Lululemon Athletica inc. (LULU), like many of the specialty apparel retailers, has seen its shares go on a tear this past year. In 2011, LULU shares are up almost 45% compared with 4% in the broader S&P 500 (SPY) year to date.
Based on our dual cash-flow, accrual and capital productivity model, LULU shares are currently 21.49% above our estimated $82.50 fair-value. Note: analysis covers the seven quarters through Jan. 30, 2011. Our full report can be viewed here (pdf).
Balance Sheet: LULU, for the most part, exhibits a very strong balance sheet. Operating cash-flow (OCF) as defined in our model indicates a widening spread when compared with cash-flows generated with accounting maneuvers.
Other signs of solid earnings quality at LULU can be seen in moderately low use of accruals and improvements in expense management and capital productivity. What’s not to like?
Valuation is our greatest concern, not the balance sheet quality or liquidity. Revenue growth has been phenomenal, averaging better than 18% sequential quarterly increases during our seven-period study. We sense that investors believe future growth rates will be even better, given the stock’s current multiple of 57 times (ttm) earnings.
In contrast, Decker’s Outdoor (DECK) is changing hands at 23 times earnings. DECK shares look extended also, but valuation on the maker of popular UGG and Teva branded footwear appears far more palatable than LULU.
In addition, LULU is the likely beneficiary of the tug-of-war with short-sellers. As of March 31, 19% of LULU’s float was held short. In momentum markets, it doesn’t take much to chip away previously established and dominant short positions. Examples of this can be seen in other momentum freaks such as Green Mountain Coffee (GMCR) or Netflix (NFLX).
As for LULU, being bearish may not be lacking merit, but being early has been costly.
The irony of margins: Investors may also be ignoring the threat to gross margins and potential impact to operating cash-flows resulting from the growing wholesale segment. Unlike retail and point-of-sale revenue, LULU recognizes sales to franchises and wholesale accounts when goods are shipped and “collection is reasonably assured”.
Accounts receivable are primarily from sales to wholesale accounts which requires management’s best estimate of probable credit losses in accounts receivable.
Although LULU’s balance sheet does not indicate problems with collections
(i.e. DSO’s) Q4 accounts receivable and inventory levels were slightly higher than the average for all periods reviewed.
(i.e. DSO’s) Q4 accounts receivable and inventory levels were slightly higher than the average for all periods reviewed.
The point being, when you add potential inflation in raw materials (see below) to a growing wholesale segment where discounting is paramount to volume sales, LULU investors may be expecting too much of the retail and direct-to-consumer to maintain their heady growth.
(Click chart to expand)
It’s always possible, but a niche lifestyle product company selling at more than nine time’s sales and over seventeen times book value won’t have much room for error. We also note that free cash-flow return on assets at LULU declined from 36% in Q3 to 29% in the latest period.
Fellow SA contributor Bret Jensen has also pointed out in several recent articles that LULU investors are paying a significant premium of market cap per store and square foot area. Investors would be wise to pay heed to his observation as Ann Taylor, if you recall, went through a similar shift in “model” and the “Loft” concept made chutney out of gross margins. When in doubt, throw it out as they say.
Input costs: Inflationary pressures are likely the greatest threat to margin expansion going forward. As you can see in the Apparel PPI data above, costs escalated dramatically in late 2010 after relatively benign increases during the previous two years.
In addition, LULU exhibits some build-up in accrued liabilities, compensation & related expenses, taxes payable and unredeemed gift card liabilities, which taken individually, don’t detract from otherwise solid financials. Collectively, they can whack a market cap to its knees.
What investors should watch for going forward: Keep an eye on adjustments to Net Income (statement of cash flow) and how they compare with changes in the balance sheet. Given the fact earnings yield in the latest period slipped almost 50 basis points, managers will need to be quite limber with their Parivrtta Surya Yantrasana (aka Compass Pose) to keep this stock afloat.
Summary:
Earnings Grade: A-
Valuation: OVERVALUED
Recommendation: AVOID
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
