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Shares of Lululemon Athletica (NASDAQ:LULU) ended Thursday's trading session with strong gains of over 7%. The manufacturer and distributor of its famous athletics and yoga apparel reported its third quarter results before the market open.

Third Quarter Results

Lululemon reported third quarter results of $316.5 million, up 37% on the year before. Sales were driven by a 18% increase in same store sales in constant currencies. Lululemon reported a spectacular 89% growth in direct to consumer revenues, coming in at $45.1 million. Revenues came in ahead of analysts' consensus of $305.1 million.

Despite the sizable revenue growth, operating profits could not keep pace with revenue growth. Gross profits rose 36% to $175.3 million as gross margins fell by 40 basis points to 55.4%.

Operating income rose 35% to $80.6 million, as operating margins fell by 40 basis points to 25.5%. Net income rose to $57.3 million, or $0.39 per diluted share. Earnings comfortably beat consensus estimates by two cents.

During the quarter, Lululemon opened 12 new stores, ending the quarter with 201 stores.

CEO Christine Day commented on the results:

"I am very proud of the team for achieving yet another strong quarter coming in ahead of our expectations. Our stellar results were driven by first-rate execution, strong community engagement, beautiful product and continued strength in our ecommerce business."

Outlook

For the fourth quarter of its fiscal year, Lululemon expects revenues to come in between $475 and $480 million. The guidance assumes that comparable store sales increase in the high single digits on a constant currency basis. Revenues missed consensus estimates of $490.5 million.

The sales guidance assumes that revenues will increase by almost 51% on a quarterly basis. Revenues are expected to increase by 28.5% on an annual basis, which compares to 37% annual growth in the third quarter.

Diluted earnings for the quarter are expected to come in between $0.71 and $0.73 per share. The guidance is a little short compared to estimates of $0.75 per share.

For the full year of its fiscal 2012, Lululemon expects revenues of $1.36-$1.365 billion. Full year diluted earnings per share are expected to come in between $1.81 and $1.83 per share.

Valuation

Lululemon Athletica ended its third quarter with $439.4 million in cash and equivalents. The company operates without the assumption of debt, for a considerable net cash position.

Lululemon generated revenues of $884.9 million for the first nine months of the year. Net income came in at $161.2 million, or $1.11 per diluted share.

The market values the firm at $10.6 billion after Thursday's gains. This values operating assets at roughly $10.2 billion. Based on the company's own outlook, this values operating assets at 7.5 times annual revenues. The company is valued at roughly 38 times annual earnings.

Lululemon Athletica does not pay a dividend.

Some Historical Perspective

Year to date, shares of Lululemon have risen some 60%. Demand for the popular but expensive apparel has remained strong despite a weak economy. Shares rose from levels around $46 in January to highs of $80 in May. Shares fell back to lows of $53 in August and rose back to levels of $73 as of this writing.

Shares of Lululemon have seen an incredible ride. Shares rose more than 20-fold from levels below $3 in 2009 to close to its all-time highs. Revenues tripled from $353.5 million in 2008 to an expected $1.36 billion this year. Earnings grew spectacularly as well.

Investment Thesis

Investors had their doubts about the earnings report on Thursday. Shares initially traded a bit lower during the morning, but a continued rally throughout the trading session sent shares to around $74 per share. Eventually, the strong third quarter overruled a cautious outlook for the fourth quarter.

Earnings growth was predominantly driven by revenue growth as margins stagnated despite the significant revenue growth. Net earnings of the company came in at 18.1% of revenues during the quarter. Despite the sky-high margins, customers are still buying yoga tank tops and stretch pants at a record pace.

Recently, more companies have tried to invade Lululemon's dominant market position, but so far the company has defied the critics. Furthermore, investors are enthusiastic about Lulelemon's growth plans in Europe and Asia, as the company will start activities in up to 15 countries. Lululemon warned that the start of the fourth quarter was a bit slow, given the many consumer distractions, including the impact of Hurricane Sandy, and problems with communication to customers.

I am negatively surprised by the degree to which same store sales growth is slowing down. Same store sales growth is slowing from 18% in the third quarter to "high single digits" in the final quarter. Revenue growth already slowed from 37% in the third quarter to 28.5% in the final quarter. Even if annual revenue growth would come in at 25% in 2013 and 2014, revenues would come in at $2.1 billion in 2014. These estimates reflect declining same store sales growth, accompanied by international store openings.

Net margins could peak from 18.1% to 20%, but eventually margins will come under pressure as a result of competition. Net earnings could come in around $400 million for 2014, valuing the firm at roughly 25 times expected earnings in two years' time.

I am surprised that shares went higher on Thursday despite the relatively cautious outlook for the fourth quarter. The company issued the first warning signs about growth and moderating margins. Lululemon needed to mark down its inventory more than last year, and the fourth quarter started relatively bad.

A month ago, I hoped that the market gave me another chance to short the stock at $75, and third quarter earnings just might give me the opportunity.

Ultimately, the best risk-reward situation is the short side of the trade. I might initiate a short position in the coming days.

Source: Lululemon Athletica: Shares Remain Dangerously Expensive Amid Weak Guidance For The Final Quarter