Thank you for standing by. This is the conference operator. Welcome to the lululemon athletica inc. Second Quarter 2020 Earnings Conference Call. [Operator Instructions] And the conference is being recorded. [Operator Instructions] I would now like to turn the conference over to Howard Tubin, Vice President, Investor Relations for lululemon athletica. Please go ahead.

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'd 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, 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 our business, including those we have disclosed in our most recent 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 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 reports 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'd like to remind investors to visit our investor site where you'll find a summary of our key financial and operating statistics for the second quarter as well as our quarterly infographic. [Operator Instructions] And now I'd like to turn the call over to Calvin.

Thank you, Howard. I'm 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're seeing in the business as we look forward to the back half of the year. The results we're 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 product, 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'm 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 will be available to answer your questions during the Q&A portion. Before I detail our results, I'd like to speak for a moment about the importance of diversity and 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,…

Thanks, Calvin. I'll start by providing details on our Q2 performance. And although we are not providing specific guidance, I will offer some color on our 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 pretax 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 a high single digit decline. In our digital channel, we posted a 157% constant dollar comp increase on top of a 31% increase last year. Given the significant number of temporary store closures in Q2, we do not feel 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 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 2 planned optimizations. In terms of our digital channel, e-comm contributed approximately $554 million of top line or 61% of total revenue. Our constant dollar e-comm comps exceeded our expectations, increasing 157%. Excluding the impact of…

Thank you, Meghan, and I want to take this moment to also thank all of the lululemon employees around the world who continue to be agile, nimble and creative as we meet and exceed the expectations of our guests during this time. I'm 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 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're now pleased to take your questions. Operator, we can now open it up for Q&A.

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

I wanted to ask about how you're thinking about managing any holiday volume challenges, whether store capacity constraints or higher shipping costs? It sounds like you'll 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?

Lorraine, it's Calvin. Absolutely. I'd break it into a couple of key strategic buckets that we've 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're anticipating. We've run a variety of scenarios. If you think, obviously, fourth quarter volume is the highest volume within a year, and we're 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 readiness on the sites and the infrastructure in order to support. And then we've 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 2 of the big important factors, and that's anticipating our online volume. In the 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've 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 a variety of innovations have gone into that from the virtual lineups that I shared as well as how we just check guests out and service them outside of the store. And then the seasonal stores 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're planning on 70. And in some locations, we may even be doubling up 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'll be ready for the volume where we need to be and maximizing the potential of physical space with some of the innovation that I shared with you.

The next question comes from Mark Altschwager with Baird.

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'm wondering how much of an impact the warehouse sale had on the quarter and whether the plus 180 you saw in the first quarter might be a better indicator of the underlying run rate of the business.

Yes. Thanks, Mark. It's Meghan. So we were really pleased with the strength we saw in product margin in the quarter. You heard we did do an online warehouse sale, which compressed really with our stores closed, markdown selling into one period. But when we look across the quarter, we saw some really nice strength out of full price selling. We're 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 of 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.

That's very helpful. And then just a follow-up. Thanks for all the detail on the productivity trends and digital. Just any further help on what you're seeing quarter-to-date in each of the channels relative to what you saw in the second quarter?

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

The next question comes from Matt McClintock with Raymond James.

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're making in terms of fulfillment volume, your ability to handle more volume on the customer service, your ability to deal with customer service with these higher, higher levels of volume. Where does that position you longer term? I understand you're getting ready for the fourth quarter, but I want to think 2 years out, 3 years out. Are you building the ability to handle volume 5 years from now, 6 years from now? Or is this because you're growing so fast, you're still trying to just kind of keep up with that and still have some safety room.

Great. Thanks, Matt. We're definitely well ahead of the volume that we had anticipated, 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're 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 orders, ensuring we have the right safety measures in place to maintain continuity of operating the DCs, which I'm very proud of the work that the team did to date to operate through while maintaining and putting the health and safety of our warehouse distribution employees front and center. On the website, improving ongoing stability, the ability to take the traffic and convert. And we saw traffic in quarter 2 increase by 91%. Conversion increased by 46%. So these, combined with the volume, are ahead of where we anticipated. And there's just general infrastructure investments you need to make to be able to scale a business like that. Fortunately, we're 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're experiencing it in all markets, and we're investing there in the infrastructure to support that volume. We're 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'll continue to invest in as we look forward to the '23 plan and then obviously, our planning beyond that, prioritizing the investments. I mean, the center of our strategy is an omni ecosystem and approach and digital plays a big part of that. We're going to keep investing to ensure that we support the growth of the business and take a long-term view on it.

And then just as a follow-up, we started noticing a lot more lululemon instructors on MIRROR. And I was just -- because you talked about starting to integrate the 2 companies a little bit. I wanted to get your thoughts on bringing your ecosystem on MIRROR and how that's impacting local communities? Are you seeing engagement, greater engagement levels in local communities where you have maybe local instructors teaching on MIRROR now?

Great. Thanks. I would say, as we've alluded, it's very early. And we 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 light integration. We're only going to be selling in 10 to 15 stores this year, selling it on lululemon.com as a 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 the light integration, we're anticipating a solid improvement in their forecast shared earlier, revenues in the $150 million. And as we continue to integrate, as we continue to tap into the ambassadors and the community and expand selling into more of our stores, we're excited about that growth opportunity. Center of how we're viewing our strategy moving forward and where we feel it's very unique versus some other players is the omni ecosystem that's 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 2 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 drive that business forward.

The next question comes from Adrienne Yih with Barclays.

Calvin, I was wondering if you can talk about product category expansion and the introduction of ongoing innovation and 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've moved through inventory through the -- I think there were 3 channels that you mentioned or strategies last time and how we should think about that at the end of both 3Q and 4Q?

Great. Thanks. In terms of our product expansion, we've shared the 4 key sweat activities that we're focused on as a business: run, train and yoga, with on the move being one of the key categories, and we're sort of taking a unique point of view as our most recent campaign sort of picked up on, which is the 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 we're working to do that. We're innovating into that, and we're excited about bringing a little continual newness as well as continuity to these 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've 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 team is doing in and around product through Science of Feel. And really believe we're early in what we offer in North America and then even more so internationally, so see a long runway of growth with product.

Great. In terms of inventory, we are pleased with the level of competition coming out of Q2. Our inventory was up 36% year-over-year, which was under our Q1 year-over-year balance. We 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, pleased with those results. But again, I'd just point back to, we're 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 just as, again, a reminder, we do benefit from core being approximately 40% of our assortment.

Great. Nice job in a tough environment.

Thank you.

The next question comes from Ike Boruchow with Wells Fargo.

Just 2 quick questions just back on the inventory. I understand the high point has been passed and it's going to moderate in the back half, but 20% to 30% is still pretty well above your sales growth. I'm just trying to understand your comfort with the inventory you're 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 break out the MIRROR revenue contribution that you're planning in Q3 and Q4?

Yes. Thanks. It's Meghan. So I think in terms of inventory, what I'd 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 above sales growth, but we feel comfortable with the level based on redeploying the 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're not going to break down the second half estimate, that $150 million, in excess of $150 million is for the full fiscal 2020.

The next question comes from Alexandra Walvis with Goldman Sachs.

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.

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

Great. Very clear. And then one more question from me. You're expanding the loyalty test to another city, in Vancouver. Any incremental color you can share on what you've learned from the loyalty pilot so far and anything that you're tweaking as you move into the subsequent pilot in Vancouver?

Yes. No, absolutely. Thanks, Alexandra. First, just to clarify, the added city is Toronto that we're adding. So we're 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 and the adjustments we've 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, be it sweat 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've 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 1 year, and we go on making it available this week, and we're excited to see the results. And in every test city we've done, we've seen very positive response from the guests, high loyalty and engagement and intent 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's 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 of the membership program, but I'm very excited about how the guest has continued to engage in it. If anything, it's 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.

The next question comes from Omar Saad with Evercore.

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 -- maybe contrast and compare the patterns you're seeing in those markets online and in stores? Did you see, experience pent-up demand there? Maybe some of the differences you would call out for the kind of consumer behavior patterns you're seeing, the guest behavior patterns you're seeing in North America and Europe as well. It would be great to get that feedback.

Great. Thanks, Omar. I'll start by just sort of teeing up the North American business. As we've sort of shared, from Q1 to Q2, we're 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. And e-commerce, obviously, picked up a large share of that additional demand. And overall, the mix of the business, we're very pleased with, and it was a significant improvement from a Q1 performance. Internationally, I'll 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're seeing incredible growth in both our e-commerce number, which was up 136% in China and stores, which are up significant growth as we saw through the quarter and heading into this quarter. They're benefiting from a lot of the domestic travel that's occurring. But from a brand perspective, we've opened up a number of additional doors and they have all performed well ahead of plan. In Tier 2 cities, we continue to see great growth and reaction to the brand. And we're 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 and the growth that it's driving, which is by far the strongest of any market that we're in to date in this quarter. And though in Europe and rest of Asia Pacific, very positive growth, led in e-commerce. E-commerce number similar to that in North America, which is really exciting for us because it's acquiring a new guest and it's resetting how high is 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'm 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're in.

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?

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're going to test and learn between the balance of making it available and increasing awareness through dot-com, making it available through stores. They're 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've been able to play catch up, and we're sitting in a good position. But we see this as an exciting position long term. And there's good momentum already in that, and we're going to add to it, but it is really test and learn with a focus on '21.

Our next question comes from Matthew Boss with JPMorgan.

We'll try this again. Calvin, on the inflection that you cited for retail and for lulu from here, can you first elaborate on investments for market share that you've accelerated during the crisis? And then also on digital, what's the best way to think about the sustainability of digital channel operating margins relative to the 40%-plus that you've achieved the last several years?

Yes. I'll touch on the inflection as well as how we're leaning in and how we're planning to continue to lean in. Clearly, health, wellness and functional apparel and trends in apparel have changed dramatically. And I don't foresee 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've 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 benefit our brand and our positioning in a number of ways, predominantly linked to our Power of Three growth strategy around product, omni guest and creating that ecosystem as well as market expansion. So I'm excited about the potential of growth. And what we do know is, and we've 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 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've traditionally done in the past and it responded very well. So the teams are going to continue to learn. We're continuing to sort of play with our rollout and what we want and expect from the investments and how we get our brand known and have that awareness metric improve in the coming months and 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 our awareness around offering it is still a big opportunity for us, and we're 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 provided. And it's also inclusive. There's 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.

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 cited relative to the second quarter or maybe just any commentary to think about as we try to think through the magnitude at all as we think about the current momentum that you guys carry so far into the third quarter.

Yes. I wouldn't say there's 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 the 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.

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