Gross Margin Decline at Lululemon has Just Begun

Lululemon Athleticas (Nasdaq : LULU) ability to capitalize off of women's athletic apparel growth has catapulted it's stock in recent years. The company's success has prompted competitors to enter the market, which is starting to put pressure on its premium pricing. With the lack of a sustainable competitive advantage, the company's gross margins will likely shrink to resemble competitors Nike (NYSE : NKE) and Under Armour (NYSE : UA). Foolish investors holding Lululemon stock risk losing their shirt since the company's Ecommerce sales strategy should accelerate Lululemon's poor competitive positioning in the maturing woman's athletic apparel market.

Woman's athletic apparel
Lululemon sells performance apparel and accessories to a primary target market of women with an active lifestyle, with items including fitness pants, shorts, tops and jackets. Lululemon competes directly against wholesalers and direct retailers, established companies expanding their production of athletic apparel, and retailers specifically focused on women's athletic apparel.

Nike and Under Armour are both established companies with the operating capability to compete heavily against Lululemon. Under Armour has primarily attacked the men's market since it came on the scene, but is currently pushing into the women's market, which explains the recent sponsorship deal with top ballet soloist Misty Copeland. While it may be tough for Under Armour to break signifigant ground, Nike's brand has the potential to provide Lululemon troubles.

Pants comparison
Women's preference for comfortable moisture wicking material helped Lululemon differentiate itself in the early stages, allowing it to charge a premium. Its woman's yoga pants range from $82 to $98. The "Wunder Under" cotton pants are priced at $92. The cheapest Luon-fabric pants are made of 87% nylon and 13% Lycra, and are priced at $82.

Lululemon's pants are approximately $20 -$40 more than the Under Armour "PERFECT SHORT PANTS" and $30-$50 more than Nike's "Legend slim Dri-FIT pants" which are shown below. The Prana yoga pants are very similar in fabric as Lululemon's, and are about 50% cheaper. Lululemon's competitors' adjustment to women's preferences at a much lower cost will likely precipitate a price drop.

No sustainable competitive advantage
Since the ability to charge a higher price is constrained to competition, abnormally high prices are only sustainable if a product has a competitive advantage through branding, quality, or technology. Since Lululemon owns no patents or intellectual property rights in the technology, fabrics or processes underlying the products, competitors are able to manufacture and sell similar products at discount prices.

Lululemon's ability to charge a price premium has primarily come from its branding to women. This brand strategy benefited the company in previous years since yoga and an active lifestyle became popular, but as the industry matures and the target market is more aware of better-value options, the brand value will likely cease to provide a competitive advantage. Whats more alarming is that the women's branding strategy will likely pigeonhole it as the company diversifies into male product markets.

Gross profit margin
A large gross profit margin is achieved through higher pricing or lower product costs. As Lululemon's pricing premium is pressured, its gross margin will likelyfall. This appears to have started, as the company's gross profit margin decreased approximately 3% to 52.8% in the most recent fiscal year. According to Lululemon's 10K, the decrease resulted primarily from a lower sales mix of higher margin core items, along with higher markdowns.

Nike and Under Armour's 2013 gross margin of 44% and 49% is well below Lululemon's 56% margin. Nike's margin averaged approximately 45%, and was very stable over the past five years, which makes sense since it is a much older company. Under Armour averaged approximately 49% over the past five years. It is likely that Lululemon's margin has been stronger than Under Armour's margin because Under Armour has had to intensely compete against veteran Nike since it started. As the woman's apparel market matures, Lululemon's margin should decline to mirror it's peers.

Lululemon's strategy to grow Ecommerce sales will be a catalyst for decreasing gross margins because the Internet provides a more transparent product comparison relative to direct-to-consumer and in-store sales. At the Lululemon sponsored yoga classes and stores, you will not find info on competitors products and pricing. Ecommerce will make current and potential Lululemon customers more willing to shop around for product attributes and pricing since it only requires a couple minutes of Internet searching.

Foolish takeaway

Lululemon has benefited greatly from women's athletic apparel growth, but as the industry matures, the companies only competitive advantage will dilute in value and force a price decline in many of it's products. Foolish investors should beware because the Ecommerce sales strategy should accelerate the difficult competitive position which will drive the company's gross profit margin to lower levels.