What to Make of Lululemon

If you're looking for high drama, you don't need to turn on the television. Just watch for the next interesting story to come out of Lululemon Athletica  (NASDAQ: LULU  ) . At least that has been the case up until this point.

The founder of the company, Chip Wilson, is hoping that the new appointment of Laurent Potdevin (formerly of Louis Vuitton, Burton Snowboards, and TOMS) as CEO will change that. Perhaps that's the case, but Potdevin is going to have an interesting challenge on his hands.

Not only is Potdevin a male attempting to run a primarily female athletic-wear company, but the company recently reduced its outlook for FY 2014. Furthermore, Lululemon must now compete with Gap's (NYSE: GPS  ) Athleta brand, and that's not going to be easy. On top of that, there are two interesting charts you should look at, which indicate an important trend.

Beating estimates and reducing guidance
Lululemon's third-quarter revenue increased 20% year over year, coming in at $379.9 million and beating analysts' consensus of $370 million-$375 million. Earnings per share came in at $0.45, also beating consensus of $0.41. Additionally, year-to-date comps improved 7% year over year. All would seem well in Lululand, but there might be difficult times ahead.

For the fourth quarter, Lululemon expects revenue of $535 million-$540 million, much lower than consensus of approximately $573.6 million. And Lululemon expects earnings per share of $0.78-$0.80, lower than consensus of $0.84.

For FY 2014, Lululemon has lowered its revenue guidance to $1.605 billion-$1.61 billion from $1.625 billion-$1.635 billion and its earnings-per-share guidance to $1.94-$1.96 from $1.94-$1.97.

The company cited the macroeconomic environment and execution issues for its reduced outlook. Regardless of the reasons, investors weren't thrilled, as the stock promptly sold off approximately 10% on the news.

That's what happened. Now let's take a look at why it happened.

Potential reasons for decline
As stated above, macroeconomic conditions and execution issues are partly to blame. However, you also have to figure that Gap's Athleta brand played a role. For instance, Athleta's patented Pilayo fabric is 88% nylon and 12% lycra, whereas Lululemon's luon fabric is 86% nylon and 14% lycra. In other words, they're nearly identical. Despite that being the case, Lululemon's prices are much higher, with some of its popular pants selling for $30 more than Athleta's pants.

Given today's value-conscious consumers, if they become more aware of Athleta's reduced prices, then many of them are likely to go that route. Gap generated $1.7 billion in operating cash flow over the past year, whereas Lululemon generated just $287.5 million over the same time frame. Therefore, Gap has much more available capital to reinvest in its business.

Granted, Gap has several other brands to commit capital to, including its namesake brand, Old Navy, Banana Republic, Intermix, and Piperlime. But it still has more marketing power and brand strength than Lululemon. On top of that, it's trading at just 13 times forward earnings while Lululemon is trading at 25 times forward earnings.

The good news for Lululemon is that it has established a cult following. Those customers aren't likely to go anywhere, and they don't mind paying for the brand. For them, it's also about the culture. The bad news is that now that Athleta is seeing some traction, it will be difficult for Lululemon to attract more new customers, as Atlheta might capture them first.

Of course, other reasons for declining performance at Lululemon relate to the recall of 17% of the company's yoga pants after the see-through fabric saga back in March. Now let's take a look at those interesting charts.

Important indicators
One of the best ways to determine a company's health is to see if its revenue is outpacing its selling, general, and administrative expenses. You could use revenue versus earnings per share, but this would include stock buybacks and skew the number. Therefore, using SG&A expenses is a good habit to get into if you're trying to establish long-term underlying business potential. With that in mind, first notice how Lululemon's top line outpaced its SG&A expenses over the past five years:

LULU Revenue (TTM) Chart

Lululemon revenue (trailing-12 months) data by YCharts

Very impressive, especially considering the economic environment. However, if you look at the last year, you will see a different story:

LULU Revenue (TTM) Chart

Lululemon Athletica revenue (trailing-12 months) data by YCharts

It's now costing Lululemon more money to drive its top line. That fact combined with all the drama surrounding the company makes it risky. This could change with a new CEO. Therefore, you might want to keep Lululemon on your watch list.

Gap offers more stability, but if you really want significant growth potential in the moisture-wicking fabric space, then you can also consider Under Armour (NYSE: UA  ) . Under Armour is trading at a lofty 42 times earnings, but it continuously makes its multiple justifiable thanks to its consistent top-line growth:

UA Revenue (TTM) Chart

Under Armour revenue (trailing-12 months) data by YCharts

The next time you go to a sporting event, the mall, a restaurant, or any public place, look around. There's a good chance you will see someone wearing Under Armour. And it's not just athletes anymore; it's everyone, including kids, men, and women.

The bottom line
Lululemon is facing more headwinds than in the past, primarily due to increased competition, which offers similar product at a more affordable price as well as more marketing support. It's likely that Potdevin will look to expand Lululemon's product offerings in order to target a broader range of consumers. But that's not a guarantee, and we don't know if it would be a success.

The best approach here might be to wait and see. If you want significant growth potential, though expensive, consider Under Armour. If you're looking to invest in a company trading at an appealing valuation that generates solid cash flow, has strong marketing power, offers brand diversification, and yields 1.9%, then you might want to look at Gap. 

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Editor's note: A previous version of this article referred to Lululemon's product recall as having happened at Athleta. The Fool regrets the error.


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