Lululemon Athletica used to be one of my favorite growth stocks. Unfortunately, the stock only enjoyed a few months of success after it’s IPO, but the initial returns were tremendous. On July 30, 2007, the stock was issued for $18 per share in the initial transaction. Shares were hard to get your hands on because the deal was over-subscribed, but my fund managed to call in a few favors and participate in the deal. On the first day of trading, the stock closed at $28 for an initial gain of 55%, and then motored higher over the next 12 weeks to reach an eventual high of 60.70 (good for more than 230% in returns). Since that time, however, shareholders have had a bumpy ride.
Similar to most economically sensitive stocks, LULU traced a low point during the panicked March trading sessions before mounting an impressive rally off the lows. Today the stock sits near $20 and just a few ticks off its recovery high set in early August. Despite flat sales and falling profits over the last two quarters, investors are willing to pay roughly 40 times expected earnings for this year. In short, the stock looks a bit extended and vulnerable to a sharp correction.
Lululemon operates with a fiscal year ending January 31, so we are currently in the 2010 year. With the extra month of lag time, we have not yet received second quarter numbers for the company, but they are scheduled to be released on September 10th before the open. It appears that investors are expecting a surprise to the upside and improving guidance from management based on the optimistic stock price.
Looking back at the most recent quarterly results, it is interesting to note that although revenue increased by a modest 6%, the comparable store measure actually saw sales decrease by 8% on a store-by-store basis. Additionally, the gross margins were 42.8% compared to 53.4% in the same quarter 2008. The bottom line is that with relatively flat sales, declining margins, and the costs associated with opening the new stores (which is the only way the company can post positive sales figures), earnings are taking a sharp hit. And yet while pricing is clearly taking a hit (as seen with the margin contraction), management appears to be overlooking this alarming trend.
We are pleased with the current pace of our business and our ability to continue to bring our customers through our doors to make full price purchases. ~Christine Day, CEO
As I dug a bit deeper into the fundamentals, I noticed that inventory has decreased from $52.1 million last year to a current level of $44.6 million at the end of the first quarter. This means that despite a broader store base, the inventory for the entire company is down significantly. That leads me to believe that management continues to expect a difficult sales environment based on the fact that they don’t have the merchandise available even if sales were to pick up sharply.
About the only positive data point that really stuck out was the fact that th company has increased their cash balance to $59.3 million. When considering the fact that LULU has no debt, this leads to a stable financing environment where further difficulty in the economy won’t likely put the company out of business.
My concern with LULU is not that I believe they will fail. The retailer operates in an attractive niche and is well respected by customers, suppliers, competitors and investors. Ten years from now I expect LULU to continue to be a healthy retailer operating as a stand-alone company or possibly as a division of a larger firm after being bought out. But unfortunately, I believe that ten years from now, we might not see very much in the way of stock appreciation from today’s levels. The company would have to grow tremendously quickly in order to justify the current PE of 40.
Looking toward the earnings call next month, I believe we are in a typical “buy the rumor, sell the news” type scenario. Traders often bid up a stock expecting good news and are anxious to sell the shares at a gain once the announcement is made. Unfortunately, this game can be played by too many participants to the point where the quick exit of many players after the announcement actually leads to a declining stock even if the news is “better than expected.” High multiple, high momentum stocks are particularly susceptible to this kind of trap.
It may not make a whole lot of sense to short LULU today. It’s more than possible that the stock will overtake its high before the earnings announcement. But I do think that wise and nimble traders can begin building positions in front of the earnings announcement. Risk should be carefully managed as the current market trend is higher, but the potential gain from a sharp reversal could be large and lead to strong profits in a turbulent market. A conservative target would be $15 where one could take some profits off the table, but over time, it wouldn’t surprise me to see LULU trading in the low teens and even touch $10 as investors grapple with a over-loved stock with no earnings growth.
FD: Author does not have a position in LULU
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