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Although luxury apparel retailer Lululemon Athletica Inc. (NASDAQ:LULU) has been an outstanding performer over recent years, returning 296% in the past five years, there's a certain point at which investors should assess the stock's valuation. Just as value investors try to make money from buying undervalued stocks, short sellers try to make money from shorting overvalued stocks; and Lululemon has attracted plenty of short sellers. So today I am going to try to determine whether these pessimists of Wall Street are right to bet against the beloved Lululemon.

Let's start with the underlying business, an important factor for any investment. Lululemon's core product is yoga apparel: "Yoga?" you may be scratching your head. That's right, yoga. It doesn't sound like the most lucrative investment; yet Lululemon has outperformed Apple Inc. (NASDAQ:AAPL) over the past two years by about 50%.

Although Lululemon doesn't appear to be a recession-proof company, revenue actually increased during the recent financial crisis. This could be credited to Lululemon's typically high-income consumer base, which consists mostly of women (who spend lots and lots of money). Similar luxury companies, such as Coach, Inc. (NYSE:COH), have been able to take advantage of this underestimated consumer base; and Lululemon has the potential to do the same, especially since people spend $5.7 billion per year on yoga gear. But is yoga just a fad?

There's no way of telling how long yoga will remain popular. I mean, who knew that portable phones would ever catch on? Only time will tell whether yoga gear is just a fad or a true staple in the lives of millions. But it's not just women's yoga apparel that Lululemon is concentrating on—management plans on expanding its consumer base to include more male customers. Keep in mind that competition is tough in the male athletic apparel market, since Lululemon would compete with companies like Nike Inc. (NYSE:NKE) and Under Armour, Inc. (NYSE:UA).

Since the strength of Lululemon's underlying business is relatively unclear at the moment, let's find some comfort in numbers.

  • Market Cap: $7.98 billion
  • Current Share Price: $55.42
  • 52 Week Range: $41.70-$81.09
  • Trailing P/E: 40.75
  • Forward P/E: 26.77
  • PEG: 1.20
  • P/B: 12.09
  • Operating Margin: 28.04%
  • Profit Margin: 17.94%
  • ROE: 35.14%
  • Total Cash: $424.33 million
  • Total Debt: $0.00
  • Current Ratio: 7.88
  • Dividend: N/A
  • Shares Short % of Float: 25%
  • Short Ratio: 4.60

(Find more stats here.)

Lululemon offers some great margins and an impeccable balance sheet; but its valuation seems very high. A forward P/E of 26.77 might be acceptable to some investors, but that is a premium that many tech companies aren't even seeing. Apple, which seems to have unlimited potential, is currently trading at a forward P/E of just over 11.

The high valuation isn't the only thing that concerns me; the high short interest is what really draws my attention. With a quarter of floating shares borrowed short, there is some very poor investor sentiment flooding Lululemon. To make matters worse, rumors have recently surfaced that famed short seller David Einhorn has gone short on Lululemon. Einhorn has had great success in the past by shorting companies like Allied Capital Corporation (NYSE:AFC), Lehman Brothers, and more recently Green Mountain Coffee Roasters, Inc. (NASDAQ:GMCR). But rumors are only rumors, as he declined to comment on the speculation.

Be aware that with such a high short interest, there is actually a very high amount of risk involved with shorting Lululemon. If the company was to release positive news to send the stock price higher, a short squeeze could occur. A short squeeze would impose tremendous losses for short sellers, and tremendous gains for Lululemon owners.

Lululemon has some great things going for it, but with sky-high valuations and expectations, I wouldn't be surprised to see a price correction. Good news, even if it is unsubstantial, it could send the stock flying, while faltering investor confidence could rapidly destroy share value. Personally, I don't find Lululemon to be an attractive investment. I find it substantially overvalued. But the high short interest is extremely dangerous, so I don't see shorting to be the right option either. In this situation, I think that the best thing to do is to just walk away.

Source: Should You Short Lululemon?