Quiet times

Sometimes doing nothing is the best policy and the last two weeks have been exactly that. There’s been a small amount of portfolio adjustments, but nothing too serious. If I have something more exciting to report, I would have. There isn’t anything. Credit spreads are tiny and investors are generally not being very adequately compensated for risk.

In a “would have, should have” world, Lululemon (Nasdaq: LULU) would have been a short in my portfolio a year ago, but that opportunity has now passed. Coach (NYSE: COH) is also on that short list. Both of these are subjected to confirmation bias by females that I know are into these sorts of things. Both of them are trading at valuations which can (now) be considered reasonable (LULU still being a tad expensive, but not as ridiculous as they were before), but both brand names are clearly on the downtrend. In fashion, trends are everything. Apparently Kate Spade (Nasdaq: KATE) is the next up-and-comer and while traditional valuation metrics say this one is very expensive, perhaps talk to some teenagers that have disposable income and your opinion may change.

No positions, just curious. It makes outlet shopping somewhat more tolerable when looking at these various brands from a purely financial perspective.

Lululemon valuation

I notice that John Hempton of Bronte Capital is scratching his head with Lululemon’s (Nasdaq: LULU) valuation.

I’ve been scratching my head since they had a $2.8 billion market cap, and now they are trading at $9.2 billion.

They are headquartered in Vancouver, British Columbia, Canada, which is right in my backyard.

The after-tax profit margin (19%, trailing 12 months) is just incredible for a clothing company. It is right up there with handbag producer Coach (NYSE: COH), although in the latter’s case they have a somewhat more reasonable valuation.

In both cases, understanding women’s sense of fashion is the key investing variable. What’s the next meme after yoga pants?

Lululemon again

Lululemon (Nasdaq: LULU) is up to US$61/share, nearly at its all-time high upon announcing that it made more money in the fourth quarter than analysts expected.

I have written about LULU before and am continually amazed at their ability to “surprise” in such a fashion. The most valuable asset such companies have is their branding, and LULU has been able to strike the sweet spot in women’s fashions for quite some time – although there is competition encroaching, they have still been able to keep surprisingly ahead.

At a market cap of 8.8 billion, it makes you wonder how much higher they can go – looking at what that capital can purchase, instinctively I would not want to put a single penny of that into Lulu given existing valuations. That said, I thought the same thing when it was trading at $4 billion. Tells you know much I know about fashion trends.

Lulu – Gaga

Although I like looking at fashion companies for their financial statements, when it comes to the wares they are selling, I am absolutely clueless. I have to ask others that know much more about the fashion aspect of clothing companies for their anecdotal opinions.

Never have I been so wrong about Lululemon:

Obviously this train ride has to end somewhere, but I just look at this chart with my jaw open. Reference my December 2010 post when I was questioning the high $2.8 billion valuation. Today: $6.3 billion.

Lululemon goes ga-ga

Lululemon (Nasdaq: LULU) is up another 18% today, as of the time of this writing, after reporting a much better than expected quarter (36 cents EPS on 25 cents analyst consensus).

This tells you what I know about fashion – I wrote about their previous blow-out quarter, warning that:

They will need to continue achieving rapid growth in order to grow into the existing valuation. If not, you will see a significant haircut in the stock price

… and …

Lululemon is a classic case of a well-run company that you do not want to own stock in.

This was back at $40/share (or a 2.8 billion market capitalization). Today, I see $66/share or a $4.6 billion dollar company!

Where did I go wrong? Don’t underestimate social trends when it comes to fashion – most importantly, I should have taken the subtle hints when I see family relatives wearing Lulu material. From my neanderthal male perspective, I remember walking into a Lulu store outlet with my wife, and while she went looking for some overpriced pants, I was looking around the store, asking myself how the heck they deserve a $2.8 billion dollar valuation when it is so clear that they will be prone to predatory competition.

Financial lesson of the day: Never underestimate the value of brand.

I have never had a position in LULU stock, and plan to keep it that way. I will disclose I did consider buying shares at $5 in the middle of the 2009 economic crisis, but decided on going with long term corporate debt of another fashion star, Victoria’s Secret (Limited Brands) instead, so I’m not kicking myself too hard about the matter.

Even though I don’t understand the fashion world, from an investment perspective I have always found it to be utterly fascinating because of the intense amount of “social research” required in order to properly value these companies.

LuluLemon’s second quarter

Headlines are being made that Lululemon (Nasdaq: LULU) beat earnings expectations and raised income estimates for the year. Their common shares were up about 13% today after their second quarter report.

Most of what I wrote about Lululemon, in terms of share valuation back in June 10, 2010 (when they announced their first quarter results) applies today – the company will have to execute high growth perfectly in order to justify their existing valuation.

It should be pointed out that despite their second quarter surprise, their valuation around the same ($2.8-$2.9 billion) as it was when I wrote my June 10 article, or about USD$40/share. They will need to continue achieving rapid growth in order to grow into the existing valuation. If not, you will see a significant haircut in the stock price.

Lululemon is a classic case of a well-run company that you do not want to own stock in.

When will the Lulu bubble burst?

People in and around the Vancouver area are probably quite aware of Lululemon, a marketing firm that sells retail apparel. Most people would consider them to be a retail apparel firm, but I would dispute this classification.

I have been watching this company since it went public, not because I ever intend to buy shares in the firm (or their clothing), but rather because it is a Vancouver-based business that has been insanely profitable and has done an incredible job permeating amongst my own age demographic.

Although I have very little intuition about fashion, I have studied the industry extensively and currently have some money where my mouth is in the form of a stake in corporate debt of Limited Brands (one major holding they own is the branding to Victoria’s Secret).

This morning, Lululemon reported their first fiscal quarter results. While I am less concerned about them beating or missing analyst estimates (they exceeded them) my focus is on their gross margins – 54% for this year’s quarterly result. This is a high gross margin for an ordinary clothing manufacturer, so they are adding much value on the marketing side and thus having their customers pay more for products that otherwise would cost the same to make.

Gildan Activewear, for example, has a gross profit of around 28% in their last quarter.

If you look at other firms to benchmark Lulu with (of which I will use Limited Brands, Abercrombie & Fitch and Nike) – Limited’s after-Christmas quarter reported gross margin of 36% (which includes “buying and occupancy” costs), while Abercrombie’s gross margin was 63% (strictly on “cost of goods sold”, not including store and distribution expenses), and Nike’s is 47% (albeit for the Christmas quarter, but their yearly results are comparable to this). If you were able to drill into the numbers and make them on an equivalent basis (which is not very easy to do when mining the details of the company’s detailed quarterly reports that they externally report), the profitability of Lululemon is not that much higher than equivalent (i.e. “high-end”) and established US corporations.

So looking at a relative valuation basis, you now have the following (not factoring in Lulu’s recent quarter):

LULU – Market cap $2.8 billion, TTM revenues $453M, net income $58M; (cash: $160M, debt: $0)
LTD – Market cap $8.0 billion, TTM revenues $8.84B, net income $558M; (cash: $1.7B, debt: $2.8B)
ANF – Market cap $3.1 billion, TTM revenues $3.01B, net income $90M; (cash: $633M, debt: $71M)
NKE – Market cap $34.8 billion, TTM revenues $18.65B, net income $1.73B; (cash: $4.0B, debt: $0.6B)

This very brief comparison gives me the belief that Lululemon is being valued as a marketing company (like Nike) rather than an “high-end retail” apparel company (like Limited and Abercrombie). It is also much, much differently valued than a “commodity clothing” firm like Gildan (which does not have a direct retail presence).

The most cursory glance at the financials would lead one to believe that if you were to believe that LULU was a “buy” at the moment, they would have to grow, considerably, into their valuation even to make it comparable to Nike’s valuation level. Assuming a “steady state” valuation of 20 times earnings and/or 2 times sales, you would have to extrapolate Lulu growing their top line at 30% a year for roughly 5 years with the share value being roughly the same as it is now.

Even though in the last quarterly result they grew their top line 70% over the previous year, it is very difficult to swallow a company’s shares thinking that they have an implicit requirement to grow their sales from $450M/year into $1.4 billion just to cut even. Will they do it? Who knows. But the level of baked growth makes the stock look very risky for the reward offered – if they have one misstep, they will see a 2008-style haircut. It won’t be nearly as bad as the 90% cut from the 2007 highs, but it will be considerable.