Lululemon: we think shares still have some upside remaining
Lululemon (LULU) has been one of the top performing momentum stocks of 2011, with shares already up nearly 80%. Many analysts seem to think LULU is a lemon in itself, and rightfully so. Not many can relate to paying $98 for a pair of yoga pants that look, to the untrained eye, identical to something one could pick up at Target (TGT) for $15.
However, while many on the street wait for Lululemon to come crashing down, we think with continued operational excellence and carefully planned growth, shares are worth $68 on a discounted cash flow basis. Like Charlie Munger, Warren Buffett’s legendary partner in crime believes, sometimes you have to pay a premium to own a premium company.
Growth still left in the United States and Canada
Many Lululemon detractors believe the company has fully saturated its market in the United States and Canada. We completely disagree. Although the days of 50%+ growth in these markets are probably limited, there are still plenty of opportunities for further expansion. We think as the brand’s recognition grows, the company will able to make surgical openings in markets that analysts previously thought were saturated, and roll out more Lululemon stores in markets where trends arrive later than the norm. Though the typical customer is generally less price sensitive, there are plenty of opportunities for the firm to insert stores in high traffic, high income areas that will only increase with lower travel costs or macro-economic improvements.
We also think Lululemon is under-producing in product offerings. Other than a few shades of gray, black, and teal, the company still has nearly limitless colors it can experiment with in the near future. Additionally, Lululemon truly is only a yoga brand at this point. Given the company’s design acumen, we expect them to produce more fashion-friendly clothing items not necessarily intended for yoga.
In addition to its fashion friendly design, we think penetration among men is extremely low. The company’s offerings for men, far more “fashion conscious” than Under Armour (UA) or Nike (NKE), don’t seem to have the same momentum that their female offerings do, but we could see this start to accelerate in 2012.
People love it
Legendary investor Peter Lynch is best-known for advocating a “buy what you know” strategy. He received some of his best investments by listening to what his wife new was hot. Right now, what many analysts can’t fathom, is just how on-fire this brand is. Every store we visited for this analysis, though confined to a few geographic areas, was low on inventory and even lower on sale items.
Not to oversimplify our analysis, the numbers support our assertions. Same store sales were up 16% in the first quarter of 2011, and the company expects mid-to-upper teen growth for the rest of the year. Additionally, since the company moved production to Asia, gross margin expansion has taken off, posting margins of 58.5% in the first quarter.
International growth a potential windfall
Lost in all of the analysis over Lululemon is the nearly unlimited international growth potential. The company tried to enter Japan about six years ago, but it was mostly a failure as management was inexperienced and somewhat out of their element when entering this market.
However, given the prudence management has exercised in choosing new locations in the US, Canada, and Australia, we think they are ready to tackle the challenge of growing internationally again. With no presence in Europe, and only a counterfeit presence in China, Lululemon has yet to enter two of the world’s most profitable and luxury friendly markets. Retailers like Coach (COH), Tiffany (TIF), and Hermes (RMS), have been experiencing 20-30% annual growth in China, which looks like a fertile ground for Lululemon to start really expanding.
Long-term growth remains a mystery, but would make the company significantly more valuable
If Lululemon continues to fire on all cylinders and begins making strides in international growth, we think shares could be worth as much as $91 (best-case scenario). However, if they fail to meet current expectations and its products turn out to be nothing more than a fad, we think shares are only worth $45 (bear-case scenario).
Given it currently trades at only a slight discount to our fair value estimate, we urge investors to be cautious. If the stock falls into the low $50 range, the company looks much more attractive. Though our $68 per share fair value estimate may seem a bit high, it really implies a 2012 P/E estimate of 21x, which is fairly low for a company growing revenues and profits at upwards of 30%.