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The Underlying Reasons for Lululemon's Fall

The recent stock price decline of Lululemon Athletica (NASDAQ: LULU  )  catalyzed by poor future guidance has illuminated issues that have been clear for awhile. The company's deficient competitive positioning, including its lack of patents in a maturing women's apparel market, has and may continue to keep margins lower than they were in previous years. Foolish investors should be wary of Lululemon, especially as the CEO's conference call comments show that the company lacks a strong strategy to combat the consumer preference for its lower-margin products.

Previous analysis
The Motley Fool article titled "Gross Margin Decline at Lululemon has just begun" written two months ago explained that the company's success has prompted competitors to enter the market, and is starting to put pressure on its premium pricing. Its lack of a sustainable competitive advantage will likely result in a lower gross margin. Since Lululemon owns no patents or intellectual property rights for the technology, fabrics, or processes underlying its products, competitors can manufacture and sell similar products at discount prices.

Lululemon's e-commerce sales growth strategy will catalyze a gross margin decline because the Internet makes product comparisons easier for direct-to-consumer and in-store sales. The women's branding strategy will likely pigeonhole the company as it tries to diversify deeper into male product markets.

Conference call catalyst
The recent first-quarter conference call validated my expectations as Lululemon dialed back its gross margin guidance, and the stock dropped 16% in a single day. Gross profit for the first quarter came in at $195.7 million or 50.9% of net revenue, compared to 170.7 million or 49.4% of net revenue in the first quarter of 2013. The 1.5% increase was largely assisted by the 5.1% improvement to the Luon write-off from last year. The abysmal 3.1% product margin decline shows that Lululemon's high-margin items continue to sell poorly. It seems improbable that Lululemon can get back to its mid-50s gross margin on a long-term basis.

At this point, it seems clear that Lululemon has a dilemma. It either has to offer product discounts on its high-margin products, or sell its lower-margin products. Lululemon's strategy to combat this negative outlook, discussed on the conference call, is simply to "operate more efficiently and just work with our factory partners". While this overgeneralized solution may help on the cost side, it does not solve the problem that customers are buying fewer high-margin products.

In fact, when CEO Laurent Potdevin  was asked about the company's customer preferences, he responded:

We've actually never used a lot of data in the history of Lululemon. And as far as looking at consumer sentiment brands strengths, we actually just launched -- we implemented NPS, Net Promoter Score, and we got our first benchmark yesterday. So I haven't had a chance to fully dig into them. But I am really looking forward to using that as a tool to sort of see where our brand initiatives are, changing the brand sentiments and improving conversion and traffic.

For the CEO of a women's apparel company to state that it has no relevant data on consumer sentiment is shocking.

CFO retirement
If the outlook wasn't poor enough, on June 12, 2014, the company announced that CFO John Currie intends to retire by the end of the fiscal year. At the age of 57, it's questionable if Mr. Currie is retiring for what he called "flexibility to take full advantage of the west coast lifestyle that I so enjoy on the water and on the slopes", or to leave a company with poor competitive positioning.

Foolish takeaway
Lululemon's poor competitive positioning within the women's apparel market is subject to the vicissitudes of consumer fashion trends. As the brand fails to extract premium pricing like it did in years past, its margins will fall. The CEO's comments on the conference call should worry Foolish investors that the brand value may fall sooner than later. Even though the stock price decreased significantly, which has attracted some buyers, it still looks like a Lemon.

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christian sgrignoli

Christian Sgrignoli is the President of CT Financial LLC. The firm was created in 2012 as a consulting business via state legislative enactments. It currently operates as an investment management and research company.

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