In the April 2013 issue of Investor Advisory Service we noted that despite headwinds from higher taxes and government spending cuts (the "Sequester"), economic growth actually seemed to be improving. The U.S. economy added an estimated 236,000 jobs in February 2013, bringing the unemployment rate down to 7.7%. The rest of the world remained a mixed bag economically. China and Japan both seemed to be doing a little better. Europe, and especially the U.K., seemed to be contracting. While we expressed our concerns about rising stock market valuations, we recommended that readers try to stay fully invested to participate in the improving economic growth. That turned out to be the right advice. During the next twelve months—measured from March 2013 to the start of March 2014—the S&P 500 produced total returns of more than 25%.
Each month we feature three companies that we think are especially interesting right now. One of our three April 2013 features, Wabtec, produced excellent returns over the next twelve months (up 60%). However, two of that month’s three featured companies haven't fared very well. Let's take a look back at one of the losers, Lululemon athletica (NDAQ: LULU), and try to see what went wrong.
Lululemon makes sportswear, with a special focus on yoga apparel. The company’s retail stores have small footprints, and its products have big gross margins. At the time of our writeup, the company boasted that its stores had the highest productivity per square foot of any retailer in North America. We thought the company could easily double its store base, which stood at slightly over 200 one year ago. With plenty of runway for new stores supplementing already excellent same-store growth trends, we saw opportunity for a lot more growth ahead.
The only visible problem at the time was valuation. Through Fiscal 2011, it wasn’t unusual for LULU to trade at a trailing P/E over 40. Even based on estimated Fiscal 2013 EPS of $2.40, the stock’s P/E remained a generous 29. Investors seem to fall in love with popular retail stocks, making it difficult for value-minded investors to participate in the space. We liked the growth potential so much that we featured the company anyway. Perhaps we lost our value-minds?
The next twelve months brought almost nothing but trouble. The company's first fiscal quarter after our feature was okay, growing in line with historical trends. Comparable store sales increased 10%, and total sales increased 31%, helped by an extra selling week during the quarter. EPS rose 45%. LULU announced an embarrassing product recall but also guided Fiscal Q1 sales up 17%-20%. Management said that 2013 EPS would probably be in the range of $1.95-$1.99, including a $0.26 charge for the aforementioned recall. That range was somewhat below our estimate, but we figured management was probably being conservative.
Not so much, as it turned out. Three months later, the company’s Fiscal Q1 once again showed decent sales growth but also brought with it a litany of problems. Q2 sales forecasts called for rapid deceleration. Gross margin slid from 55% to 49%. Inventories increased 34%, much faster than sales. CEO Christine Day announced her retirement. Suddenly, it looked like the company had a long row to hoe, and the CEO wasn't interested in sticking around to see the results. With the stock now down 10% below its price at the time of our original feature, we groused that performance needed to improve rapidly for the stock to win back its premium valuation. Growth investors hate damaged goods.
Shares had one more rally left in them. Through early October, investor sentiment improved and the stock rallied back into the mid 70’s. Fiscal Q2 sales and earnings slightly outperformed management’s guidance. Q3 forecasts disappointed investors, however, sending shares down 6% the day of the earnings release. Management blamed most of the weakness on supply disruptions, but we worried that the problems probably ran deeper.
We were right to worry. Fiscal Q3 produced just 5% same-store sales growth, along with a forecast for flat same-store sales in Q4. When we originally featured this company as a premium growth stock, we never dreamed its same-store sales would flat line within a year. Even very mature retailers typically get a little bit of positive same-store growth thanks to inflation and economic expansion, although the current environment isn’t typical in historical context. Final numbers for the year aren't in yet, but analysts think LULU should earn about $1.89 per share in Fiscal 2013. So much for that $2.40 estimate!
At a recent price of $49.12, shares have lost 29% in the past twelve months. That loss is doubly painful considering the S&P 500’s 25% gain. So, is the current price a great deal, or has LULU become a "value trap," a stock that only looks inexpensive because valuation fails to account for future deterioration? We've got our eye on the company as a potential turnaround story, but we probably wouldn't recommend throwing any new money at the stock until new management demonstrates that it can restore growth.