Lululemon Athletica Inc. In The Bargain Bin? 2014 Will Represent The High Watermark
Long Only, Value, Growth, Contrarian
Seeking Alpha Analyst Since 2013
My analysis suggests that the sharp drop off in fourth quarter sales estimates was the result of a lack of promotions during the holiday season. Fourth quarters have historically been huge for many retailers as they move into the black for the year. Yet over the past few years promotions and discounts have increase as retailers sacrifice margins for market share. With LULU deciding to remain firm on discounting (Only offering excess inventory at a discount), 2014 should see a return to normalization as the firm diversifies its product base, expands further into international markets, and puts quality control issues behind. With that said company fundamentals look stretched and if the company cannot deliver on high double digit sales and earnings growth for 2014, trouble could lie ahead. An implementation of a stock repurchase program, which I have detailed below, could boost investor confidence in the company which has struggled for much of the past year.
On January 13th management lowered 4th quarter guidance for the second time in a month to 71-73 cents from the December lowered range of 78-80 cents a share (Original expectations where for 84 cents). For the full year earnings are projected to come in at $1.88-$1.90 a share on revenue of $1.582 billion. Management highlighted a "deteriorating" start to the quarter due to sales and product execution issues. Shares sank 18% on the news as multiple analysts cut their ratings and price targets. Since the beginning of December the stock is off 34% to $47.63.
On December 12th the company announced a management shakeup that saw company founder Chip Wilson step down as Chairman of the board along with the announcement that Mr. Laurent Potdevin would become the new Chief Executive Officer (CEO), replacing Christine Day who announced her intention to depart in early June. Potdevin brings invaluable industry experience as a 20-year veteran and former CEO of Tom's Shoes.
2013 is a year the company would like to leave behind. LULU's Public Relations team has had to deal with several blunders that have caused damage to the brand's image and equity. As early as the first quarter rumors began to mount that their top selling yoga pants had quality issues (Customers began to complain that the products where see through) which proved to be a major problem effecting 17% of the company's inventory. LULU scrambled to contain the issue and enhanced quality control measures from what was originally thought to be top notch. Offering returns and exchanges to existing customers exhausted the situation but was the right move. In the fall company founder Chip Wilson made controversial comments when he said that certain women shouldn't wear the product because it was meant for women with a "gap". This proved to be a nightmare and potentially alienated many consumers. While sales are expected to increase by 16.7% for the 2014 fiscal year, it is well below last year's 36.8% increase and the 5 year average of 39.33%.
Does Lulu deserve to trade at a premium to peers?
At current levels LULU trades at a P/E ratio of 26.7. Below historical levels for the company but well above that of the apparel industry of 19X. In fact compared to the Industry Lulu trades at a higher multiple on almost every valuation metric. According to data compiled by E*TRADE Financial, LULU's P/E Ratio is greater than 89% of its peers, with its Price/Book, Price to Sales, and Price to Cash Flow at 6.61x, 4.43 and 21.76x respectively.
Ownership/Short Interest and Analyst Ratings:
Over the past year, insiders at the company have sold roughly 1,755,166 shares. While insiders can sell for many reasons the sales where committed by company founder Chip Wilson and former CEO Christine Day. At the end of the year Day held 35,232 shares while Wilson controlled 10,331,000 in a stake worth 10% of the company (This is significantly less than the reported 30% he held years ago). Understandably Day may be selling off her shares as she leaves the company, but for Wilson it could be an indication of management confidence in the stock. Looking at the insider transactions chart, we can clearly see that both executives sold at or near all-time highs despite selling additional shares after a sharp fall in the share price. While this is by no means an indication of insider trading the one fact that does stand out is that there has only been one insider purchase of shares in the entire history of the company as a publicly traded concern. On October 15th 2009 Day purchased 3000 shares (which at the time was trading around $12.75 a share). As an investor when I see management get on board the ship by purchasing shares in the open market, it gives me an extra incentive to invest knowing that they have a financial incentive at stake tied to the company's stock performance (Stock options or gifts are "free" in my view and are not the greatest incentive for management). Chart 5 labels the largest institutional owners of the stock and their investment approach. Fidelity Management and Thornburg Investments are the two largest holders with a combined stake of more than 30%. Both companies have long term investment styles contributing to stability in its shares. It should be noted that 20.28% of the company is held short (Investors betting the stock will decrease in price), while the stock is off 34% in just over a month, some of these shorts may be forced to cover if management delivers upbeat earnings driving the stock price up even further.
Lululemon has carved out a market niche in the overcrowded and competitive athletic apparel industry that is estimated to have brought in $58 billion dollars in sales last year. While Nike and Adidas are the two giants in the space, Under Armour (UA), Limited Brands Victoria's Secret (LB) and Gap Athleta (GAP), are quickly gaining market share and may prove to be the biggest competitive obstacles going forward. Lululemon has excited many investors because of its focus on yoga themed apparel, which has gained popularity among Americans over the past decade. Yet the model of "Living a stress free life" needs to shift if the company wants to continue their accelerated growth. Management will need to refocus the brand on being a more "Active" wear pioneer and leader instead of a hip "Yoga" apparel company. Recently the company announced their intentions to open stores geared solely towards men as well as the expansion of the Ivivia Atheltica brand, which is geared toward young girls. While market trends have indicated an increase in spending by males on apparel of the past five years, LULU should not loose focus on their core customers. LULU's Ivivia brand is an interesting concept, however after a quick visit of the website I have to question how many teens can either shop online and/or afford such upscale priced items. Though LULU operates eight Ivivia Atheltica stores that have shown double digit growth in sales over the past year, I do not expect this segment of the business to significantly add to the company's bottom line.
Both Under Armour and Athleta have shown that they can create high quality products at affordable prices that may attract customers away from Lululemon if they cannot expand their product offering or get production issues under control. In my analysis the company still has time to right the ship with a fundamentally sound balance sheet and ample cash position. The new CEO has experience in the "Ski and Snowboard" apparel segment which could help the company diversify its product line. One major issue hindering growth is brand awareness and marketing outside traditional avenues. With the exception of Athleta, each one of LULU's main competitors has licensing agreements or sponsors some of the largest teams and events every year. If management could secure deals with gymnastic teams it could be a huge win for Lululemon and give the company considerable international recognition.
Revenue & EPS Outlook
While revenue for the fourth quarter was originally expected to increase more than the $45-55 million or 9-11%, from the year ago quarter on flat Same Store Sales (SSS) growth, the company announced in January that it was lowering revenue estimates once more to the range of $513-$518 million on negative SSS. The nine months ending in October showed an increase of 21% compared to the same period while comparable store sales grew 7%. Historically Q4 has always showed strong growth, with gains of 30%, 51%, and 53% for 2012, 2011, and 2010 respectively, so it is expected that such a sharp reduction in revenue would be a drag on the stock. Despite expectations for negative Same Store Sales (SSS) a closely watched indicator of retail performance representing stores open for at least a year, a bright spot remains online sales which are expected to increase 11% for the quarter. Third Quarter earnings showed that "Direct to Consumer" revenue increased 39% to $165.3 million or 15.5% of total revenue for the first 39 weeks of 2013. Volatile weather in the North East could have also contributed to weak foot traffic at their retail locations. I also expect new store openings to contribute the top line. Given a basic calculation we can divide sales by the number of stores to get average sales per store. Sales for the fiscal year are expected to come in at $1,582 billion and with 247 locations we can estimated that on average each location will bring in $6,404,858. Now if management decides to open up 50 new stores over the coming year that could potential bring in $320 million in new sales (20% increase in sales).
Net Income/Earnings Per Share: (Execution is Key Going Forward):
Because of company execution and macro related issues, EPS for the 4th Quarter is expected to come in 13%-16% lower than original estimates (This is after a warning in mid-December of a 5%-7% revision downwards). Since then shares have been off more than 34%. While this was an unpleasant surprise from the company, I believe that over the next year earnings will recover substantially as quality control issues are put behind it. As I mentioned in the revenue section above, the company has been emphasizing its strong growth in online sales. Many retailers have been striving to invest online and away from traditional "brick and mortar" locations, as margins and inventory are considerably higher and more easily managed. EPS is estimated to come in only slightly above last years at $1.89 a share. This is a significant decrease from the year ago increase of 46%. Looking over income for the past three quarters we can clearly see a slowdown in revenue. However another problem is Cost of Goods Sold (COGS), which continued to increase. My analysis suggests that 2014 will be a year the company makes the necessary adjustments in order to keep costs down (albeit ensuring sales outpace COGS would also be ideal). A mixture of new locations, product lines, quality control measures, and online sales should drive the company forward.
Cash Flow (The life line of the company)
To sum up Lululemon's Statement of Cash flow for the past 5 years in one word it would be "Responsible". Management has done an excellent job of growing cash flow from operating activities while at the same time conservatively investing in property plant and equipment. Financing activities have been rather mute for the company other than small issuances of additional stock (Which are likely the result of insider sales and stock rewards). With that said however the company has historically relied on fourth quarter operating activity for the vast majority of its free cash flow. Given the likely projections from management, we can assume that free cash flow will likely remain the same as the previous year given no additional investing activity. This will translate into $187 million in FCF. While positive for the year and nearly 400% greater than five years ago, it represents a potential red flag for investors. If sales do not continue to increase, the company could decide to invest more heavily in new stores to spur stagnant growth. However warnings signs may be premature and I do not see any negative material deterioration in FCF going forward.
Balance Sheet: (Raising Debt and Hoarding Cash)
Despite a slowdown in sales Lululemon maintains a fundamentally sound balance sheet. The company's cash position will likely remain at 2013 levels when Q4 earnings are announced, while inventories have increase at manageable levels. Accounts receivables have slightly increased from $6.35 million to $12.1 million in the quarter ending October while accounts payable increased from $1.07 million in January to $4.25 million in October (Receding from $12 million during the summer). This gives the company breathing room in which they can decide to increase either account with buyers and suppliers going forward. With no long term debt on its books, the company could raise money to fund future capital expenditures or even announce a stock buyback program which would re-energize shares. This might be an attract option for 2015 if the company can manage to maintain analyst expectation through 2014. Debt financing may be less costly then equity financing (Raising additional equity dilutes existing EPS). In fiscal 2012 the company reported Return on Assets (ROA) and Return on Equity (ROE) of 30% and 37.3% respectively. My analysis suggests that the company could raise $150 million in the debt market at 4.5% (Comparable to similar debt deals for peers such as Victoria's Secret) and with the proceeds retire 2.81% of all shares outstanding. Based on the value of the shares at Friday's close, management could retire 3,151,260 shares, reducing the headcount to 142,848,740 from 146 million at the end of 2013. Hypothetical implementation of this plan last year, with net income at $271 million, would be the equivalent of raising EPS by 6 cents. If perfect execution and new store openings help increase net income by a conservative 15% to $312 million for fiscal 2014, EPS would equal $2.184 before interest expenses or $2.14 after interest expenses which are tax deferred, another benefit). The company could also use its substantial cash position to fund part of the expansion. Yet I would suggest taking advantage of low interest rates while they can.
2014 will be a pivotal year for the company. The High Water mark will either make or break investor support. The question remains whether the company can put quality control issues behind it and recover from very weak fourth quarter earnings projections from inside the company. Further product expansion will be a must in order to grow the top line as well as additional store openings. My analysis suggests that a stock repurchase program would contribute an additional 3% on conservative EPS of $2.19 for Fiscal 2014.
While I picked up shares at $49.90, I would not be surprised to see the company trade as low as the $39-$41 range before rebounding to $65 over the next twelve months (Depending on overall market sediment that could weigh on the stock). With that said Lululemon is a company that commands a premium. Though I traditional leave out of my calculations brand loyalty, it remains seen that "Yogi's" as they are called, along with superior product quality definitely should be factored into the stock price. However, after several calculations about future revenue and earnings estimates, I would recommend that investors that cannot stomach the potential volatility to stay away from this name. While I have worked off conservative growth projections, anything short of average analyst estimates of $2.27 in EPS could prove to be detrimental to my projections for the year in terms of performance. I'd start accumulating at current prices with a total portfolio position of no more than 5% in the name.
Names I rate strong buys in the apparel and retail industry are ANN Taylor (ANN), Under Armour (UA), and Burberry (OTCPK:BURBY).
Disclosure: I am long LULU, .
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