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Lululemon Athletica (NASDAQ:LULU)
Q3 2017 Earnings Conference Call
Dec. 6, 2017 4:30 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Thank you for standing by. This is the conference operator. Welcome to the Lululemon Athletica Third-Quarter 2017 Conference Call. As a reminder, all participants are in listen-only mode and the conference is being recorded.

After the presentation, there will be an opportunity to ask questions. Analysts who wish to join the question queue may press *, then 1 on their telephone keypad. Should you need assistance during the conference call, you may see signal an operator by pressing * and 0.

I would now like to turn the conference over to Howard Tubin, vice president, investor relations for Lululemon Athletica. Please go ahead.

Howard Tubin -- Vice President, Investor Relations

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 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 Investor 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 of our quarter. You can find both on our investor site. Today's call is scheduled for one hour. So please limit yourself to one question at a time to give others the opportunity to have their questions addressed.

And now, I'd like to turn the call over to Laurent.

Laurent Potdevin -- Chief Executive Officer and Director

Thank you, Howard, and good afternoon, everyone. I'm 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 are 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 toward a brand with purpose that reflects who they are and who they want to be. Lululemon empowers our guests to design a life they love. This is our DNA and has been for almost 20 years now.

Our stores are at 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 by our ambassadors. The constant from Bend, Oregon to Chengdu, China, is a deep sense 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 consumer's need 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 toward 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. We'll then take your questions.

When looking at a 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 allowed 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 under-penetrated, with only 388 locations across the globe.

Online, we saw a significant acceleration this quarter with constant-dollar comps of 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 a growing collective and we are thrilled with the guest reaction to the enhanced new experience and 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 insights 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 credited [Inaudible] of our women's pants category, with comps up an impressive 24% in Q3. Going into holidays, on Black Friday we launched another unique capsule collection for guests. Collaborating with Forster Rohner, one of Europe's premier couture [inaudible] which contributed to our biggest week ever for pants sale in North America.

I'm also pleased to see our jackets and outerwear assortments 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 to 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 this initiative. 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 on Tmall's single day this year where we tripled our business relative to last year.

Turning to Europe. In Q3, we experienced market growth of 40% and continued to focus our energy on the accelerating shift toward 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 opening a physical presence. This strategy effectively supports our Q3 new-store openings and looking to Q4, inform how we're targeting six additional stores in Asia.

In North America, we're realizing the untapped potential in our core market across store and digital. Symbolic of the opportunity ahead, Fifth Avenue in New York and W. Fourth Street in Vancouver are both [Inaudible] 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 collective. The rapport that exists between our guests, educators, and ambassadors across all our market 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 No. 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're 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 were the Align pant at regular price.

Amongst this backdrop, I know our holiday campaign is 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 a quarter of a million minutes of meditation.

We're 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. We have 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 toward an active, mindful lifestyle. We have exciting opportunities ahead of us as we expand into a new international markets, delivers category disrupting product innovation, and continue to explore how our brand deepens its connection across both men's and women.

Looking forward, I'm more confident than ever in our growth strategy and our ability to execute powerfully against this [inaudible]. As we head into the holidays, I want to extend gratitude for our teams around who put the guests at the heart of everything they do. Stuart.

Stuart Haselden -- Chief Financial Officer and Chief Operating Officer

Thank you, Laurent. As you mentioned, we are pleased with the accelerating momentum we saw in Q3 as 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 costs 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, due to the moderating growth rate in SG&A, up just 70 basis points this quarter, which contributed to our adjusted EBIT margin expansion. The 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 estimates $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're also pleased with a 25% comp we posted in e-commerce.

Our teams executed and refined 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, four in Canada, three in Europe, and three 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 and product mix and lower product costs, offset somewhat by modestly higher markdowns versus last year. Note that this increase comes on top of a 450-basis-point improvement in product margin last year. As our supply chain capabilities improve, we're continuing to identify margin opportunities to gain cost efficiencies across a number of areas. We saw a 20-basis-point favorable impact related to foreign exchange in the quarter and also posted 20 basis points of leverage in occupancy, depreciation, and product and supply chain costs as these costs in aggregate came in better than expected.

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 related 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 a 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, 13.8% of net revenue compared to 17.1% of net revenue in Q3 2016. Excluding the pre-tax 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 pre-tax 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 $65 million in cash and cash equivalents. Inventory at the end of the third quarter was $397 million or 9% higher 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 results in women's pants, our most iconic category, which continued to deliver strong results 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 at 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 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 five 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 anniversarying, 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 the 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 that 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.

Questions and Answers:

Operator

Thank you, sir. We will now begin the question-and-answer session. Analysts who wish to join the question queue may press *, then 1 on their telephone keypads. They will hear a tone acknowledging their request.

If you're using a speakerphone, please pick up your handset before pressing any keys. To withdraw your question, please press *, then 2. We will pause for a moment as callers joint the queue.

Our first question comes from Ike Boruchow with Wells Fargo. Please go ahead.

Ike Boruchow -- Wells Fargo -- Analyst

Hey, everyone. Congrats on the really fantastic quarter. 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 a 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 three months ago for Q3?

Stuart Haselden -- Chief Financial Officer and Chief Operating Officer

Sure, Ike. And just to offer a little context on Q3 and, I think, it sets us up for the guidance that we've offered on Q4. So, really pleased with the ability to post the gross margin expansion that we saw in the third quarter, lapping the big increases that we saw in 2016 and, as we mentioned, the beat to our expectations really came through the favorable selling mix, in particular the great comp that we've seen in pants, both men's and women's, and those categories bring with them some of the best margins in our assortment. And AUC results have also been quite favorable and this reflects the ongoing work of our supply chain team.

As we've talked about over the last couple of years, the work on the segmentation of our supply chain, the deduction of fabric liability, the better management of air freight, the elimination and reduction of cancellations, all these things are continuing to extend the benefits that we've been able to capture. I think we have been pleased by the runway that we've been able to build on the margin improvement, really exceeding our original expectations that we had seen, a lion's share of the improvement really happening second half of 2016, first half of 2017. We've been able to beat our own expectations there and the teams have been able to identify opportunities into the future, which is really a part of the gross margin guidance in the fourth quarter and I would say that these opportunities don't end in the fourth quarter of this year. So, the fourth-quarter guidance reflects all these factors that I just mentioned in terms of where we've been able to identify efficiencies in our supply chain, and it's worth noting that the selling mix benefits that we saw in the third quarter, it was not how we drew out the quarter, we're pleased with how it's performed.

To the extent we see selling mix favorability in the fourth quarter, there could be some upside but in general we're pleased with the results that we've been seeing not only in the third quarter but into the first period of the fourth quarter and I think what we're seeing now really reflects the new margin architecture of the business and this is a key element of the EBIT margin equation that we've been talking about for a while that will get us to an EBIT margin that starts with a 2.

Ike Boruchow -- Wells Fargo -- Analyst

Got it. Really helpful. Thanks, Stuart.

Operator

The next question comes from Matt McClintock with Barclays. Please go ahead.

Matt McClintock -- Barclays -- Analyst

Hello, everyone. Hope everyone's well. A couple of questions. The first one is, Laurent, organizational structure for merchandising, seems like there are 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?

Laurent Potdevin -- Chief Executive Officer and Director

Yeah, it's a good question. With Lee's departure, obviously, we created a void with the creative director, and we are incredibly grateful for the work that we've done with Lee for the past three years and where we've been able to take product, and during the transition we've been able to launch spring '19 and do the credit kickoff with him. So, there's really no change in strategy or direction. I mean, that's a departure that was really driven by personal reasons.

But when I look at the organization, you're going to see one announcement next week on the women's design side, which will be really powerful but I think about head of design demands, I mean, I think about how we're leading on the merchandising side, on the innovation side, and really the four, when you see about the pillars of function, design, and merchandising, I feel like we're in really, really strong shape and obviously, '18 is very much planned already, with the exception of some capsules and collaborations that we're excited about and the spring '19 kickoff that we had just a couple of weeks ago was probably one of the strongest that I've seen. So, we're going to look for a creative director but clearly we're in no rush to fill that role. It's a really, really important role, it's not an easy role to fill, and we've got incredible talent and people in all the key roles to continue to deliver and accelerate on the performance of Q4. I feel really, really good.

Matt McClintock -- Barclays -- Analyst

Thank you for that color. Then, if I may, one more quick one just on China. Outstanding growth in that region and you grew up to 40% to 50% longer-term penetration potential there. Can you maybe talk about your ability, how fast you can ramp that business up without potentially 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?

Laurent Potdevin -- Chief Executive Officer and Director

Every time I go, I learn so much and I'm amazed by it. I think it's hard to understand the scale unless you're on the ground. So, having been there and visiting Guangzhou, the Alibaba headquarters, and being in Beijing and Shanghai, it's really interesting to see you've got 45 million millennials, you've got the government that has a really strong plan, their 2030 health plan, which is pushing people to be more active, you've got 130 million Chinese people traveling the world year-round. So, picture Germany and France spending the whole year traveling.

It's massive, and so when you see this group of millennials more and more interested in an active and mindful lifestyle, more and more interested in experience. I mean, in many ways they're leapfrogging what we've experienced with brick-and-mortar retail in North America and Europe. So we've got a brand with little awareness at this point. We've got a lifestyle that is really aspirational to this group.

So really the sky is the limit. I mean, I think it's hard to say when we're going to mature, but seeing [inaudible] tripling year over year and I think actually some of the work that we've done with some of our ambassadors, with some of our influencers, we can actually accelerate that growth [inaudible]. I was really very excited to land in Shanghai and walk by the newsstand and see our product on the cover of Harper's Bazaar, something that has not happened in North America, and I think it really speaks to how well who we are and what we stand for resonates with that guest.

Matt McClintock -- Barclays -- Analyst

Thanks again for that. Best of luck.

Operator

The next question is from Brian Tunick with RBC. Please go ahead.

Brian Tunick -- RBC -- Analyst

Great, thanks. Good afternoon, all, and my congrats as well, guys. I guess one for Laurent. Maybe on the $4 billion, or this high-teens sales growth [inaudible] 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, Stuart, can you maybe talk about how we should be thinking about SG&A dollar growth going forward now that the e-com and some of the contractor work is behind us? Is the fourth quarter a good proxy for how we should be thinking about SG&A dollar growth or leverage? Thanks very much.

Laurent Potdevin -- Chief Executive Officer and Director

Brian, thanks for your question. When I think about 2020, I think about it in very simple terms and I think we outlined that in the past, but I think that by 2020 we've had a $1 billion digital business, we've got a $1 billion men's business, and we've got a $1 billion international market. And 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. I think one really simple way to think about it is $1 million men, $1 million digital, $1 million international, and obviously the balance is continuing to do what we do so well with the rest of the business, especially with women's and driven by innovation which we've seen resonating incredibly well in Q3 with the launch of Everlux in women's pants.

Stuart Haselden -- Chief Financial Officer and Chief Operating Officer

OK, Brian, let me try to answer your question on SG&A. So, as we've talked about previously, we are calling for SG&A leverage to help us achieve that EBIT margin rate in the low 20s and as we've talked about previously, Q4 was an important period for us to begin delivering on SG&A leverage. As we look forward, and I'll give a little more color on Q4 in a second, but as we look forward beyond the fourth quarter, we're going to plant a modest degree of leverage in our five-year plan, and the rationale there being out of mid-teens total revenue growth, we want to ensure that we are providing the dollars to fund our growth initiatives each year so that we're not harvesting the business and we continue to reinvest at a healthy pace that will help sustain that top-line trajectory but also in a very disciplined manner allow those top-line increases to flow through to earnings. So, that is definitely how we've drawn up a plan and we think that Q4, and also I would point to Q3 as well, is an important evidence of achieving that plan.

If you look at the third quarter, we had 70 basis points to deleverage. Sixty basis points of that was related to the e-commerce recovery. You had another 60 basis points from FX. Offsetting that was 50 basis points of leverage from some of the cost-management actions that we've been taking.

So, the overall picture in the quarter, if you take out sort of the one-time recovery for a digital business, is pretty healthy from an SG&A standpoint. And then if you look into the fourth quarter, the largest quarter from a revenue standpoint, easier for us to leverage our fixed cost, we're also getting past that digital acceleration and one-time costs so we don't have that weighing on the SG&A picture in the fourth quarter. The full benefit of the cost-management actions that we began in the beginning of the year, this connects to our SG&A leverage improvement that we guided to but this is definitely part of our thinking for the business model. We look forward to continuing to invest in growth but doing so in a disciplined manner.

Brian Tunick -- RBC -- Analyst

Makes a lot of sense. Good luck for holiday, guys.

Operator

The next question comes from Oliver Chen with Cowen & Co. Please go ahead.

Oliver Chen -- Cowen & Co. -- Analyst

Hi. Thank you. Great quarter. My question is about digital and digital plus stores and what you're thinking about for the next opportunities for innovation and digital, and also as you think about driving community and mindfulness and the integration of your online and your physical stores, and then I had a product question, Laurent.

What are your thoughts, you've had such great momentum and in the bottoms business. How are you feeling about the tops and the synergies there and the presentation of color relative to the past? That would be great. Thank you.

Laurent Potdevin -- Chief Executive Officer and Director

Thanks, Oliver. So, the first question was about digital, right? When you think about our unique point of differentiation and 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 incredible products. And when you think about product and I don't think the product is necessarily limited to three-dimensional product that you wear. So, without saying too much, I mean, we think that we've got a tremendous opportunity to enhance and amplify that [inaudible] in China right now.

We've got an opportunity to really enhance the connective tissue between our guests, our ambassadors, and our educators and I think one really good example of that is an O2O, an Offline to Online event that we did with Alibaba where we sold 250 tickets for a yoga class in Beijing. So, 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 they did about $700,000 in sales as a result of that exercise. I think that that's where you can really see our ability to amplify what we do so well at the community level on a global scale. And, again, 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.

And I totally forgot the second question.

Oliver Chen -- Cowen & Co. -- Analyst

The second question was about tops and parts of your assortment where you still see some opportunity. You had really awesome growth rate on the bottoms business. And then stores, 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?

Laurent Potdevin -- Chief Executive Officer and Director

Quickly, Oliver, on the product question, I mean, clearly what we've done with the Enlite bra and what we've seen since then really speaks to our ability to be just as strong in the bra category as we are in women's pants, and we're excited about the innovation that's coming in '18 in the bra category. So, when you think about earning her trust and her closet for both bottoms and bras, I mean, those are the two anchor categories and that trust expands across every other category. So, I think we're on a really good track there and I'm excited about the innovation that's coming in '18. Same thing with tops.

When you think about new fabrics and new construction, we know that she wants to see more natural fabric, and you're going to see natural fabric from us but where real technical functionality is incorporated. So, you're going to see the best of both worlds coming to life in 2018, and we're excited about that as well.

Stuart Haselden -- Chief Financial Officer and Chief Operating Officer

And, Oliver, on your question on omnichannel, we're excited about the new functionality we will introduce in 2018, the "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. DDR is our highest comping channel if 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 become more and more intertwined every day. So, we're excited that we were able to recognize demand in one channel and facilitate it in another in a more and more seamless manner as we develop these capabilities. I am going to invite Celeste also to offer some comments as she is with us today.

Celeste Burgoyne -- Executive Vice President, Retail -- Americas

Yeah. Thanks, Stuart. I mean, I Stuart spoke to the highlights in terms of omni the way we know it today in terms of "Ship from store," DDR and then "buy online pick up in store" launch next year. I think what I get the most excited about is how, first of all, agile our stores are in terms of really being able to adopt and to be able to integrate omni into everything they do.

And for us the way I really look at it is obviously omni and digital go hand in hand with stores, and it's becoming more of a way we operate and every touchpoint time is really a touchpoint that we own and we're leveraging both channels so that they're best able to deliver for us. As we look at our store portfolio roll out as well as our digital business, we see kind of all those rise, and our ability to use each channel strategically allows for that. And I don't know if you guys have seen today but we actually won the Glassdoor No. 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. So, again, I think omni is kind of in a lot of ways our middle name and really how we look at the business.

Oliver Chen -- Cowen & Co. -- Analyst

Thanks for that. Happy holidays. Best regards.

Operator

The next question comes from Matthew Boss with JP Morgan. Please go ahead.

Matthew Boss -- JPMorgan Chase -- Analyst

Great. Congrats on a nice quarter, guys. Stuart, as we think about gross margin from here more on a longer-term basis, any structural impediments which would prevent the model from returning to the mid-'50s prior [inaudible] margin that we saw years back. And just how would you rank the gross margin drivers of expansion next year?

Stuart Haselden -- Chief Financial Officer and Chief Operating Officer

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, and within women's, you had a much simpler raw-material palette that designers and merchants were working with. We have many more fabrics today that give a different profile from a cost structure and economic standpoint.

So, I don't see the CS returning to that gross margin from the mid-'50s. I do see room for improvement in product margins, in particular from where we are today and that's part of the comments I offered earlier. I will also add, as you look below just the product margin line and look at the cost for the product team and the supply chain teams, I do 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 opportunities there. And likewise, occupancy and we saw that in the most recent quarter where I think, we recorded 20 basis points of occupancy leverage in the third quarter. If you go back a couple years ago, we were recording like 100 basis points of occupancy and depreciation deleverage. So, I think as our real estate portfolio has matured particularly as we expanded via international, part of the portfolio in the stores have seasoned and 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.

So, we'll certainly talk more on the next call about where we see gross margin with more specificity into 2018 and beyond but the drivers that I would point to you are the same things that I mentioned earlier, in particular, the segmentation on the supply chain and what I mean by that is as we separate the different products in our assortment based on the lifecycle on our selling floor, we're able to source them differently and more efficiently. And so, that's been a big part of the savings and the improvements and efficiencies we've seen up to this point. That continues to be an opportunity although not as large and it's not the big step function that we saw in 2016 and early 2017 but it's still an opportunity and more exciting to us, as we transition our supply chain past just getting efficient and more coherent, we're beginning to be able to play offense and begin to test and implement speed models which will compress our of development cycle times. And 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 which will reduce markdowns which will in turn benefit margins.

So, those are the things I'd point to you again. When we're together again for the fourth-quarter call, we will be able to offer you additional details.

Laurent Potdevin -- Chief Executive Officer and Director

Today, you've got a very different organization that you had at the time of peak margin. Today, we've got a runway international growth, you've got a men's business, you've got a digital opportunity, and you have a real strong runway. Our destiny is in our hands and that's really driven by a rich pipeline of innovation. That's a very sustainable and profitable model.

And at the time of peak margins that you're referring, you didn't have those opportunities I had and you had a pipeline of innovation that was really dry. So, today we're in a position that is far more sustainable with far more scale up as we look to the foreseeable future.

Matthew Boss -- JPMorgan Chase -- Analyst

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

Stuart Haselden -- Chief Financial Officer and Chief Operating Officer

Sure, absolutely. The priorities for our cash, the No. 1 priority is funding the organic growth in our business, and we are excited that we continue to identify great investment opportunities whether it's category expansion within men's or international expansion into Asia and Europe. Those are the No.

1 priority for our cash but even with that, you're correct, we've generated significant free cash flow. The next parts of the use-of-cash strategy is first creating financial flexibility for us to evaluate a number of different online strategies and that would include a healthy return of cash strategy that you've seen in the last couple of years with our share-repurchase program. So, as our cash flow we will evaluate the priorities across these elements that I just mentioned and determine how best to deploy it but, again, I think as we wrap up the year and on the fourth quarter call we'll probably offer a little more detail on our use-of-cash strategy and what you should expect into next year and beyond.

Matthew Boss -- JPMorgan Chase -- Analyst

Great. Good luck.

Operator

The next question comes from Paul Lejuez with Citi. Please go ahead.

Paul Lejuez -- Citigroup -- Analyst

Hey guys. Stuart, can you talk about what was store traffic in the third quarter in the U.S. and Canada and also what 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 you anything about where the brand might resonate that you weren't thinking previously? And what percent of that store's tourists? Thanks.

Stuart Haselden -- Chief Financial Officer and Chief Operating Officer

Sure. Thanks, Paul. Store traffic in the U.S. and Canada, as I mentioned in the prepared remarks, has sequentially improved in the third quarter.

There were periods of the third quarter when we saw positive store traffic in the U.S., but for the overall quarter, U.S. store traffic is narrowly negative. Canada was a bit tougher, and 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 call guidance, there are a few things I would point to.

We have seen quarter to date in the first four 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, sequentially improved but not as strong in Canada as it has been in the U.S.

and still negative in Canada. We're not seeing necessarily a deceleration. If you look at the mid-single-digit comp versus what we reported in Q3, is a 7, we're not seeing deceleration embedded in that fourth-quarter guidance. What I would say is we're seeing peak periods so far in the fourth quarter like in the Black Friday week, outperforming expectations, with the other periods that are not as peak as that, being slower.

So the trend overall has been choppy, if you will, with the highs being higher and the lows being lower. And as we sit today, we still have 70% of the quarter in front of us, some massive weeks coming up in the next four or five weeks. So we feel like the guidance that we offered in the mid-single-digit is appropriate. And I'm going to defer to Celeste on the Fifth Avenue question.

Celeste Burgoyne -- Executive Vice President, Retail -- Americas

Cool. In terms of traffic, one thing I would want to add on the traffic is we're also going where traffic is. So, there's traffic comp and then how we're looking at our store portfolio, is we're really also super open to deepening our experiences within these markets and we have a strategy that is our seasonal store strategy. So 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.

So, again, when you look at traffic comp, that's one piece of it. And we're also really looking to see how we become and continue to be really agile. Those stores, from a seasonal perspective, we're really happy with the results so far from an acquisition perspective. They're trending at about 50% of their guests are new guests.

So, again, just shows one of the strategies we're doing and it complements our other strategies from a community perspective to drive our store comp traffic. In terms of Fifth Avenue, I'm really happy with Fifth Avenue. It's quickly risen to the No. 1 store in the West.

We're seeing really good AOB and really good BPT. In terms of tourists, it's over indexing our other New York stores in terms of the percentage of tourists, international as well as the U.S. So, mainly Midwest and international. So, we're really happy and definitely over-[Inaudible] in tourists and new acquisitions and, again, is an example of how we can definitely have more touchpoints in the market.

So, in New York City we've seen very, very, very little cannibalization from opening Fifth Avenue and we actually have Time Warner on the books to open in the second half of 2018. And another good example of our ability to kind of go deeper in a market is Robson in Vancouver. Robson is our No. 1 store in Canada and we opened Pacific Center, which is three blocks away and again a really good example of where we're not seen cannibalization and we're seeing the ability to really lead and run two very distinct businesses with a really great community impact.

Stuart Haselden -- Chief Financial Officer and Chief Operating Officer

Operator, we'll take one more question.

Operator

Yes, sir, the last question is from Mark Altschwager with Baird. Please go ahead.

Mark Altschwager -- Robert W. Baird -- Analyst

Great. Good afternoon and congrats on the quarter. A couple of product questions. First on accessories.

The assortments really ramped over the last few months. It 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 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.

Laurent Potdevin -- Chief Executive Officer and Director

Thank you. Well, on the accessories, our penetration right now, I think, is like 7% or 8% in the United States before that, 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 a nice acceleration in the latter part of Q3, probably as a result of the assortment that you're referring to.

And we see the bulk of the opportunity really in bags, socks, yoga mat, and headwear. I mean, obviously we've got sort of other accessories on the side but that's where you're going to see the bulk of the business coming from. So, a nice opportunity for us which is a great guest acquisition strategy and it's a high-margin category. So, that's the penetration in terms of, again, what we see as the potential.

And the second question was ...

Mark Altschwager -- Robert W. Baird -- Analyst

Footwear pilot.

Laurent Potdevin -- Chief Executive Officer and Director

Footwear. It's an interesting pilot. I mean, what we're learning is that our stores are incredibly nimble and they can adapt to new categories very quickly but that was rolled out in a matter of weeks really. So, that speaks to the journey of our stores and it also speaks to the fact that our guests trust us beyond the category that we're in currently.

So, we're taking those learnings and we're thinking about what categories it could apply to in the future, but not necessarily footwear.

Mark Altschwager -- Robert W. Baird -- Analyst

Thanks for the color. Best luck for holiday.

Operator

This concludes the time allotted for questions. I will return the conference back over to the presenters for any closing remarks.

Stuart Haselden -- Chief Financial Officer and Chief Operating Officer

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

Operator

This concludes today's conference call. You may disconnect your lines. Thank you for participating and have a pleasant day.

Duration: 59 minutes

Call Participants:

Howard Tubin -- Vice President, Investor Relations

Laurent Potdevin -- Chief Executive Officer and Director

Stuart Haselden -- Chief Financial Officer and Chief Operating Officer

Ike Boruchow -- Wells Fargo -- Analyst

Matt McClintock -- Barclays -- Analyst

Brian Tunick -- RBC -- Analyst

Oliver Chen -- Cowen & Co. -- Analyst

Celeste Burgoyne -- Executive Vice President, Retail -- Americas

Matthew Boss -- JPMorgan Chase -- Analyst

Paul Lejuez -- Citigroup -- Analyst

Mark Altschwager -- Robert W. Baird -- Analyst

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