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Lululemon Athletica Keeps Recovering But Faces Challenges Ahead

By Dan Caplinger - Sep 10, 2015 at 8:28AM

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The yoga-apparel retailer delivered another solid report, but guidance was discouraging.

Image: Lululemon Athletica.

It takes years to build a good reputation, but only a single miscue can destroy it. That's something that yoga-apparel retailer Lululemon Athletica (LULU 1.04%) has struggled with in recent years, as the company has worked hard to recover after quality-control issues arose with its products. Coming into Thursday morning's fiscal second-quarter financial report, Lululemon investors were excited about the retailer's progress toward a full recovery, and the latest quarterly results largely supported the bullish thesis on the stock. Yet some concerns about future guidance initially sent Lululemon shares lower and could have more dramatic implications on long-term growth. Let's look more closely at how Lululemon did this quarter and whether investor nervousness is justified.

Lululemon looks upward
The pace of Lululemon's sales recovery continued its impressive upward trajectory. Overall revenue climbed 16% to $453 million, which was quite a bit higher than the 14% growth rate that most investors were looking to see. Total comparable sales including direct-to-consumer and retail operations jumped 11% on a constant-currency basis, accelerating from last quarter's 6% pace. On the bottom line, Lululemon's results weren't as obviously impressive, with net income inching downward by 2%. Yet earnings of $0.34 per share were up a penny from the year-ago quarter and also topped expectations for flat performance for the quarter.

A closer look at Lululemon's results showed some more positives about its recent performance. Direct-to-consumer revenue soared 35%, emphasizing the importance of the yoga retailer's efforts to use all of its sales channels effectively. Yet even in the retail stores, which have lagged behind online sales growth, comparable-store sales growth of 6% on a constant-currency basis was a lot more favorable than the slight decline last quarter.

Nevertheless, Lululemon does still face some considerable challenges. Margin pressure continued to mount during the quarter, with gross margins falling by almost four percentage points and operating margins declining from 17.4% a year ago to 14.7% in the most recent quarter. Cost-cutting measures have helped somewhat, but they were insufficient to stem the troubling margin declines.

Nevertheless, Lululemon CEO Laurent Potdevin was happy with the latest quarter's performance. "We exceeded our revenue targets for the past quarter," Potdevin said, "supported by strong performance from both our store and e-commerce channels." Potdevin also noted how well the company's management team is doing at meeting its strategic goals, which is a vast improvement from the somewhat chaotic behavior seen in past years.

What's next for Lululemon Athletica?
Looking forward, Lululemon sees plenty of opportunity for further growth. In Potdevin's words, "As our momentum continues to build, we are excited by the progress made with our international expansion, the launch of our new women's pant wall last week, and successful brand-building events occurring around the globe."

Unfortunately, Lululemon's immediate guidance didn't live up to the high expectations investors have for the retailer. For its fiscal third quarter, Lululemon expects to see earnings of $0.35 to $0.37 per share, which would be a big miss compared to the $0.43 per share consensus figure among investors following the stock. Sales of $477 million to $482 million would be squarely in line with expectations, but the combination of guidance indicates Lululemon's continued worries about its ability to convert revenue into bottom-line profit by keeping margins wide.

Investors also didn't seem terribly enthusiastic about slight upgrades to Lululemon's full-year guidance. For fiscal 2015, Lululemon expects earnings of $1.87 to $1.92 per share, which was a penny higher than last quarter's guidance. The company also narrowed its revenue range to the upper end of its previous range, expecting sales to be between $2.025 billion and $2.05 billion.

Still, Lululemon itself remains confident about its stock's prospects. The company bought back another 1 million shares during the fiscal second quarter, paying an average of just less than $64 per share. The repurchases helped Lululemon boost its earnings per share despite slight downward movements in net income.

Overall, Lululemon investors reacted unfavorably to the report, sending the stock down more than 5% in the first two hours of pre-market trading following the announcement. Given the strong gains that the shares have posted so far this year, this morning's declines are only a small setback, but it's unclear whether Lululemon can get back its positive momentum going into the key holiday season. With so much at stake, investors will have to watch Lululemon closely in the months to come to make sure it can keep up the work that has once again made it a relevant player in the athletic apparel space.

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