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.

Pay attention to CRA prescribed rates

With the Bank of Canada raising interest rates, it is likely that the CRA, either starting for the July quarter, but at the latest the October quarter will be increasing the prescribed rate for taxable benefits for employees and shareholders from interest-free and low-interest loans.

A history of this rate is as follows:

Q1-2007: 5%
Q2-2007: 5%
Q3-2007: 5%
Q4-2007: 5%

Q1-2008: 4%
Q2-2008: 4%
Q3-2008: 3%
Q4-2008: 3%

Q1-2009: 2%
Q2-2009: 1%
Q3-2009: 1%
Q4-2009: 1%

Q1-2010: 1%
Q2-2010: 1%
Q3-2010: Should be announced within a week.

The reason why this rate is significant is because issuing a low-interest rate loan is the easiest way to avoid income attribution. Just as an example, if you get your company to loan you money (which you would presumably use for investment purposes), you have to pay the company a 1% interest charge. You would deduct that amount from your income, while the company would include it as interest income on its side of the income statement. Also, spousal loans can be used to avoid income attribution.

While no matter what the rate is there is symmetry (i.e. one party can deduct what the other includes as income, assuming the loaned amount is used for income-generation purposes), higher rates discourage typically discourage borrowing to invest as typically it is the asset-rich entity that loans money out to the asset-poor (and presumably income-poor) entity in order to transfer income to a lower-rate person. If the prescribed interest rate is too high, the loanee will have to take on a higher amount of income at their (presumably) higher marginal rate.

There are rules with respect to the payment of shareholder loans (i.e. you must pay back the principal amount by the end of the following fiscal year or have it be a deemed dividend) but for loans between individuals, there is no duration rule with respect to the amount of interest to be paid – you can make a loan that will expire in 30 years at the rate of 1% for the purposes of the prescribed interest rate rules. Just make sure to document the loan and if there is any question as to the dating of the document, get it notarized or otherwise documented in case if the CRA comes knocking.

Uranium One gets taken over

In a somewhat complex arrangement, Uranium One (which has a primary business of owning and operates several uranium producing mines in Kazakhstan) announced a transaction with its existing 23% owner, JSC Atomredmetzoloto (ARMZ, a Russian corporation that is state-owned by the Russian Atomic Energy Corporation) such that Uranium One will receive an economic stake in two more mines and ARMZ will receive a majority stake in the company.

The salient details are in the press release.

Although I do not have a current position in Uranium One equity or debt, I do keep an active watch of their debentures. They traded up from about 92% to 94% after the announcement. The debentures have a change of control provision, but this is for 2/3rds of the company and not majority ownership.

When dealing with majority-owned companies, you have to be very careful in knowing the motivations of those shareholders – their goals and interests might not line up strategically with the interests of the minority shareholders (which is either to derive an income stream or realize capital gains in the marketplace). As such, you should never own companies that are majority controlled unless if you can answer this question. Some majority owners are there to pillage or otherwise legally transfer the assets of a subsidiary company into a parent corporation and some majority owners like to depress the market valuation of the subsidiary firm just so they can acquire the rest of it. It is rare when the alignment is correct (i.e. the majority owner wants to sell the rest of the stake for a high price, or the majority owner wants to peacefully derive as much long-term income out of their investment).

For shareholders, I would be extremely cautious in the future about Uranium One.

Fortunately, the debenture holders do not really have to care about the motivations of shareholders (other than their willingness to pay off the debt). Even after the proposed special dividend the company is proposing, the corporation will have sufficient liquidity to pay off the $155M of debentures when they are scheduled to mature on December 31, 2011. At a price of 94, they have a current yield of 4.5% and a potential capital gain of 3.9% annualized assuming redemption at maturity.

Both shareholders and debenture holders also realize the same risks with respect to having a Canadian corporation owning and operating mineral rights in foreign countries. I have no idea as to the political stability of Kazakhstan, but would be slightly comforted in knowing there are a few directors on board that speak Russian and would have some clue about the legalities of their political system. However, I would not be comfortable as a shareholder knowing that a Russian government corporation controls the board of directors in the company. Their only vested interest would be to maintain control of the company, and at least this means they should be paying their December 31, 2011 debentures.

Market commentary for Friday

As I write this, the major US indexes are down about 3-3.5%, while the TSX is down about 2%. The usual things in market downturns are happening today – US dollar is rising, Canadian dollar is down relative to the US dollar (nearly two pennies), and there is a rush into US treasuries. Apparently this might be due to another EU country that is on the verge of requiring a bailout, but this was to be expected.

Due to the fixed-income nature of my portfolio, it is relatively stable today – assisted somewhat by the exchange rate fluctuation, but even when you back it out the damage is less than half a percentage point. Although my cash balance is roughly 8%, some of the securities in the portfolio have very little volatility and thus the risk-reward is ratio is minimized. I receive a decent return while waiting and this is by design.

Patience, and stalking targets for purchase is all you can do when the marketplace starts to become volatile. For those that have taken out cheap money on margin and invested it into the marketplace, you can be sure that they are starting to feel a lot of pressure to liquidate and reduce their leverage ratios. Ideally, you want these people to liquidate at exactly the wrong time, and at the same time, and you want to be there to place a bid for those shares or securities that are trading well below your estimated fair value, and you have sufficient buying power (or a whole bunch of cash) to take advantage of the situation.

I am continuing to look at low volatility equities and am really not interested in increasing the risk in my portfolio at present. The reward just isn’t there and there still isn’t enough panic factored into the marketplace.

Also, 2010 has so far been the lowest volatility year to date. Right now the portfolio is less than 1% down from the end of March 2010 (where I stated that I don’t expect much more in the way of performance for the rest of the year).

The state of the Canadian wireless telecom market

Back in the 1990’s, the players were the telecoms we know today (Telus, Bell) and three companies that the younger generation doesn’t know much of today – CanTel (which was taken over by Rogers), Microcell (which is most known as Fido, but was taken over by Rogers) and Clearnet (which was taken over by Telus).

Putting a long business story short, all the original competitors went away except for Telus, Bell and Rogers. Telus and Bell had their landline markets subsidizing the wireless capital construction, while Rogers had (and still has) their cable business. CanTel, Microcell and Clearnet were exclusively wireless providers and did not have enough financial capacity to remain as businesses. Microcell was the last holdout before it got munched by Rogers in 2004; although it should be noted that Microcell was in dire financial straits well before this date.

Fast forward ten years and the consolidation, and we now have some new entrants into the Canadian wireless market. They are Public Mobile (concentrating exclusively on the low end user of Toronto/Ottawa/Montreal); Wind Mobile (recently introduced in Vancouver and currently concentrating on a broad approach across metropolitan centers in Canada minus Quebec) and Mobilicity (in the same market space as Wind).

I predict that none of these companies will be making any money, but the consumer, over the next couple years, will be receiving some excellent deals for mobile voice/data service.

In particular, Wind Mobile should be a formidable competitor by virtue of having a deep-pocketed parent, Orascom. I am less certain that Mobilicty will last as long, simply because they likely are less capitalized. I have no idea how Public Mobile will do, but they appear to have a very low cost approach which may work simply because the major companies have too much fixed overhead to compete properly (on a cost basis) against Public.

I also highly suspect that the reason why Shaw Cable is waiting so long to get into the mobile market (even though they have made the proper wireless spectrum purchases) is because they want to see who consolidates with who – or maybe consider its entry into the Canadian wireless market through a purchase once Wind and Mobilicity have lost enough money and want to give up.

So my deep suspicion is that Shaw Cable and the retail consumer will be the big winner in the Canadian wireless market over the next few years.