Seeing Past Lululemon's See-Through Scandal

What a year for Lululemon Athletica (NASDAQ: LULU  ) ! After an embarrassing recall of too-sheer Luon yoga pants and the surprise resignation of CEO Christine Day (still managing the company during the search for a new CEO ), the yoga and athletic apparel retailer's stock is virtually flat for the last year after years of share price appreciation.

The second quarter call was important to investors and the Street. As predicted, analysts asked about the impact of the recall, the CEO search, sourcing initiatives, and the competitive environment.

The CEO search
  Day updated analysts on the search for a new CEO.The board has brought on search consultants, they are interviewing some serious candidates, and expect it to be nailed down in the next couple quarters.  Day said that the company is in year two of its three year strategic growth plan, so a new CEO won't be shaking things up soon.

Lululemon's stock had soared under Day's term thanks to a culture that attracted incredibly loyal customers. The company's stock was a ten-bagger from 2009 to 2011, with an earnings-per-share growth rate of 57% for Day's last five years before the Luon pants recall.

Sourcing
After the brouhaha, analyst Sam Lee of International Strategy and Investment Group said Lululemon had an immature supply chain problem and needed to exert more quality control. The company had relied on only one source for its Luon fabric.

Lululemon addressed that on the second quarter call. The company announced that it had named a senior vice president to head what were three formerly separate departments and now will be one; sourcing, quality control, and commercialization.

More importantly, CEO Day said on the second quarter call,

We are expanding our base of production for Luon and have on-boarded a second source for Luon, and are on track to onboard the third for the first part of 2014. We recognize the value of our unique fabric and technologies and are taking steps to protect this competitive advantage.

Cannacord upgraded Lululemon to Buy on October 14 based on these supply chain improvements tracking more quickly than expected, giving it a $90 price target.

Impact of the recall
The company had already estimated the impact of the recall when it reported fourth quarter earnings in March. CFO John Currie said that in addition to the $17 million write-off for the first quarter, Lululemon expected "...additional lost revenue of $45 million to $50 million for the balance of the year, primarily in the second quarter, spread over new and existing stores and e-commerce."

On this second quarter call Currie mentioned that product margins contracted by 70 basis points due to a dearth of the higher margin black Luon bottoms. The recall raised inventory levels because the sourcing team was overwhelmed with getting Luon back into stores. This pushed back delivery of fall merchandise by three weeks.

So yes, the recall is still adversely affecting the company. In response, Lululemon lowered its guidance for third quarter revenue to a range of $370-375 million. 

Most importantly, Currie answered an analyst question on the financial impact of the recall. He said the impact was less than the aforementioned estimate and it will now come in at between $40 to 45 million in lost revenue. However, he later added that the company is investing $5 million in additional quality control. Day mentioned that the company should be fully caught up by the new year.

The competitive environment
Analysts asked about the competitive environment. Day answered:

...there is a vast variety and growing variety of competitors in the marketplace. What we have seen is that as we return to black Luon, and particularly the new Full-On Luon, it has been flying off the shelves and we've increased some of our orders for that for the back half of the year. So, in our core initiatives, we do believe our customers waited and then seized the opportunity to buy

With same store sales up 8% and e-commerce sales up by 39.4% in the second quarter it looks like  loyal customers stayed loyal. That 39% rise in e-commerce numbers would indicate that the company gained satisfied customers. It received a top rating from a Women's Wear Daily e-customer satisfaction survey in June.

Lululemon's most formidable competitor is Under Armour (NYSE: UA  ) , which is reportedly spending $250 million to advertise to womenand taking a page from the Lululemon playbook by creating more sport-to-work outfits. The company is also innovating its own scent control apparel and highlighting an Under Armour sports bra. Under Armour's e-commerce compound annual growth since 2010 lags Lululemon only slightly at 35%.

However, don't count out Gap (NYSE: GPS  ) . Gap's Athleta line of women's athletic apparel and retail stores offer its customers free classes, in store performance stylists, and free hemming...not insignificant benefits. Its website also offers a community based vibe very similar to Lululemon's. Athleta sponsors women-only races to build that athletic community that Lululemon is famous for. Athleta products are close to Lululemon in price.

On Gap's second quarter earnings call, CEO Glenn Murphy extolled the success of Athleta but also noted  similar athletic wear from GapFit and Old Navy were doing well, representing three different price points and joked this apparel category could be called "the new denim".

Lesson learned
The company is moving on from the recall with the expansion of its men's line and a big push internationally with the opening of its first stand-alone UK store in Covent Garden that will be widely promoted. In e-commerce, two promising initiatives are under way. The company has created an online customer forum called 'Hey lululemon'and opening a distribution center in Columbus, OH in June 2014. Two day shipping will become the norm.

Lululemon learned a hard lesson this year. It is expanding the number of sourcing vendors and taking customer feedback seriously with its "Hey Lululemon' site. By the new year this regrettable recall should be firmly behind the company.

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