Has lululemon's good problem turned bad?

After the third-quarter earnings report, some think it has too much inventory instead of not enough.

By Motley Fool Pick of the Day Dec 2, 2011 4:34PM

By Evan Niu


Sometimes Mr. Market just expects too much. When it comes to lululemon athletica's (LULU) third-quarter earnings release and ensuing sell-off yesterday, jittery investors were clearly focusing on how the figures might not have met every heightened expectation while ignoring the ways the yoga-apparel retailer is breaking rules.


Not good enough, or is good not enough?
Expectations aside, as a shareholder I'm thoroughly pleased with the healthy growth figures that lululemon is putting up, as well as with the guidance indicating 33% to 35% growth over the next year. So why did the stock drop over 15% on the open yesterday? The consensus estimate was calling for more from the top line -- $235.7 million to be precise. Even though earnings came out on top, sales fell short of analysts' hopes. Next quarter's revenue guidance is also mostly higher than the estimate of $327.3 million.


Another issue that may be worrying shareholders is that even though comps figures decimate other apparel retailers such as Gap's (GPS) negative-6% or Urban Outfitters' (URBN) negative-3%, lulu's comps growth is slowing from the 29% put up last year and the 20% from last quarter. Guidance calls for comps in the low to mid-teens, sparking fears that the downward trend will continue.


Can't win either way
One analyst was also concerned that inventory has risen 77% from last year to $129.2 million. Foolish historians may recall when lululemon was punished on multiple occasions earlier in the year for not having enough inventory, which raised concerns of money left on the table from unsatisfied customer demand.


While having too much inventory sitting around unsold certainly isn't a good thing if it's not moving, lululemon is undoubtedly stocking up for stocking-stuffers. This last quarter ended at the close of October, so the figures don't include any of the Black Friday frenzy, and building up inventory in anticipation of heavy holiday shopping is the right call by me.


Keep 'em coming
I'm particularly pleased with the expansion of the direct-to-consumer channel, which includes online sales. The channel is growing quickly and carries a higher operating margin than the corporate-owned retail stores: 38%, compared with 34.9%.


The company now has a total of 165 corporate-owned stores worldwide, having added 32 so far this fiscal year. Earlier in the year, CFO John Currie had said that the company hoped to "open a total of up to 30 corporate-owned stores" during the full fiscal year, so the company has already topped those expansion plans with another quarter to go.


At what price?
While lululemon continues to trade at a hefty premium, the yoga guru has an Apple-esque cult-like following, and that brand loyalty is helping drive growth. Some lululemon enthusiasts even go as far as to buy the same products in multiple colors, even if we're talking about buying five of a $68 Swiftly Tech Long Sleeve running shirt.


lululemon trades at roughly 47 times trailing earnings and 34 times forward earnings, but its average revenue growth rate over the past five years is 53%. Compare that with Under Armour's (UA) trailing and forward P/Es of 48.8 and 34.7, respectively, and average five-year revenue growth of 30.5%. In addition, Under Armour relies more heavily on accruals, which can imply lower quality earnings.


I'm with CEO Christine Day when she says she's "proud to have produced another very healthy quarter" and that lululemon is "set to finish 2011 with a stronger brand [and] a stronger organization."


Are there some aspects of the results that left me wanting more? Sure. Slowing comps growth is never a good sign. Am I disappointed with the figures overall? Not at all. lululemon's inventory problems earlier this year are ultimately a good problem to have.


When it comes to having feverishly loyal customers with nearly insatiable demand, a product shortage can even create the perception of scarcity and makes them want stuff that much more so, and that pent-up demand gets unleashed when those Scuba Hoodies come back in stock. I'm not concerned about the inventory, since I expect all those luon Astro Pants to get a move on once the holidays roll around.


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Fool contributor Evan Niu owns shares of lululemon athletica and Apple, but he holds no other position in any company mentioned. The Motley Fool owns shares of Under Armour, Apple, Gap, and lululemon athletica. Motley Fool newsletter services have recommended buying shares of lululemon athletica, Apple, and Under Armour and creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.



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