The Day Ahead: Secrets to Win Stock War Games

 | Mar 22, 2013 | 8:00 AM EDT  | Comments
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Stock quotes in this article:

lulu

,

urbn

"Never bring a balloon sword to a gun battle inside an undisclosed forest."

Back when I was a young stud stock analyst at the tender age of 21, with two monstrous calls under his belt (ironically Lehman Brothers and Washington Mutual, long), there was an evening meeting scheduled at the office of a research director. You see, the really cool loafer wearer who I thought was god for he ran an entire research deportment of spreadsheet tinkerers, was intrigued by our suite of products. Since the higher ups were doing their operational thing, I gladly took the meeting figuring two mega stock calls and tons of long nights spent studying the ins and outs of discounted cash flow analysis would easily help to secure a nice wad of electronically transferred cash. My brain has always been wired to win, so with a bit of sweet talk this director would be drinking from the trough of Sozzi. Boy was I wrong.

The meeting began perfectly. I lured him in with personal stories and the intricacies of the product suite that initially grabbed his attention. Then, as if a light switch was flipped, he gruffly asked: "what stocks do you like right this second?" Naturally I was prepared with a bunch of names, or so I thought that to be the case pre-meeting. Problem was that he quickly shot down every stock suggestion because I continued to offer in a roundabout manner: "the company is a terrific brand, and nothing will stop it from achieving a future of global domination." This was the gist of my sales pitch, accompanied with buzzy mentions of "multiples." The director was having none of this crap. To him, I had to have strong data to support bold claims on a stock that his firm would very likely take a position.

What essentially happed here other than my younger self getting schooled by an individual nearly three times older? I lost the stock war game, choosing to talk for the sake of adding hot air to the environment as opposed to dealing in past and current facts that lay the planks for a longer term buy or sell thesis. Ever since that occurrence some nine years ago I have never not arrived to a field for stock war games lacking heavy artillery. You may not realize I have the info handy due to suggested word limitations in various domains, but best believe there are lines of defense just waiting to be motioned into action. The lesson is that when holding a discussion on a stock to a partner, for example, have the facts, figures and charts to sway opinion into your favor on a seemingly worthwhile investment.

Watch how I do this with the hotly debated Lululemon (LULU).

Overview

A born again Peter Lynch disciple observes these interesting items on Lululemon, collectively mirroring the weak rationale I used as a young stud analyst:

  • Lululemon is opening many stores. Growth is awesome.
  • Lululemon's online sales are approximately 17% of total revenue, trailing only Urban Outfitters (URBN) at 23% for the highest ratio amongst publicly traded specialty apparel retailers.
  • Lululemon products sell at a premium to their peers and wow, they actually sell! Annual sales are in excess of a billion.
  • Lululemon same-store sales are outpacing others in the mall. Win.
  • Lululemon has a special emotional bond with humans due to a wonderful social message.
  • Hey, eventually those black luon pants will be back available for sale online and in stores. Surely Lululemon will return to operational superiority, and somehow the stock will be able to regrow into its persistently inflated valuation.

If you look carefully there is a serious lack of substance to those six bullet points. None of them really strike to the heart of whether to buy a richly valued stock (#SozTip: you don't buy a stock because its products are everywhere....those on the ground visuals may be factored into the stock price), following a major fundamental setback, for the portfolio. In order to make that decision, as I stressed above, there has to be a robust analytical effort on whether the Street has in fact mispriced the security. Look at the truth below, it would be difficult for me to pitch the stock in one of those must nail meetings.

Tapping the Inner Power of Charts

Comparable Store Sales

The law of large numbers has caught Lululemon, plain and simple. What this sales trend shows is twofold: (1) new entrants into a low barrier to entry field have made inroads despite a glorious social message; and (2) the company has hit a bar of resistance in terms of product prices (which it slyly mentioned on the earnings call...expect more competitive priced offerings for holiday 2013).

Source: Brian Sozzi

Gross Margin

Dovetails well with the concerns displayed in the comparable store sales trend. Key takeaways: (1) off-peak gross margin in the face of excessive Street bullishness and increased store/online growth, red flag; (2) higher costs of doing business (need more systems, people to operate) inherent to a company still in its infancy stacked alongside newfound pricing resistance in the marketplace, red flag.

The List of Intangibles

Another mysterious decline in Lulelemon's income tax rate questions the quality of the minor earnings beats relative to expectations:

  • 4Q12: 29.0% vs. 36.5%
  • 3Q12: 30.1% vs. 35.5%
  • 2Q12: 29.2% vs. 35.7%

The sources of the problem in the supply chain is certainly being addressed, but is not resolved by any means. That makes it difficult to have faith in a near-term surprising acceleration in same-store sales and margin expansion. 

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