Are There Still Opportunities in Apparel?

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

Many argue that the apparel business doesn’t offer good long-term investment prospects because low barriers to entry and fashion variations make the companies in the industry highly unstable. However, some firms have proven successful in continually adapting to a changing environment and attracting clients, even through tough economic patches. Lululemon Athletica (NASDAQ: LULU), DSW (NYSE: DSW) and Wet Seal (NASDAQ: WTSL) are three of these companies. Having performed well in the past, what lies ahead? Are they worthy investments?

In the athletics business 

Lululemon Athletica operates in a niche within the athletic apparel business, mainly focused on yoga and other healthy and fun products, aimed to enhancing its customers’ quality of life. Growth prospects are strong for this firm, principally due to its client base’s discretionary spending power. Analysts expect annual EPS growth rates around 22%-26% for the years ahead. However, most of this optimism seems to be priced into its stock, which trades at 44.1 times earnings, more than double the industry average valuation. Same goes for its price-to-book and price-to-sales ratios. So, are these shares a buy? Well, I’d say they are.

Although fundamental investing is not only about financial performance, taking a look at Lululemon’s figures seems pretty important, given that it leads the industry in almost every metric. Its results look somewhat moated by the firm’s strong brand name, “which will likely make it more resilient through fashion and economic cycles (…) [Furthermore], the company stands to benefit from improving productivity, increased store count and focused merchandising in its trendy and quality-focused apparel in the near term.” (Morningstar).

After a few months of problems and complaints about the quality of its popular black yoga pants that had to be pulled out of the market for a while, the company has now restocked them and seems poised to grow. Last quarter’s results, reported on May 10, seem to confirm this. Revenue rose by 21% to $345.8 million from the $285.7 million in the first quarter of 2012, mainly on the back of a 7% increase in comparable-store sales. Additional growth should be provided by a recuperating economy and the incursion into new categories including men’s and teens' clothing.

In the footwear industry 

DSW is a footwear retailer that has been catching investors’ eyes for some time now. The company’s strategy of offering a hard-to-match array of high-end brands at attractive prices has lured many customers over the last years, when discretionary spending was limited but many people still wanted to wear branded footwear. As a result, DSW delivered an average annual EPS growth rate of 36.86% over the last five years, and is expected to deliver an extra 13%-15% over the next five.

Its low fixed-cost business model, which reduces labor expenses by operating self-service stores, has procured the firm above-average operating and net margins, of 10.5% and 6.5%, respectively. The management's track record suggests that the company will be able to continue to widen those margins in the coming years (although it could feel some pressure in the short term).

Despite weak results in the last reported quarter due to bad weather, sales started to rise as it got warmer. Management's projections for the full year are still positive but limit same-store sales growth to 0%-2%, and EPS growth between 1.5% and 7.5%. Going forward, the company expects to continue expanding its store base at mid-to-high single-digit rates. Further growth should be delivered by its web sales, which have been pretty successful lately.

However, DSW's future is pretty uncertain; with a replicable model, low barriers for new industry entrants as the economy recuperates and increased competition from companies like Zappos, the firm holds few weapons to defend its ground. Trading slightly above average industry valuations, at 22.8 times its earnings, this stock looks a little expensive for the security it offers (not much).

Targeting teenagers 

Wet Seal is an apparel retailer that targets young and active customers, through fashionable and comfortable products. By offering low-priced products, it has lured many low- and mid-income clients that have developed a certain degree of brand loyalty.

After a weak 2012, the renewal of several management positions and strong merchandising initiatives could serve to turn around the story – last quarter’s results certainly back this theory. With several growth and cost-cutting initiatives running, the outlook seems favorable; analysts expect the firm to deliver an annual EPS growth rate of 48% over the next five years. Trading at 3.4 times its book values and 0.8 times its sales, versus the 4.9 and 1.2 respective industry means, this stock looks like a buy to hold.

The company operates two retail channels, stores and e-commerce websites, and is set to revamp both. This is one of the main factors behind the confidence put in the firm's future. On the e-commerce front, the company has been investing in overhauling the shopping experience in both computers and smartphones, while expanding its product offerings to draw more web traffic. Regarding stores, the makeover has been even bigger. By hefty investments on advertising, store remodels, visual merchandising and corporate image, Wet Seal expects to attract more customers, especially young women.

Furthermore, the company has been cutting costs by reducing its workforce and closing underperforming stores. Savings are expected at over $3 million in 2013. Meanwhile, its balance sheet remains strong with over $110 million in cash and investments and zero debt. In addition to the cost reductions, Wet Seal recently announced a $25 million share-repurchase program that will return value to investors. Following several insider purchases, I believe that this is the time to purchase this stock and hold it for some time.

Bottom line

Although none of the companies above has dug a moat for itself, both Wet Seal and Lululemon offer compelling growth prospects for the years to come. While still susceptible to increased competition and new entrants, these companies have developed a certain degree of customer loyalty and a strong brand name that should continue to attract customers for a few more years, at least.

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.


Victor Selva has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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