Lululemon vows transparency over see-though pants, says recall will hit profits

Lululemon Athletica Inc. (TSX:LLL), the Vancouver-based retailer of trendy workout gear, admits the recent recall of its black Luon pants will put the pinch on earnings this year, but says keeping customer loyalty is paramount.

“Delivering the top quality our guests expect is a critical factor in our differentiation in the market place,” CEO Christine Day said in delivering an upbeat fourth-quarter earnings report Thursday that slightly exceeded expectations but produced a conference call dominated by questions from analysts over the recall.

The company, which operates 211 stores in North America and Australia, said earlier this week it was pulling some of its stretchy black pants from shelves because of manufacturing problems that made them too sheer.

Analysts wanted to know what went wrong and how the pants even made it to stores before the problem was detected?

Day said the manufacturing was a complicated, multi-stage process, adding that the pants had passed all of its standard and long-standing quality control tests before shipping.

“The only way that you can actually test for the issue is to put the pants on and bend over,” she told analysts.

Day said it wasn’t known whether it was the ingredients, specific manufacturers or problems with the manufacturing process that caused the black Luon pants to be too sheer.

Lululemon said a team has been working with suppliers to identify and correct the issue.

“We are pursuing several hypothesis in parallel with our manufacturing partners to determine the root cause,” she said.

As a result, the company now intends to have quality control people on site in the mills “and other environments” involved in the manufacturing process.

“The whole organization is very devastated obviously by what has happened and so everybody understands the sense of urgency of making sure that we alert the small noises and symptoms that we see, the little canary chirps,” said Day. “(And) getting those to us as quickly as possible so that we can deploy the resources to avoid anything like this again.”

This is the second quality problem the company has faced recently after earlier experiencing bleeding problems with dyes in some of its clothing, an issue that has since been resolved.

RBC Capital Markets analyst Howard Tubin said in a note that while a host of uncertainties remain, he didn’t expect a lasting impact from the recall.

“While not specifically laying out when they thought lost product would be back in store, the implied sales guidance for 2H would appear to assume most of the problems are alleviated for 3Q,” he said.

Tubin also noted the company has several new offerings in its pipeline and that the Lululemon brand was “still strong.”

“Management noted their commitment to working through their production issue and staying transparent with their progress on resolving the problem,” he said. “We do not believe there will be any long-term harm to the brand and once the issue is fixed, the stock could begin to gain lost ground.”

As it is, the setback is expected to reduce revenue by between US$12 million and US$17 million in the first quarter and drive down estimated earnings per share by 11 to 12 cents.

But overall, Lululemon is expecting to be profitable in the first quarter with diluted earnings of between 28 and 30 cents per share and between US$333 million and US$343 million of revenue.

However, that’s below a pre-announcement consensus estimate of 44 cents per share of earnings and US$352 million of revenue, according to figures compiled by Thomson Reuters.

In the fourth quarter, which ended before the recall, Lululemon did slightly better than analysts had been expecting.

On a per-share basis, Lululemon earned 75 cents in the fourth quarter — a penny above the consensus estimate of 74 cents per share.

Revenue during the key holiday shopping period was also up, rising by 31 per cent year-to-year to US$485.5 million — in line with expectations.

During the comparable period last year, Lululemon — which reports in U.S. currency — had $371.5 million of revenue and $73.9 million or 51 cents per share of net income.

E-commerce revenue grew 85.5 per cent over the year to US$197.3 million representing 14.4 per cent of sales, a figure expected to grow in future.

“E-commerce will be a valuable tool as we expand our brand’s presence around the world and it gives us an exciting opportunity to charter new ground in retail with an integrated footprint to meet the future in ways in which guests shop,” Day said.

For all of fiscal 2013, Lululemon expects net revenue to be in the range of US$1.61 billion to US$1.64 billion and diluted earnings per share to be in the range of $1.95 to $1.99.

Lululemon expects to expand more store openings in 2013 including six in the U.S., one in Canada and one in Australia. Another store opening is expected in Hong Kong within the next 12 months, with openings in London in 2014.

It also plans to establish local community connections and introduce products to a variety of other markets in Europe and Asia through strategic sales, showrooms and e-commerce.

On the Toronto Stock Exchange, Lululemon shares recovered somewhat from earlier losses linked to the recall — up 83cents or 1.27 per cent at $66.20— but still down sharply from around $72 last week.