Lululemon Athletica, Inc. (LULU) has become a yoga-inspired apparel powerhouse. The company has a market value of over $11B from selling clothing items that many considered a fad.
The stock remains controversial as it trades at over 37 times forward earnings. Analysts only expect a 5-year growth rate of 27% placing the stock at the top of the acceptable valuation limits.
Q2 2012 Highlights
The company reported the following highlights for Q2 2012:
- Net revenue for the quarter increased 33% to $282.6 million from $212.3 million in the second quarter of fiscal 2011.
- Comparable stores sales for the second quarter increased by 15% on a constant dollar basis.
- Direct to consumer revenue increased 91% to $35.4 million, or 12.5% of total company revenues, in the second quarter of fiscal 2012, an increase from 8.8% of total company revenues in the second quarter of fiscal 2011.
- Gross profit for the quarter increased 28% to $155.8 million, and as a percentage of net revenue gross profit was 55.1% for the quarter as compared to 57.5% in the second quarter of fiscal 2011.
- Income from operations for the quarter increased 18% to $70.2 million, and as a percentage of net revenue was 24.8% as compared to 28.0% of net revenue in the second quarter of fiscal 2011.
- The effective tax rate for the second quarter of fiscal 2012 was 19.1% after an adjustment of $7.2 million, reversing taxes provided for in Q4 of fiscal 2011 through Q1 of fiscal 2012. This adjustment resulted from the finalization of management's review of the tax impact of intercompany pricing agreements entered into in Q4 of fiscal 2011. Normalized for this adjustment, the tax rate for the second quarter of fiscal 2012 was 29.2% compared to 35.7% in the second quarter of fiscal 2011. The tax rate in the second quarter of fiscal 2012 reflects the ongoing impact of the revised intercompany pricing agreements.
- Diluted earnings per share for the quarter were $0.39 on net income of $57.2 million, compared to diluted earnings per share of $0.26 on net income of $38.4 million in the second quarter of fiscal 2011. Second quarter diluted earnings per share normalized for the tax adjustment were $0.34 and would have been $0.31 at our previously estimated effective tax rate of 36.5%.
While the company reported solid comp store sales growth of 15%, the gross margins dropped to 55.1% from 57.5% last year. Also, while most investors viewed the earnings as beating estimates, the consistent tax earnings were only $0.31 or in line with estimates. The company did officially report normalized earnings of $0.34 when taking out a tax benefit and adding back in the lower tax rates going forward.
Another concerning issue is that the profit margin was only 24.8% in Q2 versus 28.0% last year. That sharp reduction would typically be a huge red flag especially considering that 320 basis point drop was larger than the 240 basis point drop on the gross margins.
Lots of investors see the stock as ripe for shorting and logically that has some merit, but in reality momentum stocks such as Lululemon can stay at elevated levels for extended periods. The stock price is more based on perception than reality.
Any interested investor should go back and read all the articles suggesting shorting the stock over the last year. Or read the articles about Under Armour (UA) suggesting the stock is over priced even as it hit a new 52-week high on Friday.
The time to short these stocks will be when either becomes a broken company with a disrupted story. A great example is how Research in Motion (RIMM) went from a high priced, market leader in the 2000s to a broken company when Apple (AAPL) started producing a better product. Until that happens in the apparel sector, shorts are likely to be disappointed with both Lululemon and Under Armour.
The stock trades at an exceptionally high earnings multiple considering the underlying earnings aren't growing as fast due to margin compression. Unfortunately for shorts, the effective tax rate will drop about 5% going forward providing a huge boost to earnings and masking some of the underlying weakness in the margins.
The company updated guidance for 2012 to a range of $1.76 to $1.81 versus the analyst estimate of $1.63. Most of these gains were due to the lower expected tax rate for the full year of 29%.
As analysts update estimates for next year, this will help reduce the forward earnings multiple to levels that could push the stock to new highs.
The stock just can't be shorted as long as it remains a cult stock. The lower margins and much higher inventories would normally sink a momentum stock. Lululemon though powered ahead 12.5% on Friday.
Though earnings estimates will rise for 2013, the growth rate could actually shrink going forward providing for a lower multiple. One needs to consider that Q2 earnings on a consistent tax basis only grew 19%.
Unless Lululemon is able to stabilize margins, investors will eventually gravitate to this normalized growth rate. Until then, the stock appears headed higher much to the surprise of shorts.
Disclosure: I am long AAPL.
Additional disclosure: Please consult your financial advisor before making any investment decisions.