Lululemon Q1 preview

Firstly, I want to show you lululemon’s sales and earnings charts for the last 2 quarters.

Q3 2010

Sales were up 55%, earnings up 82%, and revenue’s Compounded Quarterly Growth Rate was 9.26%

Q4 2010

Sales were up 52%, earnings up 92%, and revenue’s Compounded Quarterly Growth Rate was 11.97%.

For the last 4 quarters Same Store Sales (or Comps as the are known) were:
Q4 28.00%
Q3 29.00%
Q2 31.00%
Q1 35.00%

My point is this: lululemon has grown their revenues, on average (CQGR), by around 10% per quarter for the past 3 years, their comp sales growth is incredible in the high twenties to low thirties (probably the best in retail), and earnings are growing faster than revenues. These numbers a truly amazing. lululemon obviously understands their market and they keep delivering fantastic results quarter after quarter.

What I expect in Q1:

Q1 is seasonally the weakest quarter for retail in general and this is no exception for lulu. In 2010 Q1 sales dropped 13.8% sequentially vs Q4 and 21.4% in Q1 2009. So “on average” Q1 sales drop 17.6% vs the preceding Q4 results. Earnings on average drop 35.7% vs Q4 results. What numbers did lulu tell us to expect in their Q1 guidance?

$177.5M in Sales and,
$26.7M in earnings

If you do the math, this would represent a sequential drop in sales of 27.6% (vs the 17.6% historical average) and for earnings a drop of 51% (vs 35.7% historical average). Meaning that if these numbers turn out to be what they report in June, it will be by far the worst Q1 that lulu will have had in the past 3 years. The question is, are they just lowering expectations so that they can easily beat the estimates (like Apple does every quarter), or are they really going to have a bad quarter? I’m not sure.

When I first heard the guidance I thought they were just “under-promising so they could over-deliver” however, over the last 2 months several issues have given me cause for concern:

Labor Costs
We know from the Gap conference call that it is getting increasingly expensive to employ “cheap labor” in Asian countries, like China. Some research reports that I’ve read even make the case that “labor arbitrage” will end around 2015 as hourly wages in China and Asia rise to levels similar to those of the United States. From 2005 to 2010 wages for factory workers in China increased by 69%. This is something that could hurt margins.

Input Costs Rising (Cotton, Spandex, Lycra, Nylon)
As we have all seen commodity prices have increased tremendously over the past 6 months. Corn, Silver, Wheat, Coffee, Orange Juice, Soybeans, Gold, and Cotton have all risen significantly and some of them have reached new all time highs. They are routinely trading “limit-up” in the futures pits. Cotton, Spandex, Lycra, and Nylon, the fabrics with which lulu clothing is made with, have all increased as well. Cotton for example is up 21.7% in the last 6 months ending May 21. The average price of cotton in Q4 was $167, the average price in Q1 (which ended in April) was $219, a 31% increase. Again, this will also hurt margins.

lululemon’s website was down for almost 3 weeks
In Q1 lulu renovated their website and brought it “in house” from a 3rd party web-hosting company. As a result, the website was down and pretty much non-functional for about 3 weeks in April. This is significant because their online sales make up around 10% of their total revenues. Overall, the upgrade took longer than I would have liked. I was expecting the upgrade to occur over a weekend and take 2 to 3 days at most. 3 weeks of down time equals a lot of lost sales. However, the site is back up, it’s better than ever, and running perfectly. This issue will hurt sales this quarter but it is an issue we all knew about and it will not surprise anyone, plus it sets the company up to handle future online growth.

High gasoline prices
This means less disposable income in the hands of consumers. It predominantly effects lower income shoppers and not the affluent clientele of lulu but coupled with higher food prices it is a net negative for all the retailers.

Higher crude oil prices
This translates into higher shipping costs. Shipping the clothing from Asia to Canada and then to the Retail stores in the United States and through out Canada will be more expensive as transportation companies like FedEx and UPS charge more to offset their higher fuel costs. Again, a net negative to retail margins and the economy as a whole.

Lastly, Inventory constraints
This issue was the main focus on the Q4 report. Have they found new manufacturers to source additional product from? Have the existing manufacturers ramped up capacity enough to meet demand? We need to see progress with respect to this issue. There is no doubt that the demand for lulu products is huge right now. The question is can lulu supply enough Luon to our yoga pants starved nation?

Overall Q1 was a pretty lousy quarter in terms of operating environment for retailers (look at GPS and ARO as examples). lulu’s quarter shouldn’t be as fantastic as some of its previous earnings reports but their numbers will no doubt be better than 95% of all other clothing companies out there. I am not expecting “blowout numbers” in June but I am still a strong believer in lulu’s growth over the next 3 to 5 years. Whatever happens in Q1, I will remain long and if we get a stupid panic-driven 15% to 30% sell-off, I will add to my position.

Disclosure: I am long lululemon common stock.

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