lululemon athletica: Funny Name, Serious Business

I rarely buy clothes, and I certainly don't understand fashion trends. The good news is that I don't need to do either to recognize that lululemon athletica (Nasdaq: LULU  ) is executing without missing a beat.

Not only has the company been growing revenue at a compound annual rate of 36% over the past three years, but it has also been expanding gross and net margins along the way. Gross margins have increased from 51.2% five years ago to 56.6% in the past four quarters. Similarly, net margins have also risen from 5.2% to an impressive 17.8% over the same time frame. Numbers like these explain why the company trades at a premium valuation.

Let's compare lululemon with a few other apparel retailers over the past four quarters.

Company

Market Cap

Gross Margin

Net Margin

lululemon

$8.0 B

56.6%

17.8%

Nike (NYSE: NKE  )

$43.0 B

45.6%

10.2%

Under Armour (NYSE: UA  )

$4.3 B

49.5%

6.4%

Gap (NYSE: GPS  )

$10.6 B

39.6%

7.8%

Source: Capital IQ, a division of Standard & Poor's.

The $8,000,000,000 Question

Is lululemon worth it? Or is the market getting a little too overextended about the company's moisture-wicking luon? I think it's worth every penny.

Demand is mounting for lululemon's pricey yoga-inspired gear. There's so much demand that the company can't make the stuff fast enough. CEO Christine Day even offered to sell her own personal closet to cover inventory shortages. With only 138 stores open at the end of the first quarter, there's plenty of room for growth going forward, and the company is targeting 30 store openings this year.

For yoga gurus who aren't fortunate enough to have a lululemon store near them, the company's online sales channel is developing quickly. During the first quarter, the e-commerce channel, which was previously outsourced, was brought in-house, and CFO John Currie expects to gain cost efficiencies resulting from this transition. The direct-to-consumer channel, which includes online and phone sales, accounted for 4% of revenue in 2009 and 8.1% of revenue in 2010, and Currie expects rapid growth from this channel.

As you can see, this stock has growth all over it. I'm confident that management will be able to manage these opportunities over the next several years and steer lululemon to long-term success. CEO Christine Day spent 20 years of her career as an executive at another growth company that's now a household name: Starbucks.

Don't cramp up
As the company begins expanding internationally, it may also eventually need to address its currency exchange risk, since it currently doesn't hedge against exchange-rate fluctuations. The main exposure right now is based on the company's Canadian sales, which have benefited lululemon's results, which are reported in U.S. dollars, since the Canadian dollar has been strengthening throughout fiscal 2010.

The company's revenue is increasingly being generated in the United States, but Canadian sales still comprised 52% of total revenue last year (compared with 88% five years ago). A 10% depreciation in the Canadian dollar relative to the U.S. dollar would have resulted in lost operating income of $11.3 million in fiscal 2010, which is roughly 6% of the year's total.

The company benefited last year by not hedging, but the tides in the currency market can change quickly and flow the other way. As long as a significant portion of revenue is generated outside the United States and continues to grow as quickly as it is, foreign currency exchange risk may need to be addressed sooner rather than later.

Growth companies that trade at such high multiples are prone to attract the skeptics and the short sellers (shorts are now 10.6% of shares outstanding). When the market is pricing in major growth ahead, any missteps will be severely punished. This aspect probably won't give management very much room for error, so I'd monitor the business closely to ensure that the company doesn't make any major mistakes.

Be flexible
Fashion trends are constantly changing, and when they do, they change quickly. The company's vertical retail strategy allows it to bring select products to market in as little as two months, meaning that lululemon can respond quickly to changing trends. The company still needs to preserve the high-quality premium brand image, but Day is already "maniacal about protecting that standard."

The company's balance sheet is also free of any long-term debt, which provides financial flexibility when times are tough. I like companies that aren't subjected to having bondholders breathe down their necks telling them what they can or can't do.

Although lululemon is selling at a premium relative to rivals such as Nike and Under Armour, the margin expansion, growth opportunities, and soaring demand justify the hefty price tag -- and I'm not referring to the $128 Scuba Hoodie Pillow.

Fool contributor Evan Niu needs to stretch out his hamstrings more often since he doesn't practice yoga, although he does own shares of lululemon athletica. The Motley Fool owns shares of Gap, Under Armour, Starbucks, and lululemon athletica. Motley Fool newsletter services have recommended buying shares of Nike, Starbucks, lululemon athletica, and Under Armour and creating a diagonal call position in Nike. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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