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May 23

Fitness Industry Shows Promise For Lululemon – Seeking Alpha

Fitness Comments Off on Fitness Industry Shows Promise For Lululemon – Seeking Alpha

Lululemon (NYSE: LULU) has recently been trading near its 52-week lows. The result of this bearish trend has come from disappointing 4th quarter earnings and guidance. The main thing that has spooked the market is management pointing towards a slow start in 2017, with this decline expected through the entire 1st quarter. While this initial fear has led to a sharp decline in stock price, there are many things that show that LULU has become significantly undervalued.

Industry Outlook

The apparel retail sector still looks very promising. Due to the expensive quality and premium that LULU offers its customers, it has been able to retain brick-and-mortar stores, while other apparel companies have had to decrease to make way for more internet-based operations. The luxurious positioning of LULU allows it to utilize brick-and-mortar, unlike lower-end style apparel clothing companies. Large retail companies such as Under Armor (NYSE: UAA) and Nike (NYSE: NKE) have seen a decline in sales, as they have to make the strategic shift from brick-and-mortar to online sales. This has created a ripple in the industry that has led to companies missing short-term guidance. This is an effect that has not drastically affected LULU. The company's niche and high-end quality allows it to maintain its brick-and-mortar stores over the increasing popularity of online sales. So while we have seen the Apparel Retail sector take a hit, the company should not have been affected by these concerns.

I began by running a relative valuation to consider how Lululemon fundamentally compared with its peers:

Stock

P/E

P/B

Profit Margin

ROA

ROE

LULU

22.30

4.97

12.94%

18.07%

25.41%

TJX

21.47

10.64

6.96%

19.7%

51.19%

UAA

48.23

4.16

4.81%

7.18%

15.52%

NKE

21.60

6.72

12.02%

13.06%

32.60%

GPS

13.18

3.06

4.36%

11.99%

24.81%

AVERAGE

25.41

5.91

8.22%

14%

29.91%

From this relative valuation, we can see that fundamentally LULU is performing better than its competitors. It has particularly a much better profit margin. This is very important, considering that one of the main fears is the entrance of new competitors. Given that it has such a high profit margin, it is able to use a price war to deter any new competitors that attempt to take significant market share in the short term. This shows us that LULU could be undervalued. In order to confirm this, we must value the company given its current and future predictions.

One way to value companies like LULU is using a DCF Model. There are several assumptions that need to be used in order to run an efficient DCF model. One of the key assumptions is WACC. Using GuruFocus, the WACC would be .76%. This is abnormally low, so I decided to use CAPM to determine another required rate of return. Using the CAPM model, I used a risk-free rate of 3-year Treasury note which had a rate of 1.45%. I used Damodaran's MRP of 4.51%. With these two assumptions, the last assumption made is the Beta, for which I decided to use the Yahoo Finance figure of -.16. Given these assumptions, you come up with a required rate of return of 1.02%, which is very similar to the beta provided by GuruFocus. I have decided to equally weight the two required rates and use the average of .89%

The next step in running this model was determining the FCF. I decided to use the Morningstar FCF of 236. The most ambiguous part of this model is determining an appropriate growth rate. LULU may not be growing at a rate that most analysts expected, but it is still seeing healthy growth. Over the last 5 years, its FCF has seen growth of over 38% growth year over year. Similar growth can be seen in revenue and income. However, given the recent concerns in the apparel sector, I decided to use a conservative growth rate of 3% over the next four years and a terminal growth rate of 2%.

Years

1

2

3

4

T

Growth Rate

3%

3%

3%

3%

No Terminal

FCF

243.08

250.37

257.88

265.62

29,844.95

DCF

240.94

245.97

251.12

256.37

28,805.70

Enterprise Value

29,800.10

Net Debt

Surplus 437

Equity Value

30,237.1

Shares Outstanding

137 million

Price Per Share

220.70

Upside

347.76%

As we can see from this very basic DCF Model, LULU has significant upside given its current FCF growth and valuation. We can also run this without adding back the net debt surplus of $437. From this we still get an upside of 340%, and can see that it does not affect the valuation much at all. I have also run a sensitivity analysis of the WACC, considering that the original WACC used is very low.

WACC

1%

1.5%

2%

2.5%

3%

Upside

279.45%

154.81%

92.50%

55.11%

30.19%

From this we can see that even with a much higher WACC, there is still substantial upside. Of course, it shows that LULU has a lot of potential value, but much of the sell-off has been due to weak guidance. There are many reasons why this weak guidance is unwarranted and has been blown out of proportion.

Outlook

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Fitness Industry Shows Promise For Lululemon - Seeking Alpha

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