Short Interest Suggests More Downside For Lululemon Athletica

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Lululemon Athletica
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Submitted by Investing Daily as part of our contributors program.

By: Chad Fraser

Few stocks—especially in the hotly competitive retail sector—have put on the kind of performance that yoga apparel retailer Lululemon Athletica (NasdaqGS: LULU) has recently.

Consider that on June 12, 2009, the stock closed at just $7.12 (adjusted for a 2-for-1 split in July 2011). Yesterday, Lululemon ended the session at $63.21.

(If you’re unfamiliar, Lululemon Athletica is a Vancouver, Canada-based yoga clothing supplier that has been rapidly growing in the U.S. It is now branching out overseas, with stores in Australia, the U.K., China and New Zealand.)

However, the stock is also highly volatile, with a beta rating of 2.48 (Beta ratings are a measure of a stock’s volatility versus the overall market. Stocks with ratings above 1 are more volatile than the market, and ratings less than 1 indicate less volatility.)

Short Sellers Have Taken a Strong Interest in Lululemon Athletica

That level of volatility tends to attract the interest of short sellers. In fact, according to a recent article on investorguide.com, Lululemon Athletica ranked fifth on the Nasdaq in terms of short interest as of May 31, 2012, with 10.8% of its “floated” shares (or shares available for public trading) shorted as of the end of May.

(Short selling involves borrowing shares of a company and selling them immediately with the hope of buying them back at a lower price at a later date. If successful, the investor profits from the difference between the sale price and the repurchase price.)

In “Short Sellers and the Short Interest Ratio: Ignore at Your Own Risk,” Investing Daily editor Jim Fink took a look at the correlation between short selling activity and stock performance, and the results were surprising. More on that below, but first, here’s a look at the company’s latest quarterly earnings, which it reported last Thursday evening. The aftermath undoubtedly had investors who had shorted Lululemon Athletica smiling.

Here’s how the numbers looked:

In Lululemon’s fiscal 2012 first quarter, which ended April 29, 2012, its sales jumped 53%, to $285.7 million from $186.8 million a year ago. Same-store sales rose 25%. Earnings came in at $46.6 million, or $0.32 per diluted share, up 40% from $33.4 million, or $0.23 a share, a year earlier.

The latest results beat the Street’s expectation of $0.30 a share in earnings on sales of $270.9 million.

The company opened six stores in the quarter, ending with a total of 180 outlets worldwide.

Lowered Guidance Worries Lululemon Athletica Investors

Overall, there’s a lot to like about those numbers. But even so, the stock tumbled 8.8% on Friday. That’s because, given Lululemon’s explosive growth to date, expectations are sky-high, and investors saw three other indicators in the report that prompted them to hit the sell button.

For one, the company’s sales guidance fell short of expectations, coming in at $273 million to $278 million for the current quarter, below the consensus forecast of $289.8 million. The full-year sales forecast also proved disappointing, and the company said that it expects same-store sales to slow to “low double digits.” That’s still healthy, but well off the latest quarter’s 25% clip.

One side effect of the chain’s rapid growth has been a chronic shortage of inventory that has prevented it from taking maximum advantage of rising interest in its products.

Lululemon has been working on boosting its inventory in response, but now it finds itself with the opposite problem: in the latest quarter, inventory levels jumped 67%, to $107.7 million from $64.4 million a year ago. That puts a lot of pressure on the chain to keep up its strong sales through the summer—typically a weaker period in the retail business—to minimize costly markdowns.

Finally, due to its rising costs, expansion into new areas beyond yoga and increased competition, its gross margin slipped to 55.0% in the quarter from 58.7% a year earlier. The company said that it expects margins to slip below 55.0% for the rest of the year.

Why Short Seller Interest Matters

Back to short selling. In his article, Fink argues that investors who sell stocks short are worth paying attention to, even if you avoid the practice. That’s because, in his opinion, the best short sellers are often hardened investors who have developed a keen ability to zero in on a stock’s hidden weaknesses. In his words:

“You’ve got to be smart to survive as a short seller given all of the impediments regulators place in their way, not to mention the hostility of companies that sue them and the risk of short squeezes when lenders of stock decide they want the stock back. The Economist magazine calls the life of a short seller ‘nasty, brutish, and short.’”

Fink also cites a 2004 MIT and Harvard study that found a clear relationship between stock performance and high short selling activity. The authors’ conclusion was unequivocal:

“An investor selecting stocks for a portfolio should avoid stocks with a high short interest ratio. If an investor already owns a stock that develops sustained high short interest, the clear and strong advice is to sell the stock immediately.”

Whether Lululemon proves their conclusion—or provides an exception—remains.

Article originally posted here.

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