Lululemon Recovery in the Next 5 Years?

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Lululemon Athletica (NASDAQ: LULU) has had a bit of a rough quarter. The company had a luon shortage, which caused its flagship black spandex pants to run out of stock. Sales of the luon pants will return to normal as the company will eventually bring stability to the supply chain. The company had to take pre-existing stock off of its shelves because the luon pants were overly sheer.

Lululemon Athletica’s luon is a patented and trademarked blend of nylon and lycra. The fabric is designed to breathe well and reduce sweat, it doesn’t stretch or become baggy, and it’s also pre-shrunk while being flexible and stretchy at the same time. Luon is essential to the company. It is like Apple waking up one day and realizing that it ran out of processor chips for its iPhone.

The CEO, Christine Day, will be stepping down. She will be announcing a successor that will be able to carry out a 10-year plan. The CEO is making an organized exit in order to reduce the negative effects of her departure on the company.

Earnings highlights

Lululemon reported a 21% revenue growth rate for the first quarter year-over-year, which would have been somewhat better had the company had proper inventory levels for its luon yoga pants. The company was able to grow comparable-store sales by 7%. The company is still identifying and selling new consumers its yoga-based products. The company is also finding lucrative opportunities in brand-extension into men’s polos.

The company wasn’t able to improve its net income by much, as it reported $47.3 million in net income for the current quarter. The company reported $46.6 million in net income in the same quarter last fiscal year. The growth in net income was minuscule as the company was more heavily focused in capital expenditure, sales, general, and administrative spending. The SG&A spending went up because the company is increasing the store footprint during a period of the year when sales are seasonally low.

The company has plans to open 43 corporate-owned stores for the full-year, which will directly translate into an immediate boost in terms of both top- and bottom-line growth. The full effects of the store openings are hard to determine, but the company provided guidance at around $1.6 billion to $1.7 billion. The company believes revenue will grow by around 20% for the full year.

Capital expenditure spending goes up

The company is spending a lot of money. This is because it is transitioning from short-term earnings growth to long-term growth. The company is opening a large distribution center in the second half of 2014, so its capital expenditure spending should continue to rise. Also, difficulties in the supply chains are likely to persist due to short-term manufacturing suspensions. This is going to hurt the short-term performance and cause the gross margins to decline from 55% to 50% (cost of goods sold is expected to go up).

The company provided earnings-per-share guidance at around $1.96 to $2.01. Analysts on a consensus basis are anticipating the company to report earnings at the upper end of the range at $2.00 per share. The holiday season could lead to a surprise on earnings as the company beat analyst estimates by 1.4% in the fourth quarter of 2012.

The company reported a $17.5 million write-down on losses from luon in the first quarter of 2013; the effects are temporary and somewhat negligible when considering the company generated $346 million in revenue over the same period. The real reason for the significant decline in the value of the stock was due to the departure of the CEO.

The cost of manufacturing the product should eventually stabilize. Much of the issues in net income growth have more to do with the execution on the part of the management team rather than the decline in demand for the company’s products. The brand is still in healthy condition, which can be backed by survey results from Piper Jaffray.

<img alt="" height="423" src="http://g.fool.com/editorial/images/49087/6-10-13-lulu-pic-1_large.png" width="644" />

Source: PiperJaffray

The brand’s popularity amongst teens have progressed from 5% in the fall 2011 to 10% in spring of 2013. It is only 1% away from being as popular as Nike/Jordan.

Athleticism is becoming more popular as it symbolizes a mix of prep, attractiveness, and uniqueness. Lululemon Athletica has established a proven business strategy and is likely to succeed going forward. Therefore, investors should stay vested in this company. Analysts on a consensus basis believe the company will continue to do well, with an earnings growth rate of 22.6% on average over the next five years.

Other investment opportunities

While Lululemon Athletica remains a compelling investment opportunity, investors should look to diversify in fashion retail. I believe that investors should consider investing into Macy’s (NYSE: M), and L Brands (NYSE: LTD).

Macy’s is likely to grow its earnings over the course of many years. The company carries numerous luxury brands like Ralph Lauren, Gucci, and Michael Kors. The company’s open-store layout and marketing of luxury brands paired with celebrity endorsements from Justin Bieber are keeping analysts fairly optimistic. Analysts project earnings growth of 14.4% on average over the next five years.

The company trades at a 14.4 earnings multiple, which is somewhat reasonable in light of the projected earnings growth. The company's earnings multiple is reasonable when compared to the 19.3 earnings multiple for the retail apparel sector. The company pays out a 2.1% dividend yield, which is an added bonus for investors who want income.

The company's retail operation is expected to grow earnings through a mix of cost-cutting and growth in comp-store sales, paired with new store openings. In the first quarter the company improved its operating margin from 6.4% to 6.8%, which directly translated into a 30.2% growth rate in earning per share year-over-year. The company's earnings performance drastically improves with modest cost- cutting efforts along with share buybacks.

L Brands is another strong investment opportunity. The company, similar to Lululemon Athletica, is going through a period of rising capital expenditure spending, which is why net income growth is projected to be low for 2013. To be fair, investors should look further out than a single year because investment yields tend to pay off better with a longer time horizon.

L Brands hopes to transition the pink brand into its own separate retail stores. The pink yoga branded pants are sold at a much lower average retail price when compared to Lululemon, giving women an entry-level option. Yoga came back in style because of Lululemon Athletica. Pink is planning to capitalize on Yoga-apparel at the low end. Not only that, the company's management team believes it can further maximize profitability through remodeling the Victoria’s Secret stores.

Analysts believe these measures will work out over the long term. Analysts anticipate 10.1% average growth in earnings over the next five years. The company has a generous 2.4% dividend yield. The valuation is a little rich at a 19.5 earnings multiple.

But there’s always the possibility of future earnings surprises based on a sudden improvement in consumer sentiment paired with a reduction in share buybacks, with the cash put toward investment into a greater number of store openings in emerging markets. Also, if conditions in the European economic zone were to improve, it is highly likely that L Brands will increase the rate of store openings in Europe. The company currently plans to open eight additional stores in Canada, two stores in the Middle East, and three additional stores in the United Kingdoms. The company currently has 126 international stores at the end of the first quarter and plans to open an additional 74 by the end of fiscal year 2013.

Conclusion

Fashion retailers have periods when investment is prioritized rather than maximization of net income through cost-cutting initiatives. Investors shouldn’t bail out of these company’s because of slight misses due to the need to invest into operations, product shortages, or an increase in staffing levels in order to meet the level of service expected.

The loss of the CEO will be felt, but going forward the company had a planned exit for the CEO. So it is likely that the business will continue to meet performance expectations so as long as the board has groomed a strong contender for the position.

Lululemon Athletica has a proven business model and following the investment period it is highly probably that the company will be able to report substantial improvements in earnings growth. Investors should also look to diversify by adding L Brands to their portfolio in order to even out the mix of Yoga-driven growth. Investors should also include Macy’s because high-end fashion should also include brands like Calvin Klein, Ralph Lauren, The North Face, and Levi’s.

Lululemon has the potential to grow its sales by 10 times if it can penetrate its other markets like it has in Canada, but the competitive landscape is starting to increase. Can Lululemon fight off larger retailers and ultimately deliver huge profits for savvy investors? The Motley Fool answers these questions and more in its most in-depth Lululemon research available. Thousands have already claimed their own premium ticker coverage; gain instant access to your own by clicking here now.

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Alexander Cho has no position in any stocks mentioned. The Motley Fool recommends Lululemon Athletica. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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