The last time Lululemon Athletica (LULU) was in the headlines it was dealing with a design flaw in their signature women’s yoga pants that made them too sheer. Now LULU is in the news again as CEO Chistine Day steps down for personal reasons. Investors feel there is much less transparency in this most recent headline.
Although the company beat earnings estimates with a reported $0.32 compared to a $0.30 consensus and net income rose 1.5% to $47.3 million, it was the abrupt departure of Day that overshadowed the price action in the stock and resulted in a -17.5 % pummeling on the day. The stock has continued to be depressed all week. Is the issue overblown? Or will Day’s absence portend troubled times for the upscale retailer?
A Departing CEO
LULU built its reputation on innovative design, high quality, superb fit, and a blend of fashion and function that captured the real life needs of its athletic customer base – and this was the justification for shelling out $128 for a pair of fancy workout pants or $88 for hi-tech shorts. But this reputation was precisely why the yoga pants recall back in March was disconcerting to investors and analysts. They feared the blunder was indicative of a larger concern being expressed by many of its loyal customers. Increasingly, complaints of deterioration in garment quality, corner cutting, and an overly evident “made in China” feel were becoming louder. So for Day to suddenly announce her resignation in the wake of these problems, especially after a productive and successful tenure, caused a lot of speculation about whether there were rifts in management.
It is doubtful whether that speculation will be satisfied anytime soon. In an email to Fortune magazine, Day writes, “My values include discretion. While I know everyone would like to know ‘the reason’ [I’m leaving] there are some things that should remain private because the truth is the good things outweighed the bad and by being respectful and grateful one can remember that.”
So in the meantime, it looks like LULU investors will have to navigate some crucial questions without a firm answer to the reason for Day’s departure.
The Bullish Case: given the quality issues and recent design missteps, perhaps a change in leadership could correct these issues better than Day. LULU’s stock price recovered very quickly from March’s recall problems and put in an all-time high in less than two month’s time, illustrating that there was a lot of pent-up demand for the stock. If LULU can bring in a confidence-inspiring CEO and make the transition seamless, that same demand may reassert itself.
The Bearish Case: There’s a high cost of uncertainty in a stock that commands the kind of premium valuation that LULU does: a 35x TTM P/E does not exactly leave a lot of room for forgiveness when it comes to future execution. Day’s exit may hint at deeper organizational problems that often plague high growth businesses. And the costs of righting the design and quality ship are likely to be higher than the Street is currently expecting. Any slowdown in same store sales or squeezed margins would almost certainly mean a significant reduction in its multiple.
Not to be flustered by the negative attention, LULU, in keeping with quirky and irreverent way of doing business, posted a Help Wanted ad for a new CEO on its website and its Facebook page. Some stores have even posted Help Wanted signs in their windows. Thus far the company has received over 200 responses….although it is doubtful the next CEO will be pulled from that pool of candidates.
Balancing the Future
LULU certainly has a number of factors going for it: consistent EPS beats, strong same store sales, a devoted customer base, and one of the highest operating margins in retail. However, at a 32x estimated FY14 P/E, much of LULU’s potential growth could be argued to already be priced in the stock. The recent decline takes a bit of the richness out of the stock on a fundamental basis but LULU will still have little room for error going forward, much less so for misses on revenue and EPS expectations.
At an investors’ conference on June 13, LULU announced plans to open men’s only stores starting in 2016. Although it accounts for only 10% of total sales, LULU seeks to capitalize on the fact that their men’s segment has been a better performer with stronger growth. The company also plans to roll out marketing campaigns targeted to men and to make men’s wear a more prominent part of existing stores. The move will put LULU in greater competition with Nike (NKE) and Under Armour (UA) and analysts have expressed concern over whether LULU can leverage their competitive advantage in design and trend to take market share away from these giants.
Nearer term however, LULU is still positioned well to take advantage of the activewear trend, both in the US and abroad. LULU remains less than 50% penetrated within the US market and, largely overlooked amid the commotion of Day’s exit, the company also announced the opening of new China showrooms.
While LULU could easily double its current store count over the next five to six years, much depends on whether they can take their yoga-inspired, predominantly female-centric concept and expand their brand into a broad-based athletic and street wear identity that appeals to both sexes. International growth will play a very big role in determining whether there is long term upside for its current valuation. And investors will be weighing whether LULU’s potential return on investment will be more attractive than other upscale high-growth retailers like KORS which trade at a cheaper multiple.
Click to Enlarge All of the CEO mystery aside, the stock’s drop has presented an interesting setup. Over the last two years, the $64-65 level has been a pivotal range in the stock. It is not a hard-and-fast price level and has been broken multiple times but the stock tends to get congested in that range, demonstrating that a lot of supply and demand gets worked out in that area. Second, from its summer 2012 lows to the lows during the March yoga pants recall, this recent decline sits on an uptrend that coincides with the $64-$65 support level. This will be a key area to watch.
If the stock remains weak and falls below the March lows (around $62) this would indicate a failure of conviction among bulls and that the pent up demand that materialized in the wake of the last round of weakness is now evaporating.
Stock Recommendation: This setup makes for an attractive risk/reward scenario: a tight stop below the most recent low (approximately $4 – $5 underneath the $64.96 June 17 close) versus a potential upswing of $10 – $12 or more as a bounce off of support. The stock has seen some crowding near the $75 – $78 price level and if the current support holds, this could be the range where the stock consolidates after a rally.
Options Alternative: Consider the LULU September 65 calls for $6.00 per share or less. We recommend setting a conditional stop at the same stock price level that would trigger an exit from an outright long position. The September options provide plenty of time to be ‘right’ about the trade without giving up too much time value if the move we are expecting happens very quickly.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.