Lululemon CEO's Decision Trumps a Promising Outlook

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

Lululemon Athletica (NASDAQ: LULU) is back from pants down as it resumed the retail of the controversial see-through yoga pants, following a recall in March. Analysts had projected a negative impact on the company’s revenue for the quarter, but the Canadian company romped past its estimates in its most Q1 2013 results. However, it is the news that the current CEO, Christine M. Day, would be stepping down as soon as a replacement comes through that weighed much on the company’s stock price in after-hours trading.

The company’s shares fell by as much as 14% from the day’s close of $82.28 following the announcement. It is not clear whether there is a link between the CEO’s decision to step down and the see-through pants fiasco, which prompted the company to recall about 17% of its black luon pants for being too sheer in March. However, the problem is now fixed and the pants are back in stores. During the company’s earnings conference for the Q1 2013 results, Christine Day said:

The plans have been laid for the next five years and a vision for the next 10 years. I feel that the timing is now right to bring in the next CEO candidate who will drive that 10-year vision. The board has formed a search committee and its executing a CEO succession plan. Well I will continue to lead the team until a successor is named to ensure [a] smooth transition. In keeping with our efforts to be open and transparent, we are announcing this today, so that the board can openly search for the next CEO.

The highlights of the company’s Q1 2013 results

The company’s net revenue increased by 21% year-over-year to $345.8 million, as compared to $285.7 million reported in Q1 2012. Same-store sales grew by 7%, excluding those locations that are less than one-year old. Earnings were a little flattish, increasing from $46.6 million or $0.32 a share to $47.3 million or $0.32 per share. This came below the company’s guidance of approximately $0.34 per share.

The company’s gross margin also declined from 55% to 49.4% year-over-year following the luon pants saga. The company’s CFO, John E. Currie, noted, The factors that contributed to this 560 basis-point decrease in gross margin were the $17.5 million write-off of un-sellable luon that did not meet our standards, which had a 510 basis-points impact on gross margin.”

It takes a single decision

The production of the see-through luon pants marks Lululemon’s biggest failure in quality control in its entire history. Additionally, the decision to recall the pants seems to have irked some of the brand's renowned shopaholics. According to reports, a shopper who once spent as much as $15,000 on a shopping there, revealed her embarrassment at Christine Day’s decision to recall the pants.

Day has ruined everything special about lululemon. The bullet-proof quality, the fit, the femininity, the lululemoness of the product," Beauchesne wrote in March. "She is a one-trick pony who grew the company through expansion.

I can only imagine how many more customers were disappointed at Day’s decision to recall the “too sheer” luon pants. However, according to the stock’s performance following the announcement of her imminent exit, it seems as though investors value her reign more than customers. Such is the difference between the two sets of parties with regard to Lululemon.

Personally, I concur with the investors. During Christine Day’s five and one-half year period as CEO, the company has rallied by more than 400% in market value. She steered the company to opening more than 200 new stores during her reign from a paltry handful.

This achievement will not only prove difficult to beat, but may also be challenging to match for whoever takes over. The company has began searching for a replacement, which makes her stay in office indefinite, but it will be interesting to see how it goes about it.

Favorably though, the company has already laid down the strategy for the next five-to-10 years, which might lessen the burden for the next CEO. The company also ticked its guidance on sales and earnings, which also seems to promise an impressive finale to Day’s five and one-half year period.

Competition

Lululemon competes in an industry dominated by two sporting giants, Adidas and Nike (NYSE: NKE), while Under Armour (NYSE: UA), the smallest among the four companies, is also not to be ignored. The Baltimore-based textile and apparel-clothing company tramps the likes of Nike in terms of gross margins, with 48%, the same as Adidas, while Lululemon boasts of the best gross margin for the trailing-12 months at 56%.

With an increase of 21% in net quarterly revenue year-over-year, Lululemon comes second best after Under Armour, which grew its most recent quarter's revenue by 23% from last year. On the other hand, Adidas' revenue declined by 2%, while Nike’s was up 9%. Lululemon again boasts of a massive upside in terms of operating margins, with 27%, which easily tramps Nike at 12%, Adidas 8%, and Under Armour 10%.

Nike's portfolio is quite diversified as compared to Lululemon and Under Armour. The company has sponsored several footballing clubs, in providing sportswear, as well as boots. With sponsorship deals tied with clubs such as Manchester United, and major football stars, the company's marketing campaign can only be challenged by Adidas, another giant sportswear manufacturer. 

Nike has more than $4 billion worth of cash, and a debt of $321 million; this makes its balance sheet one of the most impressive among its competitors. Nike's current ratio stands at 3.4, while Under Armour's is pegged at 4.3. However, Lululemon's stands out at 5.9. With a forward P/E of 20.1, Nike looks promising going forward, as compared to Lululemon's 32, and Under Armour's 32.4.

Valuation

With a trailing 12-month P/E of 44.5 times, Lululemon seems to be expensively priced as compared to Nike 24.6 times and Adidas 32.2 times. However, when we factor in the earnings growth rate, Lululemon is actually the cheapest among the four companies, with a PEG ratio of 1.8 times as compared to Nike’s 2.1 and Adidas’ (2.6) times. Under Armour, on the other hand, holds a P/E ratio of 52.8 times and a PEG ratio of slightly less than 2.0 times.

According to Lululemon's projection of about $2.00 in full year 2013 EPS, and based on Monday’s closing price of $82.28, its six-month forward P/E is about 41.1 times. The company’s EPS projection for full-year 2014 is about $4.50, which it believes to be within reach. This would imply a forward P/E for FY 2014 of 18.3, contrary to the current figure of 32, which presents a massive upside for the stock. 

The bottom line

There is no doubt that Lululemon's fundamentals are impressive, but the decision by the CEO to step down, regardless of whether it was due to pressure emanating from the luon pants saga, or it is indeed time as she said is worrying. Continuity is always important, especially when the company is doing well, and hence this casts a cloud of doubt on performance depending on whoever takes over from Day.

This is the reason why investors are pulling out, but the slump could yet create the best opportunity to buy Lululemon. The general outlook provides a good upside, if the CEO’s departure does not end up affecting performance. I expect Lululemon's stock to slide further for a couple of weeks before it stabilizes and then takes off for another rally.

Lululemon has the potential to grow its sales by 10 times if it can penetrate its other markets like it has in Canada, but the competitive landscape is starting to increase. Can Lululemon fight off larger retailers and ultimately deliver huge profits for savvy investors? The Motley Fool answers these questions and more in its most in-depth Lululemon research available. Thousands have already claimed their own premium ticker coverage; gain instant access to your own by clicking here now.

.


Nicholas Kitonyi has no position in any stocks mentioned. 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!

blog comments powered by Disqus