Why I Would Not Initiate a Position in Lululemon Athletica

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

I think it is an understatement that a large segment of the North American population is madly in love with Lululemon Athletica (NASDAQ: LULU). Some of those people fall in love with LULU as consumers of its products, and others fall in love with LULU as investors of the company. However, I would not initiate a long position in LULU at this point of time because:

LULU Is Grossly Overpriced

The popularity of LULU’s products may help ensure that if you ever need to sell them second-hand on eBay, you will find a buyer with a minimum discount from the prices you paid. However, that does not mean that when you want to or need to sell LULU shares; you will get the same price you paid for them. For an investor to initiate a long-term investment in a consumer company, it is not enough to see a huge crowd in its stores.

Yahoo Finance indicates that LULU has $10.7 billion capitalization, and a trailing twelve month (as of July 29, 2012) price/sales ratio of 8.95. That translates into annual total revenue of approximately $1.2 billion for LULU. The company operates 189 corporate-owned stores as of July 29, 2012.

What do these numbers tell us? It tells us that each store is on average worth $56 million and produces annual gross receipts, or sales, of about $6.4 million. Now ask yourself a simple question: Suppose I have a store to sell you with annual sales of only $1 million, will you pay me about $9 million of your cash? It will take you 9 years to recover your investment, assuming you sell the $9 million of widgets (or yoga pants) without any costs (such as cost of inventory) or expenses (such as rent, salaries to the sales staff, taxes, etc.).

The Projected Growth May Not Materialize

I will be foolhardy not to have anticipated the following argument: You cannot analyze LULU as if it were a static company with only 189 stores. The company is so richly valued today because the market is forward-looking and has collectively priced its shares with the assumption that LULU will grow rapidly in the next x, y, or z years at x%, y%, or z% each year. With the power of compounded growth, LULU’s sales and profits will grow to sizes commensurate with its $10 billion or so capitalization.

Essentially you are asked to pay a hefty price for the shares of LULU today, and count on the exponential growth of LULU to continue for many years to come. However, no matter how much people love LULU's clothes, there is a ceiling as to how much LULU can grow. There are only so many stores LULU can open. In comparison, Gap has about 3,000 stores (capitalization 18 billion), and Abercrombie & Fitch (capitalization $2.7 billion) has about 1,000 stores. There are only 1,500 shopping malls in the United States. Since LULU has positioned itself as up-scale retailer, I cannot imagine that it will move itself into strip malls. So the most stores it could have in the U.S. is 1,000, give or take. Let’s assume that the annual revenue will also grow by 400% to $6 billion. Even when and if it achieves $6 billion annual sales, I am not sure whether a capitalization of $10 billion represents a good buy.

 LULU’s Business and Share Price Are Subject to Many Risks.

Among all the risks LULU faces, the following stand out:

LULU’s profit margin might erode.

In order for LULU to grow its revenue, it has to reach out to its non-core customers. There are only so many people who are both fans of its products and who are in a financial position to buy them at their current price level. There will come a point of time when LULU has reached almost all of such consumers. After that, LULU will have to either cut prices of its products or slow the growth of its revenue. Simply put, LULU will have to cut its prices (and thus its profit margin) to reach its non-core customers. Or, if it chooses to be exclusive and focus on its core-customers, its revenue growth will slow down. Either option will slow down its earnings growth.

LULU operates in an extra-competitive market.

While LULU has a tremendously loyal and huge “base,” it is not immune from the competitive forces in the market. LULU does not command a monopoly or even near-monopoly position in the market. At the risks of being ridiculed by its fans, what LULU sells is nothing but clothes. It is not that hard to make and sell clothes that are good enough to be their substitutes. In fact, other companies are doing that, and at much more attractive prices.

Fashion trends are fickle and stock prices of companies in this business can be very volatile.

When Wall Street and Main Street both fell in love with UGG boots, Decker’s Outdoors’s (NASDAQ: DECK) stock was traded over $110 per share. Everyone thought that DECK would continue its exponential growth for the next x years. However, only a year later, DECK is now traded in 30s, and every other day you will hear someone saying that UGG boots are nothing but a fad. I don’t know whether LULU yoga pants or UGG boots are a fad. I just want to give you a counter example.

You may even want to profit from the wild mood swings that Mr. Market has had on DECK.  Currently, DECK might represent a good investment opportunity now.  Although the days of its exponential growth of UGG sales may be behind us, DECK is still a profitable company with well-recognized products. The disappointment of the last several quarters, which led to the huge stock price decline, partly resulted from a warmer winter and higher raw material (sheepskin) costs. More importantly, a lot of consumers treat UGG boots as a staple in their life and will be repeating buyers to support the current level of overall demand. The company has a clean balance sheet and a steady management team. With the stock now traded at around forward P/E of 8 and trailing price/sales ratio of around 1, Mr. Market’s expectation of DECK might have been too pessimistic. So long as DECK maintains its current level of sales and earnings, I think it is now an attractive long term buy, even without the benefits of any future growth.

They always say  "past performance does not guarantee future success."  However, Mr. Market seems to have assumed that LULU will continue the exponential growth of LULU’s business into the next 5-8 years. He has priced all of such expectations into today’s share price of LULU.  In short, LULU’s shares are priced for perfection, so any setback down in the road will send their price tumble.

Now you may ask me, “since you believe that LULU’s stock is so over-priced, why will you not initiate a short position against it?” My answer is rather simple: “I do not short any stock.” For as long as Mr. Market wants to pay $75 or more for LULU’s stock, what can I do?


TheDisciplined is long ANF and DECK.The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend 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.If you have questions about this post or the Fool’s blog network, click here for information.

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