Mayday, Mayday - Christine Day Is Leaving Lululemon

| About: Lululemon Athletica (LULU)

Shares of Lululemon Athletica (NASDAQ:LULU) took a beating after the company announced its first quarter results. More importantly, CEO Christine Day announced her resignation as the company's chief executive.

First Quarter Highlights And Day's Departure

Lululemon generated first quarter revenues of $345.8 million, up 21% on the year before. Sales were driven by new store openings as comparable store sales were up by 7% in constant currencies.

Net income improved marginally to $47.3 million, while diluted earnings per share came in unchanged at $0.32 per share. Earnings beat on the already lowered consensus estimates of $0.30 per share.

Perhaps more importantly than the earnings results was the resignation of CEO Christine Day, who has been leading the company for five and a half years. Ms. Day will only step down after the Board's committee has found a successor for her.

Ms. Day commented on her resignation, "Being a part of Lululemon for the past five and a half years has been an incredible journey. I am proud of building a world class team that has produced one of the best growth, brand and profit stories in retail. Now is the right time to bring in a CEO who will drive the next phase of Lululemon's development and growth."

A Detailed Look At The Results

Lululemon saw healthy growth across the board on the back of new store openings. Lululemon opened 38 new stores during the quarter, 29 of which in the US, bringing the total store count to 218.

The 7% increase in comparable sales was solid and excludes the impact of direct-to-consumer sales. Direct-to-consumer sales were up 40% to $54.0 million, and now make up almost a sixth of total revenues.

Disappointing were gross profits which rose by merely 9% to $170.7 million as gross margins fell by 560 basis points to 49.4% of total revenues. The margin compression is entirely due to a $17.5 million inventory charge on the pull-back of its well known black luon pants. On top of this, the company had to mark down some of its seasonal items by 15% during spring as well. This compares to normal markdowns of 10-12%.

Selling, general & administrative expenses made up 30.3% of total revenues, up 90 basis points on the year. The increase in expenses were related to an increase in store openings, including the outlet stores, and investments in the e-commerce business.

Consequently, income from operations fell by 10% to $65.9 million, making up 19.1% of total revenues. A much lower effective tax rate, which was the result of changed intercompany pricing agreements, led to flat GAAP earnings.

Updating The Outlook

For its current second quarter, Lululemon expects revenues to come in between $340 million and $345 million on the back of a 5-7% increase in comparable store sales. Diluted earnings per share are expected to come in between $0.33 and $0.35 per share. The guidance assumes that full year revenues will increase by approximately 21%, while earnings per share are expected to falls slightly.

Full year revenues are expected to come in between $1.645 billion and $1.665 billion. Diluted earnings per share are expected to come in between $1.96 and $2.01. This outlook guides for 20% annual revenue growth, while earnings growth will increase by merely 6% on the back of the pants recall and additional investments.

Valuation

Lululemon ended its first quarter with $588 million in cash and equivalents. The company operates without the assumption of debt, for a solid net cash position.

Factoring in a 17% drop on the back of the news flow, the market values Lululemon at $68 per share or $10 billion, or its operating assets at $9.4 billion. This values the operating assets of the firm at 5.7 times annual revenues and 32-33 times annual earnings.

The company does not pay a dividend at the moment.

Some Historical Perspective

Under the tenure of Day, shareholders have seen incredible returns over the past five years. Shares fell from $15 in 2008 to lows of $4 in 2009, but have steadily rallied to all time highs of $82 in recent days. The pullback sends shares towards $68 per share, a level seen as recent as April of this year.

Underlying these returns has been incredible growth in Lululemon's operations. Between 2009 and 2012, Lululemon has quadrupled its annual revenues to $1.37 billion. Net earnings grew even faster, coming in at $270 million over the past calendar year.

Investment Thesis

Investors are unpleasantly surprised by the departure of CEO Christine Day. Analysts are suspicious as well on the timing of the decision given the problems during the quarter, as Lululemon had to recall its black luon yoga pants.

Despite the operational troubles, widely blamed on the very rapid growth rates, many applaud the way in which Day has handled the crisis. She quickly took action, as the company's product officer resigned and communicated all of this in a very transparent way. All in all, the recall cost about $67 million in sales and the famous pants are back in the stores, this after being carefully checked on quality.

This has resulted in a resilient underlying performance as the company is slightly revising its full year earnings and revenue targets upwards.

Christine Day reckons Lululemon needs a new type of CEO to lead the company in the coming five years, which will mark the international expansion of the company. Lululemon aims to export the "Lululemon lifestyle" based on its yoga product abroad.

The company sees further expansion possibilities as well within the US selling golf and tennis outfits. During the quarter the company opened two showrooms in London and one in Singapore, for a total of 51 showrooms. The company also managed to finalize the legal work in China and expects to open 3 stores in the remainder of the year.

Yet competition is not standing still. Athleta, owned by the GAP (NYSE:GPS), is stepping up as well by boosting store openings and offering yoga instructions and classes. Athleta only has 35 locations, but plans to roughly double its store count during 2013. Under Armour (NYSE:UA) is also experimenting with women's sport clothing.

Still, investors are disappointed and they should. Christine Day was running the show and has created a lot of value in recent years. It is doubtful if shares can maintain their premium valuation without her leading the business.

Valued at a steep 32-33 times annual earnings, and the departure of Christine Day, the risks are to the downside. Full year revenue growth is expected to slow down to about 20% which is still impressive. This growth does is surpassing earnings growth which is hampered by additional investments and the recalls.

With comparable sales rates slowing down and the potential impact of increased competition on net profit margins, I think the risks are towards the downside.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.