Lululemon Stock – Catch This Falling Knife (LULU)

Lululemon (LULU) shares dropped like a stone in early Thursday trading thanks to full-year guidance from the company that was less than analysts’ expectations. This comes on the heels of yesterday’s news that founder Chip Wilson voted against both its new chairman Michael Casey and director RoAnn Costin.

Lululemon stockLululemon now sits below $40 for the first time since February 2011 — since then, it has been as high as $82.50, but mostly bounced between $60 and $70. So, with LULU stock trading more than 50% below its five-year high, there’s a potential buying opportunity in the face.

But Lululemon lacks for good news, and the latest Lululemon earnings report didn’t paint a rosy picture. So is there anything CEO Laurent Potdevin can do to get Lululemon turned in the right direction?

A Little Hope for Lululemon Stock

As bad as it was on its face, the Q1 report was hiding a few positives.

For one, the top line was reasonably healthy; overall revenues increased 11% year-over-year to $385 million. This double-digit gain was spurred on by its direct-to-consumer business, which saw revenues jump 22% year-over-year and now represents 17.2% of its overall sales. With greater profits to be had from e-commerce, this is definitely good news for LULU stock.

On the profitability front, Lululemon’s gross margins increased 150 basis points to 50.9%, which is hardly room for complaint. While nowhere near the 58.7% gross margin it notched in Q1 2011, it’s an indication Lululemon has stemmed the bleeding when it comes to cost of goods. If the company can continue to boost gross margins by 50 to 150 basis points in future quarters, it will be back to 57% annual gross margins in no time.

Meanwhile, Lululemon earnings of 34 cents per share — which back out a one-time adjustment of $30.9 million to account for the repatriation of foreign earnings that will be allocated to LULU stock buybacks — one penny better than in Q1 2013. While Lululemon barely improved on a non-GAAP basis, it’s important to remember that over the past four quarters, the company still has managed to generate $1.93 in diluted EPS despite all the uncertainty facing its business.

That’s a problem struggling retailers — think the three A’s of Abercrombie (ANF), Aeropostale (ARO) and American Eagle (AEO) — would love to have.

Finally, Levi’s CEO Chip Bergh appeared on The Daily Ticker, recently admitting that women have moved away from denim and now opt for yoga pants as their preferred outfit when going casual. Levi’s answer: produce “super soft, super stretchy jeans” that are equally as comfortable. Imitation is the ultimate form of flattery. Despite lots of competition from Gap (GPS), VF Corp. (VFC) and many others, this psychographic trend can only help boost LULU stock in the future.

The transition from Christine Day’s regime is ongoing. It will take a few more quarters for Potdevin to right the ship, but thankfully we’re not talking about the Titanic.

Where the Problems Creep Up

Lululemon’s comparable store sales climbed just 1% in the first quarter, 11 percentage points worse than a year earlier. If not for the strong showing by its direct-to-consumer business, the showing would have been much worse.

Also, comparable corporate store sales, which excludes direct-to-consumer, experienced a 4% decline year-over-year against the backdrop of a 7% increase in Q1 2013. Once the darling of retail, Lululemon is facing some of the same problems plaguing the broader retail sector at the moment, which is fitting considering Lululemon stock is mirroring much of the sector, too.

As mentioned before, Lululemon is taking a one-time charge so it can repatriate some of its overseas earnings to then buy back LULU stock. On one hand, you can interpret this as a sign its shares are undervalued. On the other … it might just be saying LULU has run out of ideas for growing its business and feels the best allocation of capital is into its shares. (Can a dividend announcement be that far off?)

In its Q1 press release, Potdevin stated “… 2014 is very much a transitional year for lululemon, and we are on track with the improvements we have set out to achieve … Despite a reduced outlook, I am confident that the work we are doing today will only enhance our premium positioning as we continue to lead as the market innovator.”

That’s great. Except Chip Wilson doesn’t see it that way.

The Lululemon founder voted against the two directors because he sees them leading a board that’s short on long-term vision, not to mention a lack of product innovation. The directors were easily re-elected setting up a potential battle royal between them and Wilson, who still owns 27% of LULU stock and believes its culture is slowly slipping away.

Until this issue is resolved, Wilson is going to be a major thorn in Potdevin’s side.

Bottom Line

In February, I said value investors should stay away from LULU stock. At the time, it was trading around $50. However, I did suggest that patient investors swing away, keeping some money on the sidelines in case it drifted down into the early $40s or high $30s.

Well, here we are.

I didn’t expect Lululemon stock would drop so quickly, but now that it has, you definitely should consider buying some at these prices while holding a little stash of cash in case the ground shifts in the future.

Long-term, I think Laurent Potdevin has the chops — not to mention the pedigree — to turn this around. Unfortunately, as Gap CEO Glenn Murphy can attest, you never know when the turnaround’s ultimately going to take hold. Only the passing of time can get Lululemon and LULU stock out of its tailspin.

Unfortunately, it’s that simple.

As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.

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