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Why Lululemon's Luon Recall Is Worse Than You Think

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lululemon athletica's (NASDAQ: LULU  ) stock has spent much of this week in downward dog position. Shares slid more than 5% after the yoga-apparel company was forced to recall more than 17% of its signature luon pants from its stores due to problems with the technical specifications of the fabric. Specifically, the bottoms in question were sheer to the point of being see-through.

As if that's not bad enough, the stock has lost nearly 16% year to date to where it now trades at around $64 per share. Aside from the PR nightmare this situation has caused, there seem to be deeper issues for the Canadian company.

Getting to the bottom of it
Perhaps most worrisome is the we-said, they-said situation that has arisen from this ordeal. Lululemon shifted blame to a Taiwanese supplier that the retailer has relied on for more than 10 years. The supplier, Eclat Textile, fired back, telling Reuters that "a gap between Lululemon's expectations and reaction from the market" was the source of the problem. A spokesperson for the supplier confirmed that Eclat Textile did, indeed, follow the retailer's instructions in making the material. Lululemon has yet to issue a rebuttal to this claim.

The fact that this is the company's fourth major quality control issue in less than a year is also troublesome. Last July, customers complained about bleeding dyes in some of the company's neon-hued sports bras and tank tops. Lululemon later addressed this issue by hiring a color expert to help with future designs. Ultimately, the retailer's loyal fans dismissed the issue as a fluke incident. However, Lululemon's most recent quality control mishap brings to mind the old adage: Fool me once, shame on you. Fool me twice, shame on me.

Sound the alarms
The reason Lululemon gets away with charging premium prices is because of the superior quality of its merchandise. If this changes, even slightly, in the minds of consumers, then the company will lose its edge to competitors, such as Gap (NYSE: GPS  ) , Under Armour (NYSE: UA  ) , and Nike (NYSE: NKE  ) .

Gap is already making meaningful inroads into Lululemon's niche market of athletic yoga apparel. In fact, Gap has been known to shadow the retailer's stores by opening its own Athleta branded stores near Lululemon locations throughout the United States. Moreover, Gap plans to open about 35 new Athleta retail stores in the U.S. by the end of the year. This is particularly concerning given the cheaper price points of Gap's Athleta line versus similar options offered by Lululemon.

Meanwhile, both Nike and Under Armour are well positioned to steal market share from Lululemon. Unlike Lululemon's grassroots marketing, Nike and Under Armour promote their products through multimillion-dollar advertising campaigns and celebrity endorsement deals. This should give Lululemon's competitors an added advantage as they move to capitalize on the yoga retailer's recent setbacks.

Up to this point, these issues have been widely covered in the media. However, Lululemon has more at stake here than most care to mention. For one thing, a key part of the brand's appeal is its ability to create a positive customer experience. Unfortunately, you wouldn't be able to tell based on how the company has treated its customers throughout this recall.

Consumers spoke out on Lululemon's Facebook wall this week, some complaining that when returning yoga pants for "sheerness" they were asked to bend over whilst wearing the items so that a Lululemon employee could confirm that the product was truly flawed. To be fair, Lululemon followed up by saying, "We don't need to see our guests in the garments to deem them sheer. We want our guests to be comfortable in their products and will make it right for them if they feel their black bottoms are sheer."

Nevertheless, the company could have handled the situation better overall. As it stands, Lululemon has not yet released an itemized list of the items being recalled. However, the company did say that they expect this recall will negatively affect their upcoming financial results. Lululemon reports results for its fourth quarter and fiscal 2012 tomorrow, which should give investors even more insight into the situation.

From top to bottom
Lululemon cut its first-quarter sales projection by around $20 million, according to The Wall Street Journal, because of this incident. However, for buy-and-hold investors, the company's near-term profitability shouldn't be the main concern. The bigger problem would be if this debacle were to have a lasting affect on Lululemon's brand reputation.

From a product standpoint, Lululemon is loved for its technical fabrics, which are pre-shrunk, anti-odor, and wick away sweat in a hurry. It's no secret that I'm a longtime fan of both the company and its stock. However, the way Lululemon has handled this crisis thus far should be a red flag for long-term investors -- myself included. That's because poor customer service can often be more damaging to a brand than product recalls.

Current shareholders should stay tuned for the company's quarterly and full-year results, which are due out tomorrow. Quality control is no small matter. If Lulu wants to keep its stock from hitting rock-bottom this year, it will need to take extra care in convincing investors that its supply chain issues are behind it.

Lululemon has the potential to grow its sales by 10 times if it can penetrate its other markets like it has in Canada, but without question, the competitive landscape is starting to increase. Can Lululemon fight off larger retailers like Gap and Nordstrom, and ultimately deliver huge profits for savvy investors like yourself? The Motley Fool answers these questions and more in our most in-depth Lululemon research available for smart investors like you. Thousands have already claimed their own premium ticker coverage, and you can gain instant access to your own by clicking here now.

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