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Executives

Therese Hayes

Christine M. Day - Chief Executive Officer, President and Director

John E. Currie - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Treasurer

Sheree Waterson - Chief Product Officer

Analysts

Erika K. Maschmeyer - Robert W. Baird & Co. Incorporated, Research Division

Adrienne Tennant - Janney Montgomery Scott LLC, Research Division

Omar Saad - ISI Group Inc., Research Division

Betty Y. Chen - Wedbush Securities Inc., Research Division

Dana Lauren Telsey - Telsey Advisory Group LLC

Roxanne Meyer - UBS Investment Bank, Research Division

Jim Duffy - Stifel, Nicolaus & Co., Inc., Research Division

Tal Woolley - RBC Capital Markets, LLC, Research Division

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Janet Kloppenburg

Ben Shamsian - Sterne Agee & Leach Inc., Research Division

Lizabeth Dunn - Macquarie Research

Sharon Zackfia - William Blair & Company L.L.C., Research Division

John Zolidis - The Buckingham Research Group Incorporated

Edward J. Yruma - KeyBanc Capital Markets Inc., Research Division

Camilo R. Lyon - Canaccord Genuity, Research Division

Kimberly C. Greenberger - Morgan Stanley, Research Division

Christian Buss - Crédit Suisse AG, Research Division

John D. Kernan - Cowen and Company, LLC, Research Division

Andrew Burns - D.A. Davidson & Co., Research Division

Rob Wilson - Tiburon Research Group, Inc.

Lululemon Athletica (LULU) Q3 2012 Earnings Call December 6, 2012 9:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the lululemon athletica Q3 2012 Results Conference Call. [Operator Instructions] Later we will conduct a question-and-answer session. [Operator Instructions] I would now like to introduce your host for this conference call, Ms. Therese Hayes. You may begin, ma'am.

Therese Hayes

Hi. Good morning, everybody, and thanks for joining us on our third quarter 2012 conference call. A copy of today's press release is available in the Investor Relations section of our website and furnished on Form 8-K with the SEC and available on the commission's website at www.sec.gov.

Shortly after we end this morning, a recording of today's call will be available as a replay for 30 days, also on the website. And hosting our call today is Christine Day, the company's CEO; John Currie, the company's CFO; and Sheree Waterson our Chief Product Officer will also be available during the Q&A portion of the call.

We would like to remind everyone, of course, that statements contained on this call which are not historical facts may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results 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.

[Operator Instructions] And with that, I will turn it over to Christine Day.

Christine M. Day

Thank you, Therese. Good morning, everyone, and thank you for joining us today to discuss our stellar third quarter results. I'm very proud of the team for achieving yet another strong quarter and coming in ahead of our expectations. Our robust financial results in the third quarter were largely driven by first-rate execution, beautiful product, community engagement and continued strength in our e-Commerce business.

During the course of the quarter, we celebrated the opening of an ivivva store, 3 stores in Australia and North American store openings in Omaha, Pittsburgh, New York, Memphis, Baltimore, Columbus, Franklin and Bridgewater, New Jersey. I am continually amazed with the creativity of our teams in enrolling their communities to the store opening events, which this quarter included the Gospel of Sweat at New York City's historic Upper West Side Riverside Church. Both the name of the event and the location were intentionally created to engage a conversation about spirituality and the mindfulness in New York City yoga studios, spin studios, fitness studios and the laps run around the reservoir. 200 yogis practicing mandala style mat-to-mat on the rooftop of the iconic Peabody Hotel in Memphis to celebrate the opening of that region's third store.

For the opening of our second store in Columbus, both stores came together for a huge community class, Om-H-I-O, where 500 yogis practiced yoga inside the Ohio State University Oval together. When we entered the Columbus market as a showroom 3 years ago, there was only 1 yoga studio, and today, there are 15 studios. This speaks volumes to the work both teams have done in their communities to cultivate yoga and be the resource for all things yoga related. It is this authentic connection with our guests and our community that differentiates us from many other retailers.

e-Commerce continued to be a significant growth driver for the business in the third quarter, with year-over-year increases up 89% in sales, the highest rate of growth in the active wear or vertical retail apparel categories.

In addition to our investments in bolstering our social, e-mail and blog activities to support our e-Commerce business, we are also laying the groundwork for future growth. We recently launched our Hong Kong, Singapore, U.K. and EU specific websites, which gives us access to 24 markets with local fulfillment, more localized content and the ability to connect more authentically with those communities. We established third-party logistics and distribution centers in Hong Kong and Rotterdam to better serve the Asian, European and U.K. markets.

We have said previously that we have been spending the past several months doing a lot behind the scenes work, and our international expansion is now entering a phase of more on-the-ground development. Based on the success of both Hong Kong showrooms, we are actively looking to secure real estate for a store in that market. In London, we will leverage the website and current infrastructure with the Chelsea showroom, with an additional showroom penetration in 2013. Overall, we intend to go deeper in showrooms in Europe and Asia over the next 24 months, and we will begin pre-seeding activities in up to 15 countries over the next 2 years.

Based on our experience, when we seeded the U.S. market in 2009 with 50 showrooms, we are confident that this same approach in the international market, along with the intelligence that we gained through our country and region specific websites, will allow us to create the optimal mix of bricks and mortar and e-Com for these markets.

We know that the seeding period in some of these markets may be up to 2 years. In the meantime, we are building the international team. Through our store networks and in-store -- in-country contacts, we are actively looking for showroom managers and community connectors for each of the countries that we are targeting.

And I am particularly pleased to announce that we have made a key international senior executive hire. Barbara Le Marrec is joining our team. Barbara brings great international experience in Europe and Japan, and shares a common history with me as she comes to us from her most recent position as the head of Starbucks operations for Japan. She also held the positions of SAP International Health Solutions at Starbucks and General Manager of Starbucks France.

We announced earlier this month the resolution of the infringement action related to our Astro Pants. We cannot comment specifically to the terms of the settlement with Calvin Klein and G-III. In general, lululemon protects its designs and maintains the strategy of remaining focused on our market-leading position in innovation and execution. We believe that we have taken the necessary steps to establish and protect our IP.

We experienced a slower start to the fourth quarter as we were not immune to the consumer distractions that negatively impacted many retailers for the first half of November. In addition to the November macro issues, we lost some momentum in the beginning of Q4 due to some execution issues with our e-mail product notification, our grassroots marketing communications that drive sales and traffic. These issues have since been resolved.

This season, we made a strategic shift into technical mid-layers, consistent with our strategy of building a layering systems for our run product. The what the fluff? line items are the pinnacle layering pieces for our run line. The price points of these items may have created a barrier, but like many of our products, we know that when these pieces get into our guests' hands, they will love them, so we have repriced some of the pieces to make them more accessible.

We are excited about the holiday season as we have some of the best products we have ever made available for our guests in our stores and through our extended e-Commerce network. We have seen accelerated gift card sales, indicating we are on many gift lists this holiday.

The most productive weeks of the quarter are still ahead of us, and we are excited about the back-to-gym and back-to-studio products that will hit the stores in January.

And with that recap of the quarter, I will now turn it over to John.

John E. Currie

Thanks, Christine. I'll begin by reviewing the details of our third quarter of 2012 and then I'll update you on our outlook for the fourth quarter and the full year of fiscal 2012.

For the third quarter, total net revenue rose 37.5% to $316.5 million from $230.2 million in the third quarter of 2011. The increase in revenue was driven by the addition of 36 net new corporate owned stores since Q3 of 2011, 21 new stores in the United States, 8 stores in Australia, 2 in New Zealand and 5 ivivva stores; comparable store sales growth of 18% on a constant dollar basis; and direct-to-consumer sales, which increased by 89% or $21.2 million. If we included e-Commerce as a store in our comp calculations as many retailers do, our comps would be reported as 26% on a constant dollar basis.

During the quarter, we opened 8 corporate owned lululemon stores in the U.S., 3 in Australia and 1 ivivva store in Canada. We ended the store with -- the quarter with 201 total stores versus 165 a year ago. There are 144 stores in our comp base, 39 of those in Canada, 89 in the United States, 13 in Australia and 3 ivivva stores. Corporate owned stores represented 79.6% of total revenue or $252 million versus 82.6% or $190 million in the third quarter of last year.

Revenues from our direct-to-consumer channel totaled $45.1 million or 14.3% of total revenue versus $23.9 million or 10.4% of total revenue in the third quarter of last year. Other revenue, which includes wholesale, showrooms and outlets, totaled $19.4 million or 6.1% of revenue for the third quarter versus 16.3% or 7% of revenue in the third quarter of last year.

Gross profit for the third quarter was $175.3 million or 55.4% of net revenue compared to $128.5 million or 55.8% of net revenue in Q3 2011. The factors which contributed to this 40 basis points decline in gross margin were product margin decline of 30 basis points; investment in innovation and function in our product mix, coupled with slightly higher markdowns due to a more normalized inventory position impacted product margin versus last year, but was offset with lower airfreight usage and rates in 2012; 60 basis points of deleverage in product and supply chain team costs due to investments in product development, operations and supply chain, which is partly offset by a net 50 basis points of leverage on occupancy and depreciation.

SG&A expenses were $94.7 million or 29.9% of net revenue compared to $68.8 million or 29.9% of net revenue for the same period last year. The $37.6 million 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 tremendous year-over-year revenue growth, along with continued investment in key e-Commerce support functions, such as IT development and support, site content and creative assets, and increases in expenses at our Store Support Centre including salaries, administrative expenses, professional fees, management incentive and stock-based compensation associated with the growth of the business; and finally, the higher Canadian and Australian dollar, which increased SG&A by $0.5 million or 0.5%. As a result, operating income for the third quarter was $80.6 million or 25.5% of net revenue compared with $59.7 million or 25.9% of net revenue in 2011.

Tax expense for the quarter was $24.7 million or a tax rate of 30.1% compared to $21.4 million or a tax rate of 35.5% in the third quarter of 2011. The lower effective tax rate reflects the ongoing impact of revised intercompany pricing agreements.

Net income for the quarter was $57.3 million or $0.39 per diluted share. This compares with net income of $38.8 million or $0.27 per diluted share for the second quarter of 2011. Our weighted average diluted shares outstanding for the quarter were 145.7 million versus 145.3 million a year ago.

Capital expenditures were $33 million for the quarter compared with $13.6 million in the third quarter last year. In addition to new stores, renovations and IT capital, we also acquired the building housing our Kelowna store in Canada and additional head office space in Vancouver. We ended the quarter with $439.4 million in cash and cash equivalents.

Inventory at the end of the third quarter was $164.7 million or 27.5% higher than at the end of the third quarter of 2011, and is consistent with our expected forward sales.

This now leads me to our outlook for the fourth quarter of 2012. This outlook assumes a Canadian dollar at par with the U.S. dollar compared to an average exchange rate of $0.98 in Q4 of 2011.

We anticipate revenue in the range of $475 million to $480 million. This is based on comparable store sales percentage increase in the high-single digits on a constant dollar basis compared to the fourth quarter of 2011. Keep in mind, our comp guidance excludes the additional 53rd week in 2012, which contributes approximately $20 million in sales for the quarter.

We plan to open 8 lululemon stores in the U.S., 1 in Canada and 1 in Australia during the fourth quarter. As Christine mentioned, we experienced a soft start to the quarter, and so our sales guidance is roughly $5 million lower than implied in our annual guidance given on the second quarter earnings call. We again expect gross margin for the quarter to be above 55% for Q4 and sequentially above Q3 due to the leverage on sales volumes.

We expect SG&A as a percentage of revenue to be roughly 500 basis points below the third quarter level, which is consistent with our normal historical seasonality. We also expect year-over-year leverage relative to Q4 of 2011. Our SG&A will reflect preopening costs related to the 10 stores planned to open in Q4 and additional stores planned to open in early Q1 2013. Consistent with previous quarters, we continue to invest in our international market planning and seeding efforts, while also investing SG&A in our infrastructure such as planning, scoping and building new systems within our global IT and supply-chain functions.

Assuming a tax rate of 29.4% and 145.9 million diluted average shares outstanding, we expect earnings per share in the fourth quarter to be in the range of $0.71 to $0.73 per share. This brings our full year sales to a range of $1.36 billion to $1.365 billion.

For the full fiscal year of 2012, we anticipate we will open a total of 37 corporate owned stores, including Australia and ivivva locations. We expect capital expenditures to be between $85 million and $90 million for fiscal 2012, reflecting the purchase of real estate housing stores and office premises, new store build outs, renovation capital for existing stores, IT and other head office capital.

We now expect 2012 fiscal year earnings per share to be approximately $1.81 to $1.83. This is based on 145.8 million diluted weighted average shares outstanding, and it assumes an effective tax rate of 29%.

With that, I'll turn it back to Christine.

Christine M. Day

Thanks, John. I would just like to thank, again, all of our educators and people at the support center that made this great quarter happen. And again, we're very excited about the balance of the quarter and wishing you a big happy holidays.

With that, we will open it up to questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Erika Maschmeyer with Robert W. Baird.

Erika K. Maschmeyer - Robert W. Baird & Co. Incorporated, Research Division

I wanted to ask you about your inventory position. It's close to 28% but well below your sales growth and your implied sales guidance for next year. How do you feel with regards to that? Do you think you're still on the light side there?

John E. Currie

No, we're in a solid inventory position for Q4. Remember that the quarter-end inventory number is just a point in time. It doesn't take into account the flow. We don't see ourselves being constrained by inventory in Q4.

Erika K. Maschmeyer - Robert W. Baird & Co. Incorporated, Research Division

Great. And then, exciting news about expanding your international base. Could you talk a little bit more about how you're building capacity on the supply-chain side for that? Are you going to be expanding your vendor base or building out capacity at vendors, and also, how that could impact your expected SG&A leverage?

Christine M. Day

From an operations perspective, we've had the team on the ground basically over the last 18 months building our capacity for international supply chain, doing all of the compliance, all the duty rates, so a lot of behind the scenes both modeling, information gathering, analysis, making sure that we have compliant product going into all of the markets. And so we're well on our way in that work for all of the markets that we're looking to enter, even just through e-Commerce or through strategic sales and eventually showrooms in those markets. And initially, we will focus on some of the main markets, for us, that's the U.K., Hong Kong. We'll open some on-the-ground presence in Singapore and Germany in the short term, and then we'll go through more markets until we do the 15. We'll be working in both the Asian markets and the European market simultaneously. So a lot of great progress on that operationally and both in the supply chain and building the team that's capable of doing that and building the systems, so being very prepared.

John E. Currie

And in terms of SG&A, you're already seeing some of the SG&A related to international in the second half of this year. As we go into next year, and we haven't been specific yet just in terms of how many showrooms and how many countries we'll open. But there will be some drag on SG&A leverage, but it won't be significant. But I'll talk about it more in the next earnings call.

Operator

Our next question comes from Adrienne Tennant with Janney Capital Markets.

Adrienne Tennant - Janney Montgomery Scott LLC, Research Division

Christine, can you talk about -- the what the fluff? line looks fantastic. I was wondering if you can just talk about sort of the learnings on launching it, both online and in stores, the repricing, what -- now that you've done that, have you seen a pickup in sales cadence? And are you happy with where the product is now priced?

Christine M. Day

Number one, the response to the product in terms of the technical user runner who purchase it, loves it so it's really well received as a technical product. And definitely, we see long-term being in the business of the technical mid-layer and layering pieces. So it's important for us strategically to drive the business in where we want to be in being a market leader and innovating. What we realized when we put the whole package together and saw it on the floor set that overall store price felt a little high to us, and we realized that we really want long-term commitment to this product, so we made the strategic decision to bring the price point down to a more accessible level to really get it in the hands of the people who we want it to be in and to drive the line. So that was really what guided our decision was that, first and foremost. And then the second was recognizing that overall, our price points were a little higher than we'd like to have seen in the holiday period. So we feel good about where that's at. And as John said, we're trending against our expectations, and we feel really good about that product in particular.

Adrienne Tennant - Janney Montgomery Scott LLC, Research Division

And then really quickly, John, just the high-single digit comp, does that include the anniversary of the warehouse sales that happened in January of last year?

John E. Currie

No. The warehouse sales aren't included in our comp. We do intend to have a couple of warehouse sales this year, so it is in my revenue guidance.

Adrienne Tennant - Janney Montgomery Scott LLC, Research Division

Okay. So we will see the anniversary of the -- I think it was 3 events last year, the same ones?

John E. Currie

Yes, we will do that again this year.

Operator

Our next question comes from Omar Saad with ISI Group.

Omar Saad - ISI Group Inc., Research Division

Christine, could you address a little bit the performance of the mid -- some of the mid-layer products you talked about, there's some price resistance there. Is there any sort of general takeaways from what you're seeing in the business in terms of what's -- some of the more innovative fashion, newness products versus the core products? Are you seeing kind of equal performance across the board there? And then this pricing issue.

Christine M. Day

I think one of the things that really surprised us at the end of Q3 and coming into Q4 was the strength of our basic bottoms business. We ordered an extra heavy amount kind of towards the end of the quarter because those are easily replenished items. And it really drove traffic on the Wunder Unders, the Groove Pants. The bottoms have been an exceptional performer in the core business, which has been really great to see. A strategic decision that we made was to walk away from some of the cottons that we've done in the past because they're not as technical product. Those were high-volume sales drivers for us, so transitioning the customer to a more technical guest is still always a strategy that we're optimizing. So if to do it over, I would probably not have walked away maybe as much in the holiday season from that because that scuba hoodie for young girls is a big gift giver. But I think we'll look at that again for next year, but on the whole, the technical product is great and the core business is great. And it's more a story about what strategically we chose not to do for the holiday season.

Omar Saad - ISI Group Inc., Research Division

Okay. And then just on the mid-layer where you're kind of repricing to make them a little bit more accessible. Can you just maybe expand on that a little bit?

Christine M. Day

Yes. I mean, I think, we -- we're obviously a little excited about the premiumness of that product because it truly is. And so we priced it as a premium product, but then when we stood back and really looked at it in the store and our desire to really drive it as a key line piece for long-term, we made the decision to bring it back down in margin and in price point. But it's still a very healthy margin product, so it's not like we're going below our historical margin levels in doing so.

Operator

Our next question comes from Betty Chen with Wedbush Securities.

Betty Y. Chen - Wedbush Securities Inc., Research Division

I was wondering if you can talk a little bit about the Men's versus the Women's business in the quarter. And then also, any learnings from the innovations, the capsules and how the team may be thinking about those learnings in planning for 2013?

Sheree Waterson

So the first question was about Men's. Hi, this is Sheree. And there are a lot of learnings about Men's for Q3. So one of the things that we did was shift some of our fits to a slimmer, more modern fit. And what we learned is that the guest, the male guest, is so excited about the modern detailing and the later cutting and gluing of pockets and so on and so forth. And we want to put those fits into more athletic blocks, fit blocks, so that we can satisfy a more democratic consumer base. So lots of great things happening in Men's. And I think you can see the ethos shifting quite a bit. So the only thing I'd add to that is we really are attracting a younger male guest because of those changes, and I think that's so exciting we broadened the appeal of the Men's line and I think that's one of the leading indicators we're very excited about. And the rest is -- what was the second question?

Betty Y. Chen - Wedbush Securities Inc., Research Division

In regard to the capsules this year, any learnings and how we should think about the team planning for capsules next year?

Sheree Waterson

First of all, we are so excited about what we've learned about capsules. One thing that I continue to talk about is cascading our learnings into our core line, and so when I look at our commute line, when I look at the spin line that we did and so on and so forth, what we were able to get in terms of insights for technologies and then also insights for stylings that we want to bring into the core line has been great. So cascading from more wow factor down into the core I would say is the key learning that we get from capsules. This year, we executed 8. Next year, we're going to go deeper and look at about 6, and that's exciting. We also, you should know, have just hired a Head of Innovations. His name is Dr. Tom Waller, and he is also having us or leading us into the future with some new technical fabric innovations and construction innovations, so we're really looking forward to him joining the team.

Betty Y. Chen - Wedbush Securities Inc., Research Division

Is there any way you can share with us, John, what were the comps for the Men's versus Women's business in the third quarter?

John E. Currie

The comps were very similar. Men's during Q3 continues to run around 12% of the overall sales.

Operator

[Operator Instructions] Our next question comes from Dana Telsey with Telsey Advisory Group.

Dana Lauren Telsey - Telsey Advisory Group LLC

As you think about the balance of price and margins on basics versus new categories, how are you thinking about pricing and margins? And how is -- will 2013 be different than 2012?

Christine M. Day

I think the fourth quarter is always a little bit more of an unusual situation where you've got outerwear and then this year, we led into the technical mid-layer. But our core business margins continue to strengthen. We've been able to leverage some of our supply chain, some efficiencies, so even with rising either raw materials or labor, we've been able to really hold strong margins on our core product. Always in innovation, we're going to accept slightly lower margins to drive the business. Usually, those are on higher ticket items, so from a dollars perspective, those are our key. And I think it's what the strategic choices are about the things that we do in between because we believe in not just cluttering our store with stuff. And our goal is to always innovate and have a discipline to do what we are driving strategically versus easy sales because as a market leader, that's what keeps you disruptive and innovative. So we're always leaving room in our margins to perform overall, though, hitting the target of the 55% range that John has laid out. And that's our goal is to always innovate while hitting the target that we've laid out.

Operator

Our next question comes from Roxanne Meyer with UBS.

Roxanne Meyer - UBS Investment Bank, Research Division

Can you talk about just really quickly in 3Q what the comp components were? Was the comp driven mostly by traffic, or was AUR or other metrics at play as well? And then how do you think about 4Q in terms of the difference of product flow into the stores versus last year? And how are you thinking about markdown rates as you anniversary more normalized markdowns?

John E. Currie

In Q3, the comp was made up pretty much entirely by traffic. There's a little bit of up-and-down in the other elements, but the traffic increase is pretty much equal to the comp growth. What was the second [indiscernible]?

Roxanne Meyer - UBS Investment Bank, Research Division

Okay, great. The second one is more about 4Q and how you think about both the flow of products. And as you anniversary normalized markdown rates, how you're thinking about that this year.

John E. Currie

Okay. Again, as I said, coming into the quarter, we've got a strong inventory position with additional product coming in. So the flow, whereas in the past, it has created some ups and downs, we don't see that as being a factor this year. In terms of markdowns, again, as I've been saying the last few quarters, probably up a little bit year-over-year, but still at a very low overall level of markdowns relative to our history in retail in general.

Operator

Our next question comes from Jim Duffy with Stifel, Nicolaus.

Jim Duffy - Stifel, Nicolaus & Co., Inc., Research Division

John, I was wondering, on the fourth quarter, could you quantify the impact that you saw from Sandy early in the quarter? And then with respect to the execution issues you saw early in the quarter, did those persist through Thanksgiving weekend and Cyber Monday?

John E. Currie

Okay. The impact of Sandy, I don't want to make it sound like that was material. I mean, a small number of our stores were closed for a few days. But that -- if it was $1 million, that's probably a good estimate, so that's really not a big factor. And yes, the other things that Christine mentioned in terms of product notifications, that did carry on through.

Christine M. Day

Yes, there was about a 2.5-week where we were down, and it did carry through Thanksgiving weekend and through the next week.

Operator

Our next question comes from Tal Woolley with RBC Capital Markets.

Tal Woolley - RBC Capital Markets, LLC, Research Division

I was just wondering if you can break out the CapEx budget for this year in terms of what was the sort of the base capital spending versus what was optional or real estate re-acquisitions.

John E. Currie

Oh, let's see. The real estate acquisitions totaled about $17 million, $18 million. The balance, I don't have a breakdown in front of me, but as I said, it's new stores, it's renovations and significant investment in IT.

Tal Woolley - RBC Capital Markets, LLC, Research Division

Okay. And has there been any discussion at the board level about -- thoughts about deploying the cash either share buybacks, dividends, what are the thoughts there?

John E. Currie

It's something we talk about pretty much every quarter because we do have a healthy cash position. As I've said in the past, my preference at least, is to get to a point where we've got sufficient cash reserves to fund the most aggressive expansion plan in the midst of a deep recession and can still be comfortable. And then, what I see us doing in the future would be to get to a point where we could institute a regular recurring dividend as opposed to looking at special dividends or buybacks. But it's an ongoing discussion.

Operator

Our next question comes from Lorraine Hutchinson with Bank of America.

Lorraine Maikis Hutchinson - BofA Merrill Lynch, Research Division

Once you restarted the e-mail notifications, did you see the comp return back to maybe last quarter's state, or are you still seeing some weakness, I think you mentioned macro, come through?

John E. Currie

It's getting pretty granular. I guess I'd just say, with the product notifications back, we're seeing the traffic in business on trend that's consistent with my guidance.

Operator

Our next question comes from Janet Kloppenburg with JJK Research.

Janet Kloppenburg

Christine, I wondered if you'd talk a little bit about your test of some of the more casual product and dresses in the quarter, and what you're thinking about in terms of layering in fashion versus basics as we go forward. I also wanted to learn a little bit more about the comps in the Canadian market and how they compare to the U.S. market. And John, I just wondered on the gross margin guidance, I think you said 55% -- above 55% for the fourth quarter, and I'm wondering if you could just highlight whether or not your AUC or your average unit cost per unit looks lower versus last year in the fourth quarter.

Christine M. Day

So we always do in the summer a few casual layering dresses to go either with the swimsuit pod or just for fun. They always blow out. They're well received. But that's not what we would consider a major -- that's a fun item for us. It's not necessarily what we would call the technical street. So when we talk about moving into technical street, it's always technical first. And so things like the what the fluff? line to us represents a technical street where it's beautiful enough to wear as your outerwear but it also has that highly technical element to it. So you'll see us move more into technical that crosses over. And some of the beauty of like the Men's jacket, the commuter jacket that was just out there, is so handsome on, but at the same time, you can ride a bike in the rain and show up for work and it's so handsome. So those are the things that we refer to when we talk about pushing the line into technical street. And we'll always do things like the dresses or something for a little bit of summer fun because our guest enjoys it and, frankly, so do we.

Janet Kloppenburg

Does that mean that the technical street portion of the assortments could become a bigger contribution to the assortments going forward?

Christine M. Day

I think that's the plan over time. And obviously, we have very high sales per square foot, and we have to plan in what the future growth is going to be and do that in a very strategic way, and I think that's what you see us doing.

John E. Currie

And in terms of your questions on comps. Canada, in spite of its very high productivity, continued in Q3 to deliver a positive low-single digit comp. And in the U.S., again really strong comps in the U.S. We're a little over 30%.

Janet Kloppenburg

Okay. And if I could squeeze in a question for Sheree. Sheree, I was just wondering if we had a lot to look forward to in terms of swim in the spring? Will it be a bigger product line, more frequent product line, than last year? Or how should we be thinking about that category?

Sheree Waterson

There's always something exciting to look forward to, Janet. Sure. Yes, next year, for 2013, we are doing swim, and so you'll see swim show up a couple of times, one for the early buyer and one for the in-season buyer. So for March, we'll be doing a capsule and then for June, we'll also be doing another capsule. And what you're still going to be noticing is that we're exploring the -- this category, so we're getting better and better at it, and as we do, you'll see that grow.

Janet Kloppenburg

Okay, great. And John, did you want comment on the gross margin question?

John E. Currie

Yes, sorry. Our average unit cost in Q4, I think you were saying. Like-for-like, we're seeing unit cost pretty flat on a -- by unit basis. I mean, we are innovating, so there's a slight increase when we're doing something new, but I think your point is really like-for-like, which is, as I said, pretty flat over last year Q4.

Operator

Our next question comes from Sam Poser with Sterne Agee.

Ben Shamsian - Sterne Agee & Leach Inc., Research Division

Ben Shamsian for Sam. Had a question on the comp. The last few quarters, it was entirely or mostly driven by traffic and conversion. Given that you're going more towards the technical and sort of moving more towards the Men's, will we see any help on the ASP side? Or do you think sort of ASPs are topped out going forward?

Christine M. Day

Yes. Well, I think you'll see based on outerwear in Q4, that always does drive it up, but at the same time -- which is your average ticket. But at the same time, the volume of the core being sold kind of neutralizes it, so it does depend a little bit quarter-by-quarter, but definitely, the comps with the technical line shift and a little bit higher price per piece will add -- will start to build that ticket over time.

Operator

Our next question comes from Liz Dunn with Macquarie Capital.

Lizabeth Dunn - Macquarie Research

Most of my questions have been answered, but I just -- on the capsules. So there will be fewer of them, but you'll go deeper. Is it just sort of a -- are you looking at some of the things that you experienced in 2012 and kind of evolving those, or will there be new categories? And how should that impact margins? Will there be a little bit of margin pressure because like we saw this year, there will be some experimentation?

Christine M. Day

Let me answer the second part, and I'll let Sheree answer the product piece. But our -- the overall effect of the small buy in capsules varies -- does not really drive our margin in particular. However, what I will say about that is, when we take a fabric or a new innovation from a capsule and drive it into the main line, in the beginning, there is usually a small decrease in margin until it becomes a consistent part of the line and we reach efficiency. So it's not the capsule per se. It's the translation of innovation into the main line that would have that effect until we get to a point of efficiency, which is why we always -- that investment in innovation is so critical for us. But we also know as the market leader and the disruptor while we're creating new space is what we strategically want to drive and we're constantly reinvesting the gross margin that's over the 55 into the product to be -- maintain the market leadership. I just want to make sure that our strategy is really well understood. With that, I'll let Sheree tell you what's exciting about capsule.

Sheree Waterson

This goes back to the way -- what I said earlier. As we learn from capsules, we learn what the key items are in capsules so that the capsules actually become more productive. So one of the things, as an example, that we learned from commute is that there's room for a stretch technical fixed waistband pant, which would go from your bike to work, as an example. And...

Christine M. Day

Sheree has been wearing one for 3 days. And if she took it off, I think we'd all steal it.

Sheree Waterson

Yes, it's a good one. And so -- but we see the same thing with tops. So for Men's, as an example, we've done polos, and this year for Father's Day, we will have polos that will be great for golf and cross-functional-type activities. So because those have such key item implications, we're learning, and it's becoming more productive, not less.

Operator

Our next question comes from Sharon Zackfia with William Blair.

Sharon Zackfia - William Blair & Company L.L.C., Research Division

Wanted to discuss a little bit more of the international expansion, and congratulations for the hire. Obviously, Christine, you come from a company that's been very successful internationally, but also spent a lot of money to get to that level of success. So I'm just kind of curious, on the layup in investments, as you go deeper into Europe and Asia, when do you really expect that to kind of peak? Or how do you think about the profitability arc of the international and outside of Australia business model?

Christine M. Day

One of the things that I learned tremendously was in working in international at Starbucks, and Barbara did as well, it is far better to spend your money on the infrastructure and getting ready to build a profitable business model when you go in rather than to build a loss-leading market and then cleaning it up afterwards by putting the fixes in place. So we're being very disciplined about creating a healthy business model, and it's not growth at any cost. We've built the models and are testing them, and the beauty of showrooms is it gives us the ability to test the labor rate, the real estate rate, the duty import rate so that we can fine tune the model market-by-market. We also can see what's driving the guest behavior, what's the definition of luxury in the market, what's the definition of technical. So all the pre-seeding we work, we're doing now. All those learnings are being taken in, and so the same strategy that we did in the U.S. is learned from the showrooms and have highly profitable stores from day 1. That's what we're looking to do. So it's not a first-to-market. At the same time, being an early mover in e-Commerce in the showrooms protects our IP and allows us to own the brand and the strategy in all of the markets. So what you see us doing is laying the groundwork for financial success, a healthy business model, which allows us to continue to be who we are strategically everywhere we go.

Sharon Zackfia - William Blair & Company L.L.C., Research Division

And just to follow up on that, is the economic model for the showroom the same then when you're doing it in London as when you started to do it in LA?

Christine M. Day

It's not, right? So I mean, your real estate in London is a lot more expensive. So we open -- our goal is to open a showroom a few more days and to bring in more of the wow product than the basic product than we did in U.S., so we very much localized to create the business model that's needed. And you'll see us do maybe more trunk shows in combination with our showrooms. You'll see us do slightly larger stores in those markets but fewer of them because you've got more density in the city. So we're very strategic about how we adapt yet create the same outcome in the markets. And we have a very successful profitable business in Australia, and that, as many people know, when you grow internationally, it's not easy to do.

Operator

Our next question comes from John Zolidis with Buckingham Research.

John Zolidis - The Buckingham Research Group Incorporated

I wanted to ask you a question about your store expansion in the U.S. using the Columbus Avenue store as a kind of example and point of departure. So just curious, with only 100-odd stores in the U.S., why would you choose to open a store only 10 blocks away from an existing location? And so could you just talk about why that store versus some of the other whitespace that you have? And then, could you also comment on the cannibalization that you might be experiencing at the nearby store? And then lastly, I notice you didn't put the lululemon name out the store, just the symbol, so could you talk about your thinking around that?

Christine M. Day

Yes. So when we go into a market, we've already looked at all of the penetration of potential stores that we would want to have in the market. Then what we do we is we basically create a target real estate list of where we want to be. We open the showrooms, we open stores in sequence of how we want to build the brand, so kind of hip urban, urban affluent, suburban affluent. We don't target necessarily where we think the highest volume sales [indiscernible] because we're building a brand, and that's important over the psychology of a market. So we look at each market in a stand-alone way, and we then are real estate opportunistic and say, if we want to be on this street and intersection because we've plotted the whole market and great, a real estate shows up, when people are doing 5- and 10-year leases, if I don't take it then, I'm going to let somebody else take it and it would be 10 years before I get that corner. So we do it in a very knowing mapped out way. When we do cannibalize a store, it typically is less than -- 10% is the maximum I think we've seen and it recovers very quickly. So we still have very much growing brand awareness and demand. So we want the 3 to 5 or 10, whatever the market will hold best stores on our target, that's our first priority, and if it meant that there was a little bit of short-term impact to a store, we'll take it rather than let competition because what would happen if we had -- where you don't want to be is in a B store in a market that has a potential with a lot of stores as more competition comes along. So everything we do is very strategic and has the long-term decision in mind.

Operator

Our next question comes from Edward Yruma with KeyBanc Capital Markets.

Edward J. Yruma - KeyBanc Capital Markets Inc., Research Division

John, on the change in the intercompany pricing agreements, once you cycle that next year, will the -- will there still be a continued step change there? And I guess, as more of your revenues come from abroad, is there incremental opportunity on that front?

John E. Currie

The adjusted tax rate to 30% or just under 30% is an ongoing tax rate. It will evolve over time based on the countries we go into and where our profit is generated. But the benefit really comes from the fact that a lot of our income is taxed in Canada where our -- the IP resides, et cetera. And then Canada has the benefit of a -- quite a low tax rate.

Christine M. Day

I just want to mention, I did not answer John's second part of the question which is why we don't put the logo -- or the name on every store, sorry I didn't answer that, John. The reason we don't do that is, exactly, it made you curious. And so the first store when we're building awareness in the market, we always do that. But we find actually in our model less signage, more authentically local. We deliberately try to be very community-oriented and we don't believe in putting 12 signs on our store. We're very respectful of being part of the community and the street. And we use community to engage and drive traffic, not signage.

Operator

Our next question comes from Camilo Lyon with Cannacord Genuity.

Camilo R. Lyon - Canaccord Genuity, Research Division

Just going back to the international infrastructure build out. Do you expect to add manufacturers to your supplier base? Or are your current partners expanding their capacity for you?

Christine M. Day

We've been working for the last 2 years to build our capacity with our manufacturers, and so we don't see any barriers from that perspective. We've got strategic plans in place with most of them and doing everything from extra backups from any of the fabrics that we do, alternate choices and flexed capacity and demand. Working on a 9-month calendar like we do, we don't have the luxury of 24 months' lead times to get right orders to factory. So this is something that we have to pay a lot of attention to, to make our flow and model work. And I think Linda [ph] and her team who run that for us have really done a fantastic job this last year, particularly on base products and on some more complex sewing products that we do.

Camilo R. Lyon - Canaccord Genuity, Research Division

Got it. And then just moving on to the e-mail notification execution issues that you called out, is there an opportunity to recapture those lost sales in the fourth quarter?

Christine M. Day

Yes. I think it's always a little more difficult to read a 53-week year in terms of sales build. But I believe we have great product in the store right now, we have more color than we've had all year, we have more technical pieces and we have great stock in basics. So we just -- we're ready for the consumer.

Operator

Our next question comes from Kimberly Greenberger with Morgan Stanley.

Kimberly C. Greenberger - Morgan Stanley, Research Division

I just wanted to ask about your long-term operating margin targets, and the gross margin, as I recall, target is around 55%. You seem to have settled in there this year. And I'm wondering if you can just look out over the next several years and comment on whether or not that's the level that you feel like is really achievable. And then separately, you mentioned a 25% EBIT margin, that implies I guess a 30% SG&A rate to sales. You've nicely beat that target here in 2012, and I just wondered if you could share with us the way you think about the necessary investments in the business and growing that SG&A at a pace that you think is appropriate and strategically right. But are there some offsets in that thinking in terms of making sure you're also monitoring the deleverage, if any, that you're expecting in the business?

John E. Currie

Okay, there's a bunch of questions in there. But as I've said for some time now, our target margin profile is about a 55% gross margin and 25% operating margin. Because we're growing, because we're expanding internationally, making IT investments to support a bigger company in the future, that's what keeps the operating margin down to 25%. If we were just staying in North America and simply running out the growth of that existing business, that operating margin would leverage and we'd get up into the upper 20s. But we are trying to balance both on the gross margin line and the SG&A level, delivering a strong model as we grow. I mean, that's the point, growing but maintaining that strong margin. So yes, from time to time, our gross margin can get above 55%, as I think Christine or Sheree mentioned. We like to invest that excess back into innovation. But there is leverage inherent there, especially as we leverage against occupancy and depreciation, which is in cost-of-sales. Similarly, in terms of SG&A running at about 30%, again, it will be up, it will be down, but especially as we go international, both in terms of the infrastructure investment to support that and as we get into stores, the initial stores in new markets will likely initially deliver a lower operating margin, and that will offset the leverage that we see in the core North American business.

Christine M. Day

Right. And I think what's important is that our base operating functions, we've seen a lot of leverage in all of the functions, except for IT, we're making investments. Products, we're investing in supply chain; international, quality. And as John said, we're reinvesting in preopening and new market expenses, which will normalize. But I want to assure you that in the core business, we have seen leverage across the SG&A and now, we're reinvesting that leverage to provide growth, which is what our job is.

Operator

Our next question comes from Christian Buss with Crédit Suisse.

Christian Buss - Crédit Suisse AG, Research Division

More about the seeding of international markets and if you could give us sort of a prioritized list of where you're looking and thinking about, that would be very helpful.

Christine M. Day

Yes, I think we've already declared that it's Hong Kong and Singapore where we already have a presence with strategic sales and you're kind of on-the-ground in both of those markets, and we're moving more quickly to stores in Hong Kong. And then London, you'll see us increase our penetration of showrooms this next year, and then the next market that you'll see us targeting is Germany.

Christian Buss - Crédit Suisse AG, Research Division

That's helpful. And in terms of the pre-investments you've made, could you give us some color on that?

Christine M. Day

So we don't want to give away all our secrets. So what I'll just say is that there's on the team -- on-the-ground teams that are working in a variety of markets, doing what we do best, which is build a community and engagements so that we are authentically local and that we're driving desire and demand by the time that we reach the market with a physical presence.

John E. Currie

And that's in market. And then behind the scenes, a lot of work in terms of compliance in various markets, employee relations matters, legal and tax structuring, all of that work, distribution centers, that's the groundwork that we've been laying over the past 18 months.

Operator

Our next question comes from John Kernan with Cowen.

John D. Kernan - Cowen and Company, LLC, Research Division

It's a little bit of a follow-up to the previous question. What type of market research have you done into the 15 countries that you plan to enter over the next 2 years? On the product side of things, what type of, I guess, research both from the fashion and the technical side of product have you done before entering those markets?

Christine M. Day

We, obviously, do a lot of benchmarking and we do a lot of our design meetings where we're in with athletes and asking them what they like to use. We do a lot of product testing. And so it's a very active -- and those are the ones that people know that we do. There's a lot that people don't know that we do that I don't actually want to share. So rest assured that we like the pay of [ph] travel advisory warning, which is know before you go. And so we're very disciplined about that.

John D. Kernan - Cowen and Company, LLC, Research Division

Okay. And then one quick follow-up. The Men's business continues to gain momentum, has there been any change in thought about what the long-term potential of that business is as a percentage of your total business?

Christine M. Day

Well, if I was to follow Chip's direction, it would be huge. So I think everybody's very excited and see it's a huge opportunity. And we've already got a lot of basic pieces in the line, which are very beloved, and we see Men's buy in bulk, and so we've built a really good basics assortment. And as Sheree said, it's now about refining to complete the whole architecture in the line. But we've just got some incredibly handsome pieces that are out there right now. The Men's Mission Pant is the best pant that we've ever done, extremely well received in the marketplace, getting a lot of great feedback about that. I already mentioned the Men's commuter jacket, which we did in a relatively small amount and got out there, and now all of a sudden, with people are seeing guys in it, everybody's coming in trying to get it, so very excited about the response because that's kind of a new direction for us. And as we already discussed, we've really added to the bandwidth of guests who's shopping with us. We're seeing a younger male attracted. We've got our existing core, and now we're working to really fill in the desire. So we definitely see it as a major growth opportunity for us strategically.

Operator

Our next question comes from Andrew Burns with D.A. Davidson.

Andrew Burns - D.A. Davidson & Co., Research Division

Could you spend just a little more time on outerwear? It seemed to be a bigger presence in the stores this year versus last. And so can you talk about the performance and opportunity for that category, and specifically, the consumer response to higher price points?

Christine M. Day

I think what you saw year-over-year was, if you recall last year, our factories delayed our outerwear so we canceled it, so we actually had none last year. And we had a very small drop right around Christmas of the original what the fluff? line that we were testing last year. So this year, of course, would feel like more because we actually skipped a year of doing any outerwear, and then you went from outerwear into a bigger what the fluff? So I think the overall impact in the store felt a little bit more like technical mid-layers and some outerwear, but we really didn't do too many more styles in direct outerwear than we've been historically. We did skip doing the big, big heavy down jacket that we've done in the past and boy, did we hear about that from our Canadian guests, so I think you can expect to see that back. And so it was very well received. I was just in the store over the last couple of days and we had a woman who'd come in and bought a coat at let's just say another store and she came in and saw ours, bought it and went out the door to return the one she just bought. So we were pretty excited to see that and have a really great outerwear collection. And I think the style that we bring to outerwear is exceptional.

Operator

Our last question comes from Rob Wilson with Tiburon Research.

Rob Wilson - Tiburon Research Group, Inc.

John, I'm a little surprised about the gross profit margin guidance because if I remember correctly last year, you called out specifically, the merchandise margin was down 310 basis points last year. So I'm assuming you're guiding to lower than last year gross profit margin. Can you help me understand why it would be lower than last year? I mean, last year you called out higher product cost, 230 basis points, you called out...

John E. Currie

Those higher product costs that deleverage gross margin a year ago over the prior year, those have not reversed, so that's simply carrying on. And then beyond that, as we've mentioned additional innovation, et cetera, as the product cost's up a little bit.

Rob Wilson - Tiburon Research Group, Inc.

So you've received no benefit from lower sourcing cost?

John E. Currie

Very little. A lot of retailers are more cotton-centric than we are, so they saw the spike in cotton and then the strong reversal, but cotton really isn't a factor for us. For us, it's more of things like silver, for example, in our Silverescent material. So the answer is no.

Rob Wilson - Tiburon Research Group, Inc.

Okay. One more question real quick since I'm last, why would you guys want to own real estate?

John E. Currie

It's not a core strategy, but when we have a key location that we see ourselves being in long-term and that can be at our head office or it could be a key store, such as the Newbury Street store that we acquired, we evaluate acquiring it versus entering into a lease where, of course, we're at -- exposed to, on renewal, the lease rates going up. So just strategically, it can be a better way of securing real estate on a long-term basis.

Operator

I'd like to turn the conference back to our host for closing remarks.

Christine M. Day

Great, thank you. So Sheree and I would like to thank our product team, the design, merch, supply chain for being relentless and pushing boundaries. We believe we have the best product team in the world, complemented by the best educators, creating a guest experience in our stores.

So with that, thank you, and happy holidays to everyone.

Operator

Ladies and gentlemen, that does conclude today's presentation. You may now disconnect, and have a wonderful day.

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