Can Lululemon Athletica Inc. Fight Off Competition From The Gap, Inc.?

Lululemon is suffering from declining comparable-store sales, with the problems of last year combined with increased competition from Gap's Athleta causing issues for the company. Can Lululemon recover?

May 17, 2014 at 12:00PM

Lululemon athletica (NASDAQ:LULU), known for its expensive women's yoga pants, has been struggling ever since the brand was tarnished by quality and supply chain issues last year. The last time I wrote about Lululemon, the stock was trading at 44 times earnings, and I warned that expectations had become unrealistic. Now, after falling nearly 50%, a P/E ratio closer to 23 seems a lot more reasonable.

But Lululemon is facing more competition than ever before, with Gap's (NYSE:GPS) Athleta offering lower prices and a better selection. Aggressive store growth is masking weak sales at existing stores, and international expansion seems ill advised with U.S. stores doing so poorly. All Lululemon has is its brand, and that's not nearly as strong as it used to be.

A look at Lululemon's problems
For a company that is supposed to be a growth company, the fourth quarter was terrible. While total revenue rose by 7%, this was on the back of store growth. Comparable-store sales fell by 2% in the quarter; and while including online sales improves this number by 6 percentage points, it's clear that the stores themselves are doing poorly. Management expects combined comparable-store sales, which includes online sales, to rise in the low- to mid-single digits in fiscal 2014, and this leads to the conclusion that comparable sales at the stores themselves will be flat at best.

It's no wonder, then, that investors have been dumping the stock over the past year. Part of this decline in the performance of the stores is certainly due to the scandals of the past year, but I think that the nature of Lululemon's business model and an increase in competition are also contributing to the problem.

Scarcity, high prices, and competition
Lululemon stocks a small number of each item in its stores in order to create the illusion of scarcity, hoping that this drives demand for its products and allows the company to charge high prices. This may have been fine when the company was small and before the brand was tarnished, but I suspect that this policy will have the effect of driving customers to the competition. Management has suggested that it's pulling back on this scarcity model a bit, wanting to keep guests hungry for its products but not starving; but with competitors offering lower prices and a wider selection, not having products in stock that customers want to buy is not a sustainable strategy. This simply doesn't work when there are alternatives to Lululemon.

Athleta, run by Gap, is one such competitor. While Athleta only represents 3%-4% of Gap's total revenue, the chain of stores has been growing fast. In 2013, Gap opened 30 Athleta stores, bringing the total number up to 65, and the company plans to open an additional 30 stores in 2014. This is far smaller than the 254 stores Lululemon operated at the end of the fourth quarter, but it's clear that Lululemon is no longer the only major player in the space.

Athleta certainly has some high-priced items, but it offers a far wider scale of price points that appeal to a broader audience than Lululemon. While Lululemon sells yoga pants for between $82 and $98 on its website, Athleta has prices for similar items starting at $64, with some items on sale even less expensive. That's a significant price difference, and I doubt that Lululemon will be able to maintain its sky-high margins as the competition expands.

The bottom line
Lululemon's stores are performing poorly, with the issues of 2013 still having a negative effect on traffic. Combined with increased competition from Athleta, it's hard to imagine Lululemon's high prices and frustrating scarcity business model being sustainable. Lululemon is a premium brand, but that brand isn't worth as much as it was before the quality control problems of last year; and it's not clear at this point whether it will ever fully recover. Management expects comparable-store sales to start to recover this year, but I have my doubts.

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Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Lululemon Athletica. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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