Name That Trade – $LULU: If the Market Gives You Lemons, Make Lemonade

by Dan June 5, 2014 3:16 pm • Commentary

LULU’s stock has seen better days, down almost 50% from its all time highs last spring, and down 26% year to date.  Wall Street analysts remain fairly mixed on the stock with 16 Buys, 16 Holds and 2 Sells, while Short Interest remains high at 23% of the float.

In late March the company, under its fairly new CEO, issued a fiscal earnings and forward guidance that was better than low expectations causing the stock to rise 6% the following day.  Since the one day gain on March 28th, LULU is down almost 18%, flirting with new 52 week and two and a half year lows:

LULU 3yr chart from Bloomberg
LULU 3yr chart from Bloomberg

The company is slated to report their fiscal Q1 results on June 12th prior to the open with the options market is implying about a 9.5% one day move which is essentially inline with the 4 qtr avg move of about 10%.

On CEO Laurent Potdevin’s first conference call with investors in March he highlighted three strategic focuses, detailed by Goldman Sachs in a research note March 28th:

(1) Accelerating global expansion by investing in talent and infrastructure, with an aim to build the business across multiple markets in Asia and Europe.

(2) Strengthening the brand through increased investment in grass roots marketing that is true to LULU’s culture but sufficiently amplifies LULU’s voice, as well as enhancing store selling capabilities.

(3) Reigniting the product engine by investing in talent and systems.

Most of the initiatives seem a bit touchy feely to me, and Goldman summed up the potential for success pretty decently with the following comment and estimate cuts:

Mr. Potdevin’s strategies resonated with the investment community and in our view removed some degree of uncertainty from the stock, and while we see a path forward for ongoing gross margin improvement and sustained 20% EPS growth, we believe the burden of execution is high and data points reflecting success are not likely to be visible until the fall. We reduce our FY14/15/16 EPS estimates to $1.86/$2.24/$2.64 from $2.30/$2.76/$3.27 to reflect increased investment in talent, systems and brand building

If expectations were not already low enough heading into the quarter, they are lower now, as analysts expect the company to print their first year over year earnings decline (-1%) ever.  However, if the company can demonstrate the potential for a turn sooner than later, and investors start to focus on the high teens expected growth in the two out years, coupled with mid teens sales growth, the stock at 22x trailing 12 month earnings (UA trades 70x and NKE at 25x) may start to look attractive, at a 5 year low:

LULU 5yr PE from Bloomberg
LULU 5yr PE from Bloomberg

While the stock looks like a hard press on the short side, the likelihood that the new CEO would have lower guidance in his second quarter with the company is also pretty low, but it’s hard to ignore the poor price action since the last print, poor relative strength to peers and the broad market and nasty technical set up.  If I were inclined to make a contrarian play I would look to define my risk. But there is one problem.  The gap between implied vol (the price of options) and realized vol (how much the stock is moving) is as wide as it has been in a while.  As the stock has grinded lower, the price have options has spiked into the upcoming results:

LULU 1yr chart of IV (Blue) vs Realized (white) from Bloomberg
LULU 1yr chart of IV (Blue) vs Realized (white) from Bloomberg

If I were inclined to play for a bounce I would look to do so with defined risk, and target $50 in the near term as a level that the stock should see a good bit of overhead resistance, but also look for a structure that helps to mitigate the relatively high implied vol.

Hypothetical Trade:  LULU ($43) Buy July 45/50/55 Call Butterfly for .85

-Buy 1 July 45 calls for 1.90

-Sell 2 July 50 calls at .625 each or 1.25 total

-Buy 1 July 55 call for .20

Break-Even on July Expiration:

Profits: btwn 45.85 and 54.15 make up to 4.15, max gain of 4.15 at 50

Losses: btwn 45 and 45.85 and btwn 54.15 and 55 lose up to .85 with max loss of .85 below 45 and above 55

Rationale:  We are NOT doing this trade now a week before earnings, we want to see where the stock is closer tot he report, but this is likely how we would play by defining our risk and a large range to the upside where we can profit on a bounce.