Lululemon Athletica: Three Components for a Meltdown

by Zach Scheidt Wisdom of Wealth Wisdom of Wealth

Shares of Lululemon Athletica (Nasdaq: LULU) are off sharply this week after the company’s CEO announced she would be leaving the firm. Over the past few sessions, the stock has dropped from Monday’s closing price of $82.28 to a current reading of $64. By the time you read this, the stock could be even lower.

Investors in Lululemon are a loyal breed. And over the past several years, they have been paid very well for their loyalty. The company has generated reliable growth and created a significant amount of wealth for those who have held on to the stock.

But loyalty is turning into a liability for shareholders today. Lululemon is transitioning from a growth stock to a more mature company. As painful as this week’s loss has been, it is likely just the beginning of a much larger price decline.

Many traders I have talked to are “taking advantage” of the lower stock price to buy more shares of Lululemon. They believe the stock will rebound “as it always has” and they will realize a profit when the stock turns higher.

But given the underlying dynamics behind this stock, I would recommend selling your shares today to avoid further losses as Lululemon continues to decline.

Three Components for a Growth Stock Meltdown

Growth stocks can be tremendous investments. Accelerating earnings growth, rising estimates and premium price-earnings multiples can push stock prices sharply higher for an extended period of time.

But when the story begins to unravel, these stocks often take nosedives - and continue to fall for a period of several weeks to several months! Lululemon appears to be just entering that stage.

For many of these growth stocks there are three important components that contribute to the meltdown:

  • A premium (high) price valuation.
  • Decelerating growth expectations.
  • An overarching catalyst that ignites the sell-off.

All three of these components are in play with Lulemon Athletica today. Let’s take a look at each individually.

1) A Premium Price Valuation

As growth companies continue to impress investors with strong earnings each quarter, investors become willing to pay a premium price for the stock. It’s not uncommon for growth stocks to have valuations of 35 to 55 times expected earnings, and in some instances the premiums are even higher.

Analysts are expecting Lululemon Athletica to earn roughly $2 per share this year. So at the beginning of the week when LULU was trading above $80, investors were paying more than 40 times expected earnings for this stock.

Even now, with the price point significantly lower, investors are still paying more than $30 for every dollar of earnings the company is expected to generate this year.

Premium price valuations indicate confidence that the company will continue to grow. Investors won’t pay a premium price for earnings unless they expect the company to continue to grow earnings so that they are eventually compensated for the high price they paid.

Premium price valuations also carry risk that the company will fail to live up to investors’ expectations. If you buy a stock under the assumption that the company will continue to grow earnings at a certain pace, and then those expectations prove to be optimistic, you will likely sell your shares, driving the price lower.

2) Decelerating Growth Expectations

A premium price valuation isn’t a problem in itself. Almost ALL growth stocks have premium valuations because of the expected growth.

But when you add on decelerating growth expectations, things start to get a lot more troubling. Now keep in mind, we’re not talking about a decline in earnings yet. We’re just talking about less growth than investors have become accustomed to.

This is a hard concept for some investors to grasp. They see their company continuing to make record earnings, but the stock is declining. They don’t understand why!

Realistically, if a company is growing earnings consistently by 30% every year, you can justify paying a high price for the stock. It takes only a few years of growth for earnings to quickly compound and catch up to your high purchase price.

But if a company is growing earnings by only 5% a year, it will take much longer for earnings growth to compound. If you’re a new investor looking at a company that grows by only 5% a year, you should probably pay only 6 or 7 times earnings for the stock. Note that the company is still reporting record earnings every year, but the record just isn’t that much higher than last year.

For Lululemon Athletica, analysts are expecting the company to grow earnings by only 7.6% this year. Much of this growth deceleration is due to an embarrassing product defect that the company dealt with this year. (The company’s yoga pants became “transparent” when stretched - yikes!) But even looking out into next year, analysts have been actively revising their estimates lower.

As expectations for Lululemon Athletica decline, new investors will not be willing to buy the stock at the current premium price. The imbalance between supply and demand will naturally push prices lower, leading to losses for current investors.

3) An Overarching Catalyst

For a growth stock to truly break down in spectacular fashion, there needs to be an event or a significant issue that arises and causes current investors to dump their shares.

One might have expected the fiasco with the transparent pants to ignite such a sell-off, but that wasn’t the case with LULU. Instead, the stock took a tremendous hit when Christine Day announced that she would step down as the company’s CEO.

Ms. Day has been a talented leader for Lululemon, so it’s no wonder investors are reacting negatively to the news. The company’s figurehead was a tremendous asset in that she embodied the target customer of Lululemon Athletica.

A professional woman who was competitive, active and well spoken, Ms. Day carried herself and her company very well. Her influence throughout the past several months certainly helped the company stay on track despite the major product issues.

In the absence of Ms. Day, investors are left to wonder exactly how aggressively the company will continue to grow.

  • Will LULU continue to lead the market in attracting new customers?
  • Will management be able to aptly negotiate supplies, leases and other business ventures?
  • Who will spearhead conversations with key investors and lead key presentations?

Uncertainty is never a good thing for investors - and specifically for growth stock investors. Ms. Day’s departure has served as a catalyst for the stock to start trading lower (beginning to shed its premium valuation, and to succumb to declining growth expectations).

Catalysts also have a way of triggering MORE catalysts. For instance, the departure of a CEO could lead to contract renegotiations, or the uncovering of a deep structural problem with the company (often the real reason a figurehead has decided to move on).

Better Safe, Than Losing Capital

In situations where long-term growth stocks suddenly take on water and begin selling off sharply, the temptation is to step in and buy. “True Believers” can always make an argument for why the stock will rebound and why the current issue will pass.

But the significant danger is that uncertainty will continue to pressure the stock, sending shares spiraling until they reach a point where valuations are cheap (not just “reasonable”).

Don’t let this spiral take a bite out of your net worth. If you own Lululemon Athletica, sell your shares today before they continue falling. There are plenty of growth opportunities with much more certainty that will allow you to more safely generate long-term gains.

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