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Lululemon Athletica Inc. (NASDAQ:LULU)

F2Q2013 Earnings Conference Call

September 12, 2013; 09:00 a.m. ET

Executives

Christine Day - Chief Executive Officer

John Currie - Chief Financial Officer

Therese Hayes - Vice President, Corporate Communications

Analysts

Adrienne Tennant - Janney Capital Markets

Dana Telsey - Telsey Advisory Group

Ben Shamsian - Sterne, Agee

Sharon Zackfia - William Blair

Omar Saad - ISI Group

Janet Kloppenburg - JJK Research

Barbara Wyckoff - CLSA

Kimberly Greenberger - Morgan Stanley

Jennifer Black - Jennifer Black & Associates, LLC

Robert Drbul - Barclays

Camilo Lyon - Canaccord Genuity

Howard Tubin - RBC Capital Markets

Jim Duffy - Stifel

Christian Buss - Credit Suisse

Operator

Good day ladies and gentlemen and welcome to the Lululemon Athletica’s second quarter 2013 results conference call.

At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions).

I would now like to introduce your host for today’s conference Therese Hayes. Ma’am, you may begin.

Therese Hayes

Thank you. Good morning everybody and thank you for joining us on the call. A copy of today’s press release is available on the Investor Relations section of our website or furnished on Form 8-K with the SEC and available on the Commissions website at www.sec.gov. Shortly after we end this morning, a recording of today’s call will be available as a replay for 30 days, also available on the website.

Hosting our call today is Christine Day, the company’s CEO; and John Currie, the company’s CFO. We would like to remind everyone of course, that statements contained on this call, which are not historical facts, may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Actual results may differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the company’s filings with the SEC. We have about one hour for the call today, so when we get to Q&A, if you can limit yourself to one question at a time to give everyone a chance to ask their questions, that would be great.

With that, I’ll turn it over to Christine.

Christine Day

Thank you Therese. Good morning everyone and thank you for joining us today to talk about our second quarter results. John will speak to the numbers in detail in a few minutes. Today I will speak to where we are strategically, update on the key hires, including the CEO search and report on some exciting developments within the company.

This is the time of year when our board approves the short and long-term strategic plans and we have spent the last couple of days aligning on these plans and the key initiatives and milestones for the company going forward.

A practical benefit of being in the second year of the three-year strategic plan is that with this strong plan in place, the new CEO will be able to come in and rely on the management team to run the business, while they take the time required to learn how they can incorporate their specific expertise and experience into our culture and business model.

As we announced during our last quarterly call, the board formed a search committee and began executing its CEO succession plan as soon as I communicated my intention to step-down from the CEO role.

The board engaged search consultants to screen for the full range of potential candidates for this role and over the past couple of months has reviewed a list of possible candidates. The search committee is in discussion with several high-caliber candidates and in the coming months expect to narrow the list to the final candidates. The start date for the successful person will be dependent on their required notice period, move to Vancouver, etcetera.

With a very strong senior management team in place to execute the strategy and run the business, we have plans in place for an orderly transition and speaking with key people in the organization, over the past several months, we have been focused on strengthening our product operations function, so we can continue to grow globally, while maintaining high quality standards. It is a critical area of our business, so I’m excited today to share some leadership and organizational changes we’ve made in the areas of sourcing, quality and commercialization.

First, we’ve brought these groups together under one function. This new alignment will streamline reporting and enhance working relationships internally and with our factories. It will also strengthen our quality process, including our end-to-end product life cycle.

As part of that strategy, we named Jennifer Battersby, as our new Senior Vice President of Sourcing, Quality and Commercialization. Jennifer brings more than 20 years of industry experience, having spent a large part of her career with Mast Industries.

Her last role with Mast was SVP, Victoria Secret production, Asia, where she led the production and sourcing, product development, raw materials and fit teams in Hong Kong, Sri Lanka and Korea. Most recently, she worked as a consultant on strategic sourcing solutions and established best practices from design hand-off to manufacture. Jennifer isn’t a new face to Lululemon and has been with us as a consultant since May, and has already well immersed into the culture and business.

Jennifer’s team will include some of the strongest leaders in our industry, whose dedicated efforts over the past several months have enhanced our quality standards and processes with our factories, vendors and partners around the world. We are very fortunate to have such a talented group led by Joan Mudget, our VP of Global Product Quality, since September of 2012; Linda Goldstein, our VP Global Sourcing and Production, since January of 2011; and Christa Schriber (ph), our Director of Product Commercialization since January of 2013.

We have made significant progress on the search for our new EVP of product, and at this time have identified a strong talent pool for this role and anticipated hiring will be coordinated with the CEO hire. We’ve also hired Stephen Berube, Senior Vice President, Distribution and Logistics. Steven joins us from Cole Haan, where he spent nearly 18 years, most recently serving as VP, Production, Distribution and Customer Service. He will be a big asset to our team as we continue to build and evolve our logistical capabilities to distribute our products to stores and guests around the world.

While Steve is completing his on boarding, we have been setting up the business to support our 10-year growth plans for the U.S. business and in August signed the contract for our distribution facilities in Columbus, Ohio.

The Columbus, DC is scheduled for operation in June 2014. The key benefit is enhancing our guest experience by enabling cost-effective two-day service to 100% of e-commerce guests and faster replenishments of our retail stores.

On the product side, we are continuing to support and solidify our points of differentiation. At the end of July, we introduced Full-On Luon, a next generation Luon that we have been working on for the past couple of years and it has met with great reviews from our guests in-stores and online.

We are expanding our base of production for Luon and have on-boarded a second source for Luon, and are on track to onboard the third for the first part of 2014. We recognize the value of our unique fabric and technologies and are taking steps to protect this competitive advantage.

We are making great progress on the construction of our R&D center under the direction of our Whitespace Team and you will have the opportunity to experience the facilities first hand in April, when we host our Analyst Investor Day here in Vancouver at our support center.

Today we announced the strategic global alliance for X-STATIC with Noble Biomaterials. This partnership gives Lululemon exclusivity to the use of Noble, X-STATIC, Antimicrobial Technology of our performance apparel.

Noble has been the longstanding partner of lululemon, providing its X-STATIC technology for our Silverescent fabric, since 2005. This unique opportunity allows us to continue to innovate our technical product and secure our leadership position in anti-stink athletic apparel.

X-STATIC’s properties have helped lululemon to set the industry standard by using the most powerful silver fabric technology to create our Silverescent fabrics. Made with 99.9% pure metallic silver, X-STATIC is designed to provide permanent odor protection by naturally inhibiting the growth of bacteria on the surface of fabric. The silver fiber is woven directly into the garment and will not wash out over time through laundry.

There were several key brand initiatives during the Q2, including our focus on yoga at our core, where in addition to the roughly 60,000 people per quarter who participate in our store’s regular weekly complimentary yoga classes, we brought 200,000 people to the mat, through a number of exciting yoga events around the world, including 1,500 people practicing weekly at Parliament Hill in Canada’s capital city of Ottawa; 22,000 yogis at Wanderlust events in North America; 5,000 people celebrated the Seaweed weekend with yoga music concert combination at Stanley Park, here in Vancouver; a mega yoga event at Busch Stadium in St. Louis, Missouri; and over 300 people came together on the mat in Covent Garden, in London.

Hey lululemon introduced this quarter is our first-owned online community. It is designed to create deeper level of engagement and trust with our guests, where they can share their feedback and ideas with us and join in a conversation with behind-the-scenes updates straight from our functional experts.

We were delighted to see that we were listed as the top retail performer in web customer service in July in a report published in WWD called the ‘Studies of Satisfaction’ survey, where we dominated the sportswear category with the best scores in phone, email and shipping. A big shout-out to our folks at the Guest Education Center & Distribution Centers for all their hard work; it is nice to see it recognized externally.

We are committed to earning our reputation for quality and guest experience everyday.

We saw strong guest response to our technical innovation like the sweat-proof pocket and to the functionality and styling in bags and backpacks. We have also brought back Wraps into the assortment, giving the guests off right pieces she loves.

While the fall product was later to arrive in our store, we have seen good response to the fall color palette and the texture and print we have brought into our core. We are excited about the innovation you will be seeing in functional outerwear and textured softshell fabrics, puffy jackets and belts and versatile silhouettes.

Our SVP of Men, Felix Del Toro has been with us almost six months now and he is doing a really great job of building the team to support the expansion of the men’s business. He arrived in time for the spring-buy review of 2014 and we are all really looking forward to seeing the full impact of Felix and his team in the men’s product in 2015. We are focused on creating a brand that builds on the same philosophy as our women’s product with fit, form and function at the core; however, recognizing the unique characteristics of our male guests.

The build of team and products will dovetail well with the timing of the planned expansion of men’s and our store development team is starting to process of looking for optimal sites for our men’s stores, which we anticipate opening by 2016. We see this as a tremendous opportunity for lululemon. Men’s penetration in Q2 grew to 13.2% of the business.

We’re on track with our plans to have 16 international showrooms opened by year-end, planting the seeds for our global expansion. In August, just ahead of Seaweed, we were thrilled to host 28 showroom managers and community connectors from our newest markets in Europe and Asia for a week of cultural immersion.

A number of them have worked at lululemon for several years and other had joined two weeks prior to coming to Vancouver. To give you a sense of the kind of growth in our international people, only three were in Vancouver at this time last year for the leadership conference. This year we had representation from Hong Kong, Shanghai, Singapore, Tokyo, London, Amsterdam, Berlin, Munich and Frankfurt.

As a final note on our international business, I am very excited to announce that we have just signed the lease for our first international store in London in Covent Gardens, and expect to be able to welcome guests through that door in Q2 2014.

With that, I’m going to turn it over to John to go through the numbers.

John Currie

Thanks Christine. I’ll begin by reviewing the details of our second quarter of 2013 and then I’ll update you on our outlook for the third quarter and the full year of fiscal 2013.

For the second quarter, total net revenue rose 21.9% to $344.5 million from $282.6 million in the second quarter of 2012. The increase in revenue is driven by comparable store sales growth of 8% on a constant dollar basis; direct-to-consumer sales, which increased by 39.4% or $14 million.

If we included e-commerce as a store in our comp calculations, the combined comp would be reported as 13% on a constant dollar basis and the addition of 37 net new corporate owned stores since Q2 of 2012; 28 new stores in the United States, two stores in Canada, five stores in Australia and New Zealand and two ivivva stores. These were offset with the impact of a lower Canadian and Australian dollar, which had the effect of decreasing reported revenues by $2.5 million or 0.7%.

During the quarter we opened six lululemon stores in the U.S., one in Canada and one ivivva store. We ended the quarter with 226 total stores versus 189 a year ago. There are 176 stores in our comp base, 37 of those in Canada, 113 in the United States, 19 in Australia and New Zealand and seven ivivva. At the end of the quarter, we operated 62 showrooms including three in Asia, five in Europe and 11 ivivva locations.

Corporate owned stores represented 79.5% of total revenue or $273.8 million versus 81.9% or $231.3 million in the second quarter of last year. Revenues from our direct-to-consumer channel totaled $49.4 million or 14.3% of total revenue versus $35.4 million or 12.5% of total revenue in the second quarter of last year.

Other revenue, which includes wholesale, showrooms and outlets totaled $21.4 million or 6.2% of revenue for the second quarter versus $15.9 million or 5.6% of revenue in the second quarter of last year. Gross profit for the first quarter was $186.0 million or 54% of net revenue, compared to $155.8 million or 55.1% of net revenue in Q2, 2012.

Product margin declined 220 basis points, due primarily to a lower mix of higher-margin black Luon bottoms and increases in our inventory reserves. These factors were partially offset by 70 basis points of leverage from occupancy and depreciation and 40 basis points of leverage in product and supply chain team costs, due primarily to the timing of spend.

SG&A expenses were $107 million or 31.1% of net revenue, compared to $85.6 million or 30.3% of net revenue for the same period last year. The increase is due to an increase in store labor and operating expenses associated with new stores, showrooms and outlets, as well as increases at existing locations due to higher sales volumes; increased variable operating costs associated with our e-commerce business, consistent with the 39% year-over-year revenue growth in this channel; and increases in expenses at our store support center, including salaries, administrative expenses, professional fees, management incentive and stock-based compensation associated with the growth of our business.

These increases were offset with the weaker Canadian and Australian dollar, which decreased reported SG&A by $1 million or 0.9%. In addition, we recorded a $4.4 million foreign exchange gain in our Canadian operating entity.

As a percentage of revenue, our second quarter SG&A deleveraged 80 basis points, due primarily to deleverage in store salaries and wages. As a result, operating income for the second quarter was $79.0 million or 22.9% of net revenue, compared with $70.2 million or 24.8% of net revenue in Q2 of 2012.

Tax expense for the quarter was $23.8 million or a tax rate of 29.7%, compared to $13.7 million or a tax rate of 19.1% in the second quarter of 2012. Recall that in Q2 last year, we recorded a lower tax expense to reflect the catch up in ongoing benefit of revised intercompany pricing ranges.

Net income for the quarter was $56.5 million or $0.39 per diluted share. This compares with net income of $57.2 million or $0.39 per diluted share for the second quarter of 2012. Remember, the favorable impact of the retroactive tax adjustment last year contributed $0.05 per share, so normalized for that catch up, EPS in Q2, 2012 would have been $0.34 compared apples-to-apples with the 39% we are reporting for this Q2.

Our weighted average diluted shares outstanding for the quarter were 145.9 million versus 145.7 million a year ago. Capital expenditures were $23 million for the quarter related to new stores, renovations, IT and head office capital compared to $26.4 million in the second quarter last year.

Turning to our balance sheet highlights, we ended the quarter with $610.3 million in cash and cash equivalents. Inventory at the end of the second quarter was $163 million or 30% higher than at the end of the second quarter of 2012, higher than our forward sales growth expectations.

This now leads me to our outlook for the third quarter and full fiscal year 2013. Over the past several months we’ve focused on quality and getting Luon back into our stores. While this is clearly what was important for our future, it resulted in some short-term pain. We’ve experienced a weak start to this quarter, driven primarily by late deliveries of fall products, leaving us with the summer product on the floor through August.

These late deliveries are a hangover from the disruption caused early in the year with the Luon issue. While we were successful in getting back in stores with Luon, the effort required to get there had a lingering impact on our commercialization and sourcing team’s ability to be ready to hand-off to our vendors the current season. We anticipate this knock-on effect to continue to impact timing of product deliveries in Q3 and through the balance of the year.

As a result, we now anticipate revenue for the third quarter in the range of $370 million to $375 million. The low end of guidance reflects how we’ve been trending in the first half of the quarter and the high end reflects some improvement in product flow. This is based on comparable store sales percentage increase in the mid-single digits on a constant dollar basis compared with the third quarter of 2012. This outlook assumes a Canadian dollar at $0.96 to the U.S dollar and 22 new store openings, 18 in the U.S., two in Australia and two ivivva.

We expect gross margins to be below last year and at the low end of the mid-50s range due to higher airfreight cost and the impact of foreign exchange due to a weaker Canadian dollar compared to last year.

We expect SG&A deleverage as a percentage of revenue compared to the third quarter of 2012, which is driven primarily from the run rate of IT investments made over the past year, strategic investments being made this year, and expenses associated with our international expansion.

As Christine mentioned, we plan on opening a second U.S. DC in Columbus, Ohio in the second half of 2014. In addition to costs associated with the planning and integration of the facility, a number of key systems implementations, order management, purchase order management and a new warehouse management system are necessary prior to this launch. These projects were all approved and launched in the second quarter of 2013.

Assuming a tax rate of 30% and 146 million diluted average shares outstanding, we expect diluted earnings per share in the third quarter to be in the range of $0.39 to $0.41 per share. For the full fiscal year 2013, we are still targeting to open up to 43 corporate-owned stores, including our ivivva locations. We are also on track to open 13 international showrooms this year.

We expect net revenue for the year to be in the range of $1.625 billion to $1.635 billion. We expect gross margin for the year to be between 53% and 54%. Q4 will continue to be impacted by the same factors discussed with respect to Q3 and as we’ve discussed on previous calls, we will also continue to make incremental investments in the areas of quality assurance, design and product development.

We expect SG&A to deleverage as a percentage of revenue compared 2012, due in part to lost sales in the Luon shortage and delivery delays and the investments we are making in the business to support our long-term growth. As a result, we now expect our fiscal year diluted earnings per share to be approximately $1.94 to $1.97. This is based on 146 million diluted weighted average shares outstanding and it assumes an effective tax rate of 30%.

We expect capital expenditures to be between $100 million and $110 million for fiscal 2013, reflecting new store build out, renovation capital for existing stores, IT projects, real estate purchases, including our new Ohio distribution center and other head office capital, including the build-out of expansion space and our new R&D center within our storage support center here in Vancouver.

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

Christine Day

Thanks, John. 2013 continues to be the most important and productive year in Lululemon’s history. We have not only worked our way back from black Luon set back, but have also added very talent people and important functions and have taken major steps forward on a number of key fronts, including the expansion of our international and men’s businesses and many logistical initiatives.

In addition, our exclusive partnership with Noble announced today and additional sources for Luon, will help to ensure that lululemon remains a distinct leader in quality and innovation. We are well on our way to finishing 2013 as a much stronger company than when the year began. I am confident that the leadership currently in place, coupled with the new CEO will have tremendous success, leveraging the platform for growth.

And with that we’ll go to questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question comes from Adrienne Tennant of Janney Capital Markets. Your line is now opened.

Adrienne Tennant - Janney Capital Markets

Okay, thank you. Good morning everybody. My question is, what is the actual sort of implied comp. You said that there was a tough start to the beginning of the third quarter. Should we assume that this is right in line with that guidance of mid-single-digit and does that guidance imply an acceleration in the comp as the quarter goes on?

Then just finally for the fourth quarter, what type of comp and margin is implicit in the annual guidance? Thank you very much.

John Currie

Yes, the Q3 guidance is based on a mid-single digit comp assumption and a slight improvement. As I said product flow is better as we head into the second half of this quarter. So a slight increase, but still within that mid-single digit range.

For the fourth quarter the implied guidance is high single-digits of comps.

Adrienne Tennant - Janney Capital Markets

And the margin, the gross margin?

John Currie

As I said, we’ve kind of alluded that the low end of the mid-single digits peaks at 53%, 54%, in that range.

Adrienne Tennant - Janney Capital Markets

Okay, thank you very much.

Operator

Thank you. Our next question comes from Dana Telsey of Telsey Advisory Group. Your line is now opened.

Dana Telsey - Telsey Advisory Group

Good morning everyone. Can you give any further update on black Luon and the expected impact for the year on sales and on EPS? And also with the comps complexion that you had this quarter, levers of the comp, traffic conversion, AUR and what you are seeing? Thank you.

John Currie

Okay. Let me start with the Q2 comp make up question. The comp such as it was in Q2 was driven by traffic end conversion being up and average basket being down, which makes sense. We didn’t have the $98 Groove Pants, for example, in the basket where we’re selling more lower priced items. I’m sorry, what is the rest of the – that part of the question?

Dana Telsey - Telsey Advisory Group

Expected impact of black Luon pants compared to original estimate for the year?

John Currie

Yes, the overall impact on revenue is $40 million to $45 million. As I recall initially we projected something higher than that, but since we are through it now, it will be in that range.

Dana Telsey - Telsey Advisory Group

And just Christine, can you give us any color on the competitive environment and what you are seeing?

Christine Day

I think from reading press headlines every day you would say that there is a vast variety and growing variety of competitors in the marketplace. What we have seen is that as we return to black Luon, and particularly the new Full-On Luon, it has been flying off the shelves and we’ve increased some of our orders for that for the back half of the year.

So, in our core initiatives, we do believe our customers waited and then seized the opportunity to buy. So we feel really good about our positioning long-term, based on the high-high quality and introduction of the new Full-On Luon, which will go into all pants in tight bottoms in November. So we are very excited about what that will bring us from a competitive set, as well as we announced obviously X-STATIC. So we feel good about our competitive positioning and differentiation.

Dana Telsey - Telsey Advisory Group

Great. Thank you.

Operator

Thank you. Our next question comes from Sam Poser of Sterne, Agee. Your line is now opened.

Ben Shamsian - Sterne, Agee

Hi, good morning. It’s Ben Shamsian for Sam. Thanks for taking my call. Just a couple of quick questions; you have talked about eight store openings in the quarter, you had 11, just curious what happened there?

Secondly, given the increased spending to go international, can you talk about potential leverage going into next year? If there is better top line results while most of that gets rolled back into the business or can we see some of that fall through the bottom line? Thank you.

John Currie

I’m sorry. Can you repeat your first question on the store count, because I wasn’t quite clear?

Ben Shamsian - Sterne, Agee

Yes, you had guided to 11 stores openings in the quarter, and you opened 8. I just want to know if that was…

John Currie

Yes, there were three or four openings that were right around the very end of the quarter. So, it’s just off by a bit or so. If you see there is a lot of openings lumped into Q3, so that excess would have been, like I said, right around the end of Q2.

I’m sorry, can you repeat your other questions.

Ben Shamsian - Sterne, Agee

Yes, with regards to just – as you spending goes up to go international next year, can you talk about some of the leverage points if there is better top line. Will we see that flowing through the bottom line or will most of that get reinvested back into the business?

John Currie

Consistent with the way we’ve been guiding, with the investment in international expansion and with the additional spend we’re making to shore up our quality and product capabilities, not that I’ve guided to next year yet, but I wouldn’t expect to see significant leverage next year against the normalized 2013. There is leverage in the core business, but that is being reinvested to build our foundation and to push forward on the international expansion.

Ben Shamsian - Sterne, Agee

Got it, thank you. And can you just break out for us the Canada comps versus the U.S. comps?

John Currie

Canada was flat, and the U.S. I think it was up lower to mid-teens.

Ben Shamsian - Sterne, Agee

Got it. Thank you so much.

Operator

Thank you. Our next question comes from Sharon Zackfia of William Blair. Your line is now opened.

Sharon Zackfia - William Blair

Hi. Actually just a clarification on the last question first John. When you’re talking about leverage next year off of a normalized margin, I assume you mean normalized, excluding the Luon outage?

John Currie

Yes, exactly.

Sharon Zackfia - William Blair

Okay, I just wanted to clarify that. And I guess secondarily, maybe I’ll take the – oh gosh, my new phone. I have a question for Christine, because I think there’s a lot of kind of a swirling of thought processes on how the strategic vision of lululemon may or may not change going forward, and it sounds like you just went through a process with the Board of Directors.

So maybe if you could talk about kind of where lulu has been and where it’s going and whether you think there are any major differences that are going to occur going forward versus what we’ve seen kind of in your outline of the plan previously?

Christine Day

Yes. We really look at it in a one to three year strategic plan, which I think I’ve referred to as almost an operating strategic plan and that’s really deep on foundational investments and the infrastructure we really know we need to grow, even today’s business.

Then as we start to look into the mid horizons or what are the seeds that we are planting to maintain long-term growth and then a vision that we are painting. A compelling vision that we are painting for really about that 10-year growth, and we’ve looked at all three horizons, so we know that we’re making the right investments today to support that.

What we anticipate will happen is, it’s very clear that the things we need to do over the next three years from a foundational perspective, and as the new CEO comes in, we anticipate that the senior team will be able to continue to drive that day-to-day operational and strategic plan, because what’s true today is the team does that and my focus has been and the senior team’s focus is much more on that three to five and 10.

So just balancing those two things in the beginning and the team is perfectly capable of doing and that allows a new CEO time to come on, learn the company, learn what’s different and valuable and distinct around Lululemon, and then begin to shape those really, beyond three year horizons with their own special talents and unique ambitions for the company. The board and us are very comfortable with that, and that’s honestly the discussion I’ve had with the candidates that are coming in.

Sharon Zackfia - William Blair

And just to be clear, on the pace of expansion, is everybody pretty comfortable with the pace of store expansion that the company has embarked on?

Christine Day

I mean it is very kind of slow and steady. Internationals are a very big comfort zone. If somebody wants to come in and accelerate that and change the model in the feature, there’s always an open discussion. But right now, especially the transition stage we’re on, very much on track. Everybody is committed to that.

Men’s is seen as a huge opportunity and that should go faster as we build the infrastructure and so I mean you’ve got your core business, which is on track and same strategy as we deployed.

Sharon Zackfia - William Blair

Okay, perfect. Thank you.

Operator

Thank you. Our next question comes from Omar Saad of ISI Group. Your line is now opened.

Omar Saad - ISI Group

Thanks, good morning. Could you elaborate on why the effort and how the effort to restock the Luon black bottoms. How that’s kind of holding back the inventory flow? What’s going on at the supplier level, and kind of leading to this position where you don’t necessarily have the right product for the right time of year and where you want it to be, especially since it sounds like some of the Luon products are I think you said flying off the shelf.

And is that holding back the tops business? I think last quarter you had kind of mentioned a negative impact from not having the right bottoms and negatively impacting the tops as consumer coordinate the tops and the bottoms? Thanks.

Christine Day

Great. Our main bottleneck right now is our commercialization department. Every time we change a manufacturer or every time we change a pattern or fabric for the pant. So for instance moving the Wunder Under to the new Full-On Luon requires a complete recommercialization of every size in that pant. And so we’ve had to recommercialize the original Luon, the new Luon and for every manufacturer we bring on, and we’ve got three new manufacturers, we had recommercialize the pants for all of those, plus we had to commercialize for every new style.

So plus as we correct for quality and making sure that in every step we’ve done additional inspections, which just slows it down and we’ve increased or decreased would be the correct word, our selling tolerances, which slowed the factories down a little bit to make sure that at every step in the way we were getting the quality that we wanted.

Then you add on just time constraints with the amount of quantity of product we’re trying to catch up on with Luon and kind of the seasons collapsing. If we are late with one, then it affects the start day of the next and so we are incurring a little bit more airfreight and slowdown in the shipping process.

So for us that is a short-term pain for the long-term gain of really differentiating ourselves on quality and it’s the work that we’re managing to make it through. So that commercialization impact and bringing on the third factory is still at play and we are working back through all of our other fabrics to make sure that we’re hitting the quality standard we want. So the commercialization workload will affect us for a period of time.

Omar Saad - ISI Group

And the impact on tops business, the bottoms?

Christine Day

Yes. We definitely saw that in Q3 as we were trying to get back in stock, the beginning – sorry, even the end of Q2 beginning of Q3, the top bottom ratio was definitely affected by the ability of not having bottomed.

Omar Saad - ISI Group

Thanks.

Operator

Thank you. Our next question comes from Janet Kloppenburg of JJK Research. Your line is now opened.

Janet Kloppenburg - JJK Research

Hi everybody. Congratulations on a good quarter. I wanted to ask a couple of questions. Christine, I know you probably had too much summer in the stores in August, but if you could give us an idea of the lead through that you are getting on the fall products and how confident you are on the styling there, particularly on the tops and outer wear?

As we look forward to the fourth quarter and next year, I was wondering, how confident you are that the production issues and delivery issues will begin to moderate and if you have the right people in place to manage that process?

And for John, I was wondering if you could address two issues. First, you saw productivity levels where they are and if they are meeting your internal objectives? Secondly, what we should be thinking about as a long term operating margin level for the company, because there’s been a lot of issues this year that have obscured the (inaudible) should come up with that? Thanks so much.

Christine Day

Okay, starting with your question on fall. We’ve just really dropped fall this last week and we had several pieces that actually sold out within the hour, if you tried to buy the skirt you couldn’t buy it. It features a very attractive commuter line with a great jacket and set of pants that built on the statutory fabric we use in the men’s Mission Pant.

So very successful first week on fall, lots of great customer comments, lots of great comments on the Full-On Luon and as I said in November, the Full-On Luon goes from just being in Wunder Under’s into all of our tight bottoms. So we are excited about that.

Outer wear was a smaller buy. I think with the warm weather in the states we are seeing a slower take off there, but a very strong reception in Canada and we do have ability to move inventory back and forth depending on where the guest is buying it. So we are not overly concerned about working through the smaller buy in outerwear that we did.

On the commercialization, I feel very, very good about the people. Jennifer as we said has been working with us since May and the team that we have in place and the partnership that we have with our factories and how they are working with us. So while we do anticipate some timing as spring bumps into fall, fall into winter and just rebuilding our stock in Luon to catch up with demand, we do expect it to kind of – the airfreight situation to catch up and manage flow.

We did experience some additional late deliveries and shortages due to political unrest, one of our key tops is manufactured in Egypt and so it’s mainly late shipping from that that we are working through. But we do expect that from a Luon impact that at the beginning of next year we should be caught up.

Janet Kloppenburg - JJK Research

Okay, thank you Christine.

John Currie

On your questions, NewStar productivity continues to be strong, a little bit better than our expectations. $11.50 a square foot or higher on average, because there’s a range within that, but again continuing similar to how it has in the past few quarters.

Then on your question on long-term operating margin, even though we are investing more on the product teams, etcetera, we also see future efficiencies and there’s no reason to change my longer term outlook on the 55% gross margin and 25% operating margin, again as we continue to grow and expand internationally. Again, that’s leverage above that in the core of business, reinvested into foundation and international expansion.

Janet Kloppenburg - JJK Research

Okay, thanks so much.

Operator

Thank you. Our next question comes from Barbara Wyckoff of CLSA. Your line is now opened.

Barbara Wyckoff - CLSA

Hi everybody. Can you talk about the current mix of core basics versus fashion basics and fashion? Ultimately where should it be and how long do you think it’s going to take for you to get there?

Christine Day

I would say that because of some of the delays, we haven’t had as much new product in the end of the quarter, that as we would have liked and so with the fall drop, we’re pretty much back on track with our historical percentages in probably the overall buy, the timing of when things arrive, the top that matches the bottom and some of the challenges we’ve had with that in holding certain items.

It does affect the mix on a day-to-day, week-to-week basis, and that’s really what we’re working through right now. But from an overall product strategy perspective, I feel very good about the mix and the design details in the fall and winter and offset by the challenges of the timing that we’re having.

Operator

Thank you. Our next question comes from Kimberly Greenberger of Morgan Stanley. Your line is now opened.

Kimberly Greenberger - Morgan Stanley

Oh great, thank you. Good morning. John, you mentioned in your gross margins discussion that you had an increase in reserves here in the quarter. I was just wondering if you could talk to us about what that is and any light on the magnitude will be helpful.

And then I think you said in the SG&A commentary that you experienced some deleverage in store salaries and wages. I was just wondering, given that you delivered an 8% increase in comp store sales in the quarter, maybe you could just talk about the puts and take of why with an 8% comp you would be seeing some deleverage there? Thanks so much.

John Currie

Okay. The provisions that I referred to, I mean we take a variety of provisions against our inventory, whether it’s for shrink or damaged goods or obsolescence, etcetera. So there is a variety of factors, including the fact that we were high on investment at the end of the quarter and so it was just prudent to take some additional reserves to reflect the impact of that on the gross margin.

The question about store salary deleverage, to some extent that was delivered and tied to the Luon issue with the lower revenue than we would otherwise have expected. We didn’t want the educators that we employed in the stores to be the one suffering. So we maintained labor hours that.

They were maybe higher than we’d otherwise have incurred for the level of revenue we saw and as well as we set bonus targets for the store-based employees, those bonus targets were reset downward to realistic expectations of revenue-based on products that we had available. So therefore the bonus for the store-based staff was there even though revenue was down.

Kimberly Greenberger - Morgan Stanley

Going forward, when would you expect that to normalize?

John Currie

As I said, that was an issue that’s really a Q1, Q2 issue related to the Luon shortage that should be normalized now.

Kimberly Greenberger - Morgan Stanley

Great. Thanks so much.

Operator

Thank you. Our next question comes from Jennifer Black of Jennifer Black & Associates. Your line is now opened.

Jennifer Black - Jennifer Black & Associates

Good morning. Thank you. I just had a question about – I assume that you are bringing back some of your electronic product offerings. Can you talk about what kind of response you are seeing from your new guests and your loyal guests on one of the iconic pieces?

And then I guess a follow-up would be, on your men’s business it appears that the fit, especially in the bottoms is evolving. Can you talk about what your Men’s business is and are you happy with the fits and offerings? It looks like your inventory levels have been fairly lenient and all your sizes (inaudible) online stores. Can you talk about your strategy in the men’s inventory? Thank you so much.

Christine Day

So on the men’s inventory we’re actually seeing stronger sell-throughs, which is driving some of those stock-outs that you mentioned. We’ve seen actually tremendous growth in the recent quarter in the men’s business as we started to add some more color, and some of the technical pieces were brought back. There was a little bit of some vendor issues in terms of supply on our popular Vitasea and we expect to be back in stock with that shortly with some really great colors for fall.

For fit, as we discussed in other quarters, we had gone under Rob’s leadership to a quiet tighter more European fit and now we’ve loosened that back up. Some of the initial work that Felix has done is really, we look at all of the blocks for an athletic fit and that was one of its first initiatives, that work is complete and you can expect a very consistent sizing in men’s, which is going to be a huge win.

And on the iconic styles that you mentioned, definitely bringing back wraps and we want our wraps to last five years, and so we’ve really worked with our knit manufacturers to develop a knit quality that is going to last for a long time. So we are really pleased not only that we’ve brought back some of the iconic styles, but the quality and longevity of these items we’re also very excited about.

Operator

Thank you. Our next question comes from Robert Drbul of Barclays. Your line is now opened.

Robert Drbul - Barclays

Hi, good morning. Here the question that I have is you talked about opening a store in Covent Garden. Could you give us any more color on early reach on the international showrooms that give you the confidence in Europe and in Asia specifically, and then most specifically the U.K.?

Christine Day

In the U.K., we know that we’re more than ready for stores. We’ve opened several showrooms in the London area. We are seeing get response. We’ve seen the business grow in e-commerce as well. But still with a few showrooms in the market, you don’t have a lot of big PR and we grow things with our community events.

We figured, we believe that first store will be a milestone event for us. We are going to be doing some things that we don’t normally do in the course of lululemon by increasing our PR strategy and making a little bit more of a splash with that London store opening. So we view this as really a beachhead into the opening of both the U.K. and the European market, really telling the brand story, which is important to us.

We’ve gotten great guests feedback on the products. We do know that they like more color and pattern in the U.K., particularly in the bottom and so we are prepared to address that need. We see sizing runs very similar to North America in U.K. In Asia we see brighter colors are appreciated and shift into the smaller sized runs, but no major change, because we work with stretching knit and we do hemming of tops and bottoms that we’ve not had a fit issue in the Asian markets.

In Asia, very, very strong response in Singapore, in particular and we are beginning to shift into Shanghai this year as well. So very strong response and we believe all the markets are right on track and we are seeing very positive response to the concept, and most importantly to the culture of lululemon. We had several events in Shanghai where we are doing some pre-branding, where we had several hundred people participating in the event. So we are very confident that the lululemon culture and brand translates as well as the product.

Robert Drbul - Barclays

Great. And Christine, if I could just ask one more question, which is, it’s been a little over three months now since you decided to step down. Have you given your next chapter any thought that you could share with us?

Christine Day

If I could get an end date, I’d be happier to answer that question, no. I’m going to take some time off and then I’ll evaluate what’s next for me, but I’m still here as I committed to for a period of time.

Operator

Thank you. Our next question comes from Camilo Lyon of Canaccord Genuity. Your line is now opened.

Camilo Lyon - Canaccord Genuity

Thanks. Good morning everyone. I just want to go back to the commercialization discussion. Christine or John, if you could just maybe speak to what parts of the commercialization process could lead to some potential upside in the back half here? Is it more and more air freighting that will get your product a little bit more in store on time? Is it a more streamlined and controlled process that the way the bottleneck starts to release? Is there any part of that process that could really result in a reacceleration of the product flow?

John Currie

Not really, because what we’re guiding to is based on what we now either know or have a high degree of expectation in terms of when product will deliver. So delays in other words are already baked in. We’re using more air freight than we have historically and that’s already factored in and the point we’re making is, we still have inconsistent product flows and that will carry on through Q4.

Christine Day

I think it’s important as in the raw material process of bringing on new manufacturers, in that the on-site quality inspections and being there and really ensuring we’re getting the right raw materials that then begins to rest of the process. We do expect over time to tighten tolerances we have on our sewing standards. We’ll increase the speed of production as the sewers get used to the new patterns and tolerances.

So you are talking about a lot of our core product. We had to slow them down, make sure that all of the tolerances were being sewn to the right specification. So, what I mean by that, that a sloppy four doesn’t become a bad six and so we’ve really made sure at the manufacturing sect across all of our base are tight and as they get used to sewing to the new standard, they will slow up.

But we’ve hit Q4 volume. I think the other thing that you have to recognize is that’s one of our biggest quarters and it takes a lot to get that back in stock, which is why by the time we get to Q1, it should ease up, because the volumes are down and you also have to remember there’s Chinese New Year. So we have to make the spring product in the same period. So there’s a lot of challenges with just managing kind of a peak volume of production in Q4.

Camilo Lyon - Canaccord Genuity

Great. And then just lastly on markdowns rates, what was the markdown rate in Q2 and how do you see that unfolding for Q3, given that there’s still more carryover product from the summer?

John Currie

Yes, it’s actually fairly consistent with what it’s been sort of in the low-teens. I expect that to continue.

Operator

Thank you. Our next question comes from Howard Tubin of RBC Capital Markets. Your line is now open.

Howard Tubin - RBC Capital Markets

Hey guys, thanks. So in terms of inventory being up 30%, where do you think it will be at the end of the third quarter and maybe at the end of the fourth quarter as well?

John Currie

That’s a tough one, especially with the inconsistent product flow we’re seeing. Maybe I can start by giving a little bit of color on the end of Q2. We actually had excess summer. Some of the product at the end of Q2, but then with delays in a lot of the fall product, as Christine said, we left a lot of summer product on the floor through August and ended up selling through a lot more than we would have otherwise and that means with late deliveries we now have somewhat of an excess fall product against a shortened selling season, so that’s part of what’s going on.

And again within consistent product flow through the rest of the year, it’s pretty tough for me to give you a meaningful estimate of a point in time inventory balance. But I do expect it will be a little bit higher than the level that we normally like to be at the end of Q3, which is the same as at the end of Q1 and Q2 this year.

Operator

Thank you. Our next question comes from Jim Duffy of Stifel. Your line is now open.

Jim Duffy - Stifel

Hi everyone, good morning. So I’m still unclear on some of mechanics of the supply chain delays, pardon me if I’m dense, but you talked about some of the commercialization delays. To be clear, is that specific to Luon or does it impact other products as well?

Christine Day

There is a lot of our product made in Luon, so that is the primary effect, it was both on the raw materials switchover and particularly the pants and bottoms. And then if we’ve made outfits in colors and dyes that match tops, we have to hold the tops match the bottom, so it does a have a knock-on effect to both.

But we are working or re-commercializing every single one of our tops fabrics to making sure that they really last and hold the standard, and so we’ve done everything that we should be doing to hit the quality standards that we’ve have So it’s a very much a company exercise in being quality first and so there is a knock-on effect to the other fabrics, which effect all tops at the raw material stage. The sewing process slowdowns we’ve experienced our primarily pants.

Jim Duffy - Stifel

Got you. That’s helpful, thanks. John, can you share some specific thoughts on the process around the calculation of the impact to comp and margins in the back half of the year? For instance, could you quantify the expected air-freight expense?

John Currie

Air-freight is about 80 basis points. It will impact gross margin by about 80 basis points, if that helps? Sorry, what was the rest of your question?

Jim Duffy - Stifel

The rest it is the thought process around the calculation of the impact to comps specifically and then the margins?

John Currie

Okay. So again, the guidance is based on what we’ve been seeing so far this quarter. It then gets a little bit more difficult, because I’m trying to forecast revenue based on the inconsistent product flow, but that’s the main item. As I look out, I mean also influencing my guidance is the fact that every other retailer is experiencing weakness and mall traffic is down. So it wouldn’t be a time to be bullish on the macro economy either.

Jim Duffy - Stifel

I understand. And then the fall products for instance, can you maybe speak specifically about how late that arrived in the stores?

Christine Day

We just set this last week and normally we would have set in the second or third week of August, usually actually the second week we do a transitional pod. So yes, that definitely was about three, three and a half week delay and we are still waiting for confirmation for deliveries for October and November, so that’s affecting our ability to forecast.

Operator, we have time for just one more question.

Operator

Yes ma’am. Our next question comes from Christian Buss of Credit Suisse. Your line is now open.

Christian Buss - Credit Suisse

Thank you very much for taking the time. I was wondering if you could talk about what the normalized margin rate is for 2013 implicit in your guidance. Another way of saying that is, how much is the Luon impact and how much is the investment in quality in the international and how much is coming from the sales deleverage?

John Currie

Oh buoy! the write-off on Luon and that hasn’t changed, that was roughly $17 million. The investments that we’re making to shore up our product and quality capabilities, it’s about $5 million this year, primarily in the second half and that will be a run rate going forward.

And then deleverage, we’re actually leveraging some of our fixed cost and in cost of sales, but for example as I said even in Q2, we saw positive leverage on occupancy and depreciation. Some of that’s coming from the fact that we’ve got caps on all of our percentage rents and that we are starting to see the benefit there. I don’t see overall deleverage as being a component, but the other piece are – hopefully I’ve clarified that, the quantum.

Christian Buss - Credit Suisse

Could you talk a little bit more about the international investments that you are making?

John Currie

Yes, and that’s everything from store pre-opening costs, but more significantly building all the infrastructure and fitting the headcount in place to manage the business ahead of having a revenue stream, so that’s where we are now.

So, if you look at Europe for example, we have a head of Europe on board. We’ve hired a head of real estate for Europe and several other key positions, but of course, we’re not opening the first store until the middle of next year. So overall, it’s consistent with what I’ve said in the past. I think we’re sort of high single digit millions, negative on the international and net investment.

Christian Buss - Credit Suisse

That’s very helpful. Thank you very much and best of luck.

John Currie

Thanks.

Christine Day

Okay. Thanks everybody for this morning.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude today’s program. You may all disconnect. Everyone have a wonderful day.

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