Lululemon Athletica Inc (LULU) — Q2 2019 Earnings Call Transcript

Thank you, and good afternoon. Welcome to lululemon's Second Quarter Earnings Conference Call. Joining me today to talk about our results are Calvin McDonald, CEO; Celeste Burgoyne, EVP Americas and Global Guest Innovation; and PJ Guido, CFO. Before we get started, I'd like to take this opportunity to remind you that our remarks today will include forward-looking statements reflecting management's current forecast of certain aspects of lululemon's future. These statements are based on current information, which we have assessed, but by their nature are dynamic and subject to rapid and even abrupt changes. Actual results may differ materially from those contained in or implied by these forward-looking statements due to risks and uncertainties associated with our business, including those we have disclosed in our most recent filings with the SEC, including our Annual Report on Form 10-K and our quarterly reports on Form 10-Q. Any forward-looking statements that we make on this call are based on assumptions as of today, and we expressly disclaim any obligation or undertaking to update or revise any of these statements as a result of new information or future events. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our quarterly 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 remind our investors to visit our investors site, where you'll find a summary of our key financial and operating statistics for the second quarter as well as our quarterly infographic. Today's call is scheduled for 1 hour. And now I'd like to turn the call over to Calvin.

Thanks, Howard. I'd like to welcome everyone to our second quarter earnings call. I'm pleased to take you through our results, which reflect continued strength across all areas of the business. Lululemon had another successful quarter as our teams across the world continue to build upon momentum in our business and execute on our Power of Three vision for growth. On today's call, I'll provide an overview of our quarter 2 results, including further details on some key initiatives within product innovation and our international business. Next, Celeste Burgoyne, our EVP of the Americas and Global Guest Innovation, will join us to discuss the success within the North American region, early learnings from our Lincoln Park experiential store, and the progress of our membership pilot. Then, PJ will provide a detailed financial review as well as our guidance outlook. To wrap up our call, I'll provide a few closing comments, and then we'll be happy to take your questions. Looking at our second quarter results, momentum in the business remains strong across product categories, channels, and regions. We're now 2 quarters into our 5-year vision, and I'm pleased with the strong execution and passion across the business to continue to deliver on our growth priorities. In quarter 2, total revenue grew 22%. Constant dollar comps increased 17% on top of a 19% increase last year, and earnings per share increased 35%. I'm also proud to share how we are living into our vision to be the experiential brand that ignites a community of people living the Sweatlife through Sweat, Grow and Connect. In July, we opened our first experiential store in Chicago's Lincoln Park neighborhood, and just a few weeks ago, we hosted our eighth annual SeaWheeze Half Marathon in Sunset Festival in Vancouver. These are both fantastic examples of how we are bringing innovation to guest engagement and connecting with our community both inside and outside the four walls of our store. You'll hear more specific details from Celeste shortly on these exciting initiatives. I will now update you on our Power of Three growth pillars: product innovation, omni-guest experience, and market expansion. I'll speak to product in international, and then Celeste will take you through the North America and omni-guest experience. As you'll recall, our 5-year vision details our path to grow our core business in the low double digits annually, while doubling our men's, doubling our digital, and quadrupling our international businesses between now and the end of 2023. Within our product innovation pillar, guest response to our merchandise offering was particularly strong across the board as we continue to leverage our key core franchises while always delivering new innovation through the science of feel. In women's, comps grew 13% as bottoms remained strong, driven by both pants and shorts. Within the men's business, comps grew 27% with ongoing strength in both tops and bottoms. Like women's, the men's side also saw strength in shorts. Across both men's and women's, we continue to innovate to serve our guests across key activities: yoga, run, OTC, and train. Within train this quarter, we launched our latest collaboration, Stronger As One with Barry's. This dual-gender collection was designed specifically for the type of workouts that are popular in Barry's Bootcamp sweat classes, with fabrics that offer abrasion resistance, breathability, and moisture-wicking. The strong response to the collection provides a compelling proof point of the opportunities as we push further into the train category in future seasons. Now I'll provide a quick update on Selfcare. We're thrilled with the initial guest response as performances exceeded our expectations; look for several new additions to the line between now and the end of the fiscal year. We're in the early phases of this pilot and see many opportunities to create products with our unique positioning of solving sweaty problems for athletes. Looking ahead across all categories, I'm happy with our near-term product pipeline and the many innovations that our teams have in longer-term development. Through our unique approach to innovation, the science of feel, we've recently relaunched our Metal Vent collection. This builds upon our successful franchise by offering improved performance attributes, and we're supporting the launch with compelling storytelling to attract new and existing guests to this product line. Our outerwear continues to represent a meaningful opportunity for us, and we're excited to launch waterproof wool in the fall. This fabric innovation will offer guests the warmth and texture they expect from wool, while keeping them dry as they spend time outdoors. We'll also be expanding our lab product to 45 stores and online for fall. As we showcased for you at our Analyst Day, our lab product reflects our pinnacle aesthetic and appeals to a younger, more urban guest relative to our core. Turning now to international. Let me share an update on the progress and success we're seeing in Europe. I spent several days with the team in London a few weeks ago, and we're continuing to see strong trends in this market now that we are more established in the region. In quarter 2, total revenue in Europe grew 35%. We're also pleased with the continued success of our global event strategy, and in June, we hosted our Annual Sweatlife Festival in London. This amazing event brings together guest educators, ambassadors, and other members of the local community for a weekend of sweat classes, yoga, personal development, and meditation. In August, we hosted Sweatlife Berlin for the second time, and I'm excited that we are bringing this event to Paris for the first time in early October. We're also pleased with the recent opening of our first mainline store in the Saint-Germain area of Paris and with the rollout of our local market e-commerce sites in France and Germany. Both sites went live during quarter 2, and we're happy with their performance to date. In our APAC region, the momentum continues to be driven by strength in both our store and online channels. Total revenue in APAC grew 33% in quarter 2 with particular strength in China, where we saw market growth of 68%. We opened 2 new locations in China and our fourth store in Singapore with our Marina Bay location. We're in the early stages of our growth potential and remain on track to open approximately 15 stores in China this year, almost doubling our store count when compared to the end of 2018. And we continue to see strength in our e-commerce business as guests engage with our brand across channels. In China, our e-commerce comps were over 70%, and our new local market sites in Korea and Japan are exceeding initial expectations. I will now turn it over to Celeste to share an update on North America and omni-guest experience. Celeste?

Thanks, Calvin. I'm thrilled to speak with you about the growth we're seeing across our stores and online channels, which reflect the strong connection we have with our guests. In Q2, revenue in North America increased 21% as our guests continue to respond well to our merchandise assortment, engaging store environment, and unique brand activation. Traffic remains a key driver in North America as our strategies and investments continue to drive guests into stores and to our e-commerce sites. During the quarter, we opened one new store in the U.S., and we will remain on track to open 15 to 20 stores this year in North America. In addition, we remain particularly excited with the results we're seeing from our collocated remodeled strategy, and we completed 8 projects in Q2. Within our digital business, guest engagement continues to be strong, and we are focused on pushing forward with improvements to our sites and mobile apps. We are currently in the process of rolling out new search-and-browse functionality, which will further enhance and personalize the experience for guests visiting our e-commerce site. We are also enhancing our product detail page across our digital ecosystem, which will improve product storytelling and product education and further support conversion. And finally, we now have buy online, pick-up in-store capabilities in nearly all of our stores across North America, up from 150 stores at the end of Q1. So far, the favorable response from guests shows how much they appreciate the flexibility and efficiency of this service. As Calvin mentioned, we are living into our vision and engaging with guests in compelling new ways both inside and outside of the store. Our Lincoln Park store is truly the physical manifestation of the heart and soul of lululemon, which is reflected in being active, cultivating mindfulness, and developing meaningful connections. At lululemon, we refer to these three tenets as the Sweatlife. We're really excited with Lincoln Park's performance since its opening in July as it provides our guests, educators, and ambassadors a space to sweat, grow, and connect together. All under one roof, the store offers dedicated studio space for sweat classes and meditation; a locker room for showers; healthy food at our fuel bar; a community space created simply to foster connection; and of course, an elevated shopping experience. 45 of our local ambassadors call this store home, and they lead the 6 to 10 classes we offer every day. Currently, the stores are one-of-a-kind for us as we learn from the initial results. Looking forward, we're excited to share that we have 2 key store openings planned for November, one in Minneapolis and one in New York City. In Minneapolis, we'll be opening our second full experiential store in the Mall of America. This location will offer several of the features found in Lincoln Park, and we are excited about what this store can teach us as a high-volume mall-based location. In New York City, we'll complete the relocation of our large format, Fifth Avenue store near Rockefeller Center. While this store is only moving across the street, the new 23,000-square-foot location will offer an enhanced shopping experience for our guests with a better representation of the product assortment for both men and women. These two openings illustrate the agility of our store format as we meet the wants and needs of guests in each community where we open. Let me shift gears now and update you on membership. Our program remains very much attached. However, we are happy with the engagement we're seeing from our members in the first three cities of Edmonton, Denver, and Austin. As we expected, our loyal guests make up the majority of members so far, but we have a number of members signing up for the program with their first purchase with our brand. In addition, we are seeing men connect with us via the program, with over 20% of our members being male in Austin. While we continue to test and learn, we won't get into the specific economics of the program yet, but we recently launched in our fourth test market of Chicago. With the opening of Lincoln Park, we're excited to see the potential synergies that our membership program and experiential store can create together. Looking at our community activations in Q2. I'd like to highlight several for you that help us further engage with our guests who choose running as their preferred way to sweat. We hosted our 10K runs in Toronto and Edmonton with a positive response from the local community, with 10,000 and 7,000 participants, respectively. In addition, we announced our first large-scale run event in the U.S., a 10K in San Diego that will happen in November and sold out in 3 days. Our brand momentum continued into the third quarter with our SeaWheeze Half Marathon. In addition to the race, which had 10,000 participants, including three of our global run ambassadors, we also had 6,500 guests join us for yoga. We offered Vision & Goals sessions, and we held a celebration in the evening with world-class musical acts. SeaWheeze is a powerful example of how we create lasting ways to sweat, grow, and connect with our community beyond what happens within our stores. Before turning it over to PJ, I'd like to express my sincere gratitude to our educators and store teams as they continue to bring the lululemon brand to life every day for our guests. I'd also like to specifically thank the cross-functional teams that worked to open Lincoln Park. This was a considerable undertaking, and I really don't have the words to express my gratitude for everyone involved. And now I'll pass it to PJ.

Thanks, Celeste. Before I highlight Q2 and our guidance outlook, I encourage you to check out the financial supplement on our investor site for more details. In Q2, total net revenue increased by 22% to $883 million, driven by strong performance across all business segments. In our store channel, we achieved an 11% constant dollar same-store sales increase, building on a 10% increase from Q2 last year. Our square footage rose by 17% year-over-year, attributed to adding 45 net new lululemon stores since Q2 2018. During the quarter, we opened 5 new stores and optimized 8 locations, including our experiential store in Lincoln Park. In the digital channel, we reported a 31% constant dollar same-store sales increase after a robust 47% rise last year. E-commerce contributed around $218 million to our top line, nearly 25% of total revenue. Q2 saw increased traffic driving comps for both in-store and online, with high single-digit growth in-store and over 30% online. Additionally, foreign exchange decreased revenues by $8.4 million during the quarter. Gross profit for Q2 was $485.8 million or 55% of net revenue, compared to 54.8% in Q2 2018. The gross profit rate in Q2 rose by 20 basis points compared to the previous year, driven by a 90 basis point increase in overall product margin from lower product costs, favorable product mix, and reduced markdowns. This occurred despite incurring extra air freight expenses as a hedge against potential port congestion from China tariffs. We remain satisfied with the strength of our product margins, which continue to show considerable gains over recent years. However, product margin expansion was partially offset by a 30 basis point increase in product and supply chain costs due to ongoing investments in product development and supply chain, including our new Toronto distribution center, as well as a 20 basis point rise in occupancy and depreciation expenses. We also experienced a 20 basis point adverse impact from foreign exchange. Regarding SG&A expenses, they totaled about $318 million or 36% of net revenue, compared to 36.2% the previous year. We are pleased to have achieved this leverage per our guidance for Q2 while using our business strength to enhance brand awareness and invest in growth initiatives, including data analytics, loyalty programs, self-care, and expansion into men's. These investments led to a 70 basis point deleverage, which was more than offset by a 90 basis point leverage in store costs and foreign exchange. Our operating income for the quarter was approximately $168 million, making up 19% of net revenue, compared to 18.5% in Q2 2018. The tax expense for the quarter was $45 million, or 26.4% of pretax earnings, compared to a 29.5% effective tax rate last year. The drop in our effective tax rate is attributed to new regulations that offered additional foreign tax credits for prior years, benefiting EPS in Q2 by about $0.02. We now anticipate our full-year 2019 tax rate to be around 27.5%. Net income for the quarter was $125 million, which translates to $0.96 per diluted share, compared to earnings of $0.71 per diluted share in the second quarter of 2018. Capital expenditures were about $67 million for the quarter, up from around $50 million in the second quarter last year, primarily for new store openings, relocations, renovations, and technology and supply chain investments. Looking at our balance sheet, we finished the quarter with $624 million in cash and cash equivalents. Inventory rose by 26%, totaling $494 million at the end of Q2. We repurchased around 9,600 shares this quarter at a cost of $1.6 million. Our Board has authorized a new $500 million share repurchase plan, with approximately $336 million remaining at the end of Q2. We believe buying back our shares is an effective method to return cash to shareholders and will pursue this opportunistically. Looking ahead, we expect Q3 revenues to be between $880 million and $890 million, with a low-teens percentage increase in comparable sales on a constant-dollar basis compared to Q3 2018. This assumes 22 new store openings during the quarter. We anticipate gross margin to remain flat or slightly improve compared to Q3 last year. Our guidance takes into account the impact of new tariffs on imports from China and additional air freight costs. For the full year, we expect a $0.04 to $0.05 negative impact on gross margin from these tariffs and air freight expenses, of which we incurred about $0.01 in Q2, expecting the remaining $0.03 to $0.04 to affect Q3 and Q4 more evenly. We are excited about the opportunities to further enhance product margins. We continue to execute strategies to segment our supply chain and improve efficiencies within our distribution network, coupled with ongoing benefits from scale as we grow, increasing our confidence in modest annual gross margin expansion through 2023. We expect a slight SG&A rate leverage in Q3 as we balance investments for future growth with efficient cost management. We still foresee some modest leverage for the year. Assuming a 28% tax rate and approximately 131 million diluted weighted average shares outstanding, we expect diluted earnings per share in Q3 to range from $0.90 to $0.92, compared to EPS of $0.71 a year ago. For the full year 2019, we now project revenue between $3.8 billion and $3.84 billion, based on a low-teens percentage increase in comparable sales on a constant-dollar basis. We plan to open about 45 to 50 company-operated stores in 2019, including around 30 in international markets, resulting in a mid- to high-teens percentage increase in square footage. We expect modest expansion in gross margin for the year, mainly driven by ongoing product margin improvements. SG&A is also anticipated to leverage modestly for the full year. We project our fiscal year 2019 diluted earnings per share to be between $4.63 and $4.70, based on 131 million diluted weighted average shares outstanding. This range considers around $0.04 to $0.05 in additional costs tied to tariffs and airfreight. We predict our effective tax rate to be around 27.5% in 2019. We assumed the Canadian dollar would be at $0.75 to the U.S. dollar for 2019 and Q3. We now expect capital expenditures for fiscal year 2019 to be approximately $275 million to $285 million, reflecting increased investment in store renovations, new openings, technology, and overall corporate infrastructure projects. In closing, we're enthusiastic about the ongoing strength in the business and remain optimistic for the fall season and beyond.

I would like to thank PJ and Celeste for providing these insights in our business and performance. All of us within the company are proud of what we have achieved. As I travel around the world, I see guests responding to our product, our innovations, and living the Sweatlife. Finally, I'd like to thank everyone at lululemon for their commitment and dedication in achieving these results. And with that, we'll be happy to take your questions. Operator?

Congrats on another great quarter. My first question is just related to the margin outlook for the third quarter and second half overall. Maybe just talk a little bit more about the puts and takes to the flat to up modest gross margin outlook as well as help us think a little bit more about why just modest leverage when low teen comps in the second half as you leverage some of those strategic investments that you started making last year.

Yes, Paul, it's PJ. Thanks for the question. So similar to Q2 going forward in back half for gross margin, it's a similar story. We expect continued gains in product margin, driven by lower product costs. We don't forecast into a mix benefit, but mix has been a benefit for the first part of the year, given the strength in our women's pants business. But product costs remain the big opportunity, and it comes through scale, through segmenting our supply chain, better cost visibility, and certainly greater efficiency across our distribution networks. So we expect that to continue. The takes, as you alluded to, we will see some occupancy and depreciation pressure as we continue to open stores internationally, which carry higher rents, as you know. But we also have some product development costs for newer categories such as bras, outerwear, and accessories. So those are the puts and takes we see in the back half, but net-net, we still expect modest gross margin expansion for the year and going forward.

And on SG&A?

And on SG&A, so we committed to modest SG&A leverage. Last year, we delivered. We're committing to the same for this year and going forward. We continue to use strong performance to invest in current long-term growth. We are seeing the results from that. During Q2, we invested, specifically, we expanded testing in new growth vehicles, loyalty. We continued our investment in our North American online guest experience. We continue to expand our omni capabilities, both in North America and globally. And that will continue to roll forward in the second half of the year. If we don't do these investments, we could see higher SG&A leverage for the quarter and beyond, but we continue to believe this is the right strategy for the business.

And lastly for me is one of the more impressive parts of this quarter was the brick-and-mortar comp growth. Maybe just speak a little bit more about what is leading to the traffic increases and improvement in conversion that you're seeing in-store.

Thanks, Paul. On the momentum that we're seeing in the business, I really break it down into three key categories. The first is the athletics space in general is very healthy relative to other sectors in both apparel and retail in general. Second, our business has fewer highs and lows relative to other apparel brands. And we're less dependent on seasonal fluctuations, and we have a very healthy core business that is driving our success. And then, finally, and it, to me, is what the team is doing such a wonderful job at, and that's engineering that growth. And that's coming from: one, compelling product; two, brand activations; and three, our continual improvement in our data analytics and digital marketing, where we're testing and learning and developing those strengths within the business. So it's a combination of the health of the space and the success and momentum the team is doing in terms of engineering that growth. And we're seeing that across all international businesses, and we're seeing it within, not just in traffic, but as you alluded to, very healthy conversion numbers, which normally, you don't see those two run together. And that's the work that our store teams are doing on guest engagement, investing in the educator. And I also think it's a reflection of the data analytics, as I alluded to. Guests are coming in prepped with what their intent is, and we have educators engaged and ready to assist them, and all that work is paying off.

Congrats on a nice quarter, guys. So Calvin, maybe on the gross margin. What do you see as the multi-year opportunity here? Or maybe a different way to put it, any structural feeling as we think about gross margin, considering digital's outpacing store revenues and just the overall control that you have over distribution?

I believe that our 5-year guidance and long-term plan shared on Analyst Day should be the framework for modeling our progress. We are focusing on optimizing costs as we scale and strengthen our vendor relationships. Additionally, we are introducing new product categories and ensuring we achieve the right balance. We are also exploring new markets, where cost structures vary, while expanding our North American operations by opening stores that generate impressive sales and enhance guest engagement with our full product offerings. We are dedicated to maintaining this balance in our 5-year plan and are already seeing significant success. Much of this innovation is contributing to our revenue growth, and we expect to see improvements in gross margin in line with the guidance we have provided for the upcoming years.

Great. And then, maybe just a follow-up on the expense front. So I guess, really, the question is best way to speak to the balance between in-store cost leverage versus ongoing brand investments. I'm trying to figure out, is 2Q a microcosm for the go-forward modest SG&A algorithm? And then just one follow-up would be on the comps. Have you seen any moderation, as you speak to the momentum, any moderation whatsoever in August? Or fair to say that the momentum has continued through strong?

Well, to your second question, we're pleased with the momentum. Can't give too much color on comp, but we're pleased with where we are, and we continue to see strong traffic. So good news there. On your question about SG&A, I would not say it's a microcosm of the future, but I would say given our store performance, we did leverage channel SG&A to a higher degree this quarter, but we also did have higher investment. And again, we use the upside of good performance to set us up for growth in the coming year. So I would also say we'll start to see benefit, and we already are seeing benefit from our prior investments that we've made in prior quarters. Specifically, digital marketing investment has driven guest acquisition. The enhancements to our website, search, browse, checkout are driving conversion. And our investments in data and analytics are allowing for greater personalization and a closer relationship with our guests. So our prior investment is leveraging. And again, that is a model that's been working for us and we'll continue to deploy that.

Congrats on the continued momentum. It was nice to see the trend of lower markdowns continuing in the quarter. Was wondering if you could provide some color on the percent of your total sales that are coming from markdowns today. I think you most recently commented on some numbers for the holiday periods. Just curious how that's trending year-to-date? I was also wondering if you could touch on what's been happening with some of the ship-from-store capabilities and how that may be affecting the merch margin trends on the markdown front.

Yes. We don't really give out the specific markdown number, as you said. So our markdown activity was lower this quarter, and it did contribute to gross margin expansion. Yes.

Okay. And then maybe as a quick follow-up. I was hoping you could comment on some of the trends you're seeing in the bra category. Been a tremendous amount of innovation there and a bigger marketing focus. So curious what your key learnings are from the spring season.

Mark, yes, we remain very excited about the opportunity within the bra category. The product team continues to launch and develop product that will launch in the coming quarters and years as we see opportunity to innovate into whitespace within the category and add to our assortment. One of the new areas for this quarter that we activated was a bit of that brand activation and storytelling, and we saw the guest respond well to it. In Q1, we really started to invest and set up the stores, how we merchandise. Q2, as we continue to roll out a couple of incremental SKUs, we got into some of the storytelling. Lincoln Park is a test, but an expression of how we want to lean into the category and tell our unique, innovative story behind science of feel as well as present the athletic bra category to our guests in the different segments that we see as opportunity. So it is very early for us in bra. This will be a multi-quarter, multi-year investment. We are testing and learning and moving along. But the good news is that we're very happy with the results, and we're equally excited about how we're learning as an organization and what's to come as we continue to make investments in this category.

Congratulations on the strong results. You've seen amazing strength in the bottoms business in recent quarters. Did you say how much women's bottoms were up in the second quarter? And I guess when you parse out that strength between more athletic offerings maybe versus more lifestyle offerings like office travel commute, how do you think about the strength there? Is it more broad-based? We're just trying to get a sense as to what aspects of the customers' lifestyle you guys are really appealing to, and just how to think about the trajectory of that business into the back half.

Thanks, Kate. On the bottoms business, as you know, it's a core category for us in both women's and men's. And in Q2, we saw both of those continue to perform very strong with double-digit comp performance. In fact, men's outperformed women's as we continued to see success in our men's initiative as one of the key Power of Three growth initiatives. Strength in women's was really driven by both long styles in shorts. We're fueling the strength in shorts by leveraging our core line in fashion-free franchises into a shorter inseam bike short, which is resonating very well with the guest. And in men's, the ABC franchise continued to see great success with existing guests and as a very strong new guest acquisition item. And equally, seeing success in shorts with the short and the Pace Breaker in Surge. So a very good, healthy, balanced bottoms business across both pants, shorts, men's and women's. And we continue to have innovative plans that we'll be launching to continue to drive that momentum forward. And as I alluded before, the team is doing a wonderful job in leveraging the relationships and then broadening, if you like, the share of wardrobe outside of just the bottom business. And we're seeing a lot of success in that, and that's helping to drive success across many other categories. And we anticipate to continue to see success in doing that.

Can you talk a little bit about your average ticket size in North America in-store versus online? Curious to how different the average ticket is there. And how does that compare to what you're seeing in both Europe and Asia when you look at the stores versus online business?

Yes. Paul, it's PJ. So average ticket has remained relatively stable and is pretty consistent across channels. And there are subtle differences regionally, but by and large, average ticket is fairly similar.

Got you. And then, can you maybe talk about the tops to bottoms ratio? Where you are in the men's business? Where are you in the women's business? And where do you hope to be longer term in each of the genders?

Yes. Sorry, Paul. We don't really share that. But the ratio of bottoms to tops is obviously much higher.

Great. Calvin, could you discuss your business in Asia? Even with a slight slowdown in some economies, your numbers appear to be outstanding. I know you mentioned the strength in digital, but it seems like the stores are performing well too. Can you tell us if you've noticed any changes in trends? Perhaps you are in such an early growth stage that you are outpacing what seems to be a minor slowdown. PJ, can you remind us of your current exposure to China sourcing and how we should consider the impact of tariffs, especially with the risk of them potentially increasing? Any details you could provide on that would be helpful.

Thanks, Kimberly. Our APAC business is performing exceptionally well, continuing the strong momentum from Q1 into Q3. Stuart has joined the team to work alongside Ken and Gareth, focusing on this business. We're seeing great success from this leadership team's collaboration, sharing insights, and partnering with Celeste’s team to apply global learnings effectively. In APAC, we have a balanced approach between physical stores and e-commerce, which is very promising. We opened 8 stores in Q1 and one more in Q2, with plans for a strong second half of the year. Starting the year with 15 locations in China, we aim to close with 25 to 30 stores. Guests are responding positively to both the Sweatlife vision and our products. While we are still in the early stages of our growth journey, the strength of our offerings and our community model are resonating well in the market, contributing to our business growth in these quarters, which is truly exciting.

And Kimberly, this is PJ. To answer your question on China tariffs. So just as a reminder, our direct exposure to China is relatively small, with approximately 6% of our finished goods in scope for U.S. tariffs. That percentage is down considerably, given how we have diversified our vendor base. We've never had more flexibility than we do today in our supply chain. So going forward, we do not expect it to be a big impact to the business. In terms of quantifying it, I'll just reiterate that we guided on the last call we expected a $0.04 to $0.05 impact in the back half year weighted towards Q3. We did incur $0.01 of that in Q2. We do see an additional $0.04 in the back half, but more equally weighted given the delay in the tariffs. But it's a situation. We constantly monitor it. We have airfreight in as a hedge to ensure that we deliver for our guests. But again, this is an issue that we feel is highly manageable for us.

Calvin, one for you on loyalty. So you're expanding out to Chicago. I know you can't give us too much detail, but I guess my two quick questions would be could you name maybe the most interesting or exciting thing that you've learned thus far in the small test? And then if things continue to progress in the right direction to you, when's a reasonable timeline that this could actually go across the U.S. or across North America? And then a quick one for PJ. Just on the supply chain deleverage and on the gross margin. I know you have the new DC in Toronto, and I think that recently opened. How should we think about deleverage on supply chain in the back half? And when does that headwind maybe start to flatten out?

Thanks, Ike. Two great questions. On the first, what's been quite honestly a lot of fun in the learnings from the test markets are there are a number of aspects of how the guest is interacting with the program that we're really excited to see. The two that come to mind that probably we didn't anticipate to be as strong in the test markets, and that is, one, the percentage of new guests to lululemon that we're first seeing through the membership program. And the second is the penetration of men in the program. So we kind of went in expecting, in a pilot, in these contained markets, that it would definitely appeal to our high-value guest, which it has, but to see it be another acquisition to acquire new as well as an acquisition for men was not something we initially had anticipated and has been really encouraging among many other aspects. As you mentioned, we launched in Chicago. We're excited to be in that market. And we're going to continue to test and learn and roll out. We're going to expand more in 2020 and then really hit our stride probably in '21. We'll share more as we confirm our rollout plans. But it's early, but very positive, and we are continuing and will continue to expand to more markets. And '20 will be bigger than '19 as will '21.

And Ike, it's PJ. To answer your question about the supply chain and the impact on gross margin, the startup in the Toronto distribution center has had an effect and has resulted in some modest deleverage. This is because it is in the ramp-up phase, and we are facing some costs and growing pains there. We expect to see a modest impact related to this as the facility scales, but we anticipate that it will leverage positively thereafter.

Let me add my congratulations. You provided some very helpful commentary and guidance on international profitability at the Investor Day. I'm just wondering, given the top line strength, how international profitability has trended relative to your expectations so far this year? And then I just have one quick follow-up on Europe.

So with regards to international profitability, again, we're pleased with the progress we're making in all of our regions. We are profitable from an international standpoint. So last year, we did generate profit, and our China business is profitable, our Asia business is profitable. And our Europe business, which is still generating a modest loss, is quickly marching towards profitability. So we're on plan there, and we do expect to continue to scale and achieve profitability improvement in line with how we guided at Analyst Day.

Got it. Regarding Europe, it seems to be up 35% this quarter. You mentioned some brand activations like the Sweatlife Festival. Can you share more about how Europe is progressing? You seem to be particularly excited about the region right now, and the growth supports that.

Thanks, John. I was just with Gareth and team a few weeks ago. And I would say across the management team, we're quite excited about the success of our business in Europe and what the team is executing and how the guest is responding there. We've been longest in London, and we're seeing a real healthy business driven out of that. But at the same point, the other countries we've expanded to are resonating. In Q2, we launched sites in Germany and France, in local language. And the guests are responding well to that continued to open doors. We opened our first full line in Paris in August. And as PJ indicated, we are very close to the profitability mark. And the team is doing a wonderful job in recruiting guests, building that business. And it's going to be a region that plays a big part in our international expansion and the commitment and the goal around the power of 3 of how we're going to quadruple it. And we're seeing some of that success to date.

Let me add my congrats on a great quarter. Just one, I guess, fairly specific question on the margin. With the brick-and-mortar comp up 10%, obviously, very strong by any compare. I guess I'm curious about the deleverage on the occupancy line. I know there's some lease accounting noise in there, and then you mentioned the international mix and probably some double rent during relocations. But I'm curious if you could help us just look ahead a little bit on the underlying dynamics there. What is the underlying leverage point on that line as we think ahead to things like accounting rolling off next year? And then I have a follow-up.

Yes. We previously mentioned that occupancy will be a challenge as we continue to open new stores, especially overseas. Additionally, we have incurred costs related to expanding our distribution network. While this presents a challenge for now, we anticipate being able to scale and leverage these efforts as our stores and distribution centers grow. The key aspect of our gross margin is that product margin has remained robust and will be the main driver of gross margin moving forward. However, we do expect to see the impact of occupancy and depreciation reflected in the gross margin.

Okay. Fair enough. And then, I guess with the comments on international and some of the color you gave around profitability, but at different markets. I think the longer-term plan, along with quadrupling the revenues there, was to go from, I think, pretty close to breakeven margins in total last year, slightly positive to, I think, 10% to 15% over 5 years. A big move, obviously, but I guess, would you help us think ahead a little bit on how you see the inflection in the overall margin for international? Maybe where it's coming, where you see the profitability contributing the most first? And then is the overarching strategy there similar to the corporate strategy where, look, we're going to spend back any upside on the top line to smooth it out? Or is it back half-weighted within the 5-year window, front half-weighted for any reason? Any kind of color you can help us think about because that seems like a big contributor here for the next few years.

Yes, the main driver will be the APAC region, particularly China. As that business continues to grow, it will significantly boost our profitability. Europe will also play a role in this. I believe we are on track to reach the profitability you mentioned. Regarding our business model, since our international segments are rapidly growing, we will keep investing in those areas just as we have in North America, especially considering the positive results we've seen this year. I hope that addresses your question.

Congratulations on the results. As you think about inventory and inventory growth for the balance of the year, how are you thinking about inventory and air freight, given those expenses that are wrapped in there? And how do you expect air freight expenses to be moving forward? And then Calvin, given the loyalty program and given the events that you're having in the stores, are you seeing the translation of the events leading to loyalty members, new loyalty members? And how is new guest conversion compared to what it had been?

Dana, it's PJ. So to answer your inventory question. So we feel really good about the inventory position, given our momentum. We did expedite some fall merchandise using air freight, and we'll continue to use air freight as a tool or a hedge if we start to see issues in the Southeast Asia region associated with the volatility around tariffs. But from a pure inventory standpoint, we are a low seasonal business, and our aged inventory is really low. So we feel really good about how our inventory is positioned, both at the end of the quarter and going forward.

I'll add a few points to your second question. We continue to see very strong metrics with our loyal or high-value guests in terms of retention and engagement with our brand. Our new guest acquisition remains robust from quarter to quarter, contributing significantly to the conversion numbers we celebrate across both stores and e-commerce. One area of success is the ability to convert new guests into high-value customers, and a substantial part of our growth is driven by this conversion. Our new guest acquisition numbers are very encouraging, and the teams are effectively increasing their spending percentage. Additionally, our retention rate for high-value guests is very high, demonstrating stability and growth. Overall, the metrics for our guests are healthy across these crucial areas, and our various initiatives in both digital and CRM continue to enhance and strengthen this. Events and our vision of the Sweatlife play a crucial role in how we attract new guests. We utilize membership events and 10K events in cities like Toronto, Edmonton, and San Diego to enhance guest acquisition, which is also leading to successful migrations. Everything looks very healthy across the board.

Thanks, everyone, for joining us. We appreciate the time, and we look forward to speaking with you in a few months when we report our third-quarter results. Thanks.