Lululemon’s Performance Is Flagging; Is It Worth Chasing After?

Source: https://www.flickr.com/photos/perspective/

Source: https://www.flickr.com/photos/perspective/

On Thursday morning, Lululemon Athletica (NASDAQ:LULU) announced very disappointing earnings, which sent shares tumbling in early trade. This is on the back of an already mediocre performance for the stock in 2014. What went wrong, and how can you avoid owning such a disastrous stock in your portfolio in the future?

If you look at the headlines that were released, it appears that Lululemon’s profits plummeted by 60 percent. However, this was mainly due to a 1-time expense because of the fact that the company is repatriating foreign profits in order to fund a stock repurchase program, which was announced in Thursday’s earnings release. So while net quarterly income fell from $47 million down to $19 million, the company’s operating income actually rose from $66 million to $70 million. Furthermore, sales rose from $346 million to $385 million.

The problem with the release was in the same-store sales data; same-store sales fell by 4 percent year-over-year. They fell by 7 percent if you don’t adjust for currency fluctuations. The increase that we saw in revenues resulted from new stores, although this wasn’t enough to appease investors. These numbers are simply unacceptable for a growth company.

Investors who have been following the company could have seen the writing on the wall for a while. Sales growth has been declining for a couple of years, and profit margins began to decline in the most recent year. This is also when we began to see the stock peak out around $80/share. With margins declining and sales growth decelerating, it is pretty evident that investors would be unwilling to pay a premium multiple for the company’s shares.

Despite the fact that the stock is down so much from its high, there is a good chance that it has further to fall. The reason for this is not so much that the company’s sales growth will continue to decelerate and that margins will continue to compress, but that investors will assume this to be the case and value the stock accordingly. With shares still trading with a premium price to earnings multiple, there is ultimately more downside to come.

But more importantly, I think there is a lesson to be learned here regarding the proper way to invest in companies that produce “cool” or “fashionable” items that are sold with a tremendous markup. These stocks can perform tremendously well as the underlying companies continue to sell more products at very high prices relative to production costs. Shares rose from $2.25 in 2009 to over $80/share at one point last year. Even if you had bought the peak in 2007, you would have paid $27/share, and you would have had the opportunity to triple your money by selling last year.

During the boom era, Lululemon was able to convince young Americans with disposable income that they should spend $100 on specialized yoga pants and/or $25 on a water bottle. This worked for a little while, but it is evident from the latest quarterly report that the trend is wearing off. People simply don’t have the disposable income or the desire to spend what they have on what many would view as frivolous items.

So what sort of investing strategy can we gather from this? Clearly there is a lot of money to be made in “cool” brands, but fashion and brand appeal is, in more cases than not, fleeting. With this being the case, you need to be very careful with these sorts of stocks. If you buy them, make sure you use a stop order to limit your losses. Furthermore, look for signs of problems such as decelerating sales growth, margin compression, or even a deceleration in margin growth. Also, try to go beyond just simply financial analysis. Visit the company’s stores, and if they are empty or putting a lot of items on sale, it might be time to get out of your position.

Disclosure: Ben Kramer-Miller has no position in Lululemon Athletica.

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