Lulu’s Production Chief Gets Pantsed

In a move that seemed inevitable given the stern tone the company has taken with its see-through Luon pants recall, Lululemon (TSX:LLL,NASDAQ:LULU) announced yesterday that its Chief Production Officer is “leaving” the retailer.  Specific reasons were not disclosed.

Mean ol’ Mr. Market

Since announcing the recall on March 21, Lulu’s stock has fallen from above $70 to the current $65 or so.  Nearly a $1 billion has been shorn from the company’s market capitalization for an issue that is expected to cost the company an estimated $0.11 to $0.12 in first quarter earnings.  This amounts to net income of about $16.8 million.  $1 billion in market cap for a $17 million hit to the bottom line – seems a tad excessive, no?

The hit that the stock has taken is a text-book case of what happens when a setback occurs at a company that the market has priced for perfection.

Lulu’s stock has more than tripled over the past five years and the Capital IQ earnings estimate predicts tremendous growth over the next five.  Analysts expect EPS to grow from $1.80 in 2013 to $3.77 in 2018.  For this tremendous past performance and impressive predicted growth, Lulu’s shares traded with a trailing P/E multiple of about 43.5 prior to the recall announcement.  Now, this multiple sits a smidge below 40.  Still a mighty high premium to the mid-teen multiple the rest of the market currently carries, but “cheap” relative to Lulu’s past.

Foolish Takeaway

The rewards are significant for investors that buy into stocks priced for perfection if the future plays out according to script.  These princely valuations however can be short-lived if the story begins to change.  Just ask most tech companies from the late ‘90s.

If Lulu’s production issues are a temporary hiccup, this dip will prove to be a buying opportunity as the multiple can be expected to expand back to pre-recall levels.

Given the premium to the rest of the market however, Lulu’s current valuation still does not support the production glitch being any more than a one-quarter story.  Expect the multiple to contract further and the shares to continue their decline if management can’t right the ship before the next quarter’s release.

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Fool contributor Iain Butler does not own shares in any of the company’s mentioned.  The Motley Fool has no positions in the stocks mentioned above.