Why Merrill Lynch Sees So Much Downside to Lululemon

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Lululemon Athletica Inc. (NASDAQ: LULU) reported its fiscal second-quarter financial results after the markets closed on Thursday. As a result, analysts poured into the stock after the company matched earnings estimates, and they were not impressed.

24/7 Wall St. has included some highlights from the earnings report, as well as what analysts are saying after the fact.

The yoga gear maker reported adjusted diluted earnings per share (EPS) of $0.38 on revenues of $514.5 million. That compared with EPS of $0.34 on revenues of $453 million in the same period a year ago. The consensus estimates had called for EPS of $0.38 on revenues of $515.47 million.

Total comparable sales for the quarter, including direct sales to consumers, increased by 5% year over year on a constant dollar basis. Same-store sales rose 4% and direct-to-consumer sales rose 7%, also on a constant dollar basis.

Income from operations increased by 14.4% year over year and as a percentage of revenue slipped from 14.7% in the second quarter of last year to 14.4%. Cost of goods sold rose by more than $20 million.

Merrill Lynch reiterated an Underperform rating and raised its price objective to $52 from $50. Management commented that traffic headwinds continued into the early fiscal third quarter. The brokerage firm continues to see risk in the second half same-store sales that could fall at the low end of mid-single digits.

Merrill Lynch said in its report:

Comparisons turn tougher in F2H as lululemon has to anniversary: a successful introduction of the pant wall (September), select price increases in women’s pants, acceleration in Men’s, and improved conversion on higher in-store inventory levels and promotions (now forecast inventory to grow slower than forward sales).

Gross margin expanded by 260bps y/y driven by lower markdowns, lower product costs, improved logistics/duty costs, and a more disciplined go to market process. Supply chain benefits should continue to drive significant gross margin expansion through F2H16. However, we believe gross margin expansion will moderate in F2017 given rising competition in athletic apparel and occupancy deleverage. Further operating margin expansion could also be limited by ongoing investments (especially in international) with high-single digit comps needed to leverage expenses.

In terms of the investment rationale, Merrill Lynch believes that Lululemon is one of the best square-foot growth stores in retail with strong brands and innovative products. Overall the firm believes that this has been a highly successful strategy; however, Merrill Lynch expects same-store sales to decelerate against difficult comparisons as competition in the athletic apparel market continues to increase. The firm also sees risks to operating margins given ongoing investments to support international expansion.

A few other analysts weighed in on Lululemon after the earnings report:

  • Cowen reiterated an Outperform rating.
  • BMO Capital Markets reiterated a Hold rating with a $64 price target.
  • Wedbush has an $84 price target.
  • Citigroup has a Buy rating with an $85 price target.
  • FBR reiterated an Underperform rating.

Shares of Lululemon were trading down more than 9% at $69.36 Friday morning, with a consensus analyst price target of $73.21 and a 52-week trading range of $43.14 to $81.81.

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