Lululemon Athletica: Still A Compelling Growth Story

| About: Lululemon Athletica (LULU)
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Lululemon Athletica Inc (NASDAQ:LULU) received another vote of confidence when Capital Group, one of the world's largest investment management firms, acquired another 6.8 million shares of the company. This transaction has awarded Capital Group a total stake of 11% (12.7 million shares) in the athletic apparel retailer. Previously, Capital Group's stake ownership in Lululemon was just 5.1% and it has almost doubled after this transaction. Lululemon was also upgraded by an RBC Capital Markets Analyst from sector perform to outperform. Analyst Howard Tubin believes that all of the bad news for the company has passed. Lululemon is believed to be a growth story in the long term and as a result the stock managed to move up by nearly 5% in the last two trading sessions. In this article I will try to ascertain an investor's stance during such circumstances.

Shareholders' Return

Lululemon is a growth company and therefore it does not pay any dividends like many other apparel manufacturers in the industry. It has no share buyback program either that could pay off its investors. Therefore the investors in this case realize returns on their investments from price appreciation. Lululemon's stock price skyrocketed and reached a record high level of $82.28 in June 2013. After that uplift, the stock price experienced a serious decline of 40%. This decline was majorly fueled by a massive recall of the company's signature black stretchy yoga pants that were claimed to be too sheer to wear. That recall caused costly supply chain troubles on an ongoing basis. Moreover the arrogant behavior adopted by the company towards its customers exacerbated the situation. Negative publicity followed by controversial comments by founder Chip Wilson adversely impacted the company's brand perception and resulted in slowed growth.

Earlier this year the company revised its earnings expectations for second time in just one month. It forecasted its earnings per share to be in the range of 71-73 cents, down almost 9% from the previous guidance of 78-80 cents. The decline was predicted by the company due to the significant slowdown in sales traffic. However, this revised guidance was issued in the second week of January during a negative growth in sales traffic. Therefore the meaningfulness of the data derived from just two weeks in January remains questionable. This revised guidance caused an 18% decline in the stock price, the second drop in just two months. This implies that the stock failed to transfer any returns to investors' wallets since it was caught up in the product recall scenario and mismanaged public relations arena. As indicated by the following figure, Lululemon experienced a decline of 30.1% in its stock price over a year, whereas competitors Nike (NYSE:NKE) and Under Armour (NYSE:UA) delivered price appreciations of 33.12% and 115.6% respectively.

Source: Y-Charts

Recent steps taken by Capital Group and RBC Capital Markets have caused the stock price to rise by 5%. This indicates that the market's perception of the company is taking a positive turn that will bode well for the stock's future. This may be because the company is now taking customer relations seriously under the command of its new CEO Lauren Potdevin, former CEO of Toms (shoe manufacturers). The company's efforts to polish its tarnished image will definitely help save the brand.

Impact of Increasing Competition

Despite the current scandals Lululemon is currently dealing with, the long-term growth prospects of the company remain intact. The decline in the stock's share price was more the result of negative customers' perception caused by controversy and negative publicity. In actuality, the company's customer base is loyal to the brand and isn't not ready to completely abandon its products. Also, the customer base is wealthy and therefore less reactive towards even premium prices charged by the company, preferring quality over price. In this scenario the company can drive growth by expanding its stores across the globe as indicated by the increasing trend in the company's square footage during the last 9 months of 2013.

Source: Financial news release

Globally the demand for sportswear is growing by leaps and bounds and is expected to reach $126.30 billion by 2015. This demand is mainly driven by emphasis on healthy lifestyles including enhanced participation in sports, yoga, and jogging. Acting on the strong trend, sports and fitness apparel manufacturers can derive instrumental growth worldwide.

However, Lululemon will have to deal with enormous competitive pressure from industry leading apparel manufacturers such as Nike, Adidas AG, Reebok brands and Under Armour Inc.

Source: Reuters

Despite the stiff competition faced by the company, it managed to earn higher than industry and competitors' profit margins and sales growth over the year, proving the resilience of the brand. The Lululemon brand is robust enough to attract customers in the long term due to its word of mouth marketing ever since the first day of the company's incorporation.

Moreover, e-commerce sales amounted to 16.3% of the company's latest quarter revenues and will further bolster the company's top line. Online sales offer a competitive edge and benefit the company because of the ease and time-saving benefits afforded to customers. Low double digit same store sales growth for the company's men's and young girl's business segments is positive news that was overshadowed when the company revised its guidance for the fourth quarter.

Is it expensive?

If we look at the price multiples for Lululemon, it seems very expensive. At a glance one can easily be convinced that the company is overvalued since all of the ratios are above the industry benchmarks. However, looking at the multiples at which its competitors are trading it becomes evident that the other players in the industry are also trading at high rates, meaning the industry has potential and that gives investors confidence in Lululemon's ability to outperform market. Glancing at the stock price to earnings growth (PEG) ratio it becomes evident that the company's price, after taking into account the growth prospects, stands at 1.84 (65% of the industry benchmark). This is indicative of the fact that there is still room left for the company to reach the levels attained by the industry. This tendency of the company will open doors for the stock to appreciate in terms of price in future.

Source: Reuters

Analysis: What is Hidden Behind the Numbers?

Lululemon is currently earning a return on equity of 30.84% that is far greater than the industry average of 16.39%. Lululemon's ROE is almost double the ROE of its direct competitor Under Armour Inc (UA) that stands at a level of 17.35%. With the DuPont analysis it becomes apparent that this is the norm of the industry and that net profit margin stands as the prime driver of the return on equity.

Source: Reuters

As reflected in the figure, Lululemon generates maximum profit margins in the industry far greater than its competitor Under Armour Inc . However Under Armour's asset management is better than Lululemon. Another perspective under consideration is financial leverage that demonstrates how much of the company's assets are being financed by equity. Here Lululemon stands better than both its competitor and the industry as it is financing very few assets with debts and a majority of the asset funding is derived from equity. This places Lululemon's stock with paltry financial risk since it has a debt to equity ratio of 0, implying no debt on its balance sheet. This leads us to the conclusion that the return earned by the company on its equity is not inflated due to financial leverage rather it is fueled by the company's marvelous operating performance.

What to do next

Lululemon was bruised and battered due to various reasons in fiscal year 2013 and now seems to be bouncing back in late FY 2014 aided by the changing market perception of the brand. Under the command of the company's new CEO and talented team, the product quality issues will surely be resolved. This will really help the brand regain the luster it had lost in 2013. However, it will take time to further strengthen its product portfolio and come up with quality products. However, the main thing is that the growth will ultimately continue. Meanwhile the company's existing loyal customer base will act as an advantage and support its top line. In short the new senior leadership and a strong brand can act as a catalyst propelling the company forward.

The recent dip of the stock price is a chance for investors to include Lululemon in their portfolios. When the company recovers and starts its journey towards positive growth, investors will be able to benefit from stock price appreciation. However, this stock is well positioned to be part of patient investors' portfolios as it has the capacity to outperform in the growing fitness apparel market.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by a Blackstone Equity Research research analyst. Blackstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Blackstone Equity Research has no business relationship with any company whose stock is mentioned in this article