Good day, ladies and gentlemen, and welcome to the Lululemon Athletica Q4 2012 results. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. Should anyone require technical assistance during today's conference, please press star then zero on your touchtone telephone. As a reminder, today's conference call is being recorded. I'd now like to introduce your host for today's conference, Mr. Joe Teklits of ICR. Please go ahead.
Thanks. Good morning. Thanks for joining us for our fourth quarter and fiscal 2012 conference call. A copy of today's press release is available in the investor relations section of our website at lululemon.com or furnished on Form 8-K with the SEC and available on the commission's website at sec.gov. Shortly after we end this morning, a recording of today's call will be available on our website as a replay for 30 days. Hosting our call today is Christine Day, the company's CEO, and John Currie, the company's CFO. Sheree Waterson, our Chief Product Officer, will also be available during the Q&A portion of the call. As a reminder, the 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 might 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 today's call. When we get to the Q&A, please limit yourself to one question at a time to give others the opportunity to also have their questions addressed. With that, I will turn the call over to Christine Day.
Thank you, Joe. Good morning. I'm joining you from Australia today, where it is actually just after midnight. Our board meeting was held here this quarter, and we have just finished a few days of meetings with our board and our team here in Australia. Before we talk about our fourth quarter and full year 2012 results, I will give you an update to the announcement made on Monday of this week regarding the sheerness in certain styles of our women's black Luon bottoms. Following my comments, John will speak to our guidance. We have not yet determined the specific cause for the sheerness and are pursuing several hypotheses in parallel with our manufacturing partners to determine the root cause. What is clear to us is that this is not the Luon that we and our guests have come to love.
The process for creating Luon is complex and involves a specific set of proprietary ingredients and a multistep production process. Even the slightest changes to the process can create meaningful changes in the fabric. We had already begun putting more stringent specifications in place on the production of Luon, and we will be redoubling our efforts in this area. We currently have a dedicated team working with our suppliers to identify and resolve the issue. We have recently added strong leadership in quality control, our liaison office, and our commercialization and development teams, and expect these people and other investments to solidify our quality, consistency, and delivery capabilities. Our company is rooted in integrity, and we are ready to make the tough decisions and do the right things for our guests and our communities. I am confident that we will recover from this setback and be stronger than ever.
Our confidence is based on the history of strong performance that the team here has produced, including what we achieved during the past year. In 2012, we once again had strong revenue growth in all of our markets and profit growth to match. This time last year, we were celebrating hitting the $1 billion sales milestone, and in 2012, we were able to grow by an additional $370 million. This growth gave us the leverage to invest in international expansion and implementing a broad range of foundational systems to support our further expansion. Our new financial system was implemented at year-end, and we're looking forward to the improvements that our PLM and advanced product allocation phase 1 implementations will create for managing the flow of our product. I would also like to point out that our e-commerce revenue grew by 85.5% in 2012 to $197.3 million, or 14.4% of sales.
E-commerce will be a valuable tool as we expand our brand's presence around the world, it gives us an exciting opportunity to charter new ground in retail with an integrated footprint to meet the future in ways in which guests shop. We achieved these results in a very brand-appropriate way and did not buy our comps through discounting, which ultimately would have harmed the brand. We maintained a full price strategy up to the holidays, then used our traditional warehouse sales as an effective and low-risk way to clear our inventory. We are already flowing the learnings on price sensitivity and assortment preferences from the holiday season into this year. It is fitting that I'm joining you from one of our international locations, given our increased focus on growing globally for the coming year.
This year, we will expand our foothold in two key markets, London and Hong Kong, while establishing local community connections and introducing our beautiful product to guests in a variety of markets in Europe and Asia through strategic sales, showrooms, and e-commerce. Of course, our primary growth over the next few years will still come from same-store sales increases and expansion in North America. We are being very intentional and methodical regarding how we will operate globally to maximize both our current business in North America while growing internationally. We hosted our first-ever Asia Yoga Tour in Hong Kong, Shanghai, and Singapore during the first two weeks of this month, and it was our first large community event in Asia, with a series of complimentary yoga classes and workshops with six of our ambassadors from North America and Hong Kong.
The community classes were held in some cool locations, including local radio stations, art galleries, and even an amazing rooftop bar that overlooked Marina Bay in Singapore. We're getting a great reception to these events, and the team shared that we blew the doors off in Shanghai and had to turn people away. Now turning to product. We will explore new categories once again this year through fewer but expanded capsules to build our future product pipeline. While immaterial to current revenue and earnings on their own, they do drive traffic and create demand and are key to maintaining our leadership in innovation. You will see a return of the swim and cycling commute spin capsules as we refine those product lines. This year, we are going to do golf and tennis Lululemon style.
These capsules are focused and intentional. We're excited about what we've seen so far with the combination of function and beauty in key pieces that transition perfectly from high sweat to street. Women's tennis builds on what we already do well with mid-support bras, tanks, and skirts, now engineered for tennis, solving for unrestricted arm movement and lateral movement in bottoms. They are also cross-functional for run and other high-impact sports. For women's golf, the approach is technical street with pieces that transition from sweat to street. Innovative construction methods like bonding and laser cutting are also elements we played with in this collection. For men's, we are excited to be introducing our largest polo offering to date in response to feedback from our guests, especially around Father's Day. These tops will be handsome, yet functional for tennis and golf.
Our polos will come in both athletic fit, providing enough room in the body to accommodate swings during a match, as well as slim fit for guys looking for something more modern and progressive. Sticking with this theme for a moment, we continue to see opportunity in men's and have recently enhanced that team with the addition of Felix del Toro as our new Senior Vice President and GM of Men's. He comes to us with over 22 years of merchandising and design experience with Warnaco and Gap Inc. Adds to the creative talent we have in place. Also generating some really innovative ideas in our brand team, thriving under the leadership of Laura Klauberg, who joined us last spring. Coming soon is an app that will support our guest yoga practice.
We'll help you find a yoga class wherever you happen to be, to select according to your favorite teacher or style of yoga. This is a perfect example of how we are supporting our ambassador community and helping to build their businesses. Early reports from the testing phase are that they are thrilled with this application that will be launched in April. Also have exciting plans to enhance our social media platform with a more interactive blog focused on product education. You will see us do more crowd, or in our case, guest sourcing of content, like the cool racerback series we did in February. We are looking forward to hosting our second SeaWheeze Half Marathon in beautiful Vancouver. Allison Forsyth, our organizer of our first-ever SeaWheeze Half Marathon last year, had set a goal to sell the race out in a month.
7,400 people signed up for last year's race in eight months, this year, we increased the number of participants to 10,000 and sold out in less than 30 days. We look forward to hosting the 10,000 runners who are joining us on August 10th. With that recap of the quarter, I will now turn it over to John to give you some more detail on the financials for the quarter and our guidance for 2013.
Thanks, Christine. I will begin by reviewing the details of our fourth quarter of 2012, then I will update you on our outlook for the first quarter and full year of fiscal 2013. For the fourth quarter, total net revenue rose 30.7% to $485.5 million from $371.5 million in the fourth quarter of 2011. The increase in revenue was driven by comparable store sales growth of 10% on a constant dollar basis, bringing our average store productivity at the end of the year to $2,058 per square foot. The addition of 37 net new corporate-owned stores since Q4 of 2007, 27 new stores in the United States, one store in Canada, five stores in Australia, one store in New Zealand, and three ivivva stores. Direct-to-consumer sales, which increased by 48% or $24 million.
If we included e-commerce as a store in our comp calculations, our comps would be reported as 16% on a constant dollar basis. A stronger Canadian and Australian dollar had the effect of increasing reported revenues by $5 million or 1%. Finally, the additional 53rd week of fiscal 2012 contributed $26.2 million in total sales, which included $4.2 million in e-commerce revenue and $2.3 million from a warehouse sale. During the quarter, we opened eight corporate-owned Lululemon stores in the U.S., one in Canada, and one in Australia. We ended the quarter with 211 total stores versus 174 a year ago. There are 169 stores in our comp base, 42 of those in Canada, 103 in the U.S., and 19 in Australia and five ivivva. Corporate-owned stores represented 77.9% of total revenue, or $378 million versus 78.7% or $292.6 million in the fourth quarter of last year.
Revenues from our direct-to-consumer channel totaled $78.3 million or 16.1% of total revenue versus $50.1 million or 13.5% of total revenue in the fourth quarter of last year. Other revenue, which includes wholesale, showrooms, and outlets, totaled $29.2 million or 6% of revenue for the fourth quarter versus $28.9 million or 7.8% of revenue in the fourth quarter of last year. Gross profit for the fourth quarter was $274.5 million or 56.5% of net revenue, compared to $209 million or 56.3% of net revenue in Q4 2011.
The factors which contributed to this 20 basis point increase in gross margin were product margin improvement of 10 basis points attributable to product mix and lower air freight rates and usage, offset by slightly higher markdowns compared to the fourth quarter of 2011, and fixed cost leverage of 10 basis points, made up of 40 basis points of leverage on occupancy and depreciation, offset by 30 basis points of deleverage in product and supply chain team costs. SG&A expenses were $121.9 million or 25.1% of net revenue, compared with $93 million or 25.1% of net revenue for the same period last year. The 31.1% SG&A dollar increase is due to an increase in store compensation 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 due to the significant year-over-year revenue growth, along with investment in key e-commerce support functions such as our development, demand creation, and creative teams. Increases 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. Additional expenses incurred during our 53rd week. Finally, the higher Canadian and Australian dollar, which increased SG&A by $1 million or 0.8%. As a result, operating income for the fourth quarter was $152.6 million or 31.4% of net revenue, compared with $116.1 million or 31.2% of net revenue in 2011. Tax expense for the quarter was $44.7 million or a tax rate of 29.0%, compared to $42.6 million or a tax rate of 36.5% in the fourth quarter of 2011.
The lower effective rate reflects the ongoing impact of revised intercompany pricing agreements. Net income for the quarter was $109.4 million or $0.75 per diluted share. This compares with net income of $73.5 million or $0.51 per diluted share for the fourth quarter of 2011. Our weighted average diluted shares outstanding for the quarter were 145.8 million, versus 145.3 million a year ago. Capital expenditures were $21.2 million for the quarter, compared to $16 million in the fourth quarter last year, with the increase associated with new stores, renovations, IT, and head office capital. Turning to the highlights of our full fiscal year 2012 performance, net revenue rose 36.9% to $1.37 billion from $1 billion in fiscal 2011. Our annual comp was 16% on a constant dollar basis, and if we included e-commerce, our annual comp would have been 24%, which excludes the 53rd week.
Gross profit was $762.8 million or 55.7% of net revenue, compared to $569.4 million or 56.9% of net revenue in fiscal 2011. Net income for the year was $270.6 million, or $1.85 per diluted share, compared to $184.1 million or $1.27 per diluted share for fiscal 2011. Looking at our balance sheet highlights, we ended the year with $590.2 million in cash and cash equivalents, an increase of $180.7 million over fiscal 2012 year-end. Inventory at the end of the fourth quarter was $155.2 million or 49.1% higher than at the end of the fourth quarter of 2011. The increase is due to higher levels of spring seasonal product receipts and a higher mix of winter carryover product as we entered 2012 with a lighter carryover position due to the strong holiday sales in 2011.
This now leads me to our outlook for the first quarter and full year fiscal 2013. Let me start by quantifying the estimated impact of the black Lululemon issue reflected within this guidance. The impact falls into three buckets. Firstly, lost revenue as a result of shortages of the impacted styles. Secondly, higher cost of sales resulting from the write-off of faulty products and additional costs likely to be incurred, including air freight, additional handling, testing, and other supply chain costs, offset with some duty recoveries. Lastly, higher SG&A due to additional costs likely to be incurred in managing through this situation. In estimating this impact, we think it prudent to take a conservative view as we are operating in real time to identify the full impact of this issue and do not have perfect information.
Therefore, we have assumed that all affected product that has been pulled from our stores, as well as inventory of the same styles in our DCs and in transit, is unsaleable and must be written off without offset by any potential recovery. We have also assumed that product which is still in the factories or under production for the summer season is similarly impacted and therefore must be written off without offset by any potential recovery. Although testing is underway, at this time, we believe this to be a likely scenario. On this basis, we're currently estimating lost revenue of $12 million-$17 million in the first quarter, an additional lost revenue of $45 million-$50 million for the balance of the year, primarily in the second quarter, spread over new and existing stores and e-commerce.
This assumption is based solely on the lost black Luon sales that would have been assumed based on available product for sale. It does not, for example, take into account sales that could possibly transfer to other products, but also does not take into account lost add-on sales that often accompany the purchase of black Luon pants. Next, we're estimating additional cost of goods sold of $17 million in the first quarter. Even though some of the effective product is slated for delivery over the balance of the year, a reserve for the full write-down of the product will be taken in the first quarter, and thus the full cost of this product is booked as cost of goods sold in Q1 with no related sales. This reserve is therefore estimated to impact Q1 gross margin by 500 basis points.
Finally, we estimate additional SG&A of $1 million-$2 million incurred over the first and second quarters. The estimated impact on diluted EPS is $0.11-$0.12 in the first quarter and $0.25-$0.27 for the full fiscal year 2013. The resulting outlook for the first quarter of 2013. This outlook assumes a Canadian dollar at $0.98 to the U.S. dollar and eight new store openings, six in the U.S., one in Canada, and one in Australia. We currently anticipate revenue in the range of $333 million-$343 million. This is based on comparable store sales percentage increase between 5% and 8% on a constant dollar basis compared to the first quarter of 2012.
We had indicated in our press release earlier in the week, our comp through the first six weeks of the quarter was 11%, and our guidance would have been $350 million-$355 million for the first quarter, assuming a low double-digit comp. We had anticipated gross margin would have a similar profile to the first quarter of 2012 in the 55% range. With the impact of the Luon issue outlined above, we now expect gross margin to be approximately 48%-49%. We expect modest SG&A deleverage as a % of revenue compared with the first quarter of 2012, which is driven primarily from the run rate of key investments made in 2012, new strategic initiatives in 2013, our continued focus on international, and incremental expenses outlined above associated with Luon production.
Our SG&A also reflects pre-opening costs related to the eight stores planned to be open in Q1 and additional stores planned to open in early Q2 of 2013. Assuming a tax rate of 30% and 146 million diluted average shares outstanding, we expect diluted earnings per share in the first quarter to be in the range of $0.28-$0.30 per share. For the full fiscal year 2013, we're targeting to open up to 43 corporate-owned stores, including our Australian stores and ivivva locations. We also plan on opening 10-15 showrooms in international markets and are actively searching for a site for our first store in Hong Kong. We expect net revenue to be in the range of $1.615 billion-$1.64 billion. Fiscal 2013 will, of course, be back to a 52-week year.
For the year, we expect gross margin to be approximately 53%-54%, with lower gross margins in the first two quarters and a return to more normalized gross margins in the 55% range for the back half of the year. We expect some SG&A deleverage as a % of revenue compared to 2012, as a leverage gain from our core North American business is offset by reinvestments into areas such as our supply chain, IT, and international seeding and branding, and of course, the Luon production-related expenses in the first half. As a result, we expect our overall operating margin to deleverage from 2012 and our fiscal year diluted earnings per share to be approximately $1.95-$1.99. This is based on 146.2 million diluted weighted average shares outstanding, and it assumes our effective tax rate of 30%.
We expect capital expenditures to be between $90 million-$95 million for fiscal 2013, reflecting new store build-outs, renovation capital for existing stores, IT and other head office capital, including expansion of our existing office premises. With that, I'll turn it back to Christine.
Thanks, John. This has been a challenging time for all of us. Disappointing our guests and shareholders and falling short of our own expectations is not something we take lightly, and we deeply regret. With that, we will open it up for questions.
Ladies and gentlemen, if you have a question at this time, please press star then one 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 Erika Maschmeyer of Robert W. Baird. Please go ahead.
Thanks. Good morning. To go back to the recall issue. If you identified the issue today, when would you expect to receive shipments into your stores? Could you talk about the revenue impact that you are assuming in your guidance in Q2, and also any thoughts on diversifying your vendor base?
In terms of the revenue impact in Q2, the amount that I guided to for the balance of the year, the bulk of the impact of that is in Q2. I would say roughly 85%-90% of that.
I think on the other one, we still have to find out exactly where the process broke down. What I want to say is that it's a multi-step process with multiple vendors involved, and we don't want to call attention to any one particular vendor because it would be unfair until we've completed the diagnostics that are more complicated than it being just one individual or group. Regarding identifying or diversifying the supplier base, we have actually moved in that direction, and we should have two additional sources up ready for manufacturing our key fabrics by the fall.
That's great. Do you think that by the end of Q2, you could have potentially shipments of fixed product coming into the stores?
Right now, what we're still waiting for is we have a lot of product on the water, and so it was a little complicated to get the samples from that product, and we won't receive those for a couple of days. I think our first step is to see what's correct or what we can use in that. Meanwhile, we're working with our suppliers to do some additional testing of any old stock that we have to see what we could do to flow in, and we won't have those answers probably for the next week or so.
That makes sense. On golf and tennis, could you talk about how you expect to get the word out? I'm sure you have something creative in mind, but just your overall thoughts on PR and any type of sponsorships or events.
I'm sorry, for.
For golf and tennis.
Oh, for golf and tennis. We actually have some social media campaigns ready to go with that and letting the guests out and doing some additional reach. We've also been working with our elite ambassador community. We had several of those on our Maui retreat that we did earlier this year. We've already been infiltrating, I could say, those communities in fun and unique ways, so that everybody will know that they're out there. They're small capsules, so as I said, that they're not going to be truly incremental. They're just driving a lot more energy into the store.
Very exciting.
They're not made of Luon, so we're good.
Our next question comes from Adrienne Tennant of Janney Montgomery Scott. Please go ahead.
Good morning, everybody. I wanted to know if you can tell whether the quality issue is isolated to Luon. As you do these vendor checks, is there any other chatter that you've heard from the websites and blogs on any other particular product? Then just in terms of I've looked at a lot of the blogs and the website or reviews, and the chatter seems to be taking on a very negative tone, particularly when people are returning product back to the stores. I'm wondering how are you dealing with training the store ambassadors to handle this in the best manner? Thank you.
Yeah. We have put all of our educators on high alert and making it really seamlessly easy for the guests as well as our GECs. Communication and training calls with every store manager have already occurred to make it seamless for the guest to return the product that we believe is affected. For right now, we primarily see this as an issue with Luon. There are a couple of other fabrics that occasionally will have issues, but that's fairly minor and nothing that we see as significant as what we've seen in the Luon.
Okay, great. Thank you very much.
Our next question comes from Lorraine Hutchinson of Bank of America. Please go ahead.
Thank you. Good morning. Switching topics to the international expansion opportunities, I was hoping you could give us an idea of what types of investments you'll need to make over the next couple of years to get the infrastructure ready to open stores, and then also maybe a timeline of when you'd expect to be opening stores abroad.
I'm sorry, you cut out a little bit, just before the last part. You said investment in infrastructure, and then it blanked out and said stores abroad. Sorry, we didn't hear that.
Sorry. Maybe just a timeline of when you'd expect to start opening more stores abroad.
Okay. Mainly, we have a couple of different levels of investment. One is the significant investment that's already occurring in our legacy systems, preparing them for a more complex environment of multi-channel and international, and that's already been baked into our capital investments that we've laid out. In terms of directly in markets, there's eight or nine markets where we're doing what we call [pre-seeding], where we participate in events such as I described on the call in Shanghai. Those are pretty low-cost measures where we're really doing community work, and then we're getting those ready for showrooms. That's pretty non-capital intensive. There's markets which we've already identified, such as Hong Kong and London, where we are engaged more at that showroom level.
Again, those aren't a lot of capital, and it's more just some small headcount expense, and it's pretty revenue expense neutral once they're up and running for at least six months. We've already built out the international e-commerce site, which we've already pre-announced, and we'll only be adding one additional international website this year, which will be in Shanghai.
Thank you.
Our next question comes from Betty Chen of Wedbush Securities. Please go ahead.
Oh, thank you. Good morning. I was wondering if you can talk a little bit about some of the learnings you've gleaned from pricing last year. What have you heard from your customers and guests regarding how they view the merchandise, not only from the core, but also some of the new capsules and new product extensions that you've been expanding into? Thanks.
Definitely the number one learning over the holiday, particularly in the Canadian market, was that those more $100 price point cottons that they're used to having, particularly the Scuba Hoodie, and we usually have something called the Cozy Up and the Cuddle Up, and there's a variety of versions of that that we offer, which we did not this year, significantly affected that holiday purchase in particular. We felt that we also got a little too aggressive in pricing our What The Fluff line. We pulled that back to the same pricing it had been the year before. This year, the holiday architecture will include more of those $100 price points, and the kind of cotton layering pieces that that guest is looking for.
Our next question comes from Sharon Zackfia of William Blair. Please go ahead.
Hi. Good morning. I guess, Christine, it would be helpful if you could maybe walk through the quality control process so we can understand how the product made it to the stores. Secondarily, I am assuming the guidance for the full year doesn't have any kind of pent-up demand in the second half of the year, if you could confirm that. How are you planning on communicating with your guests, kind of the return of the black Luon and getting people back in the stores that might be disappointed in the next several months?
Yeah. I think just like the Stillness Pant, as soon as we get something up there, they will eagerly know. Of course, we will communicate through our product notification system, and our other social media channels, as soon as we have the product back in stock. For the quality control, we have had a very standard metrics-based system for the Luon for a very long time that controls it within the environment at the manufacturer. There are a couple of gaps that we found in that, particularly in the overfeed process, which creates the fluff, that are harder to measure and really are more subjective. That is certainly one area that we feel that we can do a better job of controlling.
The environment after it leaves, we have to do a better job of controlling or creating standards for that process as we are shipping to more locations to manufacture it. I think the quality control around the Lycra chip itself, if it is stale or not stale. There are things that I feel that we did not have as much standard controls in place that created some variables. I think also the transition with patterns. More protocol and we have hired a very seasoned head of QA who just recently started with us, and she has already been of tremendous assistance during this process. We are definitely looking to make some more significant hires, particularly in the raw materials area going forward.
Sharon, just to confirm, no, we did not assume a benefit of pent-up demand in the second half guidance.
Thank you.
Our next question comes from Sam Poser of Sterne Agee. Please go ahead.
Good morning or good evening, depending where you are. You gave us same-store sales guidance for the quarter. Can you give us some form of how you're looking at the full year same-store sales? Number one, I got a bunch here.
Yeah. Obviously, the second quarter is probably the most impacted, and the guidance or our expectations would be a very low single-digit comp, close to flat for Q2 as a result of the Luon issue. The balance of the year, I'm not giving quarter-by-quarter guidance, but it comes out to roughly high single to low double digits.
Thank you. Secondly, I guess the question is, I understand that you don't understand how this exactly happened, I guess the question is, how did it get to where it was shipping without somebody trying on a pair of pants, like the first batch, to make sure that this wasn't an issue, and stopping it before it got so out of control? What is going to be sort of, do you see as the incremental cost?
Adding the different people and the new QA and so on and so forth at the different factories and so on to ensure that something like this doesn't happen again.
Well, that was already reflected when John mentioned some incremental costs in the SG&A, we've already built that number in. Some of these were already planned hires, so we have people on site in every factory. The truth of the matter is, the only way that you can actually test for the issue is to put the pants on and bend over. Just putting the pants on themselves doesn't solve the problem. It passed all of the basic metric tests and the hand feel is relatively the same. It was very difficult for the factories to isolate the issue, and it wasn't until we got it in a store and started putting it on people that we could actually see the issue.
Our next question comes from Kimberly Greenberger, Morgan Stanley. Please go ahead.
Great. Thank you. It sounds like quality is gonna be priority number one at Lululemon, I'm wondering if there are some permanent investments in gross margin that you think you need to make in order to make sure that your quality standards are strictly adhered to. As you think about, this is sort of the second quality issue, I think, in nine months, is there some sort of an organizational effort to make sure that whenever there are quality issues that appear anywhere, either in the supply chain or at the stores, that there is a concerted effort to sort of raise those issues to senior management and make sure that that behavior is really encouraged so that the issue can be identified early on and with the least impact to the guest?
Absolutely. Project Canary, as we're referring to it. We have made significant investments this last year. I mean, the issue you're referring to in the dye issue, where we brought the experts in, rewrote the whole process for dye, and working in partnership with our manufacturers, solved the problem. We no longer have dye issues. We can very much say that with confidence. I feel that we'll accomplish the same thing here with the fabrics once we identify exactly where in the chain the breakdown was and have long-term solutions for this. The big shift for us is making sure that we have people actually on site in the mills and the other environments, and that's the infrastructure that we started investing in this year and will continue to do so this coming year.
We've had the whole organization. I mean, it's very devastating, obviously, by what's happened. Everybody understands the sense of urgency of making sure that we alert the small noise and symptoms that we see, the little canary chirps, getting those to us as quickly as possible so that we can deploy the resources to avoid anything like this again.
Thank you, Christine.
Thanks.
Our next question comes from Liz Dunn of Macquarie. Please go ahead.
Hi. Thanks for taking my question. Just several follow-up questions. It sounds like this is really related to inputs, not manufacturing, because it's multiple factories, but it sounds like it's more the inputs. Could you just confirm that?
I don't think that I could say that at this point in time. That's one possibility, but because it's touched by so many people across the line, that at different stages, this could have happened in any one of four stages. That's what we're looking at right now.
Okay.
I don't think it's fair to say that it's inputs.
Okay. I'm sorry, it was a little unclear to me. Are you opening stores in U.K. and Hong Kong this year?
Our goal is to open a store in Hong Kong. We're evaluating several sites right now, but those leases tend to take a little bit long to negotiate, but we're confident we'll have it sometime within a 12-month period. London, the goal is to open additional showrooms this year and then move to stores the next year or so.
Okay, just finally, one for John. Was the 500 basis points that you called out in the first quarter just related to the write-down? What impact, if any, should we see from deleverage on the lower comp? I would assume that'd be mostly a Q2 impact.
Yeah. Based on the magnitude of the revenue drop as a result of lower revenue on the Luon issue, we do deleverage based on occupancy and depreciation, et cetera. Primarily Q2, but there's some impact in Q1. The other thing, just to get a little more granular on the overall impact on the gross margin. A lot of these are key styles and tend to be higher product margins. The impact's a little bit larger than it would be if it was just more seasonal items.
Our next question comes from Camilo Lyon of Canaccord Genuity. Please go ahead.
Thank you. Good morning. What is happening to all the excess Luon? Is that product that you could conceivably sell to your outlets at a discounted price?
Right now, we're holding all the product because there actually might be some treatment solutions that we're investigating that actually could solve some of the problems. Until we get those test results back, we haven't made a decision at this point in time.
I'm assuming none of that is embedded in your guidance currently.
That's correct.
Okay. Are you able to tell us what the tie ratio or the add-on purchase historically has been when a customer buys a pair of pants? What else do they buy in that basket?
Yeah, that'd be a little bit more precise than the information we have. The average number of units per transaction is between one and a half and two. I couldn't break that down to when there's black Luon pants, what's the add-on? We don't have that detailed information at this point.
Great.
No.
Sorry.
Sorry. I was just going to say, it normally works the reverse, right? Somebody comes in, they're attracted by one of the new items, they pick up additional core. Because they're looking for an outfit, or they say, "Okay, I want the extra pair of Wunder Unders." I think that what we're seeing so far is that the color has been really well received. That at least I think has been some of the good news, as well as the fact that the timing of this, we normally shift in spring to a lot more of our Swift and other lighter fabrics for run and for spring. That is the good news, is that we do have a lot of other product that's available, just based on the timing of this and the shift in spring.
Our next question comes from Dana Telsey of Telsey Advisory Group. Please go ahead.
Go ahead.
Hi, everyone. Can you talk a little bit about the people that you're adding in quality control? How many are you adding? Where do they come from? Is it here? Is it in Asia? As you think about basics going forward, do you see pricing at all changing on basics? Is there a greater percentage of the basics sold in new markets versus mature or online versus stores? Thank you.
Some of the individuals that we've added, Joan comes to us from most recently at JCPenney, and she's worked for Nordstrom before that. She's our new Director of QA. Just recently joined us, completed her training, has unfortunately had to hit the ground running very hard over the last two weeks with us. We also made a significant hire as Vice President of Commercialization and Development, which is really critical in the raw materials area. We've also made a deep hire in our R&D department, Dr. Tom Waller, who comes from the Speedo group. He also works on developing raw materials. Those are just an example of three key senior leaders that we've hired. We've also put a person on the ground in Taiwan, and he's already been in place.
He's building a team there that will actually be at the factories where we produce, as well as just doing, in addition to the outside third-party testing, which we do do, we will also have people at our manufacturing sites. Those were already all planned investments for this year.
Our next question comes from Howard Tubin of RBC Capital Markets. Please go ahead.
Hi, guys. Can you hear me?
Yep.
Yep.
Oh, sorry. Just a question on your lead time. If you could stop producing Luon today, and you started from scratch today, how long would it take for that product to get in stores and available for sale?
We were working with the manufacturer today. First we have to certify that everything that's coming off that line does actually meet the specs. We have some sample product that's being made up and sent to us, which we will then conduct complete tests on. Once that's done, then we'll feel more comfortable setting that date. In general, if we said that was 100% perfect, we could begin flowing at least the simple Wunder Unders and Groove pants within no more than 28 days. We need to make sure that that product is something we can stand behind.
Got it. Great. Thanks.
Our next question comes from Janet Kloppenburg of JJK Research. Please go ahead.
Good morning, everyone. Congratulations on a great year. A couple of questions. I was wondering, Christine or Sheree, what the substitution potential would be, when a client can't buy a Luon pant, is there a likelihood or a high likelihood that they may substitute for a different fabrication? Also, Sheree, I was wondering if perhaps your innovation level in fabric and product design may have something to do with this quality control issue. Obviously, you've been very innovative. Maybe that's put some risk into the product production and quality control. Are you examining that situation or for potential change? For John, I'm wondering if we should be expecting the gross margin decline in the second quarter to be deeper than you're forecasting for the first quarter, and I have a follow-on. Okay.
Janet, I'll go ahead and answer the product questions. Right now, there are Luon pants that are not affected. There are Luon pants in the store. It just is particular to the Groove pant and the Wunder Under, and then a couple of seasonal styles, a couple of crops that match those, and a couple of shorts. There still are Luon, there's still printed Luon, and there's Luon that's colored. It's just the black pant in particular. For the innovation level, because this was around our core fabric and not any of the new fabrics, I wouldn't say that that is the root cause, and it's not something that we feel we need to drag into all the different tests that we're conducting, because this is really about the core product. John?
Janet, the biggest gross margin hit is actually Q1, because as I said in the prepared remarks, we'd be taking a reserve to write down any expected faulty product in Q1. The impact on gross margin in Q2, therefore, comes primarily from deleverage on fixed costs and, to some extent, there's a shift in margin. As I said, the items impacted are typically higher margin than the average, so there's a little bit of averaging down. Again, not to get too granular, I'd expect gross margin in the second quarter, in the low fifties.
Our next question comes from Jim Duffy of Stifel. Please go ahead.
Thank you. Hello. John, thanks for the average store productivity information. Can you share the run rate productivity of new stores in 2012? Looking forward, how we should think about new store productivity, e-commerce, and the other revenue line items as contributors at the full year guidance? Thanks.
Okay. As has been the case throughout most of the year, we talk about it every quarter. The new stores are still running in that about $1,150 a square foot plus or minus range, which again, is what we expect. There's a lot of new stores in new markets where the guest is very early on in the discovery of us. It's a lower percentage of the mature store productivity, but again, that's expected. It's maintaining that level that it's been at for the last 12 to 18 months of new store experience.
Okay, would you expect that percentage rate to be consistent in the guidance for 2013? One of the things I've been struggling with is some volatility in the other revenue line item, and I'm trying to get my arms around how to think about the trajectory of the e-commerce business in 2013 off of what was a great year in 2012.
Okay. The first part, yeah. We continue to expect that new store productivity to be similar looking forward. Some noise in the other channels, I mean, just in general, it goes up and down. We had two warehouse sales in Q4. We've closed a lot of the strategic sales accounts in some markets.
Franchises.
There's no franchises anymore. Yeah, it's not a big line item in our revenue in general. Maybe on a follow-up, I can walk you through some of that up and down, but I understand how it's hard to model it.
Okay. How about the e-commerce, John? Any thoughts on the growth rate for that?
Yeah. I guess what I'd say is, Q4, we were, for the first time, over 16% of total revenue. It's always a little bit higher in Q4. As we've said, we certainly see e-commerce growing to 20% and beyond in the foreseeable future. For 2013, I'd expect it to be mid-teens, maybe 15%, 16% of total revenue against the overall growing base of revenue.
Okay. That's helpful. Thanks so much.
Our next question comes from Roxanne Meyer of UBS. Please go ahead.
Great. Thanks. As far as the Luon product goes, did it hit every region of the country in the entirety of your store base or just some specific segments? Then do you have a sense of how many consumers and transactions were actually tied to those purchases in the first three weeks of March that may have been impacted, and that you could think about being disgruntled and maybe pulling back a bit in the near term?
It was across the entire store base. It wasn't regional. No, we don't, at this point, have good data on number of transactions or guests that would've bought it before the pullback.
We haven't seen any significant return uptick at this point in time, but the word is still getting out. We did catch it relatively quickly and acted quickly to go through the stock. I think we'll see within the next week or so as guests learn about it and begin exchanges, whether or not that impacts or how many guests were affected.
Our next question comes from Faye Landes of Cowen. Please go ahead.
Yeah. Hi. Sorry to harp on the QC thing. It sounds like you were starting at sort of ground zero. In other words, for other manufacturers, the idea that you have to put the pants on and bend over to test them out is something that would happen before they hit the store. Is that correct? Were you sort of behind the curve on processes in general beforehand, do you think?
I don't know of anybody else who has people at final proto in garments, where we make up those, of course, you would produce all of those tests, and we do wash tests and do a lot of other things at that stage. Then when it goes to bulk manufacturing, you'll do random sample pulls. Again, I'll stress that this product passed all initial testing that we're aware of. The whole conversation at this point is then where did it break down from that initial testing? That's what we're trying to figure out. You wouldn't notice the change from hand feel, and it's not a simple put it over a mannequin or put it on. It has to be engaged in a four-way stretch for the sheerness to appear.
It's a very complex thing to test for, and that's what we're looking at, what can we do a better job of to make sure that we can identify that earlier in the process.
Our final question comes from Edward Yruma of KeyBanc Capital. Please go ahead.
Hi. Great. Thanks for taking my question. I believe that you said you're not expecting any recovery on some of your inventory write-downs. I guess, is there the potential for you to go back to your supplier or manufacturing partners for compensation in this process?
I think once we identify with certainty the real issue. In the past, we've worked very closely on the dye issue and amicably settled whatever we need to settle with our manufacturers, where we were both happy with the outcome. I think as we identify where that is with our partnerships that we have in place, I'm confident that we will resolve it in an amicable way. If the mistake was ours through something like a pattern change or whatever, then obviously we're on the hook for that. At this point in time, we don't know specifically what the issue was.
Great. One non-Luon question. It seems like you've changed some of your philosophies around men's sizing to perhaps have a more accommodating or athletic fit. How does that change the addressable market that you're attacking for the men's business? Thank you.
We definitely think that it makes it broader because our core market is that athletic males and the style should be styled slim, not a slim fit. As we've made that modification and brought back things like the favorite Kung Fu Pant, that sold out very quickly and we went back in to reorder on that.
Great. Thank you.
I'd now like to turn the conference back over to management for any closing remarks.
Thank you. Thank you for joining us this morning, and we look forward to updating you with more information as soon as we get it. We want to just reiterate our commitment to being completely transparent and passing along the information as we learn it, and so that you can have confidence and faith in us that you will always be the first to know whenever we have an issue. Thank you for joining us today.
Ladies and gentlemen, this does conclude today's conference. You may all disconnect, and have a wonderful day.