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Berman’s View

Lululemon’s real challenge is finding ways to grow profits Add to ...

The product recall at Lululemon Athletica Inc. has focused a lot of attention on the company’s near-term financial hit, but the longer-term challenge looks just as daunting.

The shares slid as much as 5.8 per cent on Tuesday before recovering much of that lost ground in afternoon trading.

The decline followed news that the company had pulled a popular line of black yoga pants because of what the company called a “level of sheerness” that fell short of its standards.

By all accounts, the short-term impact is going to be painful. The item in question accounts for about 17 per cent of all women’s yoga pants sold in Lululemon stores.

As a result, the company has slashed its sales outlook for the first quarter to as low as $333-million (U.S.) from a previous low-end estimate of $350-million.

Similarly, sales at stores open for at least one year are now expected to rise between 5 per cent to 8 per cent, down from a previous same-store sales estimate of 11-per-cent growth.

Analysts reacted on Tuesday by lowering their 12-month price targets on the stock by an average of more than 8 per cent.

For all the fretting over the current quarter, though, it is easy to miss a far more daunting fact: Lululemon’s share price has gone nowhere for about a year, suggesting that this latest setback is reinforcing the concern that the high-flying stock has run out of momentum.

Fans of the stock will note that it has endured a number of faith-testing periods before and has always emerged from those downturns looking just fine.

It took a 32-per-cent tumble in 2012, a 25-per-cent tumble in 2011 and a death-defying 90-per-cent slide between 2007 and 2009, when investors bet that consumers would no longer be interested in high-end yoga wear amid surging unemployment.

In retrospect, the setbacks were ideal buying opportunities as Lululemon proved the skeptics wrong by selling more yoga apparel and proving that its brand has lasting appeal among affluent shoppers.

However, Lululemon is facing a bigger challenge than the staying power of its brand. Its shares command a valuation of more than 42 times trailing earnings. That implies that investors harbour big expectations for the company’s ability to continue to grow its earnings at a blistering pace.

Yet, the blistering days are drawing to a close. Its five-year average earnings growth rate is certainly dazzling, at 44 per cent. But estimates point to a far slower pace beyond 2013, with earnings growth expected to fall to a level not much higher than 20 per cent.

Add in blunders like the one announced on Monday evening, which raise concerns about the company’s quality control, and it is not hard to envisage the stock commanding a far lower valuation based on far-from-certain growth.

Lululemon has overcome the skeptics plenty of times before on its journey to yoga-wear dominance.

That resilience now seems to be in short supply.

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