Why Lululemon is Far From Doomed

Despite what you might infer from Lululemon's 16% crash, its earnings report showed little to justify the panic.

Jun 18, 2014 at 5:30PM

If you judge it just by its share performance on June 12, you might think lululemon athletica (NASDAQ:LULU) is pretty much doomed. After all, the company released an earnings report that clearly disappointed, as the market sent shares down 15% on the day of the report.

Curiously, Lululemon's earnings report really wasn't all that bad. The company beat earnings estimates excluding a cash repatriation charge and posted growth across its key metrics including net sales, total comparable sales, and gross profit.

It's understandable if you're confused how a stock could crash so hard after earnings results that were mostly in line with expectations. The real culprit here, as happens so often, appears to be unrealistic expectations.

Heading into earnings, Lululemon was priced for near perfection. The stock sported a lofty valuation, meaning it had to do everything right to justify Wall Street's expectations. That didn't happen, and investors quickly rushed for the exits.

The same phenomenon has occurred for other athletic-apparel companies, like Under Armour (NYSE:UA)in the past. As both stocks rallied over the past year, analyst expectations kept ratcheting higher. Of course, a company can only grow so fast, especially when consumer spending remains restrained and competition is as fierce as it is.

Now that Lululemon has come down to a more reasonable valuation, better days probably lie ahead.

The dirty details
There really wasn't anything in Lululemon's fiscal first-quarter earnings report to induce such a sense of panic from investors. Net sales increased 11%, and comparable sales, which measure growth at locations open at least one year, inched higher by 1%. Gross profit jumped 15%.

Lulu

Source: Company website

Looking back further, it's clear that Lululemon is a successful business and has done well from a fundamentals perspective. Last year, net revenue and comparable-store sales increased 16% and 4%, respectively.

There are two things that jump out as possible culprits for Lululemon's dramatic sell-off after earnings were reported. First, the company lowered its full-year outlook. Management had previously expected as much as $1.82 billion in full-year revenue at the top end of its forecast. Now, the top end is reduced to $1.8 billion.

Moreover, earnings per share are expected to clock in at about $1.52 per share at the midpoint of management's expectations. That represents a 17% decline from the company's prior average expectation of $1.85 per share.

To be sure, much of this has to do with management's decision to repatriate $500 million back to the United States and the resulting tax charge. Excluding the impacts of this, Lululemon's earnings forecast was only reduced by 6%.

The second reason for the sell-off is simply valuation. Prior to releasing earnings, Lululemon traded for 24 times fiscal 2014 earnings per share estimates. In a sense, a sell-off was bound to happen unless Lululemon did absolutely everything right. When Wall Street expectations get that high, it only takes a slight disappointment for a stock to come crashing down.

This explains why Under Armour fell 10% after reporting its own first-quarter results, even though revenue and earnings per share soared 36% and 70%, respectively. Under Armour also announced a stock split and reaffirmed its full-year expectations, which call for 25% growth in both revenue and operating profit. As you can see, Under Armour is doing spectacularly well. Still, it wasn't good enough for Wall Street.

Importantly, though, Under Armour has steadily recovered since then. The market is slowly realizing the merits of its core business, and it's likely the same thing will happen with time as it pertains to Lululemon.

That's because Lululemon still expects growth this year. And, the company just announced a $450 million share-buyback program, which will also help boost earnings per share.

Foolish Takeaway
Lululemon's stock fell 15%, even though the company reported underlying growth and only reduced its earnings forecast by 6% excluding the repatriation charge. Revenue is still expected to grow this year, so the market reaction is confusing to say the least.

Lululemon isn't alone in the athletic-apparel space. Under Armour experienced something similar when it reported its last earnings report. This serves as a cautionary tale to take escalating Wall Street analyst expectations with a grain of salt. Now that the carnage is behind investors and Lululemon holds a much more comfortable valuation, it's likely this won't happen again next quarter.

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Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends Lululemon Athletica and Under Armour. The Motley Fool owns shares of Under Armour. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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