Can Lululemon Regain Its Mantle?

| About: Lululemon Athletica (LULU)
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"Quality is at the heart of everything we do, from the technical features we (sometimes literally) weave into our products, to the people we work with and relationships we build."

This is a quote from the quality stance that Lululemon (NASDAQ:LULU) outlines on its website. Up until recently, this stock and company was the clear winner and dominant player in the high end yoga and athletic apparel sector. Unfortunately, about a month ago Lululemon was forced to pull more than 17% of well-known luon pants off of shelves due to the pants being too thin and transparent. This recall is estimated to cost the company almost $67 million in lost revenue.

After the recall was announced, Lululemon stated that while the fabric that was used in the pants met the company's high standards of quality, it was toward the lower end of the scale. Since this story first surfaced, Lululemon has already put new standards of testing and quality checks in place to help ensure that products continue to meet the standards of its customer base. The company has stationed new employees and increased overseeing staff in its factories, and established a new leadership team to ensure quality.

I will admit that I was happy to see that Lululemon took this situation as seriously as it did and has already made some major changes to try and prevent this type of quality issue from happening again. The bigger question though is whether Lululemon's response was too late to save the company. Consumers unfortunately are not always very forgiving and can all too quickly switch allegiances without warning when products fail to meet their expectations-- especially higher end products. A classic example of this type of delayed reaction for a faulty product happened last year when Apple (NASDAQ:AAPL) launched the iPhone 5 with its own maps software, cutting out Google Maps (NASDAQ:GOOG). The entire situation turned into a giant flop, upsetting customers, and ultimately resulting in a loss of confidence in the products and leadership at Apple.

Announcements like these never are good for stock prices and Lululemon certainly was not immune from the effect of negative news and upset customers on its stock price. After Lululemon announced the recall the stock tumbled, which was then quickly followed by several analyst downgrades on the stock, which continued to put further pressure on the stock. Currently, the stock is down 14.65% so far this year. This after the company had an almost parabolic run from 2009 to 2012, gaining some $67.30 per share resulting in a 1,771% rate of return.

It is clear that Lululemon has had a great run, but is this recent sell off just the beginning of a new price searching process and valuation reset for an overpriced stock, or has the recent sell off created a new entry point? Lululemon fundamentally is a fairly strong stock. The stock has a P/E of 40.10, which I would normally consider as high, but given the firm's growth potential and margins I am inclined to believe it is fair.

The stock currently trades for around $65.50 per share, down from its 52 week high of $81.09. The company has no long term debt, $439.42M in cash on hand, and a book value of $6.14 per share. Free cash flow is quite strong at $41.20M and gross margins remain robust at 56%. Lululemon is clearly a growth stock with strong prospects, but with such success the company now faces intense pressure from its three biggest competitors, Nike (NYSE:NKE), Adidas (OTCQX:ADDYY), and Under Armour (NYSE:UA).

Below is a chart that compares Lululemon against its three big competitors on overall value and financial soundness.




Under Armour

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In the above chart Lululemon may not be the cheapest stock, but from a margin and growth standpoint the company blows its competition out of the water. Those two metrics are very important to any growth stock being able to maintain its continued grow trajectory. Additionally, the fact that Lululemon has no debt and such strong free cash flow is very encouraging for future growth or potential acquisitions that the company might want to make down the road. As good as these metrics look, it will be interesting to see if Lululemon will be to continue to produce such high quality products with such high margins.

If Lululemon is able to regain its lost ground in both its stock price and consumer trust, the company still has suffered a large misstep that its competitors have taken advantage of. Both Nike and Under Armour have already jumped at this opportunity by turning up their advertising in this sector in the hopes of gobbling up some of Lululemon's market share. Under Armour recently released a new ad campaign that promotes its yoga pants while rubbing some salt in Lululemon's wounds by saying that, 'We've Got You Covered.' Nike too has continued to promote its new Legend pants for women's yoga saying that the pants have comfortable coverage.

Even retail chains like Target (NYSE:TGT), Gap (NYSE:GPS), Nordstrom (NYSE:JWN), and Wal-Mart (NYSE:WMT) have rolled out their own (much cheaper) lines of yoga pants. This added competition from all fronts will only continue to put added pressure on Lululemon's margins and its stock. If Lululemon is to regain its mantle it needs to go back to its roots of what made it such a clear winner with consumers in the first place: outstanding products that beat the competition in both design and quality.

It's important to mention that Lululemon is new to the sports apparel game and does not have the same global market penetration that Nike, Under Armour, or Adidas have. If Lululemon is able to move past its latest stumble and begin to enter new markets, I think it is possible to see this stock regain its lost ground.

Lululemon from a financial standpoint is a sound company with a lot of growth opportunity. I would look to any additional weakness in the stock as a potential buying opportunity. Based on how quickly the company acted after its recent quality issue, I am confident that the company will be back on firm footing in no time and can once again focus on provided Wall Street with transparency in its growth and results, and not in its pants.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.