Lululemon - Bad News Continues As Growth Premium Could Erode

Dec.12.13 | About: Lululemon Athletica (LULU)

Investors in Lululemon (NASDAQ:LULU) are facing another disappointment. Following expensive product recalls earlier this year, and the departure of both its CEO and Chairman, the company is now guiding for flat comparable sales growth in the so-important fourth quarter.

Despite the modest correction so far this year, shares are still expensive, leaving investors exposed to further downside risks.

Third Quarter Results

Lululemon generated third quarter revenues of $379.9 million, up 20.0% on the year before. Revenues came in slightly ahead of consensus estimates at $376.2 million.

Earnings growth trailed revenue growth, as earnings rose by 15.4% to $66.1 million. Diluted earnings per share rose by six cents to $0.45 per share, coming in ahead of consensus estimates at $0.41 per share.

Outgoing CEO Christine Day commented on the third quarter performance, "We are proud of our third quarter results, with sales in line with our expectation and earnings ahead of our guidance and rebounding to a double digit growth rate. This so far has been a year of challenges, learning, and growth for lululemon, and while our outlook for the fourth quarter is being impacted by both macro and execution issues, I believe that the investments we are making in the business combined with the team in place create a strong platform for growth in the years ahead."

Looking Into The Results

Reported topline growth is driven by store openings as comparable store sales growth slowed down towards 5% in constant currencies. Also note that online sales continue to become more important, increasing by 37% to $62.0 million, now making up a sixth of total sales.

Despite the growth, gross margins were under pressure and fell by 150 basis points to 53.9% of total sales. The company did see modest sales leverage from higher sales, with selling, general and administrative expenses falling by 30 basis points to 29.6% of total sales.

As a result, operating earnings were still quite healthy, with operating margins coming in at 24.3% of total revenues. This is down 120 basis points compared to a year earlier.

... And Ahead

Fourth quarter sales are seen between $535 and $540 million, based on a flat comparable store sales growth estimate. At the midpoint of the guidance, revenue growth is expected to slow down to 10.7% on an annual basis.

Diluted earnings per share are seen between $0.78 and $0.80 per share, up just slightly from last year's earnings of $0.75 per share.

Analysts are very disappointed with the guidance. Consensus estimates for the final quarter stood for earnings of $0.84 per share, on revenues of $571.8 million.

Valuation

Lululemon ended the quarter with $600.7 million in cash and equivalents. The company has no debt outstanding, resulting in a solid net cash position.

Revenues for the first nine months of the year came in at $1.07 billion, up 20.9% on the year before. Earnings rose by 5.4% to $169.9 million, resulting in earnings per share of $1.16.

Full year revenues are now seen around $1.61 billion, as earnings are seen around $280 million.

Factoring in losses of 10%, with shares trading at $61 per share, the market values Lululemon at $10.7 billion, or its operating assets at $10.1 billion. This values operating assets of the firm at 6.3 times annual revenues and 36 times annual earnings.

Lululemon does not pay a dividend currently.

Some Historical Perspective

For a long time, Lululemon has been one of the momentum plays coming out of the 2008-2009 recession. Shares, which traded in the mid-twenties by 2007, fell to lows of $3 at the start of 2009. Ever since, a strong recovery has pushed shares towards $60-$80 per share, a bandwidth in which shares have traded over the past two years.

Following problems with the product re-calls, Day's departure and the weak guidance for the so important fourth quarter sales, shares are down some 20% year to date, trading at the low end of the trading range.

Between the fiscal 2009 and 2013, Lululemon is set to roughly quadruple its annual revenues towards $1.61 billion. Earnings growth has been even steeper, with earnings seen around $280 million for the year.

Investment Thesis

It has been a busy week for investors. On Monday, Lululemon announced the appointment of Laurent Potdevin as the new CEO of the company. Yet perhaps bigger news was the departure of Chip Wilson, the founder and chairman of the business. The street doesn't like it that the chairman and CEO Day are leaving at the same time, causing a modest sell-off on the back of the news.

While many retailers and investors would be happy with comparable sales growth of 5% in this environment, this is not the case for Lululemon. The company posted 18% increase in comparable sales in this period last year, and the reported number missed the 5.3% consensus estimate.

With comparable sales being guided flat for the final quarter, Lululemon resorts to store openings to boost growth. The company opened 22 stores in the quarter, compared to combined openings of 16 stores in the first two quarters of this fiscal year.

As such investors see a lot of red flags. Both the company's CEO and Chairman are leaving the firm, leaving a daunting task for incoming CEO Potdevin. The yogawear chain is still facing issues related to its recall of see-through Luon black pants, and the operational hick-ups with the company preparing for international expansion and increased competition.

Halfway through November, when analysts at J.P. Morgan issued a bullish research report on the prospects for Lululemon, I last took a look at the company's prospects. I concluded that I didn't share the optimism of analysts who placed a $84 price target on the shares, based on a re-acceleration of revenue and earnings growth in 2014. Such a scenario could result in valuation multiple expansion according to the analysts, something which I clearly doubted at the time.

The continued attention of competitors in the yoga area combined with the struggles did not warrant this premium valuation in my opinion. I concluded to be cautious given the slower growth and competition, while a short position could be too aggressive as Element could "grow" into the premium valuation if I were proved wrong. For now the operational turmoil seems greater than anticipated. As such I reiterate my conclusion. I'll stay on the sidelines with a bearish stance.

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.