After a large sell off before the open following its report, investors would assume that Lululemon (LULU) really choked and completely missed the quarter. However, as we all know, the market isn’t always rational, and after taking some time to digest the news, it realized the third quarter wasn’t that bad at all. In fact, the stock is right where it was at Wednesday’s close, after the shares rallied around 12% the same day they got hammered.
Revenue “miss” and margin compression caused immediate dump, but there were some positives
The headline came out Thursday morning, and it wasn’t exactly what we all expected. For a company that continually crushes estimates, Lululemon’s near meaningless $5 million miss caused panic, in addition to gross margins that fell sequentially for the second consecutive quarter, to 55.8%. Same store sales also came in at “only” 16%. Revenue for the quarter managed to grow by 30.5%. Earnings improved by nearly 50%, to 27 cents a share.
However, neither of these numbers is very troublesome. On the call, CEO Christine Day informed us that sales in the current stores in Australia were up in the mid-20% range, Canada was strong (in spite of the possible Canadian contraction), and the real reason for the revenue miss was not having enough inventory to sell. The company was unable to mark-down product, with inventories so slow, which in turn adversely affected overall sales and Lulu outlet sales.
Additionally, the 170 point gross margin compression shouldn’t be much of a worry. Lululemon, like every other apparel company, faced high input costs early in the year, which have come down significantly and could end up being accretive in the first and second quarters of 2012. We are confident this compression isn’t due to lower average selling points, and we think margins will be strong in the fourth quarter with the change in product mix.
Furthermore, we were encouraged to hear the company is seeing new strength in men’s apparel, which is nearly an untapped market for the company right now, especially in the
Inventories not necessarily troublesome
Generally speaking, we tend to get worried when we see large inventory builds, which we have already identified at Under Armour. In this case, however, we think Lululemon has been unable to keep pace with demand, and think an inventory build might signal higher sales ahead.
In quarters past, as well as this one, management has signaled that supply can’t keep pace with demand. When we’ve been in Lululemon stores over the past several quarters, we’ve also noticed an inability to keep popular and styles stocked, leading to missed sales opportunities and also a bleak look in the store. Inventory for several other retailers, including competitors like Nike and Under Armour, tends to lumpy and experiences large builds for the holiday season.
Therefore, since demand has exceeded supply for the last several quarters, and with high expectations for the holiday season, an inventory build is only a negative if the company can’t sell its products. We haven’t seen any reasons why strong sales shouldn’t continue, so our outlook remains optimistic.
Trading between the $49-50 range, we think Lululemon is fairly valued. However, if the holiday season comes in as strong as expected, we think shares could trade closer to the mid-point ($68) of our fair value range. We do caution investors that high fliers with poor operations have been taken to the shed lately, which could end up hitting Lululemon, even if it’s unjustified.