Don’t Shy Away From This High P/E Stock

By Gayatri Sharma - October 19, 2012 | Tickers: LULU, NKE, UA | 0 Comments

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Shares of Lululemon Athletica (NASDAQ: LULU) have surged more than 57% this year, and the stock is currently trading at a forward P/E of 32.78. The unusually high P/E ratio of this company has scared away some investors. But does a high P/E ratio really mean a stock is overvalued? Not always.

Investors steering clear of high P/E ratios often end up missing out on big winners. Let’s first compare the forward P/E multiple of Lululemon with other big names in the athletic apparel and accessories sector, including Nike (NYSE: NKE), Under Armour (NYSE: UA) and Adidas.

Source: Yahoo Finance

Much like Lululemon, Under Armour is trading at a high forward P/E and at a healthy premium to Nike and Adidas.  However, both Lululemon and Under Armour have high growth rates to support their high multiples. It is essential to dig into the growth adjusted valuation multiple before investing in any stock, as it is a better indicator of a stock’s possible true value. The following table summarizes the PEG ratio of these companies.

Source: Yahoo Finance

Although Lululemon and Under Armour have high P/E ratio, they have lower PEG ratio compared to Nike and Adidas. I do acknowledge the fact that PEG ratio relies on the projected earnings, and that these earnings are not always accurate, which in turn means that the PEG ratio is not always accurate. However, I am particularly optimistic about Lululemon’s strong growth prospects, as the company is still under-penetrated in North America (150 stores after 2011) and has significant unit growth opportunity. Lululemon enjoys strong brand loyalty (in the rapidly increasing yoga industry) and there is no major competitive threat.

Thus, I think Lululemon will continue to dominate the core yoga market brand awareness continues to grow and technical, high quality products will continue to deliver impressive sales growth. In my opinion, Lululemon is a highly differentiated retailer and has an attractive long-term opportunity, given significant square footage expansion with improving new store productivity, testing and expansion of new products and categories, rapidly growing DTC business, seeding of international rollout with early positive reads in London & Hong Kong, and incremental store potential from the ivivva brand.

Not only does Lululemon have industry-leading sales and income growth, it also operates at significantly higher margins. The following table summarizes the profit and operating margins of Lululemon with respect to Nike, Under Armour and Adidas.

Source: Yahoo Finance

Going forward, growth investments may hinder robust operating margin expansion. However, I am not overly concerned as SG&A leverage on strong sales, and contribution from e-commerce should significantly offset elevated growth investments. In addition, Lululemon has a debt/equity ratio of 0, compared to Nike’s 0.036 and Under Armour’s 0.107. Thus, Lululemon is not exposed to any risk in terms of interest rate increases, and the free cash flow it generates can be used for further expansion or may even be returned to shareholders as a dividend.

To conclude, I would suggest that investors look beyond Lululemon’s hefty valuation, as the company's long-term growth potential remains significantly better than that of most of its peer group; therefore Lululemon shares deserve the premium valuation. In my opinion, Lululemon is highly under-penetrated in North America as well as international markets, and is still in the early life-cycle of its growth. The potential for further upward estimate revisions, coupled with the solid long-term growth prospects and the strong balance sheet, will likely keep shares moving upward.

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