This article is part of our Rising Star Portfolios series. You can read about the Dada Portfolio here.

The Dada portfolio has bought retail stocks in the past. We think there are some good opportunities in the consumer sector, but we're a bit worried about middle-tier consumer goods. Not only is the U.S. middle class in danger of being hollowed out by high unemployment and rising income inequality, but value-conscious consumers have also responded to the recession by saving on middle-tier goods and buying a small number of expensive items.

So when buying retailers, we like to focus on cheap stocks, strong operators, and/or high-end brands. Today's pick -- lululemon athletica (Nasdaq: LULU) -- meets the latter two criteria in spades, though its stock is hardly cheap.

The company
Lululemon sells expensive apparel specially designed for sweaty activities such as yoga, running, and dancing. As my colleague Rex Moore also notes, Lululemon places a great deal of emphasis on its grassroots culture. It's no joke -- stores also host various events including yoga classes. That's not only pretty cool, but also helps to cement local community ties and customer loyalty.

I could describe Lululemon's target market for you, but the company's 10-K annual report does such a good job that it's worth quoting:

Our primary target customer is a sophisticated and educated woman who understands the importance of an active, healthy lifestyle. She is increasingly tasked with the dual responsibilities of career and family and is constantly challenged to balance her work, life and health. We believe she pursues exercise to achieve physical fitness and inner peace.

Unmoved by inner peace, investors tend to pursue Lululemon for its spectacular growth. Sales have grown 58%, 33%, and 42% annually over the last one, two, and three-year periods, respectively.

Lululemon's profitability is every bit as divine as its sales growth. In his most recent letter to Berkshire Hathaway (NYSE: BRK-B) shareholders, Warren Buffett sheds some light on one way he evaluates manufacturing, service, and retail businesses such as Berkshire-owned TTI, Forest River, CTB, and H.H. Brown: by comparing earnings to unleveraged net tangible assets. It's an intriguing, rarely used ratio, one that I'm beginning to appreciate for its ability to neatly capture the economics of a business. Buffett says a business that can generate returns of 25% to 100% is "terrific."

Let's see how Lululemon's efficiency stacks up against the competition. I've also included sales per square foot for each company, a common industry metric that's useful for measuring store efficiency.

Company Buffett Ratio Sales per Square Foot*
lululemon 42% $1,318
Gap (NYSE: GPS) 29% $329
Under Armour (NYSE: UA) 14% $857**
Nike (NYSE: NKE) 21% N/A
Finish Line (Nasdaq: FINL) 16% $298
bebe stores (Nasdaq: BEBE) (1%) $450

Source: Capital IQ, a division of Standard & Poor's. * As of most recent 10-k filings. ** Based on direct-to-consumer sales per square foot, as Under Armour primarily sells through other retailers instead of company owned stores.

Lululemon has the highest Buffett ratio of the bunch , and its sales per square foot of store are well above that of its peers.

Growth opportunities
The major concern about Lululemon is its greater-than 50-times price-to-earnings multiple. We could split hairs and note that the stock trades for a lower enterprise-value-to-free-cash-flow multiple, but however you want to judge it, the stock is expensive. That said, we believe the company has enough room to grow into its valuation.

  • Store expansion: Lululemon only owns 45 stores in Canada, 74 in the United States, and 11 recently opened locations in Australia. The company continues to have successful openings in secondary U.S. cities. While customers in Europe and Asia can shop online, Lululemon hasn't yet opened stores in those locations.
  • Same store sales: Sales growth at comparable stores is remarkable -- last quarter the figure was a whopping 29%. Management attributes the growth to increased brand awareness, good products, a positive store experience, as well as community outreach, involvement, and education by employees.
  • E-commerce: Internet sales currently make up a small portion of Lululemon's sales, and the company is making an effort to increase sales through that channel.
  • New brands: The company has begun opening stores focusing on their iviva brand for other, year-round athletic activities.
  • Men: Males only make up about one-tenth of sales. While not currently a primary objective, eventually Lululemon may find ways to attract a larger male following.

We're buying
Lululemon's stock is by no means cheap, but we think the company has room to grow into its valuation and the brand and operational skills to do so. For now, we're buying $500 worth of shares, or 3% of our total capital.

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