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The objective of this article is to ascertain the potential of upside and downside price movements in the stock of Lululemon Athletica Inc. (NASDAQ:LULU). With 247 corporate-owned stores, the company is engaged in the designing, manufacturing and distribution of athletic apparel that is sold through these stores, wholesale networks and e-commerce.

Industry

Consumer goods are always exposed to seasonality and fashion trends. The clothing industry is also affected by seasonality. Being in a very competitive environment Lululemon Athletica faces challenges from other players in the market. Nike (NYSE:NKE) , Adidas AG (OTCQX:ADDYY) and Under Armour (NYSE:UA) are the main and direct competitors of LULU. I have quantified the core drivers of key players in the industry using the DuPont analysis. As per the DuPont analysis, return on equity in industry is chiefly driven by profit margins. LULU is on the top of chart, having the highest profit margins compared to the other market participants. One more positive feature of the company is its low financial leverage of 1.2 compared to Nike's 1.6 and Adidas AG's 2. Figure 1 shows the graphical representation of the DuPont analysis for Lululemon, Nike and Adidas AG.

Fig 1 Fig 1 Source : Finance.yahoo

Performance

The company has announced financial results for the third quarter of 2013. LULU has outperformed the industry averages for the trailing twelve months. It experienced a three year average revenue growth rate of 44.6 compared to the industry average of 8.2. The net income growth rate of 66.8 of three years compared to the industry growth rate of 25 shows the company's productive and efficient usage of resources. Furthermore, the operating margin (TTM) of 25.1% and profit margin of 18% are way better than the industry margins of 11% and 6.4% respectively. The company has also outpaced the industry in terms of averages of return on equity and return on assets. Figure 2 compares LULU's performance to the industry.

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Fig 2 Source : Reuters

On a standalone basis, the company has been unbeatable by major players of the industry in the pursuit of better margins. The company took the lead by fetching higher gross and operating margins than other core participants in the clothing industry. Figure 3 compares the performance of the companies during the third quarter of 2013.

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Fig 3 Source : Finance.yahoo

The company operates 247 corporate-owned stores over the globe. The US is the largest area of operations and has 166 stores across the country. Canada is the second largest market with 53 stores, followed by Australia and New Zealand with 25 and 3 stores respectively. Figure 4 showcases the geographical allocation of Lululemon Athletica corporate-owned stores.

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Fig 4 Source : lululemon.com

Dominated by corporate-owned stores, the company uses a variety of mediums to generate revenues. By November 3, 2013 77% of net revenues were derived from corporate-owned stores, 16% from e-commerce and 7% from other segments. While by the same time last year, the company produced 80% from corporate-owned stores, 14% from e-commerce and 6% from other segments. It is clear that the company has somehow managed to increase sales through the direct to consumer (e-commerce) medium and this should be considered a positive milestone keeping in mind that consumers are at ease while purchasing electronically. Figure 5 showcases the portion of net revenue generated by each medium.

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Fig 5 Source : lululemon.com

An almost 20% or $63.4 million increase in net revenue was recorded for the third quarter of 2013 compared to $316.5 million for the third quarter of 2012. Corporate-owned stores fetched $38.6 million more net revenue in the third quarter of 2013 compared to the third quarter of the previous year. E-commerce and the other segments generated $16.8 million and $7.9 million more net revenue in the third quarter of 2013 respectively. Looking at net revenue generation in terms of region, the US appears to be the core contributor. Net revenues outside of North America remained relatively flat during the thirteen week period ending November 3, 2013. Figure 6 gives the details of the percentage of net revenue generated by each country.

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Fig 6 Source : Financials Q3, 2013

Valuation

LULU is a growth stock and does not pay dividends. The stock can be valued using multiples such as price to earnings, price to book value, price to sales and price to cash flows. Considering the price to earnings ratio of 31 compared to the industry average of 19.4 and price to cash flow ratio of 26.19 against the industry ratio of 15.5, the stock is overvalued and it should be avoided because of the probable decline in price towards its intrinsic value over time. Figure 7 displays the fair value calculation of LULU based on price multiples.

Fig 7 Source : Reuters

The logical trick in this case is the interpretation of the value of price multiples and stock price to earnings growth (PEG) ratio. The textile industry's price to earnings growth ratio is 2.81 which is 42% more than the stock's current PEG ratio of 1.64. Based on price multiple this stock is overvalued but logically the price to earnings growth ratio of a growth stock should catch up with the industry average. The historical performance of LULU and its future prospects favor the verdict that in the long run the stock will meet the industry ratio and experience a rise in price. In my opinion, investors should not worry about price multiples and should consider LULU as a good investment for the long term.

Source: Lululemon Athletica: A Good Investment For The Long Term.