Seeking Alpha
Recommended for you:
Long/short equity, special situations, value
Profile| Send Message|
( followers)  

Shares of Lululemon Athletica (LULU) ended Friday with losses of 7.5% on the lack of any company-specific news. The 1.7% correction in the S&P500 seemed to hit a lot of recent high-fliers, including Lululemon.

Despite the correction on Friday, shares already returned almost 50% in 2012. Is this just a correction in the uptrend, or is the valuation bubble about to burst, providing investors with an interesting short opportunity?

The company is due to release its third quarter earnings on November, 26. Ahead of this earnings release, let's investigate how the market values this company ahead on the back of some of its historical results. Furthermore, it should be noted that a lot of companies noted consumer weakness when presenting their third quarter results over the past week.

Second Quarter Results

On the 7th of September, Lululemon reported its second quarter results. Lululemon reported a 33% increase in second quarter sales to $282.6 million. The growth represents a notable slowdown of the 53% year-on-year growth rate in the first quarter. Comparable sales growth slowed down from 25% in the first quarter, to 15% in the second quarter.

Direct-to-consumer revenues rose 91% to $35.4 million in the second quarter. In the first quarter direct-to-consumer revenues rose 179% on the year to $38.4 million.

Gross profits rose 28% to $155.8 million. Gross margins came in at 55.1% for the second quarter, down 240 basis points on the year. In the first quarter of 2012, gross profits came in at $157.3 million, or 55.0%. First quarter gross margins fell 370 basis points on the year.

Second quarter earnings came in at $57.2 million, or $0.39 per share. This compares to first quarter earnings of $0.32 per share, and second quarter earnings of $0.26 in 2011. At normalized tax rates, second quarter earnings came in at $0.34 per share.

CEO Christine Day commented on the second quarter results,

We continue to strive for the right balance between strong growth and maintaining our market leader focus on execution, innovation and investments in infrastructure and while doing so delivered another strong quarter.

Outlook

For the third quarter of 2012, Lululemon expects revenues of $300-$305 million. This guidance assumes sequential revenue growth of 7.0% at the midpoint of the range. On an annual basis, revenues are expected to rise by 31.4%. Comparable sales growth is expected to slow to low to mid-teens on a constant dollar basis.

Earnings per share are expected to come in between $0.34-$0.36 per share. This compares to normalized earnings of $0.34 per share in the second quarter, and $0.27 in the third quarter of 2011.

For the full year of 2012, revenues are expected to come in at $1.345-$1.36 billion. This implies fourth quarter revenues of $482 million, for the very important holiday season quarter. The revenue guidance, implies a year-on-year growth rate of 30%.

Full year diluted earnings per share are expected to come in between $1.76-$1.81 per share, or roughly $260 million. This implies fourth quarter earnings per share of around $0.72 per share, at the midpoint of the guidance. Fourth quarter earnings per share are set to grow some 41% on the year.

Valuation

Lululemon ended its second quarter with $444.3 million in cash and equivalents. The company operates without any debt, for a comfortable net cash position. Sales for the first half of 2012 came in at $568.3 million. The company net earned $103.9 million, or $0.71 per share.

The market currently values Lululemon at $9.95 billion. Excluding the net cash position, the market values the operating assets at $9.5 billion. Based on the company's full year outlook, this values the firm at 7.0 times annual revenues and 37 times annual earnings.

Lululemon currently does not pay a dividend.

Some Historical Perspective

Year to date, shares of Lululemon have risen some 48%. Shares started the year at $47 per share and rose to $80 in May on the back of a strong first quarter outlook. A weaker second quarter outlook send shares back down to $55 in the summer. A strong third quarter guidance send shares back up to $78. After a correction last week, shares are exchanging hands at $69 per share.

Over the past five years, shares fell from $25 in the end of 2007 to lows of $2-$3 in the beginning of 2009. Shares then steadily rallied to all time highs of $80 earlier this year. Between 2008 and 2012 the company grew its annual revenues from $353 million to an estimated $1.35 billion in 2012.

Annual revenue growth accelerated from 28% in 2009 to 57% in 2010. Revenue growth slowed down to 40% in 2011 and an estimated 35% in 2012. Growth has slowed down to roughly 30% per annum based on Lululemon's third and fourth quarter guidance.

Earnings growth rose 48% in 2009 and by more than 100% in 2010. In tandem with slower revenue growth, earnings growth slowed down to 51% in 2011 and an estimated 41% in 2012. Earnings growth outpaced revenue growth over the past years, boosting net profit margins from 11.1% in 2008, to an estimated 19.3% in 2012.

Investment Thesis

Obviously competition will put a cap on ever expanding net margins. Let's look at a base-case scenario. I assume that net margins would be capped at 20% and revenue growth slows down to 25% for 2013 and 2014. By the end of 2014, Lululemon would generate annual revenues of $2.1 billion in 2014, on which it could earn $420 million. This values the firm at 4.5 times annual revenues and 22-23 times 2014s earnings.

I think that the risks are obviously towards the downside. I think that revenue growth could slow down to 15% for 2013 and 2014. As such, revenues would total $1.8 billion in 2014, and net margins could compress to 15%. As such, net profits could come in at $270 million which is similar to the expected net profits of $260 million in 2012. I don't think that a valuation of 35 times annual earnings is sustainable in such a scenario. I think that a pull back towards $40-$50 could easily materialize if the company misses on third quarter earnings, possibly accompanied by a cautious guidance for the holiday season.

Not convinced about the impact of a modest growth slowdown in growth on stock prices? Just ask shareholders in Chipotle Mexican Grill (CMG) who have seen their investment having lost 45% from the highs earlier this year. The main reason behind the fall, is a decline in same store sales growth from 12% in the begin of this year, to a standstill at the moment.

I think the short side has the best risk-reward scenario in case of Lululemon. Unfortunately I have done this analysis after Friday's drop. I am hopeful that the market gives me another chance to sell shares around $75 mark in the coming week.

Source: Lululemon: Why I Hope The Market Gives Me Another Chance To Short At $75