Behind Lululemon's lulu of a stock ride

NEW YORK (Fortune) -- Lululemon Athletica (Charts) has won a cult following from women who favor its yoga pants and other workout gear - and also from investors, who have pushed the stock to record highs in its first three months as a public company.

Fans like Jim Cramer, who recently hosted Lululemon Chief Executive Robert Meers on his CNBC show "Mad Money," argue that the company deserves a rich valuation because of its high growth potential and strong brand loyalty. Lululemon, these people say, is shaping up to be the next Coach (Charts) or Crocs (Charts), two brands that have repeatedly defied skeptics and continued to grow at rapid clips.

Lululemon's stock is hot, but how sustainable is the company's growth?

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There are signs, however, that Lululemon's stock price is overstretched. Even by the generous standards of Wall Street underwriters, the stock looks expensive. The eight analysts who participated in the company's IPO have an average target of $38.50 on the shares, less than the current price of just under $47.

After pricing at $18 a share, well above the initial offering range of $10-$12, the stock has appreciated nearly 155 percent since its Aug. 2 Nasdaq debut. Lululemon's market capitalization of $3.2 billion dwarfs that of Under Armour (Charts), another fast-growing maker of athletic clothing, which has three times Lululemon's sales. With a price-to-earnings ratio of 83 based on 2008 estimates, Lululemon is the most expensive stock in a group of 17 growth companies tracked by Thomas Weisel Partners.

"The expectations are so high that people aren't properly valuing the risks," said Allan Brown of Burlington Capital Management, a hedge fund that doesn't own Lululemon shares.

As with any young and fast growing company, the risks are plentiful. They include: ensuring proper infrastructure is installed to keep pace with exploding sales; increasing competition from rivals that offer similar products at lower prices; keeping pace with expectations for store openings.

Founded by Dennis "Chip" Wilson to take advantage of what he saw as a boom in yoga enthusiasts, Lululemon opened its first store in Vancouver, Canada in 1998. The company now operates 60 stores, of which 17 are in the United States.

In 2005, Wilson sold a 48 percent stake to a group of private equity firms led by Advent International Corp. and Highland Capital Partners. Though both firms unloaded a chunk of stock in the offering, they continue to be among Lululemon's largest shareholders. Thomas Stemberg, a Highland Capital partner and co-founder of Staples, serves on the board.

Plans call for the aggressive rollout of stores in North America over the next several years, including 25 in 2007 and as many as 35 in 2008. Meers, the CEO, has said the company could eventually operate 300 locations here.

All of those extra stores require the necessary infrastructure to make sure that inventory arrives on time and goods remain in stock. Though the company is installing a new inventory management system, it won't be fully operational until next year. In the meantime, Lululemon stores in New York are often sold out of smaller sizes favored by Manhattanites. During the Chicago half-marathon in September, stores in that city were out of running clothes.

"We are somewhat concerned that systems are only now being put in place," wrote Liz Dunn of Thomas Weisel Partners, one of the company's underwriters, in a research note last month. As such, she added, "the company is at risk for hiccups on execution in the near term."

Meers, on a recent conference call with analysts, said the issue was one of internal sales estimates that turned out to be too low, rather than snafus with the company's supply chain. "We're dealing with a Class A problem of more sales than forecasted," he said.

But analysts worry that the company's conservative planning could turn off first-time shoppers, who now have many more options for purchasing athletic apparel, often for less than Lulu's pricey duds. VF Corp. (Charts, Fortune 500) recently acquired Lucy, a 50-store chain that sells yoga and accessories, and has said there is an opportunity to turn it into a $350 million business, a seven-fold increase from current sales. Liz Claiborne (Charts, Fortune 500) has recently put the yoga-inspired brand Prana up for sale and its expected acquisition, most likely by a private equity firm, could infuse the label with cash and lead to future growth. Meanwhile, established retailers such as Victoria's Secret and Abercrombie & Fitch are adding yoga wear to their offerings.

Also of concern is the track record of Lululemon's highly touted CEO. The company's proxy refers to its seasoned management team as one of its strengths. Meers spent the bulk of his career at Reebok, where he served as president and CEO of the Reebok brand from 1996 to 1999, a period largely associated with the company's stunning loss of market share to Nike, when overall sales plunged 17 percent.

From 1999 to 2002, he served as chairman of BBM Holding, an investment vehicle set up to finance his sons' food import/export business. For three years beginning in 2002, Meers was CEO of Syratech Corp., a designer and maker of home décor items that went bankrupt in February 2005, a month before his contract expired.

In an e-mail Meers, who joined Reebok in 1984, said he worked for the company during "good and bad times," including during the high-octane growth fueled by the 1980s aerobic boom. He said he was tapped to lead the Reebok brand "because we had lost share" and under his leadership performance improved.

For now, Wall Street appears to be giving Meers the benefit of the doubt. Analysts cheered Lululemon's second quarter earnings report, despite the boost it got from one-time items. When a lower tax rate and lower expenses from fewer than expected store openings in the period are backed out, the company only just beat estimates.

To be sure, Lululemon's 30 percent sales growth at stores open at least a year in the period was impressive, even after subtracting the 5 percent gain from the strength of the Canadian dollar. The rapid pace of same-store sales growth is expected to slow next year, however, with some analysts predicting a drop to 12 percent and others going as low as 6 percent. With the company's share price continuing to climb - the stock is up 28 percent in the last month alone, despite no actual news - investors better hope that Lulu doesn't turn out to be a lemon.