LULU: Revisiting Lululemon

Lululemon Athletica, Q2 2022 Earnings

The last time I penned my thoughts about Lululemon LULU 0.00%↑ was December 2021 during a period when the core business shined and Lulu’s Mirror acquisition began to show the early signs of wilting in the face of declining demand. I was grateful that management’s commentary implied they would avoid throwing everything at an attempt to make Mirror, a business which comprised <3% of Lulu’s revenue at the time, work. They have since repurposed the business into a two-tiered subscription offering, branded under the parent’s more reputable name. The free tier (essential) is largely a loyalty program and the paid tier (Lululemon Studio) will replace the old Mirror membership, with the only remnants of Mirror being the hardware. A sensible decision to control a relatively contained ‘flop’ of an acquisition.

Elsewhere, the inflationary environment has continued to bleed into the financials via added expenditure across the supply chain and suppressed margins. Lulu’s average gross margin in the first half of this year is 55.2%, compared to 57.6% in 2021, and is expected to decline 100-130bps YoY by year’s end. However, the turnover of the business has borne witness to an unrelenting consumer. In the 9 months since I last wrote about Lululemon, YoY revenue has grown by 23%, 32%, and 29% across Q4 21’ through Q2 22’, for a trailing 12-month sum of $7.06B. One would assume that a premium apparel business would lose wallet share during the worst bout of inflation in decades, but Lulu’s core business of storefront and digital apparel distribution has continued to defy the odds. Whatsmore, executives feel so confident, that they strengthened full-year guidance for 2022; increasing mid-range revenue guidance by ~3.2% for the year (to $7.91B), suggested that an additional 5 storefronts will be opened (70→75), and improved their worst-case gross margin decline guidance by 20bps. A fair deal of time has passed since I last wrote about Lululemon, including three-quarters of results and one important Investor Day. I try not to get too bogged down with the minutiae, so will mostly be sticking to the stuff that matters. At present, Lululemon represents ~3.5% of my invested capital.

Catching Up - Verticals and the Power of Three 2.0

As far as context from the last 9 months goes, there are two developments (aside from the repurposing of Mirror) worth mentioning.

Verticals and Marketing

Firstly, the increasing breadth/depth of Lululemon’s SKUs. Some quarters ago, we learned that Lulu would be launching a shoe range, as well as a “play” range of clothing that fashions apparel for specific activities such as hiking, golf and tennis. There has yet to be any quantifiable data on either. It’s early days. The shoe range, thus far comprised of one unisex slider and four female sports sneaker designs, is a lower-margin product, but one that has created a new vertical, helping to upscale the wallet spend of existing customers and potentially aid customer acquisition. The “play” range, in my opinion, is an intelligent way of creating an illusion of product breadth. Today, the core line of Lulu apparel represents ~45% of their inventory. These are the staples, the legging pants, the ABC pants, et al. The items that bring consumers into the brand’s network. For years, customers have utilised these staples to engage in sports like golf, tennis, and hiking. There has never been a need to label a Lululemon product as “golf cargo short” or a “hike windbreaker jacket”. But doing so is smart, and here is why I think that to be the case.

Firstly, it creates a sense of specification whereby a keen golfer may purchase golf apparel simply because they feel it’s tailored for that sport. Regardless of whether or not that consumer is existing or newly activated, it alters the perception of Lululemon from “this is where I get my sportswear” to “this is where I get my golf wear”. The early evidence, according to McDonald, is that the Play range is more popular with existing consumers. It will be interesting to see if these ranges replace purchases of core items for existing customers or are supplementary to their spending patterns, thus increasing the average spend per user. I also feel that specialised ranges for individual sports may be a tailwind to new user acquisition. A way to introduce someone to the brand. I won’t go so far as to say this is a “TAM go Brrrrr” moment, but I can see how this may entice more male consumers to Lululemon, with golf, in particular, being a male-dominated sport. Outside of sports, the company’s line of accessories has proven to be a strong customer acquisition tool.

Lululemon “Everywhere Belt Bag”

The everywhere belt bag, priced at an unusually low £38 frequently brandishes a “sold out” sign and has been an exceptionally “great driver across existing guests as well as guest acquisition” according to McDonald. This, from my understanding, is why Lululemon has held off on pricing the accessory in line with the rest of their premium apparel. The success of this is evidenced by the fact that customer acquisition remains strong, with transacting frequency amongst new customers (+24% YoY) continuing to outpace that of existing customers (+17% YoY) in Q2.

The Power of Three 2.0

The other noteworthy development comes from an April investor day, where management refreshed its Power of Three growth plan by sticking a “2” on the end. Lululemon’s new 5-year plan, the Power of Three 2x, seeks to repeat the same goals they laid out in 2019; double the men’s & digital businesses and quadruple the international business. Whilst the repetition may seem uninspired, it’s worth remembering that these goals, previously set to a goal post of 2023 (with 2018 as the base year), were decimated ahead of schedule.

Lululemon doubled its digital business by 2020, its men’s business by 2022 and is set to quadruple its international business this year. Repeating those same goals, under a significantly larger base, is bold. The new plan guides for Lululemon to double annual turnover ($12.5B) and expand the DTC business to a scale that would be only ~10% smaller than the entirety of Lulu’s operation in 2021. Meaning, that management expects the LT composition of DTC to remain at ~45% of revenues. The strength of digital has been surprisingly resilient. After growing the DTC base by 100% in 2020 as digital supplemented in-store revenues, the division would grow a further 22% the following year. I recall believing that simply matching the prior year’s turnover would have been noteworthy.

All the while, store revenue has recovered in full, leaving me to believe that Lululemon did not only substitute store revenues for digital but, rather, grew their market share during this period. The sticking power of digital implies that the Lulu consumer has altered their purchasing behaviour, all the whilst increasing the number of consumers as a whole. This is important, because DTC possesses greater unit economics, and generates a higher proportion of segmented operating income per unit of revenue.

When entering a new market, Lululemon typically enters light on CapEx, building only a few stores, and pairs that with a full digital release. Just this quarter, they entered Spain for the first time, with a maiden store in Barcelona (2 more expected this year) and digital. Nike, a well-established retail company that turned over $44B in sales last year, scaled their own DTC arm from ~16% of revenues to ~42% over the past decade. Whilst I imagine Lululemon’s DTC composition oscillates between now and 5 years’ time, it doesn’t feel ostentatious to assume a mid-40s level is achievable by 2026.

As far as the men’s & international business goes nothing has changed from my comments in earlier memos. Initiatives for these goals tend to go hand in hand. Launch in new markets, release new verticals that appeal to targetted segment, and repeat. What is clear is that McDonald feels China will be a large part of the international equation; a market that is already the second largest by store count and one which is sought to be the second largest by revenue within 5 years. Mainland China is the first (presumably most important) pillar in the company’s three-pillar international strategy, followed by doubling down on core markets like the UK, Germany, South Korea, and Australia, and the scaling of existing and entrance into new markets.

As a follower of Starbucks SBUX 0.00%↑ , whose China division has been decimated this year due to the nation’s strict adherence to zero covid policy, it was surprising to note that Lululemon’s sales were up 30% YoY in the region; showing the power in an omnichannel distribution. Chinese consumers may not be allowed to leave their homes, but they can still order Lululemon online.

Demand has been unfettered

In Q4 2020 direct to consumer accounted for 52% of Lululemon’s sales. Around this time, the economy began to re-open and, over the following 12 months, investors were granted clarity on which companies had simply pulled-forward demand (revenues peaked and began to tumble) and those which had pulled-forward demand but, importantly, retained those new consumers as repeat purchasers. Things are crystal clear through the rearview mirror, I know, but each quarter this business has continued to demonstrate that demand has been strong for their goods, despite the fluctuation in spending patterns from digital to brick & mortar, despite the modest price increases in areas of Lulu’s product range, and despite the worsening macro environment. I believe Lululemon’s trailing TTM revenue base is an amicable illustration of that. Over the duration of the chart below, Lululemons trailing revenue, gross profit, and EBIT have expanded 60%, 62%, and 84%, respectively.

Consumer behaviour doesn’t appear to be relenting either. McDonald would state in the call that they are “not seeing any meaningful variation in cohort behaviour” despite the worsening macro outlook. On top of the healthy transacting volumes of customers cited earlier, traffic across both in-store (+30% YoY) and commerce (+40% YoY) remains strong.

Saving my breath before moving on, I believe the absence of declining demand is quite clear when observing each of Lululemon’s subcategories. All revenue segments have been robust, regardless of how you slice them. In the recent quarter, revenues of $1.89B (+29% YoY) came in above expectations, and comparable sales (+25% YoY) were strong with an 18% increase in stores and a 32% increase in digital. So far this year basic EPS ($3.75) is up 39% YoY. On top of all this, management has meaningfully raised its full-year guidance. These would be great results in any economic climate, but I find it particularly impressive considering the microenvironment we find ourselves in today and the fact that Lululemon is as close to the definition of discretionary retail as it gets.

Some positives with respect to costs

Seemingly absent in Lululemon’s turnover, the worsening macro environment is evident further down the income statement. Contrary to Lulu’s power of three plan, gross margins are expected to decline between 100bps to 130bps in 2022, albeit a slight concession from the 100-150bps range provided last quarter. Much of this is chalked up to declining product margins. While Lulu has marked up ~10% of its inventory to combat inflation, increasing sales volumes and declining margins are not the result of markdowns. McDonald repeated that Lulu “remains predominantly a full-price business, and we have not changed our promotional cadence or markdown strategy and we have no plans to do so”.

It’s mostly a matter of the supply chain seeping through into COGS. More specifically airfreight; a method of transportation not exhaustively used to transport inventory prior to the pandemic. Of the 150bps retraction in gross margin in Q2, 130bps of that was related to airfreight. This has been a recurring theme. I am unsure when these pressures alleviate, but alongside the rest of the goals within the Power of Three plan, McDonald has stated that over the next 5 years he expects gross (& EBIT) margin to improve relative to historic levels.

There does appear to be some near-term restitution coming, however. Commentary from the Q2 call suggests that ocean shipping times are shortening (yet remain elevated vs 2019) as well as declining airfreight rates. Previously guiding for airfreight to be ~30bps above last year, executives now believe it will come in at ~10 under 2021 levels. Improvements in vendor readiness, allowing the company to receive products sooner, and having shorted lead times were also cited. Around the same time last year, Lululemon were under-inventoried. So much so, that they feel they left revenue on the table in the Fall season. Days' inventory outstanding spiked largely as a factor of supply chain inefficiency, as opposed to any weakness in demand. To compensate, the company currently has ~$1.5B of inventory on the books (+85% YoY) and is said to be well positioned for the fall and winter seasons; important as the majority of its sales are weighted towards the back half of the year.

This additional inventory has had an outsized effect on changes to working capital when compared YoY. Despite net income for the year ($479.5M) being up 36%, the level of operating cash flow has fallen from inflows of $500M (2021 H1) to an outflow of $146M (2022 H1). However, Meghan Frank remarked that inventory levels at the close of the next quarter should represent the high-water line. It’s worth noting here that transport & handling costs are baked into the value of inventory, as they are attributable to bringing the inventories to their present location. I suspect that as these rates decline, and lead times normalise, that inventory will fall back to levels more in line with sales trends. In short, excess inventory feels temporal, so long as the demand momentum continues. Fall and Christmas are upon us, so I suspect they will.

Concluding Remarks

I believe the outlook for Lululemon’s year is set up relatively well; coming out of a 6 month period where many expected the inflationary environment to dampen the spirit of the Lululemon consumer having done exceptionally well, and with the busiest period of the year ahead of them still. It is my understanding that much of the “alpha” earned in investing comes from deciphering between what the market expects and whether or not you feel a company is set to either fall short or greatly exceed those expectations. Thus far, they have continued to exceed expectations. Looking ahead, in this case, Lululemon has provided us with the expectations; they want to compound revenue at a 15% CAGR from 2021 through 2026. Presumably, that is priced in unless the market still believes they stumble somewhere in the near term. Over the last decade, the market has, on average, priced Lululemon at ~36x NTM earnings. This is during a period where revenue, gross profit, and EBIT, all grew an average of ~20% (give or take) per year. During this period gross margin has expanded ~920bps from 2015, and EBIT margins have averaged ~21%. Today, Lululemon is priced at ~32x NTM earnings; not remarkably below 10Y averages when you consider the distortion from the last three years when the company traded at closer to 49x NTM earnings. So what are investors getting for that 32x multiple?

If we are to believe management and assume that the company meets, not exceeds as they have traditionally done, guidance, then over the coming 5 years revenue might well compound at ~15% per year, gross margin should modestly expand to the higher 50s and compound at ~15%, and EBIT margins may be closer to 25% than it is today. This is all under the assumption that Lululemon meets its audacious goals and I suspect this is where the expectations are. Thus, the expectation is that Lululemon continues to grow at an attractive clip, whilst expanding margins modestly, but at a slightly slower rate than they have in the last decade. Should Lululemon exceed expectations and grow at a similar clip to that which they have done over the past decade, then I suspect the current valuation is a fair price to pay. However, I don’t have that level of conviction or insight currently. In my case, I use the 2026 guidance as the base case, which I suspect is already baked in, and at 32x earnings, I don’t feel Lululemon screams buy here.

The company traded for between 21x to 25x earnings throughout much of 2017 and early 2018. Following that, the company dipped below 30x earnings only once, in the winter of 2018. So, the company seldom comes “cheap”, and I am not surprised. That said, at ~3.5% of my invested capital, I am not in a rush to buy whilst the market’s expectations are so positive. Despite firing on all cylinders, I feel that the expectations are pretty baked in, without much regard for the potential economic banana peels that may crop up in the near to medium term. As much as I believe they will be stronger in 5 years, I feel there may be more opportune moments to step in and buy, perhaps when sentiment is not as rosy. In the event that I am wrong, I am extremely content to continue holding my existing position for years to come.

Thanks for reading,

Conor