Markets

Is it Time to Sell Lululemon Near All-Time Highs?

Lululemon (NASDAQ: LULU) has surged since Q2 2017, outpacing other large specialty and athletic apparel peers such as Nike (NYSE: NKE)Under Armour (NYSE: UAA)Columbia (NASDAQ: COLM), and VF (NYSE: VFC). In the 12 years following the company's 2007 IPO, LULU has delivered returns 991 percentage points above the S&P. 

As recession fears loom and a market downturn becomes increasingly likely, it can be prudent to scrutinize highfliers like Lululemon to identify opportunities for redeploying capital toward less-speculative positions. 

Searching for red flags

Company analysis should begin with a study of Lululemon's operations, assessing management's efficiency, and confirming that the qualitative narrative stands up to scrutiny. Any red flags unearthed here can be sufficient to remove the name from investment consideration entirely. 

People doing yoga on mats

Image Source: Getty Images

Lululemon's efficiency and financial health metrics score well against its consumer discretionary peers. The company has delivered consistently strong revenue and earnings growth with wide operating and net profit margins that roughly double apparel industry averages. These factors will make investors confident that the company will continue to enjoy profit expansion. Lululemon has also performed exceptionally based on return on equity and return on invested capital. These indicators show that the underlying business is utilizing its resources efficiently to produce profits. 

The company has consistently outpaced its own guidance and analyst earnings estimates, and it has experienced success across multiple product lines. This overperformance is especially encouraging as other large competitors are targeting Lululemon's "bread and butter" yoga apparel.

Nonetheless, threats loom in the form of potential trade disputes as Lululemon currently sources over 12% of its volume from China. It has also been hit with allegations of abusive labor practices in its supply chain. A further risk is its reliance on consumer preferences and brand perception, which is subject to rapid change.

Price check

Next, we want to determine if Lululemon actually has an aggressive valuation. Comparing a battery of valuation metrics to industry peers can be an informative start. It can also be helpful to compare directly to industry peers.

Lululemon's 46.1 price-to-cash flow, 36.5 price-to-earnings, and 1.9 PEG ratios are all slightly higher than apparel industry averages. However, the stock price looks much more aggressive based on its 17.6 price-to-book ratio and 29.5 EV/EBITDA, the latter of which is nearly triple the industry average.

Because the company does not pay dividends, investors must realize gains in the form of price appreciation, which may be in jeopardy if the pricing already assumes strong fundamental performance in the future. Ultimately, Lululemon compares well to many of its more direct alternatives, with excellent growth potential due to brand recognition and favorable consumer opinions.

The bulls still have a case here

I hesitate to suggest exiting the apparel industry entirely because it does show some resistance to cyclicality despite some demand sensitivity-especially among high-ticket items. As such, Lululemon stock is still a viable investment today despite its soaring share price.

Risk-averse investors looking to maintain apparel industry exposure might consider Nike, which has a more diverse product offering and more attractive valuation multiples across the board. It also achieves impressive efficiency metrics and pays a modest dividend while still approaching Lululemon's growth outlook.

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Ryan Patrick has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Lululemon Athletica, Nike, and Under Armour (A Shares). The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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