Lululemon – Does Success Have To Make Sense?

By Stephen D. Simpson, CFA | September 08, 2011 AAA

For all those wishing to suggest that the so-called "Great Recession" has permanently changed consumer spending behavior and value assessment, I would present Lululemon Athletica (Nasdaq: LULU). Here is a company that has continued to grow at an impressive clip throughout this downturn and has achieved over $200 million in quarterly revenue on the basis of convincing people to pay $100 for sweatpants (very nice and comfortable sweatpants, I'm told, but still basically just upgraded, bum-sculpting sweatpants). Now the question is how long the company can maintain the momentum in its sales and the anti-gravity in its valuation.

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Second Quarter Results Very Limber
Lululemon had another startlingly good quarter from a growth perspective. Revenue rose more than 39%, with same-store comp sales up 20%. What makes that notably impressive to me is that revenue rose 35% year on year in the first quarter (with comp growth of 16%) - so even though consumer confidence and retail spending seems to be getting worse, Lululemon continues to grow apace.

Profitability also continues to improve. Gross margin improved by nearly five points, and operating income grew 74%. That operating income growth translates into margin expansion of more than five points. Consider, too, that Lululemon's store productivity continues to blow away conventional retail and track toward the more rarefied air of Coach (NYSE:COH) and Tiffany (NYSE:TIF) - and U.S. store productivity is still lagging the Canadian numbers by a meaningful degree.

Guidance Leads to a Pause
Although Lululemon beat the midpoint of estimates for this quarter, guidance for the second half of the year seems to have analysts and investors pausing and recentering themselves. While extrapolating the two- and three-year growth trends suggests that third quarter comps should be in the high teens, the company's guidance is more less on track with where the Street already is. In a market that wants "beat and raise," that's not good enough.

Crazy to Expect More ... or Crazy Not to?
One of the interesting things about Lululemon is that while the products are at least theoretically athletic apparel, it doesn't seem that buyers view them as alternative to Nike (NYSE:NKE), UnderArmour (NYSE:UA), or Berkshire Hathaway's (NYSE:BRK.A) Russell Athletic. Instead, this is at least partially a fashion brand and that puts it up more against the likes of Macy's (NYSE:M), Saks (NYSE:SKS) and Nordstrom (NYSE:JWN). Maybe that gives the company a little downside protection when looking at the sizable gap in product prices between Lululemon's products and those of rival sportswear companies.

On the other hand, there are so many examples of "this too shall pass" in retailing that it would take many columns to list them all. True Religion (Nasdaq:TRLG), for instance, seems to have gone through fits and starts where customers alternate between "I must have this" and "Wait ... I'm paying this much for jeans!?" And the same will almost certainly happen to Lululemon. Of course, True Religion isn't far off its all-time highs, so that's not to say that Lululemon shares have had their full run. That's especially relevant when considering the superb productivity of these stores and the potential to do even better.

The Bottom Line
Honestly, I don't get the idea of "destination sweatpants," but I'm long past the point as an investor where I presume that product popularity has to make sense to me in order to work. If Lululemon's products offer a better user experience (much like Under Armour does relative to conventional shirts or shorts) and a fashion kicker that people will pay for, then so be it.

The issue, though, is whether investors can handle this sort of stock. Valuation is already out of the ballpark, so it really is all about growth. If seeing a stock fall 5% on a good quarter and pretty healthy guidance drives you to distraction, this isn't the name for you. But if an investor wants to grab on to a very impressive retail growth story, it's hard to find names that come ahead of Lululemon today. (For additional reading, take a look at The Ups And Downs Of Investing In Cyclical Stocks.)

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