Lululemon Athletica CEO Discusses Q3 2013 Results - Earnings Call Transcript

Dec.12.13 | About: Lululemon Athletica (LULU)

Lululemon Athletica (NASDAQ:LULU)

Q3 2013 Results Earnings Call

December 12, 2013, 9:00 a.m. ET

Executives

Therese Hayes - VP, Communications

John Currie - CFO

Analysts

Adrienne Tennant - Janney Capital Markets

Camilo Lyon - Canaccord Genuity

Omar Saad - ISI Group

Edward Yruma - KeyBanc Capital

Liz Dunn - Macquarie Capital

Lorraine Hutchinson - Bank of America

Oliver Chen - Citigroup

Jennifer Black - Jennifer Black & Associates

Brian Tunick - JPMorgan

Lindsay Drucker Mann - Goldman Sachs

Kimberly Greenberger - Morgan Stanley

Faye Landes - Cowen and Company

Sharon Zackfia - William Blair

Matt McClintock - Barclays

Sam Poser - Sterne Agee

Robert Altschwager - Robert W. Baird

Pamela Quintiliano - SunTrust

Janet Kloppenburg - JJK Research

Operator

Good day, ladies and gentlemen, and welcome to the lululemon athletica Q3 2013 results conference call. [Operator Instructions] I would now like to introduce your host for today’s conference, Therese Hayes. Ma’am, you may begin.

Therese Hayes

Good morning everybody, and thank you for joining us on our third quarter 2013 conference call. A copy of today's press release is available on 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.

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 John Currie, our CFO. Christine sends you her very best wishes. With the announcement of Lauren Potdevin as our new CEO, she is now focusing on transitioning him into the role and will not be joining us on the call this morning.

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

And with that, I’ll turn the call over to John.

John Currie

Thanks, Therese. Let me start by saying on behalf of the lululemon team that we’ll miss Christine, both personally and professionally, and we wish her all the best.

Six months ago, in addition to initiating the search for our next CEO, we were also actively looking to fill three senior vacancies on our management team, all in the crucial product area. Since then, we’ve successfully filled each of these roles: Jennifer Battersby in the position of SVP, product operations; Steve Berube as SVP, logistics and distribution; and more recently, Tara Poseley joins us as our chief product officer.

Now, with the addition of Lauren Potdevin as our new CEO, as we announced on Tuesday, going forward we have in place the full management team needed to strengthen our foundation and capitalize on our growth opportunities.

The third quarter went pretty much as we’d planned and guided. We started the quarter running at a low single digit comp rate, as delivery issues caused us to keep summer goods on our floors through August, when we normally would have set our fall product.

The black Luon never out program in bottoms drove sales in August and September, and particularly in our tight silhouettes in both solid and patterns, as our guests loved our technical, seamless fabric for yoga in both tops and bottoms. The quarter got progressively better, and October was the strongest month.

In our continued rollout of our international infrastructure, we opened two more showrooms in Asia in the third quarter, one in Hong Kong and one in Singapore, to bring us to a total of five in Asia. We also opened two more showrooms in Europe, both in Germany, for a total of seven in Europe at the end of the quarter, including the U.K., Germany, and the Netherlands.

We have plans to open three more international showrooms in the fourth quarter, one in Asia and two in Europe, and we are still on track to open our first store in Europe, in the Covent Garden area of London, in late Q1 of 2014.

We came into the holiday season better equipped to handle high traffic volumes during peak periods, with handheld POS units for line busting. In our high volume stores, we rolled out mobile ecommerce devices to draw on ecommerce inventory when the store is out of a guest’s size or color.

Our pricing architecture has also improved over last holiday season, with a better assortment of gift giving items and key price point items, such as our Cozy Up style jackets in the $100 range. We also continue to get very positive feedback from our guests on the new Full On Luon, which is now available in all tight bottom styles.

Having said this, we’ve experienced a soft start to the fourth quarter. As we discussed on our last call, the supply chain team that we bolstered with new hires this year is now going through our entire sourcing process and putting in place new procedures to improve on time delivery and quality control.

While these improvements are being put in place for future seasons, for now we’ve enhanced our back end quality control filters at the distribution centers to ensure faulty product does not make it to our stores, and the result is that some styles have been rejected by our quality filters and not released to stores.

The late product deliveries that impacted Q3 have also continued, resulting in uneven product flow, and in some cases cancellation of purchase orders. We know that any lost sales incurred during the fourth quarter resulting from this increased focus on quality is a smart investment for the long term health of the business.

In addition, we’re seeing a slowdown in traffic to our stores. Our best guess is that this is a result of a combination of causes. There’s a difficult macro retail backdrop, with all retailers experiencing lower traffic, but it would be naïve to think that the company specific issues that we’ve been dealing with this year, from the Luon setback to the recent negative PR issues, have not also had some impact. The combination of traffic and product issues resulted in a lower expectation for fourth quarter guidance.

Now let me give you some details on the third quarter, and then I’ll come back and provide more specifics on the outlook for Q4 and the full fiscal year 2013. For the third quarter, total net revenue rose 20% to $379.9 million, from $316.5 million in the third quarter of 2012.

The increase in revenue was driven by comparable store sales growth of 5% on a constant dollar basis; the addition of 46 net new corporate owned stores since Q3 of 2012: 37 new stores in the United States, two stores in Canada, four stores in Australia and New Zealand, and three ivivva stores; and direct to consumer sales, which increased by 37.3%, or $16.8 million.

If we included ecommerce as a store in our comp calculations, the combined comp would be reported as 11% on a constant dollar basis. These were offset with the impact of a lower Canadian and Australian dollar, which had the effect of decreasing reported revenues by $7.5 million, or 2%.

During the quarter, we opened 17 net new lululemon stores in the U.S., two in Australia/New Zealand, and two ivivva stores. We ended the quarter with 247 total stores versus 201 a year ago. There are 184 stores in our comp base, 38 of those in Canada, 117 in the United States, 21 in Australia and New Zealand, and 8 ivivva . Our new store productivity also remained approximately $1,100 per square foot, which contributed positively to the third quarter performance.

At the end of the quarter, we operated 63 showrooms, which include five in Asia and seven in Europe, and 12 ivivva locations. Corporate owned stores represented 76.5% of total revenue, or $290.7 million, versus 79.6%, or $252 million in the third quarter of last year.

Revenues from our direct to consumer channel totaled $62 million, or 16.3% of total revenue, versus $45.1 million, or 14.3% of total revenue in the third quarter of last year. Other revenue, which includes wholesale, showrooms, and outlets, totaled $27.3 million, or 7.2% of revenue for the second quarter versus $19.4 million, or 6.1% of revenue, in the third quarter of last year.

Gross profit in the third quarter was $204.6 million, or 53.9% of net revenue, compared with $175.3 million, or 55.4% of net revenue, in Q3 2012. The factors which contributed to this 150 basis point decrease in gross margin were a product margin decline of 220 basis points, due primarily to higher air freight spend to improve product flow, product mix, and an increase in our inventory reserves, offset with 30 basis points of leverage from occupancy and depreciation and 40 basis points of leverage in product and supply chain team costs, due primarily to timing of spend.

SG&A expenses were $112.3 million, or 29.6% of net revenue, compared with $94.7 million, or 29.9% 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 ecommerce business, consistent with the 37% year over year growth in this channel, and increases in expenses at our store support center, including salaries, administrative expenses, professional fees, management incentives, 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 $2.3 million, or 2%. In addition, we incurred a $1.8 million foreign exchange gain in our operating subsidiaries.

As a percentage of revenue, our third quarter SG&A leveraged 30 basis points, due primarily to the foreign exchange impacts just discussed. As a result, operating income for the third quarter was $92.3 million or 24.3% of net revenue, compared to $80.6 million or 25.5% of net revenue, in Q3 2012.

Tax expense for the quarter was $27.7 million, or a tax rate of 29.5%, compared to $24.7 million, or a tax rate of 30.1%, in the third quarter of 2012.

Net income for the quarter was $66.1 million, or $0.45 per diluted share. This compares with net income of $57.3 million, or $0.39 per diluted share, for the third quarter of 2012. Our weighted average diluted shares outstanding for the quarter were 146 million versus 145.7 million a year ago.

Capital expenditures were $27.9 million for the quarter, related to new stores, renovations, IT, and head office capital, compared to $33 million in the third quarter last year.

Turning to our balance sheet highlights, we ended the quarter with $600.7 million in cash and cash equivalents. Inventory at the end of the third quarter was $206.2 million, or 25.2% higher than at the end of the third quarter of 2012, higher than our forward sales growth expectations, but partly attributable to the timing of winter receipts compared to last year due to a shift in our buying calendar.

This now leads me to our outlook for the third fiscal quarter and full fiscal year 2013. As I had discussed earlier, as a result of the supply chain issues, overall traffic trends, and a weaker Canadian dollar, we’re revising our fourth quarter guidance to a range of $535 million to $540 million of revenue from or prior quarter estimate of $565 million to $570 million. Our guidance assumes a continuation of the weaker than expected performance that we’ve seen quarter-to-date.

Our sales guidance assumes a flat comparable store sales percentage increase on a constant dollar basis, compared to the fourth quarter of 2012. Ecommerce is performing better than expected and including ecommerce, our guidance for the fourth quarter would give an 8% combined comp.

This outlook assumes a Canadian dollar at $0.94 with the U.S. dollar, and seven new store openings, four in the U.S., one in Canada, one in New Zealand, and one ivivva. We expect gross margin to be below last year, and in the mid-50s range due to higher air freight costs and the impact of foreign exchange due to a weaker Canada dollar compared to last year.

We expect SG&A as a percentage of revenue to be consistent with the fourth quarter of 2012. Investments made in the fourth quarter that deleverage on lower revenue offset with the true up of our management incentive plan expenses, given our revised projections.

Assuming a tax rate of 30%, and 146 million diluted average shares outstanding, we expect diluted earnings per share in the quarter to be in the range of $0.78 to $0.80 per share.

For the full fiscal year 2013, we’ll open 43 net new corporate owned stores, which include our ivivva locations. We’ll also open 12 international showrooms this year. We expect full year net revenue to therefore be in the range of $1.605 billion to $1.61 billion, or growth of 17%.

We expect gross margin for the year to be between 53% and 54%. We expect SG&A to deleverage as a percentage of revenue compared to 2012, due in part to lower revenue, along with the investments we’re making in the business to support our long term growth.

As a result, we expect our fiscal year diluted earnings per share to be approximately $1.93 to $1.96. 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 $105 million for fiscal 2013, reflecting new store buildouts, renovation capital for existing stores, real estate purchases, including our new Ohio distribution center, IT projects, and other head office capital, including expansion of our existing premises.

That concludes my prepared remarks, and as we turn it over to Q&A, I just want to mention that you might hear either Therese Hayes, who you know, or Chris Tham, our VP of financial planning and analysis, who are here to help me with questions today.

So, operator, we can turn it over for questions.

Question-and-Answer Session

Operator

[Operator instructions.] Our first question comes from Adrienne Tennant of Janney Capital. Your line is now open.

Adrienne Tennant - Janney Capital Markets

My question really is on the ongoing delivery/quality issues. When we’re in the stores, we’re noticing stock outs, both online and in stores, on recently flowed products, and then we’re told that perhaps you won’t get a replenishment for that. A lot of those jackets, the cold weather run stuff. And so how does this impact Q1 as we turn into the new year? Will we see a resolution of that as we go into Q1?

And just clarification, did you say that if you had included [DPC], that you would be running an 8% comp? And on that flat, do we need it to accelerate and get better? Or is that kind of a pretty constant across the remainder of the quarter?

John Currie

Maybe I’ll take the second question first. Yes, if ecommerce was included in our comp guidance, it would be at an 8%. The guidance does not require an improvement for the balance of the quarter. It reflects just an extension of the trend that we’ve been seeing.

In terms of stock outs that you’re seeing in Q4, we are seeing great guest acceptance of some of our seasonal items that we haven’t bought really deeply in, which is typically what you do, and you do see stock outs. And when I talk about late product deliveries or product that has not been released to the stores, in some cases it is the seasonal assortment that’s selling very well that is therefore impacting revenue.

As we get into Q1 and beyond, the improvements that are really underway with the new team on the supply chain side are a journey. We’re putting the processes in place, and as each season progresses, the improvements we’re making are going to improve our execution, but it’s not all at once. And so as we go through next year you’ll see continued improvement in product flow.

Adrienne Tennant - Janney Capital Markets

And can you give us the Canada and U.S. comps please?

John Currie

For Q3?

Adrienne Tennant - Janney Capital Markets

Yes.

John Currie

Canada was just slightly negative. I think it rounded to minus 1%. U.S. was high single digits positive.

Operator

Our next question comes from Camilo Lyon of Canaccord Genuity. Your line is now open.

Camilo Lyon - Canaccord Genuity

John, I was hoping you could give maybe just some historical perspective on how the fourth quarter correlation with ecommerce and stores really trends into the holiday season.

John Currie

With all the other ups and downs, one of the things we are seeing that’s positive is a shift towards ecommerce. Ecommerce has been very strong. In Q3 it was our highest penetration ever, at 16.3%. That is continuing, and I think more and more our guest is shopping both channels, and that’s why I’m making a point of also talking about the combined comp, because there’s a shift, to some extent, from stores to ecommerce.

Camilo Lyon - Canaccord Genuity

And then just with respect to the mills that you’re onboarding, it seems like the second mill that was going through the onboarding phase here, over the past couple of months, had started to produce product that was of high quality. Can you just update us on the production capacity coming from those mills, and are they starting to contribute to the better in-stock levels? Or if not, when should we see that?

John Currie

The second Luon supplier is fully onstream. We’re very pleased with the quality, and so they’re helping, both with quality and capacity. And we’re still on track to have a third Luon manufacturer onstream by spring of 2014.

Camilo Lyon - Canaccord Genuity

And if I could follow up on that, could you just break out the impact between the supply chain disruptions and the slower traffic as it relates to the flat comp in the fourth quarter? Is it a 50-50 split? Or is one the main driver over the other?

John Currie

Roughly I’d say it’s about one third the product issues, and two thirds the traffic discussion.

Operator

Our next question comes from Omar Saad of ISI Group. Your line is now open.

Omar Saad - ISI Group

Wondering if you could maybe elaborate on or discuss further the PR issue impact that you had mentioned in your prepared remarks, and what you think you’re seeing from your store associates and the guests in the stores.

John Currie

I think any time there’s negative PR for a company, there’s an impact on the business. I’m not saying we can see a one to one correlation, but let’s face it, we’ve had lots of PR issues this year, whether it’s the Luon pullback or Christine’s resignation. And there is undoubtedly some impact on traffic, and therefore on the business.

Our job is to make sure that that’s a short term impact by earning back the trust of the guest, and that’s what we’re focused on, both in terms of quality and making sure we’re connected with our communities.

Omar Saad - ISI Group

And then I think you mentioned that October, in the third quarter, was the strongest month of the quarter, but it seems like you’ve seen a sharp slowdown since then to start the fourth quarter. Is there something specifically happening around that transition from October to November that’s going on in the business?

John Currie

Not to get into weekly comps, November started somewhat slow. I think that might have been more product flow related. We saw actually a very strong Black Friday, Cyber Monday weekend, and then dipped down again after that. So, again, it’s really too early to diagnose trends, but that’s what we’ve seen.

Operator

Our next question comes from Edward Yruma of KeyBanc Capital. Your line is now open.

Edward Yruma - KeyBanc Capital

Just really quickly on the weak traffic trends, does the guidance contemplate kind of a step up in promotion, increase in marketing, or things to kind of offset these weak traffic trends that you might be seeing for the balance of the holiday?

John Currie

No, it does not. There’s some increase in our inventory reserves to contemplate some level of additional markdowns, since we’re running a little bit behind, but not terribly significant, and no other strategic changes other than that.

Operator

Our next question comes from Liz Dunn of Macquarie Capital. Your line is now open.

Liz Dunn - Macquarie Capital

In light of the PR issues, we were curious to know how you were measuring customer perception of the brand, and how you’re engaging with the customer beyond the apology video from last month.

John Currie

We are conducting brand perception surveys, etc. It’s a little too early to talk about our conclusions from that. In the very near term, as I said, the two things that we need to do are ensure that only the best quality product gets to the floor, so that we don’t disappoint the guest, and reconnect with the guest.

And so for example we’ve instituted a program over the holiday called “No Humbug” where we’ve allocated funds to each store to just surprise and delight the guest in whatever creative way they want to. It’s not discounts, but just sending somebody home to visit their parents for Christmas, or whatever else they come up with. Just random acts of kindness, because that’s who we are, and just trying to connect with the communities again.

Operator

Our next question comes from Lorraine Hutchinson of Bank of America. Your line is now open.

Lorraine Hutchinson - Bank of America

John, where are you in the investment cycle, both for sourcing and international rollout? And should we see a step up in the SG&A rate next year to support these two investments?

John Currie

In terms of sourcing, as I said it’s a journey. A lot of it is headcount, but there are significant system investments that we have been incurring over the last year to 18 months, and those will continue over the next couple of years anyway. So we’re sort of midway through that step up in investment.

And also, international, in 2013 we put in place the core teams in each of Asia and Europe. We’ve done a lot of the infrastructure build. And what you’ll start to see in 2014, as we open up more showrooms and even move to stores in some locations, you’ll see some additional SG&A drag as we get up to critical mass in those markets.

I think in 2013 international is a net negative of sort of mid-single digits, and it will be something higher than that in 2014, and depending on the pace of rollout, we’ll turn positive once we have enough stores, and have critical mass in those markets.

Operator

Our next question comes from Oliver Chen with Citigroup. Your line is now open.

Oliver Chen - Citigroup

I had a question on the nature of the current environment, with respect to the promotions in the marketplace. Is that something that’s impacting your business? And is there a view on how your merchandise margins may be in the fourth quarter?

Also, if you could just comment briefly on your inventory and the current status of it, and how we should expect the growth rate next quarter, if you’re comfortable with the level of freshness that’s in the composition now.

John Currie

Well, when I talk about the macro retail environment, it’s not just general traffic in the malls, but it is also how promotional is everybody else. And it is a promotional season, as it looks so far. And we’ve dealt with that before. We’re not promotional, but at some point, if everyone else is on sale, it does impact our performance, and that’s the environment that we’re living in this holiday season, as we have several other holiday seasons.

Of course, inventory levels, at the end of the fourth quarter, are going to depend on how the holiday season turns out. Again, we’re running a little below plan, so our inventory levels will likely be a little bit high, and we’ll be sending some product to the outlets.

In terms of composition, I guess the good thing is a lot of our heavy inventory is in our core styles, which we typically don’t mark down, and aren’t season-specific. So that will limit the amount of promotional activity.

In terms of freshness, again, holiday tends to be very different than what we’ll be looking at in Q1. As we said earlier, we’ve got some great seasonal styles that have resonated with guests, and have flown off the shelves, and we’re out of stock. When that’s the case, we would have love to have had more of those, but at the same time we don’t want to find ourselves overstocked in those items that are seasonal.

Oliver Chen - Citigroup

Do you have any flexibility to become more strategically promotional in order to kind of offset what you’re seeing versus competitors? Or is there anything that can be done with respect to that, so that you can garner your fair share of traffic?

John Currie

That gets to be a much longer conversation, but certainly we can be flexible as it comes to clearance and markdowns. Again, since a lot of our heavy inventory, as I said, is core, that may not be much of an issue. But you know, we have been creative in the past. We’ve done pop-up stores, we’ve done warehouse sales. We’ll do those again, and those should be adequate to, once again, clear the aged inventory.

Operator

Our next question comes from Jennifer Black of Jennifer Black & Associates. Your line is now open.

Jennifer Black - Jennifer Black & Associates

I just have a couple of questions. We’ve noticed that some of your price points appear to be reaching new highs, and I wondered if you could talk about the customer’s response and do you feel you’ve pushed price points too high in this economy?

And then my second question is, have you considered a loyalty program with the incredible growth that you’ve experienced, to get the word out quicker to your most loyal customers on new products and product issues?

John Currie

In terms of price points too high, you’re probably looking at some of the seasonal items, outerwear, where typically the price point is higher. We think we’ve hit a better balance this year. Remember, last year we had some of the What the Fluff and other outerwear styles had been, I think, priced too high, and we brought them down. That was more of an issue last year than what we’re seeing this year. And I don’t think we’ve pushed the price point beyond where our guest is comfortable, especially in those special items.

In terms of a loyalty program, that’s not in our near term strategy. Having said that, with digital and mobile becoming more and more important, I think our strategies to connect with the guest and let them know when new products are dropping, I think there’s lots of opportunities to improve our execution there in the future that may or may not look like a typically loyalty program. But definitely we’re looking at how we can evolve in that area.

Operator

Our next question comes from Brian Tunick with JPMorgan. Your line is now open.

Brian Tunick - JPMorgan

In terms of the slowdown in traffic, are you feeling it more in terms of new customer adoption, or is it existing customers that aren’t coming back to the brand? Just your sense in terms of who is seeking out the brand and who is not. And then also, if you could speak to any changes that you’re seeing in the competitive environment, particularly as more retailers enter the athletic and performance wear category.

John Currie

I think it’s too early to have a diagnostic on that. We are finding, as I said, the seasonal items, the unique items, are selling. Typically that’s more our repeat customer, or guest, so that might indicate that she’s continuing to come back, selling less core. So that may indicate less new guests, but again, it’s really too early in the holiday season to do that diagnostic.

Brian Tunick - JPMorgan

And then just what you’re seeing in terms of the competitive environment?

John Currie

As I’ve said repeatedly, there’s no one competitor that we’re looking at that’s opening stores that is having a particularly significant impact, but a crowded landscape, of course, makes it more difficult to stand out, and our focus has to be on making sure that our product offering is the best, and our in-store experience is the best, so we continue to stand out from that crowded field of competition.

Operator

Our next question comes from Lindsay Drucker Mann of Goldman Sachs. Your line is now open.

Lindsay Drucker Mann - Goldman Sachs

You talked about the difference between the U.S. and the Canadian comp. I was just curious if you could dig in a bit on the drivers within each market, whether you saw similar impact from traffic or product issues, or AURs, or whatever the composition might be, with the U.S. versus Canada, or if those markets were different.

And then secondly, just to approach Lorraine’s question in a different light, you talked about the supply chain story for you guys being a journey. As you’ve moved along, do you feel as if you have all the things you need to tackle under good control? Or are you considering perhaps a more material step up in the amount of investment you’ll need in order to get the systems right?

John Currie

In terms of Canada and the U.S., of course there’s still very different levels of maturity in the two markets. Canada is fully built out, and a very mature market, whereas the U.S., we’re approaching two-thirds built out and still lots of brand awareness improvement ahead of us. And in spite of that, as we’ve seen the slowdown, they’ve been in proportion to each other. So as Canada’s X percent below plan, the U.S. is the same level below plan.

So that indicates to me that it is the product flow issues that are across the board, and to some extent macro issues. It tells me that it’s less competition than those factors, because in the U.S. there are more people trying to look like us than we have in Canada. So I do think it is interesting that the softness is consistent across both countries.

In terms of the supply chain, there is a step up required that is what we’ve been incurring this year, and we’ll continue to step up next year. And there’s no change in our plan recently. Going back to March, and even before, when we were bolstering our supply chain teams and looking at the processes, we knew that there would be a step up in our SG&A related to those efforts, and it’s several million. Again, a lot of that is in our run rate today, and there will be some step up next year.

Operator

Our next question comes from Kimberly Greenberger of Morgan Stanley. Your line is now open.

Kimberly Greenberger - Morgan Stanley

The product quality issues have been there since March, and if I heard you correctly earlier, it sounds like November was really the timeframe that you started to see a dislocation in the traffic trends into your stores. I’m wondering if you have any ideas or if you’ve received any feedback from your stores or guests on what the driver of that might be. Do you think there’s any causality between Chip’s interview and that fall off in traffic?

And then as you look out into 2014 and 2015, is there a way to help us understand or dimensionalize the incremental spend or the incremental investments that you feel like you need to make in supply chain and product quality in order to make sure that there is consistent, high-quality brand standard product that’s flowing to the stores?

John Currie

As I said before, whenever there’s negative PR, it’s reasonable to assume that there is an impact on the business. I wouldn’t say we have specific feedback from the stores that their lower traffic is related to either Chip’s comments or quality concerns. But I do think, as I said, it’s realistic to assume that when there’s negative press, that there’s an impact on the business. And I do think that’s impacted us in November and early December. And again, we’re focused on reversing that trend.

In terms of incremental investment in the supply chain, again, that’s all underway. I think our run rate of spend related to how we’re changing the processes and beefing up the teams is probably in the $10 million or so annually of operating spend. And again, a lot of that’s in our run rate for Q3 and Q4, and will continue and ramp up some as we go into 2014 and 2015.

Operator

Our next question comes from Faye Landes of Cowen and Company. Your line is now open.

Faye Landes - Cowen and Company

Was or is traffic negative in Q3, or early in Q3, or so far in November? And then we frankly don’t understand why guidance is for flat in store comps if October and Thanksgiving were strong, especially given the year ago compare that’s so much easier sequentially. It just seems very Draconian.

And then finally, housekeeping, what was the percentage of the men’s business in the quarter?

John Currie

No, in Q3, traffic was not negative. The comp that we had was driven primarily by positive traffic, just not as positive as we’re used to seeing. Traffic in Q4 to date is kind of in line with the comp, it’s pretty flat. And again, that’s why the guidance is for a flat comp. And as I mentioned, but maybe didn’t highlight, the other thing in terms of the store comp is we do see a shift towards ecommerce, and it’s increasingly relevant, I think, to think about our comp as both stores and ecommerce. And as I said, the combined comp guidance for Q4 is 8%.

Men’s in Q3 was 13.5%. So men’s continues to improve penetration. If we broke out the men’s comp, I think it’s in the 20s. So men’s continues to improve, better acceptance, as we’re improving and expanding the men’s product line. So the men’s opportunity is still a real focus for us in the next year.

Faye Landes - Cowen and Company

And can you shed some light on what’s driving the 20s comp in men, what products or area?

John Currie

I think at this point it really is better product. I think we’ve hit our stride in terms of the design and product team, and we’re introducing new items, new colors, so that there’s more selection for the male guest than what they’ve seen in the past. And that will continue to be a driver, as well as we do have a pretty significant men’s team that we’ve built up that is focusing on the men’s business beyond just the product piece of that, in terms of brand and marketing and how do we connect with the male guest, who’s of course very different than the female guest. And I think, again, as we go into 2014 and beyond, that will also drive the opportunity that we see in the men’s side of the business.

Operator

Our next question comes from Sharon Zackfia of William Blair. Your line is now open.

Sharon Zackfia - William Blair

Canada, obviously it’s been slightly negative for I think a little over a year now. Can you confirm, if you include ecommerce, whether Canada has been comping positively with the ecommerce all this time?

John Currie

Yes, it has. Very high productivity, sometimes flat, sometimes slightly up, and sometimes slightly down. But ecommerce has continued to extend our reach in the Canadian market, and the combined, I believe, has been positive every quarter.

Sharon Zackfia - William Blair

And then a question on 2014, and then coming back to the fourth quarter. I guess on 2014, I know six months ago there was all this conversation about product flow and different ways to optimize that in 2014. You know, segmenting by climate and doing more strategic markdown optimization and so on. I’m wondering, given the emphasis on product quality control, whether that’s getting pushed back further now into 2015, or whether that’s still on the docket for 2014.

John Currie

There’s a pretty significant systems implementation project related to that that we are kick starting in 2014. So the IT team and the business owners related to that are going to be busy on that in 2014, but you won’t see it impacting the way we operate until 2015.

Sharon Zackfia - William Blair

And then lastly, on the fourth quarter and your outlook, it sounded as if some of the initiatives you’ve implemented like mobile POS and so on have really helped during times of high traffic, like Black Friday weekend. Last year, it seemed as if maybe your quarter slowed somewhat towards Christmas as you ran into out of stocks and some challenges handling that traffic. As you think about what you saw over Black Friday weekend, am I too optimistic to think that there’s a positive wildcard as you get into those 10 days around Christmas, where you have that really high traffic volume? Or is the product flow really going to negate the potential positives of the mobile POS and so on?

John Currie

I guess a couple of things. This is a tough time to be giving guidance because those super-busy days leading up to Christmas are still ahead of us. So we do expect, obviously, a significant step up in traffic. And because of the mobile POS, etc., we are better equipped to handle those high volume days. And to your point, I think that did help on Black Friday and wherever else we’ve had a spike.

But I wouldn’t get carried away in terms of upside expectations. To your point, last year it was actually a slow ramp and then kind of a spike just before Christmas. So I think that is likely similar to what we’re expecting to see this year.

Operator

Our next question comes from Matt McClintock of Barclays. Your line is now open.

Matt McClintock - Barclays

I was wondering if you could talk about the ecommerce business outside of the U.S. and Canada. Is that a meaningful size yet? And how does this business accelerate once you launch a regional website? Lastly, are you learning anything from this business that is changing your views towards countries that you want to prioritize for expansion?

John Currie

Actually, international ecommerce, really what we’re looking at is ramping up in conjunction with our brick and mortar presence. Because we don’t do mass advertising, similar to what we saw in the U.S., until we have a physical presence there really is very little brand awareness, and therefore the ecommerce business is not significant until we make some progress on our physical presence.

So right now, for example, if you look at Europe, we have seven showrooms. Still not a significant physical presence. We have an E.U. specific ecommerce site and one for the U.K. And they’re growing significantly as those showrooms seed the markets and improve our brand awareness. But until we have stores, that will still be quite limited.

And the other aspect is with only a handful of showrooms and ecommerce, the volumes are low and therefore the inventory levels that we can keep in Europe have to be fairly focused on the core and not too deep. And so the guest on international ecommerce sites is still at a point where they don’t have the full product assortment.

So the key is get enough critical mass, both moving to stores and ecommerce, so that we can offer the full assortment to those guests. And that’s when we expect to see international ecommerce becoming more significant. For the time being, it’s where we expect it to be, but it’s not a meaningful number in the current revenue targets.

Operator

Our next question comes from Sam Poser of Sterne Agee. Your line is now open.

Sam Poser - Sterne Agee

I have a couple of questions. Number one, what percentage of the quarter is in the books thus far, in your current, where we are, as far as revenue. And number two, the SG&A grew at just under 19% in the fourth quarter, which was a significant deceleration of absolute dollar growth. How should we think about that both in Q4 and looking into next year?

John Currie

About a third of the quarter has already been booked so far. And then in terms of the lower than maybe what you expected SG&A growth, I think you have to take into account the currency impact in that. Since most of our SG&A is in the office here in Vancouver, in Canadian dollars, as we translate to U.S. dollars, that actually reduces the reported SG&A. And as well in Q3, as I mentioned, there was a foreign exchange gain that offsets SG&A. I think when you normalize for those items, the rate of SG&A growth is probably closer to what you would have expected.

Operator

Our next question comes from Robert Altschwager of Robert W. Baird. Your line is now open.

Robert Altschwager - Robert W. Baird

You’ve talked a lot about the SG&A side of things. Just hoping, higher level, how do you feel about the 25% longer term margin target? I know you’ll be cycling some gross margin headwinds next year. So maybe just help us understand the puts and takes as you think about the margin goals.

John Currie

Long term, there continues to be no reason to expect that our margin profile would be different than what I’ve been talking about to the market. You know, 55% gross margin, 25% operating margin. And that’s an offset of positive leverage on the core business, offset by investments to continue to build the foundation, and the sort of early stage investment in international growth. So long term, nothing in my mind has changed in that regard.

In the very near term, if we see the traffic trends take longer to get back to historical levels of increase, that could cause some short term compression on margins, especially if there’s initiatives to put in place to drive that traffic back. But when I talk about long term targets of 25%, there will be periods where we’re higher, and periods where we’re lower, depending on investments that we have to make, and then harvesting those investments. But you know, longer term, no change in our view on that.

Robert Altschwager - Robert W. Baird

And then just following up real quick on the Q4, I think one of the headwinds faced last year was just underpositioning on some of the giftable items, lower priced items. Could you talk about how you are positioned this year, and the early trends you’re seeing from that?

John Currie

Yeah, I think we’ve done a better job this year, in acknowledging that this is actually a gift giving season. So there are lots of lower-priced items and great mitts, etc., that are doing very well. And not just those lower priced items, but a better selection in the key gift giving range, plus or minus around $100. That’s where there was a real void in our pricing architecture last year. So in that regard, I think we’ve done a better job this year.

Operator

Our next question comes from Pamela Quintiliano of SunTrust. Your line is now open.

Pamela Quintiliano - SunTrust

Clarification, Q3, how big an impact were the product issues in Q3, within the framework of what you were talking about with Q4 guidance? And then I know there have been a lot of questions just surrounding the sourcing improvements, but any granularity at all on timing, even if it’s what products we should see improvements with first, and just how we should think about it into next year? And then just last, any updates on ivivva?

John Currie

Q3, impact on product issues, I think when I talked about Q4 it was really in the breakdown between traffic and product issues. I think the traffic piece of that was less of a factor in Q3. So the product piece in Q3 actually maybe a little bit higher, because remember we had very late deliveries of fall product that had a significant impact on August in particular, as we had the summer product on the floor through August, when we should have had the fall product on there. So I’d say that piece was more significant in Q3 than what we’re seeing in Q4.

I wouldn’t say the sourcing improvements are in this particular style mix or that one, because they’re across the board improvements on the process that we employ with all mills, with all cut and sew factories. Having said that, Luon is definitely our most complicated fabric, and that’s where our focus has been. But I think we’re already seeing improvements there with the second supplier, and the third one coming on, and also with our new 28 gauge Full On Luon that the guest is absolutely loving. But other than that, I think it’s an across the board initiative that impacts all of our fabrics and products.

And then lastly, ivivva, sorry, I always kind of overlook ivivva, because it’s the little sister. But it’s actually becoming a really significant growth driver as we look forward. In the quarter, I believe the ivivva comp was 17%. They’re now at productivity of getting pretty close to 900 a foot, and so we are looking to increase our store rollout in ivivva for next year and I’ll include that in my guidance on the next call.

Operator

Our next question comes from Janet Kloppenburg of JJK Research. Your line is now open.

Janet Kloppenburg - JJK Research

I wanted to just ask John, has the direct business accelerated from the quarter to the fourth quarter? And perhaps if you could explain why the issues that are affecting the stores may not be affecting the direct side of the business? And I think you said your inventory is a little bit high. I was wondering if there was a way to feed the direct business with the store inventory so that perhaps the markdown levels in the store may not be as high as they might be if costs continue to be flat. And lastly, on the quality control issues, where you’re rejecting product, how long do you think that will last? Is this something you can look out to and forecast how long this may cause imbalances in your assortment?

John Currie

Ecommerce, yeah, in fact it was strong in Q3, and we’ve seen it even stronger in Q4, both in terms of year over year growth rate and penetration. So yeah, really excited about what we’re seeing there.

Your question why is ecommerce not as impacted as the stores are, in spite of the strength of ecommerce, I think there is a similar impact. It’s just that it’s got such a strong growth trajectory that it’s just a lower positive as opposed to flatter negative.

You know, if we do have excess inventory that was expected to be allocated to stores, absolutely we have the ability to shift that to ecommerce. We do buy for ecommerce as a store, but since we do the fulfillment from our own distribution centers, it’s relatively easy to shift inventory that was designated for stores into the ecommerce channel.

And the impact of quality controls, as I said, this is a journey. I feel great about the team we have in place and the progress we’re making. But the quality controls that we are evolving to are very much front end loaded. They’re having people and processes at the mills, as the fabric is being made, and then checks and balances as we go through the cut and sew process, etc. And at a minimum, improvements can only affect the seasons that are just now being planned.

In the meantime, as I said, we’re focusing on quality control at the back end, until those processes are affecting the current season. So quality control is very much focused on at the DC, making sure that product that’s already been delivered, if there are defects, that we’re not releasing that to the stores.

So, you know, at the store level, we’re dedicated to ensuring that you won’t see quality issues. But for some period of time, if those exist, they will be product not released to stores, as opposed to there were never issues from the outset. So again, as 2014 progresses, we’ll get progressively better, and by 2015… We’re not holding back on investment, etc., in hiring, and by 2015, we should be seeing a much, much smoother supply chain operation.

Therese Hayes

Okay, that’s all the time we have for this morning. Thanks, everybody, for joining us on the call today.

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