Time For Under Armour To Buy Lululemon?

| About: Lululemon Athletica (LULU)

It's a mystery to many analysts that stock in Lululemon (NASDAQ:LULU) continues to trade at a premium to other retailers despite its continuing problems.

Despite putting former TOMS President Laurent Potdevin in as CEO last year, the company continues to make stupid mistakes.

Banning online customers from daring to re-sell its yoga clothes and then apologizing to them. Government charges that it misled shareholders?

Even Jezebel feels sorry for them. "Lululemon's nightmare keeps getting worse" is their latest headline.

Yet despite this, the Capital Group has boosted its stake in the company, while CNBC jokes that it's a "downward dog no more."(Downward dog is a yoga move, guys.)

How is all this possible, and what do the pros see that the rest of us don't?

What they see is something pretty unique in the athletic business, vertical integration. Lululemon makes its own stuff and sells that stuff in its own stores. This makes it, in normal times, a profit-making machine.

Even in the quarter ending last November, at the height of its bad publicity, Lululemon had gross profit of $204 million on sales of $380 million - that's more than 50%. It reported net income of $66 million, meaning it managed to bring nearly 20% of revenues to the bottom line, even while the media and many customers were hating on it.

Contrast this with another big athletics brand, Under Armour (NYSE:UA). It managed operating profit of $350 million for the December quarter on revenue of almost $683 million. Pretty good. Net income came to $64.17 million, however, less than 10% of revenues. This was before the U.S. Speed Skating team donned its suits and fell hard in Sochi.

The big difference between Lululemon and Under Armour is vertical integration. Lululemon has it, Under Armour doesn't.

So why not put them together? Under Armour is one of the few mens' brands with a powerful enough image to make it in a direct-to-consumer model. Nike (NYSE:NKE) has some stores, but these are isolated boutiques. Nike is still going through distribution.

Imagine what Under Armour's profits could be if it controlled more of its channel. Now, imagine what it could do, in terms of profits, if it had a stronger tie with women? And imagine what the two companies would be doing together - over $1 billion in sales each quarter, with profits currently averaging 15% of sales. Pretty good for an apparel group.

What would it take? Substantial dilution. Lululemon's balance sheet currently has more cash than Under Armour's, so this would mainly be a stock deal. Under Armour is currently valued at $11.85 billion, Lululemon at $7.44 billion. Figure Lululemon shareholders take 35% of the combined company in order to give current shareholders a premium.

Sounds unlikely, but something is holding Lululemon shares up right now. It can't be the organic prospects of the company as it is. A market cap of $7.45 billion for an apparel company with annual sales under $1.4 billion - that's more than full valuation.

Yet smart money is piling in. Someone is thinking of doing something. And if not a sale to Under Armour, they are thinking of something equally audacious.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.