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Lululemon Athletica inc. (LULU), The Gap Inc. (GPS): Why’d This Stock Crash on Good News?

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Imagine that you own stock in a company that is about to report its quarterly earnings. The company reports that revenue grew by 21% year-over-year, beating analyst estimates by nearly 5% in the process, and that same-store sales rose by a solid 7%. EPS bests analyst estimates by a few cents, and guidance for the next quarter is higher than analyst expectations. Seems like good news, right? Wrong. The shares plummet after-hours by as much as 14%, and the CEO resigns.

If you’re a shareholder of Lululemon Athletica inc. (NASDAQ:LULU), this is the exact scenario that played out on Monday. Although the drop in the stock price seems counter-intuitive, it makes perfect sense if investor expectations are far higher than analyst expectations.

Lululemon Athletica inc. (NASDAQ:LULU)

Crazy expectations

Lululemon Athletica inc. (NASDAQ:LULU) sells upscale athletic wear. It’s not some hot new cloud-based tech company, it’s a clothing retailer. But before the after-hours drop the stock was trading at a mesmerizing 44 times 2012 earnings and 32 times the expected earnings for 2014. The expectations of investors were outrageously high.

A company that sells pants can only meet these expectations for so long, and on Monday the bottom fell out. Now, there’s no doubt that Lululemon Athletica inc. (NASDAQ:LULU) has the capability to grow very quickly–but growing fast enough to justify trading at 44 times earnings is just unrealistic.

One thing that will eventually hold the company back is the premium nature of its products. While the market to which Lululemon Athletica inc. (NASDAQ:LULU) caters is relatively wealthy, it’s not all that big. There are only so many people willing or able to pay $90 for a pair of exercise pants. Offering lower priced items tarnishes the brand and lowers margins, but sticking to premium products puts a cap on growth. Regardless, neither path can possibly generate the kind of growth that investors seem to have expected before earnings.

Cheaper alternatives

Stores run by The Gap Inc. (NYSE:GPS) sell the same types of items that Lululemon Athletica inc. (NASDAQ:LULU) sells but at a more attractive price. The Gap Inc. (NYSE:GPS) is much larger than Lululemon and doesn’t offer the same growth prospects, but the price you pay for what growth it does offer is far more compelling. The Gap Inc. (NYSE:GPS) sells at about 18 times 2012 earnings and 15 times the expected 2013 earnings. The average analyst estimate for annual earnings growth over the next five years is about 12%, and the first quarter of this year saw sales rise by 7% and EPS jump by 50%.

The question you have to ask yourself is: would you rather pay 44 times earnings for a company that could conceivably grow earnings by 25% per year but possibly lower, or pay 18 times earnings for a much more established company growing at 12% per year. The choice seems clear.

Another alternative, this one on the opposite side of the spectrum from Lululemon, is The TJX Companies, Inc. (NYSE:TJX). TJX Companies, Inc. (NYSE:TJX) is an off-price retailer, selling excess merchandise from manufacturers and other retailers at rock-bottom prices. TJX has been growing rapidly, with revenue increasing by 11.6% in 2013 and EPS jumping 32%. Analysts are expecting 11% annual earnings growth over the next five years, and the stock trades at about 20 times 2012 earnings and 18 times expected 2013 earnings.

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