This Stock Has Recovered, and Is Poised to Get Better

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It could have been a disaster. A company that makes yoga apparel sells pants that are too sheer when you bend over. Do customers flee? Does the press grab a hold of the story and not let go? Will the company try to cover it instead of addressing the issue?

The answer to all of these is "no." Lululemon Athletica (NASDAQ: LULU) had a problem. While the company continued to grow rapidly, it found that its yoga pants sold recently were too sheer and had to be recalled. Obviously, this impacts their bottom line in the short-term. But more importantly, Lululemon quickly put out the fire by owning up to the problem. No excuses.

The company apologized for not meeting their usual quality standards, recalled the product, and said that they would fix the problem. They didn't let someone else tell the story. They didn't let it drag on while deliberating what to do. Apologize up front, take the product back, and fix it. Sounds so simple, but many companies fail to do this. Lululemon nailed it, and gave investors a great buying opportunity as a result.

The stock

When Lululemon announced the product recall over a month ago, the stock dropped as you would expect any time there will be a negative impact to earnings. However, if you haven't been watching Lululemon's stock closely since then, you missed the fact that shares have steadily risen since that drop.

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In fact, its most recent sharp increase has brought it close to where it started 2013. That's not much to celebrate about given that the S&P 500 is up substantially in 2013. But it begs the question: is Lululemon undervalued?

The valuation

At a basic level, the company's Price-to-Earnings ratio divided by its growth rate (PEG ratio) needs to be at a reasonable level, with "reasonable" being a relative concept. Investors typically allow for a higher PEG ratio for faster growth companies, sometimes 1.5x-2.0x, simply because of the growth that the company provides always allowing for the P/E ratio to catch-up. In Lululemon's case, the PEG ratio is 1.2, which isn't super cheap, but certainly not outrageous. The sell-off back in March would have provided you with a PEG less than 1, but unfortunately, that opportunity has passed.

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What makes the 1.2 PEG ratio acceptable to many investors is Lululemon's exceptional history of growth in both revenue and earnings per share (EPS). The chart above shows how much both have soared over the past couple of years. With the company also generating solid cash flow from operations along the way, there's not much to dislike about the growth Lululemon has provided. The stock has almost quadrupled over the past three years.

To top it all off, Lululemon's balance sheet is pristine. They have $590 million in cash and only $164 million of total liabilities, none of which are long-term notes. Lululemon has plenty of capital to continue its expansion, both in store locations and on-line presence.

The competition

The two most well-known competitors to Lululemon are Nike (NYSE: NKE) and Under Armour (NYSE: UA). Nike, obviously, is a much larger company and has more things to worry about than just making yoga apparel. Nonetheless, it is a competitor to Lululemon in that Nike provides an athletic clothing alternative to wearing Lululemon's yoga-specific attire. Nike is off to a great start in 2013, providing investors with an almost 20% return, more than double the S&P 500.

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Under Armour is in a similar boat to Nike, only with about 10% of Nike's market capitalization. Under Armour is a competitor to Lululemon by providing a clothing alternative to its yoga attire. Under Armour is also off to a great start in 2013, as the stock has risen almost 15%. Nike and Under Armour are both good investments. Nike provides investors with the additional stability of a well-established brand and a 1.4% dividend yield. Under Armour is a less mature, but faster growing company that could provide investors with significant gains if it can continue to grow at a rapid pace.

Among these three companies, I like Lululemon the best. It has a great market share in a niche market and also has the opportunity to expand further outside of the yoga market as it grows. Competition isn't a huge concern yet. While all competitors can offer alternative products, there aren't many who offer customers a yoga-specific product competition, and no one has done it as successfully as Lululemon yet.

The bottom line

I put Lululemon on the list of 10 Stocks for 2013 and I'm certainly not backing away from it. It got off to a rough start with the sheer pants issue, but has rebounded nicely. The financials look great and the valuation is solid. Lululemon continues to grow with no signs of slowing yet. Hopefully, the market will provide us with another nice dip as a buying opportunity.

Dave Zaegel 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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