Splitting From lululemon, CEO Reveals Details of Sheer-pants Debacle

lululemon athletica CEO Christine Day is leaving the high-growth lifestyle apparel brand after more than five years of shepherding the company through a period of global expansion and following a tumultuous first quarter affected by the headline-grabbing quality issues with its popular black luon pants.

The company's stock dropped 10 percent in after-hours trading following news of Day's departure. The CEO did not reveal her future plans, but will remain with lululemon until the board of directors' search committee identifies a new leader.

Despite a 7 percent increase in comp store sales and a $60-million increase in total revenue year-over-year, the company's first quarter net revenue slipped 5.6 percent, dropping from $170.7 million or 49.4 percent of net revenue compared to $157.3 million or 55 percent of net revenue in the same period of 2012.

$17.5-million luon loss
Much of that decline is attributable to lululemon's $17.5-million write-off of unsellable black luon pants, which suffered from quality problems and arrived in stores without the same opaque coverage as they had in the past. In a widely maligned move, the retailer, offering a voluntary recall, asked customers seeking to return the affected pants to bring the garment into a store and bend over while wearing them in order to verify the inappropriate sheerness.

"While we regret that we had quality issues with our black luon, we are proud of the organization's ability to get luon delivered back into our stores within 90 days of having pulled it from our line, all the while keeping our guests happy and engaged with the brand," Day said on a recent call with analysts.

The incident helped lululemon understand a lot about its customers — "what they love about luon, what they love about our pants, that it was more than just about coverage, and it really is about how everything works together from compression, fit, style, that there really is no comparison," added Day. "And the guests really learned how hard this fabric is to make, and when they tried other pants, we got a lot of feedback that they were not comparable."

Quality control
The brand has taken steps to ensure that quality problems remain a thing of the past. Instead of just keeping an eye on a few technical specifications and relying on manufacturing partners to enforce quality, lululemon now closely monitors all tech specs. Day pointed to the company's growth as a factor in creating the quality issue, as lululemon didn't effectively manage the grading process as the brand expanded.

"For instance, every single factory [worked] from one master pattern, and with our tolerances," explained Day, "as we really dug deep and did a lot of investigation, we found that a size two selling to the edge of a large into the tolerance in one factory was too close to a [size] four selling to the small tolerance in another factory."

As a result, the company hired a master pattern grader; now all of its factories work from the same patterns and tolerances have shrunk from 1 inch to 0.5 inch. lululemon has increased testing of raw materials to ensure product uniformity. If a fabric doesn't have sufficient thickness and heft to pass the weight test, Day said, it's removed from consideration for pant products and shifted to styles with looser fits, such as tops.

"We invented our whole quality control process end-to-end to make sure that we were delivering a great pant, plus we do a lot more on-site inspections," Day explained. "We certainly understood the importance of quality control and running a tight sourcing operation, and we're working on upgrading our infrastructure and control. The silver lining to [this] was a big leap forward in our transition to owning our own technical standards and expertise."

To aid with quality control, lululemon tapped former Mast executive Jennifer Battersby to serve as a consultant to bolster product processes and identify strong candidates to fill a critical senior supply chain/logistics role.

These investments in areas such quality assurance protocols, raw materials management personnel, training and education are driving up MSRP, said CFO John Currie.

Bangladesh and Cambodia
lululemon includes a small group of manufacturing partners in its vendor pool, preferring to work closely with these firms on all aspects of the production process. Day pointed out that a very minor percentage of its production is sourced in Bangladesh, away from the tragedy-plagued capital city of Dhaka, which has suffered fires and collapses at apparel manufacturing facilities in recent months. The brand's two manufacturers operate in Chittagong, where wages are 30 percent higher than in Dhaka, and stronger building safety regulations more closely reflect international standards.

lululemon also produces in Cambodia, which has gained attention in recent weeks due to apparel factory worker strikes. "Labor issues can be complex in some of these countries," Day said. "Our vendor partner Sabrina, who has been highlighted in the press around this issue, actually raised workers wages ahead of the government mandate and has better benefits than any other factory in Cambodia."

Going local
Recognizing the different seasonal needs of geographically diverse markets, lululemon is moving towards offering localized assortments. Currie emphasized the company's "very heavy IT roadmap" and significant systems investments in 2012, which will help to get the right products to the right stores at the right time.

Starting with the spring 2014 season, lululemon is designing collections specific to markets with cold, hot and temperate climates, which will also help it expand its e-commerce inventory. "We've built the capacity to design the lines for those specific drops and the systems that will allow us to do store-level planning," explained Day. The company is working on tightly integrating e-commerce and store operations and building a "one-inventory" environment to enable multichannel capabilities such shipping in-store orders to customers' homes.

New DC
After relying on just one distribution center for many years, lululemon has plans underway to establish a second DC in mid- to late 2014. The new East Coast facility, which will balance out the current site in Washington state, is expected to handle up to 70 percent of volume over the following five years.

Crazy for color blocking
lululemon jumped on the color blocking bandwagon a bit too enthusiastically in the first quarter and offered the trend in too many styles while not carrying enough basics in neutral colors. "There is definitely a relationship between bottoms and tops … and between black and color," Day said. "We had an awful lot of bright color starting earlier this year in January and moving through Q2. When there is not a neutral color like black to break up the color, it gets color-on-color, which was the trend for the season, but we were publically overdoing it with having no black and we had [fewer] neutrals in the line."

Some of those trendy colors didn't sell as expected, but lululemon has adjusted inventory for the second half of the year to shift a greater concentration of black garments from tops to bottoms.