Hot Stocks for a Cool Market: lululemon athletica

Summer's heating up, but apparently the stock market didn't get that memo. Still, there are plenty of places for burned investors to find respite. In this series, we highlight companies we think will warm up your portfolio's returns.

Picture this: A crowd of investors donning moisture-wicking, preshrunk luon yoga pants and striking the downward-facing dog pose in front of the doors of retailer lululemon athletica (LULU).

It may be an incongruous image, but this yoga and fitness specialist has earned the awe of stock watchers and customers alike. While the general market has gained a respectable 5% at about the halfway mark of 2011, lululemon is up more than 70%. Its stock price has tripled in the past year, and has increased more than tenfold since the depths of the Great Recession.

Its customers are fanatical about the workout apparel that lululemon designs and sells; they shrug off the high prices and just keep exercising in style. The premium price tag extends to the stock as well. But looking five and 10 years down the road, I see this becoming one of the world's great athletic brands.

Fantastic Financials

In almost any way you can measure it, lululemon is a better operator than any of its competitors. As an investor focused on long-term rewards, this is extremely important to me.

Consider these metrics:

Source: Capital IQ. TTM = trailing 12 months. ROE = return on equity. NM = not meaningful.

This kind of dominance highlights the competitive advantage of this company's brand. Athletes are simply willing to pay a premium for the quality and durability of lululemon apparel.

Men Matter to Lulu's Future

While the company is executing every pose perfectly, the stock is richly valued by any traditional measure. So where will the growth I'm counting on come from -- the kind that would make this not only a good company, but a good investment? Four areas:

1. Expansion beyond the company's core yoga base. Yoga will always be the heart of lululemon, but it provides wonderful leverage into other sports. For example, running apparel already accounts for about 20% of revenue. Management is also moving into other activities, such as cycling, and is already big in dance and gymnastics through its ivivva brand for young girls.

2. Wooing men. Men's apparel accounts for only about 10% of the business, but CFO John Currie told Reuters that men's sales hit a record 13.7% in Q4. I think this will grow slowly but surely over the next few years as men begin to experience the quality of the products.

3. International growth. U.S. growth is still the low-hanging fruit, but that's already priced into the stock. International expansion is the key, and it's already under way. There are several corporate-owned stores in Australia. There's a showroom in Hong Kong that's showing good results. There's promise in Europe based on online sales. Speaking of which ...

4. Online sales. The in-store experience will continue to be the great growth driver, but Internet sales are already 10% of the business and growing fast. The company is just finishing up an overhaul of its e-commerce system, and is ready to concentrate more resources on the online experience.

What Could Tear the Fabric?

The biggest risk for lululemon lies outside its control: the economy (the U.S. and Canada in particular). CEO Christine Day summed it up in the most recent conference call: "We feel very in control of our business and the variables we can manage, so we see the risk and the things that we can't" in the macro environment. Another vicious recession would be very painful for any high-end retailer.

There are also the standard threats from well-financed competitors like Nike and Under Armour, and a more direct one from The Gap's Athleta line. I'm going to keep an eye on sales trends, margins, and returns on investment to monitor whether competitors are making any inroads.

The Bottom Line

This is a high-risk, high-potential-reward kind of stock, but I recommend it if you can maintain a long-term perspective. You may even want to think about buying in thirds -- that is, filling out a normal position over several weeks or months with three separate purchases. Such dollar-cost averaging gives you the advantage of getting into the game now, but also provides you with a better average cost if the stock should fall.

Lululemon's stock price will certainly jump around like a gymnast on caffeine, but if you have the temperament to keep a yoga-like calm about you, I believe you'll be well-rewarded down the road.

Motley Fool analyst Rex Moore owns shares of lululemon athletica. The Motley Fool owns shares of Under Armour, lululemon athletica, adidas, and Gap.