Good day, ladies and gentlemen, and welcome to the Lululemon Athletica second quarter 2013 results conference call. At this time, all participants are in listen only mode. Later, we will conduct a question and answer session and instructions will follow at that time. If anyone should require operator assistance, please press star then the zero key on your touchtone telephone. As a reminder, this conference call may be recorded. I would now like to introduce your host for today's conference, Therese Hayes. Ma'am, you may begin.
Thank you. Good morning, everybody, thank you for joining us on the call. A copy of today's press release is available in the investor relations section of our website or furnished on Form 8-K with the SEC and available on the Commission's website at www.sec.gov. Shortly after we end this morning, a recording of today's call will be available as a replay for 30 days, also available on the website. Hosting our call today is Christine Day, the company's CEO, and John Currie, the company's CFO. We would like to remind everyone, of course, that statements contained on this call, which are not historical facts, may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.
Actual results may differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the company's filings with the SEC. We have about one hour for the call today, so when we get to the Q&A, if you can limit yourself to one question at a time to give everyone the chance to ask their question, that would be great. With that, I'll turn it over to Christine.
Thank you, Therese. Good morning, everyone, and thank you for joining us today to talk about our second quarter results. John will speak to the numbers in detail in a few minutes. Today, I will speak to where we are strategically, update on the key hires, including the CEO search, and report on some exciting developments within the company. This is the time of year when our board approves the short and long-term strategic plans, and we have spent the last couple of days aligning on these plans and the key initiatives and milestones for the company going forward.
A practical benefit of being in the second year of the three-year strategic plan is that with a strong plan in place, the new CEO will be able to come in and rely on the management team to run the business while they take the time required to learn how they can incorporate their specific expertise and experience into our culture and business model. As we announced during our last quarterly call, the board formed a search committee and began executing its CEO succession plan as soon as I communicated my intention to step down from the CEO role. The board engaged search consultants to screen for the full range of potential candidates for this role, and over the past couple of months has reviewed a list of possible candidates.
The search committee is in discussion with several high caliber candidates, in the coming months, expects to narrow the list to the final candidate. The start date for the successful person will be dependent on their required notice period, move to Vancouver, et cetera. With a very strong senior management team in place to execute the strategy and run the business, we have plans in place for an orderly transition. Speaking of key people in the organization, over the past several months, we have been focused on strengthening our product operations function so we can continue to grow globally while maintaining high quality standards. It is a critical area of our business, I'm excited today to share some leadership and organizational changes we've made in the areas of sourcing, quality, and commercialization. First, we've brought these groups together under one function.
This new alignment will streamline reporting and enhance working relationships internally and with our factories. It will also strengthen our quality process, including our end-to-end product life cycle. As part of that strategy, we named Jennifer Battersby as our new Senior Vice President of Sourcing, Quality, and Commercialization. Jennifer brings more than 20 years of industry experience, having spent a large part of her career with Mast Industries. Her last role with Mast was SVP, Victoria's Secret Production Asia, where she led the production and sourcing, product development, raw materials, and fit teams in Hong Kong, Sri Lanka, and Korea. Most recently, she worked as a consultant on strategic sourcing solutions and established best practices from design handoff to manufacture. Jennifer isn't a new face to Lululemon and has been with us as a consultant since May and is already well immersed into the culture and business.
Jennifer's team will include some of the strongest leaders in our industry, whose dedicated efforts over the past several months have enhanced our quality standards and processes with our factories, vendors, and partners around the world. We are very fortunate to have such a talented group led by Joan Mudgett, our VP of Global Product Quality since September of 2012, Linda Goldstein, our VP, Global Sourcing and Production since January of 2011, and Krista Schreiber, our Director of Product Commercialization since January of 2013. We have made significant progress on the search for our new EVP of product, and at this time have identified a strong talent pool for this role and anticipate hiring will be coordinated with the CEO hire. We've also hired Steve Berube, Senior Vice President, Distribution and Logistics.
Steven joins us from Cole Haan, where he spent nearly 18 years, most recently serving as VP, production, distribution, and customer service. He'll be a big asset to our team as we continue to build and evolve our logistical capabilities to distribute our product to stores and guests around the world. While Steve is completing his onboarding, we have been setting up the business to support our 10-year growth plans for the U.S. business, and in August, signed the contract for our distribution facility in Columbus, Ohio. The Columbus DC is scheduled for operation in June of 2014. The key benefit is enhancing our guest experience by enabling cost-effective two-day service to 100% of e-commerce guests and faster replenishments of our retail stores. On the product side, we are continuing to support and solidify our points of differentiation.
At the end of July, we introduced Full-On Luon, a next generation Luon that we have been working on for the past couple of years, and it has met with rave reviews from our guests in stores and online. We are expanding our base of production for Luon and have onboarded a second source for Luon and are on track to onboard the third for the first part of 2014. We recognize the value of our unique fabrics and technologies and are taking steps to protect this competitive advantage. We are making great progress on the construction of our R&D center under the direction of our Whitespace team, and you will have the opportunity to experience the facility firsthand in April when we host our Analyst Investor Day here in Vancouver at our support center. Today, we announced the strategic global alliance for X-STATIC with Noble Biomaterials.
This partnership gives Lululemon exclusivity to the use of Noble's X-STATIC antimicrobial, I can never say that word, micro material technology of our performance apparel. Noble has been the longstanding partner of Lululemon, providing its X-STATIC technology for our Silverescent fabric since 2005. This unique opportunity allows us to continue to innovate our technical product and secure our leadership position in anti-stink athletic apparel. X-STATIC properties have helped Lululemon to set the industry standard by using the most powerful silver fabric technology to create our Silverescent fabrics. Made with 99.9% pure metallic silver, X-STATIC is designed to provide permanent odor protection by naturally inhibiting the growth of bacteria on the surface of fabrics. The silver fiber is woven directly into the garment and will not wash out over time through laundering.
There were several key brand initiatives during the Q2, including a focus on yoga at our core, where in addition to the roughly 60,000 people per quarter who participate in our store's regular weekly complimentary yoga classes, we brought 200,000 people to the mat through a number of exciting yoga events around the world, including 1,500 people practicing weekly at Parliament Hill in Canada's capital city of Ottawa. 22,000 yogis at Wanderlust events in North America, 5,000 people celebrated the SeaWheeze Weekend with yoga music concert combination at Stanley Park here in Vancouver, a mega yoga event at Busch Stadium in St. Louis, Missouri, and over 300 people came together on the mat in Covent Garden in London. Hey Lululemon, introduced this quarter, is our first-owned online community.
It is designed to create deeper level of engagement and trust with our guests, where they can share their feedback and ideas with us and join in a conversation with behind-the-scenes updates straight from our functional experts. We were delighted to see that we were listed as the top e-tail performer in web customer service in July in a report published in WWD called the Studies of Satisfaction Survey, where we dominated the sportswear category with the best scores in phone, email, and shipping. A big shout-out to our folks at the guest education center and distribution centers for all their hard work. It is nice to see it recognized externally. We are committed to earning our reputation for quality and guest experience every day. We saw strong guest response to our technical innovation, like the sweatproof pocket and to the functionality and styling in bags and backpacks.
We have also brought wraps into the assortment, giving the guest à la carte pieces she loves. While the fall product was later to arrive in our stores, we have seen good response to the fall color palette and the texture and print we have brought into our corner. We are excited about the innovation you will be seeing in functional outerwear and textured soft shell fabrics, puffy jackets and vests, and versatile silhouettes. Our SVP of men's, Felix del Toro, has been with us almost six months now, and he is doing a really great job of building the team to support the expansion of the men's business. He arrived in time for the spring buy review of 2014, and we are all really looking forward to seeing the full impact of Felix and his team in the men's product in 2015.
We are focused on creating a brand that builds on the same philosophy as our women's product with fit, form, and function at the core. However, recognizing the unique characteristics of our male guests, the build of team and product will dovetail well with the timing of the planned expansion of men's, and our store development team is starting the process of looking for optimal sites for our men's stores, which we anticipate opening by 2016. We see this as a tremendous opportunity for Lululemon. Men's penetration in Q2 grew to 13.2% of the business. We are on track with our plans to have 16 international showrooms open by year-end, planting the seeds for our global expansion. In August, just ahead of SeaWheeze, we were thrilled to host 28 showroom managers and community connectors from our newest markets in Europe and Asia for a week of cultural immersion.
A number of them have worked at Lululemon for several years, and others had joined two weeks prior to coming to Vancouver. To give you a sense of the kind of growth in our international people, only three were in Vancouver at this time last year for the leadership conference. This year, we had representation from Hong Kong, Shanghai, Singapore, Tokyo, London, Amsterdam, Berlin, Munich, and Frankfurt. As a final note on our international business, I am very excited to announce that we have just signed a lease for our first international store in London, in Covent Garden, and expect to be able to welcome guests through that door in Q2 2014. With that, I'm going to turn it over to John to go through the numbers.
Thanks, Christine. I will begin by reviewing the details of our second quarter of 2013, then I will update you on our outlook for the third quarter and the full year of fiscal 2013. For the second quarter, total net revenue rose 21.9% to $344.5 million, from $282.6 million in the second quarter of 2012. The increase in revenue was driven by comparable store sales growth of 8% on a constant dollar basis, direct-to-consumer sales, which increased by 39.4%, or $14 million. If we included e-commerce as a store in our comp calculations, the combined comp would be reported as 13% on a constant dollar basis. The addition of 37 net new corporate-owned stores since Q2 of 2012, 28 new stores in the U.S., two stores in Canada, five stores in Australia and New Zealand, and two ivivva stores.
These were offset with the impact of a lower Canadian and Australian dollar, which had the effect of decreasing reported revenues by $2.5 million or 0.7%. During the quarter, we opened six Lululemon stores in the U.S., one in Canada, and one ivivva store. We ended the quarter with 226 total stores versus 189 a year ago. There are 176 stores in our comp base, 37 of those in Canada, 113 in the U.S., 19 in Australia, New Zealand, and seven ivivva. At the end of the quarter, we operated 62 showrooms, including three in Asia, five in Europe, and 11 ivivva locations. Corporate-owned stores represented 79.5% of total revenue, or $273.8 million versus 81.9%, or $231.3 million in the second quarter of last year.
Revenues from our direct-to-consumer channel totaled $49.4 million, or 14.3% of total revenue, versus $35.4 million or 12.5% of total revenue in the second quarter of last year. Other revenue, which includes wholesale, showrooms, and outlets, totaled $21.4 million or 6.2% of revenue for the second quarter versus $15.9 million or 5.6% of revenue in the second quarter of last year. Gross profit for the second quarter was $186.0 million or 54% of net revenue, compared to $155.8 million or 55.1% of net revenue in Q2 of 2012. Product margin declined 220 basis points, due primarily to a lower mix of higher margin black Luon bottoms and increases in our inventory reserves. These factors were partially offset by 70 basis points of leverage from occupancy and depreciation and 40 basis points of leverage in product and supply chain team costs, due primarily to the timing of spend.
SG&A expenses were $107 million or 31.1% of net revenue, compared to $85.6 million or 30.3% of net revenue for the same period last year. The increase is due to an increase in store labor and operating expenses associated with new stores, showrooms, and outlets, as well as increases at existing locations due to higher sales volumes. Increased variable operating costs associated with our e-commerce business, consistent with the 39% year-over-year revenue growth in this channel. An increase in expenses at our store support center, including salaries, administrative expenses, professional fees, management incentive, and stock-based compensation associated with the growth of our business. These increases were offset with a weaker Canadian and Australian dollar, which decreased reported SG&A by $1 million or 0.9%. In addition, we recorded a $4.4 million foreign exchange gain in our Canadian operating entity.
As a percentage of revenue, our second quarter SG&A deleveraged 80 basis points due primarily to deleverage in store salaries and wages. As a result, operating income for the second quarter was $79.0 million or 22.9% of net revenue, compared with $70.2 million or 24.8% of net revenue in Q2 of 2012. Tax expense for the quarter was $23.8 million, or a tax rate of 29.7%, compared to $13.7 million, or a tax rate of 19.1% in the second quarter of 2012. Recall that in Q2 last year, we recorded a lower tax expense to reflect the catch-up and ongoing benefit of revised intercompany pricing arrangements. Net income for the quarter was $56.5 million, or $0.39 per diluted share. This compares with net income of $57.2 million, or $0.39 per diluted share for the second quarter of 2012.
Remember, the favorable impact of the retroactive tax adjustment last year contributed $0.05 per share. Normalized for that catch up, EPS in Q2 of 2012 would've been $0.34 compared apples to apples with the $0.39 we're reporting for this Q2. Our weighted average diluted shares outstanding for the quarter were 145.9 million, versus 145.7 million a year ago. Capital expenditures were $23 million for the quarter related to new stores, renovations, IT, and head office capital, compared to $26.4 million in the second quarter last year. Turning to our balance sheet highlights, we ended the quarter with $610.3 million in cash and cash equivalents. Inventory at the end of the second quarter was $163 million, or 30% higher than at the end of the second quarter of 2012, higher than our forward sales growth expectations.
This now leads me to our outlook for the third quarter and full fiscal year 2013. Over the past several months, we've focused on quality and getting Luon back into our stores. While this is clearly what was important for our future, it resulted in some short-term pain. We've experienced a weak start to this quarter, driven primarily by late deliveries of fall product, leaving us with the summer product on the floor through August. These late deliveries are a hangover from the disruption caused earlier in the year with the Luon issue. While we were successful in getting back in stores with Luon, the effort required to get there had a lingering impact on our commercialization and sourcing team's ability to be ready to hand off to our vendors the current season.
We anticipate this knock-on effect to continue to impact timing of product deliveries in Q3 and through the balance of the year. As a result, we now anticipate revenue for the third quarter in the range of $370 million-$375 million. The low end of guidance reflects how we've been trending in the first half of the quarter, and the high end reflects some improvement in product flow. This is based on comparable store sales percentage increase in the mid-single digits on a constant dollar basis compared with the third quarter of 2012. This outlook assumes a Canadian dollar at CAD 0.96 to the U.S. dollar and 22 new store openings: 18 in the U.S., two in Australia, and two ivivva.
We expect gross margin to be below last year and at the low end of the mid-50s range due to higher airfreight costs and the impact of foreign exchange due to a weaker Canadian dollar compared to last year. We expect SG&A deleverage as a percentage of revenue compared to the third quarter of 2012, which is driven primarily from the run rate of IT investments made over the past year, strategic investments being made this year, and expenses associated with our international expansion. As Christine mentioned, we plan on opening a second USDC in Columbus, Ohio in the second half of 2014. In addition to costs associated with the planning and integration of the facility, a number of key systems implementations, order management, purchase order management, and a new warehouse management system are necessary prior to this launch.
These projects were all approved and launched in the second quarter of 2013. Assuming a tax rate of 30% and 146 million diluted average shares outstanding, we expect diluted earnings per share in the third quarter to be in the range of $0.39-$0.41 per share. For the full FY 2013, we're still targeting to open up to 43 corporate-owned stores, including our ivivva locations. We're also on track to open 13 international showrooms this year. We expect net revenue for the year to be in the range of $1.625 billion-$1.635 billion. We expect gross margin for the year to be between 53% and 54%. Q4 will continue to be impacted by the same factors discussed with respect to Q3. As we've discussed on previous calls, we will also continue to make incremental investments in the areas of quality assurance, design, and product development.
We expect SG&A to deleverage as a percentage of revenue compared to 2012, due in part to lost sales from the Luon shortage and delivery delays and the investments we are making in the business to support our long-term growth. As a result, we now expect our FY diluted earnings per share to be approximately $1.94-$1.97. This is based on 146 million diluted weighted average shares outstanding, and it assumes an effective tax rate of 30%. We expect capital expenditures to be between $100 million and $110 million for FY 2013, reflecting new store build-outs, renovation capital for existing stores, IT projects, real estate purchases, including our new Ohio distribution center, and other head office capital, including the build-out of expansion space and our new R&D center within our store support center here in Vancouver. With that, I'll turn it back to Christine.
Thanks, John. 2013 continues to be the most important and productive year in Lululemon's history. We have not only worked our way back from the black Luon setback but have also added very talented people in important functions and have taken major steps forward on a number of key fronts.
Including the expansion of our international and men's businesses and many logistical initiatives. In addition, our exclusive partnership with Noble, announced today, and additional sources for Luon will help to ensure that Lululemon remains a distinct leader in quality and innovation. We are well on our way to finishing 2013 as a much stronger company than when the year began. I am confident that the leadership currently in place, coupled with a new CEO, will have tremendous success leveraging the platform for growth. With that, we'll go to questions.
Thank you. Ladies and gentlemen, if you have a question at this time, please press star then the one key on your touch tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Our first question comes from Adrienne Tennant of Janney Capital Markets . Your line is now open.
Okay. Thank you. Good morning, everybody. My question is, what is the actual sort of implied comp? You said that there was a tough start to the beginning of the third quarter. Should we assume that it is right in line with that guidance of mid-single digit? Does that guidance imply an acceleration in the comp as the quarter goes on? Then just finally, for the fourth quarter, what type of comp and margin is implicit in the annual guidance? Thank you very much.
Okay. Yeah, the Q3 guidance is based on a mid-single digit comp assumption and slight improvement. As I said, product flow is better as we head into the second half of this quarter, so a slight increase, but still within that mid-single digit range. For the fourth quarter, the implied guidance is high single digits of comp.
The margin, the gross margin?
As I said, it's kind of convoluted that the low end of the mid-50s range, so 53%, 54%, in that range.
Okay. Thank you very much.
Thank you. Our next question comes from Dana Telsey of Telsey Advisory Group. Your line is now open.
Good morning, everyone. Can you give any further update on black Luon and the expected impact for the year on sales and on EPS? Also, with the comps complexion that you had this quarter, levers of the comp, traffic conversion, AUR, and what you're seeing. Thank you.
Okay. Let me start with the Q2 comp makeup question. The comp, such as it was in Q2, is driven by traffic and conversion being up and average basket being down, which makes sense. We didn't have the $98 Groove Pant, for example, in the basket, and we were selling more lower-priced items. I'm sorry, what was the rest of that part of the question?
Expected impact of black Luon pants compared to your original estimate for the year.
Yeah. The overall impact on revenue is $40 million-$45 million. As I recall, initially, we'd projected something higher than that. Since we're through it now, it'll be in that range.
Christine, can you give us any color on the competitive environment and what you're seeing? Thank you.
I think, from reading press headlines every day, you would say that there's a vast variety and growing variety of competitors in the marketplace. What we have seen is that as we return to black Luon, and particularly the new Full-On Luon, has been flying off the shelves, and we've increased some of our orders for that for the back half of the year. In our core initiatives, we do believe our customers waited, and then seized the opportunity to buy. We feel really good about our positioning long term, based on the high, high quality and the introduction of the new Full-On Luon, which will go into all pants in tight bottoms in November. We're very excited about what that will bring us from a competitive set, as well as we announced, obviously, today, X-STATIC. We feel good about our competitive positioning and differentiation.
Thank you.
Thank you. Our next question comes from Sam Poser of Sterne Agee. Your line is now open.
Hi, good morning. It's Ben Shamsian for Sam. Thanks for taking my call. Just a couple of quick questions. You had talked about eight store openings in the quarter. You had 11. Just curious what happened there. Secondly, given the increased spending to go international, can you talk about potential leverage points next year? If there is better top-line results, will most of that get rolled back into the business, or can we see some of that fall through the bottom line? Thank you.
I'm sorry. Can you repeat your first question on the store count, because I wasn't quite clear?
Yeah. You had guided to 11 store openings in the quarter, you opened eight. I just wanted to know if that was-
Oh. Yeah, there were three or four openings that were right around the very end of the quarter, it's just off by a day or so. As you see, there's a lot of openings lumped into Q3, yeah, that excess would've been, like I said, right around the end of Q2. I'm sorry again, can you repeat your other question?
Yeah. With regards to just as your spending goes up to go international next year, can you talk about some of the leverage points if there is better top line? Will we see that get flown to the bottom line, or will most of that get reinvested back into the business?
Yeah. Consistent with the way we've been guiding with the investment in international expansion and with the additional spend we're making to shore up our quality and product capabilities, not that I've guided to next year yet, but I wouldn't expect to see significant leverage next year against the normalized 2013. There is leverage in the core business, but that is being reinvested to build our foundation and to push forward on the international expansion.
Got it. Thank you. Can you just break out for us the Canada comps versus the U.S. comps?
Canada was flat. The U.S. was, I think, it was up low to mid teens.
Got it. Thank you so much.
Thank you. Our next question comes from Sharon Zackfia of William Blair. Your line is now open.
Hi. Actually, just a clarification on the last question first, John. When you're talking about leverage next year off of a normalized margin, I assume you mean normalized excluding the Luon outage?
Yes, exactly.
Okay. Just wanted to clarify that. I guess secondarily, maybe I'll take the Oh, gosh, my new phone. I have a question for Christine, because I think there's a lot of swirling thought processes on how the strategic vision of Lululemon may or may not change going forward, and it sounds like you just went through a process with the board of directors. Maybe if you could talk about where Lulu has been and where it's going, and whether you think there are any major differences that are going to occur going forward versus what we've seen in your outline of the plan previously.
Yeah. We really look at it in a one to three-year strategic plan, which I think I'd refer to as almost an operating strategic plan. That's really deep on foundational investments and the infrastructure we really know we need to grow even today's business. As we start to look into the mid horizons, or what are the seeds that we're planting to maintain long-term growth, a vision that we're painting, a compelling vision that we're painting for really about that 10-year growth. We look at all three horizons, so we know that we're making the right investments today to support that. What we anticipate will happen is, it's very clear the things we need to do over the next three years from a foundational perspective.
As the new CEO comes in, we anticipate that the senior team will be able to continue to drive that day-to-day operational and strategic plan, because what's true today is the team does that. My focus has been, the senior team's focus is much more on that three to five and 10. Just balancing those two things in the beginning, the team is perfectly capable of doing, that allows a new CEO time to come on, learn the company, learn what's different and valuable and distinct around Lululemon, begin to shape those really beyond three-year horizons with their own special talents and uniques and visions for the company. The board and us are very comfortable with that's honestly the discussion that's had with the candidates that are coming in.
Just to be clear, and the pace of expansion, is everybody pretty comfortable with the pace of store expansion that the company has embarked on going forward?
Very slow and steady. International is a very big comfort zone. If somebody wants to come in and accelerate that and change the model in the future, that is always an open discussion. Right now, especially at the transition stage we're on, very much on track. Everybody's committed to that. Men's is seen as a huge opportunity, and that's a go faster as we build the infrastructure. You've got your core business, which is on track and same strategy as we've deployed.
Okay, perfect. Thank you.
Thank you. Our next question comes from Omar Saad of ISI Group. Your line is now open.
Thanks. Good morning. Could you elaborate on why the effort and how the effort to restock the Luon black bottoms, how that's holding back the inventory flow? What's going on at the supplier level, leading to this position where you don't necessarily have the right product for the right time of year where you want it to be, especially since it sounds like some of the Luon product, I think you said flying off the shelves. Is that holding back the tops business? I think last quarter you had mentioned a negative impact from not having the right bottoms and negatively impacting the tops as consumers coordinate the tops and the bottoms. Thanks.
Great. Our main bottleneck right now is our commercialization department. Every time we change a manufacturer or every time we change a pattern or a fabric for the pant, for instance, moving the Wunder Under 2, the new Full-On Luon, requires a complete re-commercialization of every size in that pant. We've had to re-commercialize the original Luon, the new Luon, and for every manufacturer we bring on, and we've got three new manufacturers, we've had to re-commercialize the pants for all of those. Plus, we had to commercialize for every new style.
As we correct for quality and making sure that at every step we've done additional inspections, which has slowed us down, and we've increased our, or decreased would be the correct word, our sewing tolerances, which slowed the factories down a little bit to make sure that at every step in the way, we were getting the quality that we wanted. You add on just time constraints with the amount of quantity of product we're trying to catch up on with Luon and the seasons collapsing. If we're late with one, then it affects the start day of the next. We're incurring a little bit more air freight and slowdown in the shipping process. For us, that is a short-term pain for the long-term gain of really differentiating ourselves on quality, and it's the work that we're managing to make it through.
That commercialization impact in bringing on the third factory is still at play, and we're working back through all of our other fabrics to make sure that we're hitting the quality standard we want. The commercialization workload will affect us for a period of time.
The impact on the tops business from the bottoms?
We definitely saw that in Q3 as we were trying to get back in stock, even the end of Q2, beginning of Q3, the top bottom ratio was definitely affected by the ability of not having bottoms.
Thanks.
Thank you. Our next question comes from Janet Kloppenburg of JJK Research. Your line is now open.
Hi, everybody. Congratulations on a good quarter. I wanted to ask a couple of questions. Christine, I know you probably had too much summer in the stores in August, but if you could give us an idea of the read through that you're getting on the fall products and how confident you are in the styling there, particularly on the tops and outerwear. As we look forward to the fourth quarter and next year, I was wondering how confident you are that these production issues and delivery issues will begin to moderate, and if you have the right people in place to manage that process. For John, I was wondering if you could address two issues. First, the new store productivity levels, where they are, and if they are meeting your internal objectives.
Secondly, what we should be thinking about as a long-term operating margin level for the company, because there's been a lot of issues this year that have obscured our ability to come up with that. Thanks so much.
Okay, starting with your question around fall. We just really dropped fall this last week, and we had several pieces that actually sold out within the hour. If you tried to buy the skirt, you couldn't buy it. It features a very attractive commuter line with a great jacket and set of pants that builds on the Satori fabric we use in the men's Mission Pant. Very successful first read on fall, lots of great customer comments, lots of great comments on the Full-On Luon. As I said, in November, the Full-On Luon goes from just being in Wunder Unders into all of our tight bottoms. We're excited about that. Outerwear was a smaller buy.
I think with the warm weather in the U.S., we are seeing a slower takeoff there, but a very strong reception in Canada, and we do have ability to move inventory back and forth depending on where the guest is buying it. We're not overly concerned about working through the smaller buy in outerwear that we did. On the commercialization, I feel very, very good about the people. Jennifer, as we said, has been working with us since May, and the team that we have in place and the partnership that we have with our factories and how they're working with us. While we do anticipate some timing as spring bumps into fall into winter, and just rebuilding our stock in Luon to catch up with demand, we do expect it to be an air freight situation to catch up and manage flow.
We did experience some additional late deliveries and shortages due to political unrest. One of our key tops is manufactured in Egypt, we've seen some late shipping from that that we're working through. We do expect that from a Luon impact, that at the beginning of next year, we should be caught up.
Okay. Thank you, Christine.
Your questions. New store productivity continues to be strong, a little bit better than our expectations. $1,150 a square foot or higher on average. Of course, there's a range within that, but again, continuing similar to how it has in the past few quarters. On your question on long-term operating margin. Even though we are investing more on the product team, et cetera, we also see future efficiencies, and there's no reason to change my longer term outlook of a 55% gross margin and 25% operating margin as, again, as we continue to grow and expand internationally. Again, that's leverage above that in the core business reinvested into foundation and international expansion.
Great. Thanks so much.
Thank you. Our next question comes from Barbara Wyckoff of CLSA. Your line is now open.
Hi, everybody. Can you talk about the current mix of core basics versus fashion basics and fashion? Ultimately, where should it be, and how long do you think it's gonna take for you to get there?
I would say that because of some of the delays, we haven't had as much new product in the end of the quarter that we would have liked. With the fall drop, we're pretty much back on track with our historical percentages in probably the overall buy, the timing of when things arrive, the top that matches the bottom, and some of the challenges we've had with that in holding certain items does affect the mix on a day to day, week to week basis, and that's really what we're working through right now. From an overall product strategy perspective, I feel very good about the mix and the design details in the fall and winter, and offset by the challenges of the timing that we're having.
Thank you. Our next question comes from Kimberly Greenberger of Morgan Stanley. Your line is now open.
Great. Thank you. Good morning. John, you mentioned in your gross margin discussion that you had an increase in reserves here in the quarter. I was just wondering if you could talk to us about what that is, and any light on the magnitude would be helpful. I think you said in the SG&A commentary that you experienced some deleverage in store salaries and wages. I was just wondering, given that you delivered an 8% increase in comp store sales in the quarter, maybe you could just talk about the puts and takes of why with an 8% comp you would be seeing some deleverage there. Thanks so much.
The provisions that are referred to, we take a variety of provisions against our inventory, whether it's for shrink or damaged goods or obsolescence, et cetera. There's a variety of factors, including the fact that we were high on inventory at the end of the quarter. It's just prudent to take some additional reserves to reflect the impact of that on the gross margin. The question about store salary deleverage, to some extent, that was delivered and tied to the Luon issue. With the lower revenue than we would otherwise have expected, we didn't want the educators that we employ in the stores to be the ones suffering, so we maintained labor hours that were maybe higher than we'd otherwise have incurred for the level of revenue we saw.
As well as we set bonus targets for the store-based employees, those bonus targets were reset downward to realistic expectations of revenue based on product that we had available. Therefore, the bonus for the store-based staff was there, even though revenue was down.
Going forward, when would you expect that to normalize?
As I said, that was an issue that was really a Q1, Q2 issue related to the Luon shortage. That should be normalized now.
Great. Thanks so much.
Thank you. Our next question comes from Jennifer Black. Jennifer Black & Associates, your line is now open.
Good morning. Thank you. I just had a question about, I see that you're bringing back some of your iconic product offerings. Can you talk about what kind of response you're seeing from your new guests and your loyal guests on some of those iconic pieces? Then I guess the follow-up would be on your men's business, it appears that the fit, especially in the bottoms, is evolving. Can you talk about where your men's business is, and are you happy with the fits and the offerings? It feels like the inventory levels have been fairly lean in smaller size runs on both online and stores. Can you talk about your strategy in the men's inventory? Thank you so much.
Yeah. On the men's inventory, we're actually seeing stronger sell-throughs, which is driving some of those stock-outs that you mentioned. We've seen actually tremendous growth in the recent quarter in the men's business as we started to add some more color and some of the technical pieces were brought back. There was a little bit of some vendor issues in terms of supply on our popular VitaSea, we expect to be back in stock with that shortly with some really great colors for fall. For fit, as we've discussed in other quarters, we had gone under Rob's leadership to quite a tighter, more European fit. Now we've loosened that back up. Some of the initial work that Felix has done is really relook at all of the fit blocks for an athletic fit, that was one of his first initiatives.
That work is complete, you can expect very consistent sizing in men's, which is going to be a huge win. Then on the iconic styles that you mentioned, definitely bringing back wraps. We want our wraps to last five years, we've really worked with our knit manufacturers to develop a knit quality that is going to last for a long time. We're really pleased not only that we've brought back some of the iconic styles, but the quality and longevity of these items, we're also very excited about.
Thank you. Our next question comes from Bob Drbul of Barclays. Your line is now open.
Hi. Good morning. I guess the question that I have is, you talked about opening the store in Covent Garden. Could you give us any more color on early reads from the international showrooms that give you the confidence in Europe and in Asia specifically, then most specifically the U.K.?
In the U.K., we know that we're more than ready for stores. We've opened several showrooms in the London area. We've seen great response. We've seen the business grow in e-commerce as well. Still with a few showrooms in the market, you don't have a lot of big PR, and we grow things with our community events. We believe the first store will be a milestone event for us. We are going to be doing some things that we don't normally do in the course of Lululemon by increasing our PR strategy and making a little bit more of a splash with that London store opening. We view this as really a beachhead into the opening of both the U.K. and the European market, really telling the brand story, which is important to us. We've gotten great guest feedback on the products.
We do note that they like more color and pattern in the U.K., particularly in the bottoms, so we're prepared to address that need. We see sizing runs very similar to North America in the U.K. In Asia, we see brighter colors are appreciated and a shift into the smaller size runs, no major change because we work with a stretchy knit and we do hemming of tops and bottoms that we've not had a fit issue in the Asian markets. In Asia, very strong response in Singapore in particular, we are beginning to ship into Shanghai this year as well. Very strong response, and we believe all the markets are right on track, we're seeing very positive response to the concept. Most importantly, to the culture of Lululemon.
We had several events in Shanghai where we're doing some pre-branding, where we had several hundred people participating in the events. We're very confident that the Lululemon culture and brand translates as well as the product.
Great. Christine, if I could just ask one more question, which is, it's been a little over three months now since you decided to step down. Have you given your next chapter any thought that you could share with us?
If I could get an end date, I'd be happier to answer that question. No. I'm going to take some time off, then I'll evaluate what's next for me. I'm still here, as I committed to, for a period of time.
Thank you. Our next question comes from Camilo Lyon of Canaccord Genuity. Your line is now open.
Thanks. Good morning, everyone. I just want to go back to the commercialization discussion. Christine or John, if you could just maybe speak to what parts of the commercialization process could lead to some potential upside in the back half year. Is it more air freighting that will get your product a little bit more in store on time? Is it a more streamlined control process where the bottleneck starts to release? Is there any part of that process that could really result in a re-acceleration of that product flow?
Not really, because what we're guiding to is based on what we now either know or have a high degree of expectation in terms of when product will deliver. Delays, in other words, are already baked in. We're using more air freight than we have historically, and that's already factored in. The point we're making is we still have inconsistent product flows, and that will carry on through Q4.
I think it's important is like in the raw materials process of bringing on new manufacturers in that the onsite quality inspections and being there and really ensuring we're getting the right raw materials, that then begins the rest of the process. We do expect over time, the tightened tolerances we have on our sewing standards will increase the speed of production as the sewers get used to the new patterns and tolerances. You are talking about a lot of our core product. We had to slow them down, make sure that all of the tolerances were being sewn to the right specification. What I mean by that a floppy four doesn't become a bad six. We've really made sure the manufacturing specs across all of our base are tight. As they get used to sewing to the new standard, they will flow up.
We've hit Q4 volume is I think the other thing that you have to recognize is that's one of our biggest quarters, and it takes a lot to get that back in stock, which is why by the time we get to Q1, it should ease up because the volumes are done. You also have to remember there's Chinese New Year, we have to make the spring product in the same period. There's a lot of challenges with just managing a peak volume of production in Q4.
Great. Then just lastly on markdown rates, what was the markdown rate in Q2, and how do you see that unfolding for Q3, given that there's still more carryover product from summer?
Yeah. It was actually fairly consistent with what it's been, sort of in the low teens. Expect that to continue.
Thank you. Our next question comes from Howard Tubin of RBC Capital Markets. Your line is now open.
Hey guys, thanks. In terms of inventory being up 30%, where do you think it'll be at the end of the third quarter and maybe at the end of the fourth quarter as well?
Boy, that's a tough one, especially with the inconsistent product flow we're seeing. Maybe I can start by giving a little bit of color on the end of Q2. We actually had excess summer product at the end of Q2. With delays in a lot of the fall product, as Christine Day said, we left a lot of the summer product on the floor through August and ended up selling through a lot more than we would have otherwise. That means with late deliveries, we now have somewhat of an excess of fall product against a shortened selling season. That's part of what's going on. Again, with inconsistent product flow through the rest of the year, it's pretty tough for me to give you a meaningful estimate of a point-in-time inventory balance.
I do expect we'll be a little bit higher than the level that we normally like to be at the end of Q3, which is the same as at the end of Q1 and Q2 this year.
Thank you. Our next question comes from Jim Duffy of Stifel. Your line is now open.
Hi, everyone. Good morning. I'm still unclear on some of the mechanics of the supply chain delays. Pardon me if I'm dense, but you talked about some of the commercialization delays. To be clear, is that specific to Luon, or does it impact other products as well?
There's a lot of our products made in Luon, so that is the primary effect, was both in the raw material switchover and particularly the pants and bottoms. If we've made outfits in colors and dyes that match tops, we have to hold the tops to match the bottoms. It does have a knock-on effect to both. We are working through re-commercializing every single one of our top fabrics to making sure that they really last and hold the standard, and that we've done everything that we should be doing to hit the quality standards that we have. It's very much a company exercise in being quality first. There is a knock-on effect to the other fabrics, which affect all tops at the raw material stage. The sewing process slowdowns we've experienced are primarily pants.
Got you. That's helpful. Thanks. John, can you share some specific thoughts on the process around the calculation of the impact to comp and margins in the back half of the year? For instance, could you quantify the expected air freight expense?
The air freight. Just trying to see. Air freight is about 80 basis points. Yeah, it'll impact gross margin by about 80 basis points, if that helps.
Yeah.
Sorry, what was the rest of your question?
The rest of it was the thought process around the calculations of the impact to comps specifically, and then the margins.
Okay. Well, again, the guidance is based on what we've been seeing so far this quarter. It then gets a little bit more difficult because I am trying to forecast revenue based on inconsistent product flow.
Sure.
That's the main item. As I look out, also influencing my guidance is the fact that every other retailer is experiencing weakness and mall traffic is down. It wouldn't be a time to be bullish on the macroeconomy either.
I understand. Then, the fall product, for instance, can you maybe speak specifically about how late that arrived in the stores?
We just set this last week. Normally we would've set in the second or third week of August. Usually, actually, the second week we do a transitional pod. That definitely was about a three-and-a-half week delay. We're still waiting confirmation for deliveries for our October and November. That's affecting our ability to forecast.
Thank you.
Operator, sorry, we have time for just one more question.
Yes, ma'am. Our next question comes from Christian Buss of Credit Suisse. Your line is now open.
Thank you very much for taking the time. I was wondering if you could talk about what the normalized margin rate is for 2013 implicit in your guidance. Another way of saying that is, how much is the Luon impact and how much is the investment in quality and international, and how much is coming from the sales deleverage?
Oh, boy. The write-off on Luon, and that hasn't changed, that was roughly CAD 17 million. The investments that we're making to shore up our product and quality capabilities, it's about CAD 5 million this year, primarily in the second half, and that'll be a run rate going forward. Deleverage, we're actually leveraging some of our fixed costs in cost of sales. For example, as I said, even in Q2, we saw positive leverage on occupancy and depreciation. Some of that's coming from the fact that we've got caps on all of our percentage rents, and that we're starting to see the benefit there. I don't see overall deleverage as being a component. The other pieces are, hopefully, I've clarified the quantum.
Could you talk a little bit more about the international investments that you're making?
Yeah. That's everything from store pre-opening costs, but more significantly, building all the infrastructure and getting the head count in place to manage the business ahead of having a revenue stream. That's where we are now. If you look at Europe, for example, we have a head of Europe on board. We've hired a head of real estate for Europe and several other key positions. Of course, we're not opening the first store until the middle of next year. Overall, it's consistent with what I've said in the past. I think we're sort of high single-digit millions negative on the international and net investment.
That's very helpful. Thank you very much, and best of luck.
Thanks.
Okay. Thanks, everybody, for this morning.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect.