On May 8, I wrote an article in which I called shares of Lululemon Athletica (LULU) "overvalued" and questioned whether the company's shares could continue to trade at nearly 50 times forward earnings. Exactly one month has passed since that article and the stock has fallen nearly 22%.
A significant portion of that decline (around 9%) came Thursday after the company reported its first quarter results. For the quarter, the numbers looked good: earnings climbed 40% and the company beat analysts' expectations on both the top and bottom line, posting a profit of $46.6 million on revenue of nearly $286 million.
Once one delves a bit deeper however, the problems are apparent. One issue is the company's policy of keeping inventory low. The idea is that if it runs out of popular products, demand will be stimulated. Of course, this is not real demand -- the company has no problem producing the products, and while intentionally understocking may artificially drive-up demand in the short-term, the strategy is patently ridiculous in the long-term. As I noted in my previous article on the company
While [running out of items] 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 ... If the company's profits slip on lower margins, it may wish it had stocked more product.
Gross margin did in fact decline, falling to 55% during the first quarter from 58.7% during the same quarter last year, while profit margin declined to 25.6% during the quarter from 27.7% in the first quarter of 2011. The company meanwhile, increased inventories in order to remedy what has happened "in the past, [when it] has been caught short on certain popular products, resulting in missed sales." The problem with the new strategy is that if sales slow, the company gets caught with more inventory than it needs, a situation which tends to worry analysts, and a predicament that is entirely contrary to its overall strategy of stimulating demand by engineering shortages.
Indeed, inventories rose to $107.7 million during the quarter compared to inventory of only $64 million at the end of 2011's first quarter -- the increase is worrisome as it "grew much more quickly than same-store sales." The company then, is stuck between a rock and a hard place: falling margins mean it must stock more inventory to ensure it does not miss sales (if you're not making as much off each sale, you must sell more), but inventory cannot rise faster than same store sales or the Street gets worried. Don't expect the pressure to moderate in the current quarter as the company sees a "comparable-store sales percentage increase in the low double digits" for the second quarter, a whopping 50% decline from the rate at which same store sales grew in the first quarter.
Adding to concerns, the company guided below analysts' expectations for the current quarter on both profit and revenue. In a demonstration of just how much investors despise lowered guidance, the stock fell more than 12% in the pre market after the announcement.
The bottom line: margins are contracting, same store sales are slowing substantially, inventories are climbing fast. None of this bodes well for a stock that still trades at 40 times earnings. Short Lululemon or long LULU puts.