After a Sharp Drop, Is Lululemon a Value or Just a Lemon?

High-flying fitness apparel designer Lululemon Athletica (NASDAQ: LULU  )  witnessed firsthand what happens when a stock's growth story deflates with its share price down sharply over the past twelve months. The latest hit to its story and its stock price came from its revelations of negative comparable-store sales and traffic in January. Of course, Lululemon's downward slide began with a well-publicized quality control issue with its popular black Luon pants in March 2013, which undoubtedly hurt its image as a seller of premium products. However, with a growing store network and a rock-solid balance sheet, is Lululemon a good bet for investors at its current price?

What's the value?
Lululemon came out of nowhere in the late 1990s as the brainchild of company founder Chip Wilson, who wanted to tap into the growing need for comfortable clothing for a fitness-focused, adult female demographic. The company has used community-based marketing and word-of-mouth advertising to create a loyal customer base, which has allowed it to move beyond its traditional outerwear into related apparel areas like jackets and accessories.  More importantly, Lululemon's immense popularity has allowed it to price its products at premium levels which has made the company one of the most profitable operations in the retail space.

In fiscal year 2013, Lululemon continued to grow at a fast pace with a top-line gain of 20.9%, aided by comparable-store sales increases and a widening of its store base beyond its core U.S. and Canadian markets. The company has continued to enjoy highly productive stores which average sales of more than $2,000 per square foot, which makes Lululemon a highly sought-after tenant by mall operators. On the downside, though, Lululemon's quality control issue with its Luon pants has dented its merchandise margin during the current period and increased its corporate overhead costs, which include rising legal expenses to fight shareholder lawsuits.

A turf war in fitness apparel
More worrisome, however, is the rise of competitors that look to poach Lululemon's fitness-focused, female customer base.  Athletic apparel juggernaut Nike (NYSE: NKE  ) , for one, has its eyes set on dominance in the apparel category by following the script that worked well in the footwear category. Namely, Nike outspent competitors in the marketing area by hiring highly paid spokespeople, like Michael Jordan and Tiger Woods. Apparel is clearly a key area of focus at roughly 30% of sales for the company, as Nike tries to leverage the trend that has seen consumers increasingly move sportswear into their daily wardrobes.

In fiscal year 2014, Nike has continued to report solid top-line growth that includes a 5.8% gain in its apparel segment, aided by notable strength in running and women's training product lines. During the period, the company's apparel segment continued to get mileage from consumers' acceptance of its product innovations in the space, like its Nike Free and Dri-Fit apparel lines that provide performance-enhancing benefits through lightweight and moisture-reducing fabrics.  More importantly, Nike's improved profitability continues to provide it with a strong cash position, fueling further growth of its product development and marketing activities.

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Similarly, athletic apparel maker Under Armour (NYSE: UA  ) has its sights set on winning greater market share in the women's apparel space, with recent introductions like its Armour Bra and UA Studio product lines.  Much like Lululemon, Under Armour has taken the cult-like popularity of a single product, moisture-wicking T-shirts in its case, and built a larger product portfolio around it; this includes successful forays into fleece activewear, shoes, and accessories.

Under Armour rose to prominence via the wholesale channel, which still accounts for a majority of sales for the company. However, it obviously sees the benefits of a sizable company-owned distribution channel, an area where it has made inroads primarily through its online initiatives and a growing portfolio of factory-outlet stores.  Under Armour has also taken a page from Nike's marketing playbook by entering into sports team partnerships, which include a recent agreement with Notre Dame to outfit its teams with Under Armour gear.  Of course, the motivation for Under Armour's strategic moves is to maintain a strong sales trajectory, a result that the company seems to be achieving as it recently reported a better than expected 27.1% top-line gain for the fiscal year ended December 2013.

The bottom line
Lululemon provides a good example of the effect that the quality control process can have on the value of a company, as a deficiency in this area has led Mr. Market to knock billions off Lululemon's market value.  While the company seems to have fixed the immediate problem, a recent decline in customer traffic would indicate that Lululemon's premium brand value might have taken a larger-than-expected hit.  With marketing dynamos like Nike and Under Armour breathing down Lululemon's neck, investors would be wise to avoid this unfolding story.


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