Lululemon: A Retail Powerhouse

© Reuters. Lululemon: A Retail Powerhouse

While many retailers struggled in 2020, Lululemon Athletica (NASDAQ:LULU) demonstrated its resilience. Although net income came in lower during 2020 than in the previous year, free cash flow was actually higher. In addition, net income in the last 12 months was higher than it was in 2019. However, the market seems to have rewarded the company with a generous premium relative to its peers. Therefore, we are neutral on Lululemon stock. (See Lululemon stock charts on TipRanks)

Lululemon designs and retails athletic apparel and accessories for women and men. It operates 521 stores globally and is based in Canada. A big part of the company's success is its digital sales. In the most recent quarter, e-commerce made up 41.2% of total revenue. Although this is down from 61.4% in Q2 2020, it shows that Lululemon was able to successfully lean on its e-commerce when it needed it the most.

Measuring Competitive Advantage

We can measure Lululemon's competitive advantage by comparing its earnings power value to the value of reproducing the business. Earnings power value is measured as adjusted EBIT after tax, divided by the weighted average cost of capital, and reproduction value can be measured using total asset value. If earnings power value is higher than reproduction value, then a company is considered to have a competitive advantage.

Adjusted EBIT After-Tax

Lululemon's average EBIT margin in the past 5 years was 19.9%. Using its revenue for the last 12 months, its adjusted EBIT is as follows:

5.523 billion x 0.199 = $1.099 billion

Using a marginal tax rate of 32%, the after tax adjusted EBIT is:

1.099 billion x (1 - 0.32) = $747.3 million

Lululemon's weighted average cost of capital is 7.2%. The earnings power value is:

747.3 / 0.072 = $10.379 billion

Finally, its total asset value is $4.4 billion. As a result, Lululemon has a competitive advantage because its earnings power value is greater than the reproduction value of the business.

Growth Catalysts and Risks

The global sports apparel market is expected to grow at a CAGR of 4.11% during the forecast period of 2020 to 2025. Although this doesn't sound too exciting, it means that the industry is healthy and continues to grow.

The growth is attributable to a few factors. To begin with, more people are becoming health-conscious, leading to more people exercising. Furthermore, more women are participating in both professional and domestic sports. In addition, athletic apparel is becoming more fashionable, which is expected to further increase the appeal to women.

Another growth catalyst that we see for Lululemon is margin expansion. In 2017, its gross profit margin was 51.2%. This number has increased steadily since then, reaching 56% in 2020. EBIT margins were also expanding up until the pandemic hit. Although EBIT took a hit, it has improved in the last 12 months to 20.7%, compared to 18.5% for 2020. This would obviously be positive if the company can continue this trend.

A risk we see for Lululemon is the valuation, since it is trading at over 60x price to earnings. Although the company is growing fast and just had a great quarter, the high multiple leaves it vulnerable to large drawdowns if future expectations aren't met.

Wall Street’s Take

Turning to Wall Street, Lululemon has a Strong Buy consensus rating, based on 13 Buys, 3 Holds, and 0 Sells assigned in the last three months. The average Lululemon price target implies 9.5% upside potential.

Final Thoughts

Lululemon is a strong retailer with great brand recognition and measurable competitive advantage. Although most analysts rate the stock a buy, we remain neutral because we believe that the potential upside is not enough to compensate for the risk of a drawdown if expectations aren't met, going forward.

Disclosure: At the time of publication, StockBros Research did not have a position in any of the securities mentioned in this article.

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