Lululemon: Is This A Buying Opportunity?

May. 8.14 | About: Lululemon Athletica (LULU)

Summary

Even with the sell-off, how do Lululemon's fundamentals look?

At this time, does Lululemon trade at an attractive valuation?

When will a buying opportunity present itself?

Over the past year, Lululemon's (NASDAQ:LULU) stock has been in a strong downward trend if you are bullish on the stock. Since reaching ~$82.50 in June of 2013, the price has dropped over 84.97% to reach its current value of $42.63.

Chart Sourced by: Finviz

In the evaluation below, we will be able to see how Lululemon has fared over the past three years regarding its profitability, debt and capital, and operating efficiency. Based on this information, we will look for strengths and weaknesses in the company's fundamentals. This should give us an understanding of how the company has fared over the past few years and will give us an idea of what to expect in the future.

Profitability

Profitability is a class of financial metrics used to assess a business's ability to generate earnings compared with expenses and other relevant costs incurred during a specific period of time. In this section, we will look at four tests of profitability. They are: net income, operating cash flow, return on assets and quality of earnings. From these four metrics, we will establish if the company is making money and gauge the quality of the reported profits.

  • Net income 2012 = $184 million.
  • Net income 2013 = $271 million.
  • Net income 2014 = $280 million.

Over the past three years, Lulu's net profits have increased from $184 million in 2012, to $280 million in 2014. This represents a 65.71% increase.

  • Operating income 2012 = $287 million.
  • Operating income 2013 = $376 million.
  • Operating income 2014 = $391 million.

Operating income is the cash generated from the operations of a company, generally defined as revenue less all operating expenses, but calculated through a series of adjustments to net income.

Over the past three years, Lulu's operating income has increased from $287 million to $391 million in 2014. This represents an increase of 73.40%.

ROA - Return On Assets = Net Income/Total Assets

ROA is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment."

  • Net income growth

    • Net income 2012 = $184 million.
    • Net income 2013 = $271 million.
    • Net income 2014 = $280 million.
  • Total asset growth

    • Total assets 2012 = $735 million.
    • Total assets 2013 = $1.051 billion.
    • Total assets 2014 = $1.250 billion.
  • ROA - Return on assets

    • Return on assets 2012 = 25.03%.
    • Return on assets 2013 = 25.78%.
    • Return on assets 2014 = 22.40%.

Over the past three years, Lulu's ROA has decreased from 25.03% in 2012 to 22.40% in 2014. This indicates that the company is making slightly less on its assets than they did in a few years ago.

Debt and Capital

The Debt and Capital section establishes if the company is sinking into debt or digging its way out. It will also determine if the company is growing organically or raising cash by selling off stock.

Total Liabilities To Total Assets, Or TL/A ratio

TL/A ratio is a metric used to measure a company's financial risk by determining how much of the company's assets have been financed by debt.

  • Total assets

    • Total assets 2012 = $735 million.
    • Total assets 2013 = $1.051 billion.
    • Total assets 2014 = $1.250 billion.
    • Equals an increase of $515 million
  • Total liabilities

    • Total liabilities 2012 = $133 million.
    • Total liabilities 2013 = $164 million.
    • Total liabilities 2014 = $153 million.
    • Equals and increase of $20 million

Over the past three years, Lulu's total assets have increased by $515 million, while the total liabilities have increased by $20 million. This indicates that the company's assets have significantly outpaced the increase in liabilities thus adding shareholder value.

Working Capital

Working Capital is a general and quick measure of liquidity of a firm. It represents the margin of safety or cushion available to the creditors. It is an index of the firm's financial stability. It is also an index of technical solvency and an index of the strength of working capital.

Current Ratio = Current assets / Current liabilities

  • Current Assets

    • Current assets 2012 = $527 million.
    • Current assets 2013 = $787 million.
    • Current assets 2014 = $943 million.
  • Current liabilities

    • Current liabilities 2012 = $103 million.
    • Current liabilities 2013 = $133 million.
    • Current liabilities 2014 = $114 million.
  • Current Ratio
  • Current ratio 2012 = 5.12.
  • Current ratio 2013 = 5.92.
  • Current ratio 2014 = 6.55.

Over the past three years, Lulu's current ratio has increased. As the current ratio is currently well above 1, this indicates that Lulu would be able to pay off its obligations if they came due at this point. If the ratio were to drop closer to 1.00 that would raise some concerns.

Common Shares Outstanding

  • 2012 shares outstanding = 145 million.
  • 2013 shares outstanding = 146 million.
  • 2014 current shares outstanding = 145 million.

Click to enlarge

LULU Shares Outstanding data by YCharts

Over the past three years, the number of company shares has remained relatively flat.

Operating Efficiency

Operating Efficiency is a market condition that exists when participants can execute transactions and receive services at a price that equates fairly to the actual costs required to provide them. An operationally efficient market allows investors to make transactions that move the market further toward the overall goal of prudent capital allocation without being chiseled down by excessive frictional costs, which would reduce the risk/reward profile of the transaction.

Gross Margin: Gross Income/Sales

The Gross Profit Margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

  • Gross margin 2012 = $569 million / $1.001 billion = 56.80%
  • Gross margin 2013 = $763 million / $1.370 billion = 55.59%
  • Gross margin 2014 = $840 million / $1.591 billion = 52.80%

Over the past three years, Lulu's gross margin has decreased. The ratio has decreased from 56.80% in 2012 to 52.80% in 2014.

Asset Turnover

The formula for the asset turnover ratio evaluates how well a company is utilizing its assets to produce revenue. The numerator of the asset turnover ratio formula shows revenue found on a company's income statement and the denominator shows total assets, which are found on a company's balance sheet. Total assets should be averaged over the period of time that is being evaluated.

  • Revenue growth

    • Revenue 2012 = $1.001 billion
    • Revenue 2013 = $1.370 billion
    • Revenue 2014 = $1.591 billion
    • Equals an increase of 62.91%
  • Total Asset growth

    • Total assets 2012 = $735 million.
    • Total assets 2013 = $1.051 billion.
    • Total assets 2014 = $1.250 billion.
    • Equals an increase of 58.80%.

Over the three years the revenue growth has increased by 62.91% while the assets have increased by 58.80%. This is an indication that the company from a percentage point of view has been more efficient at generating revenue with its assets.

Based on the information above we can see that Lululemon fundamentally has had a strong few years. Some of the strengths include the TL/A ratio which indicates that Lulu's assets are increasing much faster than the company's liabilities. Another strong point is that the growth rate of the company is very strong. This is established by the Net income and Operating income which are both up over 50% in the past three years.

Even though the company is showing many strengths there are a few blemish that an investor needs to keep an eye on. Over the past few years the ROA has dropped from 25.03% to its current level of 22.40%. Another metric to keep an eye on is the gross margin. Over the past three years the gross margin has fallen from 56.80% to 52.80%. From a fundamental point of view Lululemon has a few blemishes but overall has been showing strong results.

Valuations

In the section below, I will use a couple of different methods to find a valuation of the stock price. In this section, I will use the Discounted Cash Flow valuation model and EV/EBITDA ratios to estimate the current value and target price for each share.

I believe using the Discounted Cash Flow valuation model for Lululemon to be fair, because DCF analysis can help one see where the company's value is coming from and can generate an opinion based on that.

Click to enlarge

Even though there are variations in calculating this formula, this model is based off of a terminal value of $6.248 billion and a WACC of 10.01%. The terminal value of $6.248B is based off of the company trading at an industry average of 14.2x EBITDA. Using this valuation, I have concluded Lululemon's value to be ~$40.91 per share.

EV/EBITDA = Enterprise Value/Earnings Before Interest, Taxes, Depreciation and Amortization

In the next section, I will use the EBITDA to calculate the EV/EBITDA. The EV/EBITDA ratio is one of the most commonly used valuation metrics, as EBITDA is commonly used as a proxy for cash flow available to the firm.

Enterprise Value or EV = Market Capitalization + Total Debt - Cash and Cash Equivalents.

  • EV - $7.47 billion + $0 billion - $698.65 million = $6.771 billion
  • EV = $6.771 million
  • EBITDA = $440 million
  • EV/EBITDA = 15.39

As the Apparel sector often trades in the 14.12x trading range, an EV/EBITDA ratio of 15.39 supports the DCF valuation by indicating at current levels the stock is currently overvalued.

As the DCF and the EV/EBITDA both indicate that Lululemon is still overvalued at this point in the market, what does a future target price look like? Using the EV/EBITDA ratio along with calculating future EBITDA, cash and debt we should get a 2015 target price.

2015 Target Price

  • Estimated Net debt = $0 million
  • Estimated cash and cash equivalents = $750 million (7.3% increase)
  • Estimated future EBITDA (2015) $448 million
  • EV/EBITDA = 14.2 (industry average)
  • Shares Outstanding = 146 million
  • 2015 equity value = 14.2 x $448 million = $6.361 billion
  • Equity Value - net debt + cash = Enterprise Value = $7.111 billion
  • EV / Shares outstanding = $7.111 billion / 146 million
  • Target Price of = $48.71 per share

Based on the EV/EBITDA formula to find a target price, I have calculated a target price in 2015 of $48.71 per share.

As of May 7th, Lululemon's stock was trading at $42.36 - Using the Discount Cash Flow Formula, this indicates the stock is trading above its fair value of $40.91 by 3.5%.

In calculating a target price for 2015 using the EV/EBITDA formula ratio, this indicates a valuation $48.71 per share or potential upside of 14.99%.

Strategy

At this point in the market, I would not be surprised if there was a 5%-10% correction over the next few months. If such a correction were to occur, this could present an excellent opportunity to add positions in a company with excellent growth prospects. Currently, I believe there is further upside to equity markets as major world economies are either recovering or on the verge of recovering. As interest rates continue to remain near zero, this should favor equities.

Conclusion

The analysis above indicates that from a fundamental point of view the company is doing very well. The net income is up, the operating income is on a strong uptrend and revenue is outpacing assets. So why is the stock selling off?

The calculations above indicate that over the past few years the stock price may have "outpaced itself." Currently, I have a stock price valuation of ~$40.91 and have a 2015 target of $48.71 per share. Having stated that, the stock price is in a strong downtrend. As I expect the summer months to be volatile, this should create buying opportunities, but at this point in time, I don't recommend trying to catch a falling knife.

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.