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Rich valuation makes more Lululemon gains a stretch Add to ...

For a while there it looked like Lululemon might have been done for (the stock, not the company; there’s a big difference between the two).

But no, all is well: The pants still make bums look better, the yoga moms, among others, still love the stock and no one cares that Chip Wilson is rolling up his mat and going home.

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Still, investors should be vigilant. The company is thriving; but the stock is beginning to show signs of fatigue. If the company can grow into its multiple, so to speak, all is well. If not, some investors are going to get burned.

It’s easy to say, as plenty of pundits have, that the stock is grossly overvalued. But they’ve been saying that for years. They were wrong two years ago; they might be wrong today. At 51 times trailing earnings, Lululemon looks pricey compared to most other publicly traded businesses. But a multiple doesn’t in and of itself convey value or lack thereof. If your earnings are growing 60 per cent annually, as Lululemon’s did in the most recent nine-month period, 50 times earnings isn’t necessarily dear. Nine times earnings for a company whose profits are falling could be far more expensive, but no one ever says that.

The real question is whether or not Lululemon can manage a declining multiple. Some faddish companies have accomplished this feat (Apple) whereas others (Crocs, to name but one) have not; their stock prices have shrunk instead. Investors should concentrate on that instead of on a single statistic.

Lulu stumbled in the third quarter, and it looked like the streak might over and the stock doomed. It wasn’t that the company’s sales were falling; it’s just that they weren’t growing as fast as expected, and that is never good for the multiple. Going from 50 times earnings to 30 times means your stock drops by 40 per cent, and even though you still have a premium valuation, a loss based on this so-called multiple compression is most often permanent. I’ve seen it a million times with high-growth companies, and it’s usually accompanied by excuses from management and promises that all is well, which is often true of the underlying business but not of the stock.

But it appears that Lululemon really did have an enviable problem: too much demand, not enough inventory. The company says it’s fixed that and therefore the fourth quarter will be better than expected. Goldman Sachs loves the stock more than ever. It’s been a good week.

But will it be a good year? Investors are betting on 60-per-cent-plus profit growth. It has happened, it could happen, but it can’t go on forever. If it did we’d all be wearing nothing but Lululemon Athletica in short order, and there are already enough people wearing those pants who just shouldn’t be.

All growth rates slow over time; there is no exception to this rule, nor has there ever been. So Lululemon’s multiple should be declining. A $6-billion niche apparel company trading at 50 times earnings and whose multiple is expanding is, I would submit, a dangerous investment.

A falling multiple doesn’t necessarily mean a falling share price. Apple’s stock rose even as the multiple fell because its earnings grew faster than the PE ratio declined. But as mentioned, few hyper-growth companies can achieve this as smoothly.

It’s hard to discern a trend in Lululemon’s valuation. It’s certainly volatile, as you can see from the chart. It doesn’t seem to be falling though and that could be worrisome.

Ultimately it’s up to management. Loaded up on stock options and riding a wave of adulation and success, they might be blinded to the inevitable limitations of the market for high-end sporty wear. Lululemon spent way more than it earned on growth (new property and equipment and inventory) in the latest nine-month period. The team is clearly bullish.

If they’re right, there could be more upside even for investors buying today. If they’re wrong, there will be nothing but pain guaranteed. Rich multiples amplify mistakes.

Fabrice Taylor publishes The President's Club investment newsletter, focusing on off-the-radar small to mid-cap companies trading at a discount to net asset value. His letter and The Globe and Mail have a distribution agreement. He can be reached at fabrice.taylor@gmail.com.

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