The Gap Inc. (GPS) – Lululemon Athletica inc. (LULU): An Earnings Preview

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Lululemon Athletica inc. (NASDAQ:LULU), the yoga and athletic lifestyle apparel retailer, reports second quarter results on Sept. 12. Analysts will  want to know how the new CEO search is coming along, as well as any lingering effects from the “I see London-I see France, I see through your yoga pants” recall that hit the stock in March.

Lululemon Athletica inc. (NASDAQ:LULU)

The company beat on both the top and bottom line when it reported on June 10 despite the $17 million hit it took on the Luon yoga pant recall. Christian Buss, of Credit Suisse, noted in March ,”With the black Luon pant recall Lululemon Athletica inc. (NASDAQ:LULU) has now had its fourth quality control issue in the last year.”

The company reported fourth quarter earnings in March. CFO John Currie said that in addition to the $17 million loss for the first quarter, Lululemon Athletica inc. (NASDAQ:LULU) expected “additional lost revenue of $45 million to $50 million for the balance of the year, primarily in the second quarter, spread over new and existing stores and e-commerce.” (source Seeking Alpha transcript)

Then in June CEO Christine Day announced she was leaving but would stay on through a CEO search. Lululemon Athletica inc. (NASDAQ:LULU)’s stock had soared under her leadership as the company used a marketing strategy based on scarce inventory. All told, she lasted five plus years, or as long as a pair of the company’s yoga pants.

It has been a tough six months for Lululemon. Analysts have lowered the bar, with several downgrades immediately succeeding the recall.

When it comes to fabric innovation, building a niche brand, growing a fervent customer base, and online marketing, few companies beat Lululemon Athletica inc. (NASDAQ:LULU). This shows why the stock climbed from $5 in 2009 to $50 by 2011. With Lululemon there is so much to love: community outreach through its yogi ambassadors and company run fitness events, its strong social and web presence, but sizzling growth… not so much anymore..

Earnings past is prologue
First quarter earnings showed a deceleration in same store sales increases, from 10% in the fourth quarter to 7%, but online sales grew 40% from the year ago period (85% rise in 2012) and accounted for 15.6% of revenues. Meanwhile, its gross margin dropped from 56.5% in that fourth quarter to 49.4% in the first quarter.

The torrid EPS growth rate of the last five years of 57% has now been adjusted downward by analysts for the next five years to 22.15%, befitting a maturing company. Although Lululemon Athletica inc. (NASDAQ:LULU) has no debt, is expanding into men’s and girls’ lines, and opening more stores, it’s not as attractive an investment as before.

The company still has the problem of an immature supply chain. Witness the Luon debacle, in which only one Taiwanese company contracts to manufacture the fabric. Analyst Sam Lee of International Strategy and Investment Group told clients, “We would really like to see the company more aggressively invest in and exercise greater control over its supply chain given the importance of quality and consistent fit to the Lulu brand promise.”

Without the promise of accelerating growth, and with the market valuing sales at a 7.19 multiple and earnings at a 38.29 multiple it’s hard to justify leaping back into the stock. The number of competitors has grown as well, including L Brands Inc (NYSE:LTD), which owns PINK and Victoria’s Secret, The Gap Inc. (NYSE:GPS) Athleta line, Under Armour, Nike, and any number of smaller private rivals.

Did rivals take share?
Lululemon’s most serious competition is The Gap Inc. (NYSE:GPS) and L Brands Inc (NYSE:LTD), as yoga wear has become not only mainstream but fashionable. Both Nike and Under Armour’s yoga wear lines are utilitarian, with little style, although they are cheaper than Lululemon.

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