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.

However, I can understand what goes before my eyes, and that is people shop. I might not understand fashion retail, but I understand the economics of it – something about the marketing works. It gets people to pay more for a product that inherently has very low marginal cost to purchase. The embedded marketing costs, however, are huge.

Earlier this year, I invested in some corporate debt of Limited Brands (NYSE: LTD) – the 2033 series of debentures, which has a coupon of 6.95%. Investors back then assumed that retail was going to get thrown out the window along with the rest of the economy and especially for a discretionary retail shop like Limited Brands (their primary brand name is Victoria’s Secret), droves of people would be not shopping for lingerie. Or will they? According to their last quarterly report, they are on track to bringing in about $500-600M in free cash flow, depending on how the Christmas season works out.

For 35 cents on the dollar, I figured that the debt would be a good buy. It was tough to rationalize how being rewarded 20% interest a year (plus another 4% capital appreciation) under the assumption that Limited Brands would not blow up could lose money. And indeed, it has not lost capital – the same debt is trading for around 71 cents if you shop around carefully. This will still net you 10% a year in coupon payments, and about 1.5% a year capital appreciation compounded over the next 23.8 years.

If you look at their balance sheet, they have about $2.9 billion in debt, covered by $968M in cash, and positive earnings. Although I have no idea whether the retail chain over the next 23.8 years will survive, at least right now it is looking quite good.  The following is the debt maturity schedule from the Q2-2009 SEC filing, which shows they have staggered out their debt financing fairly well:

15. Long-term Debt

The following table provides the Company’s long-term debt balance as of May 2, 2009, January 31, 2009 and May 3, 2008:

Another similar corporation that is debt-free is Abercrombie and Fitch (NYSE: ANF), which seems to defy everybody’s expectations during recessions by coming back from the financial netherworld to make insane amounts of money. I can see the appeal of Victoria’s Secret – sex sells – but Abercrombie? When walking into the two stores to do some ‘consumer research’, I just don’t understand what keeps these names afloat in the retail fashion world.

However, I can at least invest and make some cash off of it while the going is good. Will I know when it is time to liquidate? Who knows.