Next time Lululemon Athletica (NASDAQ:LULU) holds a sale, maybe it should give Wall Street a heads-up.

The five-day online sale the athleisure apparel retailer launched on Thursday caught analysts unaware, and they immediately began fretting it would damage profit margins and lead to a decline in Lululemon's supposedly priced-to-perfection stock.

Woman doing yoga with a dog beside her.

Image source: Getty Images.

Overstocked and undersold

Lululemon is holding its first warehouse sale in three years, urging consumers to visit the site daily for the limited-time event because the merchandise offered will change regularly.

It's not surprising the retailer is looking to move merchandise. With stores shut down due to the coronavirus pandemic, the retailer reported inventory grew to $626 million, a 41% increase compared to last year.

Although many similarly situated retailers used the crisis to cancel orders and refuse shipment from vendors of those it had previously placed, Lululemon said it views its suppliers as partners and worked with them to manage inventory flow. Senior VP of Financial Planning and Analysis Meghan Frank said the combination of store closures and commitments to vendors "resulted in the Q1 inventory increase and will likely result in a higher increase at the end of Q2 before levels begin to moderate in the second half of the year."

Fortunately, the retailer said 40% of the merchandise was part of its core product selection, so it has a good shelf life. But that also means there's a good portion that could get stale, perhaps quickly, so holding the sale means it can still get a return on its investment.

Sufficient margin for error

While analysts say the sale surprised them, Frank had previously said Lululemon's clearance strategies have not changed. It has typically relied upon in-store markdowns, online markdowns, pushing inventory to its outlets, and occasional warehouse sales. "We currently have no plans to veer from these methods," she told analysts. So despite it having been three years since the retailer's last warehouse sale, it's not unprecedented, and it's within the channels the company uses.

Wall Street, though, is worried about Lululemon's profit margins, which naturally decreased last quarter. Gross margins slipped 2.6 percentage points to 51.3%, while operating margins plummeted 11.5 percentage points to 5%. 

After Lululemon's stock getting cut in half in March as the outbreak was declared a pandemic and its stores were closed, the company's shares have since risen by 140% and trade about 20% above where they were before the crisis struck.

But at least before the sale announcement, shareholders had seen that positive momentum continuing. Lululemon just closed on its $500 million acquisition of Mirror, a connected home-fitness company that presents the apparel retailer with a smart channel for extending its brand. 

It gives the retailer an opportunity to tap into the burgeoning home-exercise trend and provides it with cross-branding, advertising, and sales opportunities that can occur in an organic fashion. And because Mirror's upscale customers, well, mirror Lululemon's own base of health and wellness-inspired, fitness-conscious, middle- to high-income consumers, there is a big upsell opportunity that a warehouse sale over a couple of days can't derail. It also shows the retailer has more than just clothes in mind as a driver of future growth.

Worth every penny

Lululemon Athletica's stock is not cheap, going for 50 times next year's estimates and 120 times the free cash flow it produces. But the premium may be worth it since the company is an industry leader.

Its last earnings report shows it knows how to connect with its base even in a pandemic, as direct-to-consumer sales through its e-commerce site and app surged 70% from the year-ago period.

If Wall Street's worries over a few basis points of margin end up being realized when it reports third-quarter earnings and causes Lululemon's stock to fall, investors might just want to get exercised about the possibility of buying Lululemon's stock, if not its apparel and connected mirrors.