Lululemon Athletica Inc (LULU) — Q3 2015 Earnings Call Transcript

Thank you, and good morning. Welcome to lululemon's Third Quarter 2015 Earnings Conference Call. Joining me today to talk about our results are Laurent Potdevin, CEO; Stuart Haselden, CFO; along with Miguel Almeida, EVP of Digital, who will be available during the Q&A portion of the call. Before we get started, I'd like to take this opportunity to remind you that our remarks today will include forward-looking statements reflecting company management's current forecasts of certain aspects of the company's future. These statements are based on current information, which we have assessed, but which by its nature is dynamic and subject to rapid and even abrupt changes. Actual results may differ materially from those contained in or implied by these forward-looking statements due to risks and uncertainties associated with the company's business. Factors that could cause these results to differ materially are set forth in the company's filings with the SEC, including our annual report on Form 10-K and our quarterly reports on Form 10-Q. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release. The press release and accompanying quarterly report on Form 10-Q will be available under the Investor section of our website at www.lululemon.com. Today's call is scheduled for one hour.

Thank you, Chris, and good morning, everyone. Today, I will provide an overview of our third-quarter performance as well as highlight our progress against various initiatives, which incorporates the recent changes to our organizational structure. Stuart will then walk you through our financial guidance in more detail. First, from a top-line perspective, the third quarter was in line with our expectations. We delivered $480 million in net revenue for the quarter, up 14% over the third quarter of 2014 and up 20% in constant currency. We achieved a 9% global combined comp, the result of strong performance across our channels and regions. Once again in Q3, store comps across all regions were positive and we delivered a global e-commerce comp of 21%. This solid top-line performance is a testament to the continued strength of our brand and loyalty of our guests. Our gross margin and inventory position came in within our expectations for the quarter, and we reported EPS of $0.38 per share. In line with macroeconomic trends, the start of Q4 has been mixed. We saw lower traffic in the final weeks of Q3 and into the first couple of weeks of Q4, with steady improvement since Thanksgiving. Given the current environment, we are taking a conservative stance with revenue in Q4, while taking the necessary actions to manage inventory and control expenses. Our work to build a scalable global supply chain is beginning to pay off and we saw an inflection of our product margins beginning in Q4. I would like to start by emphasizing that this year's investments in our product engine and supply chain remain very much on track. We are now seeing sequential improvement in product margin and remain focused and confident in our goals. We continue to strategically invest in people, processes, and technology that will deliver strong, long-term profitability and support our global expansion and 10-year vision. Stuart will provide more details within his comments on our strategic investments and progress on margin expansion, along with an outlook on our inventory levels. Our women's business has continued to be strong with an acceleration in pants and bras, where both categories delivered double-digit comps for the quarter. On our last call, we had just launched our new women's pant wall. This was among the company's most significant global launches combining education, innovation, and a re-imagination of this category. We have seen a fantastic response from our guest with women's pants generating a 27% comp in Q3 and bras were not also far behind with a strong comp of 18%. With new creative leadership and direction, the design team is laser focused on delivering new styles and innovation for the top and tank categories that will give our guests varying levels of support, coverage, and fit options. Our men's business continues to outpace our overall growth, comping 24% for the quarter. This performance was and continues to be attributed in large part to our sweat category, the anchor of the men's business. The technical function of our sweat assortment, combined with our deep community relationship with our ambassador, is what gives us long-term relevance and continues to set us apart. Our ivivva brand also posted double-digit comp growth with a 23% combined comp for the quarter. This strong performance continues to demonstrate how authentically this brand resonates with our young guests. And for those of you who are listening from New York, we just opened our first ivivva pop-up location in Union Square, and I encourage you to drop in and discover it for yourself. Turning now to creating amazing experiences for our guests. We have fully deployed RFID to all North American stores. This technology is a powerful new tool in creating seamless guest experiences across all channels and has greatly enhanced our ability to access inventory quickly across all channels and locations. Our in-store ability to access our incoming inventories through our bag backroom app accounted for 8% of e-commerce revenue for the quarter. We continue to engage new communities as we open new locations across the world. In November, we opened our Flatiron flagship in New York City. This amazing location holds our largest store to date and offers dedicated concierge services delighting guests with everything from booking the most products or classes to discovering the best runs in the city. This location serves local New York guests and is a platform for the rest of the world to discover lululemon. Located on the lower level of the store, HUB seventeen is a 3,000-square foot space dedicated to connecting our guests with ambassadors amongst many other things. It's an incredible space for our collective to engage with friends, sweat, enjoy the work of local artists and live music. Throughout Q3, we made further progress expanding our global collective. We opened our first store in Dubai at the Mall of Emirates and have a second store planned by the end of the year. In Europe, we opened 2 new stores including Marylebone in London as well as 2 new showrooms. In Asia, we opened our second location in Hong Kong at Hysan Place, and I'm extremely pleased with its performance since opening. In the second week of Q4, we launched our shop-in-shop on Tmall, attracting 165,000 unique visitors on the first day, clearly validating the strength of the platform as a key to building our brand awareness in China. Tmall provides an opportunity to introduce new guests to our brand and support our existing showroom locations as we continue to build our community in China. In addition, the performance of our showroom in South Korea continues to far exceed our expectations, and we are excited to open 2 new stores in Seoul in the first half of next year. On the brand and community side, we launched a number of engaging initiatives. Om Canada was a celebration of our roots and included community events across the country. I recently visited Toronto and was amazed at the thoughtful execution of this program among our 6 stores and our continued commitment to our home market. We are seeing this focus clearly pay off as Canada posted another positive store comp in Q3. Finally, I'm thrilled to share the progress we've made to our organizational structure. Over the past 18 months, we've built a global world-class management team that is diverse and culturally aligned to drive our strategic global priorities and successfully position us to lead into our 10-year vision. In October, we appointed Lee Holman as our Creative Director, uniting both men's and women's vision under one overarching design. Lee brings a perfect balance of function, design, and craftsmanship, making his ability to solve problems for athletes second to none. Dr. Tom Waller was promoted Senior Vice President, Whitespace, our R&D facility. Tom will continue to lead our team of scientists and engineers and be the catalyst for innovation across the entire organization. By elevating our passion for design and innovation, we will continue to strengthen our position as the global market leader in the category we created. Stuart Haselden has added Executive Vice President, Operations to his title, assuming broader responsibilities focused on driving operational excellence. And we are well along in the process of selecting a Chief Supply Chain Officer who will take on the work we started to optimize our global supply chain. Last, but certainly not least, this November, we announced the appointment of Gina Warren as Executive Vice President, Culture & Talent, reporting directly to me. Patience is paying off, and after a lengthy search, I am beyond thrilled to have Gina join us with her exceptional track record of driving global culture rooted in leadership and development. Our people are the core that will drive this brand into the future. A true visionary, I look to Gina to nurture, lead and evolve our unique culture as we grow our global collective. As we near the end of the calendar year, our work is starting to pay off. We are relentless and focused in driving our priorities, thanks to a passionate group of leaders and an entire collective of smart, engaged, driven individuals throughout the organization, including our educators, store managers, ambassadors, and support teams around the globe. I am more confident than ever that we will continue to build on our current momentum and deliver long-term profitable growth. Finally, before turning it over to Stuart, I would like to take a moment to acknowledge the passing of Tom Stemberg. Tom was not only the retail legend we all know and a critical member of the lululemon Board since December of 2005, he was also a dear friend of the company and truly loved lululemon. As the Chairman of the lululemon Compensation Committee, Tom's passion for building unique programs focused on health and wellness knew absolutely no bounds. I will be forever grateful for his commitment to making me a better leader and lululemon a better company. We will all miss him dearly.

Thank you, Laurent. I'll begin today by reviewing the details of our third quarter of 2015, and then I'll update you on our outlook for the fourth quarter and the full fiscal year of 2015. For Q3, total net revenue rose 14% to $479.7 million from $419.4 million in the third quarter of 2014. The increase in revenue was driven by total constant dollar comparable sales growth of 9% comprised of a bricks-and-mortar comp store sales increase of 6% and online growth of 21%. Also, square footage growth of 22% versus last year, driven by the addition of 65 new company-operated stores since Q3 of 2014, 33 new stores in the United States, 2 stores in Canada, 1 store in Australia, 5 in Europe, 4 in Asia and 20 ivivva stores. And offset by the foreign exchange impact of a weaker Canadian and Australian dollar, which had the effect of decreasing reported revenues by $24.7 million or 5.2%. During the third quarter, we opened 18 new company-operated stores, 9 in the U.S, 2 in Europe, 1 in Asia, and 6 ivivva. We ended the quarter with 354 total stores versus 289 a year ago. There are now 266 stores in our comp base, 42 of those in Canada, 173 in the United States, 30 in Australia and New Zealand, 1 in Europe, and 20 ivivva. At the end of Q3, we also had a total of 86 showrooms in operation, 27 lululemon showrooms in North America, 19 internationally, and 40 ivivva showrooms. Company-operated stores represented 73.7% of total revenue or $353.4 million versus 73.9% or $310 million in the third quarter of last year. Revenues from our digital channel totaled $89.3 million or 18.6% of total revenue versus $77.2 million or 18.4% of total revenue in the third quarter of last year. Other revenue, which includes strategic sales, showrooms, pop-up stores, warehouse sales, and outlets totaled $37 million or 7.7% of revenue for the third quarter versus $32.2 million or 7.7% of revenue in the third quarter of last year. Gross profit for the third quarter was $224.8 million or 46.9% of net revenue compared to $211.1 million or 50.3% of net revenue in Q3 of 2014. The factors which contributed to this 340 basis point decline in gross margin were 130 basis points of overall product margin decline as the port-related product costs and selling mix pressures observed in Q2 continued to be meaningful in Q3, but were offset by improved air freight usage; 70 basis points attributable to higher markdowns; 90 basis points of decline due to the foreign exchange impact of a weaker Canadian and Australian dollar; and 120 basis points of deleverage from occupancy and depreciation, which is related to new stores, including international locations and higher lease costs associated with major renovations, relocations, and regular renewals. These items were offset by 70 basis points of leverage in supply chain overhead costs. SG&A expenses were $156.6 million or 32.7% of net revenue compared to $129.9 million or 30.9% of net revenue for the same period last year. This 21% SG&A dollar increase is due to the following: an increase in operating expenses associated with new and existing stores, showrooms, and outlets, including costs related to the expansion of our international business; increased variable operating costs associated with the growth in our e-commerce channel; increased head office costs associated with strategic investments and one-time severance of roughly $1 million; increase in net foreign exchange revaluation losses of $3.4 million. These items were offset with a weaker Canadian and Australian dollar, which on translation decreased reported SG&A by $13.5 million or 8.6%. As a result, operating income for the quarter was $68.2 million or 14.2% of net revenue compared with $81.2 million or 19.4% of net revenue in Q3 of 2014. Tax expense for the quarter was $12.1 million or a tax rate of 18.6% compared to $22.5 million or a tax rate of 27.1% a year ago. Included in our tax expense for this quarter is an income tax recovery of $7.7 million related to the company's transfer pricing arrangements and taxes associated with the repatriation of foreign earnings. This also resulted in a net interest expense adjustment of $3.6 million. Excluding these items, the tax rate would have been 28.8% for the quarter. Net income for the quarter was $53.2 million or $0.38 per diluted share, compared to net income of $60.5 million or $0.42 per diluted share for the third quarter of 2014. Excluding the impact of the tax and related interest adjustments, diluted earnings per share would have been $0.35 per share for the third quarter of 2015. The negative impact to earnings from foreign currency this quarter was $0.03 per share. Our weighted average diluted shares outstanding for the quarter were 140.5 million versus 143.4 million a year ago, which takes into account the weighted impact of 1.6 million shares repurchased during the quarter at an average price of $55.50 per share. At this point, we have approximately $100 million remaining on our share repurchase authorization and will continue to be opportunistic in completing the program. Capital expenditures were $42.9 million for the quarter, compared to $37.3 million in the third quarter last year. Turning to our balance sheet highlights. We ended the quarter with $403.4 million in cash and cash equivalents. Inventory at the end of the third quarter was $357.8 million or 56% higher than at the end of the third quarter of 2014, which was in line with our expectations that third quarter growth would be similar to the second quarter. Looking forward, we now expect total inventories to remain similarly elevated at the end of Q4 before coming fully in line with our sales trend in Q1. This change in our inventory outlook is mainly due to intentional actions we have taken that will impact quarter-end in-transit levels. Looking more closely at these projections, we still expect a sequential improvement in on-hand inventories at the end of Q4, but to a somewhat lesser degree than prior estimates due to our revised top-line outlook for the quarter. And in fact, our November results reflect a meaningful reduction in on-hand inventory levels already. The bigger change in our inventory projections is a result of actions we have taken that will increase our quarter-end in-transit inventories. Specifically, these are: First, our success in shifting shipment modes from air to ocean will have the effect of increasing in transit at quarter-end as we see the benefits of our enhanced supply chain processes and we reduce our reliance on air transit. And second, we made the decision to pull forward certain product flows into the latter part of Q4 to mitigate shipment risks related to the timing of Chinese New Year. This has the effect of increasing in-transit levels at quarter-end, but is the correct call to protect our in-stock positions and the integrity of our assortments entering Q1 to deliver on our design intent. Additionally, we are also pleased with the results of our efforts to clear the excess inventory that we incurred as a result of the port disruption in Q1, and I'd like to recap where we stand now. You may recall, we identified 1.1 million units of excess inventory at the end of Q1. We also identified a plan to clear roughly 1/3 of this or 400,000 units through normal exit channels, while the balance would be incorporated in our normal product flows at full price in Q3 and Q4. As of the end of Q3, we have cleared approximately 260,000 units through our exit channels, including our successful physical warehouse sale in Boston this past October. The remaining 140,000 units of clearance inventory will be sold in Q4 via 2 physical warehouse sales that we now have planned, 1 in the U.S. and 1 in Canada as well as through our normal exit channels otherwise. Of the remaining 2/3 of the Q1 excess that has been flowed at full price into the second half of the year, about half of this was sold in Q3 as part of our normal flows. The remainder will be sold in Q4 with a small portion incorporated into the first half of 2016. As a result of all the factors just mentioned, we now expect inventory levels to become fully aligned with forward sales in Q1 following the sequential improvements in on-hand inventories combined with the described increase in in-transit at the end of Q4. This now leads me to our outlook for the fourth quarter and full year 2015. As Laurent mentioned, trends in our business have been mixed with traffic trends soft to start Q4 followed by some improvement since Thanksgiving. As a result, we are updating our prior guidance to reflect a Q4 revenue estimate in the range of $670 million to $685 million. This is based on a comparable sales percentage increase in the mid-single digits on a constant dollar basis compared to the fourth quarter of 2014 and assumes a Canadian dollar at 0.75 to the U.S. dollar and 9 new store openings, 7 lululemon stores and 2 ivivva. That said, we are seeing the gross margin recovery in Q4 taking shape and expect this to continue and accelerate into 2016. But specifically for Q4, we now anticipate gross margin to be in the range of 49% to 50%. This sequential improvement reflects a number of positive factors, including stabilizing product margins as we move beyond port-related cost issues and benefit from leverage of air freight costs as utilization has declined significantly to last year; significant sequential improvement in occupancy and depreciation as expected, but still up year-over-year; and buying costs in line with last year. Offsetting these positive factors are the continued impact of FX, actually the biggest quarterly impact of the year; an increase in markdowns to stay on top of inventory movement as our comp trend has moderated; and we expect SG&A in the fourth quarter to deleverage from Q4 2014, due in part to our lapping $7 million in FX gains that reduced reported SG&A in Q4 2014. The remaining increases causing deleverage are associated with investments in our global website redesign, supply chain consulting costs associated with delivering on our margin improvement initiatives and incremental digital marketing expenses during the fourth quarter that drive traffic and conversion. Assuming a tax rate of 29.5% and 139 million diluted weighted average shares outstanding, we expect diluted earnings per share in the fourth quarter to be in the range of $0.75 to $0.78 per share versus $0.78 a year ago. For the full year 2015, we now expect revenue to be in the range of $2.025 billion to $2.04 billion for the year. We now expect to open 61 company-operated stores, which includes up to 8 new stores in Asia and Europe and also 21 ivivva stores. We expect gross margin for the year to deleverage from 2014, impacted by the factors we mentioned earlier. We expect modest deleverage in full year SG&A versus 2014, driven by strategic investments in guest experience, supply chain, digital, brand, and IT systems. We now expect a net negative impact to earnings from foreign exchange for the year to increase from approximately $0.07 to $0.09 per share when compared to fiscal year 2014. As a result, we expect operating margin to deleverage from 2014 and our fiscal year 2015 diluted earnings per share to be in the range of $1.81 to $1.84. This is based off of 140.9 million diluted weighted average shares outstanding, which does not reflect an estimate of shares repurchased after Q3 2015 and also assumes an effective tax rate of 27.6%, which includes the $0.03 tax benefit recorded in the third quarter. We expect capital expenditures to range between $135 million to $140 million for the fiscal year 2015, reflecting new store openings including outlets, renovations, relocation capital and also strategic IT and supply chain capital investments. We are pleased with the progress we have made in the third quarter. As we now have moved into Q4, the team remains laser focused on successfully executing all of our strategic initiatives. We will provide a detailed outlook for next year as part of our Q4 call in March, but we would like to reiterate our confidence in delivering gross margin recovery in 2016. The quarter-to-date margin trends we are now seeing reinforce this view. And at this point, we are deep into execution on the various programs that will deliver the margin improvements that will support this inflection and long-term profitability. As we've discussed, these programs and the related investments are focused on a few key areas that include reduction in air freight as we shift a higher portion of flows to ocean. This effort is beginning in Q4 of this year where we expect air utilization to be half of last year; improve logistics and duty costs; FOB cost improvements as we improve our demand planning, reduce cancellations and late stage change orders; and lastly, other efficiencies from a more disciplined go-to-market process, such as lower fabric liability and improved development ratios. These programs are all part of the evolution to a more sophisticated, scalable supply chain that can flow product more efficiently and consistently based on anticipated product life cycles. We have incurred consulting costs in both Q3 and Q4 to deliver on these programs next year, namely with Deloitte, who has been a catalyst to accelerating our efforts. Given the nature of these initiatives, we see gross margin recovery opportunity accelerating starting in the second quarter of 2016. We will see sequential improvement in Q1 gross margin, but also anticipate some impact in this period from steps we will take to fully align inventory levels. With that, I will open up the call for questions. Operator?

Stuart, you mentioned the opportunities on the supply chain. Can you maybe just talk about the different buckets, maybe dig in a little bit to some quantification on where you're furthest along and just the timing on how you see those come through? It sounds like maybe some are happening a little earlier than planned in the fourth quarter, but just wondering how we should think about the total by bucket in 2016.

Yes, as we consider margin improvement, we still see the potential for about 300 basis points of product margin improvement compared to 2014 pre-FX. However, it seems likely that we will reach that level of margin recovery by the first half of 2017, as we gain more clarity on 2015 and the first half of 2016. We're starting to see positive developments in 2016, particularly in the second quarter, although we anticipate some margin improvement in the first quarter as well, with a more significant increase into the second quarter. We outlined some key areas in my earlier remarks that will help us achieve this improvement. For example, reductions in air freight are significant; we have made considerable progress on this in 2015. In the fourth quarter, air freight utilization is less than half of what it was in 2014, which will positively impact gross margins in Q4 and continue into 2016. Specifically, we expect air utilization rates to remain under 25%, down from about 50% in the previous year. Additionally, we're improving logistics and duty costs. We have plans to optimize our mode utilization, recognizing that not all air freight is the same in terms of costs. We've also identified opportunities in ocean freight for better inventory flow through the supply chain. In terms of duty costs, we have straightforward opportunities we're focusing on now. Furthermore, we are working on reducing our FOB costs by improving demand planning, which will allow us to provide suppliers with more reliable production requirements. This change will help reduce cancellations and late-stage change orders, ultimately lowering our FOB costs. Regarding our go-to-market process, we are being more disciplined in managing our fabric liability and have made some progress earlier this year to prepare for 2016. These areas are meaningful and integral to our overall recovery, with significant acceleration expected in Q2 of next year.

And Paul, this is Laurent. What I might want to add quickly is with the structural changes that we've made on the product side, being design-led certainly doesn't come at the expense of great merchandising, and I've already seen much greater collaboration between design and merchandising resulting in a much more focused approach to the assortment, which will create better experiences for our guests, but also much more efficient targeted sourcing of our product, resulting in far greater margin. So I mean, I've seen the impacts that it will have both on the guest standpoint, but also the laser focus on a more streamlined supply chain.

One question on the product side, and then one on the expense side. I guess on the product side, bottoms up, I think you said 27%, bras up 18%. Can you maybe talk about what are the biggest opportunities in the women's assortment next year? Where do you think there's the most white space to either relaunch or have a new category? And have you learned anything about your price opportunities given the newer high price point in the compression pants? And Stuart, on the expense side, can you maybe talk about the SG&A dollar growth? Obviously, there were some consulting costs in there. How much they may have been for the third or the fourth quarter, and are there any other management holes besides the supply chain head that we need to think about for 2016 SG&A dollar growth?

Well, this is Laurent. I'll take the first part of the question. I mean, clearly, what we've learned and what we've known all along and where we probably lost our way the past 3 years is that when we are bold and when we're innovative, our guests respond really well. And the response to the launch of the pant wall has been fantastic, so both from a fabrication, from an innovation standpoint, and we have actually seen price elasticity that was much greater than what we had originally anticipated, meaning that our guests really responded well to the value that we've provided. So when you look at the success of being bold, innovative and really delivering that kind of value, and when you look at the comp that we've had in pants and bra, it's obvious that the category that we need to be really focused on right now is tanks. And with Lee coming on as Creative Director, I mean, his first area of focus is clearly to deliver the same type of innovation both from a fabric, styling, and construction standpoint that we have with the pant. So that is a very substantial opportunity for growth for us as you think about spring, summer 2016 and beyond.

Certainly. Here's the rewritten Earnings Call remark: SG&A came in higher for the quarter than we previously expected due to several factors. First, we experienced about a $3.4 million increase in foreign exchange revaluation loss compared to Q3 of last year. Additionally, we incurred about $1 million in severance costs that were not included in our earlier projections. Finally, consulting fees related to our supply chain initiatives totaled around $2.5 million for the quarter, which exceeded our earlier estimates. While some of this was anticipated in our guidance, a portion was higher than expected. These factors contributed to over 100 basis points of deleverage in the quarter and effectively brought us back to our original estimates. We believe these costs are one-time and will not lead to a permanent increase in our cost structure, providing us with an opportunity for leverage as we move into next year. Looking ahead to Q4, we expect a significant amount of SG&A deleverage, which is reflected in our guidance, although it should be to a lesser extent than what we experienced in Q3. We have noted factors affecting SG&A in the fourth quarter, with the most significant being the $7 million in foreign exchange gains from Q4 last year that we are now comparing against, which alone creates about 100 basis points of pressure. We continue to invest in our supply chain initiatives, which remains the largest factor, along with important investments in website redesign and digital marketing efforts. As we approach 2016, we will provide more detailed guidance during our Q4 call, and we plan to continue investing to support supply chain initiatives, particularly in the first half of the year as we complete key investments during that period.

I was hoping to get an update on the idea of having kind of gross margin parity or merchandise margin parity between seasonal and core. I haven't heard you talk about that in a while, and I'm not sure where you are on that initiative at this point.

It's not ideal for us to explain the situation regarding our gross margin. We believe that both our seasonal and core products will provide strong margins, contributing to margin growth from our current position. We are now about 5 to 6 weeks into Q4 and are pleased to see that our efforts throughout the year are starting to improve product margins. As we noted earlier, we are witnessing stabilizing product margins in the fourth quarter as we resolve some port-related challenges. Additionally, air freight is becoming an important leverage point as utilizations align with our targets and our supply chain normalizes. Occupancy and depreciation will also play significant roles in improving our gross margin in Q4 and will contribute even more to sequential improvements in 2016. While we will still experience some margin pressure in Q4, it will be less than what we faced earlier in the year concerning occupancy and depreciation. Foreign exchange will remain a challenge, and we expect to increase markdowns in the fourth quarter to manage inventory movement effectively. We are focused and proactive in ensuring our inventories are balanced. Regarding your question about core versus seasonal products, we are implementing a merchandise segmentation strategy to better align our assortment based on the expected product lifecycle. This approach should enhance our supply chain effectiveness and help us seize margin opportunities. Ultimately, we believe we can achieve strong margins on both seasonal and core products, which is central to our planning.

From a pure product perspective, considering what we have coming in for spring and summer in terms of print techniques, textures, and construction, I have consistently emphasized that there’s no reason seasonal products should yield lower margins than core products, particularly when we apply our scarcity strategy to seasonal offerings. We are confident that there will be no margin differences between seasonal and core products, and in fact, our thinking has evolved beyond the distinct categorization of seasonal and core. I would also like to take this moment to remind everyone that Miguel Almeida, who is leading our digital initiatives, is on the call with us. In upcoming calls, I plan to introduce you to more members of our management team. Digital is a key area of focus for us, and with Miguel's extensive experience, we are very optimistic about its potential. So please feel free to direct questions to Miguel; he would appreciate the engagement.

On the success of pants, bras, and men's products, what classifications had more opportunity this quarter in terms of contributing to your overall comparable sales? Stuart, regarding markdowns, which classifications were affected? Also, as you indicated about markdowns for the fourth quarter, is this primarily related to your warehouse sales, or what should we anticipate in-store? Miguel, concerning buy online, pick up in-store and mobile, these are significant strategies for integrating online and physical sales. I am curious about the major challenges ahead for the flagship store. The Flatiron flagship offers a lot of interactive features, so what innovations can we expect there?

So Oliver, I'll take the least amount of time to answer your question. The largest opportunity right now for us is women's tanks. And Lee and Duke on the Brighton community side have actually put a fully dedicated team to just look at that opportunity and quickly bring product to life that we're proud of and that we love. So I'll leave it at that. That's clearly the biggest opportunity, one we're focused on.

And Oliver, it's Stuart. Regarding the markdown question, there are a few points to consider. We have implemented several activities, including a physical warehouse sale, an online warehouse sale earlier this year, and two additional warehouse sales planned for the fourth quarter. These activities certainly contribute to the increase in markdowns we are experiencing and are part of the guidance we provided along with the Q3 results. Additionally, we are taking measures to manage markdowns effectively to ensure we meet our clearance goals and manage our inventory appropriately. In October, we noticed a slowdown in traffic during the last weeks, which prompted some additional markdown activity to help with the movement of inventory. Our guidance for Q4 reflects the activity so far this quarter and our expectations for the remainder of the quarter regarding the actions needed to maintain effective inventory movement.

Yes, this is Miguel. Regarding the buy online and pick up in-store initiative, it is crucial for enhancing the guest experience across all channels, as our guests have expressed a strong desire for this service. The RFID technology we have in North America will allow us to speed up the testing and learning related to these experiences. I am particularly excited about the insights that RFID and beacon technology will provide regarding guest behavior when shopping in our stores. This initiative is one of our top priorities, and we anticipate learning valuable lessons on the most effective implementation strategies. The testing and learning linked to RFID will guide us in making the right expansion decisions in North America.

Miguel, I will actually take the opportunity to ask you a question because I'm very interested in the upcoming website relaunch. Can you maybe give us a little bit of highlight of some of the functionality that you're adding, maybe content that you plan to add or add over time? And how you plan to improve the overall experience comprehensively online with digital with this new website?

Thank you for the question, Matt. We are very excited about the redesign set for Q1. It presents a fantastic opportunity for us to integrate our brand content and commerce. Currently, these two aspects are quite separate, but the new website will merge them into a unified experience for our guests, both on the web and mobile. This redesign marks just the beginning of our digital experience evolution. I'm particularly enthusiastic about the personalization capabilities that will develop throughout the year. We're making significant investments in our CRM and analytics, which will enable us to offer contextually relevant experiences that highlight our product storytelling in the digital realm. Additionally, we'll reconnect our guests with our physical stores through various features we've discussed earlier. We are thrilled to see the new site come to life in Q1.

So as we consider the 300 basis points of product margin opportunity, are you indicating that you expect aggregate gross margins to be positive in the first quarter of next year, leading to a more significant change in the second quarter? Also, regarding the timing, is it reasonable to estimate that 200 of the 300 basis points will come in 2016, with the rest in 2017?

In Q1, we anticipate a sequential improvement in gross margin compared to the previous quarter, meaning Q4. We expect to see a nice sequential improvement in Q4 compared to the recently reported quarter, though it may still be down year-over-year. Going into Q1 of 2016, we expect further sequential improvement in gross margin as we continue to enhance our supply chain efficiency and implement our initiatives. While I can't guarantee that gross margin in Q1 will be up, we will provide more detailed guidance during our Q4 call. What we can confidently state is that there will be a sequential improvement in Q1. We foresee greater opportunities for inflection in our product margin and gross margin in Q2 and beyond in 2016, as we make further progress on our initiatives. The enhancements in FOB costs are expected to be more weighted towards the second half of the year, and there will likely be some actions taken that may impact margins in the first quarter as we align our inventories. I won't specify what the product margin improvement will look like for 2016 today, but we will address that with more clarity on the Q4 call. However, we are optimistic about achieving a significant inflection in product margins, consistent with the 300 basis points pre-FX level from 2014, though it may take us until the first half of 2017 to fully realize that.

Great. And then just a follow-up, to circle back on the inventory, what's the best way to think about the content of the excess product? And then just to be clear on that, so are you basically saying that versus your initial plan for the on-hand reduction, you really only stand 10,000 units behind plan, which is about 4% below that game plan to clear 260? Is that kind of the best way to think about where you're at today versus what you had laid out 3 months ago and then just the go-forward content?

That's right. We initially aimed for 100,000 units in Q3, but we reached around 90,000, which still keeps us on track. We expect to complete that part of the plan in the fourth quarter as we outlined. However, the main change in our inventory outlook for Q4 relates to in-transit items and the decisions we've made regarding them, which we are confident are the right choices. It would be shortsighted not to protect our flows into the first quarter and to capitalize on our ability to shift from air to ocean transport from a margin perspective. Unfortunately, this will increase our in-transit levels at the end of Q4.

Okay, great. And then just one housekeeper, are same-store sales quarter-to-date in line with the fourth quarter mid-single-digit guidance?

Yes. So I think how I would answer that is that the next few weeks of the quarter in December are huge weeks from a volume standpoint. We're also up against a little tougher comparison in these weeks, and our comp assumption is probably just under the mid-single-digit range. So we're a little more conservative over the next few weeks in regards to the comp in that time frame, more conservative than we are for the quarter overall, if that makes sense.

Operator, we've now run out of time for questions. Again, thank you everyone for joining us today. We'll talk again soon. Thank you.