Investors have forgiven Lululemon Athletica Inc. for its wardrobe malfunction – at least temporarily.
The stock has surged to record highs in recent days, as the market awaits the company's quarterly results next Monday.
But not everyone is convinced that the company's quality control problems are in the past, and any unpleasant surprises in the earnings report could send the share price in reverse.
The Vancouver-based company pulled its black Luon yoga pants from store shelves and factory inventories in early March after discovering the nylon and Lycra fabric was see-through.
Lululemon shares lost 11 per cent over the next month, before Christine Day, the chief executive officer, appeased the market by announcing that the company was beefing up quality control, introducing more rigorous testing and tightening manufacturing standards.
News that the Luon pants were returning to store shelves this week gave the shares a further boost to an all-time high of $85.10 on Tuesday.
For cautious investors, the stock's lofty valuation is grounds for concern. The shares, which pay no dividend, trade at more than 40 times estimated earnings, and have become popular with short sellers. In April and May, insiders were selling, not buying, the shares.
John Morris, an analyst with Bank of Montreal, rates the stock "market perform" with a $65 price target, based on 28 times estimated share profit for the fiscal year that began in February.
He says he uncovered quality issues, included material pilling, as long ago as last August. He adds that there also appear to have been quality issues with some of Lululemon's men's clothing.
"We would continue to proceed with caution on the name until quality issues are clearly identified, contained, and remedied," Mr. Morris wrote in a report.
Lululemon announced that chief product officer Sheree Waterson left the organization in April, but it has not provided many details about what went wrong with its quality-control process.
Quality is vital to the retailer, because its competitive advantage is based on the lifestyle appeal of its brand.
Its sweeping vision statement includes a vow to "elevate the world from mediocrity to greatness." It refers to customers, who pay more than $60 for tank tops and $90 for yoga pants, as "guests."
The retailer's strong bond with consumers could prove fragile if quality control issues persist. That, in turn, will hinge on how successful the company is in controlling its far-flung manufacturing chain.
Lululemon makes neither its own products nor the raw materials that go into them. It has trademarked the Luon name, but the fabric, used in many of its key products, is developed and made by a single manufacturer in Taiwan. And that manufacturer in turn receives the special fibres for making Luon from another single-source supplier.
About 88 per cent of Lululemon's products last year were made by contract manufacturers in southeast Asia and China. The company also relies on a third-party firm to do inspection and testing of its fabrics.
For the most part, this outsourced model has been spectacularly successful. The company has been growing at an average compound rate of 55 per cent a year over the last decade. For the year ended Feb. 3, it posted profit of $271.4-million on sales of $1.37-billion.
But the model also leaves the company vulnerable to outside forces that could potentially damage the reputation of the brand.
The Luon controversy demonstrates how expensive such problems can be. In March, Lululemon executives said removing all the sheer yoga pants from store shelves and inventories, plus other related expenses, would cost between between $57-million and $67-million.
Some analysts think that actual cost will be far less, and suggest that results on Monday will be stronger than forecast.
Camilo Lyon, an analyst with Canaccord Genuity, is expecting the effect of the recall to be "negligible." The Lululemon brand is so strong that the company actually experienced increased traffic to its stores last quarter, with customers buying substitute products, he noted.