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The Case Against LuluLemon Stock

Suzanne McGee

Whoever said that all publicity is good publicity, as long as they spell your name right, may want to have a chat with the folks at Lululemon Athletica (LULU). It’s fairly safe to assert that the last thing the management there wanted was to become known as the company responsible for putting those ultra-sheer -- well, OK, nearly see-through – yoga pants on the market. That initial snafu early this spring was made even worse by the revelation that some stores were requiring customers seeking to return them to first demonstrate that the products were, indeed, nearly transparent by trying them on once more for the store manager’s ruling.

And yet this high-expectations stock continues to defy logic, behaving as if there had been no damage done to the brand’s image, trading at $80.76 a share, within a whisker of its 52-week high and at a PE ratio of about 43. True, the company has resolved the problem – a manufacturing defect with the Luon fabric – and the chief product officer, Sheree Waterson, has fallen on her sword, leaving the company hard on the heels of the news of the product snafu.

But Lululemon has said it expects the recall of yoga pants already in stores as well as some it was expecting to have in stores by the summer to deliver a hit to its second-quarter earnings that will be about three times as much as the $17 million hit it will take on its first quarter earnings, set to be released in mid-June. And even without these fresh headwinds, there were plenty of reasons to avoid adding Lululemon Athletica to your portfolio.

LULU Chart

At the root of all of these reasons is one big one: the company’s valuation. Yes, it is reasonable to pay up for growth – but it also is very possible that you’ll end up overpaying. It’s fairly hard to find a valid reason for paying such a lofty valuation for growth rates that – however impressive in absolute terms – aren’t what they had been. Most notably, the earnings haven’t been growing nearly as rapidly as the company’s share price. Its growth in earnings, revenue and EBITDA, however impressive in absolute terms, is underwhelming when compared to the levels they hit in 2011.

LULU Revenue Annual YoY Growth Chart

In some ways, Lululemon is reminiscent of Apple: it was an early mover in its space, helping to create demand for the kind of product it designed with flair and marketed with panache, and now its brand alone is enough to engage shoppers. The problem is that yoga pants and other sportswear aren’t like complex technology gadgets. Smartphone shoppers face one or two alternatives to the iPhone; someone looking for some athletic apparel can look to established brands that have jumped on the Lululemon bandwagon like Nike (NKE), retailers like Gap (GPS) and to upstart new brands like TerraFrog Clothing Company (another Canadian player in this space). The moat isn’t very wide. And it isn’t as if the price points are low, to inspire impulse purchases: a pair of yoga or sweat pants can set you back nearly $100.

These days, Lululemon appears likely to have to rely on opening new stores if it is to sustain growth: sales per square foot at its existing stores were almost flat in the 2012 fiscal year. But building new stores isn’t an automatic recipe for successful expansion, especially in light of the competitive environment: the one certainty is that it will send its operating expenses higher.

LULU Total Operating Expenses Annual Chart

Online sales are growing more rapidly. In the fourth quarter, which ended Feb. 3, 2013, comparable store sales climbed 10%, while online sales soared 56%. But they still made up only 16.1% of total Lululemon sales in the quarter and it is possible that those sales just mark a shift in where consumers make purchases, not an increase in sales that otherwise wouldn’t have taken place.

The hallmarks of a high-expectations stock that deserves a premium valuation aren’t immediately obvious here. The company’s business doesn’t have a particularly wide moat. Its growth rates, while still robust, have retreated from their highs. To the extent that disappointed consumers can’t pick up the pair of yoga pants they want in Lululemon’s stores until the sheerness problem is solved and turn instead to a competitor’s product, the risk is that loyalty to the brand may be weakened. A premium valuation demands not just healthy results but remarkable fundamentals, and those simply don’t seem to be in place right now.

Suzanne McGee, a contributing editor at YCharts, spent nearly 14 years as a reporter at the Wall Street Journal, in Toronto, New York and London. She is also a columnist for The Fiscal Times, and author of "Chasing Goldman Sachs", named one of the best non-fiction books of 2010 by the Washington Post. She can be reached at editor@ycharts.com.

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