Lululemon Is Oversold and a Value Buy Ahead of Earnings

NEW YORK (TheStreet) -- Heavily shorted stocks in decline typically have few options available. Declining revenue and income frequently means the only option available to management is to weather the storm and hope it passes. I love finding trending "it" fashion stocks that will crash the moment fickle and ever-changing tastes move on to the next thing.

I have a pair of Crocks (CROX) on a shelf that I never wear. I purchased my only Crocks as a trophy after successfully shorting it in late 2007. I've shorted many other fashion stocks since. If I believed it was a good short here I wouldn't hesitate. The fact that it's fallen so far doesn't dissuade me in the slightest.

I love shorting stocks making new 52-week lows. They almost always continue lower and it's a profitable strategy.

But there's no way I would short Lululemon (LULU) and the bear thesis is becoming incredibly fallacious.

In fact, I wrote a Real Money Pro post on Monday with a long trade idea.

Since earnings is just around the corner, let's first take a look at what Wall Street is expecting, and then I'll explain in charts why you want to buy Lululemon.

CEO Laurent Potdevin is anticipated to report 32 cents a share in this year's fiscal first-quarter earnings before the market opens on June 12. That would be a repeat performance of the corresponding quarter last year, and part of the stock's problem.

I think Lululemon will beat and report at least 34 cents per share, but lack of per share growth is the primary reason the stock isn't performing well. Fortunately, Lululemon has a relatively easy solution at its disposal that will soon become apparent.

The company also guided shareholders to expect gross margins between 50% and 51%, down from 53%, and that's the other primary concern. The Street's Herb Greenberg explains why margins matter in his fantastic piece on Michael Kors (KORS).

There's no way to sugarcoat or get around it: Luluemon needs to maintain margins or investor concern over pricing power will remain. The company claims the cost of airfreight and currency exchange rates are squeezing margins.

The Canadian dollar reached four year lows during this reporting quarter against the U.S. Dollar. The Canadian dollar also declined against the Australian dollar (CAD/AUD ) sequentially, although the CAD/AUD remains above the same quarter year-over-year.

LULU Net Income (Quarterly) Chart

In the aggregate, all else being equal, if the company can execute, reported margins should hold or expand. If the company can maintain margins and same store sales, it then boils down to simple math. New store openings results in increasing revenue and profits and Lululemon continues to expand its store count.

The company is already trading at a forward price-to-earnings discount compared to Nike (NKE) and Under Armour (UA). After considering the balance sheets, growth rate, and cash flow, I think Lululemon ranks as the best out of all three.

Under Armour is growing rapidly, but you will pay full price for it. Under Armour's forward P/E ratio is almost 50 compared to 22 for Nike and less than 20 for Lululemon. Unlike Nike and Under Armour, Lululemon is debt-free.

LULU Shares Outstanding Chart

The problem for shareholders, and why short-sellers are pounding on the stock, is the number of shares outstanding is also increasing. More shares mean the pie gets divided into smaller pieces. The pie is growing, but not fast enough to offset the bulging number of shares allowed into the float.

The simple solution is twofold. Use the strong positive cash flow and buy back shares on the open market at a greater pace than issuing employee stock options. That's a no-brainer and there's no reason the company can't use $400 million of the over $700 million expected in the next report) in cash during the next 12 months to undiluted shareholders.

Several things will happen. The buying pressure from the company will naturally stabilize and support the price. Investors will regain confidence as it becomes clear the stock isn't on a one-way street lower. Lastly, short-sellers will buy to cover and bank their gains. Keep in mind that Lululemon is one of the most shorted stocks with a 23% short interest. In other words, almost one out of every four shares is borrowed and shorted.

High-flying Under Armour's short interest is less than half and Nike's is 1.2%. If the shares begin rising, count on short sellers to step out of the way and buy to cover. Every dollar the company uses to reduce the float will have a multiplying effect as others join in.

The second part of the solution is to begin paying a dividend. I wrote why Lululemon should start paying shareholders earlier this week so I won't go into great detail here, but if the company wants to shake off the short-sellers and reward long-term investors it can and should.

The company is in a unique position with a balance sheet and cash flow to support both buybacks and a dividend. It's time to do both. If the company announces both during earnings expect a significant short squeeze.

At the time of publication, Weinstein had no positions in securities mentioned.

Follow @RobertWeinstein


This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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