This Sports Apparel Company Could Stumble and Fall

Call it the casually of America, where you are just as likely to see someone wearing sweat pants and sneakers out to dinner as on a running trail. This trend to comfort and fitness has made athletic and active wear one of the few bright spots in retail apparel.

While shares of companies like Ralph Lauren (RL) and Phillips Van Heusen (PVH) are near 52 weeks lows having declined some 25% since their Christmas time highs the stocks of Nike (NKE) and Under Armour (UA) at are at new all-time highs having sprinted up some 11% and 21% thus far this year after each delivered knockout earnings reports earlier this month.

Maker of athletic leisure gear, Lululemon Athletica (LULU) has also enjoyed a solid run, gaining some 30% from their December lows to a current $63 a share. But when the company reports earnings after the close on March 25th, I think shares could go into deep downward dog if it delivers anything less than the expected $0.73 per share on $603 million in sales.

Valuation Still Stretched

A few years ago LULU splashed on the scene became one of the hottest brands as its expensive yoga wear garnered almost a cult following among celebrities and fashionista’s allowing it cross over to the mainstream. This created a surge in sales and its stock price which gained over 220% from 2011 to its peak of $82 in May of 2013.

But at that point, much like the high profile recall if its “too sheer” pants cracks in the business were beginning to show. There was a series of management gaffes, inventory problems, uninspired new designs led to sharp drop in the sales growth trajectory. Also, LULU’s early success spurred fierce competition as Nike and the Gap (GPS) rolled out their own branded yoga wear and started stealing market share. Suddenly, at 45x forward earnings the valuation seems stretched way to far; shares began a precipitous decline, dropping some 55% to their August 2014 low of $37 a share.

Over the past few months there have been management changes and scaling back the expansion plans which seems to have convinced investors and analysts that LULU is back on track. As mentioned, over the past four months share have climbed some 30% to $63 and analysts have been playing catch up by raising their price targets and earnings estimates. I think this makes the company very vulnerable to a sell off it fails to meet these heighten expectations.

Channel checks show that it still has an inventory mismatch problems with too few of the top sellers and a glut of men’s items which have failed to gain traction and sales are tracking below their $2000 per square foot target. I’m sure the company will place some of the blame on the weather and strikes at the West Coast Port.

But I think there is deeper fundamental problem; LULU rode fashion trend in a narrow niche which soon brought in competition. It’s now a crowded space whose days of growth have passed; earnings and revenues are expected to grow just 13% and 10% respectively in 2015. With no signs of being able to broaden its line or reach the current 35x forward earnings is not justified.

The chart presents a technically bearish picture. The stock recently gapped down and has now been rolling over under the 20 and 50 dma resistance lines.

LULU 032415

It should also be noted that during the run up from December to February the number of shares sold short declined by 30%; meaning that much of the rally was made up of short covering. They made their money and were locking in gains. While there is still 12% of the shares sold short much of that embedded buying power that could cause a squeeze has already been spent.

In fact I think bears will be ready to pounce a new should tomorrow’s earnings fail to meet the high expectations.

The Trade:

I’m keeping this fairly simple with basic vertical put spread in the weekly options. The options are currently pricing in about a $5 or 7.5% move. So I’m targeting a decline to at least the $50 level. By using a spread we will mitigate the impact of the decline in implied volatility that will occur following the report.

Buy the March Week4 $62 put and sell the March Week4 $59 put for a $1.20 net debit.

These options expire this Friday March 27th. If shares are below $59 on expiration the position will realize a maximum profit of $1.80 per spread. If shares are above $62 it will result in a total loss.

As this a very short term speculative earnings play I’m keeping it small and allocating just a ¼ of the typical position size.

— Steve Smith

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About the Author: Steve Smith