LULU Q2 Earnings Preview

by Enis September 6, 2012 10:51 am • Commentary

LULU reports Q2 earnings tomorrow before the open.  I first mentioned LULU earnings in my Name That Trade post from Aug 27th, since it caught my eye as an expensively priced event.  In that post, I discussed the spread between Sept and Oct implied volatility, and the potential opportunity it offered.  In retrospect, that turned out to be a good entry point, as the proposed calendar has gone from a cost of around 1.20 on Aug 27th to 1.40 as of today.  In that time, the Sept / Oct forward volatility has gone from around 38.5 to closer to 43.5 (based on our implied move calculator), so I’m doing nothing today ahead of earnings.  Here’s the preview:  

Event: LULU reports Q2 earnings Friday morning before the open.  The options market is implying about a 8.5% move, which is higher than the 4 quarter average of 5.25%, and the 8 quarter average of 7.5%.

Sentiment: Wall Street analysts are somewhat bullish on the name, with 11 buys, 9 holds, and 1 sell.  The trading community is more bearish, with short interest at 18%, near the highest level in the past year.

Balance Sheet / Fundamentals: Lululemon has no debt and twice as much cash ($400 mln) as fixed assets ($200 mln) on its balance sheet.  This is a story that hinges on earnings growth on the income statement, and the sentiment surrounding what valuation should be assigned to that earnings growth.  LULU has seen tremendous sales and earnings growth in the past 3 years, growing sales close to 50% per annum with gross margins remaining relatively steady.

Valuation:  Revenues and earnings have moved in lock step fashion over the past 3 years, illustrated here:

 

 

However, the P/E multiple assigned to those earnings have fluctuated substantially in the past 3 years:

 

 

The P/E has fluctuated between below 30 in the summer of 2010, up to almost 70 in the summer of 2011, and it is near the midpoint of the range, around 50 right now.  With consensus earnings growth closer to 30% for the next 2 years, LULU has execute quite well to fulfill the market’s expectations.

Price Action:  Even despite its post-earnings drop in June and July, LULU has been in the green since the very first trading day of 2012.  It is currently up more than 40% on the year, even if it is almost 20% off its highs for the year.

The 3 year weekly chart shows that the stock has maintained its long term uptrend:

 

 

The $60 will be important support going forward, while the earnings gap resides at $70 on the upside.

Volatility: Implied Vol across all months is high historically. The average implied vol for the past few years is around 50.

The big story with volatility is the front expirys versus back months as the weeklies in September (red and yellow) are pricing in big event movement while the farther out months are simply above average. Expect the back months to settle in the low 40’s following earnings. So for October, that would represent a roughly 20% decrease in IV.

 

My View:  On its June 7th earnings release, LULU beat on earnings, but guided lower than street estimates for the second quarter and the full year, which was enough to send the stock on a month long selloff.  Having said that, expectations are now lower than they were this spring when the stock was trading above $70.  As a result, LULU has a better chance of beating the lowered bar, and it has executed well in the past.  It also has accumulated short interest since the last earnings release, so there are more potential buyers from short covering.  But given the stock’s lofty valuation, I don’t see much upside either, so I’m staying away from now.  All else equal, I do expect the stock to underperform its implied move, but since the Sept / Oct calendar got away from me, it feels like more of a coin flip entering today.