Earlier this week, I recommended buying Lululemon Athletica Inc. (NASDAQ:LULU) stock before the company reported third-quarter earnings. Resurgent mall traffic and renewed interest in the Lululemon brand told me that the numbers would be quite good. I reasoned that good numbers against the backdrop of positive tax reform progress and a reasonable valuation would send LULU stock materially higher.
Those numbers hit the tape last night, and they were quite good.
It was a double beat. That marks the fourth consecutive double beat quarter for LULU, the longest double-beat run the company has had in recent memory. This streak broadly illustrates that LULU stock is getting its groove back.
Comparable sales growth came in at 7%, far above Street estimates, which were sitting at 5%. Gross margins continued to expand. Operating margins flipped from compression last quarter to expansion this quarter. The full-year revenue and earnings guides were hiked.
Overall, the report was very good. LULU stock is up about 8% to around $73 as a result.
Unfortunately, I peg LULU’s fair value at $73.50, implying that LULU stock is fully valued after this big pop.
What does that mean? Time to do some profit taking.
Lululemon is clearly back to its winning ways.
After a surprise 1% drop in comparable sales in the first quarter, LULU has rebounded with two straight quarters of 7% growth in comparable sales. Moreover, this most recent quarter had a tougher lap than the previous quarter, so comparable sales trends are still improving.
Part of this sales improvement is that athletic retail, after a rough start to the year, is making a big comeback. As it turns out, the athleisure trend isn’t dead after all. It was just put on pause for a few months. Lululemon, with its trendy leggings and yoga-inspired apparel, is at the heart of this comeback.
Another part of this sales improvement is a general improvement in retail sales. By now, its no secret that Black Friday was a big hit for most retailers. With consumer confidence soaring, the market roaring higher, and tax reform around the corner, consumers are spending big.
I think both of these top-line growth drivers will stay in place into the foreseeable future. If so, that means this growth story still has a long runway.
Comparable sales are expected to rise in the mid single-digit range this year. That is about the same as last year. That mid single-digit rise in comps is expected to lead to about 11% sales growth.
Given how resilient comparable sales growth has been in the mid single-digit range, I think those growth numbers are here to stay. Revenues should continue to grow around 10% per year into the foreseeable future.
But 10% revenue growth isn’t enough to warrant LULU stock producing out-sized returns from these elevated levels.
Gross margins continue to roar higher, but the pace of gross margin expansion is slowing. Operating margins have been under pressure due to higher labor costs, but gross margin expansion has more than offset this and driven marginal operating margin expansion. Such marginal operating margin expansion should continue.
Moreover, the company’s new $200 million share repurchase program adds firepower to the company’s earnings growth potential.
Overall, 10% revenue growth plus slight margin expansion and big buybacks should drive about 15% earnings growth into perpetuity. Given LULU’s high tax rate, it makes sense for this stock to trade in line with the S&P 500. The S&P 500 is trading at a 100% premium to its growth (20x this year’s earnings for ~10% multi-year earnings growth prospects).
If you give LULU stock that same growth premium, then you are looking at a “fair” price-to-earnings multiple of 30. A 30x multiple on this year’s guided earnings of about $2.45 implies a fair value of $73.50.
The recent pop puts LULU stock just shy of where I peg its fair value. Above $73.50, I think LULU stock presents more risk than reward.
With the stock trading so close to that level, I think now may be the time to sell.
It is also worth noting that over the past several years, while LULU’s growth story has been on fire, LULU stock has time and time again failed to consistently trade above $70.
I don’t think this time around will be any different.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.