10 Best Specialty Retail Stocks To Watch Right Now
Luluemon Athletica Inc. (LULU)
Price as of writing: $44.67 (May 16, 2014)
Scaling
Mid cap – $6.2 BIL $1.6 BIL in revenues $280 MIL in net income (17.6%) 254 stores 7622 employees Locations in USA, Canada, Australia, and New ZealandBusiness Description
lululemon athletica inc. designs, manufactures, and distributes athletic apparel and accessories for women, men and female youth. It operates in three segments: Corporate-Owned Stores, Direct To Consumer and Other. The company's line of apparel include fitness pants, shorts, tops, and jackets for healthy lifestyle activities, such as yoga, running, and general fitness. Its fitness-related accessories comprise bags, socks, underwear, yoga mats, and water bottles. The company sells its products through a chain of corporate-owned and operated retail stores; direct to consumer through e-commerce Websites; and a network of wholesale channel, such as premium yoga studios, health clubs, and fitness centers. lululemon athletica inc. was founded in 1998 and is based in Vancouver, Canada. (Source: CapitalIQ)
Where do the revenues come from?
12 months Feb. 2, 2014 (USD mm)
| Segment | USD in mm | |
| United States | 1,052.1 | 66.1% |
| Canada | 454.2 | 28.5% |
| Outside of North America | 84.8 | 5.3% |
| Total | 1,591.2 | 100.0% |
Segment analysis is usually a useful tool to gauge how much exposure the company has to each market. In Lulu's case, perhaps even more important information is the untapped potential outside of North America (5.3% of total revenues). Lulu managed to build a strong brand in North America and it successfully replicated the model on a continent level. Lulu is not yet done growing in North America and international markets are virtually untapped.
Key Industry Risks
Seasonal collection miss or failure to anticipate and respond to rapidly changing consumer preferences. Consumer discretionary products are heavily affected by business cycles. Fluctuating costs of raw materials. Bad publicity from possible unethical practices in the supply chain.Key Company Risks
Brand erosion. Lululemon success was built on its ability to differentiate in the marketplace and provide high quality products to poorly attended target market. If Lululoemon's brand strength was to suffer permanent impairment, the company would lose its competitive edge. 45% of raw materials are sourced from one supplier. This exposes the company to the risk of supply chain disruption and potential quality issues on a major scale. Having tapped a new lucrative niche, increased competition is ahead of Lulu. Primary competitors include Gap's Athletica brand, Nike, Adidas and Under Armour.Why Is the Market Pessimistic on Lulu?
Quality problems amplified with sheer pants and bad PR from the former Chairman and a majority owner - Dennis Willson. In early 2013, Lululemon had a problem with a bad batch of yoga pants that were too see-through and was forced to recall the products after numerous customer complaints. This was followed with extremely bad press from Lululemon Chairman who said that yoga pants are not for women of all body types. Unsurprisingly, his comments brought significant amount of bad press and the stock went tumbling. Flat 2013 holiday sales and lowered forward guidance.Management
Lulu had considerable management turnover issues in the past. Towards the end of 2013, founder Dennis Wilson stepped down from the Chairman position and Laurent Potdevin was brought in as a CEO replacement for Christine Day. In my opinion, both changes should be good for the company given that both exhibited poor management in relation to sheer pants recall.
Using Under Armour as a close comparable, management compensation seems to be in line with the industry. Senior management receives between $1 and $1.5 million in total compensation per year (cash, bonus, and stock options).
Financial Health
Liquidity – current ratio of 8.3x indicates a very healthy short-term liquidity position. As of last annual report, Lulu had 55.9% ($699 MIL) of assets in cash and cash equivalents, giving it plenty of resources to fund future growth without seeking external financing. Solvency – Lulu doesn't have any long-term debt outstanding, however, it does have long-term real estate lease commitments. Minimum rent paid in 2013 amounted to $61.5 MIL which would imply EBIT / Contractual commitments coverage ratio of 6.6x. This is considered very safe.Normalized Net Income CAGR Past 5 Years – 46.33%
Lululemon turned profitable second year as a public company. Since then it has managed to generate net profit margins in high teens (LTM – 17.6%). This is significantly higher than any of its competitors. As a result of steady revenue growth and high profitability, normalized net income CAGR over the past five years has been 46.33%.
Economic Moat
Company has a narrow economic moat built around its brand. With further growth this moat could be expanded further.
Lululemon was a first company that managed to tap the women athletic apparel market on a grand scale. While competitors such as Nike, Adidas, and Reebok already catered to the market of women athletic apparel, they also catered to other athletic apparel markets, making their women products generic. Until Lulu, there was not one major apparel company that focused exclusively on women athletic apparel. By designing high quality products supported by strong grassroots marketing approach, Lulu managed to carve out a very lucrative niche for itself.
Gross margin vs. Competitors
Companies with economic moat derived from brand strength are able to exhibit superior pricing power comparing to its competitors. Lululemon's gross margin at 53.9% for the past twelve months is considerably higher than its closest competitors: Nike (44.3%), Gap (46.9%), Adidas (49%), and Under Armour (48.8%). Looking historically, Lulu managed to keep its gross margins between 49% and 57%, which was always more than the competition.
Return on Capital vs. Competitors
Companies with economic moat are able to exhibit superior returns on capital comparing to its peers. Lululemon's return on capital for the past twelve months is 25.8%. That compares to Nike (19.6%), Gap (31%), Adidas (9.2%), and Under Armour (16.1%). Lulu's five year return on capital is 32.8% which is higher than all of the mentioned competitors.
Sales per Square Feet
Lululemon has one of the highest sales per square feet of all retailers. In the past twelve months its sales per square feet were $1894. To put into perspective, according to Retail Sails consultancy article in Nov 2012, Lululemon was second only to Apple ($6050) and Tiffany's ($3017) with $1936. The article is outdated but it still shows where Lulu stands in the ranking.
Valuation
It is difficult to make well supported discounted cash flow projections for a rapidily growing company so instead of estimating future growth rates, I will take a different approach and try to calculate the gap between the zero-growth value of the company and and the current market valuation. Based on the size of the gap, I will make a subjective conlusion if the company can achieve this growth value or not.
All numbers are in USD '000 and are based on the last quarterly report.
| Earnings Power: | |
| Sustainable Operating Income | $408.90 |
| Depr and Amort adj. | $-22.83 |
| Options | $10.09 |
| Adjutsment for Lease | $12.04 |
| Pretax earnings | $408.20 |
| Effective tax rate | 29.6% |
| Taxes | $-120.83 |
| Earnings | $287.37 |
| Discount rate | 9.82% |
| Earnings Power | $2,926.4 |
Calculation of NAV:
| Book Value | Adjustment | Adjusted Value | |
| Cash And Equivalents | $698.65 | 100% | $698.65 |
| Accounts Receivable | $11.90 | 102% | $12.14 |
| Inventory | $186.09 | 100% | $186.09 |
| Prepaid Exp. | $46.20 | 100% | $46.20 |
| Net Property, Plant & Equipment | $255.60 | 75% | $191.70 |
| Goodwill | $25.28 | $896 | $921.28 |
| Other Intangibles | $2.92 | $2.92 | |
| Deferred Tax Assets, LT | $18.30 | 91% | $16.66 |
| Other Long-Term Assets | $4.75 | 100% | $4.75 |
| Total assets | $1,249.69 | $2,080.39 | |
| Accounts Payable | $12.65 | 100% | $12.65 |
| Accrued Exp. | $61.76 | 100% | $61.76 |
| Curr. Income Taxes Payable | $0.77 | 100% | $0.77 |
| Unearned Revenue, Current | $38.34 | 100% | $38.34 |
| Def. Tax Liability, Non-Curr. | $3.98 | 100% | $3.98 |
| Other Non-Current Liabilities | $35.52 | 100% | $35.52 |
| Capitalized lease obligations | 0 | 301.12 | |
| Value of options outstanding | 0 | 13.845 | |
| Total liabilities | $153.01 | $454.13 | |
| Net Asset Value (NAV) | $1,096.68 | $1,626.26 |
*Goodwill was calculated as 2x SGA for 2013 + existing Goodwill. If anyone was to replicate Lulu's assets, they would have to invest at least two years of SG&A into marketing. This was a conservative estimate not attempting to value the brand equity.
Values Combined:
| Total | Shares Outst. | per Share | |
| NAV | $1,626.26 | 144.8 | $11.23 |
| Earnings Power | $2,926.41 | 144.8 | $20.21 |
| Total NAV + Earnings Power per Share | $31.42 | ||
| Current Share Price | $44.69 | ||
What does this tell us? It tells us that market believes Lululemon can only grow by 42% (($44.69 - $31.42)/100) in total from from where it is today. Remember, Lulu has been growing earnings at 46.33% CAGR over the last five years. Even if the earnings growth rate decreses to 15% it would take Lululemon only 2.5 years to grow to the stage where all future growth is justified. All growth afterwards would be "free" if the stock is bought now. Therefore, based on the gap analysis bewteen zero-growth value and current market price, it appears that market is severly undepricing the future growth value of Lulu.
In order to verify the above valution with a more widely used valuation tool - below is the comp set of Lulu's closest comparables. Based on historical growth Lulu's multiples should resemble more closely those of Under Armour, however, even when Under Armour's multiples are diluted by Nike, Adidas, and Gap - it appears that Lulu is severly undervalued based on TEV/EBIT (reverse earnings yield) and P/E ratio.
| TEV/EBIT LTM - Latest | P/BV LTM - Latest | P/Normalized EPS LTM - Latest | Market Capitalization Latest | |
| Adidas AG (DB:ADS) | 16.1 | 2.9 | 27.7 | $22,686.60 |
| The Gap, Inc. (NYSE:GPS) | 8.5 | 5.9 | 14.5 | $18,194.40 |
| Nike, Inc. (NYSE:NKE) | 16.4 | 5.8 | 30 | $64,051.40 |
| Under Armour, Inc. (NYSE:UA) | 35.3 | 8.9 | 58.7 | $9,871.40 |
| Average | 19.08 | 5.88 | 32.73 | |
| Lululemon | 14.2 | 5.9 | 25.2 | $6,496.90 |
| Discount to Peers | 34% | 0% | 30% |
Short-term Catalysts
Markets accept CEO Potdevin as a credible leader with a vision. At the moment, markets are fearful about leadership at Lululemon and any move that would assure the markets of future company direction would be well received. Stronger than expected growth for 2014. With the product recall fiasco last year and flat Q4 seasonal sales (which affected all retailers), Lulu may have lowballed the guidance for 2014. If growth proves to be higher than expected, stock would gain significant momentum.Conclusion
Lululemon is a high growth company with an economic moat. The markets punished the company's stock last year because of a product recall and bad PR from its founder; however, these mismanagement issues are not enough to permanently destroy enormous future potential ahead of Lulu. At present, the stock seems to be undervalued based on its future growth potential and undervalued in comparison to peers. I believe this company is a long-term portfolio keeper with limited downside risk at this price level. Any news or results that would assure the markets of strong future for Lulu would be a big catalyst that would cause expansions of multiples to resemble more closely those of Under Armour. I would consider a price target of $60 per share a more realistic intrinsic value of the company.
Disclosure: I am long LULU.
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