Lululemon Premium Could be Deflating

Chris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Lululemon (NASDAQ: LULU) shares may have peaked. After hovering at the $75-level on at least 6 occasions in the last 6 months, shares finally dropped recently as Lululemon declined 11.5% for the quarter.

Why Shares Declined

Shares of the premium yoga clothes maker declined because investors are worried competition is heating up. Retail and apparel companies want to enter Lululemon’s niche market. The rival companies are lured by the high per square foot revenue, which is comparable to that of Apple--Lululemon generates $1,900 of revenue per square foot of retail space.

There are 6 things to consider in evaluating Lululemon’s current product and stock price premium over other retailers.

1) Potential Competitor: Gap

Gap (NYSE: GPS) is one possible threat for Lululemon, but for Gap to compete effectively, it must build a loyal customer base for the niche product from scratch. Gap would also need to differentiate itself and to win over Lululemon fans. This seems unlikely.

The lower valuation in Gap shares compared to those of Lululemon widened after Gap’s CFO Sabrina Simmons stayed on track with buying back $1 billion in shares. In the fourth quarter, Gap bought back 17 million shares, or $539 million. Gap reports earnings on Feb. 28 after the market closes. Investors should expect results to be reasonably solid: December retail holiday sales for the sector rose 0.5%.

In the premium space, Gap is diverging towards the luxury space, which would limit the competitive threat for Lululemon. Gap said earlier this year that it would acquire Intermix for $130 million. Intermix has only 30 stores, but would give Gap an edge in identifying new fashion trends.

2) Comparison to Another Premium Brand: Michael Kors

Michael Kors (NYSE: KORS) gives Lululemon shareholders excellent insight in the power of premium brands, along with issues that may arise. The premium handbag maker generates strong margins. Lately, fear is increasing that Kors needed to offer discounts to increase sales. When Kors reports on Feb. 11, profit margins will be watched closely. In 2013, Kors could expand into newer product categories, which would lower its dependence on handbags.

Lululemon has an even bigger challenge than that of Kors for growth. Growing its Athletica business in the U.S. could hurt profit margins. International growth could be tricky. Operational challenges could lead to a slower overall growth in sales.  

3) Previous Earnings Still Strong

In December, Lululemon reported quarterly earnings of $0.39 per share, beating estimates by $0.02 per share. Revenue rose 37% from the previous year to $316.5 million, beating estimates by $11 million. Lululemon said during its conference call that global growth plans are still on schedule.  The retailer plans to look at 15 or more geographies for expansion. Since line-ups are still long at its existing stores, investors should anticipate strong initial consumer interest in places like Hong Kong.

4) Current Quarterly Guidance Weak

For the quarter ending Feb. 3 2013, Lululemon guided quarterly revenue of between $475 million and $480 million. Earnings will be $0.74 per share. More worrisome is the fact that gross margins will not exceed expectations, despite inventory being at a “clean inventory position.”

5) Bearishness Increased

Short-selling rose by 1.64 million shares at the end of 2012, and short-interest was 14.78 million shares by Dec. 31 2012. Speculators bet correctly that the company had little room to miss heightened expectations.

6) Valuation

Lululemon is trading at a P/E of 41 and a forward-P/E of 32. Similarly, a premium brand like Michael Kors is valued at a P/E of 43 and a forward P/E of 40. Gap is valued at a P/E of 16.

Share Price and Forward P/E (or “Price of Profit”):

 

<img src="/media/images/user_15008/lulu3_large.jpg" />

Chart Source: Kapitall.com

Conclusion

The slight miss in analyst expectations is already priced into shares of Lululemon. Additional competitive threats are unlikely to surface at this time, given that existing stores have low inventory, high sales, and healthy line-ups. Lululemon is not a stock to buy, however. The company is richly valued, and the company must grow at the same rate internationally to support growth. Conversely, Lululemon would have to increase sales at its existing stores, which does not appear likely. Investors who missed Lululemon’s last run-up could look to accumulate the stock after the lower pattern reverses.

Conservative investors should wait until after the March 2013 quarterly report before committing to Lululemon shares.


chrispycrunch has no position in any stocks mentioned. The Motley Fool recommends Lululemon Athletica. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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