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Can Lululemon Stay Unique?

Leo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Earlier this month, yoga apparel retailer Lululemon (NASDAQ: LULU) slid 7% after the company slightly revised its fourth quarter guidance. I initially thought this was a strange response, considering that Lululemon increased its diluted earnings to 74 cents per share, up from its original forecast of 71 to 73 cents per share. However, investors were responding to the downward revision of its revenue during the key holiday season - a decrease from $480 million to $475 million.

Analysts on average had expected Lululemon to earn 74 cents per share on revenue of $488.1 million, so a downward revision of guidance that already missed expectations didn’t go over too well on Wall Street. But should investors really be too concerned that Lululemon has lost its mojo? Let’s take a look at some key factors which may help or hamper Lululemon’s growth in 2013.

Core Strengths

First off, we need to review Lululemon's core strengths and specialties:

  • Uses word-of-mouth advertising and free yoga lessons to build its brand.
  • Average revenue of $1,700 per square foot - the highest in its industry.
  • Only 165 stores and growing, with high margins and low real estate costs.

<img src="http://media.ycharts.com/charts/db12eda054718111a03f759fb8d33d7a.png" />

LULU data by YCharts

Has this growth story matured?

Lululemon’s growth story - a happy tale of a stock surging over 700% over the past five years - has been dependent on two things - youth and momentum. Wall Street loves companies when they’re young and produce impressive double to triple digit increases in earnings, revenue and comparable sales growth. Youth and strong returns breed momentum, and with a trailing P/E of 45, it’s clear that Lululemon is still being propelled by momentum.

Lululemon’s EPS has grown 72% over the past three years - which leads analysts to ask the inevitable question: “Is its growth sustainable?”

CEO Christine Day was optimistic regarding the company’s growth potential in 2013, touting the company’s strong margins and low inventory levels going into the new year. “We are also pleased that our gross margin is running slightly ahead of plan and that we are entering 2013 in a clean inventory position,” she stated.

However, a few blemishes have tainted Lululemon’s positive growth story.

First, the company now expects same-store sales growth to grow at a “high single digit” percentage in the fourth quarter, compared to an 18% increase in the third quarter. In other words, Lululemon expects comparable sales growth during the critical holiday quarter to actually be weaker than its previous, non-holiday quarter. The company attributed this slowdown to “consumer distractions that negatively impacted many retailers” and a glitch with its promotional e-mails - not entirely satisfactory answers, in my humble opinion.

Analysts at Credit Suisse also forecast a continued slowdown in 2013, with “mature” stores in Canada - which generate 59% of its total revenue - leading a decline in same-store sales momentum.

However, Sterne Agee analyst Sam Poser told clients to “buy on weakness.” Poser noted that Day’s comments regarding strong margins and a clear inventory did not make Lululemon “sound like a struggling company.” Poser maintained his “buy” rating and an $85 price target.

New threats

Much of Lululemon’s meteoric rise can be attributed to one word - uniqueness. Lululemon managed to capture a niche market and grow it into a brand new mainstream one - the dream of many retailers. However, when building a unique brand a company needs to set up high barriers to entry and a wide defensive moat to protect its core products. Unfortunately, Lululemon has neither.

Lululemon’s small size puts it at a distinct disadvantage against larger, better funded rivals, which have the capital and distribution networks to seriously hurt the company’s market share.

Gap’s (NYSE: GPS) fledgling Athleta yoga brand, which launched in 2009 as an online-only retailer, has now expanded into brick and mortar locations in North America, with plans to open 50 more by the end of next year. These new Athleta locations also offer free yoga classes. Larger companies such as Nike (NYSE: NKE) and Under Armour (NYSE: UA) have also taken notice, offering yoga apparel at lower prices than Lululemon. These three companies, which can afford to use lower margins to generate higher sales volume, are all aiming to undercut Lululemon’s bottom line.

Meanwhile, Lolë, a concept store in Montreal, was launched in 2010, focusing on "high-fashion" active apparel created by designer Andy Thê-Anh. It also offers free Zumba (Latin dance aerobics) classes in response to Lululemon’s free yoga classes. Lolë reported that sales rose 60% over the past two years. The company intends to expand from 11 stores to 50 within the next five years, aiming to crimp Lululemon’s higher-end appeal.

It’s clear that Lululemon recognizes these threats. The company has vowed to use litigation to protect its patent portfolio and core yoga apparel products. It sued Calvin Klein and G-III Apparel Group last November over these patent violations, which have since been settled.

My Foolish Bottom Line

At this point, investors need to think twice before investing in Lululemon and ask themselves the following questions.

  • Is Lululemon still a growth stock?
  • Can Lululemon maintain its niche market as mainstream companies swarm in?

NBG Productions analyst Brian Sozzi thinks that Lululemon’s answer to both of these problems is to diversify away from its core yoga line. The company recently introduced “office-friendly” cycling clothes, goose down vests, jackets and wool sweaters. It has also increased its selection of menswear.

In my opinion, treading directly into your competitors’ turf as a response to their encroachment into yours doesn’t seem ideal, especially when Lululemon stands to lose a lot - the company’s unique image - to offer mainstream apparel which can be bought at other retailers for cheaper prices.

With a forward P/E of 32, a 5-year PEG ratio of 1.29 and an impressive ROE of 37.12, I don’t think Lululemon’s growth story has hit a brick wall yet. However, it faces an uphill battle against some very ambitious startups and some very powerful multinational rivals, which can adversely impact its appeal with both higher-end and lower-end customers.

Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Lululemon Athletica, Nike, and Under Armour. The Motley Fool owns shares of Nike and Under Armour. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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