UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

 

Commission file number 001-33608

 

 

 

 

lululemon athletica inc.

(Exact name of registrant as specified in its charter)

 

 

 

 

 

Registrant’s telephone number, including area code: 604-732-6124

 

Former name, former address and former fiscal year, if changed since last report: N/A

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

Yes  þ      No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

Large Accelerated filer  o      Accelerated filer  o      Non-accelerated filer  þ

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Yes  o      No  þ

 

At November 28, 2007, there were 46,592,145 shares of the registrant’s common stock, par value $0.01 per share, outstanding.

 

      Exchangeable and Special Voting Shares :

 

At November 28, 2007, there were outstanding 20,935,041 exchangeable shares of Lulu Canadian Holding, Inc., a wholly-owned subsidiary of the registrant. Exchangeable shares are exchangeable for an equal number of shares of the registrant’s common stock.

 

In addition, at November 28, 2007, the registrant had outstanding 20,935,041 shares of special voting stock, through which the holders of exchangeable shares of Lulu Canadian Holding, Inc. may exercise their voting rights with respect to the registrant. The special voting stock and the registrant’s common stock generally vote together as a single class on all matters on which the common stock is entitled to vote.

 

 

TABLE OF CONTENTS

 

 

PART I
FINANCIAL INFORMATION

 

lululemon athletica inc. and Subsidiaries

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

See accompanying notes to the interim consolidated financial statements

lululemon athletica inc. and Subsidiaries

 

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

 

 

See accompanying notes to the interim consolidated financial statements

lululemon athletica inc. and Subsidiaries

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

See accompanying notes to the interim consolidated financial statements

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

 

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Accounts receivable

 

Accounts receivable primarily arise out of sales to wholesale accounts, sales of material, royalties on sales owed to the Company by its franchisees and landlord tenant inducements. The allowance for doubtful accounts represents management’s best estimate of probable credit losses in accounts receivable and is reviewed monthly. Receivables are written off against the allowance when management believes that the amount receivable will not be recovered.

 

Inventories

 

Inventories, consisting of finished goods, raw materials and work in process, are stated at the lower of cost and market value. Cost is determined using standard costs, which approximate average costs. For finished goods and work in process, market is defined as net realizable value, and for raw materials, market is defined as replacement cost. Cost of inventories includes acquisition and production costs including raw material, labor and an allocation of overhead, as applicable, and all costs incurred to deliver inventory to the Company’s distribution centers including freight, non-refundable taxes, duty and other landing costs.

 

The Company periodically reviews its inventories and makes provisions as necessary to appropriately value obsolete or damaged goods. The amount of the provision is equal to the difference between the cost of the inventory and its estimated net realizable value based upon assumptions about future demand, selling prices and market conditions.

 

Property and equipment

 

Property and equipment are recorded at cost less accumulated amortization. Costs related to software used for internal purposes are capitalized in accordance with the provisions of the Statement of Position 98-1, “Accounting for Costs of Computer Software Developed or Obtained for Internal Use” , whereby direct internal and external costs incurred during the application development stage or for upgrades that add functionality are capitalized. All other costs related to internal use software are expensed as incurred. Amortization commences when an asset is put into use.

 

Leasehold improvements are amortized on a straight-line basis over the lesser of the length of the lease, without consideration of option renewal periods, and the estimated useful life of the assets, to a maximum of five years. All other property and equipment are amortized using the declining balance method as follows:

 

 

Deferred revenue

 

Payments received from franchisees for goods not shipped as well as receipts from the sale of gift cards are accounted for as deferred revenue. Franchise inventory deposits are included in other current liabilities and recognized as sales when the goods are shipped. Amounts received in respect of gift cards are recorded as deferred revenue. When gift cards are redeemed for apparel, the Company recognizes the related revenue.

 

Based on historical experience, the Company estimates the value of gift cards not expected to be redeemed and, to the extent allowed by local laws, amortizes these amounts into income.

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Revenue recognition

 

Sales revenue includes sales of apparel to customers through corporate-owned and operated retail stores, phone sales, sales through a network of wholesale accounts, initial license and franchise fees, royalties from franchisees and sales of apparel to franchisees.

 

Sales to customers through corporate-owned retail stores and phone sales are recognized at the point of sale, net of an estimated allowance for sales returns.

 

Initial license and franchise fees are recognized when all material services or conditions relating to the sale of a franchise right have been substantially performed or satisfied by the Company, provided collection is reasonably assured. Substantial performance is considered to occur when the franchisee commences operations. Franchise royalties are calculated as a percentage of franchise sales and are recognized in the month that the franchisee makes the sale.

 

Sales of apparel to franchisees and wholesale accounts are recognized when goods are shipped and collection is reasonably assured.

 

All revenues are reported net of sales taxes collected for various governmental agencies.

 

Store pre-opening costs

 

Operating costs incurred prior to the opening of new stores are expensed as incurred.

 

Use of estimates

 

The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenues and expenses during the reporting period. Significant areas requiring the use of management estimates relate to the determination of inventory valuation, depreciation and amortization, impairment of long-lived assets and goodwill and recognition of breakage on gift cards. Actual amounts could differ materially from those estimates.

 

Stock-based compensation

 

The Company accounts for stock-based compensation using the fair value method as required by Statement of Financial Accounting Standards No. 123R, “Share Based Payment” (SFAS 123R). The fair value of awards granted is estimated at the date of grant and recognized as employee compensation expense on a straight-line basis over the requisite service period with the offsetting credit to additional paid-in capital. For awards with service and/or performance conditions, the total amount of compensation cost to be recognized is based on the number of awards expected to vest and is adjusted to reflect those awards that do ultimately vest. For awards with performance conditions, the Company recognizes the compensation cost if and when the Company concludes that it is probable that the performance condition will be achieved. The Company reassesses the probability of achieving the performance condition at each reporting date. For awards with market conditions, all compensation cost is recognized irrespective of whether such conditions are met.

 

Certain employees are entitled to share-based awards from a principal stockholder of the Company. These awards are accounted for by the Company as employee compensation expense in accordance with the above-noted policies.

 

The Company commenced applying SFAS 123R when it introduced stock-based awards for its employees during the year ended January 31, 2006.

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Income taxes

 

The Company follows the liability method with respect to accounting for income taxes. Deferred tax assets and liabilities are determined based on temporary differences between the carrying amounts and the tax basis of assets and liabilities. Deferred income tax assets and liabilities are measured using enacted tax rates that will be in effect when these differences are expected to reverse. Deferred income tax assets are reduced by a valuation allowance, if based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

 

In July 2006, the Financial Accounting Standards Board (the “FASB”) issued Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes , or “FIN 48”, which clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes . FIN 48 prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the de-recognition, classification, interest and penalties, accounting in interim periods, and disclosure requirements for uncertain tax positions. The Company adopted the provisions of FIN 48 beginning February 1, 2007.

 

We file income tax returns in the U.S., Canada and various foreign and state jurisdictions. We are subject to income tax examination by tax authorities in all jurisdictions from our inception to date. Our policy is to recognize interest expense and penalties related to income tax matters as tax expense. At October 31, 2007, we do not have any significant accruals for interest related to unrecognized tax benefits or tax penalties. Based on the Company’s evaluation, there are no significant uncertain tax positions requiring recognition in accordance with FIN 48.

 

Recently issued accounting standards

 

In February 2007, the FASB issued Statement of Financial Accounting Standard No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS 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. SFAS 159 is effective for the Company beginning January 1, 2008. The Company is currently evaluating the impact that adopting SFAS 159 will have on its financial position and results of operations.

 

In September 2006, the FASB issued Statement of Financial Accounting Standard No. 157, “ Fair Value Measurements ” (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 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 SFAS 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 SFAS 157 are effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact that the adoption of SFAS 157 will have on its financial position and results of operations.

 

Comparability

 

Certain comparative amounts have been reclassified to conform to the presentation adopted in the current period.

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Reorganization in connection with initial public offering

 

On August 2, 2007 the Company completed an initial public offering. In connection with the initial public offering, the Company entered into an Agreement and Plan of Reorganization dated April 26, 2007 (Reorganization Agreement), with all of its shareholders, lululemon usa inc. (Lulu USA), lululemon athletica canada inc. (LACI), Lulu Canadian Holding, Inc. (LCHI), LIPO Investments (Canada) Inc. (LIPO), LIPO Investments (USA), Inc. (“LIPO USA”) and Slinky Financial ULC: an entity owned by a principal stockholder of the Company. The parties executed a corporate reorganization of the Company on July 26, 2007, immediately following the execution of the underwriting agreement entered into in connection with the initial public offering. In the reorganization, all outstanding shares of the Company (which consisted of Series A shares and Series TS shares) and all outstanding shares of LIPO, which was combined with the Company prior to the reorganization, were exchanged for common shares of the Company or exchangeable shares issued by LCHI. Upon completion of the reorganization, Lulu USA and LACI became direct or indirect wholly-owned subsidiaries of the Company.

 

As part of the reorganization, a 2.38267841 for one stock split was effected for all authorized, issued, and outstanding shares of common stock of the Company issued in exchange for the preferred shares. All common shares presented in the consolidated financial statements and the notes to the consolidated financial statements have been restated to reflect the July 26, 2007 stock split. The reorganization and the stock split resulted in the holders of 108,495 Series A shares held prior to the reorganization of the Company receiving 31,380,425 common shares of the Company and the holders of 117,000,361 LIPO shares and 116,994 Series TS shares receiving 12,910,353 common shares and 20,935,041 special voting stock of the Company and 20,935,041 exchangeable shares of LCHI. Lulu US repurchased all outstanding shares of its non-participating preferred stock for a purchase price of $1.00 per share.

 

The exchangeable shares of LCHI and the special voting shares of the Company, when taken together, are the economic equivalent of the corresponding common shares of the Company and entitle the holder to one vote on the same basis and in the same circumstances as one corresponding share of the common shares of the Company. The exchangeable shares are exchangeable at any time, at the option of the holder on a one-for-one basis with the corresponding common shares of the Company.

 

Prior to the reorganization, LIPO and LIPO USA had created stock-based compensation plans for eligible employees of LACI and Lulu USA. The eligible employees were granted options to acquire shares of LIPO and LIPO USA. The outstanding unvested stock options of LIPO were modified and exchanged for options of LIPO USA which allow the holder to acquire shares of LIPO USA. Vested LIPO options were immediately exercised for shares in LIPO and then exchanged for a fraction of an exchangeable share or common share in the Company. The exercise price and the number of common shares of the Company subject to the new Company stock options (note 4) were set to preserve the terms and conditions of the LIPO and LIPO USA stock options being exchanged.

 

LACI and Lulu US also had share option plans to purchase common shares of LACI and Lulu US. These options were exchanged for 4,479,176 options of the Company (note 4).

 

For accounting purposes, the corporate reorganization has been reflected as if it had occurred for all periods presented.

 

Authorized share capital

 

As part of the reorganization in connection with the initial public offering, the Company’s stockholders approved an amended and restated charter that provides for the issuance of up to 200,000,000 shares of common stock, 5,000,000 shares of undesignated preferred stock and 30,000,000 shares of special voting stock. Upon completion of the reorganization there were 44,290,778 shares of common stock, 20,935,041 shares of exchangeable stock and 20,935,041 shares of special voting stock outstanding. Additionally, 10,000,000 shares of common

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

stock are reserved for issuance under the Company’s 2007 Equity and Incentive Plan (the “2007 Plan”). The holders of common stock and special voting stock are entitled to one vote for each common share held.

 

 

As described in note 3, a reorganization and stock split resulted in changes to the capital structure of the Company. Information in this note has been presented to reflect the combination of the stockholder sponsored plans. The number of options and exercise prices for options issued under the predecessor plans prior to the corporate reorganization have been presented to reflect the replacement options of the Company that have been issued as if the replacement options had always been issued.

 

In July 2007, the Board adopted, and the Company’s stockholders approved, in conjunction with the reorganization of the Company, the 2007 Equity Incentive Plan (note 3). Upon completion of the reorganization of the Company, outstanding awards under the Company’s predecessor plan were exchanged for awards under the 2007 Plan in such a way that no incremental compensation cost resulted from the exchange. The 2007 Plan provides for the grants of stock options, stock appreciation rights, restricted stock or restricted stock units to employees (including officers and directors who are also employees) of the Company or of a parent or subsidiary of the Company. Stock options granted to date have a 4-year vesting period and vest at a rate of 25% per each year on the anniversary date of the grant. Restricted stock issued under the 2007 Plan vest one year from the grant date and has no exercise price. To date, 10,458 shares of restricted stock have been issued under the 2007 Plan to certain directors of the Company.

 

The restricted common stock vests one year after the grant date. Once granted, the restricted common stock is included in total shares outstanding but is not included in the weighted average number of common shares outstanding in each period used to calculate basic earnings per share until the shares vest. There have been no stock appreciation rights issued under the 2007 Plan to date.

 

The following is a summary of the total number of outstanding stock options and restricted common stock issued under the plan:

 

 

Stockholder sponsored awards

 

During the year ended January 31, 2006, LIPO and LIPO USA, entities controlled by a principal stockholder of the Company created stock-based compensation plans (the LIPO Plans) for certain eligible employees of the Company in order to provide incentive to increase stockholder value. Under the provisions of the LIPO Plans, the eligible employees were granted options to acquire shares of LIPO and LIPO USA respectively. The board of directors of LIPO and LIPO USA would exchange the LIPO and LIPO USA shares held in trust for an equivalent number of shares of the Company to be held by LIPO and LIPO USA, respectively, on the exchange date.

 

On December 1, 2005, LIPO and LIPO USA each granted 5,295,952 Series A options with an exercise price of CA$0.00001 and an expiry date of December 1, 2009 and 11,062,179 Series B options with an expiry date of December 1, 2010, respectively. The LIPO and LIPO USA Series B options had exercise prices of CA$0.99 and $0.01, respectively. Each Series A option and each Series B option entitled the holder to acquire one share of common stock of the respective companies.

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

While all of the Series A options of both companies vested on December 5, 2005 and were immediately exercised, 3,549,444 of the common shares of LIPO and LIPO USA issued were designated as forfeitable. These forfeitable shares are considered to be non-vested for accounting purposes and were considered not to be earned as of December 5, 2005. These non-vested shares became non-forfeitable over a 4-year requisite service period ending on December 5, 2009. In addition, on December 5, 2005, 2,239,395 of the Series B options vested, with the remaining options vesting over a 5-year period ending December 5, 2010.

 

In connection with the reorganization of the Company, the LIPO Series A awards and vested LIPO Series B awards were exchanged for exchangeable shares of the Company through a series of transactions. The LIPO Series B unvested options were cancelled and new LIPO USA Series B stock options with an exercise price of $0.01 were issued using a conversion factor set out in the reorganization agreement. The cancellation of the LIPO Series B unvested options and the issuance of the new LIPO USA Series B stock options occurred with the terms and conditions being preserved through the number and terms of new options being granted.

 

The summary of activity related to forfeitable shares formerly issued under the LIPO Series A options and LIPO Series B options which were vested on July 27, 2007 and were converted to exchangeable shares pursuant to the reorganization agreement (note 3), is as follows:

 

 

The Company records compensation expense for forfeitable shares issued under LIPO Series A over the requisite service period of 5 years. Under the fair value method, compensation expenses were $196,589 and $216,141 for the three month periods ended October 31, 2006 and 2007, and $579,230 and $606,306 for the nine month periods ended October 31, 2006 and 2007, respectively

 

The summary of option grants, forfeitures, vesting and exercises under the LIPO USA Series B Plan since inception is as follows:

 

 

The Company records compensation expense for shares issued under the LIPO Series B options, over the requisite service period of 5 years. Under the fair value method, compensation expenses were $154,759 and

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

$170,153 for the three month periods ended October 31, 2006 and 2007, and $455,984 and $477,301 for the nine month periods ended October 31, 2006 and 2007, respectively.

 

The LIPO USA Series B stock options allow the holder to receive common shares upon exercise at a conversion factor as set out in the Reorganization Agreement. If all of the LIPO USA Series B options were to vest and be exercised at October 31, 2007, they would result in the delivery of 1,474,925 common shares.

 

Class B LIPO USA Options and LIPO USA Forfeitable Shares issued on exercise of Class A LIPO USA Options vest as follows:

 

 

 

On March 14, 2007, a former executive officer filed suit against the Company for breach of contract, wrongful dismissal and negligent misrepresentation seeking damages plus costs and interest. The Company believes the claim is without merit and is vigorously defending against it.

 

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 Company’s continued financial position, results of operations or cash flows.

 

 

In conjunction with the initial public offering of the Company as explained in note 3, the Company’s capital structure was reorganized such that LIPO became an indirect, wholly-owned subsidiary of the Company, and the holders of preferred shares of the Company acquired common shares of the Company in exchange for their preferred shares, while the holders of LIPO shares acquired either common shares of the Company or a combination of exchangeable shares of LCHI plus shares of special voting stock of the Company, in exchange for their LIPO shares. In connection with the reorganization, each outstanding share of the Company’s common stock was split into 2.38267841 shares of common stock, with a corresponding effect on outstanding options and exercise prices. Earnings per share has been computed based on the post reorganization capital structure as if the common shares had been outstanding for all periods presented or since the respective share transaction occurred. For diluted earnings per share the equivalent potential common stock issued on a post reorganization basis has been used. The common stock and options outstanding as of the completion of the reorganization was 65,225,819 shares and 4,479,176 options, respectively. In addition, the outstanding stock options of Lulu Canada and Lulu US were exchanged for options to acquire common shares of the Company at an adjusted exercise price. The exercise of options under the LIPO Plans have been excluded as any shares of LAI ultimately issued on exercise of these options have already been included in the exchangeable shares.

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The detail 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 of LCHI. 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 three and nine months ended October 31, 2007, 42,250 stock options were anti-dilutive to earnings and therefore have been excluded from the computation of diluted earnings per share.

 

 

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

 

Some of the statements contained in this Form 10-Q and 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 this Form 10-Q are 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 this Form 10-Q and 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:

 

 

 

Although we believe that the assumptions inherent in the forward-looking statements contained in this Form 10-Q are reasonable, undue reliance should not be placed on these statements, which only apply as of the date hereof. In addition to the assumptions specifically identified herein, assumptions have been made regarding, among other things:

 

 

The forward-looking statements contained in this Form 10-Q reflect our views and assumptions only as of the date of this Form 10-Q and are expressly qualified in their entirety by the cautionary statements included in this Form 10-Q. The following discussion should be read in conjunction with our unaudited condensed interim financial statements and this Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the financial statements and notes thereto for the year ended January 31, 2007 and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in our Prospectus filed pursuant to Rule 424(b) under the Securities Act with the Securities and Exchange Commission on July 27, 2007, and the unaudited condensed consolidated financial statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q. Except as required by applicable securities law, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events.

 

Overview

 

We believe lululemon is one of the fastest growing designers and retailers of technical athletic apparel in North America. 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 October 31, 2007, our branded apparel was principally sold through 70 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 nine months of fiscal 2007, 81.5% of our net revenue was derived from sales of our products in Canada, 17.2% of our net revenue was derived from the sales of our products in the United States and 1.3% of our net revenue was derived from sales of our products in Australia and Japan.

 

Our net revenue has grown from $40.7 million for fiscal 2004 to $148.9 million for fiscal 2006. This represents a compound annual growth rate of 91.1%. Our net revenue also increased from $36.0 million for the third quarter of fiscal 2006 to $66.2 million for the third quarter of fiscal 2007, representing a 83.9% 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 2006 resulted from the addition of 17 retail locations in fiscal 2005 and 14 retail locations in fiscal 2006 and strong comparable store sales growth of 19% and 25% in fiscal 2005 and fiscal 2006, 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.

 

The two most important determinants of our future net revenue, earnings and cash flow growth are the successful expansion of our corporate-owned store base and increases in comparable store sales. Though we expect

continued growth in net revenues, we expect our growth rate to decline in the future relative to the rate of growth we have experienced in historical periods as incremental revenue is measured against a larger revenue base. Moreover, we expect a significant portion of our new store growth to be concentrated in the United States. While we believe there is a significant opportunity to expand our store base in the United States, our brand is still relatively new in the United States and, therefore, our success is uncertain. To help manage our growth in the United States, we have hired senior-level employees over the last eighteen months with experience in the United States retail environment. Additionally, we are focused on continuing to grow our comparable store sales by increasing brand awareness through our community-based marketing efforts, developing innovative technical athletic apparel that our customers demand and offering a distinctive retail experience. Future comparable store sales growth will depend on our ability to continue to attract and retain motivated corporate and store-level employees that are passionate about the lululemon athletica vision. Other external factors that could affect our net revenue, earnings and cash flows, though to a lesser degree than the factors above, include fluctuations in currency exchange rates and general economic conditions in our target markets.

 

lululemon was founded in 1998 by Dennis “Chip” Wilson in Vancouver, Canada. lululemon athletica inc. (formerly known as Lululemon Corp. and before that as Lulu Holding, Inc.) is the holding company for all our related entities, including our two primary operating companies lululemon usa inc. and lululemon athletica canada inc. On August 2, 2007 lululemon athletica inc. completed an initial public offering.

 

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 more than 10% of our net revenues for each of fiscal 2005 and fiscal 2006 and 7.4% of our net revenues for the first nine months of fiscal 2007. Opening new franchise stores is not a significant part of our near-term store growth strategy, and we therefore expect that if the revenue derived from our franchise stores continues 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 and 3.6% of our revenues for the first nine months of fiscal 2007.

 

As of October 31, 2007, we sold our products through 62 corporate-owned stores located in Canada, the United States and Japan. Most of our corporate-owned stores are located in North America, with only four corporate-owned stores located in Japan. We plan to increase our net revenue in North America by opening additional corporate-owned stores in new and existing markets. Corporate-owned stores net revenue accounted for 81.1% of total net revenue for fiscal 2006 and 89.0% of total net revenue for the first nine months of fiscal 2007.

 

As of October 31, 2007, we also had 6 franchise stores located in North America and 2 franchise stores located in Australia. In the past, we have entered into franchise agreements to distribute lululemon athletica branded products to more quickly disseminate our brand name and increase our net revenue and net income. In exchange for the use of our brand name and the ability to operate lululemon athletica stores in certain regions, our franchisees generally pay us a one-time franchise fee and ongoing royalties based on their gross revenue. Additionally, unless otherwise approved by us, our franchisees are required to sell only lululemon athletica branded products, which are purchased from us at a discount to the suggested retail price. Pursuing new franchise partnerships or opening new franchise stores is not a significant part of our near-term store growth strategy. In some cases, we may exercise our contractual rights to purchase franchises where it is attractive to us. Franchises net revenue accounted for 14.3% of total net revenue for fiscal 2006 and 7.4% of total net revenue for the first nine months of fiscal 2007.

 

We believe that our athletic apparel has and will continue to appeal to consumers outside of North America who value its technical attributes as well as its function and style. In 2004, we opened our first franchise store in Australia. In the second quarter of fiscal 2007 we opened our second franchise store in Australia. We intend to convert the Australian franchise operations into a joint venture partnership. In 2005, we opened a franchise store in Japan. In 2006, we terminated our franchise arrangement and entered into a joint venture agreement with Descente Ltd, or Descente, a global leader in fabric technology, to operate our stores in Japan. This joint venture company is named Lululemon Japan Inc. As of October 31, 2007, we operated four stores through Lululemon Japan Inc. Because we own 60% of the joint venture and maintain control over it, the financial results of Lululemon Japan Inc. are consolidated and included in our corporate-owned stores segment. We plan to increase net revenue in markets

outside of North America primarily by opening additional stores with joint venture partners in existing markets as well as opening stores in new markets with new joint venture partners.

 

In addition to deriving revenue from sales through our corporate-owned stores and our franchises, we also derive other net revenue, which includes the sale of our products directly to wholesale customers, telephone sales to retail customers, including related shipping and handling charges, warehouse sales and sales through a limited number of company operated showrooms. Wholesale customers include select premium yoga studios, health clubs and fitness centers. Telephone sales are taken directly from retail customers through our call center. Warehouse sales are typically held at one or more times a year to sell slow moving inventory or inventory from prior seasons to retail customers at discounted prices. Our showrooms are typically small locations that we open from time to time when we enter new markets and feature a limited selection of our product offering during select hours. Other net revenue accounted for 4.6% of total net revenue for fiscal 2006 and 3.6% of total net revenue for the first nine months of fiscal 2007.

 

We believe that a number of trends relevant to our industry have affected our results and may continue to do so. Specifically, we believe that there is an increasing appreciation for the health benefits of yoga and related fitness activities in our markets and that women, our primary customers, are increasingly embracing an active healthy lifestyle. As such, we believe that participation in yoga and related fitness activities will continue to grow. There is also an increasing demand for technical athletic apparel relative to traditional athletic apparel, and we believe that more people are wearing technical apparel in casual environments to create a healthy lifestyle perception. The duration and extent of these trends, however, is unknown, and adverse changes in these trends may negatively impact our net revenue, earnings or cash flows.

 

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

 

Results of Operations

 

Three months ended October 31, 2007 compared to three months ended October 31, 2006

 

The following table summarizes key components of our results of operations for the three months ended October 31, 2007 and October 31, 2006. The operating results are expressed in dollar amounts as well as relevant percentages, presented as a percentage of net revenue.

 

Net Revenue

 

Net revenue increased $30.2 million, or 83.9%, to $66.2 million for the third quarter of fiscal 2007 from $36.0 million for the third quarter of fiscal 2006. 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 third quarter of fiscal 2006 remained constant, our net revenue would have increased $25.5 million or 70.9% for the third quarter of fiscal 2007.

 

 

Corporate-Owned Stores.   Net revenue from our corporate-owned stores segment increased $30.8 million, or 105.6%, to $59.9 million for the third quarter of fiscal 2007 from $29.1 million for the third quarter of fiscal 2006. The following contributed to the $30.8 million increase in net revenue from our corporate-owned stores segment.

 

 

Franchises.   Net revenue from our franchises segment decreased $1.1 million, or 20.9%, to $4.2 million for the third quarter of fiscal 2007 from $5.3 million for the third quarter of fiscal 2006. The decrease in net revenue from our franchises segment consisted primarily of franchises net revenue of $2.7 million that shifted to corporate-owned stores net revenue when we acquired three franchise stores in Calgary offset by increased franchise revenue of $1.6 million from our remaining franchise locations.

 

Other.   Net revenue from our other segment increased $0.5 million, or 34.2%, to $2.0 million for the third quarter of fiscal 2007 from $1.5 million for the third quarter of fiscal 2006. The $0.5 million increase was primarily the result of increased wholesale, phone and showroom sales.

 

Gross Profit

 

Gross profit increased $17.1 million, or 91.5%, to $35.9 million for the third quarter of fiscal 2007 from $18.7 million for the third quarter of fiscal 2006. 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 2.1% to 54.2% for the third quarter of fiscal 2007 from 52.1% for the third quarter of fiscal 2006. The increase in gross margin resulted from:

 

 

This amount was partially offset by:

 

 

Our costs of goods sold in the third quarter of fiscal 2007 and the third quarter of fiscal 2006 included $0.2 million and $0.1 million, respectively, of stock-based compensation expense.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses increased $10.0 million, or 71.2%, to $24.1 million for the third quarter of fiscal 2007 from $14.0 million for the third quarter of fiscal 2006. As a percentage of net revenue; selling, general and administrative expenses decreased 2.7% to 36.4% from 39.1%. The $10.0 million increase in selling, general and administrative expenses was principally comprised of:

 

 

This amount was partially offset by:

 

 

Our selling, general and administrative expenses in the third quarter of fiscal 2007 and the third quarter of fiscal 2006 included $1.6 million and $0.5 million, respectively, of stock-based compensation expense.

 

Income from Operations

 

The increase of $7.1 million in income from operations for the third quarter of fiscal 2007 was primarily due to a $17.1 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 $10.0 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 $0.3 million to $0.4 million for the third quarter of fiscal 2007 from $0.1 million for the third quarter of fiscal 2006. The increase was primarily due to interest income earned on higher cash balances.

 

Provision for Income Taxes

 

Provision for income taxes increased $1.6 million to $4.8 million for the third quarter of fiscal 2007 from $3.1 million for the third quarter of fiscal 2006. Our effective tax rate was 38.9% compared to 66.1% for the third quarter of fiscal 2006. In the third quarter of fiscal 2006, we generated losses in the United States which we were unable to offset against our income in Canada for tax purposes. In the third quarter of fiscal 2006 and the third quarter of fiscal 2007, we also incurred stock-based compensation expenses of $0.6 million and $1.8 million, respectively, which were not deductible for tax purposes during these periods as there were no option exercises.

 

Net Income

 

Net income increased $5.9 million to $7.6 million for the third quarter of fiscal 2007 from $1.7 million for the third quarter of fiscal 2006. The increase in net income of $5.9 million for the third quarter of fiscal 2007 was a result of an increase in gross profit of $17.1 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 $10.0 million and an increase of $1.6 million in provision for income taxes.

Nine months ended October 31, 2007 compared to nine months ended October 31, 2006

 

The following table summarizes key components of our results of operations for the nine months ended October 31, 2007 and October 31, 2006. The operating results are expressed in dollar amounts as well as relevant percentages, presented as a percentage of net revenue.

 

 

Net Revenue

 

Net revenue increased $73.0 million, or 75.5%, to $169.6 million for the first nine months of fiscal 2007 from $96.7 million for the first nine months of fiscal 2006. 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 nine months of fiscal 2006 remained constant, our net revenue would have increased $66.5 million or 68.8% for the first nine months of fiscal 2007.

 

 

Corporate-Owned Stores.   Net revenue from our corporate-owned stores segment increased $72.9 million, or 93.3%, to $151.0 million for the first nine months of fiscal 2007 from $78.1 million for the first nine months of fiscal 2006. The following contributed to the $72.9 million increase in net revenue from our corporate-owned stores segment.

 

 

 

Franchises.   Net revenue from our franchises segment decreased $1.6 million, or 11.6%, to $12.5 million for the first nine months of fiscal 2007 from $14.2 million for the first nine months of fiscal 2006. The decrease in net revenue from our franchises segment consisted primarily of franchises net revenue of $5.6 million that shifted to corporate-owned stores net revenue when we acquired three franchise stores in Calgary offset by increased franchise revenue of $4.0 million from our remaining franchise locations.

 

Other.   Net revenue from our other segment increased $1.7 million, or 38.5%, to $6.0 million for the first nine months of fiscal 2007 from $4.4 million for the first nine months of fiscal 2006. The $1.7 million increase was primarily the result of increased wholesale, phone and showroom sales.

 

Gross Profit

 

Gross profit increased $40.8 million, or 82.9%, to $89.9 million for the first nine months of fiscal 2007 from $49.2 million for the first nine months of fiscal 2006. 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 2.1% to 53.0% for the first nine months of fiscal 2007 from 50.9% for the first nine months of fiscal 2006. The increase in gross margin resulted from:

 

 

This amount was partially offset by:

 

 

Our costs of goods sold in the first nine months of fiscal 2007 and the first nine months of fiscal 2006 included $0.6 million and $0.2 million, respectively, of stock-based compensation expense.

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses increased $26.4 million, or 75.1%, to $61.5 million for the first nine months of fiscal 2007 from $35.1 million for the first nine months of fiscal 2006. As a percentage of net revenue, selling, general and administrative expenses remained consistent at 36.3%. The $26.4 million increase in selling, general and administrative expenses was principally comprised of:

 

 

This amount was partially offset by:

 

 

Our selling, general and administrative expenses in the first nine months of fiscal 2007 and the first nine months of fiscal 2006 included $4.2 million and $1.5 million, respectively, of stock-based compensation expense.

 

Income from Operations

 

The increase of $14.4 million in income from operations for the first nine months of fiscal 2007 was primarily due to a $40.8 million increase in gross profit resulting from increased comparable store sales and additional sales from corporate-owned stores opened during fiscal 2006 and the first nine months of fiscal 2007, partially offset by an increase of $26.4 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 nine months of fiscal 2007 from $0.1 million for the first nine months of fiscal 2006. The increase was primarily due to interest income earned on higher cash balances.

 

Provision for Income Taxes

 

Provision for income taxes increased $5.6 million to $13.0 million for the first nine months of fiscal 2007 from $7.4 million for the first nine months of fiscal 2006. For the first nine months of fiscal 2007, our effective tax rate was 44.8% compared to 52.4% for the first nine months of fiscal 2006. In both the first nine months of fiscal 2006 and the first nine months of fiscal 2007, we generated losses in the United States which we were unable to offset against our income in Canada for tax purposes. In the first nine months of fiscal 2006 and the first nine months of fiscal 2007, we also incurred stock-based compensation expenses of $1.8 million and $4.8 million, respectively, which were not deductible for tax purposes during these periods.

 

Net Income

 

Net income increased $9.4 million to $16.2 million for the first nine months of fiscal 2007 from $6.8 million for the first nine months of fiscal 2006. The increase in net income of $9.4 million for the first nine months of fiscal 2007 was a result of an increase in gross profit of $40.8 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 $26.4 million and an increase of $5.6 million in provision for income taxes.

 

Liquidity and Capital Resources

 

Our cash requirements are principally for working capital and capital expenditures, principally the build out cost of new stores, renovations of existing stores, and improvements to our distribution facility and corporate infrastructure. Our need for working capital is seasonal, with the greatest requirements from August through the end of November each year as a result of our inventory build-up and concentration of new store openings during this period for our holiday selling season. Historically, our main sources of liquidity have been cash flow from operating activities and borrowings under our existing and previous revolving credit facilities, and our initial public offering on August 2, 2007.

 

At October 31, 2007, our working capital (excluding cash and cash equivalents) was $20.1 million and our cash and cash equivalents were $36.3 million.

 

The following presents the major components of net cash flows provided by and used in operating, investing and financing activities for the periods indicated.

 

Operating Activities

 

Operating Activities consist primarily of net income adjusted for certain non-cash items, including depreciation and amortization, deferred income taxes, stock-based compensation expense and the effect of the changes in non-cash working capital items, principally accounts receivable, inventories, accounts payable and accrued expenses.

 

For the nine months ended October 31, 2007, cash provided by operating activities increased $1.7 million to $10.5 million compared to cash provided by operating activities of $8.8 million in the nine months ended October 31, 2006. The $1.7 million increase was primarily a result of:

 

 

This amount was partially offset by a net decrease in other working capital balances of $17.1 million primarily due to an increase in inventories of $16.2 million, an increase in income taxes payable of $14.8 million and an increase of $2.2 million in tenant inducement receivable offset by an increase in trade accounts payable of $8.9 million, an increase in other non-cash balances of $2.6 million, an increase in other current liabilities of $3.1 million and an increase in accrued liabilities of $0.7 million.

 

Investing Activities

 

Investing Activities relate entirely to capital expenditures and acquisitions of franchises. Cash used in investing activities increased $14.6 million to $24.7 million for the nine months ended October 31, 2007 from $10.1 million

for the nine months ended October 31, 2006. The $14.6 million increase was a result of our $5.6 million acquisition of three franchise stores in Calgary compared to our acquisition of one franchise store in Portland for $0.5 million during the comparative period and an increase in the purchase of property and equipment resulting primarily from new store openings and IT capital expenditures of $9.6 million.

 

Financing Activities

 

Financing Activities consist primarily of proceeds received from out initial public offering on August 2, 2007. Cash provided by financing activities increased to $32.0 million for the nine months ended October 31, 2007 from $0.6 million for the nine months ended October 31, 2006.

 

We believe that our cash from operations, proceeds from our initial public offering and borrowings available to us under our revolving credit facility, will be adequate to meet our liquidity needs and capital expenditure requirements for at least the next 24 months. Our cash from operations may be negatively impacted by a decrease in demand for our products as well as the other factors described in “Risk Factors.” In addition, we may make discretionary capital improvements with respect to our stores, distribution facility, headquarters, or other systems, which we would expect to fund through the issuance of debt or equity securities or other external financing sources to the extent we were unable to fund such capital expenditures out of our cash from operations.

 

Seasonality

 

In fiscal 2005 and fiscal 2006, we recognized over 35% of our net revenue in the fourth quarter due to significant increases in sales during the holiday season. We recognized 48.8% and 11.5% of our net income in the fourth quarter in fiscal 2005 and fiscal 2006, respectively. The amount of net income attributable to the fourth quarter in fiscal 2006 was substantially impacted by a lawsuit expense of $7.2 million that was accrued for in the fourth quarter of fiscal 2006. Despite the fact that we have experienced a significant amount of our net revenue and net income in the fourth quarter of our fiscal year, we believe that the true extent of the seasonality or cyclical nature of our business may have been overshadowed by our rapid growth to date.

 

The level of our working capital reflects the seasonality of our business. We expect inventory, accounts payable and accrued expenses to be higher in the third and fourth quarters in preparation for the holiday selling season. Because our products are sold primarily through our stores, order backlog is not material to our business.

 

Revolving Credit Facility

 

In April 2007, the Company executed a new credit facility with the Royal Bank that provided for a CA$20,000,000 uncommitted demand revolving credit facilities to fund the working capital requirements of the Company. This agreement cancels the previous CA$8,000,000 credit facility. Borrowings under the uncommitted credit facilities are made on a when-and-as-needed basis at the discretion of the Company.

 

Borrowings under the credit facility can be made either as i)  Revolving Loans — Revolving loan borrowings will bear interest at a rate equal to the Bank’s CA$ or US$ annual base rate (defined as zero% plus the lender’s annual prime rate) per annum, ii)  Offshore Loans — Offshore rate loan borrowings will bear interest at a rate equal to a base rate based upon LIBOR for the applicable interest period, plus 1.125 percent per annum, iii)  Bankers Acceptances — Bankers acceptance borrowings will bear interest at the bankers acceptance rate plus 1.125 percent per annum and iv)  Letters of Credit and Letters of Guarantee — Borrowings drawn down under letters of credit or guarantee issued by the banks will bear a 1.125 percent per annum fee.

 

At October 31, 2007, there were $nil USD of borrowings outstanding under this credit facility.

 

Off-Balance Sheet Arrangements

 

We enter into documentary letters of credit to facilitate the international purchase of merchandise. We also enter into standby letters of credit to secure certain of our obligations, including insurance programs and duties related to import purchases. As of October 31, 2007, letters of credit and letters of guaranty totaling $0.8 million have been issued.

 

Other than these standby letters of credit, we do not have any off-balance sheet arrangements, investments in special purpose entities or undisclosed borrowings or debt. In addition, we have not entered into any derivative contracts or synthetic leases.

Critical Accounting Policies

 

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions. Predicting future events is inherently an imprecise activity and, as such, requires the use of judgment. Actual results may vary from estimates in amounts that may be material to the financial statements. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact our consolidated financial statements. Our critical accounting policies and estimates are discussed in our recently filed Registration Statement on Form S-1 (file no. 333-142477) and in Note 2 included in Item 1 of Part I of this Quarterly Report on Form 10-Q. We believe that there have been no other significant changes during the three months ended October 31, 2007 to our critical accounting policies.

 

 

 

 

PART II
OTHER INFORMATION

 

 

 

In the past, securities class action litigation has often been instituted against companies following periods of volatility in their stock price. This type of litigation, even if it does not result in liability for us, could result in substantial costs to us and divert management’s attention and resources.

 

Failure to comply with trade and other regulations could lead to investigations or actions by government regulators and negative publicity.

 

The labeling, distribution, importation and sale of our products are subject to extensive regulation by various federal agencies, including the Federal Trade Commission, or FTC, state attorneys general in the U.S., the Competition Bureau and Health Canada in Canada as well as by various other federal, state, provincial, local and international regulatory authorities in the countries in which our products are distributed or sold. If we fail to comply with those regulations, we could become subject to significant penalties or claims, which could harm our results of operations or our ability to conduct our business. In addition, the adoption of new regulations or changes in the interpretation of existing regulations may result in significant compliance costs or discontinuation of product sales and may impair the marketing of our products, resulting in significant loss of net sales.

 

In addition, our failure to comply with FTC or state regulations, or with regulations in foreign markets that cover our product claims and advertising, including direct claims and advertising by us, may result in enforcement actions and imposition of penalties or otherwise harm the distribution and sale of our products.

 

Our business depends on a strong brand, and if we are not able to maintain and enhance our brand we may be unable to sell our products, which would harm our business and cause the results of our operations to suffer.

 

We believe that the brand image we have developed has significantly contributed to the success of our business. We also believe that maintaining and enhancing the lululemon athletica brand is critical to maintaining and expanding our customer base. Maintaining and enhancing our brand may require us to make substantial investments in areas such as research and development, store operations, community relations and employee training, and these investments may not be successful. As of October 31, 2007, our brand is sold in only 19 cities in Canada, 23 cities in the United States, 2 metropolitan areas in Australia and 2 metropolitan areas in Japan. A primary component of our strategy involves expanding into other geographic markets, particularly within the United States. As we expand into new geographic markets, consumers in these markets may not accept our brand image and may not be willing to pay a premium to purchase our technical athletic apparel as compared to traditional athletic apparel. We anticipate that, as our business expands into new markets and as the market becomes increasingly competitive, maintaining and enhancing our brand may become increasingly difficult and expensive. Conversely, as we penetrate these markets and our brand becomes more widely available, it could potentially detract from the appeal stemming from the scarcity of our brand. Our brand may also be adversely affected if our public image or reputation is tarnished by negative publicity. Maintaining and enhancing our brand will depend largely on our ability to be a leader in the athletic apparel industry, to offer a unique store experience to our customers and to continue to provide high quality products and services, which we may not do successfully. If we are unable to maintain or enhance our brand image our results of operations may suffer and our business may be harmed.

We rely on third-party suppliers to provide fabrics for and to produce our products, and we have limited control over them and may not be able to obtain quality products on a timely basis or in sufficient quantity.

 

We do not manufacture our products or the raw materials for them and rely instead on third-party suppliers. Many of the specialty fabrics used in our products are technically advanced textile products developed and manufactured by third parties and may be available, in the short-term, from only one or a very limited number of sources. For example, our Luon fabric, which is included in many of our products, is supplied to the mills we use by a single manufacturer in Taiwan, and the fibers used in manufacturing our Luon fabric are supplied to our Taiwanese manufacturer by a single company. In fiscal 2006, approximately 85% of our products were produced by our top ten manufacturing suppliers.

 

If we experience significant increased demand, or need to replace an existing manufacturer, there can be no assurance that additional supplies of fabrics or raw materials or additional manufacturing capacity will be available when required on terms that are acceptable to us, or at all, or that any supplier or manufacturer would allocate sufficient capacity to us in order to meet our requirements or fill our orders in a timely manner. Even if we are able to expand existing or find new manufacturing or fabric sources, we may encounter delays in production and added costs as a result of the time it takes to train our suppliers and manufacturers in our methods, products and quality control standards. Delays related to supplier changes could also arise due to an increase in shipping times if new suppliers are located farther away from our markets or from other participants in our supply chain. Any delays, interruption or increased costs in the supply of fabric or manufacture of our products could have an adverse effect on our ability to meet customer demand for our products and result in lower net revenue and income from operations both in the short and long term.

 

In addition, there can be no assurance that our suppliers and manufacturers will continue to provide fabrics and raw materials or manufacture products that comply with our technical specifications and are consistent with our standards. We have occasionally received, and may in the future continue to receive, shipments of products that fail to comply with our technical specifications or that fail to conform to our quality control standards. In that event, unless we are able to obtain replacement products in a timely manner, we risk the loss of net revenue resulting from the inability to sell those products and related increased administrative and shipping costs.

 

Additionally, if defects in the manufacture of our products are not discovered until after such products are purchased by our customers, our customers could lose confidence in the technical attributes of our products and our results of operations could suffer and our business may be harmed.