Lululemon: An Earnings Preview

Lululemon (NASDAQ: LULU  ) , the yoga and athletic lifestyle apparel retailer, reports second quarter results on Sept. 12. Analysts will  want to know how the new CEO search is coming along, as well as any lingering effects from the "I see London-I see France, I see through your yoga pants" recall that hit the stock in March.

The company beat on both the top and bottom line when it reported on June 10 despite the $17 million hit it took on the Luon yoga pant recall. Christian Buss, of Credit Suisse, noted in March ,"With the black Luon pant recall Lulu has now had its fourth quality control issue in the last year."

The company reported fourth quarter earnings in March. CFO John Currie said that in addition to the $17 million loss for the first quarter, Lululemon expected "additional lost revenue of $45 million to $50 million for the balance of the year, primarily in the second quarter, spread over new and existing stores and e-commerce." (source Seeking Alpha transcript)

Then in June CEO Christine Day announced she was leaving but would stay on through a CEO search. Lululemon's stock had soared under her leadership as the company used a marketing strategy based on scarce inventory. All told, she lasted five plus years, or as long as a pair of the company's yoga pants.

It has been a tough six months for Lululemon. Analysts have lowered the bar, with several downgrades immediately succeeding the recall.

When it comes to fabric innovation, building a niche brand, growing a fervent customer base, and online marketing, few companies beat Lululemon. This shows why the stock climbed from $5 in 2009 to $50 by 2011. With Lululemon there is so much to love: community outreach through its yogi ambassadors and company run fitness events, its strong social and web presence, but sizzling growth... not so much anymore..

Earnings past is prologue
First quarter earnings showed a deceleration in same store sales increases, from 10% in the fourth quarter to 7%, but online sales grew 40% from the year ago period (85% rise in 2012) and accounted for 15.6% of revenues. Meanwhile, its gross margin dropped from 56.5% in that fourth quarter to 49.4% in the first quarter.

The torrid EPS growth rate of the last five years of 57% has now been adjusted downward by analysts for the next five years to 22.15%, befitting a maturing company. Although Lululemon has no debt, is expanding into men's and girls' lines, and opening more stores, it's not as attractive an investment as before.

The company still has the problem of an immature supply chain. Witness the Luon debacle, in which only one Taiwanese company contracts to manufacture the fabric. Analyst Sam Lee of International Strategy and Investment Group told clients, "We would really like to see the company more aggressively invest in and exercise greater control over its supply chain given the importance of quality and consistent fit to the Lulu brand promise."

Without the promise of accelerating growth, and with the market valuing sales at a 7.19 multiple and earnings at a 38.29 multiple it's hard to justify leaping back into the stock. The number of competitors has grown as well, including L Brands (NYSE: LB  ) , which owns PINK and Victoria's Secret, Gap (NYSE: GPS  ) Athleta line, Under Armour, Nike, and any number of smaller private rivals.

Did rivals take share?
Lululemon's most serious competition is Gap and L Brands, as yoga wear has become not only mainstream but fashionable. Both Nike and Under Armour's yoga wear lines are utilitarian, with little style, although they are cheaper than Lululemon.

Lululemon as a lifestyle brand is still promising, but with Gap and L Brands both offering yield and lower multiples Lululemon is more speculative, especially with its 16% short interest. L Brands offers a yield at 2.00% and price to sales lower at 1.56 than Lululemon. The market gives L Brands a trailing earnings multiple of 20.98.

Gap owns Banana Republic, Old Navy, and Gap. Gap offers a slightly lower yield at 1.90%, but its trailing earnings multiple is lower still at 14.90, and its price to sales is the lowest at 1.18. Gap also reported some of the best earnings results in retail this month.

Not only did the company guide higher, but comps were up 5% and its second quarter EPS increased 31% year over year to $0.64. They also increased the dividend by 60% from $0.50 in 2012 in time for the third quarter.

Gap opened six new Athleta stores in the quarter with 65 total open by year end. The company doesn't break down sales of Athleta individually reporting sales along with  shoe company Piperlime and Intermix.

However, CEO Glenn Murphy did speak to it on the call, "Athleta, has been a very strong success for the business and we love the marketing behind it, which is Power to the She." (source Seeking Alpha transcript)

Gross profit margin expanded by 60 bp to 40.5%. Stifel Nicolaus liked what they heard well enough to maintain their Buy and predict double digit EPS growth for several years.But don't buy Gap because of Athleta; it is only a tiny fraction of revenues.

L Brands reported second quarter results of a 22% rise to EPS year over year, a 2% rise in comps, and raised its guidance. While Gap is a better buy, PINK is a threat to Lululemon, as its sales of casual yet feminine workout clothes, underwear, hoodies, and accessories have skyrocketed among the collegiate to young millennial set. So much so that the company opened 50 freestanding PINK stores this year, and it is increasing capital expenditure to increase PINK square footage at open Victoria's Secret stores.

What to expect
The Luon pants recall hit is already baked into the second quarter numbers, so analysts will want to see if competitors were able to take market share from Lululemon.

Buying before earnings would only be gambling, so wait to hear what the company says. Lululemon will still grow faster than these other two over the long term, but likely won't grow like it used to.


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