Will Lululemon Turn Sour?

Lululemon Athletica inc. (NASDAQ: LULU) has been faring very well lately. Its stock has broken out of a deep base established in early 2012 to skyrocket 41.8% in three months. Currently, Lululemon is up 51.1% YTD and is hovering extremely close to its 52-week high. Moreover, Stifel Nicolaus recently raised its price target on Lululemon to $77 a share, satisfied by the ability of Lululemon to continually release styles and color palates that resonate with its customers, the success of its revamped e-commerce site, and its low level of clearance activity.

Lululemon is expected to report fourth quarter earnings results later this month, with analysts expecting a 53% per-share gain to 49 cents. Will Lululemon continue its growth streak?

The Bearish Case

As Lululemon's stock price soars, the company is attracting an increasing number of bears. They argue that Lululemon is significantly overpriced, with Lululemon shares hovering around 43 times the $1.59 per share it is expected to earn in 2013. Lululemon is also only generating about $0.22 in free cash flow for every $1 in earnings. Moreover, bears point out Lululemon shares are operating at around 260 times Free Cash Flow and the fact that, despite all the hubbub surrounding its growth, Lululemon has 0 consecutive quarters of EPS acceleration.

From a competitive advantage, bears point out that there are no significant barriers to entry for other apparel companies to overcome in order to establish themselves in the yoga industry. Already Nike Inc. (NYSE: NKE) has established the Salvation Chain of athletic-wear stores that feature a yoga-studio format similar to that of Lululemon. Gap Inc. (NYSE: GPS) has created the Athleta stores, which sell yoga apparel and offer free yoga classes. Nordstrom Inc. (NYSE: JWN) even hired a Lululemon alum to spearhead its Zella line, which is dedicated to yoga attire. Moreover, many of these stores are "undercutting Lululemon on price," as Bloomberg notes. Bears also argue that the yoga craze is unsustainable and will ultimately prove to be a fad that will eventually cool down, taking Lululemon down with it.

The Bullish Case

Yet, there is also a compelling bull case for Lululemon as well, one which I believe ultimately trumps the bear case against Lululemon. First of all, brand loyalty, as of now, separates Lululemon from the rest of the pack. Yes, there are cheaper alternatives out there in terms of yoga apparel, and there are definitely an increasing multitude of options from which yoga aficionados can choose. However, Lululemon customers are willing to pay a premium for what they consider to be not mere products, but a lifestyle.

Sound familiar? This is the exact same brand loyalty that is driving Apple Inc. (NASDAQ: AAPL) and its legions of die-hard fans; so far it has worked out pretty well for Apple. Of course, Lululemon is a different company operating in a completely different sector, but the fact of the matter is that brand loyalty should never be underestimated, especially in the case of businesses such as Lululemon that have seen brand loyalty spur company growth year after year.

Indeed, the growth Lululemon is experiencing is spectacular. For starters, it reported $1,800 in sales per square foot last year, a 20.8% increase YOY. Lululemon has a 3-Year Sales Growth Rate of 41% and a 3-Year EPS Growth Rate of 61%. Moreover, the company has experienced 4 consecutive years of annual EPS growth; these figures show that Lululemon has experienced growth that has been consistently increasing for years and take away from the notion that Lululemon is simply riding on a temporary yoga craze.

Currently Lululemon is still going strong. Its most recently reported EPS figures constituted a 50% increase YOY and the Average EPS Growth of the last three quarters is an impressive 60%. Estimate revisions for the current quarter are up and the current quarter EPS is expected to increase 53% YOY. Current year EPS is expected to be 56.96% higher than last year's, and sales for last quarter increased 31% YOY.

Not only is Lululemon experiencing significant growth, but it is also translating this growth into significant profitability. Lululemon's Annual Pre-Tax Margin is 25.8% and its Annual ROE is 36.2%.

The yoga industry is definitely seeing an increased number of competitors, but this competition does not amount to a zero-sum game, as many Lululemon bears have portrayed. There is significant evidence that the yoga industry is not a fad that will disintegrate due to economic woes; the continued expansion of this industry is a win-win for Lululemon and its competitors. In 2001, 4.3 million people in the U.S. practiced yoga; in 2011, 14.3 million people in the U.S. practiced yoga. The percentage of people that practice Yoga increases on an average of 20-25% every year. Moreover, Americans spent $5.7 billion on yoga products, equipment, and clothing in 2008, constituting an 87% increase from 2004 expenditures. Ironically, this increase occurred in the midst of the Great Recession; banks collapsed, credit froze, houses were foreclosed, millions lost their jobs, but people still found the resources to buy $90 Lululemon yoga pants.

The Verdict

Lululemon continues to be an attractive stock despite its relatively lofty valuations. Institutional funds seem to agree: Lululemon has experienced 3 consecutive quarters of increasing fund ownership and has recently seen a 10% increase in funds owning stock.