Lululemon Athletica Inc. quarterly report, Q2 FY2014

Lululemon Athletica Inc. Form 10-Q Summary

Reporting period: The source is a Form 10-Q for the thirteen and twenty-six weeks ended August 3, 2014, compared with August 4, 2013. The request metadata identifies “2013 Q2,” but the filing itself reports fiscal 2014 second-quarter results.

Business Context

Lululemon designs and distributes technical athletic apparel through corporate-owned stores, e-commerce, showrooms, wholesale accounts, outlets and warehouse sales. At August 3, 2014, the company operated 270 corporate-owned stores, compared with 254 at February 2, 2014, across the United States, Canada, Australia, New Zealand and the United Kingdom.

Management described fiscal 2014 as a transitional year focused on product quality, supply chain investment, brand rebuilding, e-commerce growth, international expansion and scalable infrastructure. Seven net new corporate-owned stores opened during the second quarter, and the company opened an East Coast distribution center in Columbus, Ohio.

Financial Performance and Liquidity

Metric	Q2 FY2014	Q2 FY2013	Change
Net revenue	$390.7 million	$344.5 million	+13%
Gross profit	$197.3 million	$186.0 million	+6%
Gross margin	50.5%	54.0%	-350 bps
Income from operations	$67.9 million	$79.0 million	-14%
Operating margin	17.4%	22.9%	-550 bps
Net income	$48.7 million	$56.5 million	-14%
Diluted EPS	$0.33	$0.39	-$0.06

First-half revenue increased 12% to $775.3 million, while gross profit increased 10% to $393.1 million.
First-half operating income declined 5% to $137.7 million. Net income declined 35% to $67.7 million, and diluted EPS declined to $0.46 from $0.71.
First-half gross margin was 50.7%, compared with 51.7% in the prior-year period. Selling, general and administrative expense increased to 32.9% of revenue from 30.7%.
Q2 comparable sales declined 1%; excluding foreign currency effects, comparable sales were flat. First-half comparable sales also declined 1%, or increased 1% excluding currency effects.
Q2 corporate-owned store revenue rose 7% to $294.0 million, but comparable store sales declined 7%, primarily due to lower traffic. Direct-to-consumer revenue increased 29% to $63.5 million and represented 16.2% of Q2 revenue.
First-half direct-to-consumer revenue increased 25% to $129.5 million and represented 16.7% of revenue, compared with 15.0% in the prior-year period.
Cash provided by operating activities was $124.0 million for the first half, compared with $70.9 million in the prior-year period. Capital expenditures were $52.1 million.
Cash and cash equivalents were $725.1 million at August 3, 2014, compared with $698.6 million at fiscal year-end. Working capital excluding cash was $134.1 million.
The company had no borrowings outstanding under its aggregate $15.0 million unsecured revolving credit facilities, aside from letters of credit and guarantees. Letters of credit and guarantees totaled $0.6 million.
Financing cash outflows included $55.8 million to repurchase 1.4 million shares during the quarter. The board authorized repurchases of up to $450 million through June 2016; an additional $30.6 million was spent on repurchases through September 8, 2014.

Material Changes Versus the Prior Comparable Period

Revenue growth was driven by new stores, e-commerce and outlets, while comparable store performance weakened because of lower traffic.
Gross margin contracted due primarily to a higher mix of lower-margin seasonal products, higher product costs, supply-chain and product-development costs, fixed-cost deleverage and unfavorable foreign exchange. Lower markdowns and discounts partially offset these pressures.
Q2 SG&A increased 21% to $129.4 million, including higher employee, store, distribution, e-commerce, occupancy and corporate costs. A $1.3 million foreign exchange loss replaced a $4.4 million foreign exchange gain in the prior-year quarter.
First-half income taxes increased 67% to $73.5 million. The effective tax rate rose to 52.0% from 29.7%, primarily because of a non-recurring $31.3 million deferred tax liability for U.S. income and foreign withholding taxes on previously undistributed foreign-subsidiary earnings used to fund the share repurchase program.
First-half operating cash flow improved despite lower net income, benefiting from lower income tax payments and working-capital changes.
The company early adopted revised discontinued-operations guidance with no financial statement impact. The filing states that the impact of the new revenue-recognition standard and amended stock-compensation guidance had not yet been determined.

Outlook, Commentary, Risks and Contingencies

Management stated that cash flows, the balance sheet and liquidity provide flexibility to fund growth initiatives and expected liquidity needs for at least the next 24 months. The filing does not provide a specific revenue, earnings or margin guidance range.

Key operating risks include brand and product-quality deterioration, supply-chain dependence, limited fabric and manufacturing sources, raw-material costs, inventory forecasting, competition, international expansion and foreign exchange exposure.
A 10% appreciation of the Canadian dollar relative to the U.S. dollar was estimated to reduce first-half operating income by approximately $2.8 million. A 10% depreciation of the Australian dollar was estimated to reduce operating income by approximately $0.1 million. The company did not hedge currency exposure.
Several shareholder, derivative and books-and-records proceedings relate to the 2013 sheer Luon product issue, former CEO Christine Day’s resignation and certain insider stock trades. Some claims had been dismissed but appeals or related motions remained pending.
The company cannot estimate potential legal expenses, settlements or damages. It warned that adverse judgments or settlements exceeding insurance coverage could materially affect financial condition and liquidity.
The business is seasonal, with a significant portion of annual operating profit typically generated in the fourth quarter. Interim results may not indicate full-year performance.
Management concluded that disclosure controls and procedures were effective as of August 3, 2014, and reported no material change in internal control over financial reporting during the quarter.

Investor Verification Checklist

Verify the reporting-period discrepancy: the filing is for Q2 fiscal 2014, not Q2 fiscal 2013.
Assess whether comparable-store sales and traffic recover, particularly against continued store expansion.
Monitor gross-margin trends, product costs, seasonal product mix, foreign exchange and markdown activity.
Evaluate whether e-commerce growth can offset weaker store productivity without disproportionate fulfillment and administrative costs.
Reconcile the unusually high first-half effective tax rate and determine whether the deferred tax charge is non-recurring.
Track execution of the $450 million share-repurchase authorization and its effect on cash, share count and future liquidity.
Review developments in the shareholder litigation and any potential insurance, settlement or indemnification exposure.
Compare actual capital expenditures, store openings and cash generation with management’s stated ability to fund growth for at least 24 months.