This Company Is Anything but a Lemon

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When you have a name like Lululemon (NASDAQ: LULU), it’s easy for investors to misunderstand what’s going on. For a while, it seemed everyone referred to this company as a yoga clothing company and believed it would never be anything more. In recent months, the company’s trouble with production quality has left a question mark around the shares. However, for investors willing to give management the benefit of the doubt, there’s no question that Lululemon still looks like a great growth story.

218 Is a Very Important Number
Investors who believe in the Lululemon story should constantly be repeating to themselves the number 218. This is the approximate number of total stores in operation under the Lululemon name brand.

Though the company’s quality issues over the last few months can’t be understated, clearly customers are still buying Lululemon products at a fast pace. In the most recent quarter, the company reported revenue up 21%, on the back of a comparable store sales increase of 7%. While diluted EPS was flat, this should be attributed more to the company’s challenges with current production than with any long-term issue.

With just 218 locations in the company’s product line not widely distributed, Lululemon has a long road of growth ahead of it. When you look at the company’s competition, the most obvious name that comes to mind is Under Armour (NYSE: UA). The challenge that Under Armour faces is trying to convince Lululemon's largely female clientele that the company’s products are made with them in mind.

Another challenge that Lululemon faces is the lack of distribution that a competitor such as Nike (NYSE: NKE) already possesses. In fact, I would make the argument that Lululemon's management needs to begin conversing with companies such as Dick’s Sporting Goods (NYSE: DKS) to begin to broaden the company’s distribution platform, so that Lululemon can go head-to-head with both Nike and Under Armour.

Why Should Lululemon Change?
To be quite blunt, one reason that Lululemon should consider a broader distribution strategy is because the company beats its competitors in a head-to-head competition every time. For instance, the company carries the best gross margin of its peers at 49.4%. By comparison, Under Armour commands a gross margin of 45.9%, Nike carries a gross margin of 44.22%, and the traditional retailer Dick’s Sporting Goods could use a boost to their gross margin of 30.87%.

Part of the reason that Lululemon has better margins is because they are very efficient at managing their inventory levels. A traditional retailer such as Dick’s Sporting Goods may choose to carry a higher level of inventory relative to sales to try and avoid an out of stock situation. In this company’s last quarter, their inventory on the balance sheet relative to current quarter sales was 98.43%.

If we look at product manufacturers, Under Armour carried the highest level of inventory to sales at 68.6% in the last three months. You would expect that Nike, as the much larger competitor, would have excellent inventory management, and they generally do at 53.81% of current quarter sales. However, Lululemon was even more efficient with an inventory to current quarter sales percentage of just 41.56%.

Another positive for Lululemon is the company is expected to grow earnings and revenue at a very fast rate, yet they are not diluting shareholders by issuing new shares to the same extent as Under Armour. Since Nike and Dick’s Sporting Goods are expected to grow EPS by between 11% and 15% over the next few years, neither company carries the same growth profile as Lululemon or Under Armour.

Of these two faster growing manufacturers, Under Armour increased its diluted share count by about 1.3% on a year-over-year basis. By comparison, Lululemon increased diluted shares by just 0.15% during that same timeframe. This doesn’t sound like much, but could be the reason that analysts expect roughly 1.4% better earnings growth from Lululemon compared to Under Armour.

No Stretching Required
The bottom line is that growth investors have two choices in this industry, and both are expected to grow earnings by better than 20%. However, at current prices Lululemon appears to be the much better choice trading at about 33 times projected earnings for this year. Considering that Under Armour is expected to grow earnings at a slightly slower rate, yet trades for a P/E ratio of over 40, the choice looks pretty clear.

If you want fast growth, efficient inventory management, and the best gross margin, it’s no stretch to look at adding Lululemon to your portfolio. At the very least, investors should consider adding this company to their personalized Watchlist to keep up with developments.

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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Chad Henage has no position in any stocks mentioned. The Motley Fool recommends Lululemon Athletica, Nike, and Under Armour. The Motley Fool owns shares of Nike and Under Armour. 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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