Lululemon Athletica inc. (NASDAQ:LULU) stands at a similar crossroads. The company’s 31.4% operating margin is among the highest in the industry, but it is held up there by outsourcing most of its products overseas. This should unnerve investors, since Lululemon founder Chip Wilson has openly voiced his support for child labor in third world countries, stating that it provides impoverished youths with much-needed wages. Wilson even argued that Canada should be open to the idea of child labor, and employ 12 to 13-year old street youths in local factories.
Although Wilson is no longer Lululemon’s CEO, the philosophy that ‘street youths’ should be ushered into sweatshops instead of being provided a stable education is a disturbing one, that hints that Lululemon might be headed for the same fate as Gap by expanding too recklessly. Gap’s overseas practices were eventually brought down by a flurry of bad press, and by 2007 it was struggling to save its image.
No defensive moat
Lululemon’s other major problem is that it doesn’t have a defensive moat to fend off competition from larger, better funded rivals. Gap launched its Athleta yoga brand in 2009 as an online retailer, but later expanded into brick and mortar locations across North America. Gap intends to open 50 new Athleta locations by the end of the year, and is copying Lululemon’s store format of offering free yoga classes at an attached studio. Gap was even rumored to be poaching Lululemon’s yoga instructors. Gap also offers its Athleta yoga instructors 30% discounts on products, while Lululemon only offers 15%.
Meanwhile, Nike and Under Armour are selling yoga apparel at lower prices than Lululemon, since they can afford to sell the products at lower margins to drive sales volume.
Foot Locker, Inc. (NYSE:FL) is also testing out a new store format, SIX02, which looks a lot like Lululemon.
Lululemon has no real defense against these competitors, and it has attempted to use litigation in the past to protect its design patents for yoga pants. However, that threat is unlikely to stop these bigger companies to take a bite out of Lululemon’s market share. The company now understands that when a niche product is taken mainstream, the industry will be quick to commoditize it.
The Bottom Line
Although shares of Lululemon rallied 8% on April 22 after the company announced that its shipments were back on track, I have my doubts about its long-term future. Last quarter, Lululemon Athletica inc. (NASDAQ:LULU) respectively grew its top and bottom lines by 30.7% and 48.8% year-on-year. However, it is still trading with a pricey forward P/E of 28.9, nearly double the industry average of 14.9. Meanwhile, Gap trades at much cheaper 12.5 times forward earnings.
I think investors should wait a few more quarters to see if Lululemon has truly fixed its quality control problems, and if fierce competition will start to hamper its growth and weaken its margins.
The article Is This Retailer Back on Track? originally appeared on Fool.com.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.
