As One Problem Fades at lululemon athletica, Another One Emerges

By Stephen D. Simpson, CFA | June 11, 2013 AAA

Even the most patient investor in lululemon athletica (Nasdaq:LULU) has to be dreading earnings release dates from this fast-growing athletic apparel company. Not only does this stock experience the normal volatility that goes with high-growth/high-expectation names (“You missed comps by a half-point? Off with your head!”), but the announcement of a major product defect (see-through pants) and now the CEO resignation have added even more turmoil.

Through all of this, lululemon has remained an impressive growth story, but maybe the cracks are starting to appear and competitors are starting to up their games as well. While I'm solidly on board with the idea of picking up growth stocks on pullbacks that don't seem related to material events, the loss of a quality CEO seems pretty material to me. Consequently, I'd be careful about piling into lululemon with the idea that a quick rebound is guaranteed.

SEE: Why A Falling Stock Is Not Always A Bargain

Solid Operating Results, For Those Who Notice|
The resignation of CEO Christine Day is absolutely the biggest takeaway from Monday's news, but the underlying earnings for the company aren't exactly trivial either.

Revenue rose 21% as reported, with 18% growth in the retail business on top of 7% comp store growth (or 6% growth in constant currency). While those results were good for a slight beat, I would take note of the 4% decline in sales per square foot – maybe it's just a byproduct of the Luon pants issue (and LULU's sales per square foot are still excellent on a peer/industry comparison), but it's worth watching. At the same time, the 42% growth in direct-to-consumer sales was a very encouraging number.

Margins are suffering some from the pants recall, but not really any worse than expected. Gross margin was down more than five points as reported, but net merchandise margins (excluding the costs tied to the pants) were down just 90bp. Operating income was down 10% and the operating margin fell six and a half points, but lululemon nevertheless reported a two-cent operating beat (half from revenue and half from gross margin).

Ambitious Targets For The Next CEO
I honestly don't know what to make of the resignation of Christine Day. I certainly hope this was not a walk-the-plank situation tied to the Luon pants issue, as that would strike as an extreme overreaction. I also don't know if it's fair to interpret this move as a sign that Ms. Day believes the company has gone about as far as it can and wants to leave while there's still some luster to the company.

What I hope, but certainly do not know as fact, is that Ms. Day is simply looking for a new challenge. It's not uncommon for executives to prefer to run companies at particular stages of their life cycle – starting a new business presents a different set of challenges from managing the initial growth phase, and managing that growth into the next phase is yet another different set of challenges and opportunities. I don't think there would be much debate that lululemon is in a transition period between that initial “hyper-growth” and a new phase that includes expanding the product assortment and geographical footprint. At a minimum, I would expect lululemon to have a wide choice of eager CEO candidates to take over the job.

Still, this won't be an easy job to walk into for the next CEO. Management has laid out gross margin and operating margin targets (55% and 25%, respectively) that will be challenging in the near-term. What's more, customer surveys would seem to suggest that companies like Under Armour (NYSE:UA) and Nike (NYSE:NKE) have significantly stepped up their game, even if a survey published by Cowen tagged Gap's (NYSE:GPS) Athleta brand with kiss-of-death labels like “frumpy”, “unsexy”, and “middle class”.

SEE: Is Growth Always A Good Thing?

The Bottom Line
Whether Nike or Under Armour choose to increase the competitive pressure on lululemon in the yoga category, they're definitely a strong presence in other markets like cycling and menswear, and it will be interesting to see the extent to which lululemon chooses to compete directly with them or tries to avoid them. While lululemon has a reputation for sexy and attractive designs, Nike and Under Armour have quality and product R&D on their side and will likely prove to be increasingly formidable rivals.

I haven't changed much about my lululemon outlook – I still model a level of revenue growth (16%) and free cash flow (21%) that will have the company at (or near) the top of the athletic apparel market by the end of the decade. Even with that aggressive scenario, fair value comes in around the mid-$60s, meaning that even with this highly negative reaction to earnings (or more likely the CEO resignation) these shares aren't exactly a huge bargain.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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