Is lululemon athletica Destined for Greatness?

Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does lululemon athletica  (NASDAQ: LULU  ) fit the bill? Let's take a look at what the athletic apparel retailer's recent results tell us about its potential for future gains.

What we're looking for
The graphs you're about to see tell Lululemon's story, and we'll be grading the quality of that story in several ways:

  • Growth: are profits, margins, and free cash flow all increasing?
  • Valuation: is share price growing in line with earnings per share?
  • Opportunities: is return on equity increasing while debt to equity declines?
  • Dividends: are dividends consistently growing in a sustainable way?

What the numbers tell you
Now, let's take a look at Lululemon's key statistics:

LULU Total Return Price Chart

LULU Total Return Price data by YCharts.

Passing Criteria

3-Year* Change

Grade

Revenue growth > 30%

148.2%

Pass

Improving profit margin

17.8%

Pass

Free cash flow growth > Net income growth

50% vs. 192.3%

Fail

Improving EPS

187.6%

Pass

Stock growth (+ 15%) < EPS growth

108.6% vs. 187.6%

Pass

Source: YCharts. *Period begins at end of Q3 2010.

LULU Return on Equity (TTM) Chart

LULU Return on Equity (TTM) data by YCharts.

Passing Criteria

3-Year* Change

Grade

Improving return on equity

(17.2%)

Fail

Declining debt to equity

No Debt

Pass

Source: YCharts. *Period begins at end of Q3 2010.

How we got here and where we're going
Lululemon puts together a strong performance, earning five out of seven passing grades. However, Lululemon's free cash flow has lagged behind net income growth for much of our tracked period, as the company has been investing heavily in expansion plans. That's not enough to call this stock stale, as Lululemon could still earn a perfect score next year with proper progress. How might Lululemon's new CEO put the fashion-forward athletic-wear company back on its upward track? Let's dig a little deeper to find out.

Lululemon's stock recently collapsed by double-digits after management issued a weak fourth-quarter forecast. Fool contributor Joseph Gacinga notes that Lululemon has endured several manufacturing and supply chain issues over the past few quarters, which forced the company to reduce its full-year guidance and which wrecked a great deal of share-price appreciation in recent months. The company had to recall about 17% of all yoga pants due to excessive "sheerness" under certain conditions, and Lululemon still receives a large number of complaints related to product quality and poor customer service. Lululemon's misfortunes have blown open a hole for upstart yoga-apparel makers such as Under Armour (NYSE: UA  ) , which addresses Lululemon's sheerness problem head-on in its latest studio yoga wear ad campaign. However, D.A. Davidson analysts recently upgraded Lululemon to buy, citing strong growth potential if it can move past its see-through pants problems.

Gap  (NYSE: GPS  ) has also been competing head-to-head with Lululemon in yoga apparel, opening several Athleta yogawear outlets near Lululemon locations to siphon off the latter's traffic with lower-priced goods. Fool contributor Andres Cardenal points out that the company has imitated Lululemon's strategy by partnering with yoga instructors to offer fitness classes, which undermine Lululemon's uniqueness and thus minimize its competitive advantage. Under Armour has also made a series of big moves, signing endorsement deals with ballet dancer Misty Copeland, tennis star Sloane Stephens, and skier Lindsey Vonn. Moreover, Under Armour's bra line has fared extremely well across its studio platform, which competes directly with Lululemon. Fool contributor Marshall Hargrave notes that Nike (NYSE: NKE  ) seems to be aiming high in the women's yoga-apparel business, and the company expects to grow its global sports-apparel market share to 6.5% by 2019.

Lululemon's top management roster has suffered a bit of turnover over the past few quarters, which has weakened its ability to rehabilitate a deteriorating brand image. Fool contributor Chad Henage notes that Lululemon has been tapping athletic menswear for new avenues of growth, while Under Armour -- already firmly established as a manly sportswear brand -- is trying to expanding into womenswear and yogawear. Lululemon has been trying to broaden its market by opening new "ivivva athletica" stores aimed at young athletic girls, and could eventually leverage a growing demand for wearable technology as well. Over the next five years, Lululemon's earnings per share is expected to grow by a staggering 18.4% per year, while Gap and Nike will grow only by 13.5% and 12.3% annually, respectively. Since post-crash Lululemon shares now trade at a P/E of 24.3, as compared to 24.4 and 13.2 for Nike and Gap, Lululemon now seems once again to be a strong bargain for growth-focused investors.

Putting the pieces together
Today, Lululemon has many of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.

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