Has Wall Street overreacted to LULU quality issues?

Last couple of weeks have been eventful for CEOs, COOs, and quality managers. Boeing is trying to fix faulty batteries in their 787, Fisker Automotive is in dire straits and expected to file bankruptcy after quality issues with their car batteries. And another company is about to face harsh consequences of quality mismanagement — a yoga-oriented retailer Lululemon Athletica.

Ten days ago Lululemon (LULU) made an announcement of the quality issues with their yoga pants, and lost $600M or 7% of their $9B market capitalization. Ouch. More details and numbers in this video.

What fascinates me in this situation is how the stock market reacts to these kind of events. During the earnings call LULU has reported that the pants issue is going to cost them ~$15M in revenue, which seems not too big of a deal given that their latest quarter revenue was $485M. Later on they made an amendment saying that more pants currently in production and sea-shipments are affected, so that greater revenue losses are expected, but they still should be confined to the 2nd quarter. Still, they are not going to lose all Q2 revenue – so are the markets overreacting in slashing $600M from LULU’s value? Let us try a quick calculation.

Suppose that the stock price represents the NPV of cash flow. Then 7% loss of market cap corresponds to 7% profit reduction in perpetuity. LULU has a net profit margin of about 20%. 15M revenue loss represents 3% of revenue or 0.03/0.2=15% of profits. Had these losses continue to perpetuity, the stock price reduction should have been also 15%. So the market is saying that LULU will recover, but it will come back having just a half of lost profits.

That’s a rather grim prediction, but it could be a correct one. LULU is no longer the only yoga retailer. Competition is going to make them pay for the glitch.

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