Lululemon Athletica Inc (LULU) — Q3 2017 Earnings Call Transcript

Thank you, and good afternoon. Welcome to lululemon's third quarter earnings conference call. Joining me today to talk about our results are Laurent Potdevin, CEO; Stuart Haselden, COO; and Celeste Burgoyne, EVP, Retail, Americas. 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 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 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'd like to note for investors that in addition to the summary of key financial and operating statistics we began providing last month, we're now providing a supplemental slide deck, which provides highlights on our quarter. You can find both on our investor site. Today's call is scheduled for 1 hour.

Thank you, Howard, and good afternoon, everyone. I am very pleased to report strong Q3 results and an increase in our full year guidance. Before we cover this in detail, I wanted to contextualize the strong momentum in our business and the unique position we own within the market we created. The retail landscape is experiencing unprecedented disruption, characterized by increasingly commoditized transactions and short-term focus. But disruption also equates to tremendous opportunity, and lululemon is at the forefront of unlocking the future of what defines a new era of human connection and a powerful evolution of retail. Across the globe, there is a behavioral shift to live an active mindful lifestyle. Guests are drawn towards brands with purpose that reflects who they are and who they want to be. lululemon empowers our guests to design the life they'll have. This is our DNA and has been for almost 20 years now. Our stores are the heart of this community, where guests immerse themselves in the brand through products brought to life by our educators and localized experiences, such as our Mindfulosophy lounge or in-store yoga led by our ambassadors. The constant from Bend, Oregon to Chengdu, China is the distance of connection to and being part of a local community. Online, we greatly enhanced the digital experience for our guests at the end of Q3, satisfying today's consumers' needs to explore and be inspired and also transact from any device anytime, anywhere. Delivering on our strategy enabled us to drive an acceleration in our business in Q3. Comps were up 7% on a constant-dollar basis. Adjusted gross margin improved 110 basis points, and adjusted EPS grew 19%. These results exceeded our guidance and keep us on our path towards delivering $4 billion in revenue in 2020. I'm energized by the momentum we're seeing at the start of the holiday season and grateful for the incredible enthusiasm I see every day from our team serving our growing collective around the world. Today, I'll share key highlights of the quarter and update you on our plans for Q4 and the holiday season. Stuart will provide additional details on the quarter, review our financials and provide Q4 and full year guidance. When looking at our model, our vertical integration is a core competitive advantage. We have end-to-end control of every aspect of our business, from every guest interaction anywhere in the world to a margin structure that allows us to stay positioned at the pinnacle of the market we created, investing in levels of quality and functionality that are unmatched in the industry. Our nimble and constantly evolving store portfolio from locals to co-located and experiential are highly attuned to each market's needs, reflecting industry-leading productivity while our footprint remains underpenetrated with only 388 locations across the globe. Online, we saw a significant acceleration this quarter, with constant dollar comps up 25%, fueled by double-digit increases in traffic, transactions and delivering our best conversion this year. Our digital journey has much runway ahead. It is the conduit to how we amplify our uniquely human connection with the growing collective. And we are thrilled with the guest reaction to the enhanced new experience and are committed to delivering a compelling online, offline ecosystem to our guests. In Q3, through focused marketing efforts, our active contactable profile list grew by 60%. We both retained and acquired more new guests and so increased transactions from our most loyal guests year-over-year. As we scale and grow internationally, a continued focus on insight and understanding of our guests will enable us to offer increasingly relevant guest journeys. We create market-disrupting product at the intersection of function and fashion, delivering innovation in technical performance through our unique science of feel. Reflecting our unparalleled leadership in women's pants, in Q3, we launched our newest fabric innovation, Everlux. Incredibly well-received by guests, it created a revolution in our women's pants category, which comped up an impressive 24% in Q3. Going into holiday, on Black Friday, we launched another unique capsule collection for guests, collaborating with Forster Rohner, one of Europe's premier couture lace houses, which contributed to our biggest week ever for pants sales in North America. And I'm also pleased to see our jackets and outerwear assortment comping 26% in Q3. On the men's side, we saw a 21% increase in new male guests transacting with us this quarter. Due to additional focus on our co-located stores, our expanded ABC franchise, including slim and jogger styles and our first ever men's campaign, I'm excited to say that total sales in our ABC franchise doubled in Q3 versus last year, lifted by these initiatives. Our international growth pillar continues to reflect one of our most significant long-term opportunities. While at the beginning of this journey, the market growth across Asia was nearly 100% in Q3, while China itself grew over 450%. I visited China in late Q3 and I'm always in awe of the pace and scale of change, how digital is so intrinsically woven into every experience, seamlessly moving from online to offline, reimagining the future of retail. Current guest behavior informs my belief that our e-commerce penetration in China could approach 40% to 50% of our business as we continue to grow and enhance our distribution channel, including Tmall and WeChat. And as evidenced from Tmall's Singles Day this year, where we tripled our business relative to last year. Turning to Europe. In Q3, we experienced market growth of 40% and continue to focus our energy on the accelerating shift towards an active mindful lifestyle in Northern Europe. And we're excited by the market response to our first store in Munich, Germany, which has been incredibly positive. No matter where we are across the globe, our digital ecosystem fuels our insight on market readiness, allowing us to build awareness, energy, and connections in a community before putting a physical presence. This strategy effectively supports our Q3 new store openings and looking to Q4 in form how we're targeting 6 additional stores in Asia. In North America, we are realizing the untapped potential in our core market across store and digital. Symbolic of the opportunity ahead, Fifth Avenue in New York and West 4th Street in Vancouver are both performing extremely well, with little to no cannibalization. Further validating our co-located store strategy and reflecting the opportunities that we see in both the U.S. and Canada due to our agile and relevant store formats. Whether online or offline, we value and prioritize the direct connections we have with our collectives. The rapport that exists between our guests, educators, ambassadors across all our markets is the heartbeat of the brand. This quarter, the Ghost Race, a 5-mile community race powered by the Strava app, is a great example of online to offline community building, catapulting lululemon to the #1 run community on Strava despite being activated across only 15 cities. Looking at Q4 and as we head into the holidays, I'm excited and inspired by the product, experiences, and connections we are bringing to our guests. In North America, we're opening 22 seasonal stores nimbly meeting our guests where they are. And as the holiday season kicked off, we experienced our highest traffic and largest revenue day ever on Black Friday and on Cyber Monday, our largest day ever of online sales. And reflective of how our guests value our brand, our product, and the experiences we provide, our top-selling product all weekend was the Align pants at regular price. Amongst this backdrop, I know our holiday campaign is a breath of fresh air. 'Breathe it all in' reminds our guests to take a moment to be present, and guests are desiring this calm and connection like never before. It is just a few weeks in and is our most powerful campaign to-date. Our collective has donated 250,000 minutes of meditation. We are on track to acquire our most significant number of new guests per quarter ever, and our personalized emails are driving 15% conversion. In closing, the strength we exhibited in Q3 and at the start of Q4 validates our strategy, demonstrates the power of our brand and the connection we have with our growing global collective. With a strengthened foundation reinvested in the brand and innovation, and focused on operational excellence and efficiency to build a platform to create a future not yet realized, the momentum in our business validates our position as an originator brand leading the market we created and capturing the accelerating global shift towards an active mindful lifestyle. We have exciting opportunities ahead of us as we expand into new international markets, deliver category-disruptive product innovation, and continue to explore how our brand deepens its connection across both men's and women's. Looking forward, I am more confident than ever in our growth strategy and our ability to execute powerfully against this pillar.

Thank you, Laurent. As you mentioned, we are pleased with the accelerating momentum we saw in Q3 that is now extending into Q4. The strength in our business was fueled by positive performance in both our store and digital channels as well as strength in both men's and women's. We saw solid performance across an array of KPIs, notably traffic and conversion improved in both stores and e-commerce. Constant dollar comps were up 7%. Adjusted gross margin expanded 110 basis points, driven by continued strength and above-plan performance and product margin, which improved by 70 basis points, and EPS increased 19%. Also worth noting is the moderating growth rate in SG&A, up just 70 basis points this quarter, which contributed to our adjusted EBIT margin expansion. Inventory also remained well controlled and was up 9% at the end of Q3. Before taking you through our Q3 results in detail, I'd like to update you on the charges and costs associated with the evolution of our ivivva business. We now estimate that total costs associated with the transition will be $45 million to $50 million, down from our prior estimate of $50 million to $60 million. In Q3, we realized $22 million in impairment and restructuring costs related to the ivivva restructuring. Now turning to the details of Q3. Total net revenue rose approximately 14% to $619 million, with the increase in revenue resulting from strong performance across all parts of the business. In our store channel, we delivered a 1% comp store sales increase on top of a 4% store comp in Q3 of 2016. We are also pleased with the 25% comp we posted in e-commerce. Our teams executed and refined the new processes implemented in Q1 and Q2, which enabled this acceleration in our digital business. So on a combined basis, we delivered a 7% constant dollar comp increase. Excluding the ivivva store closures, square footage increased 12% versus last year, driven by the addition of 46 net new company-operated stores since Q3 of 2016. 26 net new stores in the U.S, 10 in Asia, 4 in Canada, 3 in Europe and 3 in Australia and New Zealand. The impact of foreign exchange increased revenues by $6.8 million while the hurricanes, which hit the U.S. during the quarter, decreased revenue by approximately $2.5 million. Gross profit for the third quarter was $322 million or 52% of net revenue compared to 51.1% of net revenue in Q3 2016. The gross profit rate in Q3 was adversely impacted by 20 basis points related to the ivivva restructuring. Excluding these items, adjusted gross margin increased 110 basis points versus last year. This exceeded our expectations for the quarter, with the primary driver being a 70-basis-point increase in overall product margin resulting from favorability in product mix and lower product costs, offset somewhat by modestly higher markdowns versus last year. SG&A expenses were just over $215 million or 34.8% of net revenue compared to 34.1% of net revenue for the same period last year. The deleverage in SG&A was generally in line with our expectations. Approximately 60 basis points of the increase relates to the planned costs associated with the improvements to our e-commerce platform that we previously outlined. Foreign exchange, including both translation and revaluation exposures, contributed an additional 60-basis-point increase. These were offset by lower professional fees versus last year, coupled with more efficient store and headquarters-related spend. Separately, as a result of our transition of the ivivva business, we incurred $21 million in asset impairment and restructuring costs associated predominantly with lease exits. Operating income for the quarter was approximately $86 million or 13.8% of net revenue compared to 17.1% of net revenue in Q3 2016. Excluding the pretax charges of $22 million related to the planned closures of the ivivva stores, adjusted operating income for the quarter increased to approximately $108 million or 17.4% of net revenue. As a reminder, operating margin this quarter includes approximately 60 basis points of costs associated with enhancements to our e-commerce business, as previously mentioned. Tax expense for the quarter was $28 million or 32% of pretax earnings compared to an effective tax rate of 27% a year ago. The adjusted effective tax rate for the quarter was 30.8% versus 31.3% last year. Net income for the quarter was approximately $59 million or $0.43 per diluted share compared to earnings per diluted share of $0.50 for the third quarter of 2016. Net income in Q3 2017 included $16.4 million or $0.13 per share in after-tax ivivva-related charges. Excluding these charges, adjusted EPS was $0.56 per share compared to adjusted EPS of $0.47 per share last year. We repurchased approximately 140,000 shares that remained on our $100 million authorization during the quarter at an average price of $60.27 per share. By the end of the quarter, we had completed our authorization, putting our weighted average diluted shares outstanding at 135.6 million. With that plan complete, we are pleased that our board recently approved a new $200 million share repurchase plan. Capital expenditures were approximately $57 million for the quarter compared to approximately $35 million in the third quarter last year. The increase relates primarily to higher investments in IT and new store capital. Turning to our balance sheet highlights. We ended the quarter with $650 million in cash and cash equivalents. Inventory at the end of the third quarter was $397 million or 9% higher than at the end of Q3 2016 and below our forward sales outlook. Looking forward, we continue to expect inventory growth to generally grow in line with our forward sales trend. Before taking you through our guidance, I'd like to provide some additional color on our Q3 performance. On the men's side of our business, as Laurent stated, our ABC pant franchise increased 100% in the quarter and helped drive a 26% comp in our men's bottoms business. And we were likewise pleased with the results in women's pants, our most iconic category, which continued to deliver strong results, and comped up 24% in Q3. Our Everlux launch helped drive this trend, but core styles offered in our Nulu and Nulux fabrics also performed well. We're also excited that the momentum we saw in both men's and women's jackets and outerwear at the end of Q2 continued into Q3 as our evolved offering is resonating well with guests. We continue to see outerwear and jackets as an important opportunity for us in Q4. In our e-commerce business, the 25% constant dollar comp we achieved in Q3 was an important acceleration relative to the 16% comp we reported in Q2 when excluding the online warehouse sale. As Laurent mentioned, our digital business benefited as our teams continued to develop the new processes we've put in place during Q1 and Q2, focused on better photography, more intuitive merchandising and more disciplined planning. It's also important to note that we did not launch the new website until the end of Q3. We've been happy with our guest response to the revamped site and believe this combined with the process improvements mentioned earlier can help drive double-digit gains in our digital business in Q4 and into 2018 and beyond. Turning now to our outlook for the fourth quarter and the resulting updated outlook for the fiscal year 2017. Please note that the guidance we are sharing excludes costs related to the ivivva restructuring where applicable. We are pleased with the momentum we are seeing in the business across all channels as we've entered Q4. In the U.S., we have seen positive store traffic in the first 5 weeks of the quarter and sequentially improved store traffic in our Canadian business. And our newly enhanced e-commerce site is delivering important improvements in conversion that will support continued double-digit increases in our digital business. For Q4, we expect revenues to be in the range of $870 million to $885 million. This is based on a comparable sales percentage increase in the mid-single-digit range on a constant-dollar basis compared to the fourth quarter of 2016. This also assumes the Canadian dollar at 0.78 cents to the U.S. dollar and 16 new store openings in the quarter. We anticipate gross margin to increase by approximately 100 basis points versus Q4 of last year. Despite the strong increases in product margin last year that we're now anniversary-ing, we continue to see AUC opportunities, driven by our ongoing supply chain initiatives and the great work that our sourcing, logistics and distribution teams are delivering. We expect to leverage SG&A in Q4 by 50 to 100 basis points now that the expenses related to our digital acceleration work are predominantly behind us. Assuming a normalized tax rate of 30.4% and 135.6 million diluted weighted average shares outstanding, we expect normalized diluted earnings per share in the fourth quarter to be in the range of $1.19 to $1.22 versus $1 a year ago. For the full year 2017, we expect revenue to be in the range of $2.590 billion to $2.605 billion. This is based on a comparable sales percentage increase in the mid-single-digit range on a constant-dollar basis. As we stated in prior quarters, the guidance range takes into account the closures of our ivivva stores and the associated reduction in revenues. We expect to open 46 company-operated lululemon stores in 2017. This includes 16 stores in our international markets and represents a normalized square footage increase in the low to mid-double digits. We expect normalized gross margin for the year to increase approximately 100 to 150 basis points from 2016, primarily driven by product margin improvement and the benefit of mix. We expect SG&A for the full year to deleverage by approximately 100 basis points versus 2016. This includes the digital-related investments incurred this year, which accounts for approximately 50 basis points of the increase. We now expect our normalized fiscal year 2017 diluted earnings per share to be in the range of $2.45 to $2.48. This reflects the Q3 upside along with our confidence in our outlook for Q4. Our EPS guidance is based on 136.2 million diluted weighted average shares outstanding and also assumes a normalized effective tax rate of 30.4%. We now expect capital expenditures to be approximately $170 million for the fiscal year 2017, reflecting new store openings, renovations, relocation capital and also strategic IT investments. In closing, I'm encouraged by the success achieved in Q3 as our teams executed well across all parts of the business. We see this story continuing now into Q4. And although the key holiday weeks remain ahead of us, I'm excited by what we're seeing so far, which has enabled us to raise our guidance. And with that, let's open the call for questions. Operator?

Just a quick question, Stuart, on the gross margin line. You're guiding a mid-single-digit comp in Q4 similar to what you did in Q3, but you're seeing much more gross margin opportunity, up 100 basis points. I think you guided Q3 flat. Just can you help us understand why there's so much more optimism to start Q4 relative to where we were 3 months ago for Q3?

Sure, I appreciate the opportunity to provide some context on the third quarter, which I believe sets the stage for our fourth quarter guidance. We're very pleased with our gross margin expansion in Q3, especially given the significant increases from 2016. Our performance exceeded expectations primarily due to a favorable selling mix, particularly strong sales in men's and women's pants, which have some of the best margins in our offerings. Additionally, our average unit cost results have been positive, thanks to our supply chain team's efforts. Over the past couple of years, we've worked on segmenting our supply chain, reducing fabric liability, managing airfreight better, and minimizing cancellations. These initiatives continue to yield benefits. We've been pleasantly surprised by the extent of our margin improvements, which have surpassed our initial projections, particularly after seeing most of the enhancements during the second half of '16 and the first half of '17. The teams have discovered additional opportunities that contribute to our gross margin outlook for Q4, and I expect this trend will extend beyond just this quarter. Our Q4 guidance incorporates these elements of supply chain efficiency. It's important to note that the selling mix advantages we experienced in Q3 were unexpected, but we're satisfied with the results. If we see favorable selling mix trends in Q4, there could be potential for further upside. Overall, we're pleased with the performance not only in Q3 but also as we begin Q4, reflecting our revised margin strategy. This is essential for achieving our EBIT margin target, aiming for a figure that starts with a 2.

A couple of questions. The first one just, Laurent, the organizational structure for merchandising, it seems like there's been some changes there. Can you kind of talk about what the right structure is for that part of your business and maybe where there might be some holes in leadership that you might want to fill?

Yes, that's a good question. With Lee's departure, we have created a gap in the creative director position, and we are very thankful for the contributions he made over the past three years and the progress we've achieved with our products. During this transition, we successfully launched Spring '19 and had a creative kickoff with him. There is no change in our strategy or direction; Lee's departure was due to personal reasons. Next week, we will announce something significant on the women's design side. When considering the head of design in men's, as well as our strengths in merchandising and innovation, I believe we are in a very solid position. We have already laid out plans for 2018, aside from a few capsules and collaborations that we are looking forward to. The Spring '19 kickoff we had recently was one of the strongest experiences I've witnessed. We are actively looking for a creative director, but we are not in a hurry to fill that position. It is a crucial role that is challenging to fill, and we have exceptional talent in all key areas to maintain and enhance our performance. Overall, I feel very positive about our current situation.

And then, if I may, one more quick one. Just on China, outstanding growth in that region, and you threw out the 40% to 50% longer-term penetration potential there. Can you maybe talk about your ability, how fast can you ramp that business up without initially overheating it, or is there a level of growth that's sustainable that we should be thinking about for that region? Or is it something that it's a land grab in some ways?

Every time I visit, I learn a lot and I'm impressed by the scale, which is hard to grasp unless you're actually there. After spending time at Alibaba headquarters in Guangzhou and then visiting Beijing and Shanghai, it's fascinating to see that there are 415 million Millennials in China. The government has a strong 2030 health plan aimed at encouraging more active lifestyles. Additionally, there are 130 million Chinese citizens traveling globally throughout the year. To put it in perspective, it's like having Germany and France collectively spending the entire year traveling. This is significant. As we observe this group of Millennials, they are increasingly focused on an active and mindful lifestyle and are seeking experiences that are different from what traditional brick-and-mortar retail offers in North America and Europe. We have a brand that is not widely known yet, but it embodies a lifestyle that resonates strongly with this demographic. The potential for growth is tremendous. While it's difficult to predict exactly when or how we'll reach full maturity, seeing Singles Day sales triple year-over-year suggests that we can leverage our collaborations with ambassadors and influencers to further accelerate growth. It was incredibly exciting to arrive in Shanghai and see our product featured on the cover of Harper's Bazaar, an achievement that hasn't occurred in North America. This really highlights how well our values resonate with our target audience.

I guess, one for Laurent. Laurent, maybe on the $4 billion or this high-teens sales growth CAGR over the next couple of years that you keep laying out, I guess, was curious, between the buckets of North America, international, men's and digital, sort of what line item in there are you most confident in to get you to that $4 billion revenue number? And then maybe, Stuart, can you maybe talk about how we should be thinking about SG&A dollar growth going forward now that the e-commerce and some of the contractor work is behind us. So the fourth quarter is a good proxy for how we should be thinking about SG&A dollar growth or leverage?

Brian, when I think about the 2020 target, I mean, I think about it in very simple terms. I think we've outlined that in the past. But I mean, I think that by 2020, we've got $1 billion in our digital business, we've got $1 billion in our men's business and we've got $1 billion in international markets. Within international, obviously, it's going to be more heavily weighted on Asia. Within Asia, it's going to be more heavily weighted on China. Within China, it's going to be more heavily weighted on digital. One really simple way to think about it is $1 million in men, $1 million in digital, $1 million in international. Obviously, the balance is continuing to do what we do so well with the rest of the business, especially with women's driven by innovation, which we've seen resonating incredibly well in Q3 with the launch of Everlux in women's pants.

Okay. Brian, let me address your question regarding SG&A. As we’ve mentioned before, we are expecting SG&A leverage to help us achieve an EBIT margin rate in the low 20s. The fourth quarter was crucial for us to start realizing SG&A leverage. Looking ahead, I'll elaborate more on Q4 shortly, but as we move beyond the fourth quarter, we plan a modest level of leverage in our 5-year plan. The reasoning behind this is that with mid-teens total revenue growth, we want to ensure we allocate funds for our growth initiatives each year, preventing us from merely harvesting the business. We aim to consistently reinvest at a healthy rate that will support that revenue trajectory, allowing increases in revenue to reflect positively on earnings. This is clearly outlined in our plan, and we believe that Q4—and I would also highlight Q3—is significant evidence of our progress. In the third quarter, we experienced 70 basis points of deleverage, with 60 basis points coming from the e-commerce recovery and another 60 basis points from FX. However, we also gained 50 basis points of leverage from various cost management actions we've implemented. Thus, the overall picture for the quarter, excluding the one-time recovery for our digital business, is quite strong from an SG&A perspective. As we approach the fourth quarter, which is our largest revenue quarter, it becomes easier for us to leverage our fixed costs. We are also moving past the one-time costs associated with digital acceleration, which will not impact the SG&A in the fourth quarter. The full benefits of the cost management actions we began earlier in the year are tied to the SG&A leverage improvement we have projected. This approach is indeed part of our strategy moving forward, as we plan to continue investing in growth in a disciplined manner.

Our question is about digital and digital plus stores and what your thoughts are on the next opportunities for innovation in digital. Additionally, as you consider driving community and mindfulness, how do you see the integration of your online and physical stores? I also have a product question, Laurent. Considering the strong momentum in the bottoms business, how do you feel about the tops and the synergies there, along with the presentation of color compared to the past? That would be great.

Thanks, Oliver. So the first question was about digital, right? When you think about our unique point of differentiation, really, the heartbeat of this brand is our educators, our guests, our ambassadors and our ability to create the most amazing human connection and deliver credible product. When you think about product, I don’t think product is necessarily limited to three-dimensional products that you wear. Without saying too much, I mean we think that we've got a tremendous opportunity to enhance and amplify, that's particularly true in China right now. We've got an opportunity to really enhance the connective tissue between our guests, our ambassadors, and our educators. I see that one really good example of that is an O2O, what they refer to as O2O in China, an offline to online event that we did with Alibaba, where we sold 250 tickets for a Yoga class in Beijing. They were sold on Tmall. They sold out in 30 seconds. It was pouring rain, 247 people showed up. It was live streamed to 125,000 people and I think that day, we did about $700,000 in sales as a result of that exercise. That's where you can really see our ability to amplify what we just saw at the community level on a global scale. When we talk about creating transformational experiences for our guests, it goes beyond product the way you know product today. So I think that gives you enough hints as to how we think about our digital strategy. I totally forgot about the second.

The second question was about tops and just the parts of your assortment where you still see some opportunity, as you had such really awesome growth rates on the bottoms business. And then, Stuart, just functionally, from buy online, pick up in-store and inventory accuracy, what are some of the tactical opportunities and thinking about omnichannel that you're testing and that will harvest some results potentially over the next few quarters?

Regarding the product question, our progress with the Enlite Bra demonstrates our strong presence in the bra category, similar to our success in women's pants. I'm genuinely excited about the innovations coming in 2018 for bras. We aim to earn her trust by excelling in both bottoms and bras, as these categories are foundational, and this trust influences all other categories. I'm optimistic about where we are headed. Additionally, we have plans for new fabrics and constructions in tops, recognizing that she desires more natural materials. We will offer natural fabrics with technical functionality, combining the best of both worlds, and you can expect to see this in July 2018. We're looking forward to it.

On your question on omnichannel. We're excited for the new functionality we'll introduce in '18 with buy online, pick up in-store. We're thrilled with what we've seen on other omnichannel initiatives. Ship from store has been very successful. BBR is our highest comping channel as we think of it in those terms in the company. Our business model continues to become more and more omnichannel. Our stores and digital businesses are becoming more and more intertwined every day. We're excited that we're able to recognize demand in one channel and fulfill it in another in a more seamless manner as we develop these capabilities. I'm going to invite Celeste to also offer some comments as she is with us today.

Yes, thanks, Stuart. I mean, I think, Stuart, you spoke to the highlights in terms of omni, the way we know it today, in terms of ship from store, BBR and then buy online, pick up in-store, the launch next year. I think what I get the most excited about is how, first of all, agile our stores are in terms of merely being able to adapt and to integrate omni into everything they do. The way I really look at it is, obviously, omni and digital goes hand-in-hand with stores. It's becoming more of a way we operate. Every touch point is a touch point that we own, and we're leveraging both channels for what they're best able to deliver for us. As we look at our store portfolio rollout as well as our digital business, we see all those rise in our ability to use each channel strategically allows for that. I don't know if you guys have seen today, but we actually won the Glassdoor #1 Retailer in both Canada and the U.S. from a retail employee satisfaction perspective, which again, to me, really is one of our key competitive advantages and allows us to really play local and leverage digital at the same time. Omnichannel is, in many ways, our middle name and really how we look at the business.

Stuart, as we think about gross margins from here more on a longer-term basis, are there any structural impediments that would prevent the model from returning to the mid-50s prior peak margin that we saw years back? And just how would you rank the gross margin drivers of expansion next year?

Sure. As you look at the peak gross margins of the company a few years back, the assortment was very different. The mix of men's and women's was very different. Within women's, you had a much simpler raw material palette that the designers and merchants were working with. I don't see us returning to that gross margin in the mid-50s. However, I do see room for improvement in product margins from where we are today, and that's part of the comments I offered earlier. I would also add, as you look below just the product margin line and look at the costs for the product team and the supply chain teams, I see substantial opportunity to leverage those products. We've made a lot of big investments over the last couple of years. So we do see opportunity there. And likewise, in occupancy. You saw that in the most recent quarter, where I think we reported 20 basis points of occupancy leverage in the third quarter. A couple of years ago, we were reporting 100 basis points of occupancy and depreciation deleverage. As our real estate portfolio has matured, particularly as we've expanded the international part of the portfolio and those stores have seasoned in the overall portfolio in terms of the incremental additions of rent, it's at a place where we can begin to leverage those costs into the future. We'll certainly talk more on the next call about where we see gross margin get more specificity into 2018 and beyond. The drivers that I would point to were the same that I mentioned earlier, particularly the segmentation of the supply chain. As we separate the different products in our assortment based on their life cycle on our selling floor, we're able to source them differently and more efficiently. That's a big part of the savings and the improvements, efficiencies we've seen to this point. That continues to be an opportunity, although not as large as the big step function that we saw in '16 and early '17, but it's still an opportunity. More exciting for us, as we transition our supply chain past just getting efficient and more coherent, we're beginning to be able to play offense and implement, beginning to test and implement speed models, which will compress our development cycle times. We also have the opportunity to build stronger capabilities for Fast Turn and chase, which again will enable us to have more precise and accurate assortment and inventory decisions, reducing markdowns, benefiting margin. Those are the things I'd point to. When we're together again for the fourth quarter call, we'll be able to offer you additional details.

And Matt, if I can just chime in, today you've got a very different organization than you had at the time of peak margin. Today you've got a runway of international growth, a men's business, a digital opportunity. We have a real strong runway; our destiny is in our hands, driven by a rich pipeline of innovation. That's a very sustainable and profitable model. At the time of peak margin that you're referring to, you didn't have those opportunities ahead and you had a pipeline of innovation that was very dry. Today, you're in a position that is far more sustainable with far more scale as we look to the foreseeable future.

Great. On the balance sheet, net cash position, annual free cash flow generation seems to be really nicely ramping here. Can you just talk to some of the priorities for excess cash going forward as we move into next year and beyond?

Certainly. The main priority for our cash is to fund the organic growth of our business. We are pleased to find excellent investment opportunities, such as expanding our categories with men's products and moving into international markets like Asia and Europe. These growth areas are our top focus for cash allocation. Additionally, we are generating substantial free cash flow. Another aspect of our cash strategy is to maintain financial flexibility, allowing us to explore various ongoing strategies, including a robust cash return strategy, as demonstrated by our share repurchase program over the past few years. As our cash reserves increase, we will assess the priorities I mentioned and decide the best ways to allocate those funds. We can provide more details about our cash strategy and what to expect next year and beyond during our fourth-quarter call as we conclude the year.

Stuart, can you talk about what was store traffic in the third quarter in the U.S. and Canada? Also, what do you assume for store comp within your fourth-quarter comp guidance? And then just separate, can you talk a little bit about the performance of the Fifth Avenue store? How does that store compare to some of your higher-volume stores? Is it teaching anything about where the brand might resonate that you weren't thinking previously? And what percent of that store is tourist?

Sure. Thanks, Paul. Store traffic in the U.S. and Canada, as I mentioned, in the prepared remarks, is sequentially improved in the third quarter. There were periods of the third quarter where we saw positive store traffic in the U.S. Overall, for the quarter, U.S. store traffic is narrowly negative. Canada was a bit tougher. While we saw the Canadian store traffic results improve from the second quarter to the third quarter, it's still negative. As we look at the fourth quarter comp guidance, there are a few things I would point to. We have seen, quarter-to-date, through the first 4 weeks in the U.S, positive store traffic. So that's been very encouraging to see. It's been tougher in Canada, similar to the relationship that we saw in the third quarter. While we plan to sequentially improve, the trend overall has been choppy. The highs have been higher, and the lows have been lower. As of now, we still have 70% of the quarter in front of us, some massive weeks coming up in the next 4, 5 weeks. We feel like the guidance we offered of mid-single digit is appropriate. I'm going to defer to Celeste on the Fifth Avenue question.

Paul, on the traffic, one thing I would want to add is we're also going where traffic is. There's traffic comp and how we're looking at our store portfolio; we're really open to deepening our experiences within these markets, and we have a strategy that is seasonal store strategy. This holiday, we've opened up 22 pop-up seasonal stores that will be in good traffic, decent malls and really capturing business where traffic is. When you look at traffic comp, that's one piece of it. We're also looking to see how we become and continue to be really agile. Those stores, from a seasonal perspective, are trending at about 50% of their guests are new guests. So just shows one of the strategies we're doing and it complements our other strategies from a community perspective to drive store comp traffic. In terms of Fifth Avenue, we're really happy with Fifth Avenue. It's quickly risen to the #1 store in the U.S. We're seeing really good AOV and UPT. In terms of tourist, it is over-indexing our other New York stores in terms of the percentage of tourists, primarily international and U.S. So we're really happy, definitely over-indexes in tourists and new acquisition. It's a good example of how we can have more touch points in the market. In New York City, we've been very, very, very little cannibalization from opening Fifth Avenue. We have Time Warner on the books to open in the second half of 2018. Another good example of our ability to go deeper in-market is Robson in Vancouver. Robson is our #1 store in Canada. We opened Pacific Centre, which is 3 blocks away, and again, a good example of where we don't see cannibalization and we're seeing our ability to run two distinct businesses with great community impact.

A couple of product questions. First on accessories. That assortment has really ramped over the last few months and seems like a nice opportunity over the holiday gifting period. Just curious what the penetration of accessories is today and how much you think that it can expand over the next few years here? And then separately on footwear, just curious on the learnings from the pilot and whether that can be a needle mover here in the short run.

Yes, thank you. Well, on the accessory, our penetration right now is around 7% or 8%. I mean, for a brand that is as strong and as aspirational as we are, we have the potential to be in the 12% to 15%. Certainly, we have a lot of runway. We've seen nice acceleration in the latter part of Q3, probably as a result of the assortment that you're referring to. We see the bulk of the opportunity really in bags, socks, yoga mats, and headwear. We have other accessories on the side, but that's where you're going to see the bulk of the business coming from. It's a nice opportunity for us which is a great guest acquisition strategy and it's a high-margin category. Regarding footwear, I mean, it's an interesting pilot. What we're learning is that our stores are incredibly nimble and that they can adapt to new categories very quickly. That was rolled out in a matter of weeks. That speaks to the agility of our store. It also speaks to the fact that our guests trust us beyond the category that they are in currently. We're taking those learnings and we're thinking about what category this would apply to in the future, but not necessarily footwear.

Thanks for joining us, everyone. We look forward to speaking with you in about 3 months when we report our fourth quarter results. Thanks.