Don't Trust Lululemon's Management

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It often happens that a good movie can be ruined by becoming overhyped.

“Dude – you have got to go see Love Guru! Seriously the funniest movie I have ever seen. It is Mike Myers’ best performance ever. Period. Forget Wayne’s World. Forget Austin Powers. Go see it right now. Go!” 

Many of us can relate to the feelings of disappointment, sadness and anger experienced after such a letdown - not only at Mike Myers, but at your friend. You walk out of the theater wondering, “What was my friend thinking? He thought that was funny … Can I be friends with someone that thought that was funny?!?”

In the case of movies, stocks and New Year’s Eve, it is always better to set everyone’s expectations as low as possible. That way, when you only chuckle once or twice during a movie, a company’s EPS only beats by 1 or 2 cents, or you realize that the overpriced exclusive party has hand-dipped corndogs, you can be pleasantly surprised.

Setting low expectations was exactly what Lululemon’s management was trying to do on Monday, January 14. After the market closed, they released a statement that updated their guidance for the fourth quarter of fiscal 2012. The press release stated that the company now expects revenue in the high range of $475 million to $480 million and that diluted earnings per share will be $0.74 for the quarter. This sent the stock down 8% in early trading Tuesday morning.

Lululemon (NASDAQ: LULU) has mastered the art of expectations management. Management has consistently lowballed analysts while simultaneously increasing estimates throughout the year. In 2010, Lulu’s original estimate was for earnings of $1.05 per share, which was later trounced as they finished the year with earnings of $1.69. Executives pulled a similar trick in 2011, setting their initial expectations low at $1.00, but finishing the year 27% higher at $1.27.  Fiscal year 2012 is shaping up the same way. The original estimate for the year was for $1.57, their current estimate is $1.85 and my expectation is that Lulu will actually finish with EPS of $1.87, 2 cents above their newest update. See chart below.

Over the last 15 quarters, Lululemon has reported EPS that was on average $0.05 above their estimates. If you isolate the fourth quarter results, the average doubles to $0.10 above their estimates. As stated above, I expect the company will beat their own projected EPS in the fourth quarter of 2012 by $0.02 per share. This small $0.02 beat would represent year over year EPS growth of greater than 50%.  See chart below.

What analysts should have noticed about Lulu’s press release is the company’s record setting profit margin. As I stated before, management believes that revenue will be close to $480 million with earnings of $0.74 per share for the quarter. Assuming that the diluted shares outstanding will be 145.9 million, we can expect net income of $108 million for the quarter.  This will be a record setting profit margin of 22.5% for the company and only the third time that it has exceeded 20% (with the other times being Q2 2012 & Q4 2010). See chart below.
The fact that Lululemon is earning record setting profit margins of 20% or higher is even sweeter when you compare it to industry peers. In their most recent SEC filings, Nike, The Gap (parent company of Athleta), and Under Armour (NYSE: UA) all reported net profit margins below 10%. Under Armour, which is often compared to Lululemon, has struggled to produce the same high margins, even though both companies are growing rapidly and should benefit from increased economies of scale. Under Armour’s margins have been volatile, moving between 0% and 11% over the last 5 years, collapsing in first and second quarters. Unlike Lululemon, Under Armour has struggled to reduce SG&A as a percentage of sales and the seasonality of their business, both of which have taken a toll on the company’s earnings. See chart below.
These trends lead me to believe that Lululemon’s stock is a strong buy at current levels. I believe that fourth quarter 2012 revenue and EPS will both be above management estimates. I expect net revenue for the quarter to be $488 million, with EPS of $0.76 and total fiscal year 2012 earnings of $1.87 per share. If the stock continues to trade at a P/E ratio of 45, this will push Lulu to a new highs.


jacobydavidf owns Lululemon Athletica. The Motley Fool recommends Lululemon Athletica, Nike, and Under Armour. The Motley Fool owns shares of Nike and Under Armour. 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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