At Valuentum, the primary and initial focus of our methodology is centered on calculating the long-term intrinsic value of firms based on a robust discounted cash-flow analysis (click here for a narrated, in-depth presentation on our process). We’ve written in the past about how we’re not fans of speculating on earnings releases, and we think doing so is nothing more than gambling.
Lululemon (LULU) reports earnings on Thursday, and its past post-earnings moves have been drastic. After reporting in-line earnings and modest guidance in its last report, the stock fell from $49.70 at the previous close to open at $41.94 after reporting earnings. The stock then proceeded to rally back-up to close at $47.17. That’s a lot of volatility for what turned out to be minimal movement in the stock price at the end of the day. Unless you covered your short/closed your put-option at exactly the right time, you didn’t really make money on the trade. The modest guidance was reversed in January when management reported that they actually expect earnings and revenues to surprise to the upside. The stock now trades around $73.
We’ve been bullish on Lululemon for a while, and we think earnings will probably surprise to the upside yet again. However, with the stock trading within our fair value range, and shares now trading at 44x our 2012 forecast, we aren’t too excited about the stock’s risk/reward potential at this time. Sure, the stock could easily rally after earnings, causing a short squeeze (15% of the float is short). But as we saw last time, something as minor as conservative guidance could send shares down 15%.
Even if investors were to “play” the stock with call options, they are paying a rich premium for the April duration. We think put option premiums on Lululemon are also quite expensive (despite the market’s reduced volatility), and we wouldn’t necessarily bet against a fundamentally strong company. This is something we learned recently with our now-expired Chipotle (CMG) put-options, which didn’t pan out, despite the firm being significantly overvalued.
Ultimately, we aren’t fans of taking a position in a company that experiences such high volatility on or around earnings reports. However, we think if the market dislikes another quarter of conservative guidance and shares fall, it could create a nice buying opportunity for investors that can tolerate a lot of risk. Although we like the company’s growth prospects, we aren’t likely to take a position in Lululemon in our Best Ideas portfolio, unless its shares fall below the lower end of our margin-of-safety bands, or $45 per share.