Lululemon Athletica inc. (LULU), Coach, Inc. (COH): Pants Shortage! Can Investors Take Advantage?

My feeling is that Coach’s performance over the last decade represents a sort-of best case scenario for Lululemon over the next decade. Coach succeeded because its brand continues to represent quality — it wasn’t diluted with lower-cost products. If Lululemon maintains its quality, and makes sure this pants debacle is a one-time occurrence, then the company could very well follow a Coach-like growth path. If, however, it attempts to sell lower-price, lower-quality items, its margins will erode and profitability would suffer, and its premium brand would lose much of its appeal. This would put it into more direct competition with companies like Under Armour, Inc. (NYSE:UA) and The Gap, Inc. (NYSE:GPS), which offer lower-priced products.

Valuation

Given that Coach, Inc. (NYSE:COH)’s growth path seems reasonable for Lululemon Athletica inc. (NASDAQ:LULU) over the next decade 25 times earnings is a reasonable price for the company. The current P/E ratio of 35 is far too high, and the stock would need to fall to the mid 40’s for it to be attractive. Under Armour trades at an even higher 41 times earnings while Gap trades at about 15.5 times earnings. Gap is a far larger company and doesn’t have the same growth prospects as either Lululemon or Under Armour, so the multiples may not be all that comparable. Analysts estimate five-year earnings growth for Gap to be just 9.4%, far lower than the other two companies. However, both Lululemon and Under Armour look far too expensive right now to consider.

The bottom line

Even after the pants-related drop in price, Lululemon Athletica inc. (NASDAQ:LULU) is still overvalued. It’s not outrageously overpriced, but the kind of growth needed to justify 35 times earnings is unrealistic. Both Lululemon and Under Armour stock have run up enormously over the past three years, and the expectations for both have gotten out of hand. I think that both companies have the potential to grow at Coach-like rates over the next decade, but paying 35 or 41 times earnings for that growth, which is by no means guaranteed, is not a great strategy. Lululemon is a lot more reasonable than Under Armour, but I’d wait for a substantial drop in prices before buying any shares.

The article Pants Shortage! Can Investors Take Advantage? originally appeared on Fool.com and is written by Timothy Green.

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