Lululemon ($LULU)
Opportunity in the S&P500?
Lululemon stock is down almost 49% year-to-date and trades at 19x earnings on a market cap of $29.4 billion. One of the most recognizable athletic wear brands in the last few years has been facing problems, having to mark down their inventory in Q1 by 50bps, with growth in the U.S. slowing down and new competitors picking up steam. Despite this, consumers can’t seem to get enough of its clothes, with revenue growing 10%, EPS 11%, and comparable (same-store) sales up 7% in Q1 2024. Particularly important for their growth story, international and men’s revenue increased by 35% and 15% respectively. They also bought back around 1% of their shares during the quarter and raised their total repurchase plan. So all of this raises the question, Is this an attractive entry point for $LULU, or should investors remain patient for better opportunities? This write-up will aim to address just that, with a brief overview of the situation.
(For transparency, I do not have a position in Lululemon or any of its competitors/peers, nor am I looking to change that right now).
But first, here’s a one-page infographic on the company, courtesy of my X account (@investwithaarav). For more investing content and market commentary from me, feel free to give it a follow.
( share price, market cap, and PE ratio data are from two weeks ago)
Now that you’re familiar with the basic fundamentals, business model, historical return on invested capital, general risks, and valuation based on analyst estimates, let’s dive deeper into the results.
Lululemon's Q1 results were definitely concerning for some investors. A markdown in inventory adds to the fears about a growing competitive landscape with other brands starting to take bigger market share. Add that to modest 2% growth domestically, and you have the setup for a potential weakening of their competitive position going forward. On the other side of things, there have been internal problems that the management has addressed, such as stock, sizing, and color issues. It’s good to see them taking some level of responsibility, but questions remain about their ability to execute going forward. The key is whether you think these issues are temporary and the market is being too short-term focused or if they are indicative of longer-term issues that could hurt the brand positioning.
The brand's “mind-share” with consumers doesn’t seem to be eroding, but competitors like Alo, Artizia, Vuori, and Fabletics have been quickly gaining popularity in the athletic wear market. Over the long term, Lululemon’s economics have been very attractive, and historical returns on capital suggest opening new stores is very profitable for them. Whether the past is indicative of the future or not in this scenario depends on whether their competitive position has changed. In my view, this is the biggest risk for the business and could lead to lower returns on incremental invested capital despite the runway for reinvestment they have internationally.
Below is a chart of their sales per square foot, which have stayed relatively flat throughout their massive expansion in the last 10 years.
(They didn’t report the figure for 2020 because stores were closed)
This number is not available for many of its direct competitors. Aritzia estimates their sales per square foot is around $1,000, which makes sense given their lower price point and quality of merchandise. Fabletics is rumored to be considering an IPO in late 2024 or 2025 at a valuation of $5 billion, so that might give investors a better way to put Lululemon’s data in perspective. But relatively speaking, sales per square figures like this are healthy for a retailer.
In terms of product offering, brand positioning, pricing, and quality, I think Alo is the closest competitor. Thus, it’s important to note how they have been behaving strategy-wise
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Alo prefers opening stores close to existing Lululemon stores. This has been their strategy across many regional markets. Currently, it seems Lululemon stores haven’t suffered as a result of this strategy. However, this would be a good metric to keep an eye on in the future. An important thing to note is that an estimated 90% of Alo’s total revenue comes from online sales and subscriptions to their Alo Moves platform, where they offer fitness classes. Lululemon’s version of this is called Lululemon Studio (through their acquisition of Mirror) and is responsible for 3% of sales, whereas online represents 41%. This distinction is interesting, as it seems Alo is now shifting their attention towards building out a great retail presence. In recent times, its brand has become more and more recognizable among a more fitness-oriented demographic, capturing more market share.
Shifting to future growth drivers, I like Lululemon’s prospects for international expansion, especially in China. This could be a source for significant revenue growth ahead, helping to offset slowing domestic growth. Additionally, their focus on expanding into men’s apparel is also promising, and sales of their athletic shorts have taken off despite their high price point ($70-$90) and fierce competition from brands like Nike, Adidas, Under Armour, and Gymshark. Anecdotally, the Lululemon brand seems to be well-received in the new markets they are entering, which makes me think it might be stronger than investors give it credit for.
Another key point is the departure of their Chief Product Officer, Sun Choe, in May 2024, after almost 8 years with the company. News articles stated she left for a new opportunity, which was revealed 9 days later when she became the Global Brand President for the footwear company Vans (owned by V.F. Corp). Choe has been responsible for a huge part of Lulumon’s growth story, and this issue raises another red flag for investors. The company has chosen not to replace her and instead is splitting the responsibility she had between the Global Creative Director, Chief Brand & Product Activation Officer, Chief Merchandising offer, and a team of leaders from the Merchandising and Brand functions. Whether this is a better or worse structure remains to be seen.
Their CEO, Calvin McDonald, joined the company in 2018 and earned $16.5 million in total compensation for 2023 while owning $19 million worth of stock. The CFO, Meghan Frank, joined in 2016 and earned $4 million, with $2 million of stock. The EVP and President both earned $5.8m and have been with the company since 2021 and 2006. All together, insiders own 4.5% of the company. I don’t think the management team is as aligned with shareholders as I would like to see, but considering the size of the company, it could be worse.
Before going over the valuation and my conclusion, I’d like to reiterate all of the risks I’m seeing. First and foremost, as you can tell from the preceding paragraphs, I think competition is the biggest factor that needs to be assessed, along with the strength and durability of the Lululemon brand. If you were to research this business further or even own it, you would need to have a concrete view of this with adequate data or testimonials to back it up. Next in importance comes the execution going forward and whether the internal problems they are facing can be fixed. Finally, macroeconomic factors could play a larger role in the results going forward as more of the market becomes saturated. It makes sense for consumers to pull back on purchases of $50+ clothing and maybe opt for cheaper options during a recession. Lululemon is not a pure luxury player like LVMH, Hermes, Dior, or Burberry, but in the activewear market, it falls on the more expensive side. These are the three main risk factors I think investors need to be aware of based on my preview of the business. However, I’m sure there are many more scenarios or factors that could lead to a poor investment result.
Despite how crucial it is, my valuation sections are usually the simplest parts of my write-ups because it’s pretty straightforward to analyze for a normal business. You shouldn’t get too caught up in finding the exact intrinsic value because I guarantee nobody actually can. Instead, you should focus on establishing a range of reasonable values. Either the business is expensive, fairly priced, or cheap, with some grey area in between. If it’s expensive, it’s an immediate pass for me, but fairly priced or cheap means I spend a lot more time analyzing the quality and business economics. I also like to invert the valuation to help me understand the situation better. Instead of purely focusing on the price I get from the assumptions I’m making, I like to flip it around and look at what needs to happen for the current price to be justified.
Lululemon trades at a 2.8x EV/Sales with net margins stabilizing in the 16% range and 19x earnings and free cash flow. Inverting that multiple into a 5% earnings yield, I think it is priced for around 5-7% earnings growth, depending on how much they need to reinvest. Analysts and the management team think revenue and EPS will grow at 9-11% for the next few years, which seems fair. So, at current prices, it looks to be below fair value but not a huge margin of safety either. This doesn’t look like a bad setup for something like 9-13% returns under normal conditions. Compare that to the SP500 at 24 times earnings, arguably priced at 0-6% returns ahead, and it makes sense why a lot of investors are starting to get interested in the stock on a relative basis. On the flip side, in a situation where one or more of the risks discussed become more material and net margins contract a little, current prices might look more expensive in hindsight.
Overall, my conclusion is that Lululemon is a quality business, demonstrated by its strong brand, pricing power, and returns on capital, reasonably priced for market-beating returns. I’m reluctant to label it as a very high-quality business purely because I don’t know it well enough yet to make that judgment. For my ratings, I’m going to give it a 7.5/10 on business quality and a 6/10 on cheapness, with my overall interest level being a 6/10. As an investor focused on absolute returns, my interest level would be higher if I saw a greater margin of safety, but right now, you’re still paying up a little bit. If it were to get cheaper, I would probably decide to revisit the company and dive deeper into the business quality, durability of its growth, and longevity of its market position. Maybe something like 13x earnings would get me more interested in a company this size, where you’re paying for slightly below-average quality and growth, given the other opportunities I could spend my time on. Whether or not you pursue deeper research on Lululemon depends on how confident you are in assessing the situation and risks. But I can see why shareholders of this business might look to start accumulating more shares.
If you made it to the end, you might as well check out my current highest conviction idea here:
