Why Lululemon May Be in Trouble

In the past five years, shares of Lululemon Athletica (NASDAQ: LULU  ) have appreciated an amazing 1,152%. By establishing strategic distribution relationships with spas, gyms, and health clubs, and by promoting a yoga-inspired culture, the company established itself as a leading brand in the women's athletic apparel rich niche. This allowed Lululemon Athletica to charge premium prices for its products. The company boasts the fourth-highest sales per square foot among North American retailers, only after AppleTiffany, and Coach.

However, aggressive pricing strategies taken by competitor Gap (NYSE: GPS  ) , combined with Nike's (NYSE: NKE  )  serious attempts to gain market share in the yoga apparel market, could make it hard for Lululemon Athletica to sustain its premium pricing while retaining market share. Furthermore, the company owns no patents for the technology and fabric used to manufacture its products. Insiders, including the company's ex-CEO Christine Day, are selling their shares.Is Lululemon Athletica in trouble?

Source: Lululemon Athletica Investor Relations, 2011 Presentation slides

Lululemon Athletica has issues
When it comes to athletic apparel for women, Lululemon Athletica is one of the most expensive choices. For example, Lululemon Astro yoga pants are priced at $98, while Gap charges $68 for its Chaturanga yoga pants under its Athleta brand. Even Nike, which is also famous in the industry for charging premiums, sells its Nike Gym seamless pants for $60.

The good news is that by charging a premium, Lululemon Athletica built a very profitable business model which can be seen from the company's five-year historical average gross margin of 54%. High margins also allowed Lululemon to accumulate more than one billion dollars in total assets.

However, if Lululemon -- which has no patents on any of the technical fabrics it uses to manufacture its products -- fails to provide a unique customer experience, it will simply not be able to sustain its price premium in an industry with low barriers to entry.

Quality control matters
The problem is that many of Lululemon's customers do not appear to be so happy nowadays. First, according to Business Insider, a frequent complaint among customers is the company's return policy. Lululemon does not accept any returns after two weeks. On the other hand, Gap's Athleta offers fulls refunds any time and for any reason.

Furthermore, the company needs to improve its quality control system and testing process. Early this year, Lululemon had to recall 17% of its pants for being too sheer.

To make matters worse, last week the founder of Lululemon,Chip Wilson, pointed the finger at 'some women's bodies' as part of the reason why the line of yoga pants was recalled earlier this year. His comments set the web on fire. In fact, here is already a change.org petition circulating that demands that Wilson publicly apologize for blaming customers for faulty fabric.

Competitors
Gap's Athleta is seen as Lululemon's biggest competitor. Apart from offering more affordable price points and embracing a kind return policy, Athleta offers plus-sized clothing, whereas Lululemon only sells pants and tops in sizes two to 12. In other words, more women can shop at Athleta.

Furthermore,Athleta is borrowing some business ideas from its rival. It has started to hook up with local yoga instructors in order to offer free yoga classes and fitness events in stores. It is also training its staff to make recommendations tailored to customers' pursuits, according to Bloomberg.

In Nike, Lululemon faces another formidable competitor. As the largest seller of athletic apparel in the world, Nike can use its huge distribution network to reach more customers. The company recently revealed an ambitious four-year growth plan which projects revenue of $36 billion by the end of 2017. In other words, the company expects four-year revenue growth of 42%, an amazing rate for a company with more than half a century of experience in the business of athletic apparel.

My Foolish take
A high pricing strategy, combined with poor quality control and increasing competition, have forced Lululemon's management to reduce the company's full-year guidance. Revenue is now expected to come in at $1.625--$1.635 billion. This is affecting momentum negatively.

Long term, Lululemon needs to protect its price premium strategy and strong branding in order to continue generating value for shareholders. In addition the company must pay more attention to quality control and customer experience.

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