Lululemon Stock Warrants Caution

Summary

• Lululemon has seen its growth decelerate. Return on equity and operating margins are falling.
• LULU will need to revise down its target of achieving $4 billion in revenues by 2020.
• The company currently is having a leadership vacuum which creates a possibility of execution risk.
• Lululemon stock continues to trade at rich valuations.

Lululemon (NASDAQ:LULU) has been at the forefront of the athleisure trend. Riding on the trend, the company has managed to deliver both top-line and bottom-line beats in the last four quarters. In our previous coverage on Lululemon, back in September, we had suggested that the company and by extension, the stock, would continue to do well in coming months. The stock is up 35% since then.

Source: amigobulls.com

There is no doubt that Lululemon is a very strong brand and a good business. Also, the company's main growth driver, the "athleisure trend" is here to stay. The company has been expanding its business into new products and geographies. In the last couple of years, the total number of stores has grown by 168% to a total of 776 stores. Also, there seems to be good demand for the company's products in the overseas markets.

While the company is primarily focused on women, it is also showing strong growth in the menswear segment. The company focused on providing men with more choices in the form of design and color. Lululemon has already invested significant resources on this front. The company has released new styles of its best-selling men's ABC pants. These efforts helped it drive 26% YoY growth in comparable sales in the men's pants category.

Expensive valuation

However, we must be mindful of what price we pay to acquire a piece of this business. The latest rally in Yoga brand's stock price has led to significant multiple expansion. Lululemon stock is currently trading at a P/E of 41x, up from 30x six months ago and from 23x in the beginning of April last year. This is not only much higher than the industry P/E of 27x, it is also towards the higher side of the company's five-year average. A similar movement can be seen in the PS ratio of the stock, which is up from 2.9x in April last year to 4.5x now.

Slowing growth

This higher valuation would not be a problem if the company had seen a similar improvement in the fundamentals and the growth prospects would have been on the stronger side. But this is not the case. In the previous quarter, YoY revenue growth came in at 13%. This level of growth is not enough to justify the hefty price tag on Lulu stock. The growth in the company's EPS is even worse. EPS growth fell from 31% in Q3 2017 to -14% in Q3 2018. EPS has contracted in the previous three quarters.

Source: eMarketer

Moreover, the future is also not looking so bright when it comes to the top-line growth. More and more brands are jumping on the athleisure bandwagon. Apart from obvious competitors like Nike (NKE) and Under Armour (UAA) companies like The Gap (GPS) and Urban Outfitters (URBN) are also throwing their hats into the ring. Gap's lineup under Old Navy undercuts a lot of Lululemon's products.

Fashion houses like Dior and Louis Vuitton are also jumping on the athleisure bandwagon. Then there are niche brands like Moncler's Grenoble line and Athletic Propulsion Labs. And not to mention Amazon.com (AMZN) which is working on its own line of 'athleisure' clothing. Everyone familiar with the e-commerce giant knows that it could be a strong competitor, to say the least. The increased competition will not only affect the top-line growth but will also lead to margin compression.

For FY 2018, the company is expected to report a revenue growth of 12.8%, which is likely to fall further to 11.8% growth in FY 19. Back in 2016, then CEO Laurent Potdevin had said that the company will double its revenue to $4 billion by 2020. However, given the growth prospects, investors should expect a downward revision in this target when the company reports its FY 18 earnings towards the end of this month.

Profit margin contraction

The company is also seeing headwinds when it comes to profit margin and return on equity. Company's operating margin has contracted by 150 basis points to 15.8%. The contraction has been more prominent over the long run. The main reason for this contraction is selling and general expenditure. SG&A as a percent of revenue has risen from 32.5% a year ago to 36%. Rising SG&A implies that the company needs to make higher incremental expenses for generating incremental revenue, thus limiting the growth potential. Moreover, stiff competition from the likes of Amazon could keep profit margin under pressure. The e-commerce giant is also known for deep discounts (to grab market share). Another important metric that has suffered over the past few quarters is the return on equity which has fallen to 20%.

Lululemon has seen a dramatic expansion in its valuation multiples despite a slowdown in its revenue growth and a margin compression which is not a good sign for the stock. The fact that growth is further expected to slow down in the coming years adds to the risk in the stock.

Management risk

What's more, the company is currently without a CEO. The previous CEO was forced to leave last month because of "behavior that fell short of the company’s standards." The company is in search of a new CEO and is yet to finalize the list. New CEO is likely to have his own agenda. This adds to the execution risk of the company and could further hamper top-line growth. The management turnover at the company is concerning. Last November, Lee Holman, Lululemon's creative director, who played an integral role in improving the brand's product execution, had also resigned. High management turnover could lead to instability and loss of focus. All in all, it appears that risks currently outweigh the rewards in this stock.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

This article was written by Kumar Abhishek, an equity analyst at Amigobulls. Neither Amigobulls nor any members of its staff hold positions in any of the stocks discussed in this post. The author may not be a certified/registered investment advisor, and the opinions expressed should not be treated as investment advice. Buying and selling of securities carry the risk of monetary losses. Readers/Viewers are advised to carry out their own due diligence and consult their investment advisors before making any investment decisions. Neither Amigobulls nor the author has any business relationship with any of the companies covered in this post.