The Lululemon Decision: What Would A Woman Do?

| About: Lululemon Athletica (LULU)
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After consulting with Jamie Nuss (PTT Research's Fashion/Trends Analyst), we determined that Lululemon might be doomed to the same fate playing out between Coach and Michael Kors.

Competitors like Victoria's Secret has emerged with the fits and feel that women seek, eliminating the advantage that enabled Lululemon to take the world by storm.

With falling operating margins and customer defections, the stock may be oversold in the short term, but a dour secular trend is firmly in place.

A few weeks ago, an institutional PTT Research customer requested our opinion of Lululemon (NASDAQ:LULU). After consulting with Jamie Nuss (our Fashion & Trends analyst), we determined that LULU might be doomed to the same fate we see playing out with Coach (COH) and Michael Kors (NYSE:KORS).

Yesterday's earnings disaster at LULU had talking heads on CNBC debating whether this quarter was a hiccup or something systemic. With our customer's profits in the bank, we were given the go-ahead to share our analysis, which we believe sheds light on LULU's plight.

Let's start with the contribution provided by Ms. Nuss:

I remember when I first started noticing that Victoria's Secret - a unit of L Brands (NYSE:LB) had workout clothes in its stores. It was at a time when you couldn't get me to wear anything other than Lululemon.

How things have changed…

One of my degrees is in Fashion Design, and I really believed that LULU had superior fit and superior quality. Price mattered little (after all, I'm a woman!). As someone who prefers to spend her time in the gym, I am overly specific about what I will wear. My sports bras must have support and coverage. My capris must feel snug, hide flaws, and be of breathable fabric. Second to this, I look for cut and style (something sexy, please), a variety of colors, and a few different style options. If it also happens to be the "best-in-class" brand, even better.

Over time, my frustrations grew as LULU stopped offering the kind of coverage I was looking for (working out around males, as well as having a male trainer made what I needed a must). I stopped wasting my time waiting for what I wanted from LULU and started one of my most annoying "search journeys" (women know these well... the search for that perfect thing in footwear or apparel). This was still at a time when Victoria's Secret was early in the game.

My need for the right workout clothes led me to try a variety of brands, including BEBE Sport (NASDAQ:BEBE), Gap (NYSE:GPS), Champion, Under Armour (NYSE:UA), Nike (NYSE:NKE), and even Target (NYSE:TGT). I struggled to find the total package, so I made do with what I already owned and went into a hibernated state.

I also began to lose interest in and patience with LULU. As with most names, the recession depreciated the cache of many brands, including LULU, in my opinion. The quality of LULU also started being questioned, and the price points along with it.

Only top names earn the right to charge top prices. This is because customers (especially women) are paying for quality of material, accuracy of fit, longevity, and the ability to wear in 2 years what one is wearing today. And yes, aspirational brands have the most cache and desirability.

Eventually (and not long ago) curiosity got the best of me while in a Victoria's Secret store. I was drawn to the new bright, fun colors and sexy, yet appropriate, cuts. So far, so good. Closer inspection showed that numerous SKUs had all kinds of coverage! Once I tried those sports bras on, I was hooked.

Whether you like yoga, running, lifting weights, or any other activity, the brand has a plethora of coverage and support offerings. Unlike other names, Victoria's Secret understands that some women want more than just a box-shaped sports bra.

I already knew I was walking out with a bunch of new tops. But I couldn't leave without trying on a pair of capris. The fabric wasn't too heavy (I live in Miami, so light fabric is a necessity). My body looked flattered, and I knew I wouldn't get distracted wondering if my pants were sliding around or showing anything I didn't want seen - so, those came home too. For those who prefer to be covered in full on top, there are super-light, cute and colorful matching tanks to wear over the bras.

In short, I am hooked. I have found exactly what I want and need, with lower prices to boot. I never would have believed it. I am now waiting for new colors and SKUs. Every few weeks, I pop my head into a 4 wall (brick and mortar store) or check online to see what the latest is.

As I was from Coach to Michael Kors, I am now converted to Victoria's Secret's workout line. Lululemon is no longer even a thought.


Jamie's analysis dovetailed nicely with my own. Long ago, I hypothesized that LULU's grassroots marketing approach would eventually hit a wall. When it did, my suspicion was that the company's sales and marketing costs would increase dramatically as a percent of sales. As a result, its perceived advantage in the marketplace would dissipate, much to the chagrin of shareholders.

Technically speaking, LULU's financials have not borne that out. However, indirectly, they have. SG&A for the fiscal year ended January 29, 2012 amounted to 28% of total revenue (which was almost exactly $1 billion). This percentage has remained steady in the two years since. This demonstrates no benefit for having grown its revenue by 59% over that time frame.

Meanwhile, gross margins have declined from 57% in fiscal 2012 to 53% in fiscal 2014. Basically, Lulu has become less efficient organization as it has gotten larger. Without that higher SG&A I predicted, margins have been forced to suffer.

Annual Period Ending 2-Feb-14 3-Feb-13 29-Jan-12
Total Revenue 1,591,188 1,370,358 1,000,839
Gross Profit 840,076 762,826 569,351
Gross Margins 53% 56% 57%
Selling General and Administrative 448,718 386,387 282,393
SG&A % 28% 28% 28%

Source: PTT Research

Thus, it should come as no surprise that analyst estimates for the current and next fiscal years have been declining. Estimates for the year ending January 2015 have recently fallen from $2.20 to $1.89 (a figure that will obviously move further down after yesterday's debacle). The same goes for next year's estimate of $2.24, which has declined markedly over the past 90 days from $2.57.

To investors looking at Lululemon today, we have one rule of thumb to consider: "The trend is your friend". This is especially true in fashion. Barring an acquisition (which I view as unlikely given the 27% stake held by its founder, Chip Wilson), chasing value in this name holds more risk of leading one into a value trap than the potential reward offers.

In other words, for traders, the stock may be oversold at the moment, but the secular trend (down) is firmly in place. Until the company finds a way to re-endear itself to its core customer (women), I don't see how this can change, especially in today's draconian retail environment.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.