Lululemon: A Slightly Different Angle, Which Reveals A Few Upside Opportunities

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 |  About: Lululemon Athletica Inc. (LULU)
by: Adam Levine

Summary

LULU would be better compared to athletic apparel companies than fashion retailers based on product line and margins.

The company's new marketing plan employing brand ambassadors will likely to contribute to gain a larger market share.

The company has a lot of room to expand geographically.

LULU has an unleveraged balance sheet, which gives the company financial flexibility.

Overview and Peer Group

Lululemon (NASDAQ:LULU) is a technical apparel designer and retailer that offers a wide and deep range of products for athletic pursuits such as yoga, running, general fitness and other athletic activities.

When examining comps, many analysts compare LULU to peers such as The Gap (NYSE:GPS), Abercrombie & Fitch (NYSE:ANF) and American Apparel (APP), due to a similar sales strategy that these brands employ. It's true that all the brands that I mentioned above offer their products only in their own stores. However, in the case of LULU, should one analyze the brand from a marketing perspective or should LULU be compared to peers based on a product line point of view? After all, the reason why LULU is such a unique brand is because of its unique product line which excels in its quality and appearance. LULU's competitive advantage is not sourced from the number of its stores, but from the different customer engagement strategy and the quality of its products. So when you try to compare LULU to peers, ask yourself: Who has a similar product line to LULU's?

The peer group for comparison with LULU would include brands such as Under Armor (NYSE:UA), Nike, Inc. (NYSE:NKE), Adidas (NYSE:AG), and V.F Corporation (NYSE:VFC). When you base your peer group on the line of product, valuation changes, significantly, in LULU's favor. LULU's 22.5x multiple is considerably low compared to Nike and Under Armor's multiples of 26x and 88.6x, respectively. Just to make a point, if one would compare P/Es with the wrong peer group, the average P/E would be approximately 17x (which suggests that LULU is overvalued). Instead, when comparing LULU to the peer group which I suggested is more appropriate, we see an average of 33.7x PE, which suggests that LULU in undervalued and is an attractive investment.

From an ROE standpoint, LULU's 24.41 beats its peer group average which stands at 17.6. Leaving the best for last, EV/EBITDA, which in LULU's case stands at 11.6x, and in Nike's and Adidas' case are 15.3x and 12.6x, respectively, confirms the thesis that LULU is attractive among the peer group that I suggested is appropriate. If you still believe that companies such as GPS, ANF and APP should be included in LULU's peer group, I would suggest you to at least use blended multiples (P/E and EBITDA) in order to get a clear picture of the peer group averages.

LULU's Ambassadors

LULU's fundamental story gives us many reasons to be bullish on the Vancouver brand. A small detail that many investors tend to ignore is LULU's ambassador program. One of LULU's competitive advantages is that it is putting in practice the famous phrase "if you can't beat them, join them". LULU picks inspirational individuals to lead local communities to a healthier lifestyle and to promote the Lululemon culture. While its peers are trying to dictate the best next fashion trend, LULU decided to do something that we men don't do very well -- listen. The ambassador program provides LULU with important data about the different fashion trends on a geographical basis, and provides LULU a maximum capacity to be flexible toward customer demand and lower customer taste risk. Using the data that is collected by the ambassadors, Tara Poseley, the new CPO, will be able to match her design skills to customer demand. And, finally, we may witness the increase in EPS that we all wish for in Q3 and Q4.

Overseas Growth

A main growth factor in LULU's strategy is geographical expansion. LULU's international expansion challenges its ability to implement its product in local communities in Eurasia and Australia. However, LULU's approach toward this issue is very simple -- first establish a connection with the local community, and then open a store. It is no secret that LULU's main geographical growth source is North America, specifically the U.S.

However, if LULU will be able to invest, develop and maintain a strong relationship with local communities overseas, through execution of a smart real estate strategy, I don't see a reason why LULU shouldn't split its focus evenly between its domestic and international markets, and increase its foothold overseas. I would like to see the 6% of net revenue from outside of North America grow to 8%-9% next year's second quarter.

A Closer Look at LULU's Balance Sheet

An interesting item in LULU's balance sheet is the company's lack of long-term debt. LULU's strong balance sheet gives the company financial flexibility for future expansions that the company will undertake. This will assist the company with its international expansion and its product line expansion, together with an opportunity to pay back dividends to investors (and maybe buy back even more shares at a higher sum of $450m). If we zoom in and examine LULU's liabilities more closely, we will see a decrease in LULU's unredeemed gift card liability ($30.1m). A company such as LULU should seek for a constant increase in gift cards sales since every purchase of a gift card is basically an interest-free loan of cash to the company. Unfortunately, LULU is exposed to seasonality, and February's $38.3m was most probably driven from Christmas sales.

Conclusion

All in, while many analysts are bearish on LULU and counting the days when it will prove to have been a fad, I believe that in light of all the arguments presented above, LULU is a company that is in advanced stages of recovery, and has attractive upside potential. I believe that LULU's new management, along with its loyal, non-price conscious customers and its unique business strategy, has the ability to surprise us.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.