restated. We are still assessing the impact on our results of operations and financial position upon the adoption of SFAS 123(R).

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, “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. Performance units 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.

Beginning in 2005, the Compensation and Management Development Committee of the Board of Directors (the “Committee”) began granting stock awards in the form of performance units under our 1996 Stock Option and Award

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Plan. One share of common stock is issued for each performance unit upon time-based vesting of the awards. During the first thirteen weeks of 2005, we awarded approximately 1.9 million performance units subject to time-based vesting. We recognize compensation expense for these performance units based on the fair market value of the underlying common stock on the date of grant. The award is shown as an increase to shareholders’ equity and is amortized to operating expenses over the vesting period of the performance unit.

Also, beginning in 2005, the Committee set goals under the Executive Management Incentive Compensation Award Plan (“Executive MICAP”) with awards payable in performance units issued under our 1996 Stock Option and Award Plan. These performance units will only be granted upon the achievement by the company of certain performance metrics. The final number of performance units to be awarded will be based on achievement of the performance criteria and the fair value of our common stock on the date of the award. After granting, each performance unit will be subject to time-based vesting. We recognize compensation expense for performance units over the performance and vesting period of the units. At April 30, 2005, we estimated that approximately 600,000 performance units may be awarded.

Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure an Amendment of FASB Statement No. 123” and Statement of Financial Accounting Standards No. 123 (“SFAS 123”) requires the disclosure of pro forma net earnings per share as if we had adopted the fair value method. Under SFAS 123, the fair value of stock based compensation is calculated through the use of option pricing models. These models require subjective assumptions, including future stock price volatility and expected life, which affect the calculated values. The following table illustrates the effect on net earnings and earnings per share had we applied the fair value recognition provisions of SFAS 123:

Comprehensive earnings include net earnings as currently reported under generally accepted accounting principles, and other comprehensive earnings. Other comprehensive earnings consider the effect of additional economic events that are not required to be recorded in determining net earnings but rather are reported as a separate component of shareholders’ equity. Other comprehensive earnings include foreign currency translation adjustments and fluctuations in the fair market value of certain derivative financial instruments.

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Comprehensive earnings for the thirteen weeks ended April 30, 2005 and May 1, 2004 were as follows:

As of April 30, 2005, we had $570 million in trade letters of credit issued under our letter of credit agreements totaling $900 million. There were no drawings under our $750 million revolving credit facility.

On March 11, 2005, we called for the full redemption of $1.373 billion aggregate principal amount of our 5.75 percent Senior Convertible Notes due March 15, 2009. The redemption was completed by March 31, 2005. Note holders had the option of receiving either cash at a redemption price equal to 102.46 percent of the principal amount of the note, plus accrued interest, for a total of approximately $1,027 per $1,000 principal amount of notes, or alternatively, converting their notes into approximately 62.03 shares of Gap Inc. common stock per $1,000 principal amount, at a conversion price equal to $16.12 per share, thereby forfeiting any accrued interest after coupon payment date of March 15, 2005. As of March 31, 2005, $1.373 billion of principal was converted into 85,143,950 shares of Gap Inc. common stock and approximately $0.5 million was paid in redemption.

In line with our objective of reducing long-term debt, during the first thirteen weeks of fiscal 2004, we repurchased and extinguished early an aggregate of $47 million in principal amount of our bonds due 2005, $49 million in principal amount of our bonds due 2007 and $74 million in principal amount of our bonds due 2008. Therefore, for the thirteen weeks ended May 1, 2004, we reduced our domestic debt by $170 million. We performed a net present value analysis on our outstanding debt and determined that it would be more beneficial to repurchase the debt early even though we incurred $30 million in losses on early retirement of debt due to premiums paid and issuance cost write-offs.

On February 10, 2005, Standard & Poor’s upgraded our senior unsecured debt rating to investment grade, BBB- from BB+, with a stable outlook. On April 5, 2005, Moody’s upgraded our senior unsecured debt rating to Baa3 from Ba1, with a positive outlook. As a result of these upgrades by the rating agencies, the interest rate payable by us on the 2008 notes will decrease by 50 basis points to 9.55 percent per annum as of June 15, 2005.

Stock Repurchase Program

On February 24, 2005, we announced the authorization of a new $1.5 billion share repurchase program. Under this program, shares may be repurchased over 24 months. During the first thirteen weeks of 2005, we have repurchased approximately 26 million shares of our common stock at a total cost of approximately $556 million, at an average price per share of $21.53 including commissions.

Differences between cash used in financing activities related to purchase of common stock and the comparable change in shareholders’ equity of $67 million is due to the timing difference between the recognition of common stock purchases and the cash settlement of the common stock purchases.

Dividends

On January 25, 2005 we announced that our Board of Directors declared a quarterly dividend of $0.0222 per share payable on February 23, 2005, to shareholders of record at the close of business on February 8, 2005.

On February 24, 2005 we announced our intention to increase our annual dividend per share from $0.0888 to $0.18 for fiscal year 2005, excluding the dividend paid on February 23, 2005. The dividend is expected to be payable quarterly in late April, July, October and January.

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On March 22, 2005 we announced that our Board of Directors declared a first quarter dividend of $0.045 per share payable on April 26, 2005, to shareholders of record at the close of business on April 5, 2005.

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 performance units, 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 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 35,814,023 and 30,080,033 shares of common stock during the thirteen weeks ended April 30, 2005 and May 1, 2004, respectively. For the thirteen weeks ended April 30, 2005 and May 1, 2004, 18,365 and 0 performance units have been excluded from the calculation of diluted earnings per share. The excluded amounts are calculated using the treasury stock method and the calculation is based on the number of units expected to be awarded upon achievement of the performance criteria established under Executive MICAP. The calculated amounts have been excluded because the performance conditions were not met as of the end of the quarter. See Note 4 for a discussion of the performance unit awards.

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The following table provides the liability balances and activities of our sublease loss reserve:

We record a sublease loss reserve for the net present value of the difference between the contract 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, including a review of real estate market conditions, our projections for sublease income and sublease commencement assumptions. Sublease loss charges are reflected in operating expenses in our condensed consolidated statements of operations.

Remaining cash expenditures associated with the headquarter facilities sublease loss reserve are expected to be paid over the various remaining lease terms through 2017. Based on our assumptions as of April 30, 2005, we expected our lease payments, net of sublease income, to result in a total net cash outlay of approximately $147 million for future rent.

In mid-May 2005, we decided that we would occupy one of the vacant leased properties in San Francisco. The sublease loss reserve of $58 million at April 30, 2005 will be reversed in the second quarter of 2005. See Note 11.

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, intellectual property, financial agreements and various other agreements. Under these contracts we may provide certain 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 party to a reinsurance pool for workers’ compensation, general liability and automobile liability, we have guarantees with a maximum exposure of $82 million, of which $15 million has been cash collateralized.

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, and labor and employment 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.

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.

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Letter of Credit Agreements

On May 6, 2005, we entered into four separate $125 million 3-year letter of credit agreements and four separate $100 million 364-day letter of credit agreements for a total aggregate availability of $900 million, which collectively replace our existing letter of credit agreements. Unlike the existing letter of credit agreements, the new letter of credit agreements are unsecured. Consequently, the $900 million of restricted cash that collateralized the existing letter of credit agreements was fully released as of May 6, 2005. This cash will not be reflected as restricted cash on our condensed consolidated balance sheet beginning in the second quarter of 2005. The new letter of credit agreements contain financial and other covenants substantially similar to those included in our $750 million five-year unsecured revolving credit facility, including, but not limited to, limitations on liens and subsidiary debt as well as the maintenance of two financial ratios – a fixed charge coverage ratio and a leverage ratio. A violation of these covenants could result in a default under the new letter of credit agreements, which would permit the participating banks to terminate our ability to request letters of credit and require the immediate posting of cash collateral in support of any outstanding letters of credit. In addition, such a default could, under certain circumstance, permit the holders of our outstanding unsecured debt to accelerate payment of such obligations.

Headquarters Facilities

We recently completed an assessment of our available space and future office facility needs. In mid-May 2005, we decided that we would occupy one of the vacant leased properties in San Francisco. The sublease loss reserve of $58 million at April 30, 2005 will be reversed in the second quarter of 2005. Planning efforts to design and construct this space for occupation in 2006 have not commenced.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Shareholders

The Gap, Inc.

We have reviewed the accompanying condensed consolidated balance sheets of The Gap, Inc. and subsidiaries (the “Company”) as of April 30, 2005 and May 1, 2004, and the related condensed consolidated statements of operations and cash flows for the thirteen-week periods ended April 30, 2005 and May 1, 2004. These interim financial statements are the responsibility of the Company’s management.

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, 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 the standards of the Public Company Accounting Oversight Board, the consolidated balance sheet of The Gap, Inc. and subsidiaries as of January 29, 2005, 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 25, 2005, we expressed an unqualified opinion on those consolidated financial statements and included an explanatory paragraph relating to the restatement discussed in Note 2. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of January 29, 2005 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

As discussed in Note 2, the accompanying condensed consolidated financial statements for the thirteen-week period ended May 1, 2004 have been restated.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Our Business

We are a global specialty retailer operating retail and outlet stores selling casual apparel, accessories, and personal care products for men, women and children under the Gap, Banana Republic and Old Navy brands. We operate stores in the United States, Canada, the United Kingdom, France and Japan. In addition, our U.S. customers may shop online at gap.com, bananarepublic.com and oldnavy.com. We design virtually all of our products, which are manufactured by independent sources, and sell them under our three brands: Gap, Banana Republic, and Old Navy.

Overview

Despite a challenging first quarter, we continued to make progress on driving shareholder value by returning $556 million in excess cash to shareholders through share repurchases and by completing the redemption of our $1.37 billion Senior Convertible Notes which were converted into approximately 86 million shares. Net sales for the first quarter decreased 1 percent while retail comparable store sales were down 4 percent compared to last year. Gross margin declined 2.3 percentage points from last year, primarily impacted by a highly promotional environment and weak product acceptance, which drove regular margin decreases. Our operating expenses increased 1.8 percentage points from the prior year as we continued to invest in growth initiatives to drive long term value and also incurred incremental marketing expenses in our international operations. The above factors resulted in net earnings that were 7 percent below last year and earnings per share of $0.31, which was $0.02 lower than last year.

We generated free cash flow of $113 million, a decrease of $17 million compared to prior year due to lower earnings and higher capital expenditures, which were associated with new store openings and store remodels as we invest in our future. Such factors were offset by improvements in working capital management. For a reconciliation of free cash flow, a non-GAAP measure, to a GAAP measure, see the Liquidity section of this Management’s Discussion and Analysis. In addition, Standard & Poor’s upgraded our senior unsecured debt rating to investment grade, BBB- on February 10, 2005 and Moody’s upgraded our senior unsecured debt rating to investment grade, Baa3 on April 5, 2005. Subsequent to the first quarter of fiscal 2005, we renegotiated our letter of credit agreements, which will add to our financial flexibility and decrease most of our restricted cash balance on our consolidated balance sheet.

We unveiled our fourth brand, Forth & Towne, as our newest concept in our family of brands, which will offer fashionable apparel and accessories targeting women over age 35. Forth & Towne will launch in five test stores in the fall of 2005.

Furthermore, we made solid progress on our plan to enhance shareholder value through cash distributions. We continued to return excess cash to shareholders by repurchasing approximately 26 million shares of our common stock for $556 million and doubled our quarterly dividend from $0.0222 per share to $.045 per share.

In summary, we remain focused on operational discipline and will continue to execute our strategies for the remainder of 2005. These strategies include providing innovative trend right products for our customers; rolling out size localization to drive higher regular price selling; consolidating vendors to build sustaining relationships to leverage our scale; and executing new growth initiatives such as Old Navy store growth and the launches of Forth & Towne and Banana Republic in Japan. We are focused on improving our product and believe that our strong operational discipline will continue to provide a solid foundation for earnings growth. We are confident in our brand strategies and our ability to drive long-term shareholder value.

For the full year, we are reaffirming our previous guidance with operating margin expectation of about 13 percent. We expect our annual earnings per share to be $1.44 to $1.48 per share, with more than half of the growth to come from the absence of early debt retirement costs, lower share count due to share repurchases, and interest savings. This estimate reflects the impact of the real estate decision discussed in Note 11 to the accompanying condensed consolidated financial statements, but does not include the effect of the new accounting requirement under SFAS 123R to expense stock options beginning in the first quarter of 2006.

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Forward-Looking Statements

This Quarterly Report on Form 10-Q Report 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) timing of dividends in fiscal 2005; (ii) impact of loss under contractual indemnifications; (iii) providing innovative trend right products for our customers; (iv) rolling out assortment and size localization to drive higher regular price selling; (v) building sustaining vendor relationships and leveraging our scale; (vi) execution of new growth initiatives; (vii) improving our product; (viii) providing a solid foundation for earnings growth; (ix) driving long-term shareholder value; (x) earnings per share for fiscal 2005; (xi) operating margin for 2005; (xii) interest expense savings for fiscal 2005; (xiii) gross interest expense for fiscal 2005; (xiv) effective tax rate for fiscal 2005; (xv) free cash flow in fiscal 2005; (xvi) amount of unrestricted cash available in the future; (xvii) year over year change in inventory per square foot at the end of the second quarter of fiscal 2005 and the third quarter of fiscal 2005; (xviii) capital expenditures in fiscal 2005; (xix) number of new store openings and store closings in fiscal 2005 and weightings by brand; (xx) net square footage change in fiscal 2005; (xxi) funding of capital expenditures in fiscal 2005; (xxii) dividend policy and increases in future periods; and (xxiii) maximum exposure and cash collateralized balance for reinsurance pool in future periods.

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 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 our credit ratings may have a negative impact on our financing costs and capital 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 29, 2005.

Future economic and industry trends that could potentially impact net sales and profitability are difficult to predict. These forward-looking statement are based on information as of May 31, 2005 and we assume no obligation to publicly update or revise our forward-looking statements even if experience or future changes make it clear that any projected results expressed or implied therein will not be realized.

We suggest that this document 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 January 29, 2005.

RESTATEMENT OF FINANCIAL STATEMENTS

As discussed in Note 2 to the condensed consolidated financial statements, during fiscal 2004, we re-evaluated our lease accounting practices and corrected the way we account for our leases, specifically the accounting for operating leases with scheduled rent and tenant allowances.

In addition, we have restated our first quarter of 2004 consolidated statements of cash flows to reflect changes in restricted cash balances as an investing activity rather than a financing activity.

All items in this management’s discussion and analysis have been revised for the effects of these restatements.

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RESULTS OF OPERATIONS

Business in the first quarter was challenging. Net earnings decreased 7 percent to $291 million or $0.31 per share, compared to net earnings of $312 million or $0.33 per share.

Net Sales by Brand, Region and Channel

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.

Net Sales

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 by more than 15 percent 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.

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 more than 15 percent within the past year, or the store has been permanently repositioned within the past year is considered Non-comp. Non-store sales such as online operations are also considered Non-comp.

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Our first quarter 2005 sales decreased $42 million, or 1 percent, compared to the first quarter of fiscal 2004. Our comparable store sales declined 4 percent, primarily driven by weak product acceptance of our spring merchandise, which drove higher promotions and reduced regular price selling. Gap international comparable store sales were negatively impacted by weak product acceptance in Japan, while Europe enjoyed positive response to its increased market-specific assortment. We continue to study local market preferences and are working to better tailor product assortments to be more market appropriate. In addition, we are hiring dedicated design teams for the international markets and will continue to place merchants in markets in both Tokyo and London to address local customer merchandising needs. Although we ended the first quarter of fiscal 2005 with fewer stores than the end of the first quarter of fiscal 2004, our new store openings outpaced our store closures, which drove the increase in total noncomparable store sales. Our overall net square footage increased slightly. Sales productivity in the first quarter of fiscal 2005 decreased to $95 per average square foot compared with $97 per average square foot in the first quarter of fiscal 2004. During the first quarter of fiscal 2005, we closed 25 under-performing stores, mainly for Gap brand. We opened 41 new stores, mainly for Old Navy.

Comparable store sales percentage by brand for the first quarter 2005 and 2004 were as follows:

Store count and square footage were as follows:

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Cost of Goods Sold and Occupancy Expenses

Cost of goods sold and occupancy expenses include the cost of merchandise, inventory shortage and valuation adjustments, inbound freight charges, purchasing and receiving costs, certain payroll costs associated with our sourcing operations, inspection costs, warehousing costs, rent, occupancy and depreciation for our stores and distribution centers.

Cost of goods sold and occupancy expenses as a percentage of net sales increased 2.3 percentage points during the first quarter of fiscal 2005 compared with the first quarter of fiscal 2004. The margin decline was driven by the clearance of spring merchandise, which increased promotional selling and decreased regular price margins. Rent, occupancy and depreciation expenses as a percentage of sales were flat compared to the same quarter in the prior year.

As a general business practice, we review our inventory levels in order to identify slow-moving merchandise and broken assortments (items no longer in stock in a sufficient range of sizes) and use markdowns to clear the majority of this merchandise.

Operating Expenses

Operating expenses include payroll and related benefits (for our stores, distribution network and corporate functions), advertising, and general and administrative expenses. Also included are costs to design and develop our products, pre-opening expenses related to new store openings, store closure reserves, sublease loss reserves, and the costs of maintenance and minor enhancements, which are expensed as incurred.

Operating expenses as a percentage of net sales increased 0.8 percentage points during the first quarter of fiscal 2005 as compared to the first quarter of fiscal 2004. The increase was primarily due to planned increases to support new growth initiatives, such as our new brand Forth & Towne, Old Navy store growth and Banana Republic in Japan, as well as increased advertising expenses. Gap International ran incremental advertising campaigns in U.K. compared to the prior year and Banana Republic shifted summer and fall photo shoots to the first quarter in 2005 as compared to the second quarter in 2004.

We recently completed an assessment of our available space and future office facility needs. In mid-May 2005, we decided that we would occupy one of the vacant leased properties in San Francisco. The sublease loss reserve of $58 million at April 30, 2005 will be reversed in the second quarter of 2005. Planning efforts to design and construct this space for occupation in 2006 have not commenced.

Operating margin, excluding loss on early retirement of debt, was 12.8 percent and 15.9 percent for the first quarter of fiscal 2005 and 2004, respectively. For the full year fiscal 2005, we expect operating margin to be about 13 percent.

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Loss on Early Retirement of Debt

In line with our objective of reducing long-term debt, during the first thirteen weeks of fiscal 2004, we repurchased and extinguished early an aggregate of $47 million in principal amount of our bonds due 2005, $49 million in principal amount of our bonds due 2007 and $74 million in principal amount of our bonds due 2008. Therefore, for the thirteen weeks ended May 1, 2004, we reduced our domestic debt by $170 million and incurred $30 million in loss on early retirement of debt due to premiums paid and issuance cost write-offs.

Interest Expense

The decrease of $29 million in interest expense during the first quarter of fiscal 2005 compared with the first quarter of fiscal 2004, was primarily due to the lower debt level from our debt repurchases, scheduled debt maturity and conversion of the Senior Convertible Notes, as well as savings from lower facility fees on our new credit facility.

We anticipate that fiscal 2005 earnings will reflect $112 million in interest expense savings over fiscal 2004 primarily as a result of our March 2005 redemption of the convertible notes and lower debt balances. For fiscal 2005, we expect gross interest expense to be about $55 million.

Interest Income

The increase of $13 million in interest income during the first quarter of fiscal 2005, compared with the first quarter of fiscal 2004, was primarily due to higher yields on our investments.

Income Taxes

The decrease in the effective tax rate during the first quarter of fiscal 2005 compared to the first quarter of fiscal 2004 primarily reflects the favorable resolution of several state audits (net of the effect on federal income tax) and reassessment of other tax exposures.

We currently expect the fiscal 2005 effective tax rate to be in a range of 38.0 percent to 39.0 percent, although the respective quarterly effective tax rates could be outside of this range. The actual rate will ultimately depend on several variables, including the mix of earnings between domestic and international operations, the overall level of earnings, and the potential resolution of outstanding tax contingencies.

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FINANCIAL CONDITION

The following sets forth certain measures of our liquidity:

Working capital and current ratio decreased as of April 30, 2005 due primarily to cash spend on share repurchases compared to last year.

Free Cash Flow