Tickers in this Article: LULU, GPS, NKE, LTD, ADDYY, AEO, KSS, ANF
You can think of Canadian specialty athletic clothing retailer Lululemon Athletica (Nasdaq: LULU) and the Street's reaction to this quarter, in this way: When you're just walking along the street and have a slight stumble or slip, it's no big deal; nobody notices, nobody cares and you probably don't even break stride. Now, imagine having that same stumble when you're on a wire fifty feet above the ground, with thousands of people staring up at you; the consequences of a mistake are a bit higher.

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Some Spots Show Up in the Third Quarter
Lululemon has gotten this far, largely on the basis of promising good growth and then delivering even better results. Not this time, though. Although 16% comps growth would be a level of performance that the CEOs of Gap (NYSE: GPS), American Eagle (NYSE: AEO) or Kohl's (NYSE: KSS) would sell a family member to get, it's not going to satisfy the Lululemon crowd, when the last quarter's performance was 20%. Moreover, sales growth of 31% was quite nice, but the company actually missed the average sell-side guess by about $5 million.

Profitability wasn't bad, though. Gross margin actually improved more than half a point; not a bad result, when so many retailers are suffering from higher fiber and freight costs, not to mention promotional expenses. Operating income rose 43% and the operating margin expanded almost two points, allowing the company to beat estimates at the bottom line. (To know more about income statement, read: Understanding The Income Statement.)

Another Inventory Story
Like American Eagle, Abercrombie & Fitch (NYSE: ANF), and frankly most other retailers, Lululemon posted a big jump in inventory at the end of the quarter. Inventory jumped 77%, or about 37% on a per-square-foot basis. That seems like a really steep jump,when the company is posted 16% comps growth and is guiding for somewhat less growth in the next quarter.

Still, a little perspective might be helpful. For starters, the cost of inventory is rising,so of course the reported inventory numbers are going to be going up. In addition, it is not at all uncommon for retailers to stock up ahead of the holidays. Retailers don't expect, though they may hope, to sell all of this, but they realize that the cost of being out of stock during the holiday season can be huge; not only does that mean a potential sale goes to Nike (NYSE: NKE), Gap or Victoria's Secret (owned by Limited Brands (NYSE: LTD)), but it also risks alienating that customer and a picked-over store is not very inviting.

Butts Vs. Buts
Even with rivals like the aforementioned Nike, Gap, Victoria's Secret and Adidas AG (OTCBB: ADDYY) trying to get their own piece of this lucrative market, Lululemon still has plenty of potential sales capacity. Simply put, people enjoy looking and feeling good and not only does Lululemon's clothing accomplish that, but it also has some brand appeal as well, despite a recent kerfuffle that had some customers furious that the company had a famous quote from an Ayn Rand novel on some merchandise.

However, there's an element of reality here, as well. Lululemon gets a lot of its sales from Canada and the Canadian economy is slowing. The retailer also boasts incredible per-square foot sales productivity and the problem is, that number is more apt to decrease than increase, as the company's brand matures and the store count increases. That's a lot of reality to fit under the umbrella of a hefty valuation.

The Bottom Line
With the market taking the stock down more than 10%, on the back of a disappointing quarter and guidance, the stock has come down almost one-third from its highs. That sort of retracement means a lot to some folks who follow technical analysis, but the trouble is that growth stocks can fall even further, when Wall Street decides its time to recalibrate its growth-valuation expectations.

I like the Lululemon story and I do think there will be a point where it makes sense to play a rebound thesis on this stock. Unfortunately, it's still really expensive and I'd rather stick to my tried-and-true valuation guns, and risk missing the rebound, than reach out my hand to grab a falling knife. (For additional reading, check out: Analyzing Retail Stocks.)

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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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