Quality control

Lululemon: The downside of selling hot pants

March 22, 2013: 2:16 PM ET

Keeping supply below demand has fueled Lululemon's impressive growth. How will it manage a demand shortage that's out of its control?

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FORTUNE -- The headlines are almost too easy -- fast-growing sportswear company Lululemon is recalling pants that, it turns out, are see-through. This is the worst kind of exposure the company could ask for.

Beyond the headline humor, this particular hitch may have more legs than previous setbacks at Lululemon (LULU). Some quick examples: In 2007, independent testers couldn't verify that the company's VitaSea line contained, as Lululemon claimed, beneficial "marine amino acids" from seaweed. More recently, CEO Christine Day admitted during an earnings call for the second quarter of 2012 that the company had to pull products because certain colors, including a retina-searing "Paris Pink," had been bleeding.

Lululemon, which declined to comment for this article, has handled its bottomless pants problem well. The company posted a comprehensive FAQ on its website, and Day spent much of the the company's March 21 earnings call addressing the pants problem.

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So no, it's not a communications issue, but investors are worried it might be something worse than that. "Questions had arisen recently about the company's execution, productivity of new stores, and whether management's responses to investors have had a bit too many excuses rather than answers," says a March 19 Cowen and Company analyst report. "We have now learned the hard way that various questions regarding dying and fabrication were more, well, material, than we had thought."

The problem, the report continues, came to Lululemon's management via customer feedback, which should never happen. Instead, the company should keep a close watch on quality control at every stage in its supply chain, especially since the tightness of the company's supply chain has been critical to its impressive growth.

As of the end of 2012, Lululemon share prices had more than quintupled over the previous three years. The secret to its success -- which Fortune and others have reported, is to generate buzz around new, hot products, charging full price for them, and cycling quickly through fresh inventory. It's a smart way to build demand.

But now the company is facing a real demand issue. Lululemon is pulling all of its defective pants made with a fabric called "Luon," which accounts for 17% of Lululemon's inventory in bottoms. That's big money for the company.

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"We're currently estimating lost revenue of $12 million to $17 million in the first quarter and additional lost revenue of $45 million to $50 million for the balance of the year, primarily in the second quarter," said Day during the company's March 21 earnings call.

Can Lululemon meet demand with a legitimate supply shortage? At the same time, the company will need to regain control of the word-of-mouth buzz that has been, up until this point, essential to its success.

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