LULU is actually down about 10% in 2013, quite a change in behavior compared to the stock’s soaring gains from 2010 to 2012. The stock was initiated as a New Overweight at JPM on Wednesday morning, with a 12 month price target of $84, and the stock was up 3% yesterday. Yet, it’s indicated down 2% this morning after being downgraded from neutral to underperform at Sterne Agee, with a 12 month price target of $56.
Whose argument is more persuasive on this former momentum leader?
Starting with the JPM upgrade, here were the analysts’ justification:
The Lulu story is evolving from a double-digit comp and North American unit expansion story to one of a slightly more mature, global growth retailer
We believe that the shares of Lulu deserve a premium valuation given its niche, premium positioning, top- and bottom-line growth potential, strong margins, and now, margin recovery story
“More mature” is analyst-speak for lower growth. Of course, LULU’s average earnings growth between 2009 and 2012 of more than 50% per year was unsustainable, and its projected earnings growth of 20-25% is still admirable. In the meantime, since LULU’s stock has stalled over much of the past 2.5 years, the valuation has gotten more reasonable:
But Sterne and Agee’s analyst downgraded the stock today with the premise that the recent product issues (regarding piling) are a reflection of LULU potentially “alienating the customer” over time. As a result, the analyst thinks the current valuation multiple is no longer justified, with the assumption that worsening customer relations affects the long-term business prospects.
Personally, I have no experience with LULU products, and little sense of whether those 20-25% earnings growth projections will be realized over the next few years. However, prior to the stock’s June earnings, I did point out in our earnings preview why the valuation was such a risk:
While the technicals look attractive, the valuation looks very, very stretched. Whether we use price/earnings (around 45x, with expected growth of 15-30% over the next few years), price/sales (8.6x, far above other retailing cult stories like KORS at 5.5x or UA at 3.3x, and even approaching TSLA, at 12.5x; LULU isn’t exactly comparable on the revolutionary spectrum to TSLA), or market cap per store (around $50 million per each store), the valuation looks extremely rich.
Investors in the stock are clearly betting on the stock to grow into its valuation, but the bar seems to be set very high in this name, with little margin for error.
The company’s subsequent weak guidance hammered the stock following that report (from $82 to $60 in 2 weeks), and the stock has traded in the $60 to $77 range ever since, never closing that huge earnings gap:[caption id="attachment_32575" align="alignnone" width="600"] LULU daily, 200 day ma in black, Courtesy of Bloomberg[/caption]
The stock’s weakness since early October has come despite a very strong move in the broader market (the S&P 500 is up nearly 10%), which is even more cause for caution in the near-term.
In the meantime, short interest has declined to near its lowest level in the past 6 months[caption id="attachment_32574" align="alignnone" width="600"] Short interest in shares, Courtesy of Bloomberg[/caption]
The stock still has a relatively high short interest of 17% of the float. There seems to be a subset of traders who are steadfast in their belief that LULU’s valuation is much too rich.
The real key for the stock’s next direction is the earnings report in early December. Interestingly, implied volatility in December expiry (red line) is relatively low given the upcoming earnings event:[caption id="attachment_32576" align="alignnone" width="600"] LULU 30 day implied vol (red) vs. 30 day realized vol (blue), Courtesy of LiveVolPro[/caption]
Realized volatility (blue) has been quite low in the past month, but it has picked up in the past week. More importantly, our implied move calculator indicates that LULU options are only implying about a 5% move for the earnings event. That compares to the 4 quarter average of 7.75%, and the 8 quarter average of 7.5%.
As a result, I’m interested in potentially buying 1-2 month options that capture earnings on LULU, and selling a shorter-dated options that does not capture earnings to mitigate the time decay. That calendar trade could work out quite well if LULU continues its rangebound price action until the main event next month. We’ll be sure to post if/when we pull the trigger.