By Solarina Ho
TORONTO (Reuters) - In a narrow, bustling street in Hong Kong's trendy Soho district, a small Lululemon Athletica Inc (NSQ:LULU) test boutique is helping to lay the groundwork for what the premium yoga wear maker sees as a promising avenue for growth.
The Canadian retailer is casting an eye on international markets even as it grapples with the demands of finding a new chief executive, mending a tarnished image after an embarrassing recall of overly sheer pants and pursuing expansion in the United States.
It's a tricky move even in the best of times. While the rewards are alluring, such global markets can be fickle, complicated and risky.
For now, investors looking at Lululemon's largely successful track record are betting it can juggle the numerous balls needed to maintain a lofty valuation and recapture some of its earlier meteoric growth.
The stock, which closed on Tuesday at $73.64, has soared some 500 percent since the company went public in 2007.
In the latest quarter ended August 4, revenue rose nearly 22 percent, to $344.5 million, but the retailer said sales at established stores for the coming quarter will likely be in the mid-single digits, far removed from the days when quarterly sales growth could exceed 30 percent.
The retailer may see its biggest medium-term opportunity in the United States - where industry experts say the market has the capacity to handle some 300 stores, doubling its current footprint - but analysts say it needs to look further afield for the long term.
"For a long-term investor, there has to be the potential for international expansion," said Credit Suisse analyst Christian Buss, who just returned from visiting Hong Kong's two showrooms.
Founded in 1998 in Vancouver, British Columbia, where it is still headquartered, Lululemon operates 226 stores in Canada, the United States, Australia and New Zealand. It plans to open stores in London and Hong Kong, promote its new Ivivva banner, targeted at girls, and woo men with new stores.
Lululemon declined to comment, but CEO Christine Day said in September that 2013 is "the most important" year in the company's history, as it takes major steps to tighten quality control, add three new manufacturers, launch stand-alone men's stores by 2016 and bolster global growth.
But a series of high-profile flops by other retailers, particularly in China, serves as a warning on the risks of operating in new countries, cultures and demographics.
FAILING IN CHINA
Lululemon has held grassroots events, like yoga classes, in Shanghai and is eager to launch test sites in mainland China, where shoppers with money to spend may be tiring of Nike Inc (NYS:NKE) and Adidas AG (GER:ADS), the main premium athletic brands.
Translating Lululemon's grassroots style to international markets will be challenging because of cultural and language difference, said Credit Suisse's Buss, though he noted that the company has done so successfully in Hong Kong.
China is "awash with foreign niche brands ... so they've got to plan for maintaining their longevity and not just be a flash in the pan," said Matthew Crabbe, Asia-Pacific research director at Mintel International Group, a London-based global market research firm. "If you look at the major sports brands in China, they've all had problems at some stage."
Athletic companies poured resources into China to cash in on the hype surrounding the 2008 Beijing Olympics. But once the games ended, consumers moved to outdoor wear for activities such as hiking and skiing, said Crabbe, and some companies had trouble clearing Olympics-era inventory for years after.
Britain's Marks & Spencer Group Plc (LSE:MKS) conceded that it misunderstood the market when it opened its first store in 2008 in Shanghai and quickly ran out of smaller clothing sizes.
In the broader industry, retail giants such as U.S.-based Best Buy Co Inc (NYS:BBY), Home Depot Inc (NYS:HD), Britain's Tesco Plc (LSE:TSCO) and Germany's Metro AG (GER:MEO) have all closed shop or given up tackling China on their own.
Despite the challenges, Lululemon is still a darling of investors. Thomson Reuters data puts Lulu's forward price-to-earnings ratio at 33.4, nearly double the 17.3 median of its peers. Revenue is forecast to grow 20.7 percent in the next year, versus 4.5 percent for peers.
"The growth is positioned to be sustained for many, many, many years," said Wendy Trevisani, co-manager of Thornburg International Value Fund. "The room to grow justifies what you might consider a premium."
Shares of the yoga wear maker accounted for 5.51 percent of Trevisani's fund as of July 31, 2013, and Thornburg Investment Management was the retailer's third-biggest investor with a stake of just over 10 percent as of June 30.
Of the 28 analysts who follow Lululemon, 12 have a "strong buy" or "buy" rating, 13 have a "hold" and 3 have a "strong sell" or a "sell." The median price target is $76, slightly off Monday's close of $75.88.
There is a measure of uncertainty as Lulu has yet to find a replacement for outgoing CEO Day, who led the company through half a decade of market success. Many analysts say expertise in global expansion is a must for the next boss.
Lululemon has stumbled before. In 2007, fresh to the public market, a retraction on the touted health benefits of its seaweed-infused "vitasea" fabric hurt its image. Two years later, established store sales fell 8 percent as a recession curbed spending.
Lululemon rebounded the next year. Comparable-store sales peaked at 35 percent, bolstered in part by U.S. growth, as 12-month average sales hit $1,428 a square foot. By comparison, U.S. department store sales averaged $274 per square foot in 2007, according to the most recent U.S. census data compiled by the National Retail Federation.
But recent results demonstrate new challenges. Sales at stores open at least 12 months grew just 8 percent in the last quarter, robust for many retailers but a step down for Lulu.
Meanwhile, the company has said the fallout from the March recall of its bestselling but unacceptably see-through Luon fabric pants is expected to take a $57 million to $67 million bite out of 2013 sales.
"They've got to put all their focus on getting that fixed," said Howard Davidowitz, chairman of Davidowitz & Associates Inc, a U.S. retail consulting and investment banking firm.
Davidowitz said the recall showed Lululemon was trying to do too much at once. Overseas expansion should not be a priority now, he said, given its supply chain issues and the potential for U.S. and online sales growth.
SHOWROOMS AND CAPSULES
But many analysts and investors say Lululemon has been methodical in its strategy so far.
Before it opens a new store, Lulu "seeds," or tests, demand with a showroom. This slimmed-down version of an established store is open for fewer days and has a smaller inventory. The cautious approach to exploring new markets helps rein in costs.
Lulu rarely advertises and relies on grassroots methods like local events and word of mouth. It sells very-limited-run clothing lines, or "capsules," in stores, allowing it to explore segments like apparel for tennis or swimming.
"They definitely operate a scarcity model, meaning more demand than supply, so that when you go into a store, you know you should buy it, because of the fear of it not being there the next time around," said Canaccord Genuity analyst Camilo Lyon.
Back in Hong Kong, staff and shoppers say they are ready for a full-fledged store, but this summer Lulu said it was having trouble securing real estate with the right size and location.
And it still needs to iron out the snags in its supply chain, a problem that Buckingham Research Group analyst John Zolidis said in a research note was "getting tiresome."
Even so, investors like Thornburg's Trevisani say they are in for the long haul.
"Their opportunity to expand is immense across various aspects - whether it's stores, lines, capsules, e-commerce, global ... They're very unique, and I think you pay something for that," she said.
(Additional reporting by Susan Taylor and Allison Martell in Toronto and Alexandra Hoegberg in Hong Kong; Editing by Frank McGurty, Jeffrey Hodgson and Douglas Royalty)