Shares of Lululemon Athletica (LULU) rose on strong volume Thursday after the company announced positive earnings that beat expectations.  Shares were certainly helped by a strong market as the major averages rallied and the XRT index continued to bounce off the 200 day.  So the major question is whether LULU is borrowing strength from the market or rallying on its own merit…

Here are some quick bullet points from the earnings release:

• Q1 revenue up 69.3% to $138.3 milliion
• Comp store sales increased by 35%
• Income from operations was 35.5% of sales (vs. 12.1% last year)
• EPS $0.27 versus $0.09 last year
• Finished the quarter with $173.6 mil in cash
• Sales per square foot $1,428 vs. $1,318 last year

A 200% increase in EPS is definitely an impressive feat.  But investors should remember that the first quarter of 2009 was an especially trying time with consumers reigning in spending and general fear in the retail market.  This is the last quarter of relatively easy comparisons before investors start comparing earnings to more attractive periods.

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Looking forward, management is guiding investors to expect Q2 Revenue of $140 to $145 million and earnings of $0.21 to $0.23 per share.  This guidance includes a higher tax rate than previously expected which may end up being a bit of a weight on future reported earnings.

If LULU is able to hit the high end of guidance for the second quarter, it will represent an increase of 76% over the second quarter last year.  Management also issued full year earnings guidance of $1.05 to $1.10 per share. At the high end, this would represent a 34% increase over the challenging environment of last year.

Fundamentally, I’m concerned that investors are expecting too much growth out of LULU.  Growth of 34% is likely to be more of a high point than an overall trend.  As LULU captures more market share and grows its geographic footprint, the ability to put up substantial percentage increases for sales and earnings will definitely be challenged.  But at this point investors are willing to pay a multiple of 35 – suggesting significant optimism for long-term growth.

As the retail industry has come under presure, LULU’s pattern has morphed from a steady uptrend to much more volatile, choppy trade.  This should be concerning for bullish investors – and gives Mercenary Traders an opportunity to eyeball some key inflection points for potential short entries.

On Thursday, the stock opened sharply higher after the earnings report, but failed to maintain its strength throughout the day.  While the stock still logged gains, it was disappointing to see investors selling into the strength – especially given the late afternoon strength in the market.

I’m watching the stock carefully as specialty retail remains one of the more attractive sectors for short exposure, and LULU is setting up an interesting pattern.  On a very short-term basis, a breach of the 20 day average (currently near $40) could set up a rash of selling as momentum traders become less comfortable with the action post-earnings.

Longer-term, the $35 to $37 area looks like a key support area which if breached could be very damaging.  Since LULU is trading at such a high multiple, there is plenty of room for additional trade lower once support is broken.  With the potential for a loss of confidence, I think it is relatively reasonable to envision a scenario where LULU trades at 18 times forward earnings…  Using the high end of management guidance, we could still be looking at a price south of $20.

So I’m on the sidelines right now and continuing to watch the post-earnings trade pattern emerge.  But given the fact that LULU was unable to trade sharply higher on positive earnings news, I am not expecting much in the way of strength.