"There are no coincidences, Delia... only the illusion of coincidence. "-V, V for Vendetta
Lululemon (LULU) reports this week and while I have been passively recommending being short the stock for a few months, I believe the timing is now right for a significant re-rating in the share price. My rationale here is very similar to previous shorts on Chipotle Mexican Grill (CMG), Whole Foods (WFM), and to a lesser extent Ulta Salon Cosmetics (ULTA). But before I get into that I think a little comparison to current fashion flavor Michael Kors (KORS) would be worthwhile. As Lululemon's fiscal year ends in January, the ICR investor update pretty much allows us to confidently look at the past three years of performance going into earnings and then compare that to a snapshot of where Michael Kors fiscal 2013 should come in. (it is a late reporter too so the embedded forecast for the year ending in March is pretty reliable)
Lemon (Jan 11)
Revenue Growth yr/yr
EPS Growth yr/yr
Same Store Comp yr/yr
Stock Price End of Fiscal Year
70(as of today)
55(as of today)
Looking at this data, today's Michael Kors looks a lot like the early spring 2011 version of Lululemon. The only notable difference is that Kors looks to be a lot cheaper. Whether that is the case remains to be seen, but what is clear is that the valuation differential between the current Lululemon and Michael Kors is very difficult to justify. Lulu's 2012 operating income is set to decline to half the growth rate (30% vs. 60%) of fiscal 2011, and this is despite exceptional online sales offsetting slowing store comps. In fact if you adjust for the mid-year tax rate modification (it modified inter-company transfer pricing structure to reduce tax liability), Lulu will only beat the high end of its initial annual guidance by 4% for the full year. Not bad by any means, but then again nothing close to the 27% upside surprise delivered last year. Now ask yourself this...
If given the choice would you really want to pay a 26% multiple premium for Lululemon versus the faster growing, higher margin, and more diversified Michael Kors?
The short answer to this question is no, but in Lulu's case things are a bit more complicated. If you have been following the name closely, you know management has spent the last two quarters doing the behind the scenes work for its push abroad. Now, the behind the scenes activity is going to shift to more on the ground direct investment as Lulu starts to seed new markets with showrooms. This controlled/calculated rollout approach worked well in the United States and is what it should be doing as the brand's identity abroad is weak. I see no reason for management to break from this strategy and pursue a more aggressive international store rollout approach. Lulu's brand identity is about building an ecosystem around its stores much in the same way a Chipotle must tap into local organic suppliers around its restaurants, and there is no reason for it to stray from that path. However, such an approach requires intentionally constraining short-term growth and risking losing valuable brand momentum in the very fickle consumer discretionary space. This is the type of stuff that doesn't sit well with the type of growth momentum investors who have been riding this stock for the past four years. Lulu's management team has pretty much telegraphed that it is entering a bit of a transitory phase, and that short/intermediate-term operational metrics will start to reflect this as investment ramps. That leaves the stock vulnerable with competition in North America heating up just as the same-store sales torrid growth of the past years starts to taper off.
The question you need to ask yourself is why is this seemingly obvious 'chink in the armor' not being acknowledged by the market?
This is of course the same question I ask myself whenever something in the market looks too frickin' simple, and sadly one I very rarely ever come back with a solid answer to it. What I have learned over the years is that for some innate market reason growth stocks tend to be repriced in quick large moves that come on the back of news, no matter how obvious that news may seem to be. Whole Foods a few weeks ago was a perfect example of this and so was Chipotle last summer, in both cases management pretty much telegraphed the quarter that turned the tide on the stock a good three months in advance, and yet the Street still waited to be slapped in the face to react. Lulu presently looks and feels the same way. If you want to be bullish here, you are going to be short on catalysts for several quarters if not the whole year (assuming a significant price decline doesn't reset expectations), and will need to be patient. Problem is once traders start running the updated numbers on growth rates and comparing them to alternatives; they should start worrying that they are now significantly overpaying (which they are) for the shares. They should then dump the stock consequently creating the environment for a reset of expectations, at which point a new more aligned cycle between the shares and the company's operating performance begins. By my estimates, there is little to no upside potential in Lulu's 2013 annual guidance, and there is definitely room for a considerable fade-out of the name as the year's relatively less than exciting operating metrics road map is laid out. Of course, the bulls in the stock will argue the stock is cheap on the back of future international expansion, but with this roll-out proceeding at a very calculated pace, the futility of this argument should become readily apparent as I expect the momos to go elsewhere for their action.
Just take a look at Lulu's same store comps over the past four years...
Lemon Same Store Sales Comps
(high single digits)
Impressive numbers to say the least, but what interests me here is not the past performance. This quarter will be the first in fourteen quarters in which Lulu has not thrown up a double-digit comp rate. That is not a good sign for an outlier multiple name in an already multiple contracting segment of the market, and looking ahead to Q1 the Lemon will be lapping its best quarter from last year, so don't expect things to get any easier. This problem of a company being a victim of its own past success is very familiar to me.
Remember what Chipotle management had to say on its Q1 conference call...
"While we continue to believe we have pricing power, we do not have plans for any additional menu price increases during 2012 to offset expected food inflation. Our business model is strong and we're not compelled to take short-term price increases to drive quarterly results. And instead, we're focused on driving greater customer loyalty and strong transaction trends.
Our comps held up well in the first quarter despite the toughest quarterly comparison in 2011 of 12.4%. Unseasonably mild weather through much of the quarter helped transaction trends remain strong and in addition, we benefited from the leap day in February, which added about 1% to the comp. Our sales comps continue to benefit from the menu price increases taken during the second and third quarters of 2011. Of the current menu price increase run rate of 4.9%, we will lose 3.9% of the benefit over the next 2 quarters as we lap the price increases from last year with about 30 basis points dropping off in Q2 and about 360 basis points dropping off in Q3.
We also faced tough sales comparisons in the back half of 2012 as beginning in the third quarter, we will comp against 2 full years of double-digit comps for the first time since before the recession. Taking all this into account, we reaffirm our full-year comp guidance of mid-single digits."- CMG Q1 2012 CC
This is a classic example of a management team telling you that amazing past performance is becoming a headwind. When CMG reported in Q2 the comp was just a smidgen below what the overly optimistic investors in the stock were accustomed to, the shares still got massacred. Was there a surprise/huge disappointment? No not really, for the full year CMG ended up delivering 7.1% same store sales growth which was basically at the high end of its guidance. Problem is that just wasn't good enough considering where the stock had been trading and what investors had gotten used to, and consequently the stock was repriced in one fell swoop. CMG went into Q2 results at $404, closed the next day at $316, traded as low as $233 in the months that followed, and presently trades at $320. The way this played out was amusing to say the least. Every reason attributed to the post Q2 call sell-off was something management subtly signaled was coming on the Q1 call. Then Einhorn showed up to short the stock on a competitive concerns thesis a month later. This was temporarily good short seller timing, but so far has proved to be a somewhat flimsy investment thesis (see Why Einhorn Should be Shorting WFM and not CMG).
But factoring this all in, Chipotle management delivered as promised in 2012, yet shareholders endured a roller coaster ride as domestic growth trends started to mature and the momos abandoned ship. Though what really stood out here when I compared it to Lululemon was the international growth potential defense that was tossed around by momos in the stock. My point then was, yes, CMG will eventually take the rest of the world by storm, but because of the way it grows its business, don't bank on that impacting operating performance in a meaningful way anytime soon, i.e., be prepared for the transitional period that is characterized by a leveling off in the domestic growth which has been driving operational metrics as well as rising investment for future international expansion. Lulu is in my opinion clearly entering this transitional phase. And for those that cite the under-penetration of its total addressable market in the US as a defense, all I can say is take a look at Whole Foods. WFM is at 35% of its targeted North American store count (actually more head room than Lulu which is at a penetration of 40%), but that hasn't stopped management from having to take a bit of breather this year to fend off the competition. The key takeaway here is this is not the first or last growth story to experience normal growing pains, and subsequently have the market turn on them in a seemingly irrational way. Basically, if you learned anything from Apple (AAPL) over the past few months, you won't have a hard time digesting this viewpoint. The market overpays for growth on the way up, and then overreacts to downshifts whether they are reasonable or a cause for concern.
What to keep eye on...
Same Store Sales - After two and half amazing years, the laws of gravity are starting to come into play here, and the shares are not priced for this yet.
Margins - SG&A leverage and gross margin expansion have been tailwinds throughout Lulu's recent growth cycle. I expect that to change this year. Lulu will be investing more as it seeds, so expect SG&A to become a slight headwind. Also, occupancy and supply chain should do the same.
Management Tone - The smartest management teams tend to slowly spring transitory news on the market. Lulu's team has hinted that of late, but we have not gotten anything too explicit yet. With the outlet closing in Vancouver, HK location upcoming, more aggressive seeding plans, Athleta and Under Armor (UA) competition picking up, and tough two year comps to work against, I expect management to communicate more directly that 2013 will be all about preparing for the next phase and that metrics will reflect this.
If you are looking for a hedged position, Lulu short vs. Michael Kors long works nicely here. However, if you are looking for something more aggressive, the front month put options make a lot of sense as a few days of digesting should do the trick for the stock. And since earnings are slated for the first week after March expiration, you get five solid weeks in the April contract for Lulu momos to pack up their bags. Basically, if it is not going to reset on what should be tepid annual guidance, why bother with it all. I have a price target of $58 for the stock on or before April 19th, and would be a buyer of the 67.50 strike April put contracts right here.
Really not much stock specific to fret about here if you assume weaker annual operating margins on the pre-international rollout costs, a flat to slightly higher tax rate over fiscal 2011, and a much slower North American comp growth rate (Lulu will exit the year at high single digit comp vs. a 26% rate in Q4 last year). So the risk is that the market is filled with patient investors who will choose to continue to pay a hefty premium for Lulu in anticipation of key growth metric re-acceleration into 2014/2015. Based on my experience and the current average attention span of the majority of market participants, the odds of that are extremely low. So, this does look like a classic zero upside stock, and if you are more conservative hedging with Kors or just outright short is an easy way to go. (10% return with very high confidence over a couple of months is not easy to find these days)
Some other things to consider.....
1) Short Interest is up 33% over the past three months and has doubled over the past year. I am not necessarily happy about this as the best bang for the buck shorts tend to be the ones where the short interest has really done nothing, but in this very strong market tape, this is difficult to ignore. Clearly some serious money out there is comfortable betting against Lulu, and they have really upped the ante ahead of this quarter.
2) Lulu-esque stocks have been major underperformers of late. Dicks Sporting Goods (DKS), The Fresh Market (TFM), Whole Foods, Under Armour, Michael Kors (considering how well it is doing, the stock performance is disappointing), Coach (COH), Chipotle, Ulta, and many other retail names that crushed it from 2009-2012 have been killing investors of late and the good news is you don't really hear too much about this because the mainstream media is preoccupied with the market and its new highs.