Is the Fall in Lululemon a Buying Opportunity?

Lululemon athletica  (NASDAQ: LULU  ) crashed by more than 11% on Thursday as the company's earnings report included a worrisome reduction in sales and earnings guidance. Is the recent dip in Lululemon a buying opportunity or will competitors like Gap (NYSE: GPS  ) and Under Armour (NYSE: UA  ) capitalize on the company's problems to continue gaining market share in the yogawear business?

Strong earnings, concerning guidance
The numbers for the third quarter where actually better than expected, Lululemon reported a year-over-year increase of 20% in revenue to $379.9 million. Comparable-store sales increased by a healthy 5% during the quarter and direct-to-consumer revenues were also strong, with a 37.3% annual increase during the period.

Profit margins have been under pressure lately, and the recent quarter was no exception. Gross profit margins fell to 53.9% of revenue versus 55.4% in the third quarter of fiscal 2012, and operating margin declined to 24.3% of sales compared to 25.5% in the same quarter of the previous year.

Still, the company reported better than expected earnings per share of $0.45 versus $0.39 in year-ago quarter. Wall Street analysts were on average expecting earnings of $0.40 per share.

Guidance was a big disappointment, though: Management reduced its sales expectations for the fourth quarter of fiscal 2013 to between $535 million and $540 million versus a previous guidance of between $565 million and $570 million.

Same-store sales for the upcoming quarter are expected to be flat and management expects earnings per share to be in the range of $0.78 to $0.80, materially lower than the average Wall Street estimate of $0.84 per share. Lululemon also cut sales and earnings guidance for fiscal 2014.

CEO Christine Day pointed to macroeconomic factors and execution problems as the main reason for the disappointing guidance:

This so far has been a year of challenges, learning, and growth for Lululemon, and while our outlook for the fourth quarter is being affected by both macro and execution issues, I believe that the investments we are making in the business combined with the team in place create a strong platform for growth in the years ahead.

Mistakes and competitive pressure
Lululemon has made a series of expensive mistakes this year; in March, the company had to recall 17% of the yoga pants it had in stock due to excessive sheerness. Later in June, CEO Christine Day unexpectedly announced she was leaving the company once a replacement was found, which produced another steep decline in its stock.

Adding insult to injury, founder and chairman Chip Wilson made some very unfortunate comments insinuating that women's bodies may be to blame for the problems with the company's products. "Frankly, some women's bodies just actually don't work," Wilson said on Nov. 5 in an interview with Bloomberg TV.

On Dec.9 Lululemon announced that Laurent Potdevin has been appointed as new CEO. The executive, who most recently served as president of Toms Shoes, is taking charge in January 2014. In addition to this, Chip Wilson is resigning the chairman position. So, the recent disappointment comes at a time when investors in Lululemon were starting to have hopes of a better future as a new management team could streamline operations and leave the company's problems in the past.

A renewed management team is clearly positive news for Lululemon, but investors need to consider that the company is now facing growing competitive challenges by the likes of Gap's Athleta brand and Under Armour.

Athleta is opening new stores near existing Lululemon locations, benefiting from its traffic and undercutting Lululemon products in price by a considerable difference. In addition to this, Athleta is copying Lululemon's marketing strategy by hooking up with yoga instructors and sponsoring all kinds of classes and similar activities to increase brand awareness. Athleta offers a wider variety of sizes than Lululemon, providing an alternative for customers who prefer a more inclusive brand and capitalizing on Wilson's unfortunate comments.

Under Armour is also stepping up its efforts in women's apparel; CEO Kevin Plank believes women's apparel will generate around $1 billion in revenue for the company in 2016 and yoga could be a considerable opportunity for Under Armour in the coming years. Under Armour is clearly going after Lululemon with its marketing campaigns; the company recently launched a big campaign for its studio yoga line using the tag line "We've Got You Covered," in clear reference to Lululemon's sheerness problem.

Lululemon has been one of the most successful brands in the sports apparel business over the last several years. But success attracts competition, and the company is now facing growing competitive pressure while at the same time it needs to recover from recent mistakes hurting its brand and image. The new management team will clearly be facing a demanding challenge in the coming quarters.

Bottom line: A visibility problem
Is management playing it safe by providing an excessively low guidance so it can easily overdeliver in the coming quarters? Or is increased competition from players like Gap and Under Armour seriously hurting Lululemon? Uncertainty usually creates opportunity, and there is plenty of uncertainty surrounding Lululemon. The company offers material upside potential if the new CEO can leave its problems behind and reignite growth in the coming quarters. On the other hand, Lululemon's visibility problems go well beyond its pants.

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