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Gildan products displayed at their annual general meeting in Montreal on January 31, 2008. (Christinne Muschi/Christinne Muschi for The Globe and Mail)
Gildan products displayed at their annual general meeting in Montreal on January 31, 2008. (Christinne Muschi/Christinne Muschi for The Globe and Mail)


Why I'm sweet on Gildan and sour on Lululemon Add to ...

Lululemon Athletica’s earnings miss last week nicked the stock, but the company’s shares still trade at healthy multiples. Gildan Activewear, by contrast, seems to have placed itself in the penalty box with a sharply disappointing forecast.

Which stock, then, is the better long-term buy? It’s risky to step in front of the Lululemon train, as the shares doubled after I first expressed skepticism about a year ago. Gildan shares, meanwhile, have rewarded my April recommendation by dropping nearly in half.

Nevertheless, I’m doubling down: I view Lululemon’s shares as too pricey, particularly now that its growth metrics, while still strong, have started to soften. Gildan, meanwhile, may take a couple of quarters to work its problems out, but seems to be an attractive buy, as long as your time horizon stretches into 2013.

Lululemon’s most recent results were only disappointing by the company’s own standards. Fiscal third-quarter revenue, despite missing analyst expectations, grew 31 per cent. Same-store sales increased 16 per cent when currency effects are removed. Profit was up 50 per cent over the comparable 2010 period.

Looking at the company’s numbers over the long term, however, shows the company in deceleration mode: Whereas year-over-year sales gains ranged from 55 per cent to 70 per cent in 2010, Lululemon’s 2011 growth has failed to top 40 per cent. Across a wide range of sales and profitability metrics, Lululemon just posted its smallest growth rates in any of the past nine quarters.

The company’s “cash conversion cycle,” which measures the time it takes a company to convert its inventory into cash, grew 25 per cent from the previous quarter and is now at its highest level since the summer of 2008.

Lululemon skeptics have pointed to inventory levels before and wondered whether the company was close to running out of customers for its pricey yoga wear. So far, Lululemon has proved them wrong, and seems to be executing a rollout of the brand across a wider range of active apparel.

The stock’s current forward price-to-earnings ratio is about 33, well below levels of a year ago, which prompts bulls like analyst Omar Saad of International Strategy & Investment Group to say this “may be one of the best entry opportunities … we could see for some time.”

More along my lines of thinking, however, is John Zolidis of Buckingham Research Group, who calls Lululemon’s valuation “silly” and advises clients to sell the stock. I’m not sure we’re on the cusp of a long decline in Lululemon shares, but I think the stock’s best days are behind it.

By contrast, these may be Gildan’s worst days. The company has been whipsawed by volatile cotton prices, which doubled from September, 2010, to March of this year, before giving back all those gains by summertime.

Gildan’s customers expected to benefit from the declines, but the company had plenty of inventory produced with the higher-cost cotton. So Gildan, now in the midst of its fiscal first quarter, is cutting prices – and even giving credits to previously purchased products – to stimulate demand.

As a result, the company said it expects a 40-cent-a-share loss this quarter, leading to full-year earnings per share of $1.30, compared with the previous consensus estimate of $2.30.

Analysts have responded by cutting both their EPS estimates and the multiples they use to value Gildan’s shares. Mark Petrie of CIBC World Markets Inc. reduced his multiple from 16 to 13 and applies it to a new earnings estimate of $2.02 for the four quarters starting after the current losing one. That yields a target price of $26.

GMP Securities’ Martin Landry has done similar revisions, to yield a target of $25. Mr. Landry believes Gildan’s challenges “are temporary in nature, as they stemmed mostly from unprecedented volatility in cotton prices not seen in more than 50 years.” The company’s business and growth prospects “remain intact,” he says, and current guidance “is not reflective of Gildan’s true earning power.”

For now, the market isn’t buying that. But if Gildan resumes demonstrating that earnings power in the second half of 2012, investors may look back on this week and wish they’d taken a chance on Gildan rather buying in to the pricey Lululemon story.

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