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Does This Retailer Need to Grow Up?

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In business, there’s a distinction between a company that is quirky and one that is utterly foolish. These days, yoga apparel retailer Lululemon Athletica (NASDAQ: LULU) is increasingly looking like the latter. The company’s quality control issues, the abrupt departures of its chief product officer and CEO, and its unclear vision for the future all indicate that Lululemon is a company that’s not ready to grow up yet.

Day turns into night

Former CEO Christine Day, who joined Lululemon in 2008, abruptly resigned on June 11. Prior to joining Lululemon, Day was the head of Starbucks’ Asia division. During her tenure, Lululemon’s annual revenue quadrupled to $1.37 billion, as it grew from a niche brand into a nationally recognized one.

<img alt="" src="http://media.ycharts.com/charts/d317e6fea2650ae6db78dba526055268.png" />

However, that rapid growth came at a price. In 2010, Lululemon recalled its reusable shopping bags after tests revealed that they contained lead. Last September, it experienced problems with color bleeding in its swimwear and pants. Then in March, its black luon (a proprietary Lululemon fabric) yoga pants were recalled for being too sheer. These quality control issues led to the resignation of its chief product officer, Sheree Waterson, in April. However, many of the company’s fans blamed Day for expanding the company too quickly, which led to the loss of control over its outsourced supply chain.

Although Day’s departure was celebrated by some of Lululemon’s fans, who considered her aggressive expansion to have decreased the overall quality of its clothes, investors completely disagreed. Shares of Lululemon plunged 15% after Day’s resignation. For many investors and analysts, Day was the guiding force behind Lululemon’s impressive growth, and the rapid expansion was necessary to justify Lululemon’s premium valuation. Even after its precipitous decline, the stock still trades with a P/E of 36.

Why so serious?

Lululemon, which now lacks a permanent CEO, should be reassuring its investors with a clearer plan for its future. Instead, Lululemon has addressed Day’s resignation with a joke, launching a fake job posting on its website, reading, “CEO Wanted.” The tongue-in-cheek ad asks for potential applicants to be able to speak Sanskrit, do headstands for at least ten minutes, and to have Ellen DeGeneres on speed dial.

While that goofy ad is obviously a way for Lululemon to garner free publicity from the media and make fun of itself over its current troubles, it comes off as disrespectful to the outgoing CEO as well as investors, who just had to endure a punishing week of losses. It’s a symptom of Lululemon’s big problem - it’s a company that doesn’t want to grow up, despite being aggressively challenged by two of the biggest names in retail - Nike (NYSE: NKE) and Gap Inc. (NYSE: GPS).

It’s time to grow up

Although Lululemon has a relatively small footprint of 201 brick-and-mortar stores, its solid reputation has put it on the same page as these retail giants. Lululemon’s original strength was its unique store model - it offered free yoga classes to customers through an attached studio, and used word of mouth advertising, rather than heavy marketing expenses, to grow its presence from its first store in Vancouver to the rest of Canada, the United States, Australia and New Zealand.

Prior to Lululemon’s rise, no retailer considered yoga apparel to be a growth market - it was a niche one at best. However, Lululemon’s success has shown other retailers that yoga apparel might be the magic formula to sell athletic apparel to women.

Nike has increased its yoga apparel offerings significantly over the past year, and generally sells its products at 20% to 30% less than comparable Lululemon products. Nike has also created a line of yoga footwear, Nike Studio Wrap, aimed at women who do yoga and pilates. The Studio Wrap isn’t cheap at $110, and seems like a superfluous product for exercises that women usually do barefoot, but it has been met with positive reviews.

Gap, on the other hand, is an even bigger threat to Lululemon. Its Athleta yoga apparel brand, which was originally launched as an online retailer in 2009, has since expanded into a brick-and-mortar one. Gap intends to open 50 new Athleta brick-and-mortar stores by the end of the year. Through Athleta, Gap has cloned Lululemon’s business model of offering free yoga classes at an attached studio, and has even reportedly poached Lululemon’s yoga instructors with higher product discounts.

The problem is Lululemon’s lack of a defensive moat against these threats. Its margins will be squeezed hard if it has to compete with Nike and Gap on an even price basis, which may lead to more quality control issues. Lululemon’s products and services are also looking less unique by the day, as its customers start to see competing combination shops and studios pop up across the country.

<table> <tbody> <tr> <td> </td> <td> <p><span><span><span><strong>Forward P/E</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Price to Sales (ttm)</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>5-year PEG</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Debt to Equity</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Profit Margin</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Qty. Revenue Growth (y-o-y)</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Qty. Earnings Growth (y-o-y)</strong></span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Lululemon Athletica</strong></span></span></span></p> </td> <td> <p><span><span><span>25.74</span></span></span></p> </td> <td> <p><span><span><span>6.75</span></span></span></p> </td> <td> <p><span><span><span>1.49</span></span></span></p> </td> <td> <p><span><span><span>No debt</span></span></span></p> </td> <td> <p><span><span><span>18.96%</span></span></span></p> </td> <td> <p><span><span><span>21.00%</span></span></span></p> </td> <td> <p><span><span><span>1.40%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Nike</strong></span></span></span></p> </td> <td> <p><span><span><span>20.23</span></span></span></p> </td> <td> <p><span><span><span>2.15</span></span></span></p> </td> <td> <p><span><span><span>2.10</span></span></span></p> </td> <td> <p><span><span><span>3.01</span></span></span></p> </td> <td> <p><span><span><span>9.22%</span></span></span></p> </td> <td> <p><span><span><span>9.40%</span></span></span></p> </td> <td> <p><span><span><span>54.60%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Gap</strong></span></span></span></p> </td> <td> <p><span><span><span>13.74</span></span></span></p> </td> <td> <p><span><span><span>1.22</span></span></span></p> </td> <td> <p><span><span><span>1.26</span></span></span></p> </td> <td> <p><span><span><span>39.45</span></span></span></p> </td> <td> <p><span><span><span>7.77%</span></span></span></p> </td> <td> <p><span><span><span>6.90%</span></span></span></p> </td> <td> <p><span><span><span>42.90%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><em>Advantage</em></span></span></span></p> </td> <td> <p><span><span><span>Gap</span></span></span></p> </td> <td> <p><span><span><span>Gap</span></span></span></p> </td> <td> <p><span><span><span>Gap</span></span></span></p> </td> <td> <p><span><span><span>Lululemon</span></span></span></p> </td> <td> <p><span><span><span>Lululemon</span></span></span></p> </td> <td> <p><span><span><span>Lululemon</span></span></span></p> </td> <td> <p><span><span><span><span>Nike</span></span></span></span></p> </td> </tr> </tbody> </table>

Source: Yahoo Finance, 6/17/2013

On a fundamental basis, Lululemon is still a strong contender, with a clean balance sheet, double-digit revenue growth and a much wider profit margin than either Nike or Gap. Its earnings have been dragged down to single-digit growth by the aforementioned pants recall, but its long-term bottom line growth is still intact.

The Foolish bottom line

At current prices, Lululemon is a hard investment to make. Even though the company has great growth fundamentals, its past quality control issues, the loss of two key leaders, and mounting pressure from larger retailers like Nike or Gap all present major challenges. Investors should wait to see if the company can find a worthy successor to Christine Day, who can continue to expand its footprint while maintaining the product’s quality and innovation, before they make a bullish or bearish call.

Lululemon has the potential to grow its sales by 10 times if it can penetrate its other markets like it has in Canada, but the competitive landscape is starting to increase. Can Lululemon fight off larger retailers and ultimately deliver huge profits for savvy investors? The Motley Fool answers these questions and more in its most in-depth Lululemon research available. Thousands have already claimed their own premium ticker coverage; gain instant access to your own by clicking here now.

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Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Lululemon Athletica and Nike. The Motley Fool owns shares of Nike. 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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