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Three Challenges Lululemon Needs To Address To Keep Delivering Record Results

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© 2019 Bloomberg Finance LP

Lululemon had an amazing 2018. Its revenues rose 24% over 2017 to reach $3.3 billion and direct-to-consumer sales were up an astonishing 45%. “Lululemon has delivered one of its strongest years yet, a result of broad-based strength across the business,” CEO Calvin McDonald bragged in a statement.

Lululemon’s direct-to-consumer growth took everyone by surprise. Accounting for 26.1% of total sales, McDonald announced that the company sees “a pathway for this segment to represent 50% of our business in the years to come,” during the company’s most recent earnings call. And he added, “When looking at our digital ecosystem, we are still in the early stages of our development.”

Concluding his remarks in the call, McDonald believes 2018 results will bring new energy to its nearly 16,000-member strong team. “We entered 2019 with great momentum and an energized team ready to begin this exciting new chapter in the Lululemon growth story.”

For employees and shareholders, McDonald’s place at the helm of the company is an added boost of confidence. He only joined the company at the end of last August after serving as CEO/president Sephora USA. His leadership will become more prominent in 2019 and beyond.

Amidst all the excitement, Jen Redding, an analyst for Wedbush, was more cautious, recognizing the tailwinds from 2018 could turn to troubling headwinds in 2019.

“We see LULU as positioned better than most, but also see less upside ahead as the retailer faces tough comparisons in a dynamic retail environment,” she wrote, as her company lowered LULU’s ratings from “outperform” to “neutral.”

As I look at the results, three areas give me pause: weak same-store sales growth relative to overall (7%); international expansion, mostly China, as engine for 2019; and the need to pivot toward men’s.

To get a behind-the-curtain view at Lululemon, I reached out to a friend in the company’s executive ranks, who confidentially shared some of the potential pitfalls ahead. Lululemon shared comments as well, after original publication.

In terms of 2019, my source sees the company’s premium product, its depth and innovation as the company’s core strength and its U.S. retail base is biggest weakness.

By contrast, the company pegs its future on its unique way of merging digital and in-store experiences. “We continue to evolve and integrate our digital and physical channels in order to enrich our interactions with our guests and to provide an enhanced omni-channel experience,” a Lululemon spokesperson shared.

Let’s break it down.

U.S. accounts for 72% of sales, but many stores are getting tired

With 285 U.S. stores in its total fleet of 440, a significant share of the U.S. stores are getting stale, and in many stores the shopping experience doesn’t match the company’s premium price points.

“The products are best-in-class, the price points are best-in-class, but the shopping experience is not best-in-class and some of its stores are getting pretty old,” my confidential source said.

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“For a $128 pair of pants, not getting someone helping you in the dressing room is inexcusable. That is where they are going to start to see a shift. E-commerce is going to have to pick up a lot of the slack as store sales flatten,” my source said.

New stores (15 were added in North America in 2018) are attracting more shoppers, but they represent a huge investment. Some 40 to 50 stores are planned to open in 2019, but the bulk of those, 25 to 30, are for international markets.

Lululemon views expanding its footprint, in terms of both stores and square footage, as its opportunity. We are continuing to strategically expand our store fleet in square footage as we open more stores in new and existing markets,” a company spokesperson said, and hinted that it is testing “some exciting new store formats that create unique experiences for our guests.”

Currently, it has three models: larger co-located stores with full men’s department (see below); local stores between 1,000 to 2,000 square feet, which make up the bulk of its stores; and seasonal holiday pop-up shops.

The company’s community-based marketing strategy continues to draw guests. “This is where we create a relationship with our guests and understand their passions, including how they like to sweat,” the Lululemon spokesperson said. It is from these locations that the company launches its local community events and brand activations.

But without customer service delivered at a level of excellence comparable to Lululemon’s luxury-retail peers, like Nordstrom, Saks or Ralph Lauren, it will lose customers to lower-priced competitors like Athleta or to more service-oriented retailers. Nordstrom, for example, carries Alo Yoga brand and its own Zella house brand.

“They don’t pay their store associates, called educators, very well,” my source shared. “They pay store managers, regional and area directors well, but store educators get only a flat salary and bonuses, but no commissions. They could do a better job of incentivizing the educators in order to get more premium talent at the educator level.”

Betting on China may be a bad bet in 2019

Beyond North America, international sales were a mere $360 million, so international expansion is a priority for 2019.

The company recognizes it has a “brand awareness obstacle to overcome in our international markets,” said COO Stuart Haselden during the conference call, and who will be responsible for the international business. The company also announced it is in search of a chief brand officer, who will no doubt be tasked to address its international brand awareness shortfall.

So far it has 21 stores in Europe and 34 in Asia, and while early signs of growth are strong in its international markets, Europe remains a year and a half from break even. It was further hinted that China is slated to pick up the lion’s share of the 25 to 30 new international stores planned for 2019.

In the earnings call, much was made about international e-commerce with new websites coming online in the first half of the year for France, Germany, China, Japan and Korea. But the company dodged a lot of questions about its international plans, teasing that more details will be revealed on its April Analyst Day.

But placing big bets on international expansion now may be dangerous with so many unknowns. Brexit remains a big uncertainty and not just in how it may affect Lululemon’s 12 stores in the U.K., but all of Europe, not to mention the rest of the world.

Regarding China, all signs are that luxury consumer spending is slowing there. While Lululemon doesn’t trade at ultra-premium levels, it is luxury in its athleisure-wear class. And with our mercurial president, who knows how the winds will blow in the threatened trade war with China.

Will men embrace Lululemon?

Lululemon has correctly identified men as its next big market opportunity. “There is a lot of runway for us to continue to grow our men’s business,” Haselden said in the earning call. “With just over 20% penetration today, we really believe that Lululemon can be a gender-neutral brand and that our men’s business can ultimately be as big as our women’s.”

© 2019 Bloomberg Finance LP

That is a big wish, since in pivoting to men, it is going up against strong competition from Nike and Under Armour, which are frankly more men friendly.

“The stores still read incredibly feminine,” my source said. “It is a bad shopping experience from a man’s standpoint. If men’s is going to be a continued growth area, men buying for men has to be the focus. Fortunately, today about 40% of men’s sales come from women buying for men.”

Co-located stores with a full men’s department on one side and a woman’s on the other has been the company’s solution. But only 20 stores are presently co-located models and no new ones are planned for 2019.

With a name like Lululemon and its long-standing association with women, it may be hard for the company to attract men, but the company doesn’t necessarily agree. “Our business is growing as more men discover the technical rigor and premium quality of our products and are attracted to our distinctive brand,” the company spokesperson shared.

2018 was easy, 2019 will be much harder

My confidential source said driving growth in 2018 was fairly easy given weakness in 2017, particularly in the 1Q17.

Merchandising miscues, lack of color, assortment and depth, inadequate online product imagery and low newness as compared with FY2016 caused markdowns which dragged down revenues. In 2018 we saw shifts to more full-priced sales and much better merchandise. But it was merchandising 101. These were simple things and they did those simple things very well.

My source credits Sun Choe and her product merchandising team as being the biggest contributor to company growth in 2019. But with shoppers’ expectations turning more experiential, more new product for 2019 isn’t necessarily going to cut it. “Lululemon is going to have to do the simple things 100 times better to get remotely the same growth in 2019 .”

Or Lululemon will need to do some harder things that will come at a high cost. Personnel issues aside, that will mean updates to the stores, new fixturing and more strategic allotment of inventory, not necessarily more square footage. “The density of product hanging on the shelf is astronomical. It is still trying to fit 30 pounds of potatoes in a 5-pound sack,” was said.

Finally, because of its higher price point, Lululemon continues to attract a slightly older 35 to 45-year-old woman, with more disposable income and more classic tastes. “Lululemon is still missing the boat on sexy, chic athletic fashion,” my source shared.

This is what keeps the company’s analysts up at night, as they look to the eventual spending slowdown as the economy softens. That will send its customers to lower-prices brands, of which there are many, with a better fix on the price points that younger, active women want to pay.

Rather than spend $128 for a pair of Lululemon yoga pants, they can buy a comparable brand at half the price and put the rest of the money toward more yoga classes.

Note: This story was updated with comments provided by Lululemon after publication.

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