Lululemon Athletica $LULU Earnings Update

Lululemon reported earnings last week. A few things to note:

  • Revenues increased by 14%
  • Comparable Store Sales Increased by 4%
  • Inventories fell 1.2%
  • Net Income increased by
  • Gross margins rose from 46.8% to 49.4%

Revenues, +14%, Inventories, -1.2% and rising gross margins?! – I didn’t think it was a bad quarter, but markets disagreed. I was shocked by the ensuing price action. The stock is down 15.5% (as of Friday) since the report or 13.8% even excluding last Friday’s volatile trading.

I could not figure out how the company was able to improve margins while significantly deleveraging inventories. The 260 bps of gross margin increase, per mgmt, came from lower product costs. But even assuming that there was no decrease in product costs, the fact that the company was able to maintain flat gross margins while inventories fell 1.2% and revenues ran up 14% is what is interesting, IMO. Per Stuart Haselden, CFO:

The factors that contributed to this outcome include 260 basis points of increased product margin. This was driven principally by lower overall product costs that increased merchandise margins and reductions in raw material liability expenses, along with lower markdowns compared to Q2 2015. These improvements resulted from our coordinated efforts across the supply chain. (Source: Seeking Alpha Transcripts)

When a company sells obsolete inventory to delever the balance sheet, they do so at lower prices, and thus, gross margin also falls. It’s important to understand that over 95% of the company’s inventory balance is finished good, which is why I do not differentiate between that and raw materials. In this case, Lulu sold the inventories at regular prices (gross margin flat to increase excluding the decrease in product costs) while posting sub-par comps for the quarter. Per the earnings call:

  1. They marked down less inventory compared to last year.
  2. Inventory per sq ft fell 15%.

If fewer inventories were marked down compared to last year – which implies that the average selling price was either on par with, or higher than the comparable FY 15 quarter, and inventory per sq ft fell 15% – which implies that they sold substantially more inventories/sq ft than they did last year, then why were comps just 4%? Management also mentioned that there was a favorable selling mix, and higher margin products were sold, but it seems as if they dumped all their excess inventory that had been compiled over the past two years on the market, given the significant drop in inventory/sq ft. Retail had been on a tear from 2010 to 2015 years while LULU’s gross margins peaked in 2011 at 55.5% and fell to 48.4% in FY 15. But when just about every retailer is marking down inventory in what is, so far, the weakest retail environment since the financial crisis, how is LULU now able to sell them at higher prices or hold prices stable and sell substantially more goods?

For a quarter this magnificent, I would have expected high single to low double-digit comps. The 260 bps gross margins may last going into next year, but I am doubtful they will increase any further – 260 bps lower costs savings is quite significant within retail. Management expects to see accelerating earnings growth and expanding operating margins going into Q3 and beyond. I want to see how this plays out going into this quarter next year to see if this quarter’s gross margin move is truly sustainable.

$LULU Earnings Update

Lululemon reported earnings last week. Few things to note:

Inventories rose 24%, sales rose 17% (8% comps).

Gross Margins were stable at 48.3%.

These had a positive impact on the stock. Investors apparently are okay with that because inventories rose 24% while sales rose 17%. There isn’t any way the company can get rid of these inventories without discounting them. The company still carries a historically high amount of inventories – the current inventory to sales ratio surpasses all years in its history except 2007. Free cash flow has significantly lagged the income statement earnings over the past few years because of this. They also guided higher revenues, but lower earnings. Somehow, this was positive news to other investors. I’m holding on to the short (Jan 2018) put(s) position. I will, however, sell off the 2017 puts should we see a sharp decline in the general markets.

 

Update

Hi Guys,

I’ve been a bit sick and also really busy lately, so I haven’t posted anything in about 3 weeks. So I want to update, there will be no ‘Official’ May Performance Report, but I’ll summarize the updates on each position on here as of today’s date (5/5/2016) – Happy Cinco De Mayo btw – Regular monthly performance reports will commence in June. The portfolio rose 0.49% vs 0.39% for the S&P 500. The portfolio is still about 50% invested, it’s difficult to find bargains in this market – most of the ‘cheap’ cyclical stocks are stuffed with overvalued inventories that still need to be written down, so I don’t want to buy something just because it looks cheap. I’ll update for the other indexes later on the homepage, but I believe it underperformed all other indexes except the S&P.

Flanagan Enterprises (BDL)

I want to start with BDL since I purchased this stock mid last month but didn’t have time to post about it. This is going to be a very brief summary of what I would have written. I purchased this at $21.2, the stock trades at about $18/sh so i’m about 15% underwater now.

In a nutshell, the company owns and operates restaurants and liquor stores in the Florida area. The company still generates mid to high single digit comparable store sale numbers and is growing at 10% and yet it trades at about 11x earnings.

The company partners up with other investors on the restaurants and the way the partnerships work is that the company pays the investors with the cash flows and collects no management fees beyond the money required for regular operations. Once the investors receive their invested money back in full, then the cash flow each restaurant generates is split in half between the company and the investors. So, the company is basically guaranteed to increase the bottom-line in the future. This won’t happen quickly, but if you were to model this out, the company should at least trade somewhere around 15-20x earnings. So I believe there’s at least 50% upside from these prices. S&P’s P/E ratio is about 24x, so the current P/E is less than 1/2 of S&P’s.

While the company carries about $10 million in debt, it also owns about $20 million of land and property in florida, so there is sufficient equity to conservatively eliminate the debt from any valuation calculations.

Please note that BDI and BDL are different. BDI is Black Diamond Group Ltd, BDL is Flanagan’s Enterprises.

Other Positions

Before doing this, I want to send my thoughts and prayers to the people of Fort McMurray. As some of you may have heard by now, there is a massive wildfire in the Canadian city of Fort McMurray. The city has been evacuated – though no casualties have been reported, people have lost their homes and belongings.

Canadian Trail

(Longs)

The Canadian stocks have basically offset each other over the past few days. Gamehost down 17% because of the Fort McMurray fire (more below) and Black Diamond up 28% today because it has excess capacity for temporary housing in the Oil Sands around that area.

Gamehost Inc.

Gamehost was my largest position just a few days ago. One of Gamehost’s Casinos – Boomtown Casino –  is located in the city of Fort McMurray. With the wildfire causing a complete evacuation of the city, the effect on earnings becomes obvious. Less activity at the Casino – if it even survives -and thus, less earnings for gamehost. I called the company two days ago to get more information before posting about this, but they were swamped with thousands of investors attempting to ask the same question I was – Is the building insured?

Per the company’s filing on Sedar yesterday:

The Company’s Boomtown Casino in Fort McMurray, Alberta is fully insured including property and business interruption coverage. All Gamehost properties and operations are fully insured by a leading multinational property and casualty insurance company. Management has initiated an insurance claim in anticipation of losses at our Boomtown Casino and is currently in discussions with the insurer regarding due process.

I had a 37% equity in the position wiped down to about 16%. I’m going to add more when I trim Black Diamond. I want this position and Black Diamond Group (See Below) to make up 25% of the portfolio. Any more positions on Canadian stocks will be hedged with futures or put options shorting the CAD to reduce currency exposure.

Black Diamond Group Ltd

BDI reported earnings yesterday and shot up 28% today – I don’t believe it was because investors liked the earnings, but because of the fire in Fort McMurray since BDI provides temporary housing. Total equity in this position is +19% and it’s now my largest position after the Gamehost decline.

The company reported:

  • 47% q/q decline in revenues and Q1 EPS of -0.06.
  • Total debt q/q down 20%

As I mentioned in the original thesis, the dividend was cut down to pay down debt and the company will still be cashflow positive even though earnings will turn negative. So that’s precisely what we’re seeing. While the company reported a loss of $2.4 million, it actually took in about $10 million of cash for the quarter. This is because of the discrepancy between the CapEx and Depreciation I mentioned in the original thesis.

The company has historically sold its used fleet for above book prices, but since the industry is depressed. Assuming a conservative 20% haircut on book value, the company will still trade below the new book value – this means we’re basically getting the company for free! The positive FCF and debt repayment should continue while we wait for the industry to recover.

The fire in Fort McMurray is providing support to the price, so as of 5/5, it makes up about 13% of my portfolio after the +28%. Once the stock surpasses book value, I’ll trim it down to 10% of the portfolio.

United States’ Trail

Pacific Health Care Organization

No new news on PFHO, but it has been fairly volatile. The illiquid nature of the stock leads to large swings in price. I’d buy more, but the bid/ask spread irks me. Price target remains the same at about $14/sh

Pier 1 Imports

Pier reported earnings and guided to higher margins as I anticipated in the original post. One mistake I made however, was ignoring the competitors. Piers inventories were so far in line that I thought their competitors would be irrelevant, but they are not. Virtually every cyclical company is stuffed with overvalued inventories that will have to be sold off. The company did guide to higher margins and is first in line for the industry recovery, so I’m holding on for now.

Trip Advisor (Short)

Reported earnings earlier this week. Revenues declined but investors are still not paying attention to the more important declining metrics – Trip’s Revenue per hotel shopper and Expedia’s Revenue per hotel night.

The company has investors convinced that their ‘successful expansion’ in China will fuel growth will 2017 while 2016 ‘will remain muted’. The same China where iPhone sales just fell (-25%) off a cliff?  They have been deceived into pricing a company with declining revenues at 45x earnings. The company will have to fight an uphill battle with growth since the price of the service is in a deflationary spiral.

CarMax (Short)

CarMax’s inventories remain elevated. One mistake I made on this one was buying short-term (1 year, January 2017) puts. I regret that and will get rid of all 2017 put options on the portfolio next time we have another volatility stint.

Recovery rates y/y fell from 54.2% to 51.2%. Inventories fell relative to sales, which is actually good. Past due accounts and LTV ratio trickled up a bit. The U.S. economy continues to slow and I believe we will likely see easy credit slow, which is bad for CarMax.

LuluLemon (Short)

Lulu reports earnings later this month. I’m going to address the company after that happens. I’m still yet to add my January 18′ put, but if the stock sees $65 again, I’ll add January 18′ put options.

Mind CTI Ltd

Reported earnings this week as well. Revenues fell 19%. This was expected. As I mentioned, the company’s sales has historically risen over the long-term but have wildly fluctuated, which is why it trades at 5x its Enterprise Value. Its 10% yearly dividend is basically a unicorn in today’s market.

 

Update $LULU $KMX $BDI

I increased my stake in Black Diamond Group (BDI) by 11%. Crude oil has been shooting up, and BDI has not moved. I’m still looking to add the 2018 LULU puts, but the stock has been falling, so I’m holding back until we see some price support. I don’t want to buy it only to see the puts decline the following week. Carmax reported earnings, and I want to refrain from making any comments until they file the 10-K.

 

Lululemon and Pacific Health Care Update $LULU $PFHO

Lululemon

Lululemon reported earnings last week. Things to note:

  • Revenues rose 15%, net income increased 11%
  • Comparable store sales increase 5% and 10% on a ‘constant dollar’ basis

Funny thing is the management of retail companies love the ‘constant dollar’ comparisons when the ball falls in their park. I’m yet to see one report inventory increases on a ‘constant dollar’ basis. Cash from Operating Activities fell 6% because inventories rose a staggering 37% y/y. Gross margins decreased from 50.86% to 48.4%. Management says that:

We are in fact seeing inventory levels rebalance with sales now that we are deep into Q1, so we remain confident that our inventories will be well aligned with forward sales at the end of the quarter. (Source: Q1 Transcripts)

Gross Margins are not going to stay stable while inventories move in line with sales. The problem Lululemon faces is secular. They are getting undercut by competitors selling the same apparels for lower prices. Although LULU is forced to cut prices, they are attempting to keep that to a minimum for brand image purposes. One of two things will happen:

  • Gross Margins fall
  • Inventories Rise

Since management says that inventories are in-line with sales, we should expect a decline in gross margins; and voila:

We anticipate gross margin to be approximately 47%. The factors driving this are continued improvements in product margins as we benefit from lower airfreight usage and improved initial merchandise margins. (Source: Q1 Transcripts)

They guided gross margins down to 47% from 51.4% last year! The only way to keep gross margins stable is to pile inventories. The only way to push down inventories is for gross margins to fall. The stock rose 10% after earnings. I’m going to add January 2018 puts to the portfolio. These puts will make up 1%. This means that Lululemon puts will now make up 1.5% of the portfolio. Hopefully, the markets do not open with too much volatility.

Pacific Health Care Organization

PFHO also reported earnings last week. Things to note:

  • Revenues fell 13.1% y/y
  • Net Income fell 14%

More importantly, as I mentioned in the original post, the costs are very variable because costs for the segments that those two clients were concentrated in are outsourced. The company shed the costs under that by 38% and was able to keep net margins in-line with sales.

Screen Shot 2016-04-05 at 12.38.13 AM

A look at the updated balance sheet above shows a cash balance of $3.8 million, Acct receivable of $1.04 million. If we take the rest of the current assets at face value and then assume that the rest of the assets (long-term) are worth nothing, then the hypothetical book value comes out to $5.222 – $0.385 = $4.835

The liquidation value comes out to $4.835(Book value) – 8.24 Million (Market Cap) = -$3.41 Million

Now, since Part of the AmTrust revenues were shed in Q4, shedding the total 2015 net income in half is conservative since we’ll be double counting part of the removal of AmTrust. 2015 Net Income of $1.677 million/2 = $838,500.

The company now trades at $3.41 million/$838,500 = 4.06x earnings. Now, I don’t want to speculate on what revenues will be next quarter; I’ll leave it to the real analysts to do that. I no longer use financial models, but you do not need Excel to tell you that this thing is a steal, even at $10/share.

I’m moving the price target from $11.76 to $14/sh.This still makes up just over 5% of the portfolio. Let’s hope for a stellar Q1!

 

 

Lululemon Athletica Inc.: Is Lululemon Losing Its Edge?

Current Price: $62.79 (3/8/2016) Market Capitalization: $8.08 Billion
Enterprise Value: $7.68 Billion EV/EBITDA: 17.46
Price Target: $31.4 (~50% downside) Time Frame: 6-18 months

 

LULU price chart

 

Lululemon Athletica Inc. (NASDAQ: LULU) is a designer and retailer of technical athletic apparel. The company operates under three segments:

  • Direct to Consumer – Represents sales from the Company’s e-commerce websites
  • Company-Operated Stores
  • Other – Outlet sales, showroom sales, sales to wholesale accounts, warehouse sales, and sales from temporary locations

The athletic apparel is marketed under the Lululemon Athletica and Ivivva Athletica brands. Ivivva caters to the dancing demographic, while Lululemon is more of an athleisure brand. The company has been a forefront beneficiary of the millennial health conscious trend that has propelled its sales from $18 million in 2004 to $1.8 billion in 2015, a staggering CAGR of 52%. The company’s sales per sq ft of $1678 for the fiscal year 2014 is the highest I have ever come across. I have profiled Tilly’s and Christopher and Banks, and their sales/sqft were both, at best, 1/6th of Lululemon’s.

Lululemon Revenue chart

The recent expansion into male apparel has proven successful as customers are warming up to the brand; it saw double-digit growth last year. There is also the Lululemon Ambassador program where Yoga instructors are given free apparel in exchange for holding complementary yoga classes for Lululemon shoppers. This strengthens the company’s customer retention and brand loyalty.  

 

So Why Short This growth Story?

INVENTORIES

Over the past few quarters, inventories have risen at a faster pace than revenues. Management ascribed this to the west coast port disagreements between Pacific Maritime Association (PMA) and the International Longshore and Warehouse Union (ILWU) that arose in early 2014. While I agree that the port issues do play a role in stocking inventory on time, I believe management is overstating its impact. The longer the port issue lasts, the more time management has to adjust future quarter’s inventories distribution routes. This means that the quarters that should be most impacted are the ones closest to the port issue’s arrival. So, if the cause of the inventory inflation was the port issue, then the inflation should have surfaced in Q3 and Q4 of 2014 when the issue was still new and the shipments more delayed and not in 2015 when management was already aware of the issue 6 months + in advance. Anything beyond 2014 should have been associated with higher cost of rerouting and not inventory inflation. According to former CFO, John Currie:

In terms of the port situation, I mean we’re continuing to monitor it basically every day, of course if it turned into a strike then — yes, it’s not a strike right now, so that would of course change things for everyone. But having said that, we’ve taken steps with respect to our future shipments, so even by the end of December shipments will be either – a lot of them would be rerouted through Vancouver, get down to the States by rail, so that will still likely give rise to 1 to 3 day delay, but it won’t be that 7 to 10 days that we’ve been, what that we’re seeing right now. So I think as we get into Q1 even January, the impact – if the status quo should be minimal. (Source: Q3 Transcript)

Then in Q4, Stuart Haselden, new CFO pushed the issue to the next and the following quarter:

Second, as Laurent also highlighted, while on-time factory handover delivery performance has improved, we have not been able to avoid the delays in ocean shipment times into the West Coast ports. We had previously expected this to impact late Q4, but has shifted into early Q1. We now estimate that the previously identified $10 million in sales risk for Q4 will materialize now in Q1. We also expect these delays to extend into early Q2

Lululemon’s closest publicly traded competitors – Nike and Under Armour – were barely affected by this as their inventory levels have been normal. Lululemon is the clear outlier in the inventory to revenue chart below. Ballooning inventory is clearly not just a port issue.

Lulu-Nke-UA-Inventory-Revenue

COMPETITION & UNSUSTAINABLE MARGINS

Lululemon popularized the athleisure trend amongst women and tremendously benefited from it, enjoying profit margins of 20% in FY 2013 and 18% in 2014 – Numbers that other retailers can only dream of. But with any profitable niche comes a slew of competitors offering the same products at lower prices. Gap has introduced its Athleta after the purchase in 2008, and is rapidly expanding the brand, and is even poaching Lululemon’s ambassadors. Calvin Klien and Nike have also introduced their lines. Under Armour’s propelled growth with the rise of Steph Curry recently passed Adidas in the U.S. sportswear market and is rapidly growing. There are also multitudes of smaller brands popping up, and they are all undercutting Lululemon.

gross margin line

This is evident in the gross margins that peaked in 2012 and have been falling since fiscal 2013. Gross margins fell 340 basis points q/q for October 2015. Management attributed  130 bps of it to the port issues. So in Q3 2016, we should expect to see at least a 130 bps increase in gross margins.

CYCLICAL

Paying $100+ for yoga pants may be practical for some in a booming economy, but once the economy turns, people run to viable alternatives. This is the 4th longest business cycle in U.S. history. That is statistically significant. Last time the cycle turned, Lululemon was still a small cap, revenue growth was positive. Next cycle, however, I believe we may actually see a decline in revenues since the company is now more mature.

CONCLUSION

One odd thing I noted in the Q3 10-Q balance sheet was the prepaid income taxes asset which jumped from 41 million to $125 million, this coincided with the bizarrely low tax rate in Q3.  Lets keep an eye on that. I don’t want to make anything out of it until I’m sure there’s something sinister going on.

The combination of falling gross margins which indicate that the company is already aggressively marking down its inventory to be competitive and the ballooning inventories which indicate higher future markdowns create what I believe to be a decent short at these prices. I mentioned in the February performance report that I purchased January 17 $40 put options, and I believe when Wall Street realizes what is going on here, this thing might have a 2/4/2016 LinkedIn moment. It could happen as early as Q2. If management can get inventories back in line with sales as they have said and also increase gross margins by the 105 bps in Q2 and 100 bps in Q1 that they attributed to port issues,  then this short campaign becomes moot, and I’ll sell off the put options. If these issues persist and the stock is bid higher, then I’ll buy the January 2018 put options. The rising Canadian dollar is a tailwind, so those numbers should not be too difficult to meet. The put option currently makes up 1% of the portfolio.

Source: All the charts in this article are from the corresponding company’s SEC filings.