This Apparel Company Does Not Have a Sustainable Moat

There are only a handful of apparel brands that have stood the test of time to become iconic enough to occupy the mind share and wallet share of its customers. It is too early to tell if Lululemon Athletica (NASDAQ: LULU  ) , a yoga-inspired athletic apparel retailer, will be able to book a place in history. Based on what I see now, I am worried that Lululemon's uniqueness will be eroded by 'me-too' competitors.

It is about barriers to entry, not just differentiation alone
Lululemon may have differentiated itself from its competitors in the athletic apparel space, with its focus on women, community-based marketing approach, fabric innovation, and store experience. However, none of these factors are immune to copying by its competitors, which means its differentiation will not last.

The issue lies with apparel as a business and an industry, where consumers have low switching costs. If I choose to switch to a different word processing software from Microsoft Word, I will have to spend time to master a new program. I will also risk issues associated with non-compatibility when I send out the document to my colleagues. In contrast, I face little resistance in trying a new apparel brand.

Successful consumer brands, which have stood the test of time, have made the purchasing of their branded products a habit for their customers, such as Coca-Cola. It takes decades of advertising spending and new-product innovation to convert fair-weather customers into loyal die-hard fans. At this point in time, I'm not convinced Lululemon (founded in 1998) has reached icon status for its customers.

Supplier risk
Lululemon has relied on technology-enhanced fabrics as one of its key differentiating factors, boasting features such as moisture-wicking, anti-stink, and stretchability. Unfortunately, it has little control or ownership of this particular competitive advantage.

Third party suppliers are responsible for the development and manufacturing of Lululemon's fabrics, and the intellectual property rights belong to the suppliers as well. Given that Lululemon does not engage in long-term contracts with its suppliers, there is essentially nothing to stop suppliers from providing such technology-enhanced fabrics to Lululemon's competitors or any new entrants.

Furthermore, Lululemon faces significant supplier concentration risk, with its top five suppliers accounting for approximately 60% of its products in 2012. This was exemplified by Lululemon's recall of its black Luon yoga pants in March 2013 due to sheerness issues. Following this, Lululemon has expressed its intentions to diversify its supplier base, by having two additional sources ready for manufacturing its key fabrics by the end of the year. Still, I am cautious of the fact that Lululemon is heavily reliant on its suppliers.

Future outlook
Despite decent growth rates of 8% and 22% in comparable store sales and net revenue, respectively, in the second quarter of fiscal 2013, higher-quality controls, as a result of the Luon recall, have resulted in product delays. In light of this, Lululemon has revised the lower end of its full-year earnings-per-share guidance from $1.96 to $1.94.

Also, management changes could be unsettling. The search for a new successor to former CEO Christine Day is still under way, and it might also take time for the new hires such as Steven Berube, Head of Distribution and Logistics, as well as Jennifer Battersby, Head of Sourcing Quality and Commercialization, to settle in.

Peer comparison
Lululemon's peers include Under Armour (NYSE: UA  ) and Nike (NYSE: NKE  ) .

While Lululemon is specifically focused on women's athletic apparel, Under Armour has a more diversified product mix across men's apparel, women's apparel, youth apparel, footwear, and accessories. Apart from men's apparel, which accounted for about 44% of its 2013 revenue, none of the other product categories made up more than a quarter of Under Armour's sales.

I see Lululemon's plans to expand its adjacent men's business, and running & swimming, as a validation of the importance of a diversified revenue mix to industry success. Under Armour has capitalized on broad-based growth in its various product categories, and product innovation, to deliver an impressive 31% EPS CAGR since 2005.

Notwithstanding its success, I believe size still matters. With its revenue less than one-tenth of Nike's, my view is that Under Armour does not have what it takes to dent Nike's market share and reach its 2016 target of $4 billion in sales. The key lies in Nike's economies of scale advantage, which allows it to have an edge in product innovation by spreading R&D costs over a significantly larger revenue base. As it stands now, Under Armour has a 2% share of the footwear market, compared with a 60% market share for Nike.

While Nike is a leading global athletic apparel & footwear company, it also has its own set of issues, such as the China slowdown and gross margin pressure. Nike has become heavily dependent on China in recent years, with it contributing about 30% of its EBIT in fiscal 2012. While this market still has long-term potential, intense price competition and inventory over-supply following the Beijing Olympics have depressed both growth and margins for Nike in China.

Nike's gross margin has decreased from 46.3% in fiscal 2010 to 43.6% in fiscal 2013. Labor cost pressures and an unfavorable sales mix tilted toward lower margin geographic regions have contributed to the slide. Valued at 2.0 times PEG, I fear Nike could fail to deliver on its growth prospects, leading to multiple compression, and a drop in share price.

Conclusion
Lululemon is expensive at 29 times forward earnings and 2.0 times PEG, so all the positives and high-growth prospects are factored into its stock price. Recent issues with its supply chain have exposed Lululemon's vulnerability, and I will hesitate to buy into the stock at today's lofty valuations. 

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  • Report this Comment On October 24, 2013, at 6:29 PM, DrXinLA wrote:

    When you stated: "Nike's gross margin has decreased from 46.3% in fiscal 2010 to 43.6% in fiscal 2013. Labor cost pressures and an unfavorable sales mix tilted toward lower margin geographic regions have contributed to the slide.", Which regions are you referring to ? Is the drop in Nike's gross margin the result of higher labor costs in that region (?) and sales in mainland China ?

    BTW, liked the article.

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