Shares of lululemon (click ticker for report: ) have been on a wild ride after the firm announced it had some issues with the sheerness of a batch of its black luon pants. Every possible pun regarding the situation has been made, so we’ll spare you from any comedic efforts, but the company had to recall an entire batch of pants for being “too see-through.” Regardless, lululemon reported a fantastic fourth quarter marked by strong revenue and earnings growth. Revenue exceeded consensus expectations, surging 31% year-over-year to $485 million. Earnings were a penny above consensus estimates, growing 47% year-over-year to $0.75 per share.
Revenue growth is clearly slowing on a percentage basis as the company deals with the law of large numbers. 31% revenue growth was lower than the 37% rate the company achieved in its third quarter, and its same-store sales growth of 10% year-over-year was down from 18% in the prior quarter. However, direct-to-consumer sales growth remains robust, up 56% year-over-year. Thus, online sales now account for 16.1% of total sales—up 260 basis points from a year ago. We assume the online business is starting to cannibalize the retail business to some extent, but the firm also does not seem to be rolling out more SKUs on a year-over-year basis, and the brand is (finally) starting to encounter pricing resistance.
On the cost-side, lululemon maintained a robust gross margin, which grew 20 basis points year-over-year to 56.5%. We believe this number is slightly unsustainable, especially after the Luon quality fiasco. Management noted that it had some creaks in its quality control process, saying:
“For the quality control, we’ve had a very standard metrics-based system for the Luon for a very long time that controls it within the environment at the manufacturer. There are a couple of gaps that we found in that, particularly in the overfeed process, which creates the fluff, that are harder to measure and really are more subjective. That’s certainly one area that we feel that we can do a better job of controlling.”
CEO Christine Day added that the firm has made some permanent QA investments, but quantifying the impact of the incremental investment on gross margin is difficult at this time.
The firm did not benefit from cost leveraging as compensation and a number of fixed costs increased (SG&A remained flat at 25.1% of sales). The company believes SG&A will increase $1 million to $2 million over the first and second quarter due to the Luon issue, and investments in e-commerce and international will lead to some further deleveraging in fiscal year 2013.
Still, it is hard to criticize a retailer than posted an operating margin of 31.4% during the fourth quarter and 27.5% for the full year. While this will almost certainly decline in 2013, we believe profitability will remain strong.
Bears are pointing to a 49% growth in inventory as a sign of weakness ($155 million at quarter end), but we believe the company is finally providing stores with ample inventory. In prior years, the firm literally couldn’t bring enough product to market, costing it millions of dollars in lost sales. Further, free cash flow generation during 2012 was wonderful, more than doubling to $187 million. Lululemon’s strong margins and relatively lean operating structure allowed the company to break the convention of fast-growing retailers, generating fantastic free cash flow.
Looking ahead, the company anticipates revenue of $1.61-$1.64 billion to generate $1.95-$1.99 per share in earnings, net of a $0.25-$0.27 per share loss from the pants debacle. Management did not give very specific same-store sales guidance, but did note that it could be high-single/low-double digits. While some may believe the company will experience consumer pushback from the see-through pants, we doubt it will have a material impact on the brand’s perception. Not only will some consumers not even hear about the issue, but lululemon’s aggressive handling of the situation could instill confidence in its consumer base.
Overall, we thought fourth-quarter results were fantastic, and we believe the brand’s reputation will remain intact. Most companies—even Apple (click ticker for report: ) and Nike (click ticker for report: )—have dealt with quality issues that had little, if any, long-term impact on the brand. Nevertheless, we believe lululemon looks fairly valued at current levels.