On May 8, I published an article recommending a short position in shares of yoga-gear maker Lululemon (LULU) citing slowing growth and contracting margins. Over the course of the following two months, shares of LULU fell more than 20%. On June 8, I published another article on the stock which reiterated the original short recommendation, this time adding that inventories had begun to rise sharply as the company attempted to dispel criticism that it was deliberately running out of certain items to create artificial demand. Shares had fallen around 9% the day before the second article was published after the company guided below analysts' expectations for the second quarter in its Q1 earnings report.
The pessimistic guidance paid off Friday as the company reported second quarter earnings that handily beat its own sandbagged numbers -- revenue was $282.6 million well above its top end guidance of $278 million and EPS came in at 39 cents per share also well above its own lowered guidance of 30 cents. This quarter however, the company raised its guidance for the full year both for revenue and earnings. The shares rose around 11% after the report.
Leaving aside the absurdity inherent in guiding lower in one earnings report and seeing your stock fall 9% only to beat that lowered guidance so your stock can rise 11% three months later, it is worth revisiting my original concerns about the company. Recall that LULU's forward price-to-earnings ratio (based on the upper end of the new guidance) is around 42, meaning investors are optimistic about the company's growth prospects. The company needs to continue to keep the growth story going to justify the multiple and avoid piling up excess inventory in the mean time as it tries to combat shortages while maintaining frenzied demand for its trendy products.
Knowing this, consider that same store sales continued to decline although they remained inline with company estimates. Same store sales grew 15% during the quarter, down from 20% during the same quarter in 2011. Meanwhile, inventories rose from $107.7 million at the end of April to $125.378 million at the end of July, an increase of around 14% sequentially. More importantly, inventories were only $88.9 million at the end of the second quarter of 2011, meaning inventories rose nearly 30% YOY. Inventories then, are now rising at twice the rate of same store sales. This is not a good sign.
Also, it should be noted that the company's margins are continuing to fall, albeit slowly. Both gross margins and operating margins fell during the quarter from the year earlier period and operating margins at 24.8% are barely keeping pace with the company's targets. The company attributed the lower profit margins to "increased innovation and function" -- remember, the company makes yoga wear.
When you consider the alarming rise in inventories coupled with falling same store sales and declining margins, one wonders whether investors are wise to pay 42 times earnings for the shares. Also, it is worth mentioning that the company actually earned 34 cent per share during the second quarter, not 39 cents, as a nickel of earnings was wholly attributable to a tax adjustment. In my opinion, these shares are overvalued considering the factors outlined above. I recommend shorting shares of Lululemon if you have the patience and a tolerance for some pain in the interim.