Albert Einstein once defined insanity as doing the same thing over and over again and expecting different results. I remind myself of that every time I consider buying shares of a company with a nosebleed valuation. You've heard the arguments before and they always start like this "If there was ever a stock that deserves to trade at 75 times earnings, this is the one." The problem is that in nearly all cases, that was not the one. And as soon as whatever was fueling the inflated multiple (usually ridiculous expectations for future earnings growth) shows the slightest sign of slowing down, the shares collapse under their own weight and find their way back to some more appropriate valuation (say, around 20 times earnings).
Take a look at some recent examples. It wasn't an accounting probe that killed Green Mountain Coffee Roasters (GMCR) (as everyone expected), it was weak forecast for revenue growth. Similarly, shares of Netflix slip every time someone suggests subscriber growth is slowing.
To say that Lululemon (maker of high end yoga wear) has performed well since its 2007 IPO would be something of an understatement. The shares have risen from $18 to around $70 in the space of five years. The company has a curious business plan: It runs out of things on purpose (an attempt to boost demand by creating scarcity), it doesn't generally discount its products, it doesn't open new stores very often, and it doesn't electronically track customer purchases. The plan has worked. Lululemon (LULU) has reported sales growth in twelve consecutive quarters (in nine of those periods sales grew 30% or more) and recently reported a 34% year over year increase in fourth quarter profit and a 51% year over year increase in fourth quarter revenue. These kinds of numbers have fueled a 100% increase in the shares over the past year and a 400% increase over the past 24 months.
Unfortunately, all the hype surrounding the company has led to overbought conditions in its shares. The stock trades for 61 times trailing twelve month earnings and 45 times forward earnings, twice as expensive (on a price to earnings basis) than other clothing retailers. The price of the shares then, is a reflection of investors' lofty growth expectations, not of the company's fundamentals. This kind of sentiment is fine as long as the company continues to post 30% year over year gains in profits. The minute these numbers slip however, there will no longer be a reason to pay a 100% valuation premium over other retailers, and the stock could fall to levels more inline with its actual earnings.
The kind of growth LULU has experienced is simply not sustainable. In fact, the numbers are already beginning to slip. Notably, sales at stores open more than a year grew 16% in the fourth quarter of 2011 compared to 29% in the fourth quarter of 2010. While the company's most recent earnings report was stellar, the forecast it delivered was something of a disappointment. Margins slipped on higher input costs, something the company clearly expects to continue. This was indicated by the fact that while LULU's revenue forecasts for Q1 and full year 2012 beat Wall Street's expectations, the company's profit forecast for both the first quarter and the full year were below the Street's estimates.
This is disturbing because it means that LULU's profit growth could fall even as its revenue growth continues to rise. This effectively means that investors will have to pay an even higher earnings multiple to keep the shares inflated, driving the company even further into nosebleed territory.
In addition to concerns about the sustainability of its growth, some have questioned the company's policy of understocking popular items. While it seems appealing on the surface (it's nice to have customers clamoring for the latest hot offering), the idea of a clothing retailer that consistently runs out of clothing on purpose seems a bit absurd. It's one thing to create a product that people want and legitimately sell out every once in a while. It's quite another to launch a product 'intended' to stay on the shelf for two and half months and have it sell out in less than 7 days (this actually happened with 'Paris Pink' last December). Would it really be that hard (or that damaging to demand) to stock enough new items to last at least as long as the projected product life cycle? We are, after all, talking about producing yoga pants, not a complex product like an iPhone. If the company's profits slip on lower margins, it may wish it had stocked more product.
Make no mistake, Lululemon has created a wonderful business and a strong brand. The shares have simply become too expensive. As Whitney Tilson told CNBC in February "It's a fine company - but we're short because it's trading at 10.6 times sales - and 41 times earnings - and operating at 20% net margins." For the P/E multiple to come down, one of two things has to happen: Either the share price must fall, or the earnings must rise rather quickly. Don't bet on the latter happening before the former. On its investor relations page, LULU says "friends are more important than money". The company has plenty of friends, but its going to need to make some more money to justify its current share price. Short LULU or long LULU puts.
Disclosure: Long LULU puts