Lululemon: The Downward Dog Will Rise
Since falling close to 20% since Jan. 13, I can assure you Lululemon (LULU) is the same company today as it was two weeks ago. In-house guidance for their holiday quarter's earnings per share was revised down just over 10% (78-80 cents to 70-73 cents). These short-term estimates are having a burdensome effect on further dated estimates as we saw theoretical model adjustments and new target prices coming from the Street. These reactions may be unwarranted in the growth picture of Lululemon.
The company is making tremendous strides to grow its business and brand. The new leadership team of the company is looking to put a more socially conscious and friendly spin on the brand. The number of yoga gear-flaunting and thatched-roofed storefronts has been increasing every quarter at a faster quarter-over-quarter rate. With a growing set of over 250 stores, new management and a loyal clientele that is steadfast in branding themselves as "lulu," don't bet against Lululemon to rebound in the first half of 2014.
Who They Are
Lululemon Athletica designs and retails athletic clothing. The company produces fitness pants, shorts, tops and jackets for yoga, dance, running, and general fitness. Lululemon operates mainly in the U.S. and Canada and also has a small but significant operation in Asia-Pacific. They operate at around a 50% gross margin and a 16%-18% profit margin.
Why Buy Now?
Retailers blame weather, promotions, and traffic for weak holiday sales. It's been a strenuous beginning to the new-year for specialty retailers. For the Russell 3000 Retailers, the group of 175 names is down close to 4% (as of Jan. 16, 2014). Much of the tribulation is due to weaker-than-expected holiday sales. Many of the traditional retailers are being averted for the newer e-commerce sites that harbor cheaper prices and easier accessibility. Lululemon has only been the most recent victim of the downtrend in retailers and its stock was burned for it when the market received its new information on Monday. While the earnings potential may have been downgraded in the short term due to lofty goals of pants flying off the shelves, the exorbitant long-term growth rate and growth story are far from moderate.
Speaking to the decree of the management team, Lululemon is now being run by the former CEO of Toms, a socially conscious footwear brand. Laurent Potdevin not only brings a fresh new appeal to the overall vision of the company but has tremendous experience in working with athletic apparel. Potdevin's appointment to the team should overshadow any of the misguided verbiage that came from Chip Wilson and other board members in the dreadful second half of 2013. LULU looks to put that in the past and expects a more fruitful future.
Despite what many of the Street analysts are deeming to be a "sell" or market perform, some of the more hawkish analysts on the stock like William Blair & Co.'s Sharon Zackfia and Stifel's Jim Duffy believe in the recovery. Duffy is so optimistic of LULU that he even has a hold rating on alternative growth companies Under Armour (UA) and Nike (NKE).
As a growth play, LULU's Price to earnings should be considerably higher than the majority of its peer group. Some of its peers include The Gap (GPS), Urban Outfitters (URBN), UA, and NKE. On a next-12-months basis to account for estimated figures, Lululemon is being priced at around 22x earnings, which is only about an 18% premium to its comp group. On average over the last six months, Lulu has traded at a 94% premium to the same comparable companies. The current premium is actually trading cheaply on a standardized basis. So cheap in fact that they are almost at a 2.5 standard deviation rift from the six-month average premium. Now is the time to buy a bruised and battered Lululemon. If we take the historical average premium to its comps, our implied price that Lulu should be trading at is around ~79.77. That would generate a slightly below 70% return figure.
Discounted Cash Flow Valuation
Looking at a classic DCF model, I have priced Lulu's theoretical value at $61.19/share. With the most up to date street estimates for year-over-year sales growth at around 16% for the next three years and a 38% growth rate in the terminal year (2023), LULU can be projected at $8.3 billion in revenue by 2023. With slightly lower EBIT growth multiples and a decrease in capex in the short term but revived CAPEX in the long term, the expected free cash flow could extend to close to 10x last fiscal year's reported value. At an 11% WACC, which has come a long way in the last five years, the discounted free cash flow by the terminal year would reach just short of $500.
The discounted cash from 2014 to 2023 amounts to $3.01 billion while the terminal value, which is derived from the Gordon growth model ((Final Year Projected Cash Flow) / Discount Rate - Long Term Cash Flow Growth Rate)/(1+Discounted Rate)^ N)) sums to 5.27B. The total EV of 8.28B plus .6B of cash (no debt) would yield a total equity value of 8.88B. On a per-share basis (145M Shares out) the value of Lululemon stands at $61.19. On a fair value basis we could see close to a 30% return.
|Perpetual Growth Method|
|NPV of Free Cash Flow||3,011|
|+ PV of Terminal Value||5,274|
|+ Cash and Near Cash||601|
|- Total Debt||-|
|- Minority Interest||-|
|Total Equity Value||8,885|
|Theoretical Value per Share||61.19|
|Premium / (Discount Price)||27.88%|
From a technical standpoint LULU is giving off buy signals that suggest the worst is in the rear view mirror. Using the relative strength index as the primary driver for the technical buy signal, RSI can identify over purchased and oversold territories of a stock using price movements. The indicator, which ranges from 1 to 100 suggests a buy signal if it touches 30 (oversold) and a sell signal if it approaches 70 (oversold). the RSI 14-day is at a staggering level of 22. The 30-day is at 28 and a longer-term, less drastic 50-day RSI is hovering just above 34. Due to the heavy downward price influence in the short term, the recent negative momentum provides a strong indicator for a mean reversion to a more moderate level. As a result of the moving averages and up/down days that compose the indicator, I feel confident in my belief that such aggressive overselling can not withstand on such a cheap valuation.
What to Do Next
Lululemon may have been gashed by poor holiday sales and faltering earnings, but the growth story of high profitability is still very much intact. Lululemon is far from a maturing business and one that is in fact playing with a chip on its shoulder. Athleta, Gap Body, Nike, and Under Armour are all strong competing forces that could chip away at top-line revenue for the company, but the market for high end athletic wear continues to expand. Lululemon is leading that charge. Lululemon's determination to its brand and grassroots following will drive them well into the future. The market sentiment on Lululemon has been anything but supportive recently, but with strong valuations from optimistic analysts and depressed levels of the stock, now is the right time to enter into a three- to six-month long position.