Lululemon Athletica Inc. (LULU) is a high-growth apparel business that has forged a decent niche for itself among yoga practitioners. However, despite its profitability and its growth prospects, I do not believe it warrants its current high valuation.

The Vancouver, Canada-based firm has done well in gaining market share within the competitive sector of athletic apparel, having to contend with established names such as Nike (NKE), adidas (OTCQX:ADDDF) (OTCQX:ADDYY), and the beleaguered Under Armour (UA) (NYSE:UAA). It has done this due to several factors: the quality of its products in terms of function and form; and the trend globally towards improved physical fitness.

The Lululemon brand has become synonymous with quality, owing to its jackets, pants, shirts, shoes, and shorts being made from cutting-edge materials that are light to wear and sweat-absorbent. Not only are these items of high quality, they permit Lulelemon to charge premium prices which its high-income customers are only happy to pay.

The Lululemon brand has become synonymous with quality athletic apparel. Image provided by Glassdoor.

That number of customers is only likely to grow going forward. The trend is towards a growing number of people engaging in physical fitness, and yoga in particular has become rapidly popular. The casual style of clothing that Lululemon offers can be worn either in the gym or out and about, and the company’s ability to ride the ‘athleisure’ trend should serve it well going forward. That it has been beneficial hitherto can be gleaned from the revenue and net income figures provided over the past five years.

Year Revenue ($) Net Income ($)
2014 1.8 billion 239.03 million
2015 2.06 billion 266.05 million
2016 2.34 billion 303.38 million
2017 2.65 billion 258.66 million
2018 3.29 billion 483.8 million

Figures collated from annual reports available on Lululemon’s investor relations page.

Quarterly reports for the current financial year show that this trend shows no signs of abating.

2019 Quarter Revenue ($) Net Income ($)
Q1 782.32 million 96.6 million
Q2 883.35 million 124.99 million
Q3 916.14 million 125.98 million
Total 2.58 billion 347.57 million

Figures collated from quarterly reports available on Lululemon’s investor relations page.

The profitability of Lululemon is not in doubt, especially with an operating margin (trailing twelve months) of 21.45%. And while shareholders are not in receipt of a dividend, the 37.05% return on equity (trailing twelve months) shows that they have benefited from having Lululemon stock. Going forward, shareholders are likely to continue benefiting as Lululemon pursues its “power of three” strategy, which aims by 2023 to double sales in the men’s and digital business, and quadruple sales in the international business. That earnings-per-share growth over the next five years, projected to be 21.18%, augurs well for this strategy.

Financially, Lululemon is well-placed to confront the future. Long-term debt of $563.93 million is offset by a net worth of $1.65 billion, and total current liabilities of $574.77 million is offset by total current assets of $1.45 billion, cash-on-hand worth $586.15 million, and total accounts receivable of $35.74 million. The firm is in a strong position to possibly pay dividends at some point, or engage in share repurchasing – which is more likely.

However, with all of that said, I remain unconvinced that Lululemon is a buy at this time. By every single metric, it is trading at a valuation in excess to that of the apparel manufacturing sub-sector and to the S&P 500 (SPY).

Metric Lululemon Sub-Sector Index
P/E 56.56 34.86 22.02
P/CF 60.79 32.11 14.07
P/B 19.27 11.95 3.21
P/S 8.47 3.32 2.26

Figures collated from Morningstar and TheStreet.

While Lululemon does have decent growth prospects, it is hindered by the high prices for its premium products which means only high-income clientele can avail of their products. This shuts out low-income clientele that competitors such as Nike and adidas can retain, and stymies growth in market share one way.

Competitors such as Nike and adidas also retain two key advantages over Lululemon: they are longer-established and have greater brand recognition than Lululemon in the apparel market, and to overcome these two advantages will test Lululemon to the limit, especially since both firms have larger operating budgets than Lululemon. As stated above, Lululemon certainly deserves credit for gaining market share in the apparel market up to this point, but whether it can put itself on the map in the same manner as its better-known rivals have done remains to be seen, and throws its projected growth into question.

For these reasons, and despite the fact that a profitable, high-growth stock can often warrant a premium price, I would be reluctant to buy Lululemon at present, especially given how high the share price has run up in recent months.

Currently, Lululemon is trading in the mid-$250 range. Chart generated by FinViz.

At present, Lululemon is trading at a share price of $254.41 with a price-to-earnings ratio of 56.56, which is a considerable premium to its five-year average of 39.92. The stock is trading a mere 0.93% below its 52-week high of $141.01 and 80.42% above its 52-week low of $256.80. These facts, in tandem with the metric table above, strongly suggest that Lululemon is overvalued – but by how much?

To determine fair value, I will first divide the current P/E by the historical market average of 15 to get a valuation ratio of 3.77 (56.56 / 15 = 3.77) and divide the current share price by this valuation ratio to get a first estimate for fair value of $67.48 (245.41 / 3.77 = 67.48). Then I will divide the current P/E by the five-year average P/E of 39.92 to get a valuation ratio of 1.42 (56.56 / 39.92 = 1.42) and divide the current share price by this valuation ratio to get a second estimate for fair value of $179.16 (245.41 / 1.42 = 179.16).

Finally, I will average out these estimates to get a final estimate of $123.32 (67.48 + 179.16 / 2 = 123.32). On the basis of this estimate, Lululemon is overvalued by 106%, which confirms my view that it is too overvalued at this time to be considered a buy even with its excellent growth prospects.

Lululemon certainly has qualities that seem to justify a high valuation – its quality products, its profitability, and its excellent balance sheet. However, despite double-digit projected growth, Lululemon needs to branch out beyond its high-income clientele to establish itself on the same footing as its competitors, and this seems unlikely at present. The current valuation, therefore, is unjustified, and so while Lululemon is a hold, it is not a buy at this time.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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2020-02-19