Is Lululemon Part of a Speculative Frenzy Market?

By Chad Henage - March 7, 2012 | Tickers: LULU, JWN | 0 Comments

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(Editors Note: A previous version of this post incorrectly stated that Herb Greenberg is a contributor at thestreet.com. He is currently a contributor at CNBC. We apologize for this error.)

I couldn't help but write something in response when I saw CNBC commentator Herb Greenberg make the comment that this market was in a "speculative frenzy”. Don't get me wrong, I like a lot of what Herb has to say, but the wording of this remark seemed short-sighted at best. He mentioned specifically, that he couldn't believe that the market value of Lululemon (NASDAQ: LULU) with $847 million in annual revenue, could be valued equally with Nordstrom (NYSE: JWN) with $10.8 billion in annual revenue.

The part that frustrated me about his comment, is the fact that companies are not valued just on revenue. His statement assumes that a company with more revenue is worth more. This ignores the growth potential of a company and its future prospects. This also ignores debt levels, cash flow, and other metrics that investors use to value stocks. Herb believes that zero percent short term rates are driving this speculation. My thought is, let's compare these two companies and see if the market is pricing the stocks correctly, or if there is indeed a speculative frenzy at work here.

It's interesting when you look at valuations, what you find. The stocks are valued similarly, with Lululemon actually valued at a 6% premium on a PEG basis. However, I think these numbers are misleading. The issue I find odd is Lululemon's prior growth compared to Nordstrom's prior growth. Lululemon has been growing earnings at over 50% in the last few years. By comparison, Nordstrom has only been growing earnings at just over 4%. For analysts to suggest that Lululemon's growth will slow by 40%, while Nordstrom's growth will increase by over 180% seems like a reach. This point is made even more clear, by the fact that Lululemon is expected to have average revenue growth of over 30% in the next two years. Nordstrom is only expected to average about 8.5% revenue growth. I think the real numbers are likely somewhere in the middle. Lululemon may grow by closer to 35%, while Nordstrom might do 10% growth. Using those more realistic expectations the PEG ratios become 1.17 for LULU and 1.53 for JWN. If I'm right, today's price on Lululemon could be considered a decent entry point.

Since reported earnings only tell us just so much, we have to look at cash flow to determine if these earnings are real. In making a free cash flow comparison, it makes sense to use free cash flow per $1 of assets. This evens the playing field, and allows us to compare companies in the same industry of different sizes. In the last 4 quarters, Lululemon has generated about $0.057 per $1 of assets in free cash flow. Nordstrom has generated about $0.089 per $1 of assets in the same period. Both companies are doing well, but Nordstrom seems to generate more free cash flow per $1 of assets. This makes some sense, because Nordstrom is the more established company. If there is one additional thing to keep an eye on with these two companies, it would be their growth in capital expenditures. Lululemon has grown their capital expenditures in the last 4 quarters by 59%. This is somewhat expected for a retailer that has been growing earnings by 50%. What is not expected is Nordstrom has been growing their capital expenditures by 44%. This seems unusually high, in light of their earnings growth only being 4% in the last few years. This is a major issue to watch if you are a Nordstrom shareholder.

When it comes to these two companies balance sheets, you can see why Nordstrom needs their higher free cash flow. Lululemon has no long term debt and shows cash of about $300 million. Nordstrom has a debt-to-equity ratio of 1.48, and is dealing with over $2.8 billion in debt. Since debt can be a major drag on operations this is also a concern. Nordstrom management apparently doesn't see this as an issue, as long term debt has risen slightly in the last year.

Lululemon is a fast growing company, that is just beginning to scratch the surface of their potential. Nordstrom is an established retailer, that has to grow by getting more shoppers and cutting costs. In both cases, the companies are generating good free cash flow. The difference in my mind, is the balance sheet comparison. Lululemon has no debt, Nordstrom has almost 1.5 times as much debt as equity. If Lululemon continues to grow at their current pace, today's stock price might look like a bargain. I don't believe the market is in a frenzy buying Lululemon. I believe investors see the beginnings of a multi-year growth story, and are willing to pay an appropriate price for that growth.

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