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Better Buy: Lululemon vs. Peloton

By Jon Quast – Aug 13, 2020 at 9:00AM

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Lululemon was already a winner. Then it started becoming a more-rounded business.

If winning stocks are something you're into, then athletic-apparel company lululemon athletica (LULU 1.09%) and connected-fitness company Peloton Interactive (PTON 13.00%) are for you. Both stocks have outperformed the market averages since going public.

These two companies are delivering outsize financial gains, warranting their impressive stock charts. For Lululemon, it generated revenue of only $453 million in 2009. A decade later, it racked up $4 billion in yearly sales. Peloton doesn't have as much history, but its revenue grew 66% year over year in its fiscal third quarter of 2020, its most recent quarter.

All investors should aspire to hold stocks in companies delivering these kinds of results. But many fear buying Lululemon and Peloton shares because they look expensive by traditional valuation metrics. For example, Peloton trades at 10 times trailing sales, while Lululemon trades at 11 times trailing sales. For perspective, that's more than double the valuation of competitor Nike.

Having acknowledged this valuation risk, there's still good reason to consider buying each stock today. But I think Lululemon is the better buy right now. Here's why.

A woman exercises with a Peloton Bike in a bedroom setting.

Image source: Peloton.

Why buy Peloton?

Peloton wasn't the first player in exercise bikes, but it quickly outperformed its rivals thanks to its swelling customer base. And that was before the COVID-19 pandemic. Once the pandemic started, Peloton began signing up a plethora of new stuck-at-home customers looking to take control of their fitness. Revenue from connected-fitness products (its treadmill and stationary bike) surged 61% year over year in Q3, with connected-fitness subscribers increasing 94%.

This growth is even more impressive considering Peloton paused treadmill sales during the quarter to help prevent the spread of the coronavirus. So sales could have been even higher. The company is clearly proving it's recession-resistant

Long term, the surge in connected-fitness subscribers bodes well. Peloton's 12-month retention rate is 93%, so most subscribers continue paying every month. This high-margin subscription revenue, therefore, is picking up steam and will pay off for years.

Peloton might look expensive with a price-to-sales ratio over 10. But at its current growth rate, the stock could actually look attractively inexpensive in a year or two, giving investors with foresight an opportunity today.

Four people sit on yoga mats in a studio doing stretches.

Image source: Getty Images.

Why buy Lululemon?

To start 2019, Lululemon's management laid out a five-year plan. Here are some highlights:

  • Annual revenue growth at a low teens percentage.
  • Earnings per share growing faster than revenue.
  • Quadrupling its international business.
  • Doubling its digital business.

If you extrapolate these targets from 2018 results, Lululemon could generate revenue over $6 billion and earn around $7 per share in 2023. This means the stock trades at over seven times 2023 envisioned sales, and around 50 times 2023 hoped-for earnings. That's pricey even for a growth stock like this.

But management said this guidance was a baseline. Indeed, full-year 2019 results exceeded guidance. And remember: The company grew its revenue ninefold in 10 years. Its track record gives its bold plan credibility.

Lululemon's revenue growth and earnings have made it a long-term winner. And it's focusing on largely untapped opportunities like international expansion and digital. It's often a good idea to buy stocks like this, even when valuations seem stretched. These kind of companies have a knack for pulling unforeseen growth levers, justifying the price tag in the end.

A clock displays the phrase "the time is now" instead of numbers.

Image source: Getty Images.

Why Lululemon is a better buy now

And Lululemon did indeed pull an unforeseen growth lever. In June, the company acquired connected-fitness device company MIRROR for $500 million. I believe it was a steal at just five times MIRROR's expected revenue in 2020. And I'm betting both businesses just got better.

Lululemon has a loyal customer base. Among those in the top 20% of spending at Lululemon, management says it has a 92% retention rate. Given the loyalty and affluence of this group, it seems probable that a large number won't balk at MIRROR's $1,500 price tag and ongoing subscription service. In other words, MIRROR's already high revenue growth could accelerate as Lululemon's clientele is introduced to the product.

Apparently, Lululemon is now building a business beyond apparel, opening the door for further acquisitions. For example, I believe SoulCycle (a Peloton competitor) could be a good add-on business. In its Q3 letter to shareholders, Peloton's management said 30% of all connected-fitness subscriber workouts are in floor-based disciplines -- the kind Lululemon and MIRROR are known for. People who exercise are often interested in multiple disciplines, and acquiring a stationary-bike company like SoulCycle could really round out what Lululemon offers.

The point is, Lululemon was a good company made better by MIRROR. And its ambitious five-year plan has expanded. By becoming a more rounded business, it appears there's plenty of underappreciated upside here.

Jon Quast has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Lululemon Athletica, Nike, and Peloton Interactive. The Motley Fool has a disclosure policy.

Stocks Mentioned

Lululemon Athletica Stock Quote
Lululemon Athletica
LULU
$385.99 (1.09%) $4.17
Peloton Interactive Stock Quote
Peloton Interactive
PTON
$13.30 (13.00%) $1.53
Nike Stock Quote
Nike
NKE
$112.20 (1.29%) $1.43

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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