Shares of Lululemon Athletica inc. (NASDAQ:LULU) took a hit recently when news broke that a recall of the upscale apparel company’s popular yoga pants due to a quality issue would effect 17% of its inventory. Shares dropped about 11% from $70 to a low of $62 a few days later, and the company has stated that its guidance for first-quarter sales has been lowered to $343 million from $355 million previously, and that same-store sales were expected to increase 5-8% instead of 11% as previously estimated.
A meteoric rise
Lululemon Athletica inc. (NASDAQ:LULU) has been growing extremely quickly, more than quadrupling annual revenue since 2008 while growing both gross margin and operating margin. The company sells high-end athletic gear and is most well known for its popular yoga pants which sell for $90 and up. Along with the revenue growth the company’s stock has exploded since the financial crisis, rising more than 20 times its low.
This pants problem is clearly a short-term issue, so the reaction seems far stronger than it should be. But maybe it has something to do with the extremely lofty valuation of the stock. The stock trades at about 39 times the trailing earnings per share (EPS) of $1.61 and about 35 times the average analyst estimate for full-year earnings of $1.84. Analysts expect sales to be $1.37 billion for the full year, up from $1 billion in 2011.
How long can this kind of growth last? How many people are willing to spend $100 on a pair of workout pants? The market for the kinds of products which Lululemon Athletica inc. (NASDAQ:LULU) sells is fairly small; a $60 tank top does not have mass market appeal. A good company to compare Lululemon to might be Coach, Inc. (NYSE:COH), the seller of high-priced handbags. Both companies sell expensive fashion products which compete with lower-priced alternatives, and conveniently Coach was about the same size in terms of revenue and profit in 2003 as Lululemon is today.
Coach’s growth path
In 2003 Coach, Inc. (NYSE:COH) had $953 million in revenue and $147 million in net income, close to Lululemon’s 2011 numbers of $1 billion in revenue and $184 million in net income. Over the next decade Coach grew its revenue at an annualized rate of 19.6% and its net income at an annualized rate of 24.3%. Because of share buybacks EPS grew even faster at 27.4% per year.
During that time, Coach managed to improve both its gross margin and its operating margin. The stock has gone up five-fold since then, hitting a high in 2011 which was nearly eight times higher than its price in 2003.
You could buy a share of Coach during 2003 for about $10 per share, which was 25 times the EPS. The PEG ratio, using the real EPS growth, was a bit under one, suggesting growth at a reasonable price. If you bought Coach for $10 per share exactly 10 years ago, you realized a 17.5% annualized gain on the stock, even after shares dropped from their highs in 2011.
Lululemon Athletica inc. (NASDAQ:LULU) trades at 35 times estimated earnings for 2012, which puts the PEG ratio, assuming Coach-like EPS growth, at 1.27. Coach, Inc. (NYSE:COH) over the last decade seems to be a reasonable proxy for Lululemon over the next decade, but Coach was trading at a significantly lower valuation 10 years ago than Lululemon is today. If you had bought Coach shares 10 years ago at 35 times earnings instead of 25, a share price of $14, you’re annualized return would have been just 13.6% instead of 17.5%. Still exceptional, but quite a bit lower.
My feeling is that Coach’s performance over the last decade represents a sort-of best case scenario for Lululemon over the next decade. Coach succeeded because its brand continues to represent quality — it wasn’t diluted with lower-cost products. If Lululemon maintains its quality, and makes sure this pants debacle is a one-time occurrence, then the company could very well follow a Coach-like growth path. If, however, it attempts to sell lower-price, lower-quality items, its margins will erode and profitability would suffer, and its premium brand would lose much of its appeal. This would put it into more direct competition with companies like Under Armour, Inc. (NYSE:UA) and The Gap, Inc. (NYSE:GPS), which offer lower-priced products.
Valuation
Given that Coach, Inc. (NYSE:COH)’s growth path seems reasonable for Lululemon Athletica inc. (NASDAQ:LULU) over the next decade 25 times earnings is a reasonable price for the company. The current P/E ratio of 35 is far too high, and the stock would need to fall to the mid 40’s for it to be attractive. Under Armour trades at an even higher 41 times earnings while Gap trades at about 15.5 times earnings. Gap is a far larger company and doesn’t have the same growth prospects as either Lululemon or Under Armour, so the multiples may not be all that comparable. Analysts estimate five-year earnings growth for Gap to be just 9.4%, far lower than the other two companies. However, both Lululemon and Under Armour look far too expensive right now to consider.
The bottom line
Even after the pants-related drop in price, Lululemon Athletica inc. (NASDAQ:LULU) is still overvalued. It’s not outrageously overpriced, but the kind of growth needed to justify 35 times earnings is unrealistic. Both Lululemon and Under Armour stock have run up enormously over the past three years, and the expectations for both have gotten out of hand. I think that both companies have the potential to grow at Coach-like rates over the next decade, but paying 35 or 41 times earnings for that growth, which is by no means guaranteed, is not a great strategy. Lululemon is a lot more reasonable than Under Armour, but I’d wait for a substantial drop in prices before buying any shares.
The article Pants Shortage! Can Investors Take Advantage? originally appeared on Fool.com and is written by Timothy Green.
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