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Lower your discount rate, then value LULU

|Includes:Lululemon Athletica Inc. (LULU)

There are two types of investors who follow LULU, the bear focused on valuation and the bull who loves the company and its products. For the value bear the fundamentals of the industry do not permit the multiples at which LULU trades. Despite the obvious quality of the products, North American retailers cannot be worth so much in this climate. Moreover, LULU has no patents on the materials they are so famous for and they compete with larger retailers such as Nike, Under Armour, Gap, Adidas and VF Corp who presumably could easily mimic the styles at lower prices. There is also the long list of fad clothing retailers who in the past have reached LULU's lofty valuation levels only to tank at the first sign of weakness never to regain their former glory (GAP, ANF). 

For the Bull, LULU is the first athletic apparel company to truly capture and maintain the interest of the female demographic. We are witnessing the development of an epoch changing retailer that over the next ten years will carry its appeal to active and professional women all over the world. Just as the simplicity and beauty of Apple's products have brought older generations to MP3 players and smart phones, the style, sexiness, durability and comfort of LULU's products have brought women to yoga and pilates while altering the definition of suitable casual female attire.

Over the past year sentiment has leaned towards the Bull camp as LULU continues to come out with spectacular earnings that dwarf even the highest of analyst estimates. The analysts following the stock seem to lack any sense of imagination and fail to do proper field work. I went to the University of Toronto when LULU was just starting to branch into the United States but was still primarily a Canadian company. Quickly young women all over the city were wearing the pants. Today, if you go to a high end gym in Toronto or Vancouver more than half of the women are wearing a LULU garment of some sort. Recently I travelled to London and despite the fact that London has no stores, LULU was all over the gyms and yoga studios over there. 

At this point I had to accept that despite astronomical multiples, LULU was perhaps undervalued. The cost of equity is meant to reflect the possiblity that a series of cash flows will not be realized. The higher the riskiness of the cash flows, the higher the cost of equity. If one is absolutely certain a series of cash flows will grow at a certain rate, the only justifiable opportunity cost is the risk free rate.  Over the past two years, the various risk premiums investors used to value LULU have disappeared from the discount rate. They have proven immune to falls in consumer spending and income, volatile input prices, and copycat offerings from larger competitors. All available evidence tells me that LULU will grow to $2 Billion in revenues within the next seven years. If margins stay stable, Lulu will earn $5 dollars per share for the year ending 2017. Because LULU will still be a growing company at this point, a market multiple of 15 seems conservative putting LULU's stock at 75 in 2017 generating a return of 7% a year over the holding period. Where bond yields are generating peanuts, and economic uncertainty prevails LULU is a safer bet than it seems.           



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Stocks: LULU