Is it time to buy Lululemon?

Shares of apparel-maker lululemon athletica (Nasdaq: LULU) have tumbled 30% since reaching an all-time high at the beginning of May, at over US$80. The stock fell 10% on June 7, thanks to a disappointing outlook in its first-quarter earnings report. The quarter itself was actually stellar, though, despite weaker-than- expected forecasts, with the following highlights:

• Revenue up 53% to US$285.7 million
• Same-store sales up 25%
• Direct-to-consumer (online) revenue up 179% to US$38.4 million
• Net income up 39.8% to US$46.6 million

Second-quarter projections were well below Wall Street's estimates, however,  as the company predicted an EPS of just 28 to 30 cents per share, when analysts had expected 33 cents. Revenue for the quarter was also short by US$10 million, as were full year forecasts.

While shares may have seemed overpriced at US$80, at US$57, they could be a good buy. Let's take a closer look and see what's in store for the yoga retailer's future.

New stores
With only 180 stores in the world, it's easy to see how Lululemon is only at the beginning of its growth phase. By comparison, the Gap Inc. (NYSE: GPS) brand family, which includes Gap, Banana Republic, and Old Navy, has more than 3000 stores worldwide. H&M has about 2500 stores in 44 countries, and Spain-based Inditex, the parent of Zara and other brands, has over 3000 locations around the globe, as well. While these retailers have admittedly more broad product appeal than a niche player like Lululemon, it puts a little perspective on Lulu's potential for expansion.

Founded in Vancouver, the clothing chain expanded first in Canada, and its most successful and mature stores can still be found there. The chart below shows revenue and store count by region for Q1 2012.

Source: Company 10-Q

If Lululemon's stores in the U.S./Australia and New Zealand were to achieve the level of sales of its older Canadian stores, the company would unlock an additional US$81 million in revenue in just one quarter. That's an increase of about 30% over what it did last quarter and, because those sales would come from real estate the company already occupies, margins should increase along the way. Clearly, there's room to even further improve same-store sales, as well as open new stores. While the company is opening new locations at a moderate pace, with 33 in fiscal 2011 and another 32 expected in fiscal 2012, I expect management to keep up this rate at a minimum for several years to come, especially considering that the company has not even entered Europe or Asia yet. It has dipped its toes in both continents with showrooms — its prelude to a store — in Hong Kong and London. CEO Christine Day was especially upbeat about the response in Asia.

The online channel
To compliment its growth in bricks and mortar, the exercise retailer's online sales are skyrocketing, jumping almost 200% in the past quarter. The company's philosophy centres around building out community relationships and brand awareness through its stores and its brand ambassadors, and it only launched its e-commerce site three years ago. The online channel provides a low-cost method for Lululemon to sell its goods to customers who don't have access to its stores, or prefer to shop from the convenience of their own homes. Online sales now make up 13.5% of total revenue. Peers like Nike (NYSE: NKE) and Under Armour (Nasdaq: UA) only make 18% and 25% of their sales, respectively, through those channels. For Under Armour, that includes factory houses and specialty stores, but I can see Lululemon surpassing those percentages, because its products are not as widely distributed as those of its two competitors.

This is also where Lululemon's brand advantage comes into play. Unlike Nike and Under Armour, the brand has grown out of its stores and, because of its unique approach to retailing, which includes offering free yoga classes as well as other forms of community outreach, the company has made itself a lifestyle brand in a way that the two other athletic apparel sellers have not. Nike and Under Armour, by comparison, rely heavily on advertising as opposed to Lululemon, which employs alternative marketing strategies. The company shuns virtually all forms of traditional advertising.

The valuation puzzle
With its huge margins and brand power, even Lululemon bears acknowledge that the company itself is strong. Their beef is with the high price tag, but at a current P/E of 42, Lululemon might be a steal. It's easy to see the company tripling its earnings in the next five years, which would bring the P/E down to a very reasonable 14 at today's share price.

• If the apparel chain opens another 30 stores each year for the next five years, and those stores bring in average of US$6 million a year, the company will add US$900 million in revenue in 2017.
• If same-store sales grow at a conservative percentage of 12% using its base of 180 stores, it will add another US$700 million, approximately.
• Finally, based on last quarter's growth, it seems reasonable to estimate online sales growing from about US$100 million last year to US$400 million by 2017.

That would mean sales would triple within five years, making its current P/E seem reasonable, assuming earnings moves with it. And even in 2017, there will be plenty of growth opportunities available, such as Europe and Asia, the Ivivva line of stores for girls, and who-knows-what-else in the pipeline.

The bears may point to competition from the likes of the Gap's Athleta looking to take a bite out of Lululemon's fat margins, but the favourable factors outweigh the negative ones in the macro environment. Lululemon will benefit from the trend towards fitness and healthier living, and observers must note that this is a high-end brand that is still growing at an incredible pace in a down economy.

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