Lululemon notified the investing community Monday of manufacturing concerns regarding its signature Luon black pants. Coverage of the fabric is weak, causing sheerness in the pants. The company has removed from its shelves the units that do not meet its stringent technical specifications.

While this sounds like a small concern, the press release noted that the affected items were nearly 20% of all women’s bottoms in the retail channel and that there would probably be a shortage of these styles during the first quarter, lowering profitability.

Before last weekend, the company was on track for doubledigit comparable-store sales growth and expected revenue of $350 million-$355 million for the first quarter. Since discovering the problem, management has revised its forecast to include comparable-store sales growth of 5%-8% and revenue of $333 million-$343 million for the first quarter. This could weigh on the gross margin and selling, general, and administrative expense ratio over at least the first two quarters of 2013 as the company experiences a mix shift away from these high-margin and high-volume items and has to spread its costs over fewer units.

Lululemon is currently trading slightly above analysts fair value estimate of $62, and a wider margin of safety is required since management is still working with its manufacturers to understand what the cause of the problem was and is trying to understand the impact on the balance of the fiscal year. When the company report earnings Thursday, investors hope to hear more about what has caused this recall and better understand the manufacturing significance of this shortfall.

The main concern is that this discovery will cause Lululemon to change manufacturers, causing a more lengthy shortage of high-demand inventory and affecting profitability further out than just the first quarter.


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