Stock Investing

These stocks are trading at premiums to their fair value, but they merit keeping an eye on.
By Vikram Barhat | 08/08/18

Hollywood star Kate Hudson's athletic wear company Fabletics has garnered much media attention the past month. That the brand is rapidly expanding its global footprint is a testament to the growing popularity and profitability of athletic wear, fuelled by changing consumer tastes.

About the Author
Vikram Barhat is a Toronto-based financial writer specializing in investing, personal finance and small business. His experience working in various editorial capacities in digital and print media spans more than a decade across three continents. He has written for CNBC, BBC, The Globe and Mail, the Toronto Star and other publications. He can be reached on Twitter @vikrambarhath.

As fitness and fashion clothing continue to blend into everyday casual wear, leading companies in the sports apparel industry are pulling out all the stops to bring innovative activewear that marry the elegance of fashionwear to the comfort of sportswear. From yoga pants to designer hoodies, consumers globally are lapping up high-performance gear whether to sport them at fitness sessions or just to lounge around in them at home.

Fittingly, global athletic wear sales are projected by Morgan Stanley to grow from US$279 billion in 2016 to US$357 billion in 2021, or 28%, with Asia and Latin America accounting for the bulk of sales.

Leading brands have been investing heavily in research and development, and are well positioned to take advantage of newer trends that are fuelling the industry growth. The following companies have strong fundamentals, robust brand equity, consumer affinity and a business mix that caters to a wide array of sartorial preferences across demographics, according to Morningstar research.

Given their growth trajectory and industry dominance, it's little surprise their stocks are trading at premiums. Investors may want to wait for a meaningful pullback to create some margin of safety and an attractive entry point.

Nike Inc. Class B
Ticker:NKE
Current yield:0.99%
Forward P/E:29.8
Price:US$78.49
Fair value:US$70
Value:12.1% Premium
Data as of Aug. 3, 2018

 Nike (NKE) is the world's largest athletic apparel, footwear and performance sporting goods company, whose iconic swoosh logo and 'Just Do It' tagline are globally recognized. The firm sells to more than 50,000 retailers across 170 countries.

The company's international expansion and association with high-profile dominance will continue to make Nike a standout brand with a long growth runway, says a Morningstar report.

Nike holds 50% market share in the United States and 19% in China, and is a key sponsor of some of the world's biggest sporting events. "Despite its leading share and global reach, we expect the firm to enjoy outsize top-line growth as a result of opportunities in its international segment, as athletic participation rates expand globally, particularly in the fast-growing soccer market where it holds a dominant position," says Morningstar sector strategist R.J. Hottovy, noting the sports brand has "the potential for long-run expansion in China" as the middle class is set to triple by 2020.

Nike's sustainable competitive advantage stems from strong brand recognition and dominant cost advantages. "Nike is one of the best-known sports brands in the world and has become synonymous with performance and innovation, backed by superior product-development technologies and marketing efficiency," says Hottovy, who estimates the stock is worth US$70.

Nike is beefing up its direct-to-consumer network, comprising owned retail stores and its website as it responds to shifting purchase patterns, adds Hottovy. To bring merchandise closer to the end consumer, Nike has forged a partnership with Amazon to sell footwear, apparel and accessories on the platform starting later this year.

VF Corp.
Ticker:VFC
Current yield:1.95%
Forward P/E:29.2
Price:US$92.25
Fair value:US$80
Value:15.3% Premium
Data as of Aug. 3, 2018

 VF Corporation (VFC) owns a large portfolio of leading lifestyle brands across outdoor, active, jeanswear and work segments. The company, which owns the North Face, Wrangler, Timberland and Lee brands, generated 46% of revenue internationally, while the direct-to-consumer channel accounted for 32% of revenue.

"The international channel will be another high-growth channel with the potential to continue growing at a high-single-digit annual rate over the next five years," says a Morningstar report, noting the growth will be "particularly driven by China, with 300 million new consumers entering the middle class."

The company's sustainable competitive advantage, or wide moat, is built on brand assets and pricing power, which it has kept intact by shedding declining brands, nurturing growing brands and acquiring strong brands. "The company bases its acquisition strategy and brand positioning on intense consumer research and reviews its brand portfolio annually to divest itself of any brands that do not make strategic sense for the overall portfolio," says Morningstar equity analyst Dan Wasiolek, adding that the strategy will ensure that the VF brand remains strong over a significant period.

VF has retained absolute control over product and experiences in the e-commerce space. The firm's direct-to-consumer channel accounted for as much as a third of revenue in 2017, prompting Wasiolek to raise the stock's fair value from US$76 to US$80.

Morningstar forecasts VF to achieve 21.8% average return on invested capital over the next five years, far above its 8.6% average cost of capital, and projects its outdoor and active segments (representing nearly 70% of total revenue) to clock annual sales growth of 7% and 8%, respectively, over the next five years.

Lululemon Athletica Inc.
Ticker:LULU
Current yield:-
Forward P/E:38.8
Price:US$124.92
Fair value:US$73
Value:71.1% Premium
Data as of Aug. 3, 2018

Vancouver-based  Lululemon (LULU) designs and retails athletic wear sold globally under its namesake brand. The maker of contour-clinging stretch yoga pants generates most of its revenue from women's apparel, but is expanding into menswear and accessories. In addition to direct-to-consumer online sales, Lululemon operates roughly 400 stores, with more than 300 in North America, and the rest sprinkled across the globe.

Lulu's high-quality products and brand recognition have helped the company gain market dominance and successfully fend off competition without diluting pricing power. "Its business model -- selling almost exclusively directly to consumers -- allows it to keep a grip on customer relationships, which enhances loyalty and gives the company further insights into evolving consumer trends," says a Morningstar equity report.

The company benefits from a greater acceptance of casual clothing in multiple environments. "We expect that acceptance to persist and for many consumers to choose comfort when given the option," says Morningstar equity analyst Sonia Vora. "Far more important, a shift in what people wear while exercising -- higher-quality, technologically advanced fabrics that offer style -- is the main fuel for our growth assumptions."

Lululemon's competitive edge is evidenced by its industry-leading gross margins (averaging 53%) and double-digit average annual same-store sales growth since 2010. Moreover, the firm has generated average annual returns on invested capital of over 30% over the past 10 years, and will continue to generate returns in excess of its cost of capital for the next decade, says Vora, who recently raised the stock's fair value from US$69 to US$73, boosted by near-term revenue outlook.

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