By Peter Konefal
Lululemon Athletica (LULU), a growth stock darling in Canada’s apparel industry, has potent brand power, sells out of its product before it hits the shelves and is in the early stages of its international and online sales development. Lululemon’s traditional focus has been its yoga-apparel and running markets, with significant sales to a broader market of buyers who are attracted to the casual wear products. Its strategy has been highly successful in diversifying beyond a yoga niche market, and capturing the hearts of a relatively broad, mostly female buyer for luxury sports and casual wear. The brand has benefitted significantly from its early mover advantage in what was once a very nascent market, broadening the appeal of yoga culture into the up-market athletic buyers of east and west coast North America and Australia. Under the leadership of Christine Day, formerly the president of Starbucks Asia Pacific’s region, the company is well positioned to continue to capitalize on its strong culturally distinct brand and premium quality reputation among its customer groups.
Its current financial situation is strong and its stock has reflected its consistently aggressive growth trend over recent years. This success has attracted short-sellers in droves. From a combination of both retained earnings and leftover shareholder injections, the company has a sizeable war chest of $276 million in the bank with which to fund future growth. Lululemon is in the midst of completing the remaining buy-backs of its franchise locations and with no immediate dividend pressures to worry about, can concentrate on remaining a growth story for years to come. Many investors may look at the company's 38% drop in share value since its exuberant July peak of $64.49 a share, and ask, what’s not to like?
Ultimately, all the above is true and compelling, and yet, value investors should be conscious of signs that earnings growth may be slowing, and to consider the fundamentals in order to avoid over-paying for a much-hyped stock.
Lululemon earned $230 million during the quarter ended Oct 30, 2011, and is on pace for revenue of $950.70 million assuming it can maintain its Q4 2010 comparable sales growth of 28% (the target is $337 million for Q4). This would be a significant achievement; particularly in light of recent difficulties the company has had maintaining adequate stock levels. Jefferies and Company analyst Taposh Bari has used these continuing difficulties as a reason to “wait and see” on Lululemon until into 2012. Not all of Lulu’s slowing growth can be attributed to stock-outs, and evidence is emerging of Lululemon reaching an inevitable saturation point in the growth that can be achieved with organic same-store sales growth: compared with Q3 2010’s comparable sales growth of 29%, last week’s announcement of 16% for Q4 2011 was a disappointment for investors.
Evidence is emerging as well, that the stock is more than well priced at present. An investor who purchased the shares at the beginning of 2011 would have experienced a rocky, but mostly upwards ride, gaining 34.05% year to date. On a five year, annualized basis, investors were rewarded with an average annual return of 45.4% - quite strong considering we are talking about a Canadian company outside of technology, mining or resources, and an industry with relatively few barriers to entry (proponents will argue the brand and early mover advantage on the yoga culture front create barriers).
On a broad basis, assuming the investor has no specific interest in growth stocks in the apparel sector, and notwithstanding the recent discount the stock has experienced in recent weeks, Lululemon’s P/E at 40 remains costly relative to global growth stock or apparel substitutes. If investors are willing to assign significant P/E premiums to the growth potential for a company, why is a giant such as Apple’s (AAPL) P/E a relatively modest 14.21 despite more than doubling its sales in the past two years? Under Armour (AU) is perhaps one of the most similar to Lululemon from a P/E perspective, at 47.45, and showing no signs of coming down to earth any time soon. In the apparel industry, more mature firms such as Nike (NKE) , Ralph Lauren (RL) and the Gap (GPS), to provide counterpoints, also possess more modest valuations, in the 10-20 range. Granted these are not growing at Lululemon’s rate, but they provide less risk, and are more justified from a fundamental perspective. With a beta of 2.48, Lululemon’s stock has fluctuated from a high P/E of 44 (currently it is at 39.7) to 15 this year, and experienced a range in values of 38 to 5 in 2010. Assuming the stock continues its volatility, at least in the near term, it is likely there will be attractive entry points for savvy buyers in the future. Most analyst coverage hovers in the “hold” range, noting that the company only looks weak when compared against its own prior growth (it still far outperforms most similarly sized peers), and allowing for fickle sell-offs for negative future news on comp sales growth or inventory issues.
Currently, the outlook for the Lululemon is more subdued than it has been from a fundamental economic perspective. Jason Asaeda of Standard & Poors has issued a neutral outlook on global demand in the apparel, accessories and luxury goods sub-industry segment, noting, however that the resiliency of core affluent shoppers will continue to bolster luxury brands. Overall apparel sales grew 1.9% in 2010, versus a 5.1% decrease in 2009. Growth in 2011 was modest overall at 0.7%, and the outlook remains neutral. These trends, while important, are not expected to effect Lululemon significantly, as its customers are already less price-sensitive than mass channel customers, however the indication of slower growth, even in the luxury segment reinforces the trend seen in lower Q3 year-over-year comp sales growth: growth will come, but it will increasingly be slower, and more dependent on new store openings. Lulelemon’s senior management continue to note the lack of price resistance amongst their “guests” and if anything, are likely to develop more expensive apparel in the future.
Ultimately, Lululemon currently, as I’ve said, is overvalued – even despite factoring in its growth. Using a price-to-sales ratio, a measure of the cost investors pay for one dollar of sales, Lululemon at $5.70 is above its peers such as Under Armour ($3), Nike ($2.03) and PVH ($0.83). Factoring in growth prospects, using a price/earnings to annual EPS growth ratio, or PEG ratio, we can see why the street is still calling for a $54-$65 price target in 2012. Compared with its peers, Lululemon’s PEG ratio is 0.56 relative to 1.12 for Under Armour and Nike. Nonetheless, these measures are backward looking, and should be modestly discounted based on decreased comp performance, a still volatile economy and somewhat dampened luxury goods demand. Our recommendation remains hold or sell in favour of more attractive opportunities, and we maintain a price target of $52.
Shares of Lululemon opened at 45.30 on Thursday. Lululemon has a 52-week low of $30.91 and a 52-week high of $64.49. The stock’s 50-day moving average is $51.64 and its 200-day moving average is $53.06.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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