Lululemon Deserves A Sell Rating

Jan.24.13 | About: Lululemon Athletica (LULU)

Shares of Lululemon Athletica (NASDAQ:LULU) have declined by 14.3% from their 3-month high of $77.19 attained in December 2012 to the current price at $66.13. Is now an opportunity to buy this high-growth stock on the dip? In this article, I will elaborate on my stock valuation analysis which may assist you in formulating the investment decision.

Relative Valuation

Sell-side analysts on average predict LULU's revenue, EBITDA, and EPS to rise by CAGRs of 23.3%, 24.1%, and 23.8%, respectively, over the next 2 fiscal years (see comparable analysis below). Those growth estimates are considerably above the averages of 7.4%, 12.7%, and 16.0%, for a group consisting of LULU's primary industry peers. However, the company's EBITDA margin is forecasted to expand by just 0.4% over the same period, compared to the peer average of 0.9%. On the profit side, LULU has demonstrated a superior margin performance as all of the firm's profitability and capital return metrics are significantly above the par. Compared to the peer-average debt level at 11.3% debt to capitalization ratio and 0.5x debt to EBITDA rate, LULU has a clean balance sheet and carries no debt. In terms of liquidity, the company's free cash flow margin is markedly above the peer average. Both the firm's current and quick ratios are above the par, reflecting a very healthy balance sheet performance.

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To summarize the financial performance, LULU's superior growth potential, profitability, and liquidity position should justify a significant valuation premium for the stock. According to the chart shown above, the stock's various trading multiples together represent an average valuation premium of 221.5% over the peer-average valuation multiples (see chart above), suggesting that LULU's stock price has fully factored in the company's premium financial performance and may even be somewhat stretched.

From a historical valuation standpoint, LULU appears to be somewhat overvalued. The stock's trailing P/E and EV/EBITDA multiples are currently trading at an average discount of approximately 14.3% to their 3-year historical averages (see chart below). However, I believe the stock's current valuation should command a deeper discount to the historical level provided that 1) there has been almost no improvement in the company's capital return measures including ROE, ROIC, and ROA over the past 3 years; 2) similarly, LULU's various profitability margins have also been flat over the period; and 3) the company's revenue, EBITDA, and EPS growth rates have dropped substantially since fiscal 2010, and the growth estimates over the current and next 2 fiscal years are pointing to a lower growth state (see charts below).

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DCF Valuation

I also performed a DCF analysis which incorporates the market's consensus revenue and EBITDA estimates from fiscal 2013 to fiscal 2017 (see DCF chart below). My analysis hereby is not meant to predict a fair stock value, but to gauge the key assumptions that are factored in the current share price and thus to test the margin of safety on the stock investment. The revenue growth from fiscal 2018 to the terminal year is assumed to gradually drop to a terminal growth rate of 5.0%. The EBITDA margin over the same period is set to be 30.5%, which is consistent with the market's estimated margin for fiscal 2017. Other free cash flow related items including depreciation and amortization, tax expense, capital expenditure, and net working capital investment are projected based on their historical ratios relative to the total revenue.

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As such, based on a WACC of just 9.7%, a terminal growth rate of 5.0%, and an implied terminal EV/EBITDA multiple of 12.6x, the DCF model yields a stock value of $66.62, which is fairly close to the current share price at $66.13. I am of the view that the various assumptions reflected by the current market share price are somewhat aggressive given that 1) the WACC of 9.7% appears to be low for a growth stock like LULU that has a 5-year average beta of 2.34 (my analysis used a 5-year peer-average beta); 2) although LULU's forward EV/EBITDA multiple is currently trading at 19.2x, the aforementioned terminal EV/EBITDA multiple at 12.6x still appears to be high as both the revenue and EBITDA growth rates are assumed to be 5.0% in the terminal year and LULU's peers whose expected growth rates are above 5.0% are now trading at even a lower valuation level (see comparable analysis chart above); and 3) the DCF model assumed constant capital expenditure/revenue and net working capital investment/revenue ratios at 3.5% and 1.0%, respectively, which are much more conservative than their historical ratios. Therefore, the DCF analysis implies a limited margin of safety.

On the qualitative side, the company's recent operational performance has demonstrated a sign of slowing momentum. According to Christian Buss, a research analyst at Credit Suisse (sourced from Thomson ONE, equity research):

"LULU's mature store (59% of stores) comp momentum has slowed in Canada over the past several quarters. We believe 3Q12's low-single-digit comp highlights LULU's challenges in driving incremental sales in these highly productive mature stores (Canada stores doing ~$3,000/sq ft vs. U.S's ~$2,000.) With this recent deceleration, our prior thesis for sustained double digit comps is at risk, as it was predicated on mature stores comping high single digits."

Bottom line, LULU's robust financial performance has been completely priced in and the stock's valuation offers very limited margin of safety. Given the likelihood of continued slowdown ahead, the stock should deserve a sell rating.

The comparable analysis and DCF charts are created by the author, all other charts are sourced from Capital IQ, and all historical and consensus estimated financial data in the article and the charts are sourced from Capital IQ.

Disclosure: I am short LULU. 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.