Lululemon Athletica Inc (LULU) 2012 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the lululemon athletica Q3 2012 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 call, Ms. Therese Hayes.

You may begin ma'am.

Hi.

Good morning, everybody.

Thanks for joining us on our third quarter 2012 conference call.

A copy of today's press release is available in the Investor Relations section of our website and furnished on Form 8-K with the SEC and available on the Commission's website at www.sec.gov.

Shortly after we end this morning, a recording of today's call will be available as a replay for 30 days, also on the website.

And hosting our call today is Christine Day, the Company's CEO; John Currie, the Company's CFO; and Sheree Waterson, our Chief Product Officer will also be available during the Q&A portion of the call.

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

Actual results might differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the Company's filings with the SEC.

We have about one hour for today's call so when we get to the Q&A, if you would please limit yourself to one question at a time to give others the opportunity to also have their questions addressed, that would be great.

And with that, I will turn it over to Christine Day.

Thank you, Therese.

Good morning, everyone, and thank you for joining us today to discuss our stellar third quarter results.

I am very proud of the team for achieving yet another strong quarter and coming in ahead of our expectations.

Our robust financial results in the third quarter were largely driven by first-rate execution, beautiful product, community engagement, and continued strength in our e-commerce business.

During the course of the quarter, we celebrated the opening of an ivivva store, three stores in Australia, and North American store openings in Omaha, Pittsburgh, New York, Memphis, Baltimore, Columbus, Franklin, and Bridgewater, New Jersey.

I am continually amazed with the creativity of our teams in enrolling their communities to the store opening events which this quarter included the Gospel of Sweat at New York City's historic upper west side Riverside Church.

Both the name of the event and the location were intentionally created to engage a conversation about spirituality and the mindfulness in New York City yoga studios, spin studios, fitness studios, and the last run around the reservoir.

200 yogis practicing Mandala style mat-to-mat on the rooftop of the iconic Peabody Hotel in Memphis to celebrate the opening of that region's third store.

For the opening of our second store in Columbus, both stores came together for a huge community class, Om-H-I-O, where 500 yogis practiced yoga inside the Ohio State University Oval together.

When we entered the Columbus markets as a showroom three years ago, there was only one yoga studio and today there are 15 studios.

This speaks volumes to the work both teams have done in their communities to cultivate yoga and be the resource for all things yoga related.

It is this authentic connection with our guests and our communities that differentiates us from many other retailers.

E-commerce continues to be significant growth driver for the business in the third quarter with year-over-year increases of 89% in sales, the highest rate of growth in the active wear or vertical retail apparel categories.

In addition to our investments in bolstering our social, email, and blog activities to support our e-commerce business, we are also laying the groundwork for future growth.

We recently launched our Hong Kong, Singapore, UK, and EU specific websites which gives us access to 24 markets with local fulfillment, more localized content, and the ability to connect more authentically with those communities.

We established third party logistics and distribution centers in Hong Kong and Rotterdam to better serve the Asian, European, and UK markets.

We have said previously that we have been spending the past several months doing a lot behind the scenes work and our international expansion is now entering a phase of more on-the-ground development.

Based on the success of both Hong Kong showrooms, we are actively looking to secure real estate for a store in that market.

In London, we will leverage the website and current infrastructure with the Chelsea showroom with an additional showroom penetration in 2013.

Overall, we intend to go deeper in showrooms in Europe and Asia over the next 24 months and we will begin preceding activities in up to 15 countries over the next two years.

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

We know that the seeding period in some of these markets may be up to two years.

In the meantime, we are building the international team.

Through our store networks and in-country contacts, we are actively looking for showroom managers and community connectors for each of the countries that we are targeting.

And I am particularly pleased to announce that we have made a key international senior executive hire.

Barbara Le Marrec is joining our team.

Barbara brings great international experience in Europe and Japan and shares a common history with me as she comes to us from her most recent position as the head of Starbucks operations for Japan.

She also held the positions of SEP International Op Solutions at Starbucks and General Manager of Starbucks Friends.

We announced earlier this month the resolution of the infringement action related to our Astro pant.

We cannot comment specifically to the terms of the settlement with Calvin Klein and G3.

In general, lululemon protects its designs and maintains a strategy of remaining focused on our market leading position in innovation and execution.

We believe that we have taken the necessary steps to establish and protect our IP.

We experienced a slower start to the fourth quarter as we were not immune to the consumer distractions that negatively impacted many retailers for the first half of November.

In addition to the November macro issues, we lost some momentum in the beginning of Q4 due to some execution issues with our email product notifications; our grass roots marketing communications that drive sales and traffic.

These issues have since been resolved.

This season we made a strategic shift into technical mid layers consistent with our strategy of building a layering systems for our run product.

The What The Fluff Line items are the pinnacle layering pieces for our run line.

The price points of these items may have created a barrier but like many of our products, we know that when these pieces get into our guests' hands, they will love them so we have repriced some of the pieces to make them more accessible.

We are excited about the holiday season as we have some of the best product we have ever made available for our guests in our stores and through our extended e-commerce network.

We have seen accelerated gift card sales indicating we are on many gift lists this holiday.

The most productive weeks of the quarter are still ahead of us and we are excited about the Back to Gym and Back to Studio product that will hit the stores in January.

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

Thanks, Christine.

I will begin by reviewing the details of our third quarter of 2012 then I will update you on the outlook for fourth quarter and the full year of 2012.

For the third quarter, total net revenue rose 37.5% to $316.5 million from $230.2 million in the third quarter of 2011.

The increase in revenue was driven by the addition of 36 net new corporate owned stores since Q3 of 2011, 21 new stores in the United States, 8 stores in Australia, 2 in New Zealand and 5 ivivva stores.

Comparable store sales growth of 18% on a constant dollar basis and direct to consumer sales which increased by 89% or $21.2 million.

If we included e-commerce as a store in our comp calculations as many retailers do, our comps would be reported as 26% on a constant dollar basis.

During the quarter, we opened eight corporate owned lululemon stores in the US, three in Australia, and one ivivva store in Canada.

We ended the store with -- the quarter with 201 total stores versus 165 a year ago.

There are 144 stores in our comp base, 39 of those in Canada, 89 in the United States, 13 in Australia, and 3 ivivva stores.

Corporate owned stores represented 79.6% of total revenue or $252 million versus 82.6% or $190 million in the third quarter of last year.

Revenues from our direct to consumer channel totaled $45.1 million or 14.3% of total revenue versus $23.9 million or 10.4% of total revenue in the third quarter of last year.

Other revenue, which includes wholesale, showrooms, and outlets, totaled $19.4 million or 6.1% of revenue for the third quarter versus $16.3 million or 7% of revenue in the third quarter of last year.

Gross profit for the third quarter was $175.3 million or 55.4% of net revenue compared to $128.5 million or 55.8% of net revenue in Q3 2011.

The factors which contributed to this 40-basis-points decline in gross margin were a product margin decline of 30 basis points.

Investment in innovation and function in our product mix coupled with slightly higher markdowns due to a more normalized inventory position, impacted product margin versus last year, but was offset with lower air freight usage and rates in 2012.

60 basis points of de-leverage in product and supply chain team costs due to investments in product development, operations, and supply chain, which is partly offset by a net 50 basis points of leverage on occupancy and depreciation.

SG&A expenses were $94.7 million or 29.9% of net revenue compared to $68.8 million or 29.9% of net revenue for the same period last year.

The $37.6 million SG&A dollar increase is due to -- an increase in store compensation and operating expenses associated with new stores, showrooms, and outlets as well as increases at existing locations due to higher sales volumes; increased variable operating costs associated with our e-commerce business due to the tremendous year-over-year revenue growth along with continued investment in key e-commerce support functions such as IT development and support, site content, and creative assets; 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 the business; and finally, the higher Canadian and Australian dollar which increased SG&A by $0.5 million or 0.5%.

As a result, operating income for the third quarter was $80.6 million or 25.5% of net revenue compared with $59.7 million or 25.9% of net revenue in 2011.

Tax expense for the quarter was $24.7 million or a tax rate of 30.1% compared to $21.4 million or a tax rate of 35.5% in the third quarter of 2011.

The lower effective tax rate reflects the ongoing impact of revised inter-company pricing agreements.

Net income for the quarter was $57.3 million or $0.39 per diluted share.

This compares with net income of $38.8 million or $0.27 per diluted share for the second quarter (sic-see press release "third quarter") of 2011.

Our weighted average diluted shares outstanding for the quarter were 145.7 million versus 145.3 million a year ago.

Capital expenditures were $33 million for the quarter compared with $13.6 million in the third quarter last year.

In addition to new stores, renovations, and IT capital, we also acquired the building housing our Kelowna store in Canada and additional head office space in Vancouver.

We ended the quarter with $439.4 million in cash and cash equivalents.

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

This now leads me to our outlook for fourth quarter 2012.

This outlook assumes a Canadian dollar at par with the US dollar compared to an average exchange rate of $0.98 in Q4 of 2011.

We anticipate revenue in the range of $475 million to $480 million.

This is based on comparable store sales percentage increase in the high single digits on a constant dollar basis compared to the fourth quarter of 2011.

Keep in mind our comp guidance excludes the additional 53rd week in 2012 which contributes approximately $20 million in sales for the quarter.

We plan to open eight lululemon stores in the US, one in Canada, and one in Australia during the fourth quarter.

As Christine mentioned, we experienced a soft start to the quarter and so our sales guidance is roughly $5 million lower than implied in our annual guidance given on the second quarter earnings call.

We again expect gross margin for the quarter to be above 55% for Q4, and sequentially above Q3 due to the leverage on sales volumes.

We expect SG&A as a percentage of revenue to be roughly 500 basis points below the third quarter level which is consistent with our normal historical seasonality.

We also expect year-over-year leverage relative to Q4 of 2011.

Our SG&A will reflect pre opening costs related to the 10 stores planned to open in Q4 and additional stores planned to open in early Q1, 2013.

Consistent with previous quarters, we continue to invest in our international market planning and seeding efforts while also investing SG&A in our infrastructure such as planning, scoping, and building new systems within our global IT and supply chain functions.

Assuming a tax rate of 29.4% and 145.9 million diluted average shares outstanding, we expect earnings per share in the fourth quarter to be in the range of $0.71 to $0.73 per share.

This brings our full-year sales to a range of $1.36 billion to $1.365 billion.

For the full fiscal year of 2012, we anticipate we will open a total of 37 corporate owned stores including Australia and ivivva locations.

We expect capital expenditures to be between $85 million and $90 million for fiscal 2012, reflecting the purchase of real estate, housing stores and office premises, new store buildouts, renovation capital for existing stores, IT and other head office capital.

We now expect 2012 fiscal year earnings per share to be approximately $1.81 to $1.83.

This is based on 145.8 million diluted weighted average shares outstanding and it assumes an effective tax rate of 29%.

With that, I will turn it back to Christine.

Thanks, John.

I would just like to thank, again, all of our educators and people at the support center that made this great quarter happen.

Again, we're very excited about the balance of the quarter and wishing everybody happy holidays.

With that, we will open it up to questions.

(Operator Instructions)

Erika Maschmeyer, Robert W. Baird.

Thanks so much.

I wanted to ask you about your inventory position, up close to 28% but well below your sales growth and your implied sales guidance for next year.

How do you feel with regards to that?

Do you think you're still on the light side there?

No, we're in a solid inventory position for Q4.

Remember that the quarter end inventory number is just a point in time doesn't take into account the flow.

We don't see ourselves being constrained by inventory in Q4.

Great.

Then exciting news about expanding your international base.

Could you talk a little bit more about how you're building capacity on the supply chain side for that?

Are you kind of expanding your vendor base or building out capacity at vendors?

And also how that could impact your expected SG&A leverage?

Thanks.

From an operations perspective, we've had the team on the ground, basically over the last 18 months, building our capacity for international supply chain, doing all of the compliance, all the duty rates so a lot of behind the scenes, both modeling, information gathering, analysis, making sure that we have compliant product going into all of the markets, and so we're well on our way in that work for all of the markets that we're looking to enter.

Even just through e-commerce or through strategic sales and eventually showrooms in those markets.

Initially we will focus on some of the main markets.

For us that's the UK, Hong Kong.

We'll open some on-the-ground presence in Singapore and Germany in the short term, and then we'll go through more markets until we do the 15.

We'll be working in both the Asian markets and the European markets simultaneously.

So a lot of great progress on that operationally, and both in the supply chain and building the team that's capable of doing that and building the systems.

So being very prepared.

And in terms of SG&A, you're already seeing some of the SG&A related to international in the second half of this year.

As we go into next year, and we haven't been specific yet, just in terms of how many showrooms and how many countries we will open, but there will be some drag on SG&A leverage, but it won't be significant, but I will talk about it more in the next earnings call.

That is very helpful.

Thanks and congratulations.

Adrienne Tennant, Janney Capital Markets.

Good morning.

Congratulations on the quarter.

Thanks, Adrienne.

Christine, can you talk about the What The Fluff line looks fantastic.

I was wondering if you can just talk about sort of the learnings on launching it, both online and in stores.

The repricing, now that you have done that have you seen a tick-up in sales cadence, and are you happy with where the product is now priced?

Thank you.

Number one, the response for the product in terms of the technical user runner who purchases it, loves it, so it's really well received as a technical product.

Definitely we see long term being in the business of this technical mid layer and layering pieces, so it's important for us strategically to drive the business in where we want to be and being a market leader in innovating.

What we realized when we put the whole package together and thought on the floor set that the overall store price felt a little high to us, and we realized that we really want long-term commitment to this product so we made the strategic decision to bring the price point down to a more accessible level to really get it in the hands of the people who we want it to be in and to drive the line.

So that was really what guided our decision with that first and foremost.

And then the second was recognizing that overall our price points were a little higher than we would like to have seen in the holiday period.

We feel good about where there is at and as John said, we're trending against our expectations and we feel really good about that product in particular.

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

No, the warehouse sales aren't included in our comp.

We do intend to have a couple of warehouse sales this year so it is in my revenue guidance.

Okay.

So we will see the anniversary of the -- I think it was three events last year, the same one?

Yes, we will do that again this year.

Okay.

Thank you very much.

Omar Saad, ISI Group.

Christine, could you address a little bit the performance of the -- some of the mid layer products you talked about?

There's some price resistance there.

Is there any sort of general take-aways from what you are seeing in the business in terms of what's -- some of the more innovative fashion newness products versus the core products?

Are you seeing kind of equal performance across the board there and then this pricing issue.

Thanks.

I think one of the things that really surprised us at the end of Q3 and coming into coming into Q4 was the strength of our basic bottoms business.

We ordered an extra heavy amount kind of towards the end of the quarter because those are easily replenished items.

We really drove traffic on the Wunder Unders, the groove pant, the bottoms have been an exceptional performer in the core business which has been really great to see.

A strategic decision that we made was to walk away from some of the cottons that we've done in the past because they are not as technical product.

Those were high volume sales drivers for us so transitioning the customer to a more technical guest is still always a strategy that we're optimizing, so to do it over I would probably not have walked away maybe as much in the holiday season from that because that scuba hoodie for young girls is a big gift giver.

I think we'll look at that again for next year but on the whole, the technical product is great and the core business is great and it's more a story about what strategically we chose not to do for the holiday season.

Okay.

Then just on the mid layer, you kind of repricing to make them a little bit more accessible.

Can you just maybe expand on that a little bit?

Yes.

I think we're obviously a little excited about the premiumness of that product because it truly is, and so we priced it as a premium product but then when we stood back and really looked at it in the store and our desire to really drive it as a key line piece for long term, we made the decision to bring it back down in margin and in price point.

But it's still a very healthy margin product so it's not like we're going below our historical margin levels in doing so.

Got you.

Thanks.

Nice job.

Betty Chen, Wedbush Securities.

Good morning, everyone, and congratulations on a great quarter.

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

Thank you.

So the first question was about men's.

Hi, this Sheree.

Good morning.

There are a lot of learnings about men's for Q3.

So one of the things that we did was shift some of our fit to a slimmer, more modern fit, and what we learned is that the guest, the male guest, is so excited about the modern detailing and the laser cutting and gluing of pockets and so on and so forth.

And we want to put those fits into more athletic blocks that block so that we can satisfy a more democratic consumer base.

Lots of great things happening.

I think you can see the ethos shifting quite a bit.

The only thing I would add to that is we really are attracting a younger male guest because of those changes, and I think that's so exciting.

We broadened the appeal of the men's line.

I think that's one of the leading indicators we're very excited about.

The rest is -- what was the second question?

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

First of all, we are so excited about what we've learned about capsules.

One thing that I continue to talk about is cascading our learnings into our core line and so when I look at our commute line, when I look at the spin line that we did and so on and so forth, what we were able to get in terms of insights for technologies and then also insights for styling that we want to bring into the core line has been great.

So cascading from more wow factor down into the core I would say is the key learning that we get from capsules.

This year we executed eight.

Next year we are going to go deeper and look at about six.

That's exciting.

We also, you should know, have just hired a head of innovation.

His name is Dr. Tom Waller.

And he is also having us or leading us into the future with some new technical fabric innovations and construction innovations so we're really looking forward to him joining the team.

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

The comps were very similar.

Men's during Q3 continues to run around 12% of the overall sales.

Great.

Thank you so much and best of luck.

Again, ladies and gentlemen, there are a lot of participants in queue to ask a question.

We ask that you limit yourself to one question so everyone has a chance to ask a question.

Dana Telsey, Telsey Advisory Group.

Good morning, everyone.

Congratulations on the very good results.

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

Thank you.

I think the fourth quarter is always a little bit more of an unusual situation where you've got outerwear and then this year we led into the technical mid layer.

But our core business margins continue to strengthen.

We've been able to leverage some of our supply chain, some efficiencies so even with rising either raw materials or labor we've been able to hold strong margins on our core product.

Always an innovation, we're going to accept slightly lower margins to drive the business.

Usually those are on higher ticket items so from a dollar's perspective, those are key.

I think it's what the strategic choices are about the things that we do in between because we believe in not just cluttering our store with stuff and our goal is to always innovate and have the discipline to do what we are driving strategically versus easy sales because as a market leader that's what keeps you disruptive and innovative so we're always leaving room in our margins to perform, overall though, hitting the target of the 55% range that John has laid out and that is our goal is to always innovate while hitting the target that we have laid out.

Thank you.

Roxanne Meyer, UBS.

Thanks.

Let me add my congratulations on a terrific quarter.

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

Thanks.

In Q3, the comp was made up pretty much entirely by traffic.

There's a little bit of up and down on the other elements but the traffic increase is pretty much equal to the comp growth.

What was the second question?

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

Again, as I said, coming into the quarter, we've got a strong inventory position with additional product coming in, so the flow, whereas in the past, it has created some ups and downs, we don't see that as being a factor this year.

In terms of markdowns, again, as I have been saying the last few quarters, probably up a little bit year-over-year, but still at a very low overall level of markdowns relative to our history and retail in general.

Okay.

Great.

Thanks.

Best of luck for holiday.

Thank you.

Jim Duffy, Stifel Nicolaus.

Thank you.

Happy holidays, and nice quarter.

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

The impact of Sandy, I don't want to make it sound like that was material.

A small number of our stores were closed for a few days but that -- if it was $1 million, that's probably a good estimate.

So that's really not a big factor.

Yes, the other things that Christine mentioned in terms of product notifications, that did carry on through.

It was about a two and a half week where we were down and it did carry through Thanksgiving weekend and through the next week.

I see.

Thank you.

Tal Woolley, RBC Capital Markets.

Good morning, everybody.

Just wondering if you can break out the CapEx budget for this year in terms of what was the base capital spending versus what was optional or real estate reacquisitions.

Let's see.

The real estate acquisitions totaled about $17 million, $18 million.

The balance, I don't have a breakdown in front of me, but as I said, it's new stores, it's renovations, and significant investment in IT.

Okay.

And has there been any discussion at that the board level about thoughts about deploying the cash, either share buybacks, dividends?

What are the thoughts there?

That's something we talk about pretty much every quarter because we do have a healthy cash position.

As I have said in the past, my preference at least is to get to a point where we've got sufficient cash reserves to fund the most aggressive expansion plan in the midst of a deep recession and can still be comfortable.

And then what I see us doing in the future would be to get to a point where we could institute a regular recurring dividend as opposed to looking at special dividends or buybacks.

But it's an ongoing discussion.

Okay.

Thanks very much.

Lorraine Hutchinson, Bank of America.

Once you restarted the email notifications, did you see the comp return back to maybe last quarter's state, or are you still seeing some weakness?

I think you mentioned macro come through.

It's getting pretty granular.

I guess I would just say with the product notifications back, we're seeing the traffic and business on trend consistent with my guidance.

Thank you.

Janet Kloppenburg, JJK Research.

Congratulations on a great quarter.

Christine, I wondered if would you talk a little bit about your tests of some of the more casual product and dresses in the quarter and what you're thinking about in terms of layering and fashion versus basics as we go forward.

I also wanted to learn a little bit more about the comps in the Canadian market and how they compare to the US market and John, I just wondered on the gross margin guidance I think you said 55%, above 55% for the fourth quarter.

And I'm wondering if you could just highlight whether or not your AUC, or average unit cost per unit, looks lower versus last year in the fourth quarter.

Thank you.

So we always do in the summer a few casual layering dresses to go either with the swimsuit pod or just for fun.

They always blow out.

They're well received.

But that's not what we would consider a major -- that's a fun item for us.

It's not necessarily what we would call the technical street.

So when we talk about moving into technical street, it's always technical first.

So things like the What the Fluff line to us represent the technical street where it's beautiful enough to wear as your outerwear but it also has that highly technical element to it so you will see us move more into technical that crosses over.

Some of the beauty of like the men's jacket, the commuter jacket, that was just out there is so handsome on, but at the same time, you can ride a bike in the rain and show up for work and it's so handsome.

So those are the things that we refer to when we talk about pushing the line into technical street.

We'll always do things like the dresses or something for a little bit of summer fun because our guest enjoys it and frankly so do we.

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

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

Great.

In terms of your questions on comps, Canada, in spite of its very high productivity continued in Q3 to deliver a positive low single-digit comp, and in the US, really strong comps in the US were a little over 30%.

If I could squeeze in a question for Sheree.

Sheree, I was just wondering if we had a lot to look forward to in to terms of swim in the spring.

Will it be a bigger product line, more frequent product line, than last year or how should we be thinking about that category?

There's always something exciting to look forward to, Janet.

That's for sure.

Yes, next year for 2013 we are doing swim and so you will see swim show up a couple of times, one for the early buyer and one for the in season buyer so for March we'll be doing a capsule and then for June we will also be doing another capsule.

What you are still going to be noticing is that we're exploring this category.

So we're getting better and better at it and as we do, you will see that grow.

Okay.

Great.

Thanks.

John, did you want to comment on the gross margin question?

Yes, sorry.

Average unit cost in Q4 I think you were saying.

Like for like, we're seeing unit cost pretty flat on a by unit basis.

We are innovating so there's a slight increase when we're doing something new but I think your point is really like for like which is as I said pretty flat over last year, Q4.

Okay.

I just want to wish you guys a great holiday season.

Thank you.

Thanks, Janet.

Sam Poser, Sterne, Agee.

Ben Shamsian for Sam.

Thanks for taking my call.

Had a question on the comp.

Last few quarters, it was entirely or mostly driven by traffic and conversion.

Given that you go more towards technical and sort of moving more towards the men's, will we see any help on the ASP side or do you think sort of ASPs are topped out going forward?

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

Liz Dunn, Macquarie Capital.

Hi.

Good morning.

Let me add my congratulations on the strong third quarter.

Most of my questions have been answered but I just -- on the capsules, so there will be fewer of them but you will go deeper?

Is it just sort of a -- are you looking at some of the things that you experienced in 2012 and kind of evolving those, or will there be new categories, and how should that impact margins?

Will there be a little bit of margin pressure because, like we saw this year, there will be some experimentation?

Thanks.

Let me answer the second part, then I will let Sheree answer the product piece.

Our -- the overall effect of the small buy in capsules does not really drive our margin in particular.

However, what I will say about that is when we take a fabric or a new innovation from a capsule and drive into it the main line, in the beginning there is usually a small decrease in margin until it becomes a consistent part of the line and we reach efficiency.

So it's not the capsule per se, it's the translation of innovation into the main line that would have that effect until we get to a point of efficiency, which is why we always bet investment in innovation is so critical for us.

But we also know is the market leader and the disrupter where we're creating new space is what we strategically want to drive and we're constantly reinvesting the gross margin that's over the 55, into the product to be and maintain the market leadership.

Just want to make sure that our strategy is really well understood.

With that, I will let Sheree tell what you is exciting about capsules.

(laughter)

This goes back to what I said earlier.

As we learn from capsules, we learn what the key items are in capsules so that the capsules actually become more productive.

So one of the things as an example that we learn from commute is that there's room for a stretch technical fixed waistband pant which would go from your bike to work, as an example.

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

(laughter) Yes, it's a good one.

And so we see the same thing with tops.

So for men's as an example, we've done polos, and this year for Father's Day, we will have polos that will be great for golf and cross-functional type activities.

So because of have such key item implications, we're learning and it's becoming more productive, not less.

Sharon Zackfia, William Blair.

Wanted to discuss a little bit more the international expansion, and congratulations on the hire.

Obviously, Christine you come from a company that's been very successful internationally but also spent a lot of money to get to that level of success so I'm just kind of curious on the ramp in investment as you go deeper into Europe and Asia.

When do you really expect that to kind of peak or how do you think about the profitability arc of the international, outside of Australia business model?

One of the things that I learned tremendously was in working in international at Starbucks, and Barbara did as well, is it is far better to spend your money on the infrastructure and getting ready to build a profitable business model when you go in rather than to build a loss leading market and then cleaning it up afterwards by putting the fixes in place.

So we're being very disciplined about creating a healthy business model.

It's not growth at any cost.

We've built the models and are testing them and the beauty of showrooms is it gives us the ability to test the labor rate, the real estate rate, the duty import rate, so that we can fine tune the model market by market.

We also can see what's driving the guest behavior.

What's the definition of luxury in the market, what's the definition of technical.

So all the preceding we work we're doing now, all those learnings are being taken in and so the same strategy that we did in the US is learned from showrooms and have highly profitable stores from day one, that's what we're looking to do so it's not a first to market.

At the same time, being an early mover in e-commerce in the showrooms protects our IP and allows us to own the brand and the strategy in all of the markets.

So what you see us doing is laying the groundwork for financial success, a healthy business model which allows us to continue to be who we are strategically everywhere we go.

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

It's not, right?

Your real estate in London is a lot more expensive.

So we open -- our goal is to open a showroom a few more days and to bring in more of the wow product than the basic product than we did in US so we very much localize to create the business model that's needed and you will see us do maybe more trunk shows in combination with our showrooms.

You'll see us do slightly larger stores in those markets but fewer of them because you've got more density in the city.

We're very strategic about how we adapt yet create the same outcome in the markets.

And we have a very successful profitable business in Australia and that, as many people know, when you go internationally it's not easy to do.

Okay.

Thank you.

John Zolidis, Buckingham Research.

Congratulations on a great quarter.

I wanted to ask you a question about your store expansion in the US using the Columbus Avenue store as a kind of example and point of departure.

Just curious, with only 100-odd stores in the US, why would you choose to open a store only 10 blocks away from an existing location?

Could you just talk about why that store versus some of the other white space that you have and then could you also comment on the cannibalization that you might be experiencing at the nearby store?

Lastly, I noticed you didn't put the lululemon name on the store, just the symbol.

Could you talk about your thinking around that?

Thank you.

When we go into a market, we've already looked at all of the penetration of potential stores that we would want to have in the market.

Then what we do is we basically create a target real estate list of where we want to be.

We open the showrooms, we open stores in sequence of how we want to build the brand.

So kind of hip urban, urban affluent, suburban affluent.

We don't target necessarily where we think the highest volume sales will be because we're building a brand and that's important over the psychology of a market.

So we look at each market in a stand-alone way.

We then are real estate opportunistic and say if we want to be on this street and intersection because we've plotted the whole market and great A real estate shows up, when people are doing 5 and 10-year leases, if I don't take it then, I am going to let somebody else take it, and it would be 10 years before I would get that corner.

So we do it in a very knowing, mapped out way.

When we do cannibalize a store, it typically is less than 10% is the maximum I think we've seen, and it recovers very quickly so we still have very much growing brand awareness and demand.

So we want the 3 to 5 or 10, whatever the market will hold, best stores on our target.

That's our first priority.

And if it meant that there was a little bit of short-term impact to a store, we will take it rather than let competition, because what would happen if we had.

Where you don't want to be is in a B store in a market that has a potential with a lot of stores as more competition comes along.

So everything we do is very strategic and has the long-term decision in mind.

Edward Yruma, KeyBanc Capital Markets.

Thanks for taking my question.

John, on the change in the inter-company pricing agreements, once you cycle that next year, will there still be a continued step change there?

And I guess as more of your revenues come from abroad, is there incremental opportunity on that front?

Thanks.

The adjusted tax rate to 30% or just under 30% is an ongoing tax rate.

It will evolve over time based on the countries we go into and where our profit is generated.

But the benefit really comes from the fact that a lot of our income is taxed in Canada where the IP resides, et cetera.

And Canada has a benefit of quite a low tax rate.

Got you.

Thank you.

I just want to mention I did not answer John's second part of the question which is why we don't put the logo or the name on every store.

Sorry I didn't answer that, John.

The reason we don't do that is exactly, it made you curious.

And so the first store when we're building awareness in the market, we always do that.

But we find actually in our model, less signage, more authentically local.

We deliberately try to be very community oriented and we don't believe in putting 12 signs on our store.

We're very respectful of being part of the community in the street.

And we use community to engage and drive traffic, not signage.

Camilo Lyon, Canaccord Genuity.

Thank you and good morning, everyone.

Just going back to the international infrastructure buildout, do you expect to add manufacturers to supplier base, or are your current partners expanding their capacity for you?

We've been working for the last two years to build our capacity with our manufacturers.

And so we don't see any barriers from that perspective.

We've got strategic plans in place with most of them.

And doing everything from extra backups from any of the fabrics that we do, alternate choices, and flex capacity, and demand.

Working on a nine-month calendar like we do, we don't have the luxury of 24-month lead times to get right at orders to factories, so this is something that we have to pay a lot of attention to make our flow and model work.

And I think Linda and her team who run that for us have really done a fantastic job this last year, particularly on base products and on the more complex sewing products that we do.

Got it.

Just moving on to the email notification execution issues that you called out, is there an opportunity to recapture those lost sales in the fourth quarter?

It's always a little more difficult to read a 53-week year in terms of sales build but I believe we have great product in the store right now.

We have more color than we've had all year.

We have more technical pieces and we have great stock in basics.

So we're ready for the consumer.

Kimberly Greenberger, Morgan Stanley.

I just wanted to ask about your long term operating margin targets and the gross margin as I recall target is around 55%.

You seem to have settled in there this year.

And I'm wondering if you can just look out over the next several years and comment on whether or not that's the level that you feel like is really achievable.

And then separately, you mentioned a 25% EBIT margin that implies I guess 30% SG&A rate to sales.

You've nicely beat that target here in 2012 and I just wondered if you could share with us the way you think about the necessary investments in the business and growing that SG&A at a pace that you think is appropriate and strategically right.

But are there some offsets in that thinking in terms of making sure you're also monitoring the de-leverage, if any, that you're expecting in the business?

Okay.

There's a bunch of questions in there, but as I have said for some time now, our target margin profile is about a 55% gross margin and 25% operating margin.

Because we're growing, because we're expanding internationally, making IT investments to support a bigger company in the future, that's what keeps the operating margin down to 25%.

If we were just staying in North America and simply running out the growth of that existing business, that operating margin would leverage, and we'll get up into the upper 20%s.

But we are trying to balance both on the gross margin line and the SG&A level, delivering a strong model as we grow.

That's the point, growing but maintaining that strong margin.

So, yes, from time to time, our gross margin can get above 55%, as I think Christine or Sheree mentioned, we like to invest that excess back into innovation.

But there is leverage inherent there, especially as we leverage against occupancy and depreciation which is in cost of sales.

Similarly, in terms of SG&A running at about 30%, again it will be up, it will be down, but especially as we go international both in terms of the infrastructure investment to support that, and as we get into stores, the initial stores in new markets will likely initially deliver a lower operating margin and that will offset the leverage that we see in the core North American business.

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

Christian Buss, Credit Suisse.

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

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

That's helpful.

In terms of the pre-investments you've made, could you give us some color on that?

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

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

John Kiernan, Cowen.

Thanks for taking my question.

A little bit of a follow-up to the previous question.

What type of market research have you done into the 15 countries that you plan to enter over the next two years?

On the product side of things, what type of I guess research both from the fashion and the technical side of product have you done before entering those markets?

We obviously do a lot of benchmarking and we do a lot of our design meetings where we're in with athletes and asking them what they like to use.

We do a lot of product testing, and so there's a very active and those are the ones that people know that we do.

There's a lot that people don't know that we do that I don't actually want to share, so rest assured that we like the Canadian travel advisory warning which is know before you go and so we're very disciplined about that.

Then one quick follow-up.

The men's business continues to gain momentum.

Has there been any change in thought about the what the long-term potential of that business is as a percentage of your total business?

Thanks.

Well, if I was to follow Chip's direction, it would be huge.

So I think everybody is very excited and sees a huge opportunity.

We've already got a lot of basic pieces in the line which are very beloved, and we see men buy in bulk and so we've built a really good basics assortment, and as Sheree said it's now about refining to complete the full architecture in the line but we've just got some incredibly handsome pieces that are out there now.

The men's mission pant is the best pant that we've ever done, extremely well received in the marketplace.

Getting a lot of great feedback about that.

I already mentioned the men's commuter jacket which we did in a relatively small amount and got out there.

Now all of a sudden people are seeing guys in it, everybody is coming in trying to get it.

Very excited about the response because that's kind of a new direction for us.

As we already discussed, we really added to the bandwidth of guests who shop with us.

We're seeing a younger male attracted.

We've got our existing core and now we're working to really fill in the desire.

So we definitely see it as a major growth opportunity for us strategically.

Andrew Burns, of DA Davidson.

Thanks for taking the question.

Could you spend just a little more time on outerwear?

It seems to be a bigger presence in the stores this year versus last.

I was hoping you could talk about the performance and opportunity for that category and specifically the consumer response to higher price points.

Thank you.

I think what you saw year-over-year was if you recall last year, our factories delayed our outerwear so we canceled it so we actually had none last year and we had a very small drop right around Christmas of the original What the Fluff line that we were testing last year.

So this year, of course, would feel like more because we actually skipped a year of doing any outerwear.

And then you went from outerwear into a bigger What the Fluff.

So I think the overall impact in the store felt a little bit more like technical mid layers and some outerwear but we really didn't do too many more styles in direct outerwear than we've done historically.

We did skip doing the big, big heavy down jacket that we've done in the past and boy did we hear about that from our Canadian guests so I think you can expect to see that back.

And so it was very well received.

I was just in the store over the last couple of days and we had a woman who had come in and bought a coat at let's just say another store and she came in and saw ours, bought it and went out the door to return the one she just bought.

So we were pretty excited to see that and have a really great outerwear collection and I think the style that we bring to outerwear is exceptional.

Operator, we have time for just one more question.

Rob Wilson, Tiburon Research.

Thanks for taking my call.

John, I'm a little surprised about the gross profit margin guidance because if I remember correctly last year you called out specifically the merchandise margin was down 310 basis points last year.

So I'm assuming you are guiding to lower than last year gross profit margin.

Can you help me understand why it would be lower than last year?

I mean, last year you called out higher product cost, 230 basis points.

You called out --

Right.

Those higher product costs that de-leveraged gross margin a year ago over the prior year, those have not reversed.

So that is simply carrying on.

Then beyond that, as we've mentioned, additional innovation, et cetera, has the product cost up a little bit.

So you have received no benefit from lower sourcing costs?

Very little.

A lot of retailers are more cotton centric than we are, so they saw the spike in cotton, and then the strong reversal, but cotton really isn't a factor for us.

For us, it's more thinks like silver, for example, in our silverescent material.

So the answer is no.

Okay.

One more question real quick since I'm last.

Why would you guys want to own real estate?

It's not a core strategy, but when we have a key location that we see ourselves being in long term, and that can be our head office or it could be a key store such as the Newbury Street store that we acquired.

We evaluate acquiring it versus entering into a lease where, of course, we're at the -- exposed to, on renewal, lease rates going up.

So strategically it can be a better way of securing real estate on a long-term basis.

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

Thank you.

So, Sheree and I would like to thank our product team, the design, merch supply chain for being relentless and pushing boundaries.

We believe we have the best product team in the world complemented by the best educators for creating the guest experience in our stores.

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

Ladies and gentlemen, this does conclude today's presentation.

You may now disconnect and have a wonderful day.