Downgraded LULU from top pick to mere buying opportunity; still holds position with 24% upside to $128 fair value despite rising risks.

Lululemon sales fell by 4% compared to the same quarter last year and comparable store sales fared even worse. Unsurprisingly, the stock price collapsed following this update as investors were disappointed in its performance. I'm certainly disappointed.

I own Lululemon stock in my portfolio and I had previously ranked Lululemon stock as one of the best stocks to buy this year.

It's underperforming the overall markets considerably and in this video, I'm going to review the company's results and update my ranking for Lululemon and let you know if I still think it's one of the best stocks to buy right now or if this quarter's performance was so bad that it warranted a downgrade of Lululemon.

So, the interim co-CEO said, "While we continue to navigate some challenging dynamics, we are taking a prudent approach with our revised full-year outlook." Their strategy remains accelerating growth by strengthening their product offerings, increasing their marketing investment, and maintaining disciplined expense management.

So, this is a disappointing statement and one that investors don't like to see very often, but I will say this happens often times when there's a new CEO that's about to take the helm.

The existing management team or the incoming CEO will want the company to clean house ahead of the incoming CEO. In this way, if the former CEO lowers the target and then the incoming CEO comes in and delivers a good quarter in the upcoming quarter or in the upcoming year, that CEO can say, "Look, I outperformed expectations upon my arrival."

So, there is some of that going on undoubtedly, but within the business it had been slowing down already amid broader macroeconomic challenges, tariffs, increasing trade barriers have been very bad news for Lululemon and the management team has found it difficult to adjust to those changing dynamics.

They went on to say, "We look forward to welcoming our incoming CEO Heidi O'Neill next week as we begin an exciting new chapter for the company." And this gives the incoming CEO a lower bar to jump over, right?

Cleaning house, getting everything out into the open, all of the losses, all of the challenges, revising the outlook significantly lower, sending the share price significantly lower, that makes it a lot easier for the incoming CEO to outperform, to have a better record on performance, on shareholder returns, and unfortunately this happens often times when companies are transitioning from leader to leader.

Overall, net revenue decreased by 4% to 2.4 billion. America's net revenue decreased by 8%. Of course, this is where it faces the most headwind as increasing trade barriers make it more difficult for Lululemon to sell its products in the United States at competitive prices.

It manufactures nearly all of its products outside of the United States and sends its products to its United States, so it's exposed to significant tariffs, as are many retailers, many brands.

Gross margin actually increased by 200 basis points for Lululemon because of a tariff refund. They got back $135 million, which which is because the Supreme Court in the United States ruled that one of the many tariffs that President Trump implemented was illegal, so the US government had to provide provide refunds.

They've so far delivered several billions of dollars of refunds to companies that were forced to pay these tariffs.

But, what was most disappointing to me was international sales for Lululemon only increased by 4%. This was a category where Lululemon was growing 20-30%, and a category that it was a significant tailwind, but in the most recently completed quarter, the growth rate significantly slowed down.

Operating income decreased by 13% to 454 million, and operating profit margin declined by 190 basis points, even including a $135 million benefit from tariff refunds. So, this was an absolute disaster of a quarter for Lululemon.

They repurchased 2.7 million of their shares during the quarter for $330 million. Also, a curious decision from the management team to repurchase shares ahead of what they knew to be a very disappointing quarterly update.

Uh perhaps this was already pre-programmed and already implemented earlier in the quarter.

Uh the company Another disappointing thing is they still opened nine net new stores during the second quarter. I And I say this with about Starbucks as well. When you're finding it challenging to operate your business as it is, I wouldn't be looking to expand or add new locations in the middle of these significant headwinds.

I would prefer the attention be focused on improving operations at existing locations rather than opening new locations amid this difficult and challenging macroeconomic moment.

Again, but this might have been things that were already planned in advanced and these stores were just completed during the most recent quarter, which was more likely what happened.

Uh because it takes time, as you know, to pick a location, do all of the things necessary, and get that location opened. It takes several months, perhaps sometimes even up to a year.

And so, what I would like to see from Lululemon now is in the upcoming quarters a real reduction in new store openings. Really, you know, put that on the back burner and focus on right-sizing your operations, figuring out how to adjust to these tariffs, and compete in this macroeconomic backdrop, which is not improving anytime soon, sorry to say.

So, the good news is this company has an absolutely pristine balance sheet, and that remains the case. They're still generating, even though their profits are shrinking, they're still generating hundreds of millions of profits every quarter and cash flow every quarter, and that's improving their balance sheet further still.

They now have $1.4 billion in cash and zero debt.

So, they now revise their outlook for 2026 where they expect revenue to decline about 6% at the midpoint. So, -6% for a business that's supposed to be growing. That was a very disappointing downgrade of their expectations.

So, Lululemon stock is now trading at its cheapest valuation ever. And it was already trading at its cheapest valuation ever coming into these results, and it's gotten even cheaper.

It's now trading at a forward price to earnings of just 11. Just 11. That's extremely low for a business that had previously been trading at forward price to earnings ratios approaching 50, and it's now trading at 1/4 of those valuations.

So, I updated my discounted cash flow for Lululemon with a few estimate changes. First of all, I changed the amount of free cash flow I expect the business will generate over the next few years.

So, I'm forecasting continued declines year 2026. I'm forecasting cash flow to drop from 2025, and 2027 I'm forecasting another year of decreases. 2028 I'm forecasting another year of decreases before 2029 I finally expect them to turn things around and start generating growth again.

I also revised my risk for the business higher by about 20% because now it's an increasing risk of losing more market share and becoming one of those falling knives, a value trap rather than a value stock.

Those risks have accelerated. I increased the risk by about 25% as I adjusted the beta higher.

So, that all had the impact of decreasing the fair value estimate down to $128 per share. And compared to the current market price of 103, there still remains about 24% upside, but it's now becoming as I mentioned an increasing risk of being a value trap rather than a value stock.

So, I did downgrade Lululemon stock. It was formerly ranked as one of the best stocks to buy. I downgraded it to just a buying opportunity. And I downgraded that on September 4th, uh the day after the results.

I evaluated and downgraded it. The Investor Tier members that have access to the spreadsheets were able to see that on that day. Everyone else is getting to see that as I'm uh publishing this video on and I'm updating it again on September 8th.

I still own Lululemon stock in my portfolio. I haven't sold. I'm not interested in buying more, and I am now considering selling this stock for tax loss harvesting purposes by the end of the year.