Mar 215 2020 - Lululemon: Digging Into The Valuation After The Drop

Lululemon has fallen more than 50% from its highs, making matters worse for the deceleration in sales growth that was in place prior to COVID-19 scare.

Fortunately, this 50% drop has improved the company's valuation considerably, and much of the slowdown is  now likely priced in near 0.00.

The good news is that technical support has held for now, with a strong bounce near the 5.00 level quarterly support.

As long as we do not see a drop through the 5.00 level on a monthly close, the bulls will remain in control of the big picture.

It's been the most volatile month in more than a decade for the markets (SPY), and even the strongest market leaders have been unable to sidestep the turbulence. Lululemon (LULU), which was up 90% last year, has seen the majority of these gains given up, with a more than 50% decline from peak to trough since February. Unfortunately, for investors that chased the stock earlier this year, the clear deceleration in sales growth expected in Q1 2020 and Q2 2020 will likely be exacerbated, given that the company chose to close its North American and European stores from March 16th through the 27th. We could certainly see a re-test of the March 18th low at 8.00, given the uncertainty in the market, but the bulls will remain in control of the bigger picture as long as they defend the 5.00 level. For now, I'm staying on the sidelines as I want to see a bottoming pattern develop before jumping in the stock.

(Source: TC2000.com)

Just over three months ago, I wrote on Lululemon, discussing that we were likely to see a deceleration in sales growth for the stock as we headed into FY-2020. While the company had just reported a massive quarter in Q3 with 6.1 million in revenues and 23% growth year-over-year, the prior-year comps for Q4 would be challenging to beat, given the 26% growth rate. Given the high likelihood of deceleration, I suggested it might be wise to take some profits as the stock was priced for near perfection. Obviously, no one could have predicted a virus that would spur a tsunami of closures across the retail sector, but this is the risk when chasing stocks that are priced expensively. Although the company's Q4 results will only see mild deceleration, the more significant issue is now Q1 and Q2 sales growth, and estimates seem far too ambitious. Let's take a closer look below:

(Source: Seeking Alpha Premium)

Quarterly Revenue & Current Estimates As Of December 2019

(Source: YCharts.com, Author's Chart)

If we take a look at the table above, we can see how revenue estimates looked three months ago, and compare them with where we sit today. As we can see, Lululemon was set to see a sequential slowdown of 800 basis points in Q4 2019, with quarterly revenue growth dropping from 23% to 15%. Meanwhile, Q1 2020 and Q2 2020 revenue estimates were expected to slip to mid-double-digit levels, down from average revenue growth of 21.6% in the first nine months of 2019. Since that time, we've seen a significant revision in estimates, with estimates rising significantly in Q4 2019, now forecasting a more modest deceleration. However, we are seeing revenue estimates dragged down for Q1 and Q2 2020 on the assumption that the virus will be a moderate headwind for revenues. Let's take a closer look below:

Quarterly Revenue & Current Estimates As Of March 2020

(Source: YCharts.com, Author's Chart)

As we can see from the table above, revenue estimates are to just 17.5% growth year-over-year for Q4 2019 revenues, with estimates currently sitting at .37 billion. This would mark a quarter of material deceleration, as we would see a slowdown of 550 basis points. However, revenue estimates have only been dragged down by million for Q1 2020, from 6 million in late December to 9 million currently. I would argue that these estimates are quite ambitious, given that only 27% of the company's sales were online as of Q3 2019, and sales will slump due to two weeks of store closures. However, even if we assume these estimates are correct, this will mark the first time in over two years that the company's sales have decelerated sequentially for two quarters in a row. Therefore, even in a best-case scenario under the assumption that Lululemon can report 9 million in Q1 revenue, we will clearly see a slowdown here, whether it's at the fault of the company or not.

(Source: YCharts.com, Author's Chart)

If we look ahead to the Q2 2020 revenue estimates, we've also seen them pulled lower, with expectations for only 10.5% growth year-over-year vs. previous forecasts of 15% growth. The current revenue estimates for Q2 2020 are sitting at 5.5 million, and are more conservative as they've shaved over million off of the prior estimates. However, if the company can't meet or beat these estimates, we will revenue growth rates contract to low double-digit levels in Q2, which is less than half of the two-year average revenue growth rate of 22.5% currently. Therefore, investors should not be surprised by the sell-off we've seen, as we're likely to see material deceleration going forward in Lululemon's sales growth, assuming things aren't back to normal starting by mid-April. I would argue that the consumer is likely to be a little shell-shocked following this COVID-19 black swan, and we are less likely to see the same spending habits show up until at least mid-summer. Based on this, the Q2 revenue estimate of 9 million may end up being on the high end as well.

The material deceleration is undoubtedly a negative development for Lululemon, as the company is in for a rocky couple of quarters ahead. The good news about the recent 50% correction, however, is that it has significantly improved the company's valuation. Therefore, a good chunk of the uncertainty around forward revenues have been priced into the stock. As the chart below shows from my December article, Lululemon was trading at 8.1x sales heading into the holiday season, and more than 30% above the median peak valuation for market-leaders in the apparel industry over the past 20 years. However, at a share price of 4.00, the company is now trading at 5.7x sales, a giant step in the right direction to resetting the valuation.

(Source: YCharts.com, Author's Chart)

While a revenue multiple of 5.7 is still a little expensive for an apparel company with decelerating growth amid less enthusiastic consumer spending habits, I would argue that a revenue multiple of 4.5 would leave the stock undervalued. Therefore, if we could see Lululemon drop below 0.00 per share at closer to a billion market capitalization, I believe that valuation would start to become a tailwind. This would be the exact opposite of what we saw above 0.00 per share when the valuation was a massive headwind. Let's move over to the technical picture below:

(Source: YCharts.com)

As we can see from the monthly chart below, Lululemon has dropped beneath its 10-month moving average (white line), and this has put a dent in short-term momentum. However, the stock has a strong support level at 5.00 near its Q4 2018 lows, and the bulls played defense here Wednesday with the market briefly limit-down. As long as the bulls can defend this area on a monthly close, they will remain in control of the bigger picture. Therefore, while the bears may have the short-term momentum which should lead to rallies being sold, the bulls seem to be showing up where they need to for now in terms of the long-term support levels. For now, we have a wide and volatile range, with the rallies to the 5.00-7.00 level being selling opportunities, and corrections to the 5.00 level being an area where valuation begins to improve considerably.

(Source: TC2000.com)

In summary, it looks like Lululemon is going to see a massive deceleration in sales growth for FY-2020, but the good news is that the market often discounts ahead of time. After a 50% decline from the highs, I would argue that two weak quarters (Q1 and Q2) have been mostly priced in at the Wednesday lows and that any drops to the 5.00 level have a good chance at being bought up. If the bulls can defend the 5.00 level on a monthly close and we see a constructive bottom put in, this would be the ideal buying opportunity that investors on the sidelines have been waiting for. For this reason, I have not started a position in the stock, as I see a high probability that we head back to the 5.00-6.00 level at a minimum before this correction runs its course.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: Taylor Dart is not a Registered Investment Advisor or Financial Planner. This writing is for informational purposes only. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Taylor Dart expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.