Let's Demystify Lululemon

• Lululemon Athletica inc. LULU reported its second quarter financial results on September 10 – pretty much in line with expectations.
• Since that moment, the stock has lost more than 25 percent.
• Following this decline, Oppenheimer analysts Anna Andreeva and Janet Lynne Knopf took a look at the company’s margin opportunities and reiterated an Outperform rating on the stock, while lowering their price target from $75 to $62.

Following its second quarter earnings call, Lululemon quickly went from being one of the most loved companies in Wall Street, to being one of the most feared. In a recent report, Oppenheimer analysts noted that, while top-line momentum remains “one of the best in retail (modeling 7% comps in 3Q15) and athletic still strong, with 60% inventory build and margin miss last quarter,” the market is still questioning the adequate profitability level and the management team, especially as competition continues to strengthen (Nike Inc NKE plans to open more than 1,100 new women's stores over the next 5 years).

The next earnings call is expected for December 12; “assuming in-line comps/gross margins, any sequential improvement in inventories would be viewed favorably,” the experts assured. So, they decided to walk through the company’s margin opportunities, adding that 20 million shares held by private equity “(Advent International, acquired at $42) should provide some downside support.”

According to the note, Lululemon’s margins fell ~800 bps over the past four years, and are expected to contract by 35 percent in 2015. However, this creates an opportunity into 2015, “even with occupancy & forex drags,” the analysts added.

They explicated that the largest opportunity is represented by the reduction in airfreight. Oppenheimer estimates the company “could capture 50-200 bps+ of gross margins by cutting air dependency in half (assuming air freight 30-50% more expensive than boat).” Moreover, the experts anticipate inventories will be in line with sales by the end of 2015.

The report went on to look into weather concerns, noticing that while the current quarter’s mixwas intentionally "wear now," with only 25 percent of the mix adequate for cold weather, the next quarter could see a surge in demand driven by seasonable weather.

Can Lululemon Grow Earnings In 2016?

Finally, the analysts looked into earnings, which have been coming in in a tight $1.80-$1.90 per share range over the last four years. So, the market is somewhat skeptical that 2016 can be any different. “Even assuming $2.00 EPS as our ‘bear case’ (GM down another 150 bps, EBIT margins sub 17%) and 20x multiple (levels stock never traded) yields attractive risk/return, for one of few consumer growth names,” the report concluded.

Disclosure: Javier Hasse holds no positions in any of the securities mentioned above.