Lululemon Athletica Inc

NASDAQ:LULU

Earnings Call Transcript 2020-Q2

[Operator]

Thank you for standing by. This is the conference operator. Welcome to the Lululemon Athletica Inc. Second Quarter 2020 Earnings Conference Call. As a reminder, all participants are in listen-only mode and the conference is being recorded. After the presentation, there will be an opportunity to ask questions. [Operator Instructions] I would now like to turn the conference over to Howard Tubin, Vice President, Investor Relations for Lululemon Athletica. Please go ahead.

[Howard Tubin, Vice President, Investor Relations]

Thank you and good afternoon. Welcome to Lululemon’s second quarter earnings conference call. Joining me today to talk about our results are Calvin McDonald, CEO; Meghan Frank, SVP Financial Planning and Analysis; and Alex Grieve, VP, Controller.

Before we get started, I would like to take this opportunity to remind you that our remarks today will include forward-looking statements reflecting management’s current forecast of certain aspects of Lululemon’s future. These statements are based on current information, which we have assessed 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 our business, including those we have disclosed in our most recent filings with the SEC, including our annual reports 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 assumptions as of today and we expressly disclaim any obligation or undertaking to update or revise any of 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 our quarterly report on Form 10-Q and in today’s earnings press release. The press release and accompanying quarterly report on Form 10-Q are available under the Investors section of our website at www.lululemon.com.

Before we begin the call, I would like to remind investors to visit our investor site where you will find a summary of our key financial and operating statistics for the second quarter as well as our quarterly infrograph. Today’s call is scheduled for 1 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 Calvin.

[Calvin McDonald, Chief Executive Officer]

Thank you, Howard. I am excited to be here with you today to provide an update on our performance for the second quarter, share our learnings as we continue to adapt to and navigate the uncertain COVID-19 environment and highlight trends we are seeing in the business as we look forward to the back half of the year. The results we are sharing today demonstrate the strength of the Lululemon brand as we face these unexpected times and see the future of retail accelerate through an expansion of e-commerce and digital sweat offerings. Our products built with technical innovation and performance fabrics is ideal for enabling the work from home and versatile lifestyle that has grown exponentially in the COVID-19 world. Building upon these components, our acquisition of at-home fitness innovator, MIRROR and our continued expansion globally demonstrates our ability to navigate the near-term while planning for the long-term growth.

Today, I am joined by Meghan Frank, our SVP of Financial Planning and Analysis, who continues to be a supportive partner as she works with me and the team on strategic and operational finance, while our CFO search is ongoing. Alex Grieve, our VP and Controller is also on the call today and be available to answer your questions during the Q&A portion.

Before I detail our results, I would like to speak for a moment about the importance of diversity inclusion at Lululemon. As I mentioned on our last call, we are committed to increasing our investment in education, behavior change and diverse representation within our organization. The Black Lives Matter movement has ignited Lululemon and our collective serving as a powerful catalyst to critically examine our culture and practices. Back in June, we created idea, a commitment to create real and lasting change through inclusion, diversity, equity and action. As a company, we are focused on meaningful transformation, shifting our mindsets and behaviors and living into our core value of inclusion everyday. I look forward to sharing our progress on this going forward as the diversity of our workforce truly begins to reflect the global communities in which we operate.

Let me turn now to our business performance in the second quarter, which exceeded our expectations. Total revenue increased 2%. Consistent with quarter one, we are not reporting same-store sales due to the significant number of stores that remain closed during the beginning of the quarter. Our e-commerce business continued to accelerate with comps in quarter two increasing 157%. Gross margin declined 80 basis points and our product margin was flat with last year. Adjusted earnings per share were $0.74 versus $0.96 last year and our financial position remains strong as we ended the quarter with $1.2 billion in total liquidity.

As we continue to operate and move through the COVID-19 environment, we are seeing a shift in behavior in terms of working from home, sweating from home and the increased importance of living an active and healthy lifestyle. These trends play to our strengths and setup an opportunity for us to continue to innovate and gain market share. We are learning how our guests are changing their behaviors and we are adapting engaging with them in new ways. We remain committed to our Power of Three growth plan, including the doubling of men’s, doubling of e-commerce and quadrupling international by 2023.

But we also recognize that 2020 is likely an inflection point for retail and for Lululemon, with certain changes in guest behaviors likely to endure in the post COVID-19 world. We believe Lululemon is uniquely positioned to engage with our guests when, where and how they want based on the strength of our brand, the strength of our operating model and the investments we have been making across the business.

One of our key strengths is our omni operating model. For the last several years, we have been investing in our ecosystem to ensure we have the capabilities to enable a seamless and enjoyable experience whether guests want to engage with us virtually in stores or in the community. What we are learning now during the COVID-19 environment is that omni means much more to our guests and simply enabling purchase transactions across our channels. While our recent investments in transactional omni capabilities are clearly paying off as evidenced by our recent results, we have begun to view other areas of our business, including sweat and events through an omni lens.

Let me now share some of the details. As our stores continue to recover, our e-commerce business has accelerated from a 41% comp in quarter four of last year to 157% comp in the current quarter. Similar to quarter one, we have seen a healthy mix of new guests, existing e-commerce guests and historically retail-only guests now shopping with us online. In order to support growth in the business, capture a potential further increase in demand in quarter four and ensure our guests continue to receive the highest level of service we have accelerated investments this year within our e-commerce channel. These investments include developing site enhancements, building our transactional omni functionality and increasing fulfillment capabilities. These further enhancements were on our roadmap for the next 2 years and given our ecommerce business has currently accelerated beyond our expectations we prioritize and pull forward these investments.

We are also continuing to grow our brand and engage with our guests across our international markets. In China, we are experiencing a strong rebound in store with same-store sales up over 30%, coupled with strengthen in e-commerce, which grew over 130% in quarter two and in Europe, a greater than 160% lift in e-commerce is driving our business as guests are engaging with us more online than ever. When looking at store growth in our regions in quarter two, we opened 9 new locations across Asia and Europe, including our 100th location in APAC, an exciting milestone for our brand in this key growth market.

Let me shift now to speak about the recovery of our store business. While this period continues to be unpredictable, we currently have approximately 97% of our stores open across the globe to serve our guests. On average, our reopened stores are performing at 75% of last year’s volume. As you know, our stores are small and designed to be an efficient use of space with high levels of traffic, which results in high productivity. While these are appealing attributes, the current capacity constraints understandably limit the number of guests who can be in the store at one-time. While we are seeing traffic declines relative to last year and expect these constraints to endure at least through the end of the year, the underlying health of our brand remains strong. Guests are patiently lining up to get into our stores both physically and to our virtual tools. Our product continues to resonate well as evidenced by the strength of our e-commerce channel. And while we expect productivity for stores that we have reopened to remain consistent with the current levels for the remainder of the year, we still expect to grow our top line in quarter three and quarter four.

We continue to believe physical stores are and always will be an extremely important part of our ecosystem. From a sales standpoint, our stores are highly productive and they enable so much more than simply the purchase of apparel by our guests. Our stores are our local hub and communities across the globe, gathering spots for our ambassadors and our connection to local studios facilitate e-commerce transactions via our ship-from-store and buy online pickup in store capabilities and our portal to bring new guests into our brand, particularly men. This year, we plan to open 30 to 35 net new stores, while also accelerating our seasonal store strategy.

In quarter two, we operated just over 50 seasonal stores and we plan to increase to approximately 70 in the second half of the year. Our strategy this holiday will include seasonal stores in key centers in markets where we have existing stores to help us mitigate the current capacity constraints. That being said, we are building new and leveraging our current transactional omni capabilities to ensure a quick and seamless shopping experience for both our store and e-commerce guests. Some of our actions include, first, we have evolved our buy online, pickup in store functionality to buy online pickup by curbside. Second, we have enabled virtual waitlist so guests no longer have to wait in line and instead can be notified via text when it is their turn to enter the store. This functionality has been particularly well received. In the month of August alone, we had nearly 400,000 individual guests utilizing our virtual waitlist across nearly 280 locations, where we implemented the technology. Third, we have continued to expand the number of our Omni educators who receive special training enabling them to help guest in-store and virtually through our guest education center. And fourth, we continue to offer our digital educator and virtual concierge programs and both initiatives continue to be well received by guests. This innovation demonstrates our consistent ability to be agile and anticipate the evolving needs of our guests. We have also enabled omni sweat life capabilities to help our guests stay active both physically and digitally. Many of our ambassadors have been offering live streams on our social channels and we now offer digital content as part of our membership program in the cities where our tests are underway.

I am also excited that in August, we were able to convert our Annual SeaWheeze Half Marathon into an extremely successful virtual event, which over 23,000 people for more than 100 countries participated, including myself. We have partnered with the running app, Strava and offered a 10-K distance in addition to our half marathon. We also curated virtual training programs for both races to help runners prepare and compete at the height of their ability.

Shifting now to product innovation, our guests are now working and sweating from home more than ever and we continue to be there for them with merchandise that offers versatility and flexibility powered by the technical innovation of signs of feel. I am excited to share the ways in which we are making our assortment relevant to more of our guests. Last month, we expanded our on-the-move collection with the introduction of new pant styles for both women and men. Supported by our everyday is a workout campaign. These styles leverage our expertise in technical construction in developing technical fabrics, but they were explicitly designed for out of studio use. For women, we launched the City Sleek 5 pocket powered by our Warpstreme fabric, and for men, we rolled out the Bowline pant in our new utility TAC fabric. Initial response to these new styles has been strong. In particular, the City Sleek has exceeded expectations by a factor of two as the number one performing style in the company during the initial days of the launch and we are chasing into additional inventory to help keep up with demand. While we will always lead with performance-based apparel and technical innovations, we see continued opportunity to grow the on-the-move portion of the business for both women and men.

I am also pleased with our move toward more inclusive sizing. This is an important step forward for Lululemon and I am excited that later this month we will start to offer some of our core styles in sizes 0 to 20 and this is just the beginning. By the end of 2021, the majority of our women’s assortment will be available in our more inclusive size range. When looking at the men’s business overall, we saw sequential improvement relative to quarter one, although it lagged behind the growth in the women’s business. As the work-from-home and sweat-from-home environment continues, we have seen our male guests respond more enthusiastically to shorts, sweats and hoodies. Our merchant teams are chasing into these categories so we can maximize these businesses based on the current shift in demand. And our brand teams are focused on continuing to raise awareness among men and our dual gender line such as on-the-move provide an opportunity to grow in both the men’s and women’s business. Our opportunity within product remains in the early innings. We have only just begun to leverage our work within the signs of feel innovation platform and we have ample ways to expand our key categories run, train, yoga, and on-the-move. In addition, the Lululemon brand is positioned well to take advantage of the shifts we are seeing in the marketplace towards apparel that provides versatility, comfort and technical innovation.

Before shifting to our outlook, let me update you on two of our omni guest initiatives, MIRROR and Membership. MIRROR is a further example of how we are considering and evolving new aspects of our business through an omni lens. As you know, we closed on the MIRROR transaction in early July and I couldn’t be more excited with the potential MIRROR brings to Lululemon and the opportunities Lululemon brings to MIRROR. As I stated, when we announced the acquisition, MIRROR is a standalone revenue generating company and their management team will continue to operate the business from their offices in New York. There is no need for heavy integration work and we have begun the process of bringing them into the Lululemon family so that we benefit from our collective strengths. We are on track to begin offering the MIRROR in 10 to 15 Lululemon stores in the United States by early quarter four when we will also begin leveraging our digital channels to help build the brand awareness.

From a financial standpoint, we continue to believe that MIRROR will be modestly dilutive to earnings this year. We plan to ramp up marketing and advertising spend in the second half of the year to fuel MIRROR’s momentum during the holiday season and into 2021. The initial work we are doing with MIRROR during the upcoming fall season will set the stage for next year when we expect to be more aggressively leveraging the power of the Lululemon ecosystem to grow the MIRROR business. Meghan will provide you with more details in a moment.

Shifting to Membership, I am excited to announce we are continuing to test a program in Edmonton, Chicago and Denver and starting this week we will also bring the program to our guests in Toronto for the first time. The membership program continues to celebrate community connection and provides a range of offering such as special product, dedicated online sweat classes and inspiring guest speakers to extend the Lululemon experience. With COVID-19 in mind, I am proud of how our teams have evolved to a virtual event format with plans to return to studio classes and physical gatherings once safe to do so. As we continue to test and learn through membership and integrate MIRROR into the Lululemon family, we are gaining valuable insights on guest behavior that can help us further improve our offering and enhance the ability of our guests to fully experience the sweat life.

Let me now share our thoughts on how we are approaching the second half of the year. Meghan will share some specifics regarding our financial outlook, but I wanted to provide you with our planning framework for the fall season. Our starting point is that the environment remains uncertain. COVID is not yet contained in many of the markets where we operate and while we expect the recovery to advance, we continue to plan for multiple scenarios this fall and particularly for the holiday season. We have pulled forward several IT investments related to our e-commerce business, increased our DC and fulfillment capabilities, and are continuing to grow the ranks of our omni educators to ensure our guests receive the service and experience they are accustomed to should our e-commerce business spike even more in quarter four. We continue to work with our vendors to ensure the proper timing of upcoming merchandise flows and can pull forward deliveries of select styles should unanticipated demand develop and we continue to protect our downside by tightly managing expenses and the outlay of capital.

Let me now turn it over to Meghan.

[Meghan Frank]

Thanks, Calvin. I will start by providing details on our Q2 performance and although we are not providing specific guidance, I will offer some color on outlook for the remainder of the year. I will also discuss specifics on our balance sheet, including our cash position, liquidity and inventories. Please note that the adjusted Q2 financial metrics I will share include the operating results of MIRROR beginning on July 7, the date the transaction closed, but exclude $11.5 million of pre-tax acquisition related costs. You can refer to our earnings release and Form 10-Q for more information and reconciliations to our GAAP metrics.

For Q2, total net revenue increased 2% to $903 million. And while we are still in the COVID-19 recovery phase, this was above our expectations of high single-digits decline. In our digital channel, we posted a 157% constant dollar comp increase on top of the 31% increase last year. Given the significant number of temporary store closures in Q2, we do not know store comp is a meaningful metric to evaluate performance. As we evaluate our top line performance, we will continue to be focused on total revenue, our digital business trends and open store recovery trends, which I will offer some additional color on as we move into our outlook. Square footage increased 15% versus last year and driven by the addition of 46 net new stores since Q2 of 2019. During the quarter, we opened 17 new stores 8 in North America, 4 in Mainland China, 3 in other markets across Asia and 2 in Europe. We also completed two planned optimizations. In terms of our digital channel, e-com contributed approximately $554 million of top line or 61% of total revenue. A constant dollar e-com comps exceeded our expectations increasing 157%. Excluding the impact of our online warehouse sale, e-com comps grew 137%, while we were pleased with our online warehouse sale results, I did want to highlight that overall for the quarter, we saw strength and full price sales as reflected on our flat product margin results year-over-year.

In terms of e-com drivers, we continue to see strength and traffic, and conversion which increased over 90% and 45%, respectively. Traffic was driven by channel shift coupled with investments in digital marketing, and conversion continues to benefit from guests response to our product, and the investments we have made in our global digital platforms to improve guest experience. Those profits for the second quarter was $489.5 million, or 54.2% of net revenue compared to 55% of net revenue in Q2 2019. The gross margin decline of 80 basis points was driven by 130 basis points of de-leverage on DC related costs, which was offset by 40 basis points of product team costs leverage and 30 basis points of occupancy and depreciation leverage. Product margin was flat year-over-year inclusive of the online warehouse sale, as lower product costs and product mix offset higher markdowns. They also experienced a 20 basis point negative impact from foreign exchange.

Moving to SG&A, our approach in the current environment has been to protect against downside while also ensuring we continue to invest in our long-term growth opportunities. SG&A expenses for approximately $353 million or 39.1% of net revenue compared to 36% of net revenue in Q2 2019. The deleverage in the quarter resulted predominantly from lower revenues due to COVID-19 related store closures and our commitment to continue to pay our employees through this period of disruption. We also associated with COVID-related supplies and PPE, de-leverage and depreciation and de-leveraged from here. These are partially offset by expense reductions relative to our original budget coupled with a recognition of some government wage subsidies in the quarter.

Adjusted operating income for the quarter was approximately $136 million or 15% of net revenue compared to 19% of net revenue in Q2 2019. Adjusted tax expense for the quarter was $39.2 million or 28.9% of pretax earnings, compared to an effective tax rate of 26.4% a year ago. The increase in our adjusted effective tax rate compared to last year relates primarily to changes and guidance associated with certain U.S. tax reform measures, which reduced the effective tax rate in the second quarter of fiscal 2019. Adjusted net income for the quarter was $96.3 million or $0.74 per diluted share, compared to earnings per diluted share of $0.96 in Q2 of 2019. Capital expenditures were approximately $53 million for the quarter, compared to approximately $67 million in the second quarter last year. Q2 spend relates primarily to store capital for new locations, relocations and renovations technology spent to support our business growth, digital channel and analytics capabilities and supply chain investments.

Turning to our balance sheet highlights, we ended the quarter of $1.2 billion of total liquidity. We have had $523 million in cash and cash equivalents and approximately $700 million of available capacity under our committed revolving credit facilities Inventory grew 36% versus last year with $673 million at the end of Q2. We now believe Q1 was the high point for year-over-year inventory increases for 2020. We expect levels in the second half to moderate further and increase in a 20% to 30% range. Our repurchase program remains on pause as part of our COVID-19 cash management strategy. They have approximately $264 million remaining on our current $500 million purchase plan.

Let me shift now to current trends and share with you some color on how we are looking at the remainder of the year. Due to the dynamic nature of the macro environment, we are not returning to our historical cadence to providing specific guidance for the current quarter and fiscal year. We continue to plan for a number of scenarios in order to ensure we have the appropriate flexibility to manage the business through a range of second half outcomes. These include scenarios around store trend recovery and let us continue COVID-19 impacts across the globe.

We are focused on and benefiting from leveraging our omni-model and digital strength as we navigate this uncertainty. We have continued to see guests shift between channels, which has driven outsized growth on our e-commerce sites. As Calvin mentioned, we have pulled forward investments in our digital channel to ensure our guests continue to receive an elevated experience when shopping our sites and to maximize second half and holiday business. In terms of stores, we currently have approximately 97% of our stores open across the globe with only a handful of closures in North America and Australia. All of our distribution centers are up and running. The average productivity of our reopened service is approximately 75% of last year’s volume.

As we continue to prioritize our people in our guests, we are still limiting capacity and operating on reduced hours in many locations. We believe these restrictions coupled with our relatively small store size and high productivity comparisons continue to impact guest traffic. When looking at new store openings for 2020, we expect to open 30 to 35 net new stores with 15 net new stores open through the end of Q2. These openings will contribute to a low double-digit increase in square footage for the year. In addition, we are maintaining our seasonal store strategy. We operate at just over 50 seasonal stores in Q2 and plan to operate approximately 70 in the second half of the year.

Looking forward for the business overall, we continue to anticipate the trend in total revenue growth to improve sequentially throughout the remainder of the year. Inclusive of MIRROR in Q3, we expect total revenues to increase in the mid to high single-digit range with Q4 increasing in the high single to low double-digit range. It’s important to note that our view on total revenue growth in the back half assumes no improvement to the 75% productivity levels we are currently experiencing in reopened stores. In our digital channels, we expect revenue to remain strong and well above our pre-COVID growth rates of 30% to 40%, but moderate in the second half relative to Q2 with the majority of stores open.

And finally, we are now assuming that MIRROR will generate in excess of $150 million in revenue for the full year 2020. As from our initial expectation, which was revenue in excess of $100 million, we made the strategic decision to increase marketing spend for MIRROR in the second half to take advantage of current trends towards spending from home and capitalize on the opportunity to drive business during the holiday season and into next year. The increased marketing spend, which will help acquire new guests in the near-term and should also produce a return over the longer term through increased product and brand awareness will contribute to modest earnings dilution reflected in our outlook. For gross margin, we continue to expect the second half of the year to be better than the first half with the decline relative to last year in Q3, followed by flat to modestly up gross margin in Q4. We remain on track to deliver savings of $40 million in non-merchandise expenses included with a gross margin relative to our original budget.

In terms of SG&A for the full year, we expect de-leverage to continue in the back half as we prudently invest in select growth initiatives, particularly digital and store traffic likely remains below last year’s levels. In addition, while MIRROR’s dilution on our P&L would be modest for the year overall, the bulk of this will be realized within SG&A contributing to de-leverage in Q3 and Q4. We remain on track to realize $130 million in gross SG&A savings by the end of the year relative to our original budget.

With regard to earnings per share compared to a year ago, if we look at just the Lululemon business, we expect an adjusted EPS decline in the 10% to 15% range in Q3 and adjusted EPS to grow modestly in Q4. When looking at our combined results for Lululemon and MIRROR, we expect an adjusted EPS decline in the 15% to 20% range in Q3 and a modest decline in Q4. For the full year 2020, excluding acquisition costs, we continue to expect MIRROR to be modestly dilutive at less than 5%. In terms of capital spending, we expect CapEx for 2020 to be below our original budget and generally in line with last year. We are prioritizing spending on digital and omni initiatives and fulfillment capabilities, while pulling back somewhat on new store openings and remodels.

Before handing it back to Calvin, I would like to reiterate that we are cautiously optimistic with regard to the holiday season and we continue to plan the business based on multiple performance scenarios. Our guidance assumes store productivity remains consistent with the levels we have seen recently and we experienced ongoing strength in our e-commerce business. Longer term, we remain committed to our power free growth plan and we are excited with the opportunities to remain in front of us.

And now back to Calvin for some closing remarks.

[Calvin McDonald, Chief Executive Officer]

Thank you, Meghan. And I want to take this moment to also thank all of the Lululemon employees around the world to continue to be agile, nimble and creative as we meet and exceed the expectations of our guests during this time. I am proud of the resiliency and flexibility of the business that allows us to deliver results like these that demonstrates both our near-term and long-term strength and I continue to be impressed by how our leadership team is is showing up both as they lead their teams and strategically co-create our future. We all feel that Lululemon is becoming stronger quarter by quarter. And it’s a testament to our people, our ability to innovate, and our enduring connection with our guests. We love to serve. We are now pleased to take your questions. Operator, we can now open it up for Q&A.

[Operator]

[Operator Instructions] The first question comes from Lorraine Hutchinson with Bank of America. Please go ahead.

[Lorraine Hutchinson, Bank of America]

Thanks. Good afternoon, I wanted to ask about how you are thinking about managing any holiday volume challenges, whether store capacity constraints or higher shipping costs. It sounds like we will be opening some seasonal stores to help with that. Are there any other plans in place to try to ensure that you can successfully manage through this tough 4Q environment?

[Calvin McDonald, Chief Executive Officer]

Yes, hello, it’s Calvin. Absolutely we I break it into a couple of key strategic buckets that we have been working on early on. The first was pulling forward our investments to ensure that the infrastructure both our supply chain, as well as our websites around the world, were ready for the type of volume that we are anticipating. We have run a variety of scenarios if you think obviously fourth quarter volume is the highest volume within a year. And we are seeing exponential growth on e-commerce. So we sort of applied that modeling to the back half as sort of the benchmark of what we needed to prepare for. And we pulled those investments forward to ensure a readiness on the site and the infrastructure in order to support and then we have been investing into the guest experience, call center, being one of the key areas, looking at how we can mobilize our educators to not just be able to work in the physical but as well as being able to service our guests online, both through a concierge service as well as a call center. So leaning in and ensuring that we have the infrastructure to support and the guest Education Center to support are two of the big important factors and that is anticipating our online volume in a physical space there is a variety of initiatives that we keep innovating to take away the operating constraints, that’s the reality of operating through COVID. We have all seen the lines at our stores we know that guests are, willing and are waiting to queue up. And our challenge is, how do we get more into the store and transact at a quicker rate. So variety of innovations have gone into that from the virtual line lineup that I share, shared as well as how we just check guests out and service them outside of the store. And then the seasonal stores is a is a big shift as well tapping into our nimble fleet where, last year in fourth quarter, we had 51 seasonal stores This year, we are planning on 70. And in some locations, we may even be doubling up in a in a mall or a location where we have an existing store so we can pick up some of that overflow. So those things combined. We feel good that we will be ready for the volume where we need to be in maximizing the potential physical space with some of the innovation that I shared with you.

[Lorraine Hutchinson, Bank of America]

Thank you.

[Operator]

The next question comes from Matthew Boss with JPMorgan. Please go ahead.

Matthew Boss, your line is live. The next question comes from Mark Altschwager with Baird. Please go ahead.

[Mark Altschwager, Baird]

Hey good afternoon. Thanks for taking my question. On the product margin, can you walk through some of the drivers there relative to the strength that you saw in Q1? I guess specifically, I am wondering how much of an impact the warehouse sale had in the quarter and whether the plus 180 we saw in the first quarter might be a better indicator of the underlying run-rate in the business.

[Meghan Frank]

Yes, thanks, Mark. It’s Meghan. So, we were really pleased with the strength we saw in product margin in the quarter. As you heard, we did do an online warehouse sale, which compressed really with our stores closed, markdowns selling into one period. But when we look across the quarter, we saw some really nice strength out of full-priced selling. We are not going to offer color on product margin specifically as we move into the second half, but we are expecting gross margins in the second half the year to be better than the first half and expect a decline in Q3, returning to gross margin expansion year-over-year in Q4.

[Mark Altschwager, Baird]

That’s very helpful. Thank you. And then just a follow-up, thanks for all the detail on the productivity trends and digital, does it – any further help on what you are seeing quarter-to-date in each of the channels relative to what you saw in second quarter?

[Meghan Frank]

Yes. So we are tracking relatively in line with the top line color we have provided, which is total revenue growth in the mid to high single-digit range for the quarter.

[Mark Altschwager, Baird]

Thank you very much. Best of luck.

[Operator]

The next question comes from Matt McClintock with Raymond James. Please go ahead.

[Matt McClintock, Raymond James]

Thank you everyone. And it’s McClintock, but good job trying. Honestly, I wanted to start with just fulfillment capacity and it’s kind of a follow-up to Lorraine’s question, but I want to understand the investments that you are making in terms of fulfillment volume, your ability to handle more volume versus customer service your ability to deal with customer service with these higher levels of volume, where does that position you longer term? I understand you are getting ready for the fourth quarter, but I want to think 2 years out, 3 years out that you are already building the ability to handle volume of 5 years from now, 6 years from now or is this because you are going so fast, you are still trying to just kind of keep up with that and still add some safety room? Thanks.

[Calvin McDonald, Chief Executive Officer]

Thanks, Matt. We are definitely well ahead of the volume that we had anticipated and modeled in our 5-year growth plan that we shared last spring. And under the Power of Three and when we looked at doubling our digital business, we are definitely trending ahead of that run-rate. So, these investments that we are making this year, I would break into a number of factors, one is our distribution capability of both fulfilling stores as well as e-commerce, e-commerce orders, ensuring we have the right safety measures in place to maintain continuity of operating the DCs, which I am very proud of the work that the team did today to operate through while maintaining and putting the health and safety of our warehouse distribution, employees front and center on the website, improving this ongoing stability, the ability to take the traffic and convert and we saw traffic in quarter two increase by 91%, conversion increase by 46%. So, these combined with the volume are ahead of where we anticipated and there is just general infrastructure investments you need to make to be able to scale the business like that. Fortunately, we are predominantly cloud based now, which allows us to more easily expand both in North America and internationally. Internationally, our total business was up 37%, that’s including stores in the quarter. Every region in Europe and APAC and China grew and we saw significant growth in e-commerce. So, we are experiencing it in all markets and we are investing there in the infrastructure support that volume. We are definitely going to come out of the year ahead of where we thought we would be in the 5-year plan on a dollar perspective and we will continue to invest in as we look forward to the 23 plan and then obviously our planning beyond that prioritizing the investments. I mean, what’s centered at our strategy is an omni ecosystem and approach and digital plays a big part of that. And we are going to keep investing to ensure that we support the growth of the business and take a long-term view on it.

[Matt McClintock, Raymond James]

Thanks for that color. And then just as a follow-up, we have started noticing a lot more Lululemon instructors on MIRROR and I was just because we talked about starting to integrate the two companies a little bit, I wanted to get your thoughts on bringing your ecosystem on to MIRROR and how it’s impacting local communities? Are you seeing engagement, greater engagement levels in local communities where you have maybe local instructors teaching on MIRROR now? Thanks.

[Calvin McDonald, Chief Executive Officer]

Great, thanks. I would say, as we have alluded, it is very early. And we, we have started a partnership with MIRROR over a year ago last spring. And, in fact, through that partnership, we had some of our Lululemon ambassadors on the MIRROR platform last fall and that gave us a lot of test and learn opportunities to see how the MIRROR guest was interacting with both that Ambassador as well as the interaction of at home sweat, and that among with many other metrics, gave us the confidence and led to the excitement about making the acquisition so we look forward, we are moving forward with, the notion of a line integration, we are going to be selling in 10 to 15 stores this year, selling it on lululemon.com as it means to building awareness, and it really is set up as a test and learn and focus on 21. And as Meghan shared, even with a light integration, we are anticipating, solid improvement in their forecasts shared earlier, revenues in 150 million. And as we continue to integrate as we continue to, tap into the ambassadors in the community, and expand selling into more of our stores. We are excited about that growth opportunity center of how we are viewing our strategy moving forward, and where we feel it’s very unique versus some other players is the Omni ecosystem that is going to include both physical and digital sweat, so the Lululemon membership is rooted in physical sweat MIRROR is rooted predominantly in digital sweat and we see a relationship between the two and at the community level, so we will continue to innovate and expand into that with more to share. But that is really the unique point of our strategy and vision and MIRROR fits into it well, and will be a part of the community both digitally as well as within the physical representation of our ambassadors, our stores and others as we look to, to drive that business forward.

[Matt McClintock, Raymond James]

Thanks for those very exciting times.

[Operator]

The next question comes from Adrienne Yih with Barclays. Please go ahead.

[Adrienne Yih, Barclays]

Calvin, I was wondering if you can talk about product category expansion, and the introduction of ongoing innovation newness for both the back half of this year, and then into 2021. And then Meghan, if you can just talk to us about how you have moved through inventory through the, I think there were three channels that you mentioned, or strategies last time, and how we should think about that at the end of both 3Q and 4Q? Thank you very much.

[Calvin McDonald, Chief Executive Officer]

Great, thanks. In terms of our product expansion, we have shared the four key sweat activities that we are focused on as a business, run train and yoga with on the move, being, you know, one of the key categories and we are sort of taking unique point of view is our most recent campaign, sort of picked up on which is notion life is a sport and we see a lot of growth just in how we provide head to toe options and solutions for the guests in those activities equally. We have a number of sweat activities that our loyal guests choose as either their secondary or tertiary sweat options that we equally see opportunity to expand our current assortment. And, and we are working to do that we are innovating into that. And we are excited about bringing a little, continual newness as well as continuity to the sweat activities for both our men’s business as well as our women’s business and accessories. So, there is a lot of new innovation in the pipeline. We shared the launch of our pant business this quarter with the City Sleek initiative with much more OTM planned for the back half and into next year and into these new sweat categories. So, I continue to be incredibly energized about the product pipeline, both the newness as well as the opportunity we have and what we have already declared and then the expansion of new categories that would be completely incremental for us building business, footwear in the coming years. So, I think it’s exciting to see the work that Sun and the teams doing in and around product through signs of feel and really believe we are early in what we offer in North America and then even more so internationally, so see a long runway of growth with product.

[Meghan Frank]

Great. In terms of inventory, we are pleased with the level of composition coming out of Q2. Our inventory was up 36% year-over-year, which was under our Q1 year-over-year balance. We have previously thought end of Q2 would be our high point and now we expect that will be Q1. So as you know, we did do an online warehouse sale during the quarter we are pleased with those results. But again, I just point back to we are also very pleased with our full price sales results. We do expect inventory to moderate in the second half of the year up 20% to 30% as we move into the third and fourth quarter and I just as again, a reminder, we do benefit from core being approximately 40% of our assortment.

[Adrienne Yih, Barclays]

Great, thanks so much. Nice job in a tough environment.

[Meghan Frank]

Thank you.

[Calvin McDonald, Chief Executive Officer]

Thank you.

[Operator]

The next question comes from Ike Boruchow with Wells Fargo. Please go ahead.

[Ike Boruchow, Wells Fargo]

Hi, just two quick questions. Just back on the inventory, we understand this is the highpoint has been past and it’s going to moderate in the back half, the 20% to 30% is still pretty well above your sales trend, I am just kind of trying to understand your comfort with inventory you are carrying, if we should be on the lookout for more potential events to clear inventory in the third or fourth quarter. And then any chance you guys could explicitly breakout the MIRROR revenue contributions that you are planning in Q3-Q4? Thanks.

[Meghan Frank]

Yes, thanks. It’s Meghan. So I think in terms of inventory, what I would say is again, just 40% of our assortment is approximately 40% is core and we expect inventory levels to moderate through the second half of the year as we mentioned, 20% to 30% as you know that is about sales growth, but we feel comfortable with the level based on reflowing inventory and taking into consideration that core portion. We do expect gross margin in the second half of the year to improve relative to the first half and we expect again a decline in Q3 and returning to growth in Q4. And then in terms of MIRROR, we are not going to breakdown on the second half estimate, about $150 million, in excess of $150 million for the full fiscal 2020.

[Ike Boruchow, Wells Fargo]

Okay, thanks.

[Operator]

The next question comes from Alexandra Walvis with Goldman Sachs. Please go ahead.

[Alexandra Walvis, Goldman Sachs]

Good afternoon. Thanks so much for taking the question. I had a question on the e-commerce growth. I was wondering if you could share any more color on the cadence of that growth through the quarter and indeed quarter-to-date. And also whether you might be able to share the composition of e-commerce revenue between existing customers and new to Lululemon customers? That would be really helpful.

[Meghan Frank]

Great. So, in terms of the e-commerce cadence, we have mentioned that we saw 125% when we were reporting Q1 at the start of the quarter. So, we did see a pickup as we move throughout Q2. And we saw 157% for the quarter and it was 137% excluding online warehouse sales. We have seen as I mentioned in line with our expectation of that year-over-year growth rate moderating as stores opened for the full period of Q3 and into the second half. We do expect e-com to be above the 30% to 40% growth rate that we experienced prior to COVID.

[Alexandra Walvis, Goldman Sachs]

Great. Very clear. And then one more question from me, you are expanding this loyalty test to another city in Vancouver, any incremental color you can share on what you have learned from the loyalty pilots so far or anything that you are tweaking as you move into the subsequent pilot in Vancouver?

[Calvin McDonald, Chief Executive Officer]

Yes, absolutely. Thanks, Alexandra. First just to clarify the added cities Toronto that we are adding, so we are repeating in 3 of the 4 cities, repeating at Edmonton, Chicago and Denver and we tested in Austin with great results. But we elected to bring in a larger city with Toronto to test and learn so Toronto is going to be the new market. And what we continue to see in the adjustments we have made, obviously the essence of the program is rooted in connection and community with physical being a big part, the team has done a wonderful job shifting to virtual events, the sweats or speaker series, or other tutorials that guests have engaged incredibly well in that really set up a lot of interesting learning as we think forward around the program. And we will moderate as we see studios open and guests being able to physically sweat, but where we have landed is a good balance of physical sweat combined with access to product and then rooted at the notion of community and connection, $168 for the one year, and we go on making it available this week, and we are excited to see the results. And in every test city we have done, we have seen very positive response from the guests, a high loyal team engagement and intend to repeat, and it does have a positive impact on their overall purchases of Lululemon as well as recruitment of new guests. So from a guest metric standpoint, it’s very encouraging. And it is early and we are taking it through a test and learn phased approach Toronto is going to be a great new addition. COVID has been an interesting balance based on the positioning and the membership program, but I am very excited about how the guest has continued to engage in it, if anything has given us more confidence than not about the potential, and we will, test and learn through these markets with, plans to, continue to look at adding additional markets in the coming year.

[Alexandra Walvis, Goldman Sachs]

Great. Thank you so much for all the color and all the best.

[Operator]

The next question comes from Omar Saad with Evercore. Please go ahead.

[Omar Saad, Evercore]

Hi, thanks. Good afternoon. Congratulations on another great quarter. I wanted to ask a little bit more about your international results kind of compare and contrast versus your core North America market the China number was pretty impressive.

Is that a good may be a contrast to compare the patterns you are seeing in those markets online and stores? Did you see experienced pent up demand there? Maybe some of the differences you would call out for the kind of consumer behavior patterns, you are seeing the guest behavior patterns you are seeing in North America and Europe as well it will be great to get that feedback? Thanks.

[Calvin McDonald, Chief Executive Officer]

Great. Thanks, Omar. I will start by just sort of teeing up the North American business as we have sort of shared from Q1 to Q2, we are really pleased with the progression we saw in both Canada and the U.S. Stores performed similar in both markets. Predominantly, that’s linked to the operating constraints that we had to operate under with small stores that were incredibly productive. And we just had challenges being able to match the same productivity numbers as the previous year. Any commerce obviously picked up a large share of that additional demand and overall the mix of the business we are very pleased with and it was a significant improvement from the Q1 performance. Internationally, I will start with China because it continues to just build steam and momentum from, Q1 when we had the early closings to when the stores reopened, and we are seeing incredible growth in both our e-commerce number which was up 136% in China in stores, which are up, significant, growth, as we saw through the quarter and heading into this quarter. They are benefiting from a lot of the domestic travel that is occurring. But from a brand perspective, we have opened up a number of additional doors, and they have all performed well ahead of plan. In tier two cities, we continue to see great growth and reaction to the brand and we are acquiring new guests and both channels are performing very strong, so very excited about what we continue to see as an inflection in our business in China and the momentum behind it in the growth that it’s driving, which is by far the strongest of any market that we are in to-date in this quarter. And when Europe and rest of Asia-Pacific very positive growth lead in e-commerce, e-commerce numbers similar to that in North America, which is really exciting for us, because it’s acquiring new guests and it’s resetting how high it’s high with our online business and potential as we think about assortment, think about our physical real estate strategy and entering into new markets. So, I am excited overall with the performance of our business internationally and continue to see guest acquisition increase the expansion of the brand led by China, but very strong in all markets that we are in.

[Omar Saad, Evercore]

Great. And then a quick follow-up on MIRROR, why only 10 to 15 stores for the fourth quarter, are there capacity constraints or you just want to build it slowly? Thanks.

[Calvin McDonald, Chief Executive Officer]

Yes, it’s definitely, build it slowly and test and learn and be able to go a little bit more aggressive in ‘21 and we are going to test and learn between the balance of making it available and increasing awareness through dotcom, making it available through stores, we are in a good supply chain perspective now. Their average delivery is 7 to 10 days in terms of inventory flow obviously during early COVID, that number was expanded. They have been able to play catch up and we are sitting in a good position, but we see this as an exciting position long-term and there is good momentum already in that and we are going to add to it, but it is really test and learn with the focus on ‘21.

[Omar Saad, Evercore]

Thanks. Best wishes.

[Calvin McDonald, Chief Executive Officer]

Thank you.

[Howard Tubin, Vice President, Investor Relations]

Operator, we will take one more question. Thanks.

[Operator]

Certainly. Our next question comes from Matthew Boss with JPMorgan. Please go ahead.

[Matthew Boss, JPMorgan]

Great, thanks. We will try this again. Calvin, on the inflection that you cited for retail and for Lulu from here, can you first elaborate on investments from market share that you have accelerated during the crisis? And then also in digital, how – what’s the best way to think about the sustainability of digital channel operating margins relative to the 40% plus that you have achieved the last several years?

[Calvin McDonald, Chief Executive Officer]

Yes, I will touch on the inflection as well as how we are leaning in and how we are planning to continue to lean in. Clearly, health, wellness and functional apparel and trends in apparel have changed dramatically and I don’t perceive them defaulting back to pre-COVID sort of awareness with the guests, I think health and wellness trends are here to stay, I think that some of the trends we have seen in fashion and what guests are going to expect in apparel and in how they dress and how they want their apparel to perform are here to stay. And both of those benefits, our brand and our positioning in a number of ways, predominantly linked to our Power of Three growth strategy around product omni guest in creating that ecosystem as well as market expansion. So, I am excited about the potential of growth. And what we do know is and we have shared this before is even with the success of our business to-date, we have awareness opportunities. We have significant awareness opportunities with men in North America and in our international markets, awareness and consideration is – and remains our – one of our big exciting opportunities. So, we definitely leaned in, in Q3 with digital marketing plan to do more of that in the back half and into next year. Part of the success we saw internationally was turning on digital marketing and CRM in a more aggressive way than we have traditionally done in the past and it responded very well. So, the teams are going to continue to learn. We are continuing to sort of play with our rollouts and what we want and expect from the investments in how we get our brand known and have that awareness metric improve in the coming months, in the coming years. So, I just think the world is looking for more of what we have to offer and our opportunity we know is that awareness around offering it is still a big opportunity for us and we are going to lean in and invest in the back half of this year and into next year to do that and that’s all part of the guidance and margin that Meghan has provided and it’s also inclusive – there is no change to our Power of Three 5-year view of the financial model that we shared as well last spring. So, it’s all incorporated in that how we chase and lean, but it’s an exciting opportunity for us to drive awareness and we see the opportunity and we are shifting investment to go after it.

[Matthew Boss, JPMorgan]

Great. And then just one follow-up, just on the digital trend in August and early September, is there any driver of the moderation that you have cited relative to the second quarter or maybe just any commentary to think about as we have tried to think through the magnitude at all as we think about the current momentum that you guys carry so far into the third quarter?

[Meghan Frank]

Yes, I wouldn’t say there is a driver to the moderation, it’s really looking at the omni trend overall, which again we see in the mid to high single-digit range and just with a lion’s share of the stores open, just not seeing as much of a channel shift trend with our guests being able to access our store fleet.

[Matthew Boss, JPMorgan]

Great. Best of luck.

[Meghan Frank]

Great. Thank you.

[Operator]

That’s all the time we have for questions today. Thank you for joining the call and have a nice day.