Lululemon Athletica Inc (LULU) 2015 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the lululemon athletica third-quarter FY15 results conference call.

(Operator Instructions)

As a reminder, today's call is being recorded.

I would you now like to turn the conference over to Chris Tham, Senior Vice President of Finance.

Sir, you may begin.

Thank you, and good morning.

Welcome to lululemon's third-quarter FY15 earnings conference call.

Joining me today to talk about our results are Laurent Potdevin, CEO; Stuart Haselden, CFO; along with Miguel Almeida, EVP of Digital, who will be available during the Q&A portion of the call.

Before we get started, I'd like to take this opportunity to remind you that our remarks today will include forward-looking statements reflecting Company Management's current forecasts of certain aspects of the Company's future.

These statements are based on current information, which we have assessed, but which by its nature is dynamic and subject to rapid and even abrupt changes.

Actual results may differ materially from those contained in or implied by these forward-looking statements due to risks and uncertainties associated with the Company's business.

Factors that could cause these results to differ materially are set forth in the Company's filings with the SEC, including our annual report on Form 10-K and our quarterly reports on Form 10-Q.

Any forward-looking statements that we make on this call are based on assumption as of today, and we undertake no obligation to update these statements as a result of new information or future events.

During this call, we will present both GAAP and non-GAAP financial measures.

A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release.

The press release and accompanying quarterly report on Form 10-Q will be available under the investor section of our website at www.lululemon.com.

Today's call is scheduled for one hour, so please limit yourself to one question at a time to give others the opportunity to have their questions addressed.

And now, I would like to turn the call over to Laurent.

Thank you, Chris, and good morning, everyone.

Today, I will provide an overview of our third-quarter performance as well as highlight our progress against various initiatives which incorporates the recent changes to our organizational structure.

Stuart will then walk you through our financial and guidance in more detail.

First, from a top-line perspective, the third quarter was in line with our expectations.

We delivered $480 million in net revenue for the quarter, up 14% over the third quarter of FY14 and up 20% in constant currency.

We achieved a 9% global combined comp, the result of strong performance across our channels and regions.

Once again in Q3, store comps across all regions were positive, and we delivered a global e-commerce comp of 21%.

This solid-top line performance is a testament to the continued strength of our brand and loyalty of our guests.

Our gross margin and inventory position came in within our expectations for the quarter, and we reported EPS of $0.38 per share.

In line with macroeconomic trends, the start of Q4 has been mixed.

We saw lower traffic in the final weeks of Q3 and into the first couple of weeks of Q4, with steady improvement since Thanksgiving.

Given the current environment, we are taking a conservative stance with revenue in Q4, while taking the necessary actions to manage inventory and control expenses.

Our work to build a scalable global supply chain is beginning to pay off, and we saw an inflection of our product margins beginning in Q4.

I would like to start by emphasizing that this year's investments in our product engine and supply chain remain very much on track.

We are now seeing sequential improvement in product margins and remain focused and confident in our goals.

We continue to strategically invest in people, processes, and technologies that will deliver strong, long-term profitability and support our global expansion and 10-year vision.

Stuart will provide more details within his comments on our strategic investments and progress on margin expansion, along with an outlook on our inventory levels.

Our women's business has continued to be strong with an acceleration in pants and bras, where both categories delivered double-digit comps for the quarter.

On our last call, we had just launched our new women's pant wall.

This was one of the Company's most significant global launches, combining education, innovation, and a reimagination of this category.

We have seen a fantastic response from our guest with women's pants generating a 27% comp in Q3, and bras were not also far behind with a strong comp of 18%.

With new creative leadership and direction, the Design Team is laser focused on delivering new styles and innovation for the top and tank categories that will give our guests varying levels of support, coverage, and fit options.

Our men's business continues to outpace our overall growth, comping 24% for the quarter.

This performance was, and continues to be, attributed in large part to our sweat category, the anchor of the men's business.

The technical function of our sweat assortment, combined with our deep community relationship with our ambassador, is what gives us long-term relevance and continues to set us apart.

Our ivivva brand also posted double-digit comp growth, with a 23% combined comp for the quarter.

This strong performance continues to demonstrate how aesthetically this brand resonates with our young guests.

And for those of you who are listening from New York, we just opened our first ivivva pop-up location in Union Square, and I encourage you to drop in and discover it for yourself.

Turning now to creating amazing experiences for our guests.

We have fully deployed RFID to all North American stores.

This technology is a powerful new tool in creating seamless guest experiences across all channels and has greatly enhanced our ability to access inventory quickly across all channels and locations.

Our in-store ability to access to our incoming inventory through our bag backroom app accounted for 8% of e-commerce revenue for the quarter.

We continue to engage new communities as we open new location across the world.

In November, we opened our Flatiron flagship in New York City.

This amazing location holds our largest store to date and offers dedicated concierge services, delighting guests with everything from booking the most (inaudible) classes to discovering the best runs in the city.

This location serves local New York guests and is a platform for the rest of the world to discover lululemon.

Located on the lower level of the store, Hub Seventeen is a 3,000-square foot space dedicated to connecting our guests with ambassador among many other things.

It's an incredible space for our collectives to engage with friends, sweat, enjoy the work of local office and live music.

Throughout Q3 we made further progress expanding our global collective.

We opened our first store in Dubai at the Mall of Emirates and have a second store planned by the end of the year.

In Europe, we opened two new stores, including Marylebone in London as well as two new showrooms.

In Asia, we opened our second location in Hong Kong at Hysan Place and are extremely pleased with its performance since opening.

In the second week of Q4, we launched our shop-in-shop on Tmall, attracting 165,000 unique visitors on the first day, clearly validating the strength of the platform as the key to building our brand awareness in China.

Tmall provides an opportunity to introduce new guests to our brand and support our existing showroom locations as we continue to build our community in China.

In addition, the performance of our showroom in South Korea continues to far exceed our expectations, and we are excited to open two new stores in Seoul in the first half of next year.

On the brand and community side, we launched a number of engaging initiatives.

Home Canada was a celebration of our roots and included community events across the country.

I recently visited Toronto and was amazed at the thoughtful execution of this program among our six stores and our continued commitment to our home market.

We are seeing this focus clearly pay off as Canada posted another positive store comp in Q3.

Finally, I'm thrilled to share the progress we've made to our organizational structure.

Over the past 18 months, we've built a global world-class Management Team that is diverse and culturally aligned to drive our strategic global priorities and successfully position us to lead into our 10-year vision.

In October, we appointed Lee Holman as our Creative Director, uniting both men's and women's vision under one overarching design.

Lee brings a perfect balance of function, design, and craftsmanship, making his ability to solve problems for athletes second to none.

Dr. Tom Waller was promoted to Senior Vice President Whitespace, our R&D facility.

Tom will continue to lead our team of scientists and engineers and be the catalyst for innovation across the entire organization.

By elevating our passion for design and innovation, we will continue to strengthen our position as the global market leader in the category we created.

Stuart Haselden has added Executive Vice President, Operations to his title, assuming broader responsibilities focused on driving operational excellence.

And we are well along in the process of selecting a Chief Supply Chain Officer who will take on the work we started to optimize our global supply chain.

Last, but certainly not least, this November, we announced the appointment of Gina Warren as Executive Vice President, Culture and Talent, reporting directly to me.

Patience is paying off, and after a lengthy search, I am beyond thrilled to have Gina join us with her exceptional track record of driving global culture rooted in leadership and development.

Our people are the core that will drive this brand into the future.

A true visionary, I look to Gina to nurture, lead, and evolve our unique culture as we grow our global collective.

As we near the end of the calendar year, our work is starting to pay off.

We are relentless and focused in driving our priorities, thanks to a passionate group of leaders and an entire collective of smart, engaged, driven individuals throughout the organization, including our educators, store managers, ambassadors, and support teams around the globe.

I am more confident than ever that we will continue to build on our current momentum and deliver long-term profitable growth.

Finally, before turning it over to Stuart, I would like to take a moment to acknowledge the passing of Tom Stemberg.

Tom was not only the retail legend we all know and a critical member of the lululemon Board since December of 2005, he was also a dear friend of the Company and truly loved lululemon.

As a Chairman of the lululemon Compensation Committee, Tom's passion for building unique programs focused on health and wellness knew absolutely no bounds.

I will be forever grateful for his commitment to making me a better leader and lululemon a better Company.

We will all miss him dearly.

I'll now turn things over to Stuart to review our financial results and provide guidance for the upcoming quarter and full fiscal year.

Thank you, Laurent.

I'll begin today by reviewing the details of our third quarter of 2015, and then I'll update you on our outlook for the fourth quarter and the full FY15.

For Q3, total net revenue rose 14% to $479.7 million, from $419.4 million in the third quarter of FY14.

The increase in revenue was driven by total constant dollar comparable sales growth of 9% comprised of a bricks-and-mortar comp store sales increase of 6% and online growth of 21%.

Also, square footage growth of 22% versus last year driven by the addition of 65 new Company-operated stores since Q3 of 2014, 33 new stores in the United States, two stores in Canada, one store in Australia, five in Europe, four in Asia, and 20 ivivva stores.

And offset by the foreign exchange impact of a weaker Canadian and Australian dollar, which had the effect of decreasing reported revenues by $24.7 million, or 5.2%.

During the third quarter we opened 18 new Company-operated stores, nine in the US, two in Europe, one in Asia, and six ivivva.

We ended the quarter with 354 total stores, versus 289 a year ago.

There are now 266 stores in our comp base, 42 of those in Canada, 173 in the United States, 30 in Australia and New Zealand, one in Europe, and 20 ivivva.

At the end of Q3, we also had a total of 86 showrooms in operation, 27 lululemon showrooms in North America, 19 internationally, and 40 ivivva showrooms.

Company-operated stores represented 73.7% of total revenue, or $353.4 million, versus 73.9%, or $310 million in the third quarter of last year.

Revenues from our digital channel totaled $89.3 million, or 18.6% of total revenue, versus $77.2 million, or 18.4% of total revenue in the third quarter of last year.

Other revenue, which includes strategic sales, showrooms, pop-up stores, warehouse sales, and outlets, totaled $37 million, or 7.7% of revenue for the third quarter, versus $32.2 million, or 7.7% of revenue in the third quarter of last year.

Gross profit for the third quarter was $224.8 million, or 46.9% of net revenue, compared to $211.1 million, or 50.3% of net revenue in Q3 of 2014.

The factors which contributed to this 340-basis point decline in gross margin were 130 basis points of overall product margin decline as the port-related product costs and selling mix pressures observed in Q2 continued to be meaningful in Q3, but were offset by improved air freight usage; 70 basis points attributable to higher markdowns; 90 basis points of decline due to the foreign exchange impact of a weaker Canadian and Australian dollar; and 120 basis points deleverage from occupancy and depreciation, which is related to new stores, including international locations, and higher lease costs associated with major renovations, relocations, and regular renewals.

These items were of offset by 70 basis points of leverage in supply chain overhead costs.

SG&A expenses were $156.6 million, or 32.7% of net revenue, compared to $129.9 million, or 30.9% of net revenue for the same period last year.

This 21% SG&A dollar increase is due to the following: an increase in operating expenses associated with new and existing stores, showrooms, and outlets including costs related to the expansion of our international business; increased variable operating costs associated with the growth in our e-commerce channel; increased head office costs associated with strategic investments and one-time severance of roughly $1 million; increase in net foreign exchange revaluation losses of $3.4 million.

These items were offset with a weaker Canadian and Australian dollar, which on translation, decreased reported SG&A by $13.5 million, or 8.6%.

As a result, operating income for the quarter was $68.2 million, or 14.2% of net revenue, compared with $81.2 million, or 19.4% of net revenue in Q3 of 2014.

Tax expense for the quarter was $12.1 million, or a tax rate of 18.6%, compared to $22.5 million, or a tax rate of 27.1% a year ago.

Included in our tax expense for this quarter is an income tax recovery of $7.7 million related to the Company's transfer pricing arrangements and taxes associated with the repatriation of foreign earnings.

This also resulted in a net interest expense adjustment of $3.6 million.

Excluding these items, the tax rate would have been 28.8% for the quarter.

Net income for the quarter was $53.2 million, or $0.38 per diluted share, compared to net income of $60.5 million, or $0.42 per diluted share for the third quarter of 2014.

Excluding the impact of the tax and related interest adjustments, diluted earnings per share would have been $0.35 per share for the third quarter of 2015.

The negative impact to earnings from foreign currency this quarter was $0.03 per share.

Our weighted average diluted shares outstanding for the quarter were 140.5 million, versus 143.4 million a year ago, which takes into account the weighted impact of 1.6 million shares repurchased during the quarter at an average price of $55.50 per share.

At this point, we have approximately $100 million remaining on our share repurchase authorization and will continue to be opportunistic in completing the program.

Capital expenditures were $42.9 million for the quarter, compared to $37.3 million in the third quarter last year.

Turning to our balance sheet highlights, we ended the quarter with $403.4 million in cash and cash equivalents.

Inventory at the end of the third quarter was $357.8 million, or 56% higher than at the end of the third quarter of 2014, which was in line with our expectations that third-quarter growth would be similar to the second quarter.

Looking forward, we now expect total inventories to remain similarly elevated at the end of Q4 before coming fully in line with our sales trend in Q1.

This change in our inventory outlook is mainly due to intentional actions we have taken that will impact quarter-end in-transit levels.

Looking more closely at these projections, we still expect a sequential improvement in on-hand inventories at the end of Q4, but to a somewhat lesser degree than prior estimates due to our revised top-line outlook for the quarter.

And in fact, our November results reflect a meaningful reduction in on-hand inventory levels already.

The bigger change in our inventory projections is a result of actions we have taken that will increase our quarter-end in-transit inventories.

Specifically, these are, first, our success in shifting shipment modes from air to ocean will have the effect of increasing in transit at quarter end as we see the benefits of our enhanced supply chain processes and we reduce our reliance on air transit.

Second, we made the decision to pull forward certain product flows into the latter part of Q4 to mitigate shipment risks related to the timing of Chinese New Year.

This has the effect of increases in-transit levels at quarter end but is the correct call to protect our in-stock positions and the integrity of our assortments entering Q1 to deliver on our design intent.

Additionally, we are also pleased with the results of our efforts to clear the excess inventory that we incurred as a result of the port disruption in Q1, and I'd like to recap where we stand now.

You may recall, we identified 1.1 million units of excess inventory at the end of Q1.

We also identified a plan to clear roughly one-third of this, or 400,000 units, through normal exit channels, while the balance would be incorporated in our normal product flows at full price in Q3 and Q4.

As of the end of Q3, we have cleared approximately 260,000 units through our exit channels, including our successful physical warehouse sale in Boston this past October.

The remaining 140,000 units of clearance inventory will be sold through in Q4 via two physical warehouse sales that we now have planned, one in the US and one in Canada, as well as through our normal exit channels otherwise.

Of the remaining two-thirds of the Q1 excess that has been flowed at full price into the second half of the year, about half of this was sold in Q3 as part of our normal flows.

The remainder will be sold if Q4, with a small portion incorporated into the first half of 2016.

As a result of all the factors just mentioned, we now expect inventory levels to become fully aligned with forward sales in Q1, following the sequential improvements in on-hand inventories combined with the described increase in in-transit at the end of Q4.

This now leads me to our outlook for the fourth quarter and full year 2015.

As Laurent mentioned, trends in our business have been mixed, with traffic trends soft to start Q4, followed by some improvement since Thanksgiving.

As a result, we are updating our prior guidance to reflect a Q4 revenue estimate in the range of $670 million to $685 million.

This is based on a comparable sales percentage increase in the mid single digits on a constant dollar basis compared to the fourth quarter of 2014 and assumes a Canadian dollar at $0.75 to the US dollar, and nine new store openings, seven lululemon stores and two ivivva.

That said, we are, in fact, seeing the gross margin recovery in Q4 taking shape and expect this to continue and accelerate into 2016.

But specifically for Q4, we now anticipate gross margin to be in the range of 49% to 50%.

This sequential improvement reflects a number of positive factors, including stabilizing product margins as we move beyond port-related cost issues and benefit from leverage of air freight costs, as utilization has declined significantly to last year; significant sequential improvement in occupancy and depreciation as expected, but still up year-over-year; and buying costs in line with last year.

Offsetting these positive factors are the continued impact of FX, actually the biggest quarterly impact of the year; an increase in markdowns to stay on top of inventory movement as our comp trend has moderated; and we expect SG&A in the fourth quarter to delever from Q4 2014, due in part to our lapping $7 million in FX gains that reduced reported SG&A in Q4 2014.

The remaining increases causing deleverage are associated with investments in our global website redesign, supply chain consulting cost associated with delivering on our margin improvement initiatives, and incremental digital marketing expenses during the fourth quarter that drive traffic and conversion.

Assuming a tax rate of 29.5% and 139 million diluted weighted average shares outstanding, we expect diluted earnings per share in the fourth quarter to be in the range of $0.75 to $0.78 per share, versus $0.78 a year ago.

For the full year FY15, we now expect revenue to be in the range of $2.025 billion to $2.04 billion for the year.

We now expect to open 61 Company-operated stores, which includes up to eight new stores in Asia and Europe and also 21 ivivva stores.

We expect gross margin for the year to delever from 2014, impacted by the factors we mentioned earlier.

We expect modest deleverage in full-year SG&A versus 2014, driven by strategic investments in guest experience, supply chain, digital, brand, and IT systems.

We now expect a net negative impact to earnings from foreign exchange for the year to increase from approximately $0.07 to $0.09 per share when compared to FY14.

As a result, we expect operating margin to delever from 2014 and our FY15 diluted earnings per share to be in the range of $1.81 to $1.84.

This is based off of 140.9 million diluted weighted average shares outstanding, which does not reflect an estimate of shares repurchased after Q3 2015, and also assumes an effective tax rate of 27.6%, which includes the $0.03 tax benefit recorded in the third quarter.

We expect capital expenditures to range between $135 million to $140 million for the FY15, reflecting new store openings, including outlets, renovations, relocation capital, and also strategic IT and supply chain capital investments.

We are pleased with the progress we have made in the third quarter.

As we now have moved into Q4, the Team remains laser focused on successfully executing all of our strategic initiatives.

We will provide a detailed outlook for next year as part of our Q4 call in March, but we would like to reiterate our of confidence in delivering gross margin recovery in 2016.

The quarter-to-date margin trends we are now seeing reinforce this view.

And at this point, we are deep into execution on the various programs that will deliver the margin improvements that will support this inflection and long-term profitability.

As we discussed, these programs and the related investments are focused on a few key areas that include reduction in air freight as we shift a higher portion of flows to ocean.

This effort is beginning in Q4 of this year where we expect air utilization to be half of last year.

Improved logistics and duty costs.

FOB cost improvements as we improve our demand planning, reduce cancellations, and late stage change orders.

And lastly, other efficiencies from a more disciplined go-to-market process, such as lower fabric liability and improved development ratios.

These programs are all part of the evolution to a more sophisticated, scalable supply chain that can flow product more efficiently and consistently based on anticipated product life cycles.

We have incurred consulting costs in both Q3 and Q4 to deliver on these programs next year, namely, with Deloitte, who has been a catalyst to accelerating our efforts.

Given the nature of these initiatives, we see gross margin recovery opportunity accelerating starting in the second quarter of 2016.

We will see sequential improvement in Q1 gross margin, but also anticipate some impact in this period from steps we will take to fully align inventory levels.

With that, I will open up the call for questions.

Operator?

Thank you.

(Operator Instructions)

Our first question is from Paul Lejeuz with Citi Research.

You may begin.

Hey, guys.

Stuart, you mentioned the opportunities on the supply chain.

Can you maybe just talk about the different buckets, maybe dig in a little bit to some quantification on where you're furtherest along and just the timing on how you see those come through.

It sounds like maybe some are happening a little earlier than planned in the fourth quarter, but just wondering how we should think about the total by bucket in FY16.

Thanks.

Hey, Paul.

It's Stuart.

So as we think about the margin improvement and the order of magnitude, we still see the potential -- we still expect to achieve the area of 300 basis points of product margin improvement versus FY14 pre-FX, but I think what we're seeing now that we're a little farther into FY15 and have more visibility on the first half of FY16, that it will likely take us into the first half of FY17 to fully achieve that level of margin recovery.

But as we mentioned, we are seeing the opportunity taking shape in FY16, particularly beginning in the second quarter, and again, but we will see improvement in margin in the first quarter but a greater inflection accelerating into the second quarter.

And so we feel like the overall story is intact.

We tried to lay out, in my prepared remarks, some of the primary buckets for how we'll deliver that.

I can give you a little color now on each of those.

So as you look at the reductions in air freight, that's a big piece of the equation and one of the more tangible that we've been able to make probably the most progress on in FY15.

As I mentioned, we're seeing air freight utilization in the fourth quarter less than half of what it was in FY14.

So that's going to translate into an important point of leverage for gross margins in the current quarter, in Q4.

We see that extending into FY16.

And to quantify it, we're looking at air utilization rates that are under 25%, where in much of the prior year, they were approaching 50%, easily north of 40%.

So that's a critical element that is tangible, that we're seeing current benefits.

The other areas, the improved logistics and duty costs, so on the logistics side, there's programs we've identified to optimize our mode utilization.

All air freight isn't created equal, and there's different tiers of air that you can leverage at different levels of cost to the Company.

So we've identified ways to optimize that where we choose to use it.

The same thing for ocean freight.

It's not all created equal, and we've, again, identified where we can do a better job of flowing inventory through the supply chain, through the logistics elements of how we move product.

And duty costs, there's just some pretty straightforward first sale opportunities we've identified that we're going to work on now.

So again, those are, again, meaningful opportunities from a cost reduction standpoint.

FOB cost improvements, this is really us getting our house in order.

We've talked about this earlier in the year.

Improving our demand planning, being able to look forward and have a more reliable estimate of our production requirements that we can take to our suppliers to deliver more consistent production requirements, reducing the amount of cancellations that we've seen, and as well, late stage change orders.

All those things will improve our ability to lower our FOB costs.

And then also as I mentioned, the go-to-market process, more discipline around how we manage our fabric liability.

We've taken some steps earlier in this year to clean up our positions.

We feel like we should be in a good place to enter FY16 in that regard.

And also as our internal processes for product development improve, we can improve our development ratio, as I mentioned which, again, is an important part of the liabilities that we generate to support our product process.

So those are the big areas we'd like to identify, and not going to break out the details around each in terms of what they're worth, but each of those are meaningful and will be part of the overall recovery that we see really accelerating in Q2 of next year.

And Paul, this is Laurent.

What I might want to add quickly is with the structural changes that we've made on the product side, being design led certainly doesn't come at the expense of great merchandising, and I've already seen much greater collaboration between design and merchandiser, resulting in a much more focused approach to the assortment, which will create better experiences for our guests, but also, much more efficient targeted sourcing of our product, resulting in far greater margin.

I've seen the impacts that it will have both on the guest standpoint, but also the laser focus on a more streamlined supply chain.

Great.

Thanks, guys.

Good luck.

Thanks, Paul.

Thank you.

Our next question is from Brian Tunick with the Royal Bank of Canada.

You may begin.

Thanks.

Good morning, guys.

One question on the product side, and then one on the expense side.

On the product side, bottoms up I think you said 27%, bras up 18%.

Can you maybe talk about what are the biggest opportunities in the women's assortment next year?

Where do you think there's the most white space to either relaunch or have a new category?

And have you learned anything about your price opportunities given the newer high price point in the compression pants.

And Stuart, on the expense side, can you maybe talk about the SG&A dollar growth?

Obviously, there was some consulting costs in there, how much they may have been for the third or the fourth quarter, and are there any other Management holes besides the Supply Chain Head that we need to think about for FY16 SG&A dollar growth?

Thanks very much.

This is Laurent.

I'll take the first part of the question.

Clearly, what we've learned and what we've known all along and where we probably lost our way the past three years, but when we're bold, when we're innovative, our guests respond really well.

And the response to the launch of the pant wall has been fantastic, both from a fabrication, from an innovation standpoint, and we have actually seen price a elasticity that was much greater than what we had originally anticipated, meaning that our guests really responded well to the value that we provided.

When you look at the success at being bold, innovative, and really delivering that kind of value, and when you look at the comps we've had in pants and bra, it's obvious that the category that we need or be really focused on right now is tanks.

With Lee coming on as creative director, his first area of focus is clearly to deliver the same type of innovation both from a fabric, styling, and construction standpoint that we have with the pant.

That is a very substantial opportunity for growth for us as you think about spring-summer 2016 and beyond.

Great.

And Brian, it's Stuart.

I'll speak to your SG&A question.

So SG&A did come in high for the quarter versus our prior expectations.

There were a few factors that explain where we landed, a couple of which we mentioned in the prepared remarks.

There was really three things I'll call out.

First, we did see about $3.4 million of increase in FX revaluation loss versus Q3 of last year.

We also had about $1 million in severance that was not incorporated in our earlier estimates.

Finally, the consulting fees, which in total were $2.5 million in the quarter, related to our supply chain initiatives primarily, came in above our prior estimates.

A portion of that was contemplated in the guidance, but there was some portion that was above what we expected.

The combination of those factors accounted for over 100 basis points of the deleverage that we saw in the quarter and essentially bridge us back to our original estimates.

We're comfortable that these costs are one-time in nature and do not represent a permanent increase in our cost structure and really offer us an opportunity for leverage as we lap these costs into next year.

And as we think about Q4, we do anticipate a meaningful amount of SG&A deleverage in Q4, and that's implied in the guidance that we gave, but to a somewhat lesser degree than what we saw in Q3.

You also heard in our prepared remarks some of the factors that we pointed to that will affect SG&A in the fourth quarter, the biggest of these being the $7 million in FX gains in Q4 last year that we are now lapping.

That by itself is about 100 basis points of pressure.

Otherwise, we are continuing to invest in our supply chain initiatives.

That's probably the largest of the factors otherwise.

But we also have important investments in website redesign and our digital marketing efforts.

As we look into FY16, we'll certainly give more detailed guidance around FY16 on our Q4 call.

We'll continue to make investments to support the supply chain initiatives, which will likely be heavier in the first half of the year as we draw closer to completing those key investments in that time frame.

So hope that's helpful.

That's super.

Thanks very much.

Good luck for holiday.

Thanks.

Thank you.

Our neck question is from Sharon Zackfia with William Blair.

You may begin.

Hi.

Good morning.

I was hoping to get an update on the idea of having gross margin parity or merchandise margin parity between seasonal and core.

I haven't heard you talk about that in a while.

I'm not sure where you are in that initiative at this point.

It's not a great way that we would explain what's going on in our gross margin picture.

I think we believe our seasonal products and our core products should both offer great margins that should lead to margin expansion from where we currently are.

What I would say is, we're five, six weeks now into Q4, and we're excited to see that the efforts that we've been making over the course of the year are starting to get traction from a product margin standpoint.

As we mentioned in the opening, we are seeing stabilizing product margins that are happening now in the fourth quarter as we begin to clear some of these port-related issues.

As I just mentioned a few minutes ago, air freight is a an important source of leverage for us as the utilizations are coming in line with our targets and our supply chain begins to normalize.

Occupancy and depreciation will also be a big point, big part of leverage for our gross margin in Q4, and then even a greater source of sequential improvement into FY16.

Just to be clear, there will still be deleverage in Q4, but just not as much as what we've seen in the earlier parts of the year related to occupancy and depreciation.

FX will continue to be a headwind.

We will have some increased markdowns in the fourth quarter so that we can stay on top of the inventory movement.

We are committed to and aggressive in ensuring that we get our inventories rebalanced.

But coming back to your question, Sharon, on core versus seasonal, we are developing a merchandise segmentation strategy that will enable us to balance the product, different elements of our assortments based on the anticipated life of those, the product life of those different parts of the assortment.

And that should give us an advantage in how we build supply chains to deliver those and capture margin opportunities.

So again, the punch line here is that we think we should be able to deliver great margins on both seasonal and core products, and that's how we're drawing up our plans.

And Sharon, looking at it from a pure product standpoint, looking at what's coming in in spring and summer from a print technique, from a texture, or from a construction standpoint, I've said that all along.

There's no reason why seasonal should deliver less margin than core, especially when you compound that with our scarcity strategy around the seasonal product.

So we feel very confident that there shouldn't be any margin discrepancies seen seasonal and core, and I actually think that we're not even thinking about seasonal and core that way anymore.

I'd love to take this opportunity to remind all of you that Miguel Almeida, who is leading Digital, is on the call with us.

Over the next few calls, I'd love to expose more of you to more of the Management Team.

Obviously, Digital is a center of excellence that we're building.

Miguel has got a massive experience in that area.

We're very excited about it.

And it's obviously a great opportunity for us.

So if you've got questions for Miguel, don't make him feel bad for being silent here.

Just ask him some questions.

Thank you.

Our next question is from Oliver Chen from Cowen and Company.

You may begin.

Hi.

Thank you.

On the success of pants and bras and men's, what were the product classifications that had more opportunity this quarter in terms of getting to your overall comp?

And Stuart, on the markdown front, which classifications had the markdown?

And as you guided to markdowns for the Q4 period, does that mainly have to do with what you've articulated with your warehouse sales, or what should we expect in store?

And then Miguel, on your side, buy online pick up in store in mobile, they are major ideas for integrating bricks and clicks.

Just curious on what are the next major hurdles in the flagship?

The Flatiron flagship has a lot of interactivity, so wondering what we can see there for the innovation ahead.

Thank you.

Oliver, I'll take the least amount of time to answer your question.

The largest opportunity right now for us is women's tanks and Lee and [Dugan], the (inaudible) actually put a fully dedicated Team to just look at that opportunity and quickly bring product to life that we're proud of and that we love.

So I'll leave it at that.

That's clearly the biggest opportunity, one we're focused on.

And Oliver, it's Stuart.

On the markdown question, there's a couple pieces there.

Certainly, we have added activities, namely the physical warehouse sale and the online warehouse sale that we did earlier in the year and the two warehouse sales we now have teed up for the fourth quarter.

Those certainly serve to increase the amount of markdowns that we have and are a part of the guidance that we gave and the results in Q3.

And otherwise, we are taking steps with regards to markdowns to make sure that we are staying on track with the clearance goals that we have to move through the inventory we have in an orderly manner.

So in October, we did see -- we saw traffic slow in the final weeks of October, and there was some incremental markdown activity there to, again, stay on top of the inventory movement.

And the guidance we have given for Q4 reflects the quarter-to-date activity, and as well, our expectations at this point for the balance of the quarter in terms of actions we'll need to take to, again, stay on top of that inventory movement.

And this is Miguel.

On the buy online and pick up in store, it's one of our critical initiatives to improve the guest experience across channels, something that our guests have been telling us that they really want to see from us.

The RFID that we have in North America will enable us now to accelerate the testing, learning of those experiences.

I'm mostly excited about what then the RFID technology, beacon technology will help us learn about guest behavior as they are buying and browsing products in our stores.

So that's -- it's one of the key priorities for us.

We will learn significant things about the best way to implement these.

The testing and learning on top of the RFID will help us do the right expansion in North America.

Great.

Best regards.

Happy holidays.

Thanks.

You too.

Thank you.

Our next question comes from Matt McClintock with Barclays.

You may begin.

Yes, good morning everybody.

Good morning.

Miguel, I will actually take the opportunity to ask you a question because I'm very interested in the upcoming website relaunch.

Can you maybe give us a little bit of highlight of some of the functionality that you're adding, maybe content that you plan to add or add over time, and how you plan to improve the overall experience comprehensively online with digital with this new website?

Thanks.

Thank you for the question, Matt.

So we're very excited about the redesign coming in in Q1.

It's an outstanding opportunity for us to bring our brand content and commerce together.

The current experience is very decoupled from a commerce and content perspective.

The new website will allow us to bring those two elements into one cohesive experience for our guests, both across web and the mobile experience as well.

That, the redesign itself will be just step one in terms of our digital experience evolution.

What gets me most interested is then the personalization capabilities that will come over the course of the year.

We're investing significantly in building our CRM and analytics capability, and the new website will allow us to really deliver contextually relevant experiences to our guests that bring the story telling of our product and brands into the digital space and then will connect those guests back with our stores as well, through some of the capabilities that we were discussing before.

We're very excited about seeing the new site coming to life in Q1.

Thanks a lot, Miguel.

Can't wait to see it.

Perfect.

Thank you, Matt.

Thank you.

Our next question is from Matthew Boss with JPMorgan.

You may begin.

Hey, good morning.

So as we think about the 300 basis points of product margin opportunity, is basically what you're saying you're expected aggregate gross margins positive in the first quarter of next year, for us to think about a larger inflection in the second quarter?

And then just on the phasing, is it fair to think about 200 of the 300 in FY16 with the remainder in FY17?

Hey, Matt.

Let me try to sharpen what we said a little bit there.

In Q1, we expect to see sequential improvement in gross margin year over year versus the prior quarter, meaning the Q4.

So I think we're going to see a nice sequential improvement in Q4 versus the quarter we just reported, but still will likely be down year over year.

As we get into Q1 of FY16, we'll see a further sequential improvement in gross margin, again, as our work to improve our supply chain efficiency and all the things we mentioned gets farther along.

I didn't say necessarily that gross margin in Q1 would be up.

We'll give more specific guidance on our Q4 call, but I think what we are comfortable committing to is that we will see a sequential improvement in Q1.

We see greater opportunity in Q2 and beyond in FY16 to see a greater inflection in our product margin and gross margin opportunities, and that's a combination of, again, just being farther along in the initiatives that we have.

The FOB cost improvements in particular are going to be more second-half weighted than first half.

And there will likely be some actions we'll take that will weigh on margins related to just getting our inventories aligned in the first quarter.

So I'm not going to put a number on what that product margin improvement looks like in FY16 today.

We'll be able to speak with more precision to that, again, on the Q4 call.

But conceptually, we're just saying given what we know now about inventory flows into the first half of FY16, we still feel confident about the order of magnitude of inflection that we can achieve being consistent with that 300 basis points pre-FX product margin back to FY14, but it's likely going to take us a little bit more time into FY17, first half of FY17 to fully achieve that.

Great.

And then just a follow-up.

To circle back on the inventory, what's the best way to think about the content of the excess product?

And then just to be clear on that, so are you basically saying that versus your initial plan for the on-hand reduction, you really only stand 10,000 units behind plan, which is about 4% below that game plan to clear 260?

Is that the best way to think about where you're at today versus what you had laid out thee months ago on just the go-forward content?

That's right.

I think what we had laid out was 100,000 units in Q3, and we came in around 90,000.

So still feel good directionally.

That keeps us on track, and we'll be able to complete that part of the plan in the fourth quarter as we had described.

But again, the biggest change in the inventory outlook for Q4 is really that in-transit, the decisions we made around it, we feel strongly that those are the right calls.

We think otherwise it would be short sighted to not ensure that we're protecting our flows into the first quarter and otherwise not take advantage from a margin standpoint of our ability now to shift from air to ocean.

The consequence of that unfortunately increases our in-transit at the end of Q4.

But nonetheless, again, we feel strongly those are the right decisions.

I think what we will plan to do at the end as part of our Q4 call, we'll break out and provide some details on our on-hand inventory levels versus the in-transit so that we can demonstrate the degree to which our on-hand inventories are coming in line, and also quantify what the impact of the in-transit increase will have been.

Okay.

Great.

And then just one housekeeper.

Are same store sales quarter to date in line with the fourth quarter mid-single-digit guidance?

I'm sorry.

Could you repeat that?

Are same store sales so far quarter to date in line with the fourth quarter guidance for mid single digits?

I think how I would answer that is that the next few weeks of the quarter in December are huge weeks from a volume standpoint.

We're also up against a little tougher comparison in these weeks.

And our comp assumption is probably just under the mid-single-digit range.

So we're a little more conservative over the next few weeks in regards to the comp in that time frame, more conservative than we are for the quarter overall, if that makes sense.

Okay.

Great.

Best of luck.

Great.

Operator, we've now run out of time for questions.

Thank you, everyone, for joining us today.

We'll talk again soon.

Thank you.

Ladies and gentlemen, this concludes today's conference.

Thanks for your participation, and have a wonderful day.