LULULEMON ATHLETICA INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) This discussion summarizes our consolidated operating results, financial condition and liquidity during the three-year period ending February 3, 2013.

Our fiscal year ends on the Sunday closest to January 31 of the following year, typically resulting in a 52 week year, but occasionally giving rise to an additional week, resulting in a 53 week year. Fiscal 2012 is a 53 week year. Net sales numbers include results from the 53rd week; however, comparable stores sales calculations exclude the 53rd week. Fiscal 2012, 2011 and 2010 ended on February 3, 2013, January 29, 2012 and January 30, 2011, respectively. The following discussion and analysis should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K.

This discussion and analysis contains forward-looking statements based on current expectations that involve risks, uncertainties and assumptions, such as our plans, objectives, expectations and intentions set forth in the "Special Note Regarding Forward-Looking Statements." Our actual results and the timing of events may differ materially from those anticipated in these forward looking statements as a result of various factors, including those set forth in the "Item 1A-Risk Factors" section and elsewhere in this Annual Report on Form 10-K.

Overview Our results for fiscal 2012 demonstrate the ongoing success of our efforts to execute the goals we set at the end of last year. We committed to continued investment in our stores and our people, making infrastructure enhancements and funding working capital requirements, while remaining conscious of our discretionary spending. These goals included driving store productivity along with North American store build out and ecommerce, seeding international markets via a community, showroom and ecommerce model, and reinvesting in product innovation to create value and differentiation in our product lines and to enhance our leadership position for the long term. We continually assess the economic environment and market conditions when making decisions regarding timing of our investments.

Our investments in our stores and people were reflected in our comparable stores net revenue growth, which leveraged our fixed operating costs. We increased our store base through execution of our real estate strategy, when and where we saw opportunities for success. For example, we opened 37 new corporate-owned stores in North America, Australia, and New Zealand since fiscal 2011. Where we find opportunities for growth through opening showrooms, or other community presence efforts, we expect to expand our store base and therefore our business. Our growth strategy relies on positive comparable store sales and expansion in North America, particularly in the United States. We have also determined that international growth is an opportunity and are expanding our foothold in markets by establishing local community connections, distributing to strategic sales partners and opening showrooms where we feel our key guests are shopping.

Throughout fiscal 2012, we were able to grow our e-commerce business which has further increased our brand awareness and has made our product available in new markets, including those outside of North America. This sales channel offers a higher operating margin than our other segments and accounted for 16.1% of total revenue in the fourth quarter of fiscal 2012 compared to 13.5% of total revenue in the same period of the prior year. Continuing increases in traffic and conversion rates on our e-commerce website lead us to believe that there is potential for our direct to consumer segment to become an increasingly substantial part of our business and we plan to continue to commit a portion of our resources to further developing this channel. In fiscal 2012 we launched country and region specific websites in Australia, Europe and Asia to provide our online guests with local content, assortment and pricing.

In mid-March 2013, we determined that certain shipments of women's black Luon bottoms received from our factories and available in our stores from March 1, 2013, did not meet our technical specifications. As we became aware of this issue, we pulled what we believe to be all of the affected items from our stores, showrooms 22 -------------------------------------------------------------------------------- Table of Contents and e-commerce sites and began working with our supplier to replace the fabric and with our other manufacturers to replace these items as quickly as possible.

The lost revenue, additional costs expected to be incurred and the write down of affected product on hand from this issue will negatively impact our results from operations in Fiscal 2013.

We believe that our brand is recognized as premium in our offerings of run and yoga assortment, as well as a leader in technical fabrics and functionality.

This has made our product desirable to our consumers and has driven demand, which we are able to meet given our increased product depth compared to last year. Delivering quality to our customers is a critical factor in our market place differentiation and removing items that do not meet our standards is key to maintaining our brand reputation. In fiscal 2013, we plan on investing in new and legacy information technology systems to develop new capabilities in our vertical retail strategy. We have recently added strong leadership in Quality Control, our Liason Office and our commercialization and development teams, and expect these people and other investments to solidify our quality consistency and our delivery capabilities. We believe our strong cash flow generation, solid balance sheet and healthy liquidity provide us with the financial flexibility to continue executing the initiatives which we believe will lead to quality growth.

Operating Segment Overview lululemon is a designer and retailer of technical athletic apparel operating primarily in North America and Australia. Our yoga-inspired apparel is marketed under the lululemon athletica and ivivva athletica brand names. We offer a comprehensive line of apparel and accessories including fitness pants, shorts, tops and jackets designed for athletic pursuits such as yoga, running and general fitness, and dance-inspired apparel for female youth. As of February 3, 2013, our branded apparel was principally sold through 211 corporate-owned stores that are located in the United States, Canada, Australia and New Zealand and via our e-commerce websites through our direct to consumer sales channel. 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. In fiscal 2012, 61% of our net revenue was derived from sales of our products in the United States, 34% of our net revenue was derived from the sales of our products in Canada and 5% of our net revenue was derived from sales of our products outside of North America. In fiscal 2011, 53% of our net revenue was derived from sales of our products in the United States, 43% of our net revenue was derived from the sales of our products in Canada and 4% of our net revenue was derived from sales of our products outside of North America. In fiscal 2010, 46% of our net revenue was derived from sales of our products in the United States, 52% of our net revenue was derived from the sales of our products in Canada and 2% of our net revenue was derived from sales of our products outside of North America.

Our net revenue increased from $1,000.8 million in fiscal 2011 to $1,370.4 million in fiscal 2012, representing a 37% increase. Our increase in net revenue from fiscal 2011 to fiscal 2012 resulted from the addition of 37 retail locations, and comparable store sales growth of 16% in fiscal 2012, excluding the impact of the 53rd week. Our ability to open new stores and grow sales in existing stores has been driven by increasing demand for our technical athletic apparel and a growing recognition of the lululemon athletica brand. We believe our superior products, strategic store locations, inviting store environment, grassroots marketing approach and distinctive corporate culture are responsible for our strong financial performance.

We have three reportable segments: corporate-owned stores, direct to consumer 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 corporate-owned stores segment accounted for 80% of our net revenue in fiscal 2012, 82% in fiscal 2011 and 83% in fiscal 2010. Our direct to consumer segment accounted for 14% of our net revenue in fiscal 2012, 11% in fiscal 2011 and 8% in fiscal 2010. Our other segment, consisting of franchise sales, wholesale accounts, sales from company-operated showrooms, warehouse sales and outlets, each accounted for less than 10% of our net revenue in each of fiscal 2012, fiscal 2011 and fiscal 2010. We previously reported our franchise channel as an operating segment; however, we reacquired our remaining four franchised stores in fiscal 2011 and opening new franchise stores is not part of our growth strategy.

23-------------------------------------------------------------------------------- Table of Contents As of February 3, 2013, we sold our products through 211 corporate-owned stores located in, the United States, Canada, Australia, and New Zealand. We plan to increase our net revenue in North America and Australia by opening additional corporate-owned stores in new and existing markets. Corporate-owned stores accounted for 80% of total net revenue in fiscal 2012, 82% of total net revenue in fiscal 2011 and 83% of total net revenue in fiscal 2010.

As of February 3, 2013, our direct to consumer segment included our lululemon and ivivva e-commerce websites. E-commerce sales are taken directly from retail customers through www.lululemon.com and www.ivivva.com and other country and region specific websites. Our direct to consumer segment is an increasingly substantial part of our growth strategy, and now represents 14% of our net revenue.

In addition to deriving revenue from sales through our corporate-owned stores and direct to consumer, we also derive other net revenue, which includes wholesale customers, as well as warehouse sales and sales through a number of company-operated showrooms and temporary locations. Wholesale customers include select premium yoga studios, health clubs and fitness centers. Warehouse sales are typically held 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. Our temporary locations are typically opened for the holiday season in markets in which we may not already have a presence. We reacquired our four remaining franchise stores during fiscal 2011, and as such, franchise sales, which included inventory sales and royalties, are no longer a part of our other net revenue. Other net revenue accounted for 6% of total revenue in fiscal 2012, 7% of total net revenue in fiscal 2011 and 9% of total net revenue in fiscal 2010.

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 store in Australia which was operated under a franchise license. In fiscal 2009 we made a 13% equity investment in lululemon athletica australia Pty, our franchise operator. During fiscal 2010 we increased our investment to 80% which provided us with control over lululemon athletica australia Pty. During fiscal 2012 we purchased the remaining non-controlling interest in lululemon athletica australia Pty. In fiscal 2008, we opened our first company-operated showroom in Hong Kong and in fiscal 2012 we opened our first company-operated showroom in the United Kingdom.

Basis of Presentation Net revenue is comprised of: • corporate-owned store net revenue, which includes sales to customers through corporate-owned stores in North America and Australia; • direct to consumer revenue, which includes sales from our e-commerce websites; and • other net revenue, which includes wholesale accounts, franchises net revenue, which consists of royalties as well as sales of our products to franchises, warehouse sales, outlets and sales from company-operated showrooms.

in each case, net of an estimated allowance for sales returns and discounts.

In addition, we separately track comparable store sales, which reflect net revenue at corporate-owned stores that have been open for at least 12 months.

Therefore, net revenue from a store is included in comparable store sales beginning with the first month for which the store has a full month of comparable prior year sales. Non-comparable store sales include sales from new stores that have not been open or otherwise not operated by us for 12 months or from stores which have been significantly remodeled or relocated. Also included in non-comparable stores sales are sales from direct to consumer sales, wholesale, franchises, warehouse sales and 24-------------------------------------------------------------------------------- Table of Contents showrooms, and sales from corporate-owned stores which we have closed. The 53rd week of fiscal 2012 is excluded from the calculation of comparable store sales.

By measuring the change in year-over-year net revenue in stores that have been open for 12 months or more, comparable store sales allows us to evaluate how our core store base is performing. Various factors affect comparable store sales, including: • the location of new stores relative to existing stores; • consumer preferences, buying trends and overall economic trends; • our ability to anticipate and respond effectively to customer preferences for technical athletic apparel; • competition; • changes in our merchandise mix; • pricing; • the timing of our releases of new merchandise and promotional events; • the effectiveness of our grassroots marketing efforts; • the level of customer service that we provide in our stores; • our ability to source and distribute products efficiently; and • the number of stores we open, close (including for temporary renovations) and expand in any period.

Opening new stores is an important part of our growth strategy. Accordingly, comparable store sales has limited utility for assessing the success of our growth strategy insofar as comparable store sales do not reflect the performance of stores open less than 12 months.

Cost of goods sold includes: • the cost of purchased merchandise, which includes acquisition and production costs including raw material and labor, as applicable; • the cost incurred to deliver inventory to our distribution centers including freight, non-refundable taxes, duty and other landing costs; • the cost of our distribution centers (such as labor, rent and utilities) and the depreciation and amortization related to our distribution centers; • the cost of our production, merchandise and design departments including salaries, stock-based compensation and benefits, and operating expenses; • the cost of occupancy related to store operations (such as rent and utilities) and the depreciation and amortization related to store-level capital expenditures; • hemming; and • shrink and valuation reserves.

Cost of goods sold also may change as we open or close stores because of the resulting change in related occupancy costs. The primary drivers of the costs of individual goods are the costs of raw materials and labor in the countries where we source our merchandise.

Selling, general and administrative expenses consist of all operating costs not otherwise included in cost of goods sold. Our selling, general and administrative expenses include marketing costs, accounting costs, information technology costs, human resource costs, professional fees, corporate facility costs, corporate and 25 -------------------------------------------------------------------------------- Table of Contents store-level payroll and benefits expenses, stock-based compensation and occupancy, depreciation and amortization expense for all assets other than depreciation and amortization expenses related to store-level capital expenditures and our distribution centers, each of which are included in cost of goods sold. We anticipate that our selling, general and administrative expenses will increase in absolute dollars due to anticipated continued growth of our corporate support staff and store-level employees.

Other income (expense), net includes interest earned on our cash balances and our advances to franchise, interest costs associated with our credit facilities and with letters of credit drawn under these facilities for the purchase of merchandise and our share of the operations of our investment in lululemon athletica australia PTY prior to obtaining control in fiscal 2010, including the remeasurement of our investment immediately before obtaining control of the business. We expect to continue to generate interest income to the extent that our cash generated from operations exceeds our cash used for investment. We have maintained relatively small outstanding balances on our credit facilities and expect to continue to do so for the foreseeable future.

Provision for income taxes depends on the statutory tax rates in the countries where we sell our products. Historically we had generated taxable income in Canada and we had generated tax losses in the United States. In fiscal 2010 we earned taxable income in the United States and fully utilized any net operating losses available from prior periods. We anticipate continued growth in the United States and consequently foresee an increase in taxable income reported.

We have recorded deferred tax assets in respect of deductible temporary differences of $15.0 million.

Our effective tax rate for fiscal 2012 was 7.3% lower than the effective rate for fiscal 2011 due primarily to the ongoing impact of revised intercompany pricing agreements. Our effective tax rate in fiscal 2012 was 28.8%, compared to 36.1% in fiscal 2011 and 33.3% in fiscal 2010.

We anticipate that in the future we may start to sell our products directly to some customers located outside of Canada, the United States, the United Kingdom, Hong Kong, Australia and New Zealand, in which case we would become subject to taxation based on the foreign statutory rates in the countries where these sales take place and our effective tax rate could fluctuate accordingly.

Results of Operations The following tables summarize key components of our results of operations for the periods indicated, both in dollars and as a percentage of net revenue: Fiscal Year Ended February 3, January 29, January 30, 2013 2012 2011 (In thousands) Consolidated statements of operations: Net revenue $ 1,370,358 $ 1,000,839 $ 711,704 Cost of goods sold 607,532 431,488 316,757 Gross profit 762,826 569,351 394,947 Selling, general and administrative expenses 386,387 282,393 214,556 Income from operations 376,439 286,958 180,391 Other income (expense), net 4,957 2,500 2,886 Income before provision for income taxes 381,396 289,458 183,277 Provision for income taxes 109,965 104,494 61,080 Net income 271,431 184,964 122,197 Net income attributable to non-controlling interest 875 901 350 Net income attributable to lululemon athletica inc. $ 270,556 $ 184,063 $ 121,847 26 -------------------------------------------------------------------------------- Table of Contents Fiscal Year Ended February 3, January 29, January 30, 2013 2012 2011 (% of net revenue) Net revenue 100.0 100.0 100.0 Cost of goods sold 44.3 43.1 44.5 Gross profit 55.7 56.9 55.5 Selling, general and administrative expenses 28.2 28.2 30.1 Income from operations 27.5 28.7 25.4 Other income (expense), net 0.3 0.2 0.4 Income before provision for income taxes 27.8 28.9 25.8 Provision for income taxes 8.0 10.4 8.6 Net income 19.8 18.5 17.2 Net income attributable to non-controlling interest 0.1 0.1 0.1 Net income attributable to lululemon athletica inc. 19.7 18.4 17.1 Comparison of Fiscal 2012 to Fiscal 2011 Net Revenue Net revenue increased $369.5 million, or 37%, to $1,370.4 million in fiscal 2012 from $1,000.8 million in fiscal 2011. Assuming the average exchange rates in fiscal 2012 remained constant with the average exchange rates in fiscal 2011, our net revenue would have increased $370.5 million, or 37%.

The net revenue increase was driven by increased sales at locations in our comparable stores base, sales from new stores opened, and the growth of our direct to consumer segment. The constant dollar increase in comparable store sales was driven primarily by the strength of our existing product lines, successful introduction of new products and increasing recognition of the lululemon athletica brand name, especially at our U.S. stores, that drove higher transactions per store.

Our net revenue on a segment basis for fiscal 2012 and fiscal 2011 are expressed in dollar amounts as well as relevant percentages, presented as a percentage of total net revenue below.

Fiscal Year Ended February 3, 2013 and January 29, 2012 2012 2011 2012 2011 (In thousands) (Percentages) Corporate-owned stores $ 1,090,181 $ 816,925 79.6 81.6 Direct to consumer 197,255 106,313 14.4 10.6 Other 82,922 77,601 6.0 7.8 Net revenue $ 1,370,358 $ 1,000,839 100.0 100.0 Corporate-Owned Stores. Net revenue from our corporate-owned stores segment increased $273.3 million, or 33%, to $1,090.2 million in fiscal 2012 from $816.9 million in fiscal 2011. The following contributed to the increase in net revenue from our corporate-owned stores segment: • Comparable store sales increase of 16% in fiscal 2012 resulted in a $118.3 million increase to net revenue, including the effect of foreign currency fluctuations. Excluding the effect of foreign currency fluctuations, comparable store sales increased 16%, or $119.3 million, in fiscal 2012; 27 -------------------------------------------------------------------------------- Table of Contents • Net revenue from corporate-owned stores we opened during fiscal 2012, and during fiscal 2011 prior to sales from such stores becoming part of our comparable stores base, contributed $136.3 million of the increase. New store openings in fiscal 2012 included four stores in Canada, including three ivivva branded stores, 27 stores in the United States, five in Australia, and one in New Zealand; and • Net revenue of $18.7 from the 53rd week of fiscal 2012, which was excluded in the calculation of comparable store sales.

Direct to Consumer. Net revenue from our direct to consumer segment increased $90.9 million, or 86%, to $197.3 million in fiscal 2012 from $106.3 million in fiscal 2011, including $4.2 million of net revenue from the 53rd week of fiscal 2012. The increase in net revenue from our direct to consumer segment was a result of increasing traffic, conversion rates and average order value on our e-commerce website, as well as making our products available in new markets outside of North America.

Other. Net revenue from our other segment increased $5.3 million, or 7%, to $82.9 million in fiscal 2012 from $77.6 million in fiscal 2011. The increase in net revenue from our other segment was primarily due to increased sales from our outlets and showrooms sales channels. The increase was partially offset by decreased net revenue from wholesale. In addition, we reacquired our four remaining franchise stores during fiscal 2011, therefore revenue from these stores is now included in our corporate-owned stores segment. We continue to employ our other segment strategy to increase interest in our product in markets where we may not have corporate-owned stores.

Gross Profit Gross profit increased $193.5 million, or 34%, to $762.8 million in fiscal 2012 from $569.4 million in fiscal 2011. Increased net revenue in most of our operating segments resulted in an increased gross profit.

The increase in gross profit was partially offset by increases in fixed costs, such as occupancy costs and depreciation, as well as increased costs related to our design, merchandising, and production departments.

Gross profit, as a percentage of net revenue, or gross margin, decreased 120 basis points, to 55.7% in fiscal 2012 from 56.9% in fiscal 2011. The decrease in gross margin resulted primarily from: • an increase in product costs of 200 basis points due to increased labor and raw materials costs related to increased product innovation, function and garment complexity, as well as an increase in markdowns and discounts due to a more balanced inventory position in fiscal 2012 compared to fiscal 2011; • an increase in expenses related to our product and supply chain departments, relative to the increase in net revenue, which had a deleveraging effect on gross margin of 30 basis points.

The decrease in gross margin was partially offset by: • a decrease in air freight of 60 basis points due to lower air freight usage than in fiscal 2011; and • a decrease in fixed costs, such as occupancy costs and depreciation, relative to the increase in net revenue, which had a leveraging effect on gross margin of 50 basis points.

Selling, General and Administrative Expenses Selling, general and administrative expenses increased $104.0 million, or 37%, to $386.4 million in fiscal 2012 from $282.4 million in fiscal 2011. The increase in selling, general and administrative expenses was principally comprised of: • an increase in employee costs of $39.2 million as we experience natural growth in labor hours associated with new and existing corporate-owned stores, outlets, showrooms and other, as well as an increase in wages as we invest in our employees; 28 -------------------------------------------------------------------------------- Table of Contents • an increase in variable store costs of $7.0 million as a result of increased sales volume from new and existing corporate-owned stores, outlets, showrooms and other; • an increase in variable costs such as distribution costs, credit card fees and packaging related to our direct to consumer segment of $10.2 million as a result of increased sales volume; • an increase in administrative costs related to our direct to consumer segment of $8.0 million associated with the growth in this channel and increased head count to support it; • an increase in head office employee costs, including stock-based compensation expense and management incentive-based compensation, of $18.9 million from increased head count incurred in order to position us for long-term growth; • an increase in other head office costs of $11.2 million as a result of the overall growth of our business and investment in strategic initiatives and projects; and • an increase in other costs, including occupancy costs and depreciation not included in cost of goods sold, of $9.5 million as a result of the expansion of our business and in order to position us for long-term growth.

As a percentage of net revenue, selling, general and administrative expenses remained unchanged at 28.2% in both fiscal 2012 and fiscal 2011.

We expect selling, general and administrative expenses to increase throughout fiscal 2013 as we add administrative and sales personnel and increase our infrastructure to support the growth in our store base.

Income from Operations Income from operations increased $89.5 million, or 31%, to $376.4 million in fiscal 2012 from $287.0 million in fiscal 2011. The increase was a result of increased gross profit of $193.5 million, partially offset by increased selling, general and administrative costs of $104.0 million. The increase in selling, general and administrative costs was primarily driven by the increase in our business, as seen in our net revenue increases.

On a segment basis, we determine income from operations without taking into account our general corporate expenses. We have reviewed our general corporate expenses and determined some costs previously classified as general corporate are direct segment expenses. Accordingly, all prior year comparable information has been reclassified to conform to the current year classification.

Income from operations before general corporate expenses for fiscal 2012 and fiscal 2011 are expressed in dollar amounts as well as percentages, presented as a percentage of net revenue of their respective operating segments below.

Fiscal Year Ended February 3, 2013 and January 29, 2012 2012 2011 2012 2011 (In thousands) (Percentages) Corporate-owned stores $ 379,670 $ 297,809 34.8 36.5 Direct to consumer 82,947 44,175 42.1 41.6 Other 17,370 21,103 20.9 27.2 Income from operations before general corporate expense $ 479,987 $ 363,087 General corporate expense $ 103,548 $ 76,129 Income from operations $ 376,439 $ 286,958 29 -------------------------------------------------------------------------------- Table of Contents Corporate-Owned Stores. Income from operations from our corporate-owned stores segment increased $81.9 million, or 27%, to $379.7 million for fiscal 2012 from $297.8 million for fiscal 2011 primarily due to an increase of $137.1 million in gross profit, which was offset partially by a natural increase in selling, general and administrative expenses related to employee costs as well as operating expenses associated with new stores and net revenue growth at existing stores. Income from operations as a percentage of corporate-owned stores revenue decreased by 170 basis points primarily from a decrease in gross margin related to increased product costs.

Direct to consumer. Income from operations from our direct to consumer segment increased $38.8 million, or 88%, to $82.9 million in fiscal 2012 from $44.2 million in fiscal 2011 due to increased sales through our e-commerce website and the addition of regional websites, with gross profit increasing $56.2 over fiscal 2011. Income from operations as a percentage of direct to consumer revenue increased by 50 basis points in fiscal 2012 compared to fiscal 2011 due to leverage on fixed costs.

Other. Income from operations from our other segment decreased $3.7 million, or 18%, to $17.4 million in fiscal 2012 from $21.1 million in fiscal 2011. The decrease was primarily the result of our reacquisition of our four remaining franchise stores during fiscal 2011, as revenue from these stores is now included in our corporate-owned stores segment. We continue to employ our other segment strategy to increase interest in our product in markets we have not otherwise entered with corporate-owned stores.

General Corporate Expense. General corporate expenses increased $27.4 million, or 36%, to $103.5 million in fiscal 2012 from $76.1 million in fiscal 2011. This increase was primarily due to an increase in expenses related to our head office growth of $19.4 million, which was largely related to the growth of our information technology department for systems implementations and infrastructure investments, our human resources department as a result of the overall growth of our business, and increased professional fees related to investment in strategic initiatives and projects. General corporate expenses also increased as a result of increased stock-based compensation expense of $4.7 million and increased depreciation and amortization expense of $3.3 million. General corporate expenses are expected to continue to increase in future years as we grow our overall business and require increased efforts at our head office to support our corporate-owned stores, direct to consumer and other segments.

Other Income (Expense), Net Other income (expense), net increased $2.5 million, to $5.0 million in fiscal 2012 from $2.5 million in fiscal 2011. The increase was primarily a result of increased interest income earned in fiscal 2012 compared to fiscal 2011 on our increased cash balances.

Provision for Income Taxes Provision for income taxes increased $5.5 million, or 5%, to $110.0 million in fiscal 2012 from $104.5 million in fiscal 2011. In fiscal 2012, our effective tax rate was 28.8% compared to 36.1% in fiscal 2011. The lower effective tax rate was due to the ongoing impact of revised intercompany pricing agreements.

We have not recorded deferred taxes on undistributed earnings and other temporary differences of our Canadian subsidiary which are considered to be indefinitely reinvested. If management's intentions with respect to these undistributed earnings and other temporary differences were to change in the future, deferred taxes may need to be provided that could materially impact our financial results.

Net Income Net income increased $86.5 million, or 47%, to $270.6 million in fiscal 2012 from $184.1 million in fiscal 2011. The increase in net income in fiscal 2012 was primarily due to a $193.5 million increase in gross profit resulting from sales growth at existing and additional corporate-owned stores opened during fiscal 2012 and 30 -------------------------------------------------------------------------------- Table of Contents increasing traffic on our e-commerce website and the addition of regional websites and a $2.5 million increase in other income (expense), net, offset by an increase of $104.0 million in selling, general and administrative expenses, and an increase of $5.5 million in provision for income taxes.

Comparison of Fiscal 2011 to Fiscal 2010 Net Revenue Net revenue increased $289.1 million, or 41%, to $1,000.8 million in fiscal 2011 from $711.7 million in fiscal 2010. Assuming the average exchange rate between the Canadian and United States dollars and the Australian and United States dollars in fiscal 2010 remained constant, our net revenue would have increased $274.7 million, or 39%, in fiscal 2011.

The net revenue increase was driven by increased sales at locations in our comparable stores base, sales from new stores opened, sales from franchised stores that were reacquired during fiscal 2011 and the growth of our direct to consumer segment. The constant dollar increase in comparable store sales was driven primarily by the strength of our existing product lines, successful introduction of new products and increasing recognition of the lululemon athletica brand name, especially at our U.S. stores.

Our net revenue on a segment basis for fiscal 2011 and fiscal 2010 are expressed in dollar amounts as well as relevant percentages, presented as a percentage of total net revenue below.

Fiscal Year Ended January 29, 2012 and January 30, 2011 2011 2010 2011 2010 (In thousands) (Percentages) Corporate-owned stores $ 816,925 $ 590,389 81.6 83.0 Direct to consumer 106,313 57,348 10.6 8.1 Other 77,601 63,967 7.8 8.9 Net revenue $ 1,000,839 $ 711,704 100.0 100.0 Corporate-Owned Stores. Net revenue from our corporate-owned stores segment increased $226.5 million, or 38%, to $816.9 million in fiscal 2011 from $590.4 million in fiscal 2010. The following contributed to the increase in net revenue from our corporate-owned stores segment: • Comparable store sales increase of 22% in fiscal 2011 resulted in a $125.2 million increase to net revenue, including the effect of foreign currency fluctuations. Excluding the effect of foreign currency fluctuations, comparable store sales increased 20%, or $114.2 million, in fiscal 2011; • Net revenue from corporate-owned stores we opened during fiscal 2011, and during fiscal 2010 prior to sales from such stores becoming part of our comparable stores base, contributed $94.8 million of the increase. Net new store openings in fiscal 2011 included three stores in Canada, 26 stores in the United States, seven in Australia, and one in New Zealand; and • The reacquisition of four U.S. franchise stores in fiscal 2011 contributed $6.5 million of the increase.

Direct to Consumer. Net revenue from our direct to consumer segment increased $49.0 million, or 85%, to $106.3 million in fiscal 2011 from $57.3 million in fiscal 2010. The increase in net revenue from our direct to consumer segment was a result of increasing traffic, conversion rates, and average order value on our e-commerce website.

Other. Net revenue from our other segment increased $13.6 million, or 21%, to $77.6 million in fiscal 2011 from $64.0 million in fiscal 2010. The increase was a result of increasing net revenue across most of our sales channels included in our other segment: wholesale, showrooms, warehouse sales and outlets. Net revenue from our franchise channel decreased due to the reacquisition of our remaining four remaining franchise stores in the United States, now included in our corporate-owned stores segment.

31-------------------------------------------------------------------------------- Table of Contents Gross Profit Gross profit increased $174.4 million, or 44%, to $569.4 million in fiscal 2011 from $394.9 million in fiscal 2010. Increased net revenue as well as a strengthening Canadian dollar relative to the U.S. dollar improved product margin in all of our operating segments, and ultimately resulted in an increased gross profit.

The increase in gross profit was partially offset by increases in fixed costs, such as occupancy costs and depreciation, as well as increased costs related to our design, production, distribution and merchandising departments.

Gross profit, as a percentage of net revenue, or gross margin, increased 140 basis points, to 56.9% in fiscal 2011 from 55.5% in fiscal 2010. The increase in gross margin resulted primarily from: • a decrease in fixed costs, such as occupancy costs and depreciation, relative to the increase in net revenue, which had a leveraging effect on gross margin of 80 basis points; • strengthening of the Canadian and Australian dollars, relative to the U.S. dollar, decreased foreign exchange impacts on product costs and contributed 70 basis points; and • a decrease in expenses related to our product and supply chain departments, relative to the increase in net revenue, which had a leveraging effect on gross margin of 10 basis points.

The increase in gross margin was partially offset by a decrease in product margins, which contributed 20 basis points. This was primarily a result of product cost pressures from raw materials and labour costs which were partially offset by strong sell through of merchandise with fewer markdowns and discounts than in fiscal 2010.

Selling, General and Administrative Expenses Selling, general and administrative expenses increased $67.8 million, or 32%, to $282.4 million in fiscal 2011 from $214.6 million in fiscal 2010. The increase in selling, general and administrative expenses was principally comprised of: • an increase in employee costs of $29.1 million as we experience natural growth in labor hours associated with new and existing corporate-owned stores, outlets and other, as well as an increase in wages as we invest in our employees; • an increase in head office employee costs, including stock-based compensation expense and management incentive-based compensation, of $15.4 million incurred in order to position us for long-term growth; • an increase in other head office costs of $12.4 million as a result of the expansion of our business; • an increase in other costs, including occupancy costs and depreciation not included in cost of goods sold, of $7.0 million associated with new and existing corporate-owned stores, outlets and other; • an increase in variable store costs of $6.7 million as a result of increased sales volume from new and existing corporate-owned stores, outlets and other; and • an increase in administrative costs of $3.3 million related to our Australian business, in which we increased our investment significantly in the second quarter of fiscal 2010, which we now report on a consolidated basis.

32 -------------------------------------------------------------------------------- Table of Contents The increase in selling, general and administrative expenses was partially offset by a decrease in administrative costs of $6.1 million related to our direct to consumer segment. This decrease was primarily associated with a reduction in professional fees resulting from bringing our e-commerce operations in-house in the first half of fiscal 2011, offset by higher costs associated with volume growth in this channel.

As a percentage of net revenue, selling, general and administrative expenses decreased 190 basis points, to 28.2% in fiscal 2011 from 30.1% in fiscal 2010.

Income from Operations Income from operations increased $106.6 million, or 59%, to $287.0 million in fiscal 2011 from $180.4 million in fiscal 2010. The increase was a result of increased gross profit of $174.3 million, partially offset by increased selling, general and administrative costs of $67.8 million. The increase in selling, general and administrative costs was primarily driven by the increase in our business, as seen in our net revenue increases.

On a segment basis, we determine income from operations without taking into account our general corporate expenses. We have reviewed our general corporate expenses and determined some costs previously classified as general corporate are direct segment expenses. Accordingly, all prior year comparable information has be reclassified to conform to the current year classification.

Income from operations (before general corporate expenses) for fiscal 2011 and fiscal 2010 are expressed in dollar amounts as well as percentages, presented as a percentage of net revenue of their respective operating segments below.

Fiscal Year Ended January 29, 2012 and January 30, 2011 2011 2010 2011 2010 (In thousands) (Percentages) Corporate-owned stores $ 297,809 $ 207,692 36.5 35.2 Direct to consumer 44,175 14,035 41.6 24.5 Other 21,103 16,925 27.2 26.5 Income from operations before general corporate expense $ 363,087 $ 238,652 General corporate expense $ 76,129 $ 58,261 Income from operations $ 286,958 $ 180,391 Corporate-Owned Stores. Income from operations from our corporate-owned stores segment increased $90.1 million, or 43%, to $297.8 million for fiscal 2011 from $207.7 million for fiscal 2010 primarily due to an increase of $137.2 million in gross profit, which was offset partially by a natural increase in selling, general and administrative expenses related to employee costs as well as operating expenses associated with new stores and net revenue growth at existing stores. Income from operations as a percentage of corporate-owned stores revenue increased by 130 basis points primarily from leverage gained over fixed costs.

Direct to consumer. Income from operations from our direct to consumer segment increased $30.1 million, or 215%, to $44.2 million in fiscal 2011 from $14.0 million in fiscal 2010 due to increasing traffic and conversion rates on our e-commerce website. Income from operations as a percentage of direct to consumer revenue increased by 1710 basis points in fiscal 2011 compared to fiscal 2010 due to decreased professional fees paid as our e-commerce operations were brought in-house near the beginning of fiscal 2011. We discontinued our phone sales channel during fiscal 2011, and therefore our direct to consumer segment will only include e-commerce sales in future fiscal years.

Other. Income from operations from our other segment increased $4.2 million, or 25%, to $21.1 million in fiscal 2011 from $16.9 million in fiscal 2010. This increase was primarily the result of temporary locations open 33-------------------------------------------------------------------------------- Table of Contents in the fourth quarter of fiscal 2011 and additional warehouse sales held during the fourth quarter of fiscal 2011 compared to fiscal 2010. This increase was also a result of increased income from strategic sales, showrooms and outlets, partially offset by decreased income from our franchise operating channel. We reacquired our four remaining franchised locations during the third quarter of fiscal 2011; as a result, income from operations from the reacquired stores is now included in our corporate-owned stores segment.

General Corporate Expense. General corporate expenses increased $17.9 million, or 31%, to $76.1 million in fiscal 2011 from $58.3 million in fiscal 2010. This increase was primarily due to an increase in expenses related to our head office growth of $15.8 million, which was largely related to the growth of our information technology and human resources departments to support the growth of our business. Income from operations also increased as a result of increased stock-based compensation expense of $2.2 million, an increase in foreign exchange losses of $1.2 million, and increased depreciation and amortization expense of $0.5 million. The increase was partially offset by a decreased provision for impairment and lease exit costs of $1.8 million.

Other Income (Expense), Net Other income (expense), net decreased $0.4 million, to $2.5 million in fiscal 2011 from $2.9 million in fiscal 2010. The decrease was primarily a result of re-measuring our 13 percent non-controlling equity investment in Australia immediately prior to obtaining control of the business, which led to a $1.8 million gain on investment in fiscal 2010. This was offset by increased interest income earned in fiscal 2011 compared to fiscal 2010 on our increased cash balances.

Provision for Income Taxes Provision for income taxes increased $43.4 million, or 71%, to $104.5 million in fiscal 2011 from $61.1 million in fiscal 2010. In fiscal 2011, our effective tax rate was 36.1% compared to 33.3% in fiscal 2010. The higher effective tax rate was due to the proportional increase of taxable income in the United States in fiscal 2011 compared to taxable income in Canada which is taxed at a rate lower than the US statutory rate combined with the declining Canadian corporate tax rate.

We have not recorded deferred taxes on undistributed earnings and other temporary differences of our Canadian subsidiary which are considered to be indefinitely reinvested. If management's intentions with respect to these undistributed earnings and other temporary differences were to change in the future, deferred taxes may need to be provided that could materially impact our financial results.

Net Income Net income increased $62.2 million, or 51%, to $184.1 million in fiscal 2011 from $121.8 million in fiscal 2010. The increase in net income in fiscal 2011 was primarily due to a $174.3 million increase in gross profit resulting from sales growth at existing and additional corporate-owned stores opened during fiscal 2011 and increasing traffic on our e-commerce website, offset by an increase of $67.8 million in selling, general and administrative expenses, an increase of $43.4 million in provision for income taxes, and a $0.4 million decrease in other income (expense), net.

Seasonality In fiscal 2012, fiscal 2011, and fiscal 2010, we recognized a significant amount of our net revenue in the fourth quarter due to significant increases in sales during the holiday season. We recognized 35%, 37%, and 36% of our full year gross profit in the fourth quarter in fiscal 2012, fiscal 2011 and fiscal 2010, respectively. Despite the fact that we have experienced a significant amount of our net revenue and gross profit 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. As our expected growth rate slows, we believe that we will experience fourth quarter gross profits as a percentage of full year gross profits as high, or higher, than in the current year.

34 -------------------------------------------------------------------------------- Table of Contents 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.

Liquidity and Capital Resources Our primary sources of liquidity are our current balances of cash and cash equivalents, cash flows from operations and borrowings available under our revolving credit facility. Our primary cash needs are capital expenditures for opening new stores and remodeling existing stores, making information technology system enhancements and funding working capital requirements. Cash and cash equivalents in excess of our needs are held in interest bearing accounts with financial institutions.

As of February 3, 2013, our working capital (excluding cash and cash equivalents) was $63.5 million and our cash and cash equivalents were $590.2 million.

The following table summarizes our net cash flows provided by and used in operating, investing and financing activities for the periods indicated: Fiscal Year Ended February 3, January 29, January 30, 2013 2012 2011 (In thousands) Total cash provided by (used in): Operating activities $ 280,113 $ 203,615 $ 179,995 Investing activities (93,229 ) (122,311 ) (42,839 ) Financing activities (5,491 ) 15,364 13,699 Effect of exchange rate changes (651 ) (3,517 ) 5,858 Increase in cash and cash equivalents $ 180,742 $ 93,151 $ 156,713 Operating Activities Operating Activities consist primarily of net income adjusted for certain non-cash items, including depreciation and amortization, deferred income taxes, realized gains and losses on disposal of property and equipment, 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.

In fiscal 2012, cash provided by operating activities increased $76.5 million, to $280.1 million compared to cash provided by operating activities of $203.6 million in fiscal 2011. The increase was primarily a result of increased net income, an increase in items not affecting cash, and an increase in income taxes payable, offset by decreased accounts payable. The net increase in items not affecting cash was primarily due to an increase in depreciation and amortization related to our increased store base, and an increase in stock-based compensation.

Depreciation and amortization relate almost entirely to leasehold improvements, furniture and fixtures, computer hardware and software, equipment and vehicles in our stores and other corporate buildings.

Depreciation and amortization increased $12.7 million to $43.0 million in fiscal 2012 from $30.3 million in fiscal 2011. Depreciation for our corporate-owned store segment was $27.5 million, $18.5 million, and $15.6 million in fiscal 2012, fiscal 2011 and fiscal 2010, respectively. Depreciation for our direct to consumer segment was $3.4 million, $2.4 million and $0.2 million in fiscal 2012, fiscal 2011 and fiscal 2010, respectively. Depreciation related to corporate activities was $12.1 million, $9.4 million, and $8.8 million fiscal 2012, fiscal 2011 and fiscal 2010, respectively. We have not allocated any depreciation to our other segment as these amounts to date have been immaterial.

35-------------------------------------------------------------------------------- Table of Contents Investing Activities Investing Activities relate entirely to capital expenditures and acquisitions of franchises.

Cash used in investing activities decreased $29.1 million, to $93.2 million in fiscal 2012 from $122.3 million in fiscal 2011. Capital expenditures for our corporate-owned stores segment were $64.9 million in fiscal 2012 which included $29.8 million to open 37 corporate-owned stores and $10.9 million to purchase the land and buildings of two of our corporate-owned stores, and $34.1 million in fiscal 2011 which included $21.9 million to open 41 corporate-owned stores.

The remaining capital expenditures for our corporate-owned stores segment in each period were for ongoing store refurbishment. Capital expenditures for our direct to consumer segment were $4.9 million and $6.7 in fiscal 2012 and fiscal 2011, respectively. Capital expenditures related to corporate activities and administration were $23.5 million and $76.1 million in fiscal 2012 and fiscal 2011, respectively. The decrease in capital expenditures related to corporate activities and administration compared to fiscal 2011 was primarily due to the purchase of our principal executive and administrative offices for $65.1 million plus acquisition-related costs in fiscal 2011. The capital expenditures in each period for corporate activities and administration were for improvements at our head office and other corporate buildings as well as investments in information technology and business systems.

Capital expenditures are expected to range between $90 million to $95 million in fiscal 2013, including approximately $30 million for approximately 43 new stores and the remainder reflecting renovation capital for existing stores, information technology enhancements and other corporate activities.

Financing Activities Financing Activities consist primarily of cash received on the exercise of stock options, excess tax benefits from stock-based compensation and cash paid to acquire the remaining non-controlling interest in Australia. Cash provided by financing activities decreased $20.9 million, to cash used of $5.5 million in fiscal 2012 from cash provided of $15.4 million in fiscal 2011. The cash used in financing activities for fiscal 2012 included $26.0 million for the purchase of the non-controlling interest in lululemon australia.

We believe that our cash from operations 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 facilities, 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.

Revolving Credit Facility In April 2007, we entered into an uncommitted senior secured demand revolving credit facility with Royal Bank of Canada. The revolving credit facility provides us with available borrowings in an amount up to CDN$20.0 million. The revolving credit facility must be repaid in full on demand and is available by way of prime loans in Canadian currency, U.S. base rate loans in U.S. currency, bankers' acceptances, LIBOR based loans in U.S. currency or Euro currency, letters of credit in Canadian currency or U.S. currency and letters of guaranty in Canadian currency or U.S. currency. The revolving credit facility bears interest on the outstanding balance in accordance with the following: (i) prime rate for prime loans; (ii) U.S. base rate for U.S. based loans; (iii) a fee of 1.125% per annum on bankers' acceptances; (iv) LIBOR plus 1.125% per annum for LIBOR based loans; (v) a 1.125% annual fee for letters of credit; and (vi) a 1.125% annual fee for letters of guaranty. Both lululemon usa inc. and lululemon FC USA inc., Inc. provided Royal Bank of Canada with guarantees and postponements of claims in the amounts of CDN$20.0 million with respect to lululemon athletica canada inc.'s obligations under the revolving credit facility. The revolving credit facility is also secured by all of our present 36 -------------------------------------------------------------------------------- Table of Contents and after acquired personal property, including all intellectual property and all of the outstanding shares we own in our subsidiaries. As of February 3, 2013, aside from the letters of credit and guarantees, we had $nil in borrowings outstanding under this credit facility.

Contractual Obligations and Commitments Leases. We lease certain corporate-owned store locations, storage spaces, building and equipment under non-cancelable operating leases. Our leases generally have initial terms of between five and 10 years, and generally can be extended only in five-year increments, if at all. Our leases expire at various dates between one and 10 years, excluding extensions at our option. A substantial number of our leases for corporate-owned store premises include renewal options and certain of our leases include rent escalation clauses, rent holidays and leasehold rental incentives, none of which are reflected in the following table. Most of our leases for corporate-owned store premises also include contingent rental payments based on sales volume, the impact of which also are not reflected in the following table. The following table summarizes our contractual arrangements as of February 3, 2013, and the timing and effect that such commitments are expected to have on our liquidity and cash flows in future periods: Payments Due by Fiscal Year Total 2013 2014 2015 2016 2017 Thereafter (In thousands)Operating Leases (minimum rent) $ 302,893 $ 57,691 $ 56,920 $ 53,195 $ 47,712 $ 37,192 $ 50,183 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 February 3, 2013, letters of credit and letters of guarantee totaling $1.4 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 and Estimates 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.

We believe that the following critical accounting policies affect our more significant estimates and judgments used in the preparation of our consolidated financial statements: Revenue Recognition. Net revenue is comprised of corporate-owned store net revenue, direct to consumer sales through www.lululemon.com, www.ivivva.com and other country and region specific websites, and other net revenue, which includes, franchise royalties as well as sales of products to franchisees, sales to wholesale accounts, warehouse sales and sales from company-operated showrooms, in each case, net of an estimated allowance for sales returns and discounts. Sales to customers through corporate-owned stores and company-operated showrooms are recognized at the point of sale, net of an estimated allowance for sales returns. Direct to consumer sales are recognized when goods are shipped and collection is reasonably assured, net of an estimated 37 -------------------------------------------------------------------------------- Table of Contents allowance for sales returns. Other net revenue related to franchise royalties are recognized when earned, in accordance with the terms of the franchise/license agreements. Royalties are based on a percentage of the franchisees' sales and recognized when those sales occur. Other net revenue related to warehouse sales is recognized when these sales occur. Amounts billed to customers for shipping and handling are recognized at the time of shipment.

Sales are reported on a net revenue basis, which is computed by deducting from our gross sales the amount of sales taxes, actual product returns received, discounts and an amount established for anticipated sales returns. Our estimated allowance for sales returns is a subjective critical estimate that has a direct impact on reported net revenue. This allowance is calculated based on a history of actual returns, estimated future returns and any significant future known or anticipated events. Consideration of these factors results in an estimated allowance for sales returns. Our standard terms for retail sales limit returns to approximately 14 days after the sale of the merchandise. For our wholesale sales, we allow returns from our wholesale customers if properly requested and approved. Employee discounts are classified as a reduction of net revenue.

Revenue from our gift cards are recognized when tendered for payment, or upon redemption. Outstanding customer balances are included in "Unredeemed gift card liability" on the consolidated balance sheets. There are no expiration dates on our gift cards, and lululemon does not charge any service fees that cause a decrement to customer balances.

While we will continue to honor all gift cards presented for payment, management may determine the likelihood of redemption to be remote for certain card balances due to, among other things, long periods of inactivity. In these circumstances, to the extent management determines there is no requirement for remitting card balances to government agencies under unclaimed property laws, card balances may be recognized in the consolidated statements of operations in "Net revenue." Inventory. Inventory is valued at the lower of cost and market. Cost is determined using weighted-average costs. For finished goods, 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 and labor, as applicable, and all costs incurred to deliver inventory to our distribution centers including freight, non-refundable taxes, duty and other landing costs.

We periodically review our inventories and make provisions as necessary to appropriately value obsolete or damaged goods. The amount of the provision is equal to the difference between the book cost of the inventory and its estimated market value based upon assumptions about future demands, selling prices and market conditions. In addition, as part of inventory valuations, we provide for inventory shrinkage based on historical trends from actual physical inventories.

Inventory shrinkage estimates are made to reduce the inventory value for lost or stolen items. We perform physical inventory counts throughout the year and adjust the shrink provision accordingly. In fiscal 2012, we wrote-off $6.4 million of inventory and in fiscal 2011 we wrote-off $3.1 million of inventory.

Property and Equipment. Property and equipment are recorded at cost less accumulated depreciation. Direct internal and external costs related to software used for internal purposes which are 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. Buildings are amortized on a straight-line basis over the expected useful life of the asset, which ranges from 10 to 20 years. 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, up to a maximum of five years. All other property and equipment are amortized using the declining balance method as follows: Furniture and fixtures 20 % Computer hardware and software 30 % Equipment and vehicles 30 % 38 -------------------------------------------------------------------------------- Table of Contents We recognize a liability for the fair value of a required asset retirement obligation, or ARO, when such obligation is incurred. Our AROs are primarily associated with leasehold improvements which, at the end of a lease, we are contractually obligated to remove in order to comply with the lease agreement.

At the inception of a lease with such conditions, we record an ARO liability and a corresponding capital asset in an amount equal to the estimated fair value of the obligation. The liability is estimated based on a number of assumptions requiring management's judgment, including store closing costs, cost inflation rates and discount rates, and is accreted to its projected future value over time. The capitalized asset is depreciated using the convention for depreciation of leasehold improvement assets. Upon satisfaction of the ARO conditions, any difference between the recorded ARO liability and the actual retirement costs incurred is recognized as an operating gain or loss in the consolidated statements of operations.

We recognize a liability for a cost associated with a lease exit activity when such obligation is incurred. A lease exit activity is measured initially at its fair value in the period in which the liability is incurred. We estimate fair value at the cease-use date of its operating leases as the remaining lease rentals, reduced by estimated sublease rentals that could be reasonably obtained for the property, even where we does not intend to enter into a sublease.

Estimating the cost of certain lease exit costs involves subjective assumptions, including the time it would take to sublease the leased location and the related potential sublease income. The estimated accruals for these costs could be significantly affected if future experience differs from that used in the initial estimate. Lease exit costs are included in provision for impairment and lease exit costs.

Long-Lived Assets. Long-lived assets, including intangible assets with finite useful lives, held for use are evaluated for impairment when the occurrence of events or changes in circumstances indicates that the carrying value of the assets may not be recoverable as measured by comparing their net book value to the estimated future cash flows generated by their use and eventual disposition.

Impaired assets are recorded at fair value, determined principally by the estimated future cash flows expected from their use and eventual disposition.

Reductions in asset values resulting from impairment valuations are recognized in income in the period that the impairment is determined. Long-lived assets, including intangible assets with finite useful lives, held for sale are reported at the lower of the carrying value of the asset and fair value less cost to sell. Any write-downs to reflect fair value less selling cost is recognized in income when the asset is classified as held for sale. Gains or losses on assets held for sale and asset dispositions are included in provision for impairment and lease exit costs.

Income Taxes. We follow the liability method with respect to accounting for income taxes. Deferred income 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 are expected to be in effect when these differences are anticipated to reverse. Deferred income tax assets are reduced by a valuation allowance, if based on the weight of available positive and negative evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

The recognition of a deferred income tax asset is based upon several assumptions and management forecasts, including current and proposed tax legislation, current and anticipated taxable income, utilization of previously unrealized non-operating loss carry forwards and regulatory reviews of tax filings. Given the judgments and estimates required and the sensitivity of the results to the significant assumptions used, we believe the accounting estimates used in relation to the recognition of deferred income tax assets are subject to measurement uncertainty and are susceptible to a material change if the underlying assumptions change.

For financial reporting purposes, we generally provide taxes at the rate applicable for the appropriate tax jurisdiction. Because our present intention is to reinvest the unremitted earnings in our foreign operations, we do not provide U.S. income taxes on unremitted earnings of foreign subsidiaries.

Management periodically assesses the need to utilize these unremitted earnings to finance our foreign operations. This assessment is based on cash flow projections that are the result of estimates of future production, fiscal requirements by tax jurisdiction of our operations and operational and fiscal objectives by tax jurisdiction for our operations. Such estimates are inherently imprecise since many assumptions utilized in the cash flow projections are subject to revision in the future.

39-------------------------------------------------------------------------------- Table of Contents We file income tax returns in the United States, Canada and various foreign and state jurisdictions. The 2011 and 2012 tax years remain subject to examination by the U.S. federal and state tax authorities. The 2008 tax year is still open for certain state tax authorities. The 2008 to 2012 tax years remain subject to examination by tax authorities in certain foreign jurisdictions. Our policy is to recognize interest expense and penalties related to income tax matters as a selling, general and administrative expense. At February 3, 2013, we do not have any significant accruals for interest related to unrecognized tax benefits or tax penalties. Our intercompany transfer pricing policies are currently subject to audits by various foreign tax jurisdictions. Although we believe that our intercompany transfer pricing policies and tax positions are reasonable, the final determination of tax audits or potential tax disputes may be materially different from that which is reflected in our income tax provisions and accruals.

Goodwill and Intangible Assets. Intangible assets are recorded at cost.

Non-competition agreements are amortized on a straight-line basis over their estimated useful life of five years. Reacquired franchise rights are amortized on a straight-line basis over their estimated useful lives of 10 years. Goodwill represents the excess of the purchase price over the fair market value of identifiable net assets acquired and is not amortized. Goodwill and intangible assets with indefinite useful lives are tested for impairment annually or more frequently when an event or circumstance indicates that goodwill or indefinite useful live intangible assets might be impaired. We use our best estimates and judgment based on available evidence in conducting the impairment testing. When the carrying amount exceeds the fair value, an impairment loss is recognized in an amount equal to the excess of the carrying value over its fair market value.

Stock-Based Compensation. We account for stock-based compensation using the fair value method. 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. Our calculation of stock-based compensation requires us to make a number of complex and subjective estimates and assumptions, including future forfeitures, stock price volatility, expected life of the options and related tax effects. The estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results differ from our estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. We consider several factors when estimating expected forfeitures, such as types of awards, size of option holder group and anticipated employee retention. Actual results may differ substantially from these estimates.

Expected volatility of the stock is based on our review of companies we believe of similar growth and maturity and our peer group in the industry in which we do business because we do not have sufficient historical volatility data for our own stock. The expected term of options granted is derived from the output of the option valuation model and represents the period of time that options granted are expected to be outstanding. In the future, as we gain historical data for volatility in our own stock and the actual term employees hold our options, expected volatility and expected term may change which could substantially change the grant-date fair value of future awards of stock options and, ultimately, the expense we record. For awards with service and/or performance conditions, the total amount of compensation expense to be recognized is based on the number of awards that are expected to vest and is adjusted to reflect those awards that do ultimately vest. For awards with performance conditions, we recognize the compensation expense over the requisite service period as determined by a range of probability weighted outcomes. For awards with market and or performance conditions, all compensation expense is recognized if it is probable that the underlying market or performance conditions will be fulfilled.

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