Analyzing Lululemon's Growth And Current Valuation

| About: Lululemon Athletica (LULU)

Investors are often confused about the differences between growth stocks and value stocks. The main way in which they differ is not in how they are bought and sold, nor is it how much ownership they represent in a company. Rather, the difference lies mainly in the way in which they are perceived by the market and, ultimately, the investor. Growth stocks are associated with high-quality, successful companies whose earnings are expected to continue growing at an above-average rate relative to the market. In this article, I describe a very interesting growth company and analyze its recent and historical earnings, sales, margins, and valuation trends.

I think that Lululemon (NASDAQ:LULU) is a compelling investment opportunity for growth-oriented investors. The company has a strong management team, key competitive advantages, and superb potential markets. Shares are up 55% YTD, and several institutional investors have bought the stock in recent quarters.

I think that Lululemon is a compelling growth pick to analyze because the company boasts the highest retail sales per square foot in the retail apparel industry, with comparable-store sales hovering around $2,004 per square foot, nearly six times The Gap, Inc.'s (NYSE:GPS) $337 in sales per square foot across its portfolio in FY 2011. In addition, the company is growing in different areas and markets. Lululemon shows a strong combination of innovation and growth.

It is important to use checklists in analyzing growth stocks. As I stress in my blog Warren Trades, it is important to organize all of your financial analysis, predictions, and information in one place, and the majority of top institutional fundamental analysts use a checklist to ignore distractions and focus on the essentials. A checklist or fundamental routine helps experienced investors to refine and enhance their current fundamental analysis strategy. Here I will analyze the stock as I do when completing my own checklist.

Analyzing Lululemon's EPS and Sales Growth

If you go back through the history of the stock market, there is a recurring theme among those stocks that have had some of the strongest price appreciation -- it's related to their earnings growth. If you plot a chart of earnings growth vs. a company's stock price, there is a usually a strong relationship between the two. So, the first step when analyzing Lululemon is evaluating its earnings potential.

The first question to ask is how well the stock is growing when compared to the same quarter last year. Lululemon grew quarterly earnings at 44% compared to the same quarter in the previous year. I like the fact that Lululemon generated more than 15% EPS growth. My first requierement for growth stocks is quarterly EPS growth above 15%. Why? Because historical stock market winners showed quarterly EPS growth levels above this number before the stock made huge price increases.

Sell-side analysts just upgraded EPS projections for the company, increasing EPS estimates by 46% for the current year. Lululemon also shows a three-year annual growth rate of 72%. It is essential to evaluate the company's EPS growth trend in the past year in order to get a clear perspective on how the company has been growing.

The company generated strong growth in the past three years that was above my 15% threshold growth level. A key step in analyzing Lululemon is studying how sales grew in the recent quarters or years. Why is this important? Revenue growth cannot be masked with accounting tricks or via cost cutting strategies. This metric tells you in simple terms how demanded a company's products or services are.

LULU generated 37% quarterly revenue growth compared to the same period last year. LULU generated strong quarterly growth levels. I am confident in Lululemon's continued success in emerging economies.

It is important to not only watch quarterly earnings, which are more short-term oriented, but also to pay attention to how annual sales grew in the past three years. Lululemon reports 48% three-year annual sales growth. I require a minimum three-year annual sales growth above 13%, and Lululemon meets that criteria.

Lululemon ROE Analysis

The next step is analyzing LULU's return on equity (ROE). To quickly gauge whether a company is an asset creator or a cash consumer, look at the ROE it generates. By relating the earnings to the shareholder equity, an investor can quickly see how much cash comes from existing assets.

LULU's ROE is 35%, which is very good. I consider ROEs above 15% as good performance indicators. This is a good measure that the company has used reinvested earnings to generate additional earnings.

The company has a return on assets (ROA) of 30%. This is important to analyze because this ratio shows how profitable a company's assets are in generating revenue.

Institutional Investors Bought LULU in the Recent Quarter

I also evaluate recent institutional activity in the stock. In other words, which hedge funds bought the stock of late. In the recent quarter, both Goldman Sachs and Lone Pine Capital -- among other prominent investors -- bought LULU at an average price of $62.50. This shows that "smart investors" like this company.

Lululemon Valuation

The final step in any fundamental analysis of Lululemon is analyzing how cheap or expensive the stock is in relation to its industry and the S&P 500. For many stock market investors, the price-to-earnings ratio, or P/E, is the single most important number when considering the valuation of a company. Lululemon is trading at 46 times trailing P/E, in comparison to its industry average P/E of 19 times and S&P 500 P/E of 15 times.

It is important to evaluate why Lululemon trades at a premium P/E to the general market. I think that management sounded optimistic in the last earnings call, and investors are pricing a reasonable level of growth for the next two years. Lululemon also trades at a higher P/E than its industry average.

Another important step is analyzing LULU's five-year average P/E trend to get a perspective on how the stock is trading in comparison to the overall earnings multiple picture. The company has a five-year average P/E of 65 times. In addition, LULU also trades at 13.7 times book and 8.5 times sales, which I consider reasonable multiples from the kind of growth that the market expects.

Conclusion

Lululemon is a stock that generated high EPS and revenue growth. The company has a strong ROE, ROA, and profit margins. In addition, several institutional investors have been buying the stock in recent quarters, showing that the company passes strict fundamental standards these kinds of investors require. While its current valuation could be overvalued in relation to the general market and Lululemon's industry, I believe that the market is optimistic for the right reasons and expect more growth coming from this company.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in LULU over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.