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Shares of Lululemon Athletica (LULU) took a beating in Thursday's trading session following the release of its second quarter results which were accompanied by a soft third quarter outlook.

The combination of slowing comparable store sales growth, increased competition, and a premium valuation continue to make me cautious. At the same time I refrain from shorting as the company could easily "grow" into the valuation in the coming years.

Second Quarter Results

Lululemon generated second quarter revenues of $344.5 million, up 22% on the year before. Revenues were roughly in line with consensus estimates of $343.9 million.

Net income fell slightly from $57.2 million last year to $56.5 million, as diluted earnings per share came in unchanged at $0.39 per share. Earnings came in ahead of consensus estimates at $0.35 per share.

CEO Christine Day commented on the performance, "2013 continues to be the most important and most productive year in lululemon's history. We have not only worked our way back from the black luon setback, but have also added very talented people in important functions and have taken major steps forward on a number of key fronts including the expansion of our international and men's businesses and many logistical initiatives.

Looking Into The Results..

Lululemon posted healthy 22% revenue growth supported by an 8% increase in comparable store sales. Direct-to-consumer revenues rose an impressive 39% to $49.4 million, now making up a seventh of total sales.

Gross margins were under pressure and fell by 110 basis points to 54.0% of total revenues. The lower mix of high-margin black Luon bottoms and higher inventory reserves are to blame.

Selling, general & administrative expenses rose by 80 basis points to 31.1% of total revenues. Increased expenses associated with store openings, and higher cost related to support functions are behind the increase in costs.

All in all, operating income fell by 190 basis points to 22.9% of total revenues, for still very high margins. Diluted earnings per share of $0.39 were unchanged from the year ago. Note that Lululemon's earnings saw headwinds of $0.05 per share last year.

..And The Remainder Of The Year

Third quarter revenues are now seen between $370 and $375 million, based on mid single digit comparable store sales growth. The guidance implies that revenues are up almost 18% on the year before. Diluted earnings per share are seen between $0.39 and $0.41, roughly flat compared to last year's earnings of $0.39 per share.

The third quarter guidance fell short of consensus estimates of earnings of $0.45 per share on revenues of $390.1 million.

For the full year, Lululemon now sees revenues of $1.625 to $1.635 billion. Diluted earning per share are seen between $1.94 and $1.97. Full year revenues are seen up 19%, while earnings per share are set to increase by some 5%.

The guidance is disappointing as back in June, Lululemon guided for full year earnings of $1.96 to $2.01 per share on revenues of $1.65 to $1.66 billion.

Valuation

Lululemon ended its second quarter with $610.3 million in cash and equivalents. The company has no debt outstanding for a solid net cash position.

One slight reason to worry is the 30% increase in inventories, outpacing sales growth. Yet these inventory balances seem to represent roughly 3 months of total sales, so this is not a great worry yet.

For the first six months of the fiscal year, Lululemon generated revenues of $690.3 million, which is up 22% on the year before. Net income was unchanged around $103.7 million, resulting in earnings of $0.71 per share.

Shares eventually fell 5% in Thursday's trading session, valuing the equity in the business around $7.3 billion. Excluding the net cash position, operations are valued at $6.7 billion. This values operations at 4.1 times annual revenues and 30-31 times annual earnings.

Lululemon does not pay a dividend a the moment.

Impact Of Competition

Other companies have noted Lululemon's success as well. Competitors like GAP (NYSE:GPS) and Macy's (NYSE:M) are just among the few which have placed yoga apparel into their assortment.

While this is a long term concern, Lululemon stands to enter other sports businesses including tennis and golf. With a focus on men it could also become a niche competitor to global athletic giants including Nike (NYSE:NKE) and Adidas (NYSE:ADS).

Investment Thesis

Investors are not impressed with the soft outlook for the third quarter. Third quarter comparable store sales are expected to increase in their mid-single digits, compared to 8% over the past quarter. Fourth quarter comparable sales are expected to improve again, coming in the high single-digits.

For now the company remains committed to its plan. The company plans for a reasonably slow but steady expansion of its stores internationally. Lululemon expects to show more rapid growth by driving comparable sales growth. This should be driven by the Men's business in the future, which is a far less capital intensive method to grow, and should result in solid operating leverage.

The company remains committed to focus on quality, and invest in the control processes, after getting Luon back in its stores. Lululemon has furthermore focused on the construction of its R&D center. The company also announced that it has formed a strategic alliance with Noble Biomaterials for X-STATIC. Both companies have already worked together since 2005 in creating anti-stink athletic apparel.

Including e-commerce sales, comparable store sales would have come in at 13% over the past quarter, compared to the 8% as reported. Adding to that the opening of 37 stores compared to last year, and you have decent revenue growth. The fiasco from its sheer pants and the repair measures which the company had to take are still slowing the company down, according to outgoing CEO Day.

Back in June when the company reported its first quarter results, I last took a look at the company's prospects. I concluded that the performance was solid despite the troubles with the pants recall and Day's departure.

I concluded to be very cautious as shares trade at premium valuation levels, of currently 4 times revenues and 30 times earnings. While I am concerned about slowing growth, potential competition and a premium valuation, I refrain from initiating a short position as the company could grow into the valuation.

Source: Lululemon Athletica - Remain Cautious On Premium Valuation