Is Lululemon Losing Its Edge?

Lululemon Athletica Inc. (LULU, Financial)Â 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 square feet of $1678 for fiscal year 2014 is the highest I have ever come across. I have profiled Tilly's (TLYS, Financial) and Christopher and Banks (CBK, Financial), and their sales/sqft were both, at best, one-sixth of Lululemon's.

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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 royalty.

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 six month 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, new CFO Stuart Haselden 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 (NKE) and Under Armour (UA) - 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.

Competition and 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 own 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.

This is evident in the gross margins that peaked in 2012 and have been falling since fiscal 2013. Gross margins fell 340 basis points quarter over quarter 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 fourth longest business cycle in U.S. history. That is statistically significant. Last time the cycle turned, Lululemon was still a small cap, and 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, and 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 Feb. 4 LinkedIn moment. It could happen as early as Q2. If management is able to 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.