Lululemon Stock Down 25%: Buying Opportunity or Time to Run?

Shares of Lululemon Athletica (LULU -1.35%) are down by nearly 25% from their highs of the last year, as investors reacted with disappointment to the company's latest earnings report. However, the business seems to be moving in the right direction, and Lululemon stock looks attractively valued in comparison to competitors such as Nike (NKE -0.89%) and Under Armour (UAA -2.26%). 

Is the dip in Lululemon a buying opportunity, or should investors stay away from the company before things turn for the worse?

The reasons behind the decline
Lululemon is a business in transition. The company is still trying to fully recover from the see-through pants scandal and the boardroom battles that seriously disrupted its operations in 2013. Lululemon is clearly making progress on the sales front, but there are still some reasons for concern.

Total sales during the quarter ended on August 2 jumped by a healthy 16%, to $453 million. Total comparable sales grew 11% on a constant-currency basis, and the direct-to-consumer segment was particularly strong during the quarter, with sales growing 30%, and accounting for a big 18% of Lululemon's total revenue.

On the other hand, profit margins are under heavy pressure: gross profit margin declined from 50.5% of sales to 46.8%. In addition, inventory levels increased by a worrisome 35%, from $208 million to almost $281 million at the end of last quarter. Understandably, this raised some eyebrows among investors trying to discern if Lululemon is, in fact, on a sustainable path to recovery.

According to management, none of this is reflecting excessive pricing discounts or merchandising problems. CEO Laurent Potdevin specifically said during the earnings press conference that Lululemon is positioning itself for global growth, and that investors should expect both profit margins and inventory levels to stabilize in the middle term. In Potdevin's own words:

It's really really important for everybody to understand that the short-term gross margin pressure that we're experiencing is not the result of higher markdown of quality issues. We're building a very scalable complex platform at a time when we're growing internationally, and we've added resources to team, and we've validated that not only we will see the margin expansion that we've committed to, but still see it in 2016 and beyond as we have stated before.

Attractive upside potential
Sports apparel is a particularly strong segment in the clothing industry. Many consumers are using these products for both sports activities and in their everyday lives, a trend which industry analysts refer to as athleisure -- athletic apparel that people can wear in non-athletic settings, too. 

Lululemon is well positioned in this category due to the popularity of its yoga pants and its trendy designs, and competitors such as Nike and Under Armour are delivering rock-solid financial performance for investors by capitalizing on this promising trend.

Nike is the undisputed leader in athletic shoes and apparel. The company is expected to deliver $32.8 billion in global revenue this fiscal year, and the business is doing remarkably well on a global scale. Nike announced a 14% increase in constant-currency sales last quarter, while worldwide future orders increased 17% when excluding currency fluctuations. This kind of performance is downright extraordinary for a company as big as Nike.

Under Armour is materially smaller than Nike, but the business is clearly firing on all cylinders. Under Armour delivered a whopping 28% increase in revenue last quarter, reaching $1.2 billion, and breaking the $1 billion mark for the first time in the company's history. On a currency-neutral basis, net revenue jumped by an even stronger 31% year over year.

The fact that Nike and Under Armour are doing so well shows that Lululemon is facing tough competition; but it also proves that the company operates in a particularly promising industry niche with plenty of growth potential. Besides, Lululemon stock is priced at a discount to both Nike and Under Armour when looking at ratios such as price-to-earnings and price-to-sales, especially since Lululemon enjoys enormous room for expansion due to its relatively small size.

For investors who believe that Lululemon is on track to deliver sustained sales growth and improving profitability in the coming quarters, the stock offers substantial upside potential from current levels. The recent decline in Lululemon could be providing a compelling buying opportunity.