Why Lululemon’s Stock Is So Volatile

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Lululemon Athletica‘s(NASDAQ: LULU) stock has been fairly volatile over the last couple of years. While the company has recovered from its product recalls, faulty inventory challenges, misguided statements by management and declining profit margins, its stock is down about 25% from its 2015 peak. The Vancouver based manufacturer and distributor of yoga apparel posted a strong 16% jump in sales in its most recent quarter, while boosting its store count to 300 and announcing a new 11,500 square foot flagship store launch in New York City. Despite these nuggets of good news, the market doesn’t seem to be wooed by the company and consequently the stock has been volatile over this period. Below, we talk about the three main reasons why investors cannot yet be completely confident about the company’s growth prospects.

We have a $57 estimate for Lululemon, which is about 8% above the current market price.

Declining Margins

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Lululemon’s net profit margin is significantly higher than that of competitors Nike and Under Armour. At the beginning of 2013, Lululemon’s profit margin stood at 19% compared to Nike’s 9%, but as of the previous quarter, it had declined to just above 14%, while Nike’s has grown at 11.3%. The reasons behind this are normal: as a company tries to expand, it spends more and more on expanding manufacturing partners, raw materials, stores, wholesale partners, licensing partners and product design. It takes a while for economies of scale to set in as fixed costs are amortized over a larger and larger number of unit sales. But for this to happen, the company must retain its popularity with consumers and expand its appeal to attract new buyers. It needs to gain market share, in short. This competition for market share puts pressure on margins as companies try out various new products and marketing strategies—a number of which fail to gain any buyers.

This is one reason why Lululemon posted a 2% year-over-year drop in net income in the most recent quarter. Competition can also sometimes result in reducing the pricing power of companies. If competitors introduce similar or equally attractive products, it is difficult to retain pricing power in the market. The result of this is that revenue growth fails to keep pace with the rate at which expenses are growing. As competitors such as Under Armour, Nike, The Gap and Victoria’s Secret enter the yoga apparel market, Lululemon’s market share is being put under pressure.

Sluggish International Growth

Lululemon initially started out as a community based company in Vancouver, Canada. From there, to expand to over 300 stores in a number of countries is a significant achievement. The buzz of a famous international company opening stores locally can drive sales initially in international markets, but to sustain this growth companies need to either cultivate a taste for their product offerings via advertising or make their offerings attractive to local buyers. So far Lululemon hasn’t really seemed capable of doing either of these things. The company opened stores in Japan but had to shut them down in 2009. In Australia, its growth seems to have tapered off. The rate at which it is opening stores in Australia has slowed down, with just one new opening in 2015. Meanwhile, the company is looking to open stores in Europe and elsewhere in Asia.

To be sure, the company’s international sales are growing. In the last fiscal year, international revenue grew by nearly 25%, but as international sales only account for just over 5% of the overall sales, this growth isn’t very significant. In contrast, much bigger companies such as Under Armour and Nike are growing their international sales much more organically. Under Armour, in particular, grew its international revenues by close to 100% over the same period.

Small Product Offering

One reason Lululemon’s market cap is much lower than Under Armour’s is because it is targeting a much smaller market. The market for yoga apparel, dance based apparel and small assorted offerings is much smaller than that for the much differentiated product offerings Under Armour has. This limits the pool of consumers to which the company can target its products. Moreover, Lululemon isn’t doing much to leverage the emerging trend of technology interacting with fitness wear to bring new buyers to the company. Under Armour’s Connected Fitness endeavor has managed to expose over 150 million people to the brand. Meanwhile Nike is using Nike+ and NikeID to bring new customers into the brand. Moreover, both these companies are making efforts to modernize their manufacturing processes in order to significantly alter the economics of the industry. So far Lululemon seems to have made no efforts in this regard. This means that the company is open to disruption from above. Lululemon is very good at making a high priced product for a specific demographic. Competitors can meanwhile introduce lower priced versions of the same product to customers Lululemon currently ignores.  And by expanding the range of services and customization available on these products, customers can slowly move up the value chain and capture slices of the market that Lululemon is currently targeting. These are all worrying signs for the company.

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