lululemon athletica - 10-Q quarterly report FY

lululemon athletica inc., a Delaware corporation (“lululemon” or “LAI” and, together with its subsidiaries unless the context otherwise requires, the “Company”) is engaged in the design, manufacture and distribution of healthy lifestyle inspired athletic apparel, which is sold through a chain of corporate-owned and operated retail stores, independent franchises and a network of wholesale accounts. The Company’s primary markets are Canada, the United States, Japan and Australia, where 38, 32, 4 and nil corporate-owned stores were in operation as at May 4, 2008, respectively. There were 71 and 74 corporate-owned stores in operation as of February 3, 2008, and May 4, 2008 respectively.

The unaudited interim consolidated financial statements as of May 4, 2008 and for the 13-week period ended May 4, 2008 and for the three months ended April 30, 2008 are presented using the United States dollar and have been prepared by the Company under the rules and regulations of the Securities and Exchange Commission (“SEC”). In the opinion of management, the financial information is presented in accordance with United States generally accepted accounting principles (“GAAP”) for interim financial information and, accordingly, do not include all of the information and footnotes required by GAAP for complete financial statements. These unaudited interim consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and related notes included in the Company’s 2007 Annual Report onForm 10-Kfiled with the SEC on April 8, 2008.

The Company reorganized its corporate structure on July 26, 2007. This reorganization was accounted for as a transfer of entities under common control, and accordingly, the financial statements for periods prior to the reorganization have been restated on an “as if” pooling basis. Prior to the reorganization, the Company had prepared combined consolidated financial statements combining LAI and LIPO Investments (Canada) Inc., an entity owned by a principal stockholder of the Company.

Through fiscal 2006, the Company’s fiscal year ended on January 31st in the year following the year mentioned. Commencing with fiscal 2007, the Company’s fiscal year ends on the first Sunday following January 30th in the year following the year mentioned.

Our business is affected by the pattern of seasonality common to most retail apparel businesses. The results for the periods presented are not necessarily indicative of future financial results.

In March 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 161, Disclosures about Derivative Instruments and Hedging Activities(“FAS 161”). FAS 161 is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. The provisions of FAS 161 are effective for the fiscal years and interim periods beginning after November 15, 2008. The Company is currently evaluating the impact of adopting FAS 161 on its consolidated financial statement disclosures.

In December 2007, the FASB issued SFAS No. 141R,Business Combinations (revised 2007)(“FAS 141R”). FAS 141R replaces FAS 141 and requires the acquirer of a business to recognize and measure the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree at fair value. SFAS 141R also requires transaction costs related to the business combination to be expensed as incurred. SFAS 141R is effective for business combinations for which the acquisition date is on or after fiscal years beginning after December 15, 2008. The Company is currently evaluating the impact of adopting SFAS 141R on its consolidated financial statements.

In December 2007, the FASB issued SFAS No. 160Noncontrolling Interests in Consolidated Financial Statements (“FAS 160”). FAS 160 changes the classification of noncontrolling (minority) interests on the balance sheet and the accounting for and reporting of transactions between the reporting entity and holders of such

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities(“FAS 159”). This Statement permits entities to choose to measure various financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. The Company adopted FAS 159 on February 4, 2008 and did not elect the fair value option for any of its eligible financial assets or liabilities.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value in accordance with GAAP, and expands disclosures about fair value measurements. FAS 157 applies under other accounting pronouncements that require or permit fair value measurements and accordingly does not require any new fair value measurements. The provisions of FAS 157 are to be applied prospectively as of the beginning of the fiscal year in which it is initially applied, with any transition adjustment recognized as a cumulative-effect adjustment to the opening balance of retained earnings. The provisions of FAS 157 are effective for fiscal years beginning after November 15, 2007, however the FASB has delayed the effective date of FAS 157 to fiscal years beginning after November 15, 2008 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis. The adoption of FAS 157 for financial assets and liabilities in the first quarter of fiscal 2008 did not have a material impact on the Company’s consolidated financial statements. The Company is currently evaluating the impact of the adoption of FAS 157 for nonfinancial assets and nonfinancial liabilities on its financial position and results of operations.

The Company’s employees participate in various stock-based compensation plans which are either provided by a principal stockholder of the Company or by the Company directly.

Stock-based compensation expense charged to income for the plans was $2,172,382 and $1,407,533 for the thirteen weeks ended May 4, 2008 and the three months ended April 30, 2007 respectively. Total unrecognized compensation cost as at May 4, 2008 was $12,617,507 for all stock option plans, which is expected to be recognized over a weighted-average period of 3.0 years.

A summary of the Company’s stock options and restricted shares activity as of May 4, 2008 and changes during the period then ended is presented below:

During the thirteen weeks ended May 4, 2008 there were no grants, exercises or forfeitures related to any of the stock options issued and outstanding under the stockholder-sponsored awards.

The Company’s Board of Directors and stockholders approved the Company’s Employee Stock Purchase Plan (“ESPP”) in September 2007. The ESPP allows for the purchase of common stock of the Company by all eligible employees. Eligible employees may elect to have whatever portion of his or her base salary equates, after deduction of applicable taxes, to either 3%, 6% or 9% of his or her base salary withheld during each payroll period for purposes of purchasing shares of our common stock under the ESPP. Additionally, we, or the subsidiary employing the participant, will make a cash contribution as additional compensation to each participant equal to one-third of the aggregate amount of that participant’s contribution for that pay period, which will be used to purchase shares of our common stock, subject to certain limits as defined in the ESPP. The maximum number of shares available under the ESPP is 3,000,000 shares. During the quarter ended May 4, 2008, 9,201 shares were purchased under the ESPP, which were funded by the Company through open market purchases.

The performance options issued to an officer of the Company became fully vested during the thirteen weeks ended May 4, 2008. The Company has recognized the remaining portion of the fair value of the performance awards during the thirteen week period ended May 4, 2008, and there is no further unrecognized compensation cost related to the performance options.

James Jones, one of our former executive officers, filed suit against us in the Supreme Court of British Columbia, Canada. The action, captioned James Jones v. Lululemon Athletica Inc., Case No. S071780, was filed on March 14, 2007 against us. Mr. Jones claims that we terminated his employment contract without cause and lawful compensation resulting in breach of contract, wrongful dismissal and negligent misrepresentation. Mr. Jones also alleges that we misrepresented the terms of the employment contract, and seeks damages in an unspecified amount, plus costs and interest. We believe this claim is without merit and are vigorously defending against it.

We are a party to various other legal proceedings arising in the ordinary course of our business, but we are not currently a party to any legal proceeding that management believes would have a material adverse effect on our consolidated financial position or results of operations.

The details of the computation of basic and diluted earnings per share is as follows:

Our calculation of weighted-average shares include the common stock of the Company as well as the exchangeable shares. Exchangeable shares are the equivalent of common shares in all respects. All classes of stock have in effect the same rights and share equally in undistributed net income. For the thirteen weeks ended May 4, 2008, 249,393 stock options were anti-dilutive to earnings and therefore have been excluded from the computation of diluted earnings per share.

A summary of certain balance sheet accounts is as follows:

The Company’s reportable segments are comprised of corporate-owned stores, franchises and other. Phone sales, warehouse sales and showrooms sales have been combined into Other. Information for these segments is detailed in the table below:

Some of the statements contained in thisForm 10-Qand any documents incorporated herein by reference constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical facts, included or incorporated in thisForm 10-Qare forward-looking statements, particularly statements which relate to expectations, beliefs, projections, future plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts, such as statements regarding our future financial condition or results of operations, our prospects and strategies for future growth, the development and introduction of new products, and the implementation of our marketing and branding strategies. In many cases, you can identify forward-looking statements by terms such as “may”, “will”, “should”, “expects”, “plans”, “anticipates”, “believes”, “estimates”, “intends”, “predicts”, “potential” or the negative of these terms or other comparable terminology.

The forward-looking statements contained in thisForm 10-Qand any documents incorporated herein by reference reflect our current views about future events and are subject to risks, uncertainties, assumptions and changes in circumstances that may cause events or our actual activities or results to differ significantly from those expressed in any forward-looking statement. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future events, results, actions, levels of activity, performance or achievements. Readers are cautioned not to place undue reliance on these forward-looking statements. A number of important factors could cause actual results to differ materially from those indicated by the forward-looking statements, including, but not limited to, those factors described in “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” These factors include without limitation:

The forward-looking statements contained in thisForm 10-Qreflect our views and assumptions only as of the date of thisForm 10-Qand are expressly qualified in their entirety by the cautionary statements included in this

lululemon is a designer and retailer of technical athletic apparel. Our yoga-inspired apparel is marketed under the lululemon athletica brand name. We offer a comprehensive line of apparel and accessories including fitness pants, shorts, tops and jackets designed for athletic pursuits such as yoga, dance, running and general fitness. As of May 4, 2008, our branded apparel was principally sold through 85 corporate-owned and franchise stores that are primarily located in Canada and the United States. We believe our vertical retail strategy allows us to interact more directly with and gain insights from our customers while providing us with greater control of our brand. For the first quarter of fiscal 2008, 69.1% of our net revenue was derived from sales of our products in Canada, 29.3% of our net revenue was derived from the sales of our products in the United States and 1.6% of our net revenue was derived from sales of our products in Australia and Japan. After reevaluating our operating performance in Japan and our strategic priorities, we plan to discontinue our operations in Japan in the second quarter of fiscal 2008. We opened our first store in Japan in 2005 and have operated in Japan through a joint venture with Japanese apparel company, Descente, Ltd., since 2006. Japan represented less than 1.5% of our revenues in fiscal 2007 and required a disproportionate amount of management time and attention during fiscal 2007. We believe that our time, attention and capital resources are best spent focused on our top priorities, which are growth in the United States, where we plan to open 35 stores in fiscal 2008, and the development of an e-commerce business.

Our net revenue has grown from $40.7 million for fiscal 2004 to $274.7 million for fiscal 2007. This represents a compound annual growth rate of 88.9%. Our net revenue also increased from $44.8 million for the first quarter of fiscal 2007 to $78.2 million for the first quarter of fiscal 2008, representing a 74.5% increase. By the end of fiscal 2004, we operated 20 stores including 14 corporate-owned stores and six franchise stores in Canada, the United States and Australia. The majority of our stores were located in Canada, with only three corporate-owned stores in the United States and one franchise store in Australia. Our increase in net revenue from fiscal 2004 to fiscal 2007 resulted from the addition of 17 retail locations in fiscal 2005, 14 retail locations in fiscal 2006, 31 retail locations in fiscal 2007, and four retail locations in the first quarter of fiscal 2008 and strong comparable store sales growth of 19%, 25%, 34%, and 28% in fiscal 2005, fiscal 2006, fiscal 2007, and the first quarter of fiscal 2008, respectively. Our ability to open new stores and grow sales in existing stores has been driven by increasing demand for our technical athletic apparel and a growing recognition of the lululemon athletica brand. We believe our superior products, strategic store locations, inviting store environment, grassroots marketing approach and distinctive corporate culture are responsible for our strong financial performance.

We have three reportable segments: corporate-owned stores, franchises and other. We report our segments based on the financial information we use in managing our businesses. While we receive financial information for each corporate-owned store, we have aggregated all of the corporate-owned stores into one reportable segment due to the similarities in the economic and other characteristics of these stores. Our franchises segment accounted for 17.3% of our net revenues for fiscal 2005, 14.3% for fiscal 2006, 6.6% for fiscal 2007 and 5.8% for the first quarter of fiscal 2008. Opening new franchise stores is not a significant part of our near-term store growth strategy, and we therefore expect that the revenue derived from our franchise stores will continue to comprise less than 10% of the net revenue we report in future fiscal years. Our other operations accounted for less than 10% of our revenues in each of fiscal 2005 and fiscal 2006, fiscal 2007 and the first quarter of fiscal 2008.

For fiscal years through fiscal 2006, our fiscal year ended on January 31st in the year following the year mentioned. Commencing with fiscal 2007, our fiscal year ends on the first Sunday following January 30th in the year following the year mentioned.

The following table summarizes key components of our results of operations for the thirteen weeks ended May 4, 2008 and the three months ended April 30, 2007. The operating results are expressed in dollar amounts as well as relevant percentages, presented as a percentage of net revenue.

Net revenue increased $33.4 million, or 74.5%, to $78.2 million for the first quarter of fiscal 2008 from $44.8 million for the first quarter of fiscal 2007. This increase was the result of increased comparable store sales and sales from new stores opened. Assuming the average exchange rate between the Canadian and United States dollars for the first quarter of fiscal 2007 remained constant, our net revenue would have increased $26.2 million or 58.4% for the first quarter of fiscal 2008.

Corporate-Owned Stores.  Net revenue from our corporate-owned stores segment increased $32.6 million, or 85.7%, to $70.6 million for the first quarter of fiscal 2008 from $38.0 million for the first quarter of fiscal 2007. The following contributed to the $32.6 million increase in net revenue from our corporate-owned stores segment:

Franchises.  Net revenue from our franchises segment decreased $0.4 million, or 7.7%, to $4.5 million for the first quarter of fiscal 2008 from $4.9 million for the first quarter of fiscal 2007. The decrease in net revenue from our franchises segment consisted primarily of franchises net revenue of $1.8 million that shifted to corporate-owned stores net revenue when we acquired three franchise stores in Calgary offset by increased franchise revenue of $1.4 million from our remaining franchise locations.

Other.  Net revenue from our other segment increased $1.2 million, or 63.7%, to $3.1 million for the first quarter of fiscal 2008 from $1.9 million for the first quarter of fiscal 2007. The $1.2 million increase was primarily the result of increased wholesale, phone sales and showroom sales.

Gross profit increased $18.9 million, or 83.6%, to $41.5 million for the first quarter of fiscal 2008 from $22.6 million for the first quarter of fiscal 2007. The increase in gross profit was driven principally by:

This amount was partially offset by:

Gross profit as a percentage of net revenue, or gross margin, increased 2.6% in absolute terms, to 53.1% for the first quarter of fiscal 2008 from 50.5% for the first quarter of fiscal 2007. The increase in gross margin resulted from:

This amount was partially offset by:

Our costs of goods sold in the first quarter of fiscal 2008 and the first quarter of fiscal 2007 included $0.2 million and $0.2 million, respectively, of stock-based compensation expense.

Selling, general and administrative expenses increased $14.0 million, or 89.1%, to $29.8 million for the first quarter of fiscal 2008 from $15.8 million for the first quarter of fiscal 2007. As a percentage of net revenue, selling, general and administrative expenses increased 2.9% in absolute terms, to 38.1% from 35.2%. The $14.0 million increase in selling, general and administrative expenses was principally comprised of:

Our selling, general and administrative expenses in the first quarter of fiscal 2008 and the first quarter of fiscal 2007 included $2.0 million and $1.2 million, respectively, of stock-based compensation expense.

The increase of $4.9 million in income from operations for the first quarter of fiscal 2008 was primarily due to a $18.9 million increase in gross profit resulting from increased comparable store sales and additional sales from corporate-owned stores opened, partially offset by an increase of $14.0 million in selling, general and administrative expenses.

On a segment basis, we determine income from operations without taking into account our general corporate expenses such as corporate employee costs, travel expenses and corporate rent. For purposes of our management’s analysis of our financial results, we have allocated some general product expenses to our corporate-owned stores segment. For example, all expenses related to our production, design and distribution departments have been allocated to this segment.

Income from operations (before general corporate expenses) from:

Other income, net increased $0.4 million to $0.5 million for the first quarter of fiscal 2008 from $0.1 million for the first quarter of fiscal 2007. The increase was primarily due to interest income earned on higher cash balances.

Provision for income taxes increased $0.4 million, to $3.8 million, for the first quarter of fiscal 2008 from $3.4 million for the first quarter of fiscal 2007. Our effective tax rate was 30.8% for the first quarter of fiscal 2008 compared to 49.6% for the first quarter of fiscal 2007. In the first quarter of fiscal 2007 we generated losses in the United States for which we recorded no tax benefit, whereas our operations in the United States were profitable in the first quarter of fiscal 2008. The income generated in the first quarter of fiscal 2008 in the United States was fully offset by non-operating losses generated in prior periods.

Net income increased $4.9 million to $8.5 million for the first quarter of fiscal 2008 from $3.5 million for the first quarter of fiscal 2007. The increase in net income of $4.9 million for the first quarter of fiscal 2008 was a result of an increase in gross profit of $18.9 million resulting from increased comparable store sales and additional sales from corporate-owned stores opened, offset by increases in selling, general and administrative expenses of $14.0 million.

Our operating locations by country, state and province as of May 4, 2008, and the overall totals as of May 4, 2008, are summarized in the table below.

Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in interest rates and foreign currency exchange rates. We do not hold or issue financial instruments for trading purposes.

Foreign Currency Exchange Risk.  We currently generate a majority of our net revenue in Canada. The reporting currency for our consolidated financial statements is the U.S. dollar. Historically, our operations were based largely in Canada. As of May 4, 2008, we operated 38 stores in Canada and four stores in Japan. As a result,

Interest Rate Risk.  In April 2007, we entered into an uncommitted senior secured demand revolving credit facility with Royal Bank of Canada which replaced our prior credit facility. Because our revolving credit facility bears interest at a variable rate, we will be exposed to market risks relating to changes in interest rates, if we have a meaningful outstanding balance. At May 4, 2008, we had no outstanding borrowings on our revolving facility. We do not believe we currently are significantly exposed to changes in interest rate risk. We currently do not engage in any interest rate hedging activity and currently have no intention to do so in the foreseeable future. However, in the future, if we have a meaningful outstanding balance, in an effort to mitigate losses associated with these risks, we may at times enter into derivative financial instruments, although we have not historically done so. These may take the form of forward sales contracts, option contracts, and interest rate swaps. We do not, and do not intend to, engage in the practice of trading derivative securities for profit.

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined inRules 13a-15(e)and15d-15(e)under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report, or the Evaluation Date. Based upon the evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of the Evaluation Date. Disclosure controls and procedures are controls and procedures designed to reasonably ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this report, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include controls and procedures designed to reasonably ensure that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

During the 13 weeks ended May 4, 2008, the Company implemented a new inventory subledger system. The implementation has involved changes to processes, and accordingly, has required changes to internal controls.

Other than the changes discussed above, there have not been any changes in the Company’s internal control over financial reporting during the Company’s most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

The Company is, from time to time, involved in routine legal matters incidental to its business. Management believes that the ultimate resolution of any such current proceedings will not have a material adverse effect on the

In addition to other information set forth in this report, you should carefully consider the risk factors discussed in our Annual Report onForm 10-Kfor our 2007 fiscal year. There have been no material changes to the risk factors previously disclosed in our Annual Report onForm 10-K.

Our initial public offering of common stock was effected through a Registration Statement onForm S-1(FileNo. 333-142477),which was declared effective by the Securities and Exchange Commission on July 26, 2007. We sold 2,290,909 shares of common stock in the offering and the selling stockholders sold 18,639,091 shares of common stock in the offering, including the over-allotment option. We did not receive any of the proceeds from sales by the selling stockholders. We received net proceeds of approximately $31.4 million from the offering, and since August 2, 2007, the settlement date of the offering, we have used all of the net proceeds for capital expenditures, including new store openings, and inventory purchases.