Lululemon Is A Sell After Weak Guidance

| About: Lululemon Athletica (LULU)

Shares of Lululemon (NASDAQ:LULU) traded down 15% Monday morning after the company issued truly terrible quarterly guidance (press release here). Once the darling of growth investors, LULU is now struggling to maintain any enthusiasm from investors or customers. Shares are sitting at a fresh 52-week low and are down 28% over the past twelve months. Even though shares are down so much, I believe investors will be far better off taking losses and selling here than trying to buy on the dip.

For the fourth quarter, the company now expects revenue of $513-$518 million compared to previous guidance for $535-$540 million. As a consequence, EPS will now be in the range of $0.71-$0.73 from a previously forecasted $0.78-$0.80. The company said sales trends weakened appreciably in the month of January, which makes me increasingly worried about how the company will perform in the first quarter. In the fourth quarter, same-store sales are down low-to-mid-single digits.

Last year, the company reported earnings of $0.75 in the fourth quarter, so we will actually see a year over year decline in fourth quarter profitability. Full year profitability will also be slightly below last year's $1.85 at $1.80 to $1.84. In other words, Lululemon's growth trajectory has come to a screeching halt. Nonetheless, the company has a current multiple of 27.75x earnings. For the upcoming year, analysts expect the company to grow earnings by over 27% to $2.35, which translates to a forward multiple of 21.5x. I believe this analyst consensus is no longer reasonable and will be significantly lower by the end of the week.

Essentially, investors have to ask why LULU's sales trends declined so rapidly and whether those pressures will dissipate in the coming months. There were basically three reasons for Lululemon's problems in 2013. First, the company had the sheer pants disaster at the beginning of last year, which did some serious damage to LULU's brand image as the company had positioned itself as quality-centric. If there are no further mishaps, the company could regain its image, though I expect this process to take another 6-12 months.

Second, there was a significant self-inflicted wound when founder Chip Wilson essentially said fat people shouldn't wear Lululemon. This obviously led to significant public outcry and a further tarnished brand. Now, Wilson has since stepped down, and the company's new CEO has tried to make amends. While these actions should help to lessen the damage, LULU's already weakened brand took another hit and is a major reason why sales remain disappointing.

Finally, the women's athletic wear space has grown significantly more competitive over the past two years. Increased competition also exacerbated LULU's first two missteps as consumers could easily switch to different stores. Athleta, which is owned by Gap (NYSE:GPS), has made a major push in the segment, and it has grown sales nearly seven fold over the past five years from $37 million to roughly $250 million. While the company is still significantly smaller than Lululemon, its presence is growing dramatically, which is pressuring Lululemon's sales. Further, companies like Under Armour (NYSE:UA) and Nike (NYSE:NKE) are making major pushes into women's clothing to grow sales and are starting to see some success.

Women now have choice in the yoga and athletic space, and Lululemon has ceded some ground to these rivals. It remains an open question whether LULU can regain customers it lost to these companies even if its brand image heals. As a consequence, I don't expect sales to rebound as quickly as some. Other brands have stolen some Lululemon customers for good. Further with so much more competition, pricing is likely to be more competitive, which could pressure margins going forward. Simply put, Lululemon no longer operates as a quasi-monopoly; its past success has brought well-funded competitors to its market.

As a consequence, I don't believe Lululemon will be able to grow earnings nearly as quickly as previously hoped. I do expect 2014 to be mildly better than 2013 because events like the recall will fade from consumers' minds to a degree, and there are some relatively easy comps. I am looking for EPS in the $1.85-$2.00 range or about 0-10% year over year growth. Investors need to ask if they are willing to pay 25-27x forward earnings for a company that currently has negative comps and will grow earnings by about 10% in 2014.

I believe the answer is no, and that the current valuation is still unreasonable as years of 20% growth are in the rear view mirror. The sector is far more competitive, and Lululemon's brand remains impaired compared to its status twelve months ago. I would be unwilling to pay more than 20x forward earnings or about $40 per share. Until it reaches that level, investors have to sell Lululemon. Risk simply far outweighs the reward.

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.