Lululemon (NASDAQ:LULU) fell 10% after reporting its results for the second quarter. EPS was in line at $0.38, but revenue came up short by $1 million on weaker-than-expected comps. Total comps including DTC increased 4% (5% on a constant currency basis), but analysts were expecting 5.8% growth. Given that shares were priced for perfection the selloff is not a surprise. I wrote in a previous article about why I believed LULU was overvalued, but the stock has continued to climb higher (up more than 45% YTD) as the company has bucked the trends plaguing many retailers. I believe the factors I wrote about in the last article explain the weaker than expected comp in Q2, and still believe that LULU faces some major long-term headwinds. That being said, many investors view the recent sell-off as a buying opportunity, and I think it is worth examining the bull and bear cases for an investment in Lululemon.
The Bull Case:
Many apparel retailers are struggling with the shift to e-commerce and a more price-sensitive consumer, which has led to discounting throughout the sector. But LULU has distinguished itself with its popular products and loyal customer base, which has enabled the firm to maintain a premium pricing strategy. LULU's transition to e-commerce has gone relatively smoothly (DTC sales increased 16% in Q2), and menswear and international markets open up new growth opportunities. The weak comp in Q2 reflects last year's warehouse sale, which negatively impacted this year's comp by 2%. Adjusting for this, comps would have beat expectations. Just as important, the firm's supply chain and efficiency initiatives are finally paying off. Gross margin expanded 260 basis points in Q2 to 49.4%, and is set to improve y/y for the first time in 5 years. Gross margins have reached an "inflection point" according to the CEO, and are set for long-term expansion. The combination of strong underlying growth and improved profitability will support a steady rise in the stock price over time.
The Bear Case:
The deceleration in comps is the result of increased competition in the active apparel market. Despite higher pricing and higher units per transaction, traffic slowed in the second quarter, and the expectation of weak traffic through the back half of the year caused management to lower its FY16 guidance. LULU still trades at a lofty valuation that implies a substantial improvement in profit margins over the next five years. Margins are unlikely to reach the levels that investors expect for two reasons: 1) competition will continue to increase from athletic apparel retailers who possess the technological resources, expertise in product development, capital, and supply chain infrastructures to take share from LULU. As competitors floods the market, pricing will come under pressure. Fashion trends come and go, and while active lifestyle trends are a tailwind, much of LULU's strong top line performance in recent times reflects the rising popularity of "athleisure apparel" rather than an increase in the amount of people doing yoga. 2) SG&A is growing at a faster pace than revenues. In the second quarter, the SG&A rate expanded 290 basis points to 35% of sales, which caused operating margin to fall 30 basis points. Higher wages and investments in digital, IT, and branding will offset the supply chain efficiencies and prevent margins from expanding very far.
I got a lot of flack after my last LULU article, which focused on the long-term picture for LULU and some key challenges the company will face going forward. LULU's slowdown in comps suggests that some of these challenges are starting to manifest themselves. I can appreciate the bull case, and the stock could climb higher this year. But the margin of safety is still too small after the sell-off, and investors should be wary of the long-term headwinds that will make it difficult for LULU to grow margins to the levels implied in the stock price.
Disclosure: I/we 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.