Lululemon: 3Q13 Review & Roadmap

12/13/2013
Companies mentioned:

Lululemon (LULU) - $60.39

Why Read?

Growth has been king and yoga has been HOT! Specialty retailer Lululmeon has been riding this trend,
growing store count, sales, and earnings. In turn, the concept has garnered premium valuation. We
believe that investor optimism has become overblown citing leadership concerns, execution hurdles and
increasing competition.
_________________________________________________________________________________________________________

! Comparable store sales trending down: Yesterday morning LULU reported 3Q13 results,
including a +5.0% increase comparable store sales (+2.0% constant currency), inline with
their +MSD guidance from the 2Q13 call. Alarmingly, management lowered 4Q13 guidance,
implying a flat comparable store sales result vs. a previously implied +7.0% increase. This
would be LULUs first flat comparable store sales result since the recession and we see
greater downside to guidance/next years estimate as the quarter continues. We are currently
forecasting a -1.0% comp in 4Q13 and +2.0% in FY14.

! Supply chain issues adding to gross margin pressure: Current CEO Christine Day has been
nice enough to leave LULU while the supply chain is still on shaky feet. Lululemon has been
switching some key suppliers and shifting their production regions. Expect further GPM%
deleverage from increased air freight expenses as LULU rushes product to stores. Luckily,
Christine Day was nice enough to get on the 3Q13 conference call, her last as CEO, and offer
investors some contrived excusesor not. Another day in retail land.

! Long-term fundamentals eroding: Investors have been drawn to growing retailers with hot
concepts. Lululemon was the first to corner the yoga wear trend/market but we have seen
margins erode as other retailers such as Athelta, Aerie, etc. enter the space. We also believe
Lululemon has become complacent in the newness of product offering and has been late to
offer more color in its mix. Despite the strong runway still remaining for store growth, we
expect investor expectations will continue to fall back in line with reality. At the end of the
day, Lululemon is a decent growth company, but not necessarily a great stock. We give it a
fair value of $55.00, 25x FY14 earnings.


! Laurent Potdevin Review: Lululemon is ~$10bn company looking to make the next step in
its growth cycle to become a mature large-carp retailer worth 2-3x todays cap. Whats a great
way to get there? Hire someone with no brick & mortar retail experience; whose main
experience is giving away TOMs shoes and Burton Snowboards in the niche snowboard
market. Were not impressed.


2

"#$%&'&()* +,#'* +&)*- .'*/01/2 3#4/5


Over the last few years, comparable store sales growth at Lululemon has slowed as the comparable store
base matures. The real disappointment comes when seeing the deceleration in the trend as we move
from one-year results to the two and three-year comparable store stacks.

LULU Comparable Store Sales
Q1
2012
Q2
2012
Q3
2012
Q4
2012
Q1
2013
Q2
2013
Q3
2013
LULU - 1 Year
25.0% 15.0% 18.0% 10.0% 7.0% 8.0% 5.0%
LULU - 2 Year Stack
41.0% 35.0% 34.0% 36.0% 32.0% 23.0% 23.0%
LULU - 3 Year Stack
76.0% 66.0% 63.0% 64.0% 48.0% 43.0% 39.0%

+6%%)7 "8&1/ 9--6*-5

Over the last few quarters, LULU has been plagued by supply chain issues and quality control. From
Luon-gate in 1Q13, mobile POS systems, political unrest, new suppliers and new supply chain team
hires, the Lululemon supply chain has seen it all in 2013.



Lululemon Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2 Year Stack Q1 Q2 Q3
Gross Profit Margin 2011 2011 2011 2011 2011 2012 2012 2012 2012 2012 2012 2013 2013 2013
LULU Gross Profit Breakdown
Product Costs and Markdowns 150 210 (20) (310) (20) (340) (310) (60) 10 (200) (220) (90) (220) (220)
Supply Chain Costs 40 (60) 10 (30) (30) (20) 40 30
Air Freight 70 50 60 neg neg
Fixed Costs 130 120 70 50 80 120 (10) 40 50 130 40 70 40
Other - One Time Tax Adjustments 140 (140) (510)
Weakening Dollar 70 100 80 40 70 (20) neg
MD&A BREAKDOWN TOTAL 490 470 70 (220) 140 (360) (240) (40) 20 (120) 20 (560) (110) (150)

S
For a brand that is supposed to be protecting its competitive moat through higher price points and brand
cache, we find LULUs gross product margin results disheartening. As you can see the margin erosion
story began long before the Luon issues arose in 1Q13, throwing off the supply chain timing.

We expect to see some reversal in gross margins as we lap the negative impacts from this years product
and markdown impacts though we expect pressure to remain heavy as LULU relies on greater airfreight
to rush core inventory and new Luon products to store for the second half of 4Q13. We expect some
sequential benefit from supply chain spend was pulled forward from Q4 into Q3.

Overall the only consistent gross margin sub-metric LULU has been able to hit on is fixed cost leverage,
which is a function of sales growth. We would like to see greater visibility (and results) in FY14 now
that the supply chain and commercial process has had managements focus for an entire year.


To see how we got here lets take a quick blast through the past and highlight LULUs committed
supply chain transformation efforts in 2013. (Warning: This gets lengthy)

Without further adieu, Ladies and Gentleman

1Q13 Call
LULU hires a consultant to improve supply chain logistics.

We now have Jennifer Battersby formerly of Mast working with us on a consulting basis for
five months to enhance and improve our product processes and to get strong round of
candidates for a senior supply chain and logistic position. Were also well into the process of
interviewing candidates for the EVP product role. CEO Christine Day, 1Q13 Conference Call

Great. Well be out of our supply shortage hole and get our pants back in stores.

However, we are getting back into stock gradually as production and delivery of these styles
ramps up and will not be fully back in stock until the end of Q2. CFO John Currie, 1Q13
Conference Call

In fact, we are going to see timing improve and regional buys/shipping implemented (retail 101, this
should have happened a long, long, time ago.)

So by next February what you will see us doing is there will be an actually time to release our
product thats appropriate for the market, so we will start lighter colors sooner in the south and
hot climate, well start the transition to crop sooner in those markets. And then well move
into more of a localized even more localized buy strategy as we move forward and a much more
fuller integration of e-commerce and stores. CFO John Currie, 1Q13 Conference Call

But wait, you just said those pant styles were going to be fully back in stock by the end of Q2?!?

I mean I wouldnt say we would be completely back to our ideal inventory level by the end of Q2
thats a little bit too quick. But certainly by Q3, well clear that again this isnt a huge backlog
and we have the outlets to handle it and I think well be back in a balanced inventory position
by Q3. CFO John Currie, 1Q13 Conference Call

Fine, as long as its all hunky-dory by Q3.


4
So we bought in a master pattern grader and weve sent, every single factory has all the same
patterns now and we also reduced our tolerances from a inch to half an inch, which takes more to
sell, which is part of the reason why it took us a little longer to get back in stock because the
factories had to show to a new technology level.- CEO Christine Day, 1Q13 Conference Call

2Q13 Call
Time flies and LULU has been hard a work for 3 months on their supply chain, lets see what theyve
come up with!
Step 1: Hire the consultant who has already been working with you! This makes sense as LULU moves
production away from China to South East Asia (49%/41% in 2011 to 34%/54% in 2012).
As part of that strategy, we named Jennifer Battersby, as our new Senior Vice President of
Sourcing, Quality and CommercializationHer last role with Mast was SVP, Victoria Secret
production, Asia, where she led the production and sourcing, product development, raw
materials and fit teams in Hong Kong, Sri Lanka and Korea. CEO Christine Day, 2Q13
Conference Call

More supply chain timing issues? Are the factories still sewing slow because of quality demands?

While the fall product was later to arrive in our store, we have seen good response to the fall
color palette and the texture and print we have brought into our core. We are excited about the
innovation you will be seeing in functional outerwear and textured softshell fabrics, puffy jackets
and belts and versatile silhouettes. CEO Christine Day, 2Q13 Conference Call

And some more

Over the past several months weve focused on quality and getting Luon back into our stores.
While this is clearly what was important for our future, it resulted in some short-term pain.
Weve experienced a weak start to this quarter, driven primarily by late deliveries of fall
products, leaving us with the summer product on the floor through August. CFO John
Currie, 2Q13 Conference Call

Ugh. This hangover never ends, lets start focusing blame on our commercialization department! No one
knows who they are /ever asks about them! And wait, product timing issues through the balance of the
year!?! But you said everything was going to be okay by 3Q
These late deliveries are a hangover from the disruption caused early in the year with the Luon
issue. While we were successful in getting back in stores with Luon, the effort required to get
there had a lingering impact on our commercialization and sourcing teams ability to be ready to
hand-off to our vendors the current season. We anticipate this knock-on effect to continue to
impact timing of product deliveries in Q3 and through the balance of the year.- CFO John
Currie, 2Q13 Conference Call

Good thing we are going to have better product flow in the second half of Q3, cant wait to see the
results!

Yes, the Q3 guidance is based on a mid-single digit comp assumption and a slight improvement.
As I said product flow is better as we head into the second half of this quarter. So a slight
increase, but still within that mid-single digit range. CFO John Currie, 2Q13 Conference Call

Just in case you wanted to know how the commercialization process works, here is how they are
teaching factory workers in Asia to sew accurately. Showing off how they did such a great job at picking
best in class suppliers the first time around, since this is a high quality product and all

S

Great. Our main bottleneck right now is our commercialization department. Every time we
change a manufacturer or every time we change a pattern or fabric for the pant...plus as we
correct for quality and making sure that in every step weve done additional inspections, which
just slows it down and weve increased or decreased would be the correct word, our selling
tolerances, which slowed the factories down a little bit to make sure that at every step in the way
we were getting the quality that we wantedThen you add on just time constraints with the
amount of quantity of product were trying to catch up on with Luon and kind of the seasons
collapsing. If we are late with one, then it affects the start day of the next and so we are incurring
a little bit more airfreight and slowdown in the shipping processSo that commercialization
impact and bringing on the third factory is still at play and we are working back through all of
our other fabrics to make sure that were hitting the quality standard we want. So the
commercialization workload will affect us for a period of time. CEO Christine Day, 2Q13
Conference Call

But no set of excuses is complete without blaming an act of God, the weather, or in this case, Egyptian
political unrest. Expect a mix increase in magic carpet yoga mats going forward (I kid, I kid).

We did experience some additional late deliveries and shortages due to political unrest, one of
our key tops is manufactured in Egypt and so its mainly late shipping from that that we are
working through. But we do expect that from a Luon impact that at the beginning of next year we
should be caught up. CEO Christine Day, 2Q13 Conference Call

Okay, we got it, everything is back on plan, sure hope we dont see anymore issues going forward!

I would say that because of some of the delays, we havent had as much new product in the end
of the quarter, that as we would have liked and so with the fall drop, were pretty much back on
track with our historical percentages in probably the overall buy, the timing of when things
arrive, the top that matches the bottom and some of the challenges weve had with that in holding
certain items.- CEO Christine Day, 2Q13 Conference Call

Hmm, good thing we now know your historical percentages for your buying pace includes inconsistent
product flow, keep setting the bar high!

Were using more air freight than we have historically and thats already factored in and the
point were making is, we still have inconsistent product flows and that will carry on through
Q4.- CFO John Currie, 2Q13 Conference Call

Okay, lets wrap up the Q2 call with the reassurance that LULUs late Fall sets were not only their supply
chains fault from a quality/product flow issue but also because they cant get communication flowing
properly to forecast. Excellent.

We just set this last week and normally we would have set in the second or third week of August,
usually actually the second week we do a transitional pod. So yes, that definitely was about
three, three and a half week delay and we are still waiting for confirmation for deliveries for
October and November, so thats affecting our ability to forecast.- CEO Christine Day, 2Q13
Conference Call

3Q13 Call
Finally, the 3Q call. Lets start out with some good news; we finally got the POS systems ready that
weve been talking about all year, hurray!

We came into the holiday season better equipped to handle high traffic volumes during peak
periods, with handheld POS units for line busting. In our high volume stores, we rolled out

6
mobile ecommerce devices to draw on ecommerce inventory when the store is out of a guests size
or color.- CFO John Currie, 3Q13 Conference Call

But wait, you have to be kidding me, you didnt get everything fixed by Q3?!? Shocker.

The late product deliveries that impacted Q3 have also continued, resulting in uneven product
flow, and in some cases cancellation of purchase orders. CFO John Currie, 3Q13
Conference Call

You mean the product issues, traffic has been weak all year

The combination of traffic and product issues resulted in a lower expectation for fourth
quarter guidance. CFO John Currie, 3Q13 Conference Call

Dont worry though, the product and supply chain issues from the last year are just a symptom. We can
get excited, because now we are going on a supply chain journey!

As we get into Q1 and beyond, the improvements that are really underway with the new team
on the supply chain side are a journey. CFO John Currie, 3Q13 Conference Call

And now for some complete BS. Lets just place most of the blame on traffic for guiding down, no focus
on sequentially declining AURs/product mix. Nothing to see here.

Roughly Id say its about one third the product issues, and two thirds the traffic discussion.
CFO John Currie, 3Q13 Conference Call

And lower adoption from new customers do to mix shift away from core.

We are finding, as I said, the seasonal items, the unique items, are selling So that may
indicate less new guests, but again, its really too early in the holiday season to do that
diagnostic. CFO John Currie, 3Q13 Conference Call

To wrap things and up and put us all at rest, find solace that the bar has been set low for supply chain
issues well into next year. Congratulations Potdevin, blank check. Cha-ching.

So again, as 2014 progresses, well get progressively better, and by 2015 Were not holding
back on investment, etc., in hiring, and by 2015, we should be seeing a much, much smoother
supply chain operation. - CFO John Currie, 3Q13 Conference Call

Needless to say the excuses and expectations have been continually pushed forward and out, are we
really surprised Christine Day is choosing to leave now? Cant wait to see what happens when they turn
the European supply chain on

(Cont. Next Page)








7
Long Term Expectations:

As fundamentals deteriorate, what can we really expect from LULU, now that they reaching a
more mature point in their store rollout plan? Currently, the comparable store sales runway for
new stores is shorter than in the early years. New stores are producing around $1,100 sales per
square foot, just 10.5% below the company wide average.
















If anyone thinks that the above chart reflects a company growing share and pricing power in their
market, it doesnt. LULU focuses on returning to historical ~55.0% gross margins. We ask what
about ~ 57.0% gross margins? Yes we understand we are facing currency headwinds, but why is
the bar being lowered so far? On a 4-quarter trailing basis, gross margins did not cross below
55.0% until after the Luon pant recall. Perhaps the opportunity for margin recapture is not as
strong as investors were initially led to believe.

















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Almost all of the gross margin deleverage has trickled down to the bottom line. In fact, 3Q13
was the first quarter where SG&A leveraged since 1Q2012 (+36 Bps). We expect to see further
leverage in 4Q13 until FY14 where, once again, we expect further SG&A deleveraging
(estimating -67 Bps impact in FY14).

Examining segment profitability
further exposes the continued
profitability erosion in LULUs
core company-owned store
segment, which accounted for 80%
of sales in 2012.

The erosion to the Company
Owned Store segment has come on
top of a combined +130 Bps fixed
cost and occupancy leverage
benefit in FY11/FY12 and +40
Bps, +70 Bps, and +40 Bps, in 1Q,
2Q, and 3Q, respectively.

Conversely, weve seen a returned
positive trend to the Direct To
Consumer segment as investment
spending has begun to leverage on
top of meaningful top-line
segment results.

We expect/dont care about declining profitability in the Other segment. Sales in this segment
are a dwindling portion of LULUs overall business and used to clear inventory.


Another deeper metric we like to look at is the spread between sales per average store and sales
per average square foot. Ideally we would like to see sales per average square foot grow faster
than sales per average store, indicating higher productively in incremental square footage.



As we can see, LULUs decline in sales per average square foot has been declining faster than
sales per average store. Although this metric improved through FY12, the trend has reversed in
FY13. We would like to see this trend reverse and spread tighten to reflect improving
incremental fundamentals on the store level.


Average Sales Spreads
Average Sales per Store
Sales per Average Square Feet
Spread
Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013
15.4% 3.1% 7.5% 6.4% -2.9% -1.6% -4.9%
11.1% -0.5% 5.8% 6.0% -4.0% -3.4% -6.6%
-4.3% -3.5% -1.7% -0.3% -1.2% -1.7% -1.7%
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9
Lululemon Guidance Analysis

Lululemons management has been very adept at hitting their quarterly guidance, their yearly
guidance not so much. We have included our guidance analysis sheet below to track the changes in
guidance as the year progresses.






































Notice the consistent EPS beats in 1Q-3Q. 3Q was even weaker than expected, missing both the high-
end of the sales and gross margin ranges. Despite these misses LULU still reported 3Q EPS of $0.45,
beating the high-end guide of $0.41. LULU was able to pull this off through SG&A leverage despite
guiding deleverage. We suspect LULU delayed certain variable expenses (marketing spend slush fund
perhaps?) into 4Q13 to make the quarter.
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1u
New CEO Laurent Potdevin:

We'ie not impiesseu with Lululemon's choice foi theii new CE0,
Swiss boin Lauient Potuevin. Potuevin joins L0L0 having iun T0Ns
shoes anu Buiton Snowboaius befoie piioi.

Be has no biick & moitai ietail expeiience, the coie of the
Lululemon business. 0nlike most tiansfoiming "0mni-channel"
bianus, stoie locations aie even moie impoitant to L0L0 as they
iemain the focal point foi customei expeiience. The ietail locations
uiaw in inciemental customeis anu uiive conveision with in stoie
yoga classes etc.

Suie, Potuevin is a yoga enthusiast but we woulu have likeu to see
someone with a gieatei uiveisity in segment expeiience besiues
snow spoits (something along the line of moie active weaisummei
spoits), to bioauen the L0L0's customei base.

In the enu, foi the amount of time it took to finu a ieplacement, the supply chain complications
faceu in 2u1S, anu the bianu's tiansition to a matuie global stoie base, Lauient Potuevin seems to
be a veiy lacklustei choice. We'll wait anu see what his plans aie foi the business, but foi the now
the lack of a blockbustei hiie iemains less than inspiiing.

"#/:)6-1#/5
As the promotional Holiday season continues expect Lululemon to lose share and gross margin to
competitors. The easy pickings of the 2000s are over, everyone knows about yoga and the retail
competition does too. LULU has been successful in capturing an ever shrinking market, upper middle
class affluent consumers who have dramatically shifted their spending patterns to incorporate e-
commerce. What makes LULU so special is the connection their customers have with the product and
the in store services/classes/experience that allows them to command a dominate place in the market.
The most important thing LULU can do is protect this share. Product position and mix becomes even
more important to the brand because of their limited ability to markdown product without eroding brand
equity. LULU has to get it right, and get it right the first time!

We worry that LULU could become another COH story (we are far from it on a brand image level/outlet
strategy). In 2012, we heard many concerns Michael Kors (KORS) was significantly impacting COH
market share. Whether or not people believe this theory, the company reacting poorly by defensive
posturing. LULU, dont get defensive! Dont hide behind qualitative examples of your brand success.
We would like to see the new CEO Laurent Potdevin step up and create some hard, concrete goals for
his team to be met by 2015, adopting Christines partially completed 3-year plan is not enough.

Valuation/trade talk. Over the last few years LULU has exemplified itself as a strong growth momo
stock, in the ranks with ULTA, GMCR, and KORS. With its middling performance in 2013 and the
3Q13 top-line miss, LULUs multiple is taking a large haircut. The transformation from momo growth

11
stock to a more terrestrial valuation is often hairy, volatile, and involves many cuts from all those falling
knives.

Consumer Fox doesnt like to lose money and definitely doesnt like to get cut. With shares down to
around $60, we see further downside and shares continuing to exchange hands, fleeing the ownership of
momo growth owners in exchange for more reasonable GARP styled investors. Were waiting for the
flush to end. That could be today, or it could be a month from now. Until then we are placing a $55.00
PT based on 25x our 2014 estimate ($2.18). We can easily envision scenarios where we will take this
estimate down further and who really knows what multiple the market will get comfortable with. With
that in mind, we wouldnt mind entering under $55.00 and below.



































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