After some retail stocks were hit with relatively bearish price action, some investors might be weary of looking into the space for a new potential investment. That might make sense for those looking to avoid unnecessary risks, but keeping that attitude after last week’s rally in the overall market could be a mistake.
When it comes to apparel stocks, you have two main options: established legacy brands that are already scaled and well-known—like Nike Inc. (NYSE: NKE)—and smaller, more agile brands that are rapidly gaining popularity among new demographics and fashion-forward generations.
In the athleisure space, look at Lululemon Athletica Inc. (NASDAQ: LULU) and On Holding AG (NYSE: ONON). Both companies are thriving in a fast-growing U.S. market and offer significant upside potential. But how do you choose between them? Let's look at their latest quarterly financial results to help you decide.
Why ONON's Flat Price Action Doesn’t Tell the Whole Story
Even though the stock was relatively flat to the end of the day after its quarterly earnings announcement, On's results offer a clearer perspective on where the price may be headed in the coming quarters. Starting with some common key performance indicators (KPIs), here’s what investors can deduce from those results.
Revenue for the quarter grew by 32.3% over the past 12 months, far from a trend that belongs to a stock that should be flat on these numbers. Then there is the company's gross profit margin, which expanded by over 1% to reach a high of 60% today, leading the industry’s average.
In contrast, Lululemon’s latest quarter showed revenue growth of only 7% on the year, significantly below On. Both companies are still within the 60% to 58% range on a gross margin basis, so there is nothing one can say about the other there. However, if On can keep delivering double-digit revenue growth with high margins, the stock price should follow.
This is why investors should not focus solely on On's multi-million dollar loss in foreign exchange rates, which significantly drew down the company’s reported net income by as much as 48% from the previous year. You can get a better idea about the company’s true earning power by looking at its cash flow statement. Specifically, cash flow from operating activities, which showed growth of over 208% in the year. On the other hand, Lululemon’s cash flow statement shows an operating cash flow growth of only 9.3% for the year.
It’s becoming clear which company has the stronger momentum behind it.
The divergence between On stock’s price action and the actual business results, which isn’t fully reflected in the income statement, should catch the attention of buyers seeking a growth stock in the retail sector.
Market View: On Holding vs. Lululemon
Let's start with one of the most important metrics of all: price action and momentum. ONON trades at 97% of its 52-week high—bullish momentum fit for a company that has just grown its operating cash flows by 208% in just one year. On the flip side, LULU traded down to 62% of its 52-week high, reflecting the reduced optimism of the market.
Why pay a premium for a stock with only single-digit growth?
This question is highlighted by short interest: LULU's short interest rose by 3.9% in the past month, while ONON's declined by 2.3%.
These numbers show that bears think Lululemon could still have more downside room and that On's stock may still have room to set new highs, even if Wall Street analysts won’t reflect the financial discrepancy in their price targets. That’s not a problem for investors, though, as eventually, the market will close the gap to reflect what is seen in the cash flow statement.
Today, markets are willing to pay up a price-to-earnings (P/E) of as much as 97.7x for On stock, while only 24.8x for Lululemon stock. Some may call this expensive, but those who understand the mechanics of the markets will know that stocks expected to outperform in the near term will typically have a higher valuation attached to them.
Will these expectations be fulfilled?
Only time will tell, but for the coming quarters, investors might find more upside with On in the apparel sector, even if Lululemon remains the more recognizable brand for now.
