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Introduction

Lululemon Athletica (NASDAQ:LULU) is valued very high, and paired with its recent quarterly earnings reports, we believe that LULU is strongly overvalued. In the article that follows, we will show you how indicators in its Q3 2012 earnings report show that its stock will devalue over the next fiscal year due in part to over valuation. LULU is a company that is working against rising competition from other high-quality fitness clothing brands and we do not see any concrete plans for the 2013 fiscal year that counteract this. Although LULU should maintain increases in profits we believe that the company will devalue over 20% in 2013 to become more fair valued, so we maintain this stock at Sell.

Profile

Lululemon Athletica is an apparel manufacturer that specializes in technical yoga and run clothing for women, men, and female youth. LULU was established in 1998 by founder Chip Wilson and held its first retail space offering clothing for healthy lifestyle activities in a yoga studio in Vancouver BC. LULU also sells fitness-related accessories including bags, socks, underwear, instructional yoga DVDs, water bottles, and yoga mats. Customers can purchase LULU products directly through e-commerce, in corporate-owned and franchise stores, and in independent yoga studies, health clubs, and fitness centers making up LULU's wholesale network. LULU has a global presence and as of January 2012 had 47 stores in Canada, 108 in the United States, 18 in Australia, and 1 store in New Zealand. Today LULU's headquarters is in Vancouver BC, where it was originally founded.

Thesis

Valuation

LULU's current PE is 42.9, nearly double the industry average of 22.7, and the future PE is 30.9. This company is among the highest valued stocks in the industry. A strong valuation means that investors need to continue to have the utmost confidence in growth. Any signs of growth slowing will cause shares to decrease significantly.

For LULU's Q3 of 2012FY, LULU saw an increase in net revenue YoY of 37% from $230.2 million to $316.5 million. During this quarter LULU also saw a 36% increase in gross profit from $175.3 million and an increase in income from operations up 35% to $80.6 million. For the 39-week period ended in October of 2012, LULU saw an increase of 41% in net revenue from $629.3 million in 2011 to $884.9 million in 2012. The company's gross profit increased 36% to $488.3 million, although the percentage of revenue gross profit decreased from 57.3% to 55.2% YoY. Under Armour, Inc. (NYSE:UA) saw an increase in revenue during Q3 of 2012 of 24% from $466 million in 2011 to $575 million in 2012. UA's net income also increased by 25% from $46 million in 2011 to $57 million in 2012. PVH Corp (NYSE:PVH) saw a decrease in revenue YoY of 1% down to $1.643 billion in 2012. As for the 39-week period of 2012 PVH saw an increase in revenue of 1% to $4.407 billion, which includes a negative impact of 4% attributable to foreign currency translation and the exited sportswear businesses. LULU is the leader in the market compared with these two competitors, UA and PVH. LULU has seen the highest increase in revenues and profits, which indicates why the company is currently valued so high with a PE over 40.

LULU's EPS increased during Q3 of 2012 by 48% from $0.27 to $0.40. For the 39-week period its EPS increased 45% from $0.77 to $1.12. UA also saw an increase in EPS during Q3 of 2012 by 23% to $0.54 and PVH's EPS increased 24% during this period of the same year to $2.34. Again LULU has seen the largest percentage of increase against other competitors in the market. LULU also has very high key ratios with ROE at 21.1%, ROA at 30.8%, and ROIC at 36.3%. All these increased numbers explain LULU's inflated PE and could point toward an overvaluation.

With all of these positive numbers and the increase in revenue, why is LULU rated as a Sell? Let's look at what we predict will bring LULU's price down.

Catalyst

As we've stated before, LULU is currently overvalued. The current PE at 42.9 is much higher than the industry average at 22.7. Its value is indicated to drop according to its future PE of 30.9. Even though LULU saw large percentage increases in revenues, its operating margin and gross margin did not reflect this change. Instead of increasing as well, operating margin decreased YoY from 27.2% to 25.3%. Gross margin decreased during this same period from 57.3% to 55.2%. These slight decreases in profitability margins show us the vulnerability LULU finds itself in while it is overvalued. An overvalued PE and declining problems forecast larger problems to come during the 2013 fiscal year. A second aspect of our catalyst lies in continually rising competition. UA recently announced its new line of sportswear called Armour39 and the Spine running shoe. Without sustained innovation on LULU's part, it will be left behind. Even so, UA is not LULU's only competitor. Nike (NYSE:NKE) as well as other less traditional sportswear brands like Gap and Nordstrom are also contending for LULU's revenue. LULU has the potential to increase its global presence but without any concrete plans for expansion in the future we cannot count on it to continue to hold its presence in the market against the competition. In short, other sportswear companies have concrete plans for new and exciting products that will grab consumers' attention but we do not see LULU meeting this rising competition, and it is not compensating with any expansion plans.

Economic Moat

LULU is an apparel manufacturer for healthy lifestyle activities for men and women. IT offers high-quality exercise clothes and fitness accessories, which means with a higher price tag. If high-quality designs and materials is the selling point, there are more affordable options that offer similar advantages. LULU does have the advantage of a diverse range of retailer venues. It is taking advantage of e-commerce, franchise stores, and wholesale through independent studios and fitness enterprises. While LULU offers a high-quality product through a variety of retail options, we believe this company has a fairly light economic moat, another disadvantage we identify for this vulnerably over-valued company.

Revenue and EPS Outlook

LULU has seen large increases in profits year over year, as we have outlined previously in this article. For example, LULU saw its net revenue increase in the 39-week period from $629 million in 2011 to $885 million in 2012. The current EPS is 1.61 and is predicted to increase to 2.25 by January of 2014. LULU's competitor UA is predicted to move from a current EPS of 1.21 to 1.81 in December of 2014. PVH, another competitor is forecast to increase from a current EPS of 5.81 to 7.46 in January of 2014. As we are seeing in other areas LULU's biggest obstacle is the competition. Although LULU is currently a healthy company it needs to meet the competition, and we do not see any proposed plans to do that.

Price Target Analysis

The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices.

Here is how to calculate price targets using discounted cash flow analysis:

(all figures in millions)

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2012 Projections

2013 Projections

2014 Projections

2015 Projections

2016 Projections

Operating Income

347

438

523

599

649

Taxes

101

127

152

174

156

Depreciation

40

52

62

75

98

Capital Expendit.

-88

-50

-65

-70

-103

Working Capital

70

70

70

70

70

Available Cash Flow

128

243

298

360

386

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).

WACC for LULU: 10.00%

2012

2013

2014

2015

2016

PV Factor of WACC

0.9091

0.8264

0.7513

0.6830

*

PV of Available Cash Flow

117

201

224

246

*

Step 3.

For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you the cap rate.

Cap Rate for LULU: 4.00%

2016

Available Cash Flow

$386

Divided by Cap Rate

4.00%

Residual Value

8645

Multiply by 2016 PV Factor

0.6830

PV of Residual Value

$6587

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

$788

PV of Residual Value

$6587

Cash/Cash Equivalents

439

Interest Bearing Debt

0.00

Equity Value

7814

Step 5.

Divide equity value by shares outstanding:

Equity Value

7814

Shares Outstanding

144.16

Price Target

$54

Profit/Value Industry Comparisons

Profitability:

Q1-Q3 2012

Q1 - Q3 2011

Operating Margin

25.3%

27.2%

Gross Margin

55.2%

57.3%

Return on Equity

21.1%

18.3%

As touched on briefly before, LULU has seen spikes in revenues, but its profitability margins are not reflecting those increases. We see this as an indicator of larger problems. LULU's operating margin decreased from 27.2% to 25.3% and its gross margin decreased from 57.3% to 55.2%. The company did see an increase in ROE, from 18.3% to 21.1%. How do these margins compare to competitors?

PVH also saw a decrease in operating margin from 11.9% to 10.8%. Its gross margin increased from 57.0% to 58.7%, as well as ROE from 8.5% to 11.4%. UA's operating margin increased from 11.1% to 11.4%. Its gross margin decreased from 48.4% to 47.9%, and ROE increased from 15.2% to 15.6%. V.F. Corporation's (NYSE:VFC) operating margin increased from 13.3% to 13.5%. Its gross margin increased from 45.2% to 46.5%, and ROE also increased from 19.7% to 21.2%. Lastly, Quicksilver Inc.'s (NYSE:ZQK) operating margin decreased from 4.4% to 2.8% and gross margin decreased from 51.9% to 46.0%. ROE increased from -3.5% to -1.8%. Compared with competitors in the industry LULU has a high operating margin, is more towards the average with gross margin, and has a relatively high ROE. These elevated profit margins that show signs of decline indicate overvaluation.

Value:

Current

Industry Average

P/E

42.9

22.7

Future P/E

30.9

N/A

We've already discussed at different moments that LULU is overvalued with a PE at 42.9 and a future PE of 30.9. Let's look at LULU compared with the competitors.

PVH has a PE of 21.1 and a future PE of 16.4. UA is also valued very high with a PE at 41.5 with a future PE of 27.7. VFC has a PE at 16.8 and a future PE at 13.5. ZQK, because of its recent financial health does not currently have a PE, and has a future PE of 18.9. These numbers confirm that LULU is over valued.

Variant

What could go differently? It's true that LULU has seen increases in revenues and could continue to see those profits. We are not at all confident that this could happen but the LULU could sustain the numbers and justify this high PE. Like any apparel manufacturer, LULU is continually offering new designs of its products for each season. During the 2013 fiscal year it could meet the competition and develop innovative products for the marketplace. LULU could also expand globally to bring in revenues from previously untapped markets.

The Bottom Line

All in all we see LULU as a company that is over valued and left vulnerable for the coming fiscal year. Already in its latest quarter earnings announcement for Q3 of 2012 we see signs of mistakes being made. While it increased profits its profit margins decreased. Without any concrete plans for expansion or innovative products for the forward fiscal year, it will not be able to stand up against growing competitors. We believe that in the 2013 fiscal year LULU will devalue to an extent that we firmly maintain this company at Sell.

Source: Lululemon Remains Top Sell In 2013, Under Armour And Nike Competition Rising