How Low Can Lulu Go?
Tom is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
One must commend a corporation that is able to create an empire from the sale of a seemingly simple product line that exists in a relatively fragmented industry and is not subject to any sustainable competitive advantage – preferential access to raw materials, patent protection, disproportional customer captivity combined with superior economies of scale. Female athletic apparel designer, manufacturer, and retailer Lululemon Athletica (NASDAQ: LULU), which has grown its top line by an average of more than 45% per year since January 2007, is but one of these entities that has been able to woo the market with little more than a relatively strong brand value and quickly growing consumer awareness.
Is the thesis surrounding the corporation’s growth story beginning to unwind, however? After enjoying an incredible surge to nearly $80/share (225% per year since early 2009), shares have begun to correct themselves and are down nearly 20% following Lululemon’s Q1 2012 filing. The price correction has not been driven by the retailer’s results, as quarterly revenues of $285.7 million and earnings of $0.32 per share were up 53% and 39%, respectively, and outpaced average analyst expectations of $270.9 million in revenue and $0.30 per share in earnings. Lululemon’s outlook for the upcoming quarter was the worry point. Are shares sustainable at their – albeit recently corrected – still rather enthusiastic 40x earnings (based on 2012 guidance)?
- Slower Growth
As soon as the law of large numbers begins to kick in, it becomes increasingly difficult to place such elevated multiples on a corporation’s earnings potential. Reconfirmed guidance for the 2012 fiscal year of around $1.33 billion in revenue and between $1.57 per share in earnings represents year-over-year revenue and earnings increases of 33% and 22%, respectively. The average five-year growth rate for both top and bottom line are 47% and 61%, respectively.
After a significant resurgence in comparable store metrics following the bottom out in the 2009 fiscal year, Lululemon management also expects same store sales to continue gravitating towards the high teens in time. This is by no means a metric for any established and mature retailer to be ashamed of, but compared to Lululemon’s high 20%s to 30+% comparable store sales growth in early 2010 and 2011, the decrease is disheartening. It will become increasingly difficult for investors to pay many tens of times the retailer’s earnings as competition sets in and Lululemon’s top and bottom lines continue to moderate.
Gap (NYSE: GPS) has already experienced meaningful growth in its Athleta division. Acquired in 2008, the traditional catalogue and Internet sales apparel retailer has made a swift jump into the brick-and-mortar realm. Fifty stores are expected to be in play by the end of 2013, many of which are in the high traffic areas of Lululemon’s back yard. VF Corp’s (NYSE: VFC) acquisition of Lucy and Nike’s (NYSE: NKE) own further push into the profitable women’s athletics and yoga niches only point to the fact that individual portions of the pie are being cut and distributed faster than the entire dessert is growing.
- Inventory Concerns
Lululemon has made a significant shift in its inventory strategy. Once a perpetual under-stocker of popular items to grow brand prestige and “boost demand” (even though it was simply delaying demand, not creating more), the retailer is now focusing on rapidly growing inventory levels to prevent missed sales. The focus has paid off, and average inventory levels over the past three quarters of $113.6 million are more than double the past three year average.
This would appear to be acceptable on the surface, as the reasoning is sound – consumers like choices in colors/styles/sizes, and many consumers shop on impulse and would either delay or completely eliminate a purchase if the correct item was not in stock during a shopping visit. Likewise, as general sales levels increase and more distribution channels are opened (Lululemon’s quarterly direct-to-consumer sales increased 178% year-over-year) a retailer needs more inventory on hand.
The problem with the dramatic rise in Lululemon’s inventory levels is that it is not leading to disproportionately improved performance. First, the corporation has experienced year-over-year inventory turnover declines in six of the past seven quarters. As sales have not increased disproportionately with the inventory increases over the past three quarters, the inventory turnover decline over the same time period has increased. 
The larger levels of inventory, which have been greater than comparable store sales increases in eight of the past nine quarters, have also led to an unattractive drop in margins. Gross margins dropped 370 basis points in the most recent quarter to 55%, and company management states that a heavier use of markdowns was one of the key drivers of the margin decline. The corporation will need to pushing volume to make up for the gross margin drop (especially with the combined effect of higher labor and raw material costs), so in order to maintain the level of top line growth that commands a 40x forward P/E average inventory levels will not decrease anytime soon. Based on the corporation’s lower projections for same store sales increases, Lululemon is setting itself up for a serious over-investment in inventory.
Some might see Lululemon being a relative bargain at current valuations. The 40x forward P/E multiple applied to the shares at today’s price around $64/share is, after all, a 20% sale price compared to the 50x multiple the shares commanded earlier this year in March. Despite the corporation’s commendable ability to build a fast-growing, cult-followed empire from a simple product line, the growth story already seems to be showing the signs of slowing down. Several key – well-funded – competitors have already made a legitimate stab at the product segment, the corporation has already guided towards slower growth going forward, and a dramatic increase in inventory levels appears that it may have a good chance of leading to a serious overstocking issue. The combined effect of the three points leads to an entity that is no bargain at 40x earnings, even if it has made a significant correction from all-time highs.
gibbstom13 has no positions in the stocks mentioned above. The Motley Fool owns shares of Lululemon Athletica. Motley Fool newsletter services recommend Lululemon Athletica and Nike. 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.If you have questions about this post or the Fool’s blog network, click here for information.
