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Lulu Short-Sellers Got Their Payday, and You Could Be Next

Robert Weinstein

NEW YORK ( TheStreet) -- Lululemon Athletica Christine Day's timing on announcing her departure as CEO wasn't by accident. By revealing her resignation first, the company had hoped that its report of decent quarterly results would overshadow her loss, or at least provide damage control. Lulu is developing into a strong buy, but not just yet. First, allow me to describe why short-sellers may want to take the money and run.

Just announcing earnings of 32 cents a share, a beat by 2 cents, wasn't enough. The rest of the earnings followed along a similar path. All in all, it wasn't bad, but ho-hum in relation to the bombshell dropped earlier.

Speaking of bombshells, it appears investors were shell-shocked and totally missed Day describing Lulu's international progress. Last quarter's results were an exceptionally successful accomplishment, and short-sellers had better take note also. In China, for example, Lulu expects to have three retail locations open by the end of the year. Using what we know about China's luxury goods market from brands, including Coach and Tiffany , we can expect very good things.

Coach receives about one-third of its revenue from sales outside North America, based on the latest earnings announcement in April. China sales are strong, growing about 40% year over year.

Tiffany's China success story offers greater bullishness for Lulu's expansion plans. Tiffany expected sales in the Middle Kingdom to be up 20% before adjusting for currency depreciation (resulting in a tepid 2%).

According to the earnings call, Lulu expanded international operations in retail and online. Notable locations include new retail locations in London, Berlin and Singapore. Lulu's expansion materialized while growing net revenue 21%, compared to first-quarter 2012. Gross margins slipped from 55% of net revenue to 49.4%, a trend on which investors will want to keep an eye.

When reading financial statements and listening to earnings calls, I expect some margin squeeze during a period of rapid expansion. Apple is a superb example. After it introduced more new products than it had in any previous quarter, its margins contracted, and investors without their eye on the ball may have thought that Apple was experiencing price pressure to maintain market share. The Comscore numbers suggest, however, that Apple continues to increase its market share. International expansion is rarely cheap, and for luxury brands, it's expensive. It's a testament to Lulu's leadership that they are able to grow their base and the bottom line simultaneously. The short-sellers have the best of it right now, but the ground is shifting under their feet. The panic selling will subside within a day or two, setting up a buying opportunity.

The rule on the street is that it takes three days of selling to wash and rinse out all the weak hands. The first event is a gap lower, followed by two days of unrelenting selling. It's a painful process, but if you have the patience and composure to watch it play out, late Wednesday or Thursday offers the best risk/reward ratio, based on historical norms.

When the news is a one-time event, such as the departure of a CEO, a recovery tends to proceed ever faster. Based on this information, scaling in later Wednesday compared to waiting until late in the day Thursday and or Friday, may give better results.

I wouldn't be the risk-hedging advocate I'm known as if I didn't mention writing put options as a strategy. Selling puts allows you to capture a slice of the market fear while lowering your overall risk. Starting late Wednesday, if Lulu shares continue declining, look to sell $60 strike September puts. Investors can lower the total risk of exposure by 15%. At the current option premium price of $2.42, your downside risk is reduced to $57.58 a share and as long as Lulu is trading above $60 on expiration day, you can expect a 4% gain on your capital in about three months.

If Lulu does fall below $60 and you're exercised, you can decide if you want to keep the shares (and possibly write call options against your stock), or close out the position. As you can see, your potential loss using options is much lower than if you had bought the shares outright.

If you want exact entry and exit points with timing, be sure to watch my Real Money Pro feed as I update my thoughts in in real time.

At the time of publication, the author held no position in any stock mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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