Why Lululemon's Buyback Plan Is a Bad Idea

The bad news keeps on coming for athletic-apparel company lululemon athletica (NASDAQ: LULU  ) . The company's first-quarter results were disappointing, guidance was slashed, it was announced that the CFO is planning to leave the company, and Chip Wilson, former CEO and owner of 27% of Lululemon's shares, recently called out board members publicly for only focusing on short-term results.

A $450 million buyback was also announced, funded with repatriated cash, but based on the market's reaction, investors weren't thrilled. A growth company like Lululemon should be plowing its earnings back into the company, not buying back its own shares, and the move reeks of desperation. Wilson just might have a point.

Things are still getting worse
During the fourth quarter, total comparable-store sales, which include online sales, rose by 4%, while comparable-store sales excluding online sales fell by 2%. At the time, management guided for an improvement over the course of 2014, expecting total comparable-store sales to rise in the low- to mid-single digits for the full year.

This guidance was cut to just low-single digit growth after the company reported its first-quarter earnings. This may not seem like much of a cut, but it means that the best-case scenario is now that sales at the stores themselves, excluding online sales, still decline. In the first quarter, total comparable-store sales rose by 1% but declined by 4% when online sales are excluded. Lululemon is not expecting its stores to show growth in 2014, and that's a big problem.

The athletic-apparel market grew by 8% over the past year, according to NPD. While Lululemon managed to grow total revenue by 11% year over year in the first quarter, this was mainly the result of opening new stores. In existing markets, Lululemon significantly underperformed the industry, and that means that those sales went to competitors like Gap's (NYSE: GPS  ) Athleta.

Gap is rapidly expanding the Athleta brand, with plans to open 35 locations this year, pushing the total store count above 100. Gap doesn't break down Athleta sales directly, combining it with other small brands Piperlime and Intermix, but collectively these three brands grew revenue by about 24% year over year during the first quarter.

Much of this is the result of growing the number of stores, and it's difficult to determine exactly how existing Athleta stores fared. But given Gap's planned store- count increase of more than 50% this year, I think it's safe to say that things are going well.

Why a buyback is a bad idea
Retail is a difficult business, and coupled with changing fashion trends and fickle customers, the apparel-retail business is doubly difficult. Retailers of all shapes and sizes will eventually need to weather a storm, be it a recession or a temporary loss of interest in the brand, and having a fortress balance sheet is a good way to make sure that short-term problems don't kill the company.

Lululemon's $450 million buyback seems reckless; propping up the per-share earnings during difficult times is not worth weakening the balance sheet, and the $30.9 million the company spent in taxes to repatriate the cash needed for the buybacks is an expense that didn't need to happen.

Lululemon management should be focused on fixing the problems at the company's stores. Instead, they're engaging in short-term financial engineering in order to make the company's results not look as bad. The stock is near its 52-week low, but it still trades at 20 times earnings, a lofty multiple for an apparel retailer struggling to grow comparable-store sales. Shares of Lululemon aren't cheap, they just appear that way because they were so overpriced in 2013.

In 2013, Lululemon's return on equity was 25.5%. This means that for every dollar that Lululemon invested into growing the company, an additional 25.5 cents of earnings was generated. Compare this to the 5% earnings yield that is represented by a P/E ratio of 20, and it's clear that this buyback is not the optimal use of cash. There are two possibilities here. One, management may not be confident that this high level of ROE is sustainable, and that may mean that the days of rapid earnings growth are over. Or two, management is simply attempting to give the stock price a short-term boost. Either way, it's bad news for long-term shareholders.  

This isn't to say that Lululemon can't recover, and the company can certainly keep opening new stores. The activewear industry is worth about $31 billion annually, and Lululemon has only $1.6 billion in annual revenue. Lululemon's high prices relegate the company to a fraction of this market, but there is still plenty of room to grow. If stores continue to be weak, however, expenses are going to rise faster than revenue, much like what occurred during the first quarter, and the company's lofty margins will be at risk.

The bottom line
Lululemon's buyback plan is a bad idea given the problems that the company is facing, and it will weaken the balance sheet at a time when the brand is struggling. Investors are right to be upset with Lululemon, and the former CEO has a point when he claims that management is too focused on the short term.

While investors may be tempted by the stock sitting well below the highs of last year, Lululemon has yet to prove that it deserves its current valuation, let alone a higher one. At 20 times earnings, and with earning per share guided to decline in 2014, shares of Lululemon are priced much like the products that it sells.

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  • Report this Comment On June 26, 2014, at 7:53 PM, agamemnus wrote:

    Maybe they don't want themselves to become a buyout target. A company with a lot of cash is ripe for buyout.

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