Have See-Through Pants Created An Opportunity In Lululemon Shares?
For a stock with a take-no-prisoners valuation, the reaction to lululemon Athletica's (Nasdaq:LULU) sizable product recall has been quite restrained. Even with a defective batch of the company's top product taking steam out of the first quarter's comp growth, this company is still growing and seeing good success in broadening its product offerings. While there is a limit to how many missteps customers will tolerate from a company selling premium-priced products, lululemon has been relatively proactive and upfront in dealing with the issue. Although I still believe the growth expectations here are still pretty aggressive, investors who believe otherwise could see this as an opportunity to pick up shares.
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Strong Growth To Close The Year
Christmas was good to lululemon, as the company continues to be one of the hottest performers in the sportswear market.
Revenue rose 31% this quarter, helped by a 10% improvement in store comps and 56% growth in direct-to-consumer sales. As has become the norm, the company's performance was basically on target with its guidance and sell-side expectations. On the margin side, the company saw a slight improvement in gross margin (up 20bp) and a similar improvement in operating margin (20bp), as operating income rose about 31%.
I See Paris, I See France...
Management at lululemon took most of the steam out of this earnings announcement earlier in the week with a significant product recall announcement. Due to a defective product shipment of its core/signature black Luon pants and crops, the company had to pull the product. While the company is of course going to try to get product back on the shelves as quickly as possible, these pants were about 17% of the company's woman bottom business and it looks like it will take about two to three points out of the first quarter same-store sales growth number.
SEE: 5 Most Costly Product Recalls
All in all, though, I question how big of a deal this really will be. It's true that this is the company's second major product quality issue in less than a year, with the company previously having issues with bright colors bleeding in the middle of 2012. It's also true that customers expect a lot when you charge them more than $100 for yoga pants, and the product shortage (and/or frustration with lululemon's quality problems) could lead shoppers to give VF (NYSE:VFC), Gap (NYSE:GPS), or Limited (NYSE:LTD) a try.
But I think it's worth mentioning a few counterpoints. First, it's not like lululemon found the problem and tried to sell the product anyway – quite a few retailers have proven over the years that they'd rather sell the product, hope for the best, and offer refunds as needed. Second, the company has significantly broadened its product offerings, including multiple alternative styles and fabrics to the see-through Luon pants.
It's also worth noting that lululemon's rivals have been trying to cut into the company's business for a while now with only limited success. In the case of Gap, for instance, the growth in the company's Athleta brand has been similar to lululemon's recent growth, even despite the much smaller base of business at Gap. As we've seen before with Nike (NYSE:NKE) and Under Armour (NYSE:UA), it can be difficult to unseat even a premium-priced brand when the company behind the brand is committed to compelling design and product performance offerings.
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The Bottom Line
Even with the stock selling off on the news of the product recall, it's hard to call lululemon cheap or the growth expectations modest. A $65 fair value still demands long-term revenue growth of over 16% and free cash flow growth of over 20%. That means a level of free cash flow production similar to Nike and a much higher free cash flow margin. I won't call that sort of growth impossible, but it is not very common.
There are still ample avenues of growth for lululemon – including a larger store base and product line extensions across sport categories (including a recently-announced move into golf). Investors who believe we're looking at the next Nike could perhaps find some value here today, but I would prefer to seek out stories with less demanding growth trajectories.