Conclusion: LULU's blunder has near-term financial implications, but the bigger question is whether high 20s margins are sustainable. We know that costs are going up, but now with such a major process breakdown that threatens one of its most important products it will surely call into question whether the real margin level is high 20s, 25%, 20%, 15%? The reality is that we simply don’t know. Regardless, this kind of uncertainty does not help with the stock trading at 30x earnings.
There’s one key question that we think should be asked about LULU’s ‘wardrobe malfunction’ announcement, and it has nothing to do with the impact on comps, the quarter, or the year.
The question is whether or not this issue is worth the $1.5 billion in market cap that the company collectively lost today (when the news leaked) and in after hours trading. We think that the answer is ‘Yes’.
We don’t understand how could this company possibly have had such a breakdown in its procurement process that 17% of the most important product (women’s bottoms) became compromised in quality to the extent that it could not be sold.
Some people on the Street will come out and defend this as LULU making a great move to do what it needs to in order to protect its brand image. Yes, that’s a fair argument. But it’s irrelevant in the context of how big of a mistake this was.
This is a company that has huge top line growth opportunity as it expands its reach globally. But margins are already in the high 20s, and we already know that costs are heading up to support more expensive growth. On top of that we’ve got proof of a hole in the company’s process that will hurt financially near-term.
Could this be a one-off 1-timer? Yes, it could, and we hope it is. But ‘hope’ is not an investment process. This will call into question how far LULU’s margins could potentially fall to preclude issues like this from happening again before finding a new baseline that will support future growth.
Is the real margin level 26%, 25%, 20%, 15%? If it's at the higher end, then the stock is probably a buy on this sell-off. But the harsh reality is that we simply don’t know. Regardless, this kind of uncertainty does not help with the stock trading at 30x earnings.