Earnings Call: Q4 2013

Mar 21, 2013

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. As a reminder, today's conference call is being recorded. I'd now like introduce your host for today's conference, Mr. Joe Teckless of ICR. Please go ahead. Thanks. Good morning. Thanks for joining us for our Q4 fiscal 2012 conference call. Today, 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 ks with the SEC and available on the Commission's website atsec.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 Curry, the company's CFO. Sherry Watterson, our Chief Product Officer will also be available during the Q and 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 1 hour for today's call. So when we get to the Q and 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. Now we have just finished a few days of meetings with our board and our team here in Australia. Before we talk about our Q4 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 lulan 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 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 $1,000,000,000 sales milestone. And in 2012, we were able to grow by an additional $370,000,000 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 percent in 2012 to $197,300,000 or 14.4 percent of sales. E commerce will be a valuable tool as we expand our brand's presence around the world and 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 2 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. But of course, our primary growth over the next few years will 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 1st 2 weeks of this month, and it was our first large community event in Asia with a series of complementary yoga classes and workshops with 6 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 overlooks Marina Bay in Singapore. We're getting a great receptionist 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. And this year, we are going to do golf and tennis Lululemon style. These capsules are focused and intentional, and 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. Innovation innovative construction methods like bonding and laser cutting are also elements we played within 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 Warneco and Gap Inc. And adds to the creative talent we have in place. We are also generating some really innovative ideas in our brand team, thriving under the leadership of Laura Clauberg, who joined us last spring. Coming soon is an app that will support our guest yoga practice, will help you find a yoga class wherever you happen to be and 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. We also have exciting plans to enhance our social media platform with a more interactive blog focused on product education and 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 2nd SiWi's half marathon in beautiful Vancouver. Alison Forsyth, our organizer of our first ever SiWi's 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 8 months and 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 10. And 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'll begin by reviewing the details of our Q4 of 2012 and then I'll update you on our outlook for the Q1 and full year of fiscal 2013. For the Q4, total net revenue rose 30.7 percent to $485,500,000 from $371,500,000 in the Q4 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, 1 store in Canada, 5 stores in Australia, one store in New Zealand and 3 Aviva stores. Direct to consumer sales, which increased by 48% or $24,000,000 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 $5,000,000 or 1%. And finally, the additional 53rd week of fiscal 2012 contributed $26,200,000 in total sales, which included $4,200,000 in e commerce revenue and $2,300,000 from a warehouse sale. During the quarter, we opened 8 corporate owned Lululemon stores in the U. S, 1 in Canada and 1 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 5 Aviva. Corporate owned stores represented 77.9 percent of total revenue or $378,000,000 versus $78,700,000 or $292,600,000 in the Q4 of last year. Revenues from our direct to consumer channel totaled $78,300,000 or 16.1 percent of total revenue versus $50,100,000 or 13.5 percent of total revenue in the Q4 of last year. Other revenue, which includes wholesale, showrooms and outlets, totaled $29,200,000 or 6% of revenue for the Q4 versus $28,900,000 or 7.8 percent of revenue in the Q4 of last year. Gross profit for the Q4 was $274,500,000 or 56.5 percent of net revenue compared to $209,000,000 or 56.3 percent 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 Q4 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 and A expenses were $121,900,000 or 25.1 percent of net revenue compared to with $93,000,000 or 25.1 percent of net revenue for the same period last year. The 31.1 percent SG and 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 and finally, the higher Canadian and Australian dollar, which increased SG and A by 1,000,000 dollars or 0.8 percent. As a result, operating income for the 4th quarter was $152,600,000 or 31.4 percent of net revenue compared with 116.1 $1,000,000,000 or 31.2 percent of net revenue in 2011. Tax expense for the quarter was $44,700,000 or a tax rate of 29.0 percent compared to $42,600,000 or a tax rate of 36.5 percent in the Q4 of 2011. The lower effective rate reflects the ongoing impact of revised intercompany pricing agreements. Net income for the quarter was $109,400,000 or $0.75 per diluted share. This compares with net income of $73,500,000 or $0.51 per diluted share for the Q4 of 2011. Our weighted average diluted shares outstanding for the quarter were 145,800,000 versus $145,300,000 a year ago. Capital expenditures were $21,200,000 for the quarter compared $16,000,000 in the Q4 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 percent to $1,370,000,000 from $1,000,000,000 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 20 4%, which excludes the 53rd week. Gross profit was $762,800,000 or 55.7 percent of net revenue compared to 569,400,000 dollars or 56.9 percent of net revenue in fiscal 2011. Net income for the year was $270,600,000 or $1.85 per diluted share compared to $184,100,000 or $1.27 per diluted share for fiscal 2011. Looking at our balance sheet highlights, we ended the year with $590,200,000 in cash and cash equivalents, an increase of $180,700,000 over fiscal 2012 year end. Inventory at the end of the 4th quarter was $155,200,000 or 49.1 percent higher than at the end of the Q4 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 Q1 and full year fiscal 2013. Let me start by quantifying the estimated impact of the Black Luan issue reflected within this guidance. The impact falls into 3 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 and lastly higher SG and 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 unsalable 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. So on this basis, we're currently estimating lost revenue of $12,000,000 to $17,000,000 in the first quarter and additional lost revenue of $45,000,000 to $50,000,000 for the balance of the year, primarily in the Q2, 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 Lulon pants. Next, we're estimating additional cost of goods sold of $17,000,000 in the Q1. 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 Q1 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. And finally, we estimate additional SG and A of $1,000,000 to $2,000,000 incurred over the 1st and second quarters. The estimated impact on diluted EPS is $0.11 to $0.12 in the Q1 and $0.25 to $0.27 for the full fiscal year 2013. So now the resulting outlook for the quarter of 2013. This outlook assumes a Canadian dollar at $0.98 to the U. S. Dollar and 8 new store openings, 6 in the U. S, 1 in Canada and 1 in Australia. We currently anticipate revenue in the range of $333,000,000 to $343,000,000 This is based on comparable store sales percentage increase between 5% 8% on a constant dollar basis compared to the Q1 of 2011 sorry 2012. As we had indicated in our press release earlier in the week, our comp through the 1st 6 weeks of the quarter was 11% and our guidance would have been $350,000,000 to $355,000,000 for the Q1 assuming a low double digits comp. We had anticipated gross margin would have a similar profile to the Q1 of 2012 in the 55% range. But with the impact of the Luan issue outlined above, we now expect gross margin to be approximately 48% to 49%. We expect modest SG and A deleverage as a percentage of revenue compared with the Q1 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 Luan production. Our SG and A also reflects pre opening costs related to the 8 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 146,000,000 diluted average shares outstanding, we expect diluted earnings per share in the Q1 to be in the range of $0.28 to $0.30 per share. For the full fiscal year 2013, we are targeting to open up to 43 corporate owned stores, including our Australian stores and Aviva locations. We also plan on opening 10 to 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 $1,615,000,000 to 1,640,000,000 dollars Fiscal 2013 will of course be back to a 52 week year. For the year, we expect gross margin to be approximately 53% to 54% with lower gross margins in the 1st 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 and A deleverage as a percent of revenue compared to 2012 as the leverage gain from our core North American business is offset by reinvestments into areas such as our supply chain, IT and international seating and branding and of course the Luan 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 to 1.99 dollars This is based on 146,200,000 diluted weighted average shares outstanding and it assumes our effective tax rate of 30%. We expect capital expenditures to be between $90,000,000 $95,000,000 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. So 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'll open it up for questions. Our first question comes from Erica Maschmeyer of Robert W. Baird. Please go ahead. Thanks. Good morning. Just to go back to the recall issue, if you identified the issue today, when would you expect to receive shipments in your stores? And then could you talk about the revenue impact that you're assuming in your guidance in Q2? And also any thoughts on diversifying your vendor base? Okay. 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'd say roughly 85%, 90% of that. I think on the other one, we still have to find out exactly where the process broke down. And what I want to say is that it's a multistep 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 1 individual or group. As regarding identifying or diversifying the supplier base, we have actually moved in that direction and we should have 2 additional sources up ready for manufacturing our key fabrics by the fall. That's great. So do you think that by the end of Q2, you could have potentially shipments of fixed products coming into the stores? Right now, what we're still waiting for is that 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. So I think our first step is to see what's correct or what we can use in that. And then and meanwhile, we're working with our suppliers to do some additional testing of any old stock that we have to see what we can do to flow in and we won't have those answers probably for the next week or so. That makes sense. And then on golf and tennis, could you talk about how you expect to get the word out? Any 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. So 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. And 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. And they're not made of they're not made of luon. So we're good. Our next question comes from Adrienne Tennant of Janney Capital Markets. 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? And then just in terms of dealing with sort of we've looked at a lot of the blogs and the website reviews and the chatter seems to be taking on a very negative tone, particularly when people are returning stores 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. Yes. We have put all of our educators on high alert and making it really seamlessly easy for the guests as well as our GEC. So communication and training calls with every store manager have already occurred to make it seamless for the guests to return the product that we believe is affected. And for right now, we primarily see this as an issue with Luan. 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 Luan. 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 time line of when you'd expect to be opening stores abroad? I'm sorry, you cut out a little bit, just before the last part. So you said investment in infrastructure and then it blanked out and said stores abroad. So sorry, we didn't hear that. Time line of when you'd expect to start opening more stores abroad. Okay. So 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 multichannel and international. And we've that's already been baked into our capital investments that we've laid out. In terms of directly in markets, there's 8 or 9 markets where we're doing what we call preceding 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. So that's pretty non capital intensive. Then 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 6 months. So we've already built out the international e commerce site, which we've already preannounced and we'll only be adding 1 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. Thank you. Good morning. I was wondering if you can talk a little bit about some of the learnings you gleaned from pricing last year. What have you heard from your customers and guests regarding sort of 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 was 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. And then we felt that we also got a little too aggressive in pricing our What's the Fluff line. So we pulled that back to the same pricing it had been the year before. So 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. And then secondarily, I'm 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? And then how are you planning on communicating with your guests kind of the return of the black luan and kind of getting people back in the stores that might be disappointed in the next several months? Okay. So I think just like the steel pants, as soon as we get something up there, they'll eagerly know. And of course, we'll 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, there are we've 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 really are more subjective. And that's certainly one area that we feel that we can do a better job of controlling. And then the environment after it leaves, we have to do a better job of controlling or creating standards for that process as we're shipping to more locations to manufacture it. And then I think the quality control around the Lycra chip itself, if it's stale or not stale. So there's things that I feel that we didn't have as much standard controls in place that created some variables. And I think also the transition with Pattern. So more protocol and we've hired a very seasoned head of QA who just recently started with us, And she's already been of tremendous assistance during this process. And we're definitely looking to make some more significant hires, particularly in the raw materials area going forward. And 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 Stern AG. Please go ahead. Good morning or good evening, depending where you are. What can you give us 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 1, I guess, on share. Yes. 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 Luan 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. And then secondly, I guess the question is, I understand that you don't understand the how this exactly happened, but I guess the question is, how did it go get to where it was shipping without somebody trying on a pair of pants like the 1st batch to make sure that this wasn't an issue? I mean, and stopping it before it got so out of control. And then what is going to be sort of do you see as the incremental cost of adding the different people in the new QA and so on and so forth to 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 and A. So we've already built that number in. And some of these were already planned higher, 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. So just putting the pants on seldom doesn't solve the problem. So because it passed all of the basic metric tests and the hand feel is relatively the same. So it was very difficult for the factories to isolate the issue, and it wasn't until we got into the store and started Kimberly Greenberger, Morgan Stanley. Please go ahead. Great. Thank you. It sounds like quality is going to be priority number 1 at Lululemon. And 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? And then as you think about the this is sort of the second quality issue, I think, in 9 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 since last year. I mean, the issue referring to in the DYE issue, we brought the experts in, rewrote the whole process for DYE and working in partnership with our manufacturers, solved the problem. And so we no longer have dye issues. And so we can very much say that with confidence. And 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. And we 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 we'll continue to do so this coming year. And we've had the whole organization, I mean, very devastated obviously by what's happened. And so 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, Christy. Thanks. Our next question comes from Liz Dunn of Macquarie. Please go ahead. Hi, thanks for taking my question. Just like several kind of 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 wouldn't 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 4 stages. So that's what we're looking at right now. And so I don't think it's fair to say that it's input. Okay. And then, I'm sorry, it was a little unclear to me. Are you opening the stores in U. K. And Hong Kong this year? We're opening 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 sometimes within like a 12 month period. And then London, the goal is to open additional showrooms this year and then move to stores the next year or so. Okay. And then just finally one for John. Was the 500 basis points that you called out in the Q1 just related to the write down? And what impact, if any, should we see from deleverage on the lower comp? I would assume that'd be mostly a Q2 impact. Yes. I mean based on the magnitude of the revenue drop there as a result of lower revenue on the Luan issue, we do deleverage based on occupancy and depreciation etcetera, primarily Q2, but there's some impact in Q1. The other thing just to get a little more granular on the overall impact of on the gross margin, a lot of these are key styles and tend to be higher product margins. So the impact is 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's happening to all the excess luon? Is that a product that you could conceivably sell to your outlets at a discounted price? Right now, we were holding all the product because there actually might be some treatment solutions that we're investigating that actually could solve some of the problems. So until we get those test results back, we haven't made a decision at this point in time. And I'm assuming none of that is embedded in your guidance currently? That's correct. Okay. And then 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? Yes. That would be a little bit more precise than the information we have. I mean, the average number of units per transaction is between 1.5% and 2%. But I couldn't break that down to when there's black wool and pants, what's the add on. We don't have that detailed information at this point. Great. And then just No, I didn't. Sorry. Sorry. I was just going to say, it normally works the reverse, right? So somebody comes in, they're attracted by one of the new items, and then they pick up additional core. By one of the new items and then they pick up additional core. So I because they're looking for an outfit or they say, okay, I want the extra pair of under unders. But so I think that what we're seeing so far is that the color has been really well received. And so 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. So that is the good news is that we do have a lot of other products 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. 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? And as you think about basics going forward, do you see pricing at all changing on basics? And 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's and she's worked for Nordstrom before that. So she's our new Director of QA, just recently joined us, completed her training and has unfortunately had to hit the ground running very hard over the last few weeks with us. And we also made a significant hire as Vice President of Commercialization and Development, which is really critical in the raw materials area. And we've also made a deep hire in our R and D department, Doctor. Tom Waller, who comes from the Speedo Group. And so he also works on developing raw materials. So those are just an example of 3 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, and he's building a team there that will actually be at the factories where, we produce and 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 Tuvan of RBC Capital Markets. Please go ahead. Hi, guys. Can you hear me? Yes. Yes. Sorry, just a question on your lead time. So if you stopped producing Nuon 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, but first, we have to certify that everything that's coming off that line does actually meet the specs. So we have some sample product that's being made up and sent to us, which we will then conduct complete tests on. And once that's done, then we'll feel more comfortable setting that date. But in general, if we said that was 100% perfect, we could begin flowing at least the simple wonder unders and group pants within no more than 28 days, but 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, and congratulations on a great year. A couple of questions. I was wondering, Christine or Sherry, 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, Terry, 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? And for John, I'm wondering if we should be expecting the gross margin decline in the Q2 to be deeper than you're forecasting for the Q1? And I have a follow on. Okay. Yes. Janet, I'll go ahead and answer the product questions. Right now, there are Luan pants that are not affected. So there are Luan pants in the store. It just is particular to the Groove pants and the Wonder Under and then a couple of seasonal styles, a couple of crops that match those and a couple of shorts. So there still are luwon, there's still printed luwon and there's luwon that's colored. So it's just the black pants in particular. And then 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. And then John? Yes. 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. So again, not to get too granular, I'd expect gross margin in the 2nd quarter in the low 50s. 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 12? And then 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 and we talk about it every quarter, the new stores are still running in that about $11.50 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. So it's a lower percentage of the mature store productivity, but again that's expected. But it's maintaining that level that it's been at for the last 12 to 18 months of new store experience. Okay. And then would you expect that percentage rate to be consistent in the guidance for 13? And then 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. So the first part, yes, we continue to expect that new product new store productivity to be similar looking forward. Some noise in the other channels, I mean, just in general, it goes up and down based we had 2 warehouse sales in Q4. We've closed a lot of the strategic sales accounts in some markets. There's no franchises anymore. So it's not a big line item in our revenue in general. So 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. And then how about the e commerce, John? Any thoughts on the growth rate for that? 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 growth 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. 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? And then do you have a sense of how many consumers and transactions were actually tied to those purchases in the 1st 3 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. And no, we don't at this point have good data on number of transactions or guests that would have 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. And so we did catch it relatively quickly and acted quickly to go through the stock. So, acted quickly to go through the stock. So I think we'll see within the next week or so as guests learn about it and begin exchanges whether or not that impact or how many guests were affected. Our next question comes from Faye Landis of Cowen. Sorry to harp on the Q3, but I just want to it sounds like you were starting at sort of ground 0. In other words, for other manufacturers, the idea that you have to put their hands on and bend over to test them out is something that would happen before they hit the store. So do you think that there was sort of is that correct? I mean, are you really sort of behind the curve on processes in general beforehand, do you think? I don't know of anybody else who has people actually I mean, 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. And then when it goes to bulk manufacturing, you'll do random sample pulls. But again, I'll stress that this product passed all initial testing that we're aware of. So the whole conversation at this point has been where did it break down from that initial testing and 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. So I think it was a very complex thing to test for, and that's what we're looking at what can we do 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. But I guess is there the potential for you to go back to your supplier manufacturing partners for compensation in this process? I think once we identify with certainty the real issue. And in the past, we've worked very closely like on the dye issue and amicably settled whatever we need to settle with our manufacturers where we were both happy with the outcome. And 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 AMCA way. If the mistake was ours through something like a pattern change or whatever, then obviously, we're on the hook for that. But at this point in time, we don't know specifically what the issue was. Great. And one nonlawan question. It seems like you've changed some of your philosophies around men's sizing to perhaps have a more accommodating or athletic fit. And 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. And as we've made that modification and brought back things like the favorite kung fu pant, that's sold out very quickly and we went back into 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. So thank you for joining us today. Ladies and gentlemen, this does conclude today's conference. You may all disconnect and have a wonderful day.