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Lululemon Athletica (LULU)

Q4 2012 Results Earnings Call

March 21, 2013 9:00 a.m. ET

Executives

Joe Teklits - IR

Christine Day - CEO

John Currie - CFO

Sheree Waterson - Chief Product Officer

Analysts

Erika Maschmeyer - Robert W. Baird

Adrienne Tennant - Janney Capital Markets

Lorraine Hutchinson - Bank of America

Sharon Zackfia - William Blair

Stan Poser - Sterne Agee

Kimberly Greenberger - Morgan Stanley

Liz Dunn - Macquarie

Camilo Lyon - Canaccord Genuity

Dana Telsey - Telsey Advisory Group

Howard Tubin - RBC Capital Markets

Janet Kloppenburg - JJK Research

Jim Duffy - Stifel Nicolaus

Roxanne Meyer - UBS

Faye Landes - Cowen and Company

Edward Yruma - KeyBanc Capital

Operator

Good day, ladies and gentlemen, and welcome to the lululemon athletica Q4 2012 results. [Operator Instructions] I would now like to introduce your host for today’s conference, Mr. Joe Teklits of ICR. Please go ahead.

Joe Teklits

Thanks, good morning. Thanks for joining us on our fourth quarter and fiscal 2012 conference call. A copy of today's press release is available in the Investor Relations section of our website at lululemon.com or furnished on Form 8-K with the SEC and available on the commission's website at www.sec.gov.

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

As a reminder, the statements contained on this call which are not historical facts may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results might differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the company's filings with the SEC.

We have about one hour for today’s call, so when we get to the Q&A, please limit yourself to one question at a time to give others the opportunity to also have their questions addressed. With that, I will turn the call over to Christine Day.

Christine Day

Thank you, Joe. Good morning. I’m joining you from Australia today, where it actually just after midnight. Our board meeting was held here this quarter, and we have just finished a few days of meetings with our board and our team here in Australia. Before we talk about our fourth quarter and full year 2012 results, I will give you an update to the announcement made on Monday of this week regarding the sheerness in certain styles of our women’s black Luon bottoms. Following my comments, John will speak to our guidance.

We have not yet determined the specific cause for the sheerness, and are pursuing several hypotheses in parallel with our manufacturing partners to determine the root cause. What is clear to us is that this is not the Luon that we and our guests have come to love. The process for creating Luon is complex and involves a specific set of proprietary ingredients and a multistep production process. Even the slightest changes to the process can create meaningful changes in the fabric.

We had already begun putting more stringent specifications in place on the production of Luon, and we will be redoubling our efforts in this area. We currently have a dedicated team working with our suppliers to identify and resolve the issue. We have recently added strong leadership in quality control, our liaison office, and our commercialization and development teams, and I 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 thing 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 as produced, including what we achieved during the past year.

In 2012, we once again had strong revenue growth in all of our markets and profit growth to match. This time last year, we were celebrating hitting the $1 billion sales milestone, and in 2012, we were able to grow by an additional $370 million.

This growth gave us the leverage to invest in international expansion and implementing a broad range of foundational systems to support our further expansion. Our new financial system was implemented at year-end, and we’re looking forward to the improvements that our PLM and advanced product allocation phase I implementations will create for managing the flow of our product.

I would also like to point out that our ecommerce revenue grew by 85.5% in 2012 to $197.3 million or 14.4% of sales. Ecommerce 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 ways in which guests shop.

We achieved these results in a very brand-appropriate way, and did not buy our comps through discounting, which ultimately would have harmed the brand. We maintained a full price strategy up to the holidays, then used our traditional warehouse sales as an effective and low-risk way to clear our inventory. We are already flowing the learnings on price sensitivity and assortment preferences from the holiday season into this year.

It is fitting that I’m joining you from one of our international locations, given our increased focus on growing globally for the coming year. This year, we will expand our foothold in two key markets, London and Hong Kong, while establishing local community connections and introducing our beautiful product to guests in a variety of markets in Europe and Asia through strategic sales, showrooms, and ecommerce.

But of course, our primary growth over the next few years will still come from same-store sales increases and expansion in North America. We are being very intentional and methodical regarding how we will operate globally to maximize both our current business in North America while growing internationally.

We hosted or first-ever Asia yoga tour in Hong Kong, Shanghai, and Singapore during the first two weeks of this month, and it was our first large community event in Asia, with a series of complementary yoga classes and workshops, with six of our ambassadors from North America and Hong Kong. The community classes were held in some cool locations, including local radio stations, art galleries, and even an amazing rooftop bar that overlooked Marina Bay in Singapore. We’re getting a great reception to these events, and the team shares 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 capital 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 midsupport bras, tanks, and skirts now engineered for tennis, solving for unrestricted arm movement and lateral movement in bottoms. They are also cross-functional for run and other high impact sports.

For women’s golf, the approach is technical street with pieces that transition from sweat to street. Innovative construction methods like bonding and laser cutting are also elements we’ve played with in this collection.

For men’s, we are excited to be introducing our largest polo offering to date in response to feedback from our guests, especially around father’s day. These tops will be handsome yet functional for tennis and golf. Our polos will come in both athletic fit, providing enough room in the body to accommodate swings during a match, as well as slim fit, for guys looking for something more modern and progressive.

Sticking with this theme for a moment, we continue to see opportunity in men’s and have recently enhanced that team with the addition of Felix Del Toro as our new senior vice president and GM of men’s. He comes to us with over 22 years of merchandising and design experience with Warnaco and Gap Inc., 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 Klauberg, who joined us last spring. Coming soon is an app that will support our guests’ 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 second SeaWheeze half marathon in beautiful Vancouver. Allison Forsyth, our organizer of our first-ever SeaWheeze half marathon last year, has set a goal to sell the race out in a month. 7,400 people signed up for last year’s race in eight 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.

John Currie

Thanks, Christine. I’ll begin by reviewing the details of our fourth quarter of 2012, and then I’ll update you on our outlook for the first quarter and full year of fiscal 2013. For the fourth quarter, total net revenue rose 30.7% to $485.5 million, from $371.5 million in the fourth quarter of 2011. The increase in revenue was driven by comparable store sales growth of 10% on a constant dollar basis, bringing our average store productivity at the end of the year to $2058 per square foot.

The addition of 37 net new corporate owned stores since Q4 of 2007, 27 new stores in the United States, one store in Canada, five stores in Australia, one store in New Zealand, and three ivivva stores. Direct to consumer sales increased by 48%, or $24 million. If we included ecommerce as a store in our comp calculations, our comps would be reported as 16% on a constant dollar basis.

A stronger Canadian and Australian dollar had the effect of increasing reported revenues by $5 million, or 1%. And finally, the additional 53rd week of fiscal 2012 contributed $26.2 million in total sales, which included $4.2 million in ecommerce revenue and $2.3 million from a warehouse sale.

During the quarter, we opened eight corporate owned lululemon stores in the U.S., one in Canada, and one in Australia. We ended the quarter with 211 total stores versus 174 a year ago. There are 169 stores in our comp base, 42 of those in Canada, 103 in the U.S., and 19 in Australia and five ivivva.

Corporate owned stores represented 77.9% of total revenue, or $378 million versus $78.7 million or $292.6 million in the fourth quarter of last year. Revenues from our direct-to-consumer channel totaled $78.3 million, or 16.1%, of total revenue versus $50.1 million, or 13.5%, of total revenue in the fourth quarter of last year.

Other revenue, which includes wholesale, showrooms, and outlets, totaled $29.2 million, or 6% of revenue for the fourth quarter versus $28.9 million or 7.8% of revenue in the fourth quarter of last year.

Gross profit for the fourth quarter was $274.5 million, or 56.5% of net revenue, compared to $209 million, or 56.3% of net revenue in Q4 2011. The factors which contributed to this 20 basis point increase in gross margin were product margin improvement of 10 basis points attributable to product mix and lower air freight rates and usage, offset by slightly higher markdowns compared to the fourth quarter of 2011, and fixed cost leverage of 10 basis points made up of 40 basis points of leverage on occupancy and depreciation offset by 30 basis points of deleverage in product and supply chain team costs.

SG&A expenses were $121.9 million, or 25.1% of net revenue, compared with $93 million, or 25.1% of net revenue for the same period last year. The 31.1% SG&A dollar increase is due to an increase in store compensation and operating expenses associated with new stores, showrooms, and outlets, as well as increases at existing locations due to higher sales volumes, increased variable operating costs associated with our ecommerce business due to the significant year over year revenue growth, along with investment in key ecommerce support functions such as our development, demand creation, and creative teams.

Increases in expenses at our store support center included salaries, administrative expenses, professional fees, management incentives 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&A by $1 million, or 0.8%.

As a result, operating income for the fourth quarter was $152.6 million, or 31.4% of net revenue, compared with $116.1 billion, or 31.2% of net revenue, in 2011. Tax expense for the quarter was $44.7 million, or a tax rate of 29.0%, compared to $42.6 million, or a tax rate of 36.5% in the fourth quarter of 2011. A lower effective rate reflects the ongoing impact of revised intercompany pricing agreements.

Net income for the quarter was $109.4 million, or $0.75 per diluted share. This compares with net income of $73.5 million, or $0.51 per diluted share, for the fourth quarter of 2011. Our weighted average diluted shares outstanding for the quarter were $145.8 million, versus $145.3 million a year ago.

Capital expenditures were $21.2 million for the quarter, compared to $16 million in the fourth quarter last year, with the increase associated with new stores, renovations, IT, and head office capital.

Turning to the highlights of our full fiscal year 2012 performance, net revenue rose 36.9% to $1.37 billion, from $1 billion in fiscal 2011. Our annual comp was 16% on a constant dollar basis, and if we included ecommerce, our annual comp would have been 24%, which excludes the 53rd week.

Gross profit was $768 million, or 55.7% of net revenue, compared to $569.4 million, or 56.9% of net revenue in fiscal 2011. Net income for the year was $270.6 million, or $1.85 per diluted share, compared to $184.1 million, or $1.27 per diluted share for fiscal 2011.

Looking at our balance sheet highlights, we ended the year with $590.2 million in cash and cash equivalents, an increase of $180.7 million over fiscal 2012 year-end. Inventory at the end of the fourth quarter was $155.2 million, or 49.1% higher, than at the end of the fourth quarter 2011. The increase is due to higher levels of spring seasonal product receipts and a higher mix of winter carryover product as we entered 2012 with a lighter carryover position due to the strong holiday sales in 2011.

This now leads me to our outlook for the first quarter and full year fiscal 2013. Let me start by quantifying the estimated impact of the black Luon issue reflected within this guidance. The impact falls into three buckets: firstly, lost revenue as a result of shortages of the impacted styles; secondly, cost of sales resulting from the writeoff of bulky 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&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’ve 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 million to $17 million in the first quarter, and additional lost revenue of $45 million to $50 million for the balance of the year, primarily in the second quarter, spread over new and existing stores and ecommerce.

This assumption is based solely on the lost black Luon sales that would have been assumed based on available product for sale. It does not, for example, take into account sales that could possibly transfer to other products, but also does not take into account lost add-on sales that often accompany the purchase of black Luon pants.

Next, we’re estimating additional cost of goods sold of $17 million in the first quarter. Even though some of the effective product is slated for delivery over the balance of the year, a reserve for the full writedown of the product will be taken in the first quarter, and thus the full cost of this product is booked as cost of goods sold in Q1, with no related sales. This reserve is therefore estimated to impact Q1 gross margin by 500 basis points.

And finally, we estimate additional SG&A of $1 million to $2 million incurred over the first and second quarters. The estimated impact on the diluted EPS is $0.11 to $0.12 in the first quarter and $0.25 to $0.27 for the full fiscal year 2013.

So now the resulting outlook for the first quarter of 2013. This outlook assumes a Canadian dollar at $0.98 to the U.S. dollar and eight new store openings, six in the U.S., one in Canada, and one in Australia. We currently anticipate revenue in the range of $333 million to $343 million. This is based on a comparable store sales percentage increase between 5% and 8% on a constant dollar basis, compared to the first quarter of 2012.

As we had indicated in our press release earlier in the week, our comp through the first six weeks of the quarter was 11%, and our guidance would have been $350 million to $355 million for the first quarter, assuming a low double digit comp. We had anticipated gross margin would have a similar profile to the first quarter of 2012, in the 55% range, but with the impact of the Luon issue outlined above, we now expect gross margin to be approximately 48% to 49%.

We expect modest SG&A deleverage as a percentage of revenue, compared with the first quarter of 2012, which is driven primarily from the run rate of key investments made in 2012, new strategic initiatives in 2013, our continued focus on international, and incremental expenses outlined above associated with Luon production.

Our SG&A also reflects pre-opening costs related to the eight stores planned to be opened in Q1 and additional stores planned to open in early Q2 of 2013. Assuming a tax rate of 30% and 146 million diluted average shares outstanding, we expect diluted earnings per share in the first quarter to be in the range of $0.28 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 ivivva 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 billion to $1.64 billion. Fiscal 2013 will of course be back to a 52-week year.

For the year, we expect gross margin to be approximately 53% 5o 54%, with lower gross margins in the first two quarters and a return to more normalized gross margins in the 55% range for the back half of the year. We expect some SG&A deleverage as a percentage of revenue compared to 2012, as the leverage gained from our core North American business is offset by reinvestments into areas such as our supply chain, IT, and international seeding and branding, and of course, the Luon production related expenses in the first half.

As a result, we expect our overall operating margin to deleverage from 2012, and our fiscal year diluted earnings per share to be approximately $1.95 to $1.99. This is based on 146.2 million diluted weighted average shares outstanding, and it assumes an effective tax rate of 30%.

We expect capital expenditures to be between $90 million and $95 million for fiscal 2013, reflecting new store buildouts, 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.

Christine Day

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.

Question-and-Answer Session

Operator

[Operator instructions.] Our first question comes from Erika Maschmeyer of Robert W. Baird. Please go ahead.

Erika Maschmeyer - Robert W. Baird

Just to go back to the recall issue, if you identified the issue today, when would you expect to receive shipments into 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?

John Currie

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.

Christine Day

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 is 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 have completed the diagnostics. It’s more complicated than it being just one individual or group. Regarding identifying or diversifying the supplier base, we have actually moved in that direction, and we should have two additional sources ready for manufacturing our key fabrics by the fall.

Erika Maschmeyer - Robert W. Baird

So do you think that by the end of Q2 you could have potentially shipments of fixed product coming into the stores?

Christine Day

Right now what we’re still waiting for is we have a lot of product on the water, and so it was a little complicated to get the samples from that product, and we won’t receive those for a couple of days. So I think our first step is to see what to correct, or what we can use in that. And meanwhile, we’re working with our suppliers to do some additional testing of any old stock that we have to see what we could do to flow in, and we won’t have those answers probably for the next week or so.

Erika Maschmeyer - Robert W. Baird

That makes sense. And then on golf and tennis, could you talk about how you expect to get the word out? I’m sure you have something creative in mind, but just your thoughts on PR and any types of sponsorships or events.

Christine Day

We actually have some social media campaigns ready to go with that, and letting the [guest] 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 should say, those communities in fun and unique ways, so that everybody will know that they’re out there. And they’re small capsules, as I said. They’re not going to be truly incremental. They’re just driving a lot more energy into the store. And they’re not made of Luon, so we’re good.

Operator

Our next question comes from Adrienne Tennant of Janney Capital Markets. Please go ahead.

Adrienne Tennant - Janney Capital Markets

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 products? And then I’ve looked at a lot of blogs and website reviews, and the chatter seems to be taking on a very negative tone, particularly when people are returning product back to the stores. I’m wondering how you’re dealing with training the store ambassadors to handle this in the best manner.

Christine Day

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. For right now, we primary see this is as an issue with Luon. There are a couple of other fabrics that occasionally will have issues, but that’s fairly minor, and nothing that we see is as significant as what we’ve seen in the Luon.

Operator

Our next question comes from Lorraine Hutchinson of Bank of America. Please go ahead.

Lorraine Hutchinson - Bank of America

Switching topics to the international expansion opportunities, I was hoping you could give us an idea of what types of investments you’ll need to make over the next couple of years to get the infrastructure ready to open stores? And then also maybe a timeline of when you’d expect to be opening stores abroad?

Christine Day

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. That’s already been baked into our capital investments that we’ve laid out.

In terms of directly in markets, there’s eight or nine markets where we’re doing what we call pre-seeding, where we participate in events such as I described on the call in Shanghai. Those are pretty low cost measures where we’re really doing community work, and then we’re getting those ready for showrooms. 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 six months. So we’ve already built out international ecommerce site, which we’ve already preannounced and we’ll only be adding one additional international website this year, which will be in Shanghai.

Operator

Our next question comes from Betty Chen of Wedbush Securities. Please go ahead.

Betty Chen - Wedbush Securities

I was wondering if you could talk a little bit about some of the learnings you’ve gleaned from pricing last year. What have you heard from your customers and guests regarding how they view the merchandise, not only from the core but also some of the new capsules and new product extensions that you have been expanding into?

Christine Day

Definitely the number one learning over the holiday, particularly in the Canadian market, was that those more $100 price point cottons that they’re used to having, particularly the Scuba Hoodie, and we usually have something called the Cozy Up and the Cuddle Up, and there’s a variety of versions of that that we offer, which we did not this year, significantly affected that holiday purchase in particular. And then we felt that we also got a little too aggressive in pricing our What 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.

Operator

Our next question comes from Sharon Zackfia of William Blair. Please go ahead.

Sharon Zackfia - William Blair

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 the return of the black Luon and kind of getting people back in the stores that might be disappointed in the next several months?

Christine Day

I think just like the [unintelligible], 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, 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 and really are more subjective. 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 [chips] 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 then I think also the the transition with patterns. 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. We’re definitely looking to make some more significant hires, particularly in the raw materials area going forward.

John Currie

And just to confirm, no, we did not assume a benefit of pent up demand in the second half guidance.

Operator

Our next question comes from Stan Poser of Sterne Agee. Please go ahead.

Stan Poser - Sterne Agee

You gave us same-store sales guidance for the quarter. Can you give us some of how you’re looking at the full year same-store sales?

John Currie

Obviously the second quarter is probably the most impacted and our expectations would be a very low single digit comp, close to flat for Q2 as a result of the Luon issue. The balance of the year, I’m not giving quarter by quarter guidance, but it comes out to roughly high single to low double digits.

Stan Poser - Sterne Agee

And then secondly, I understand that you don’t understand how this exactly happened, but I guess the question is, how did it get to where it was shipping without somebody trying on a pair of pants, like the first batch, to make sure that this wasn’t an issue, and stopping it before it got so out of control? And then what do you see as the incremental cost of adding the different people, the new QA and so on and so forth at the different factories, to ensure that something like this doesn’t happen again?

Christine Day

That was already reflected when John mentioned some incremental costs in the SG&A. So we’ve already built that number in. And some of these were already planned hires, so we have people onsite in every factory. The truth of the matter is the only way that you can actually test for the issue is to put the pants on and bend over. Just putting the pants on themselves doesn’t solve the problem. So 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 in a store and started putting it on people that we could actually see the issue.

Operator

Our next question comes from Kimberly Greenberger of Morgan Stanley. Please go ahead.

Kimberly Greenberger - Morgan Stanley

It sounds like quality is going to be priority number one 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 this is sort of the second quality issue, I think, in nine months. Is there some sort of an organizational effort to make sure that whenever there are quality issues that appear anywhere, either in the supply chain or at the stores, that there is a concerted effort to 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?

Christine Day

Absolutely. Project Canary, as we’re referring to it. We have made significant investments since last year. The issue you’re referring to, the dye issue, where we brought the experts in, rewrote the whole process for dye, and working in partnership with our manufacturers solved the problem. So we no longer have dye issues, and so we can very much say that with confidence.

And I feel that we will accomplish the same thing here with the fabrics once we identify exactly where in the chain the breakdown was, and have long term solutions for this. The big shift for us is making sure that we have people actually on site in the mills and the other environments, and that’s the infrastructure that we started investing in this year. And we’ll continue to do so this coming year.

The whole organization is obviously very devastated 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.

Operator

Our next question comes from Liz Dunn of Macquarie. Please go ahead.

Liz Dunn - Macquarie

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?

Christine Day

I don’t think that I could say that at this point in time. That’s one possibility, but because it’s touched by so many people across the line, that at different stages, this could have happened in any one of four stages. 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.

Liz Dunn - Macquarie

And then I’m sorry, it was a little bit unclear to me, are you opening stores in U.K. and Hong Kong this year?

Christine Day

Our goal is to open a store in Hong Kong. We’re evaluating several sites right now, but those leases came to take a little bit longer to negotiate. But we’re confident we’ll have it sometime within a 12-month period. And then London, the goal is to open additional showrooms this year and then move to stores next year.

Liz Dunn - Macquarie

And then just finally, one for John. Was the 500 basis points that you called out in the first quarter just related to the writedown? And what impact, if any, should we see from deleverage on the lower comp? I would assume that would be mostly a Q2 impact.

John Currie

Yeah, based on the magnitude of the revenue drop, as a result of lower revenue on the Luon issue, we do deleverage based on occupancy and depreciation, etc., primarily Q2. But there’s some impact in Q1. The other thing just to get a little more granular on the overall impact on the gross margin, a lot of these are key styles, and tend to be higher product margin, so the impact’s a little bit larger than it would be if it was just more seasonal items.

Operator

Our next question comes from Camilo Lyon of Canaccord Genuity. Please go ahead.

Camilo Lyon - Canaccord Genuity

What’s happening to all the excess Luon? Is that a product that you could conceivably sell to your outlets at a discounted price?

Christine Day

Right now we’re holding all the product, because there actually might be some treatment solutions that we’re investigating, that actually could solve some of the problems. So until we get those test results back, we haven’t made a decision at this point in time.

Camilo Lyon - Canaccord Genuity

I’m assuming none of that is embedded in your guidance currently?

John Currie

That’s correct.

Camilo Lyon - Canaccord Genuity

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?

John Currie

That would be a little bit more precise than the information that we have. The average number of units per transaction is between 1.5 and 2, but couldn’t break that down to when there’s black Luon pants, what’s the add on. We don’t have that detailed information at this point.

Christine Day

It normally works the reverse. Somebody comes in, they’re attracted by one of the new items, and then they pick up additional core, because they’re looking for an outfit, or they say, okay, I want the extra pair of Wunder Unders. 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 the good news is that we do have a lot of other product that’s available, just based on the timing of this and the shift in spring.

Operator

Our next question comes from Dana Telsey of Telsey Advisory Group. Please go ahead.

Dana Telsey - Telsey Advisory Group

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, or 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?

Christine Day

Some of the individuals that we’ve added, Joan comes to us from most recently at JC Penney, and she’s worked for Nordstrom before that. So she’s our new director of QA, just recently joined us, completed her training. And then unfortunately had to hit the ground running very hard over the last few weeks. And we also made a significant hire as vice president of commercialization and development, which is really critical in the raw materials area.

We’ve also made a deep hire in our R&D department, Dr. Tom Waller, who comes from the Speedo group. And so he also works on developing raw materials. So those are just an example of three key senior leaders that we’ve hired. We’ve also put a person on the ground in Taiwan, and he’s already been in place, and he’s building a team there that will actually be at the factories where we produce. In addition to the outside third party testing, which we do do, we will also have people at our manufacturing sites. So those were already all planned investments for this year.

Operator

Our next question comes from Howard Tubin of RBC Capital Markets. Please go ahead.

Howard Tubin - RBC Capital Markets

Just a question on your lead time. If you [unintelligible] Luon today, and you started from scratch today, how long would it take for that product to get in stores and available to sell?

Christine Day

We are working with the manufacturer today, but first we have to certify that everything that’s coming off that line does actually meet the specifications. 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 Wunder Unders and Groove Pants within no more than 28 days. But we need to make sure that that product is something we can stand behind.

Operator

Our next question comes from Janet Kloppenburg of JJK Research. Please go ahead.

Janet Kloppenburg - JJK Research

I was wondering what the substitution potential would be when a client can’t buy a Luon Please also note that? Is there a likelihood or a high likelihood that they may substitute for a different fabrication? Also, Sheree, I was wondering if perhaps your innovation level in fabric and product design may have something to do with this quality control issue. Obviously you’ve been very innovative, so maybe that’s put some risk into the product production and quality control. Are you examining that situation for potential change? And for John, I’m wondering if we should be expecting the gross margin decline in the second quarter to be deeper than you’re forecasting for the first quarter.

Christine Day

Right now there are Luon pants that are not affected, so there are Luon pants in the store. It just is particular to the Groove Pant and the Wunder Under, and then a couple of seasonal styles, a couple of crops that match those and a couple of shorts. So there still are Luon, there are still printed Luon, and there’s Luon that’s colored. So it’s just the black pant 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’d feel we need to drag into all the different tests that we’re conducting, because it’s really about the core product. And then John?

John Currie

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 second quarter in the low 50s.

Operator

Our next question comes from Jim Duffy of Stifel. Please go ahead.

Jim Duffy - Stifel Nicolaus

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 you should think about new store productivity, ecommerce, and the other revenue line items as contributors to the full year guidance?

John Currie

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 $1,150 a square foot plus or minus range, which, again, is what we expect. There’s a lot of new stores in new markets where the guest is very early on in the discovery of us. 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.

Jim Duffy - Stifel Nicolaus

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 trying to get my arms around how to think about the trajectory of the ecommerce business in ’13 off of what was a great year in 2012.

John Currie

We continue to expect that new store productivity to be similar looking forward. Some noise in the other channels, just in general, it goes up and down. We had two warehouse stores 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.

Jim Duffy - Stifel Nicolaus

And then how about the ecommerce? Any thoughts on the growth rate for that?

John Currie

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 ecommerce growing to 20% and beyond in the foreseeable future. For 2013, I’d expect it to be midteens, maybe 15-16%, of total revenue against the overall growing base of revenue.

Operator

Our next question comes from Roxanne Meyer of UBS. Please go ahead.

Roxanne Meyer - UBS

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 first three weeks of March that may have been impacted that you could think about being disgruntled and maybe pulling back a bit in the near term?

John Currie

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.

Christine Day

We haven’t seen any significant return uptick at this point in time, but the word is still getting out. We did catch it relatively quickly, and acted quickly to go through the stock, 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.

Operator

Our next question comes from Faye Landes of Cowen. Please go ahead.

Faye Landes - Cowen and Company

Sorry to harp on QC, but it sounds like you were starting at sort of ground zero. In other words, for other manufacturers, the idea that you have to put the pants on and bend over to test them out is something that would happen before they hit the stores. So is that correct? Are you really sort of behind the curve on processes in general beforehand, do you think?

Christine Day

I don’t know of anybody else who has people actually… I mean, at final proto in garments, where we make up… 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, it has to be engaged in a four-way stretch for the sheerness to appear. So it’s a very complex thing to test for, and that’s what we’re looking at, what can we do a better job of to make sure that we can identify that earlier in the process.

Operator

Our final question comes from Edward Yruma of KeyBanc Capital. Please go ahead.

Edward Yruma - KeyBanc Capital

I believe that you said that you’re not expecting any recovery on some of your inventory writedowns, but I guess is there the potential for you to go back to your supply and manufacturing partners for compensation in this process?

Christine Day

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 needed 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 an amicable way. If the mistake was ours due to 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.

Edward Yruma - KeyBanc Capital

And one non-Luon question, it seems like you’ve changed some of your philosophies around men’s sizing to perhaps have more accommodating or athletic fit. How does that change the addressable market that you’re attacking for the men’s business?

Christine Day

We definitely think that it makes it broader, because our core market is that athletic male 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 sold out very quickly and we went back into reorder on that.

Operator

I’d now like to turn the conference back over to management for any closing remarks.

Christine Day

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, so that you can have confidence and faith in us that you will always be the first to know whenever we have an issue. Thank you for joining us today.

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