By
Road Less Invested
:
A typical discussion on
lululemon athletica inc.
(
LULU
) is like a typical discussion on climate change. People are
labeled "believers" or "skeptics," and little actual science is
ever discussed. This article intends to present the science behind
LULU as an investment today. Unfortunately, our findings suggest
long-term holders will be disappointed, but not because the
business model is broken. Long-term holders will be disappointed
because LULU's stock price already discounts a best case
scenario.
Executive Summary
lululemon has achieved truly atmospheric returns on capital and
growth due to its innovative business model. However, with limited
barriers to entry, we believe the environment will get more
competitive over time. In addition, lululemon's business model
involves tradeoffs between operational efficiency and growth.
Therefore, we do not see the underlying growth drivers accelerating
from 2012 levels. In fact, same store sales growth and new store
economics should naturally moderate over time.
We believe the company is fairly valued near $44.00 per share.
While we believe there are plausible cases that present significant
upside to this valuation, we have little reason to be aggressive
considering margins appear to have peaked, growth is declining and
earnings quality has deteriorated. We strongly caution against
investing in LULU at current market prices and suggest looking for
a margin of safety even on our $44 estimate.
Brief Company Overview
lululemon athletica inc. is a designer and retailer of yoga
inspired, technical athletic apparel operating primarily in North
America and Australia. The company's target customer is a
sophisticated and educated woman who is engaged in an active,
healthy lifestyle. The company has introduced some men's products
as well. As of July 29, 2012, the company operated 189 store
locations worldwide, and additionally sells its products online
through its own website.
The company boasts the highest retail sales per square foot in
the retail apparel industry with comparable store sales hovering
around $2,004 / s.f., nearly 6 times Gap Inc.'s $337 in sales /
s.f. across its portfolio in FY2011. The company has grown its
revenues at over a 40% CAGR over the past five years and its
earnings per share at over 70% per year. The company currently
trades for approximately 45.8x trailing twelve month earnings per
share (based on Friday's close of $68.02).
(click to enlarge)
Source: Price and volume data from finance.yahoo.com.
Industry Competitive Dynamics
The retail and athletic apparel markets can be characterized as
highly competitive, with many well capitalized competitors such as
athletic apparel maker Nike (
NKE
) and traditional retail apparel companies such as Gap Inc. (
GPS
) Firms compete on price and quality, with brand and perceived
quality playing an important role. Fashion trends and changing
consumer preferences are also important. We believe LULU has
developed a unique strategy that has proven both successful and
hard for existing competitors to replicate (to be described in more
detail in the next section).
It is important to note that there are limited to no barriers to
entering this industry. Manufacturing and distribution can be
outsourced; real estate can be leased. For little more than the
cost of opening a store, an idea can be tested. Several direct
competitors, in fact, have emerged, such as lucy activewear, which
was acquired by VF Corporation (
VFC
), and Athletica, which was acquired by Gap Inc. We expect others
to enter the market going forward.
Why These Competitive Dynamics Matter
lululemon's economics provide competitors a compelling rationale
to compete with them. Below is our calculation of lululemon's
return on average capital employed. Note that we have backed out
capital tied to the company's $65 million purchase of its corporate
headquarters building in March 2011 (this purchase converted a
small operating lease into a fairly significant capital investment
relative to other assets which we believe skews the metrics).
(click to enlarge)
Source: Company Financials and Road Less Invested analysis.
LULU's return on invested capital is more than 100%. For every
$1 million it invests in a new store, it is getting approximately
$1.25 million back in earnings. If LULU had been turning out 30%
ROEs, competitors might be less compelled to chase them because
there would be less room to maneuver competitively (in terms of
margins vs. asset turns). But in this case, competitors can pass
meaningful economics on to customers and still earn a fair return
on capital.
Bottom line: we expect the market to get more competitive going
forward, not less.
Understanding LULU's Business Strategy
Michael Porter, the grandfather of competitive strategy, defines
strategy as "deliberately choosing a different set of activities to
deliver a unique mix of value." lululemon's innovative strategy is
an excellent example. The core of LULU's business strategy is five
self reinforcing activities that are challenging to replicate and
offer unique value to customers. The key components are as
follows:
-
Focus on Underserved and Growing Customer Segment.
lululemon's business is focused on sophisticated and educated
women interested in an active and healthy lifestyle, particularly
yoga and running. The "underserved" part of the story may no
longer be true.
-
Provide Innovative, High Quality Products Designed for this
Target Audience.
lululemon's products are highly technical and are designed to
perform better for the intended activities and audience. Designed
with its target customer segment in mind, products offer a
"flattering fit" and intricate, "beautiful" design details.
-
Community Based Marketing.
LULU's grass roots marketing approach intertwines the lifestyle
with the brand. LULU develops relationships with local
"ambassadors," or local yoga and other fitness instructors. In
addition, it sponsors and supports community boards and events,
and even in-store yoga and running clubs.
-
Store Locations Chosen to Support Brand.
lululemon targets street and lifestyle center locations that are
integral parts of its community, effectively helping to support
community based marketing efforts noted in point 3.
-
Highly Educated Employees.
Store employees, referred to as "educators," are highly trained
to understand benefits and features of products. Employees are
encouraged to form personal relationships with customers.
Points 1 and 2 boil down to this: target a specific customer,
then give that customer what they want. This is marketing 101, and
a simple strategy that practically any competitor can follow. The
key to appreciating LULU's success is to understand points 3
through 5. Fundamentally, these activities support and validate its
customer's lifestyle: LULU helps its customers live the life that
they desire and add unique value. Further, it is extremely
challenging, if not impossible, for an existing competitor to mimic
LULU in points 3 through 5. This has thus far given LULU a
competitive advantage.
However, with limited barriers to entry, it should be expected
that new competitors will enter the industry and that these new
competitors will try to replicate part or all of lululemon's
strategy. This explains why larger competitors, such as Gap and VF
Corporation, have purchased smaller upstart brands in this space
rather than directly competing with lululemon from within its
existing platforms. The benefit from lululemon's perspective is
that it will take these competitors considerable time to build out
its own platforms to compete. Therefore, we believe the company has
a fairly significant runway ahead of it, but should feel modest
competitive pressure on its margins and asset turnover over
time.
LULU's Business Model - Other Considerations
lululemon's business model and strategy requires tradeoffs
between growth and what we will label operational effectiveness. It
is important to realize that competitors attempting to copy the
company will face similar tradeoffs.
Community Based Marketing Approach Slows Geographic
Expansion
Community based, grass roots marketing is the most
differentiating factor of lululemon. However, to successfully
execute this strategy requires careful planning and maintenance.
Prior to entering a market, lululemon often spends years
cultivating relationships with local "ambassadors" and other
stakeholders. While this strategy creates strong brand identity and
loyalty, it takes considerable time to develop. Ultimately, this
limits how quickly the company can expand geographically outside of
its current footprint.
Employee Training Requirements Limit Ability to Open New
Stores
Opening new stores requires that LULU find and train new
employees. In addition, it must instill the company values and
culture onto these new employees. This is a process that takes both
time and resources, and you must have the resources in the market
you are targeting. Maintaining this culture and control over the
store environment ultimately limits how quickly it can open
stores.
Store Size Limits Ability to Expand Into New Product
Categories
Store size is an important component of LULU's strategy. LULU
targets stores that are smaller than 4,000 s.f. in size. In fact,
its stores average approximately 2,850 s.f.. Management has
indicated that smaller size stores help keep the energy level of
its store environment high, and prevents employees from having to
chase customers around a seemingly empty store. However, small
stores limit LULU's ability to expand into new product categories
or target new customers. Don't take our word for it. When analysts
asked the company whether it planned to expand the sizes it
carries, here is its response:
"We are not planning on introducing larger sizes. If you took
all of our colors and styles in our size of store and added
additional sizes, we just physically cannot put the product in
the size stores that we have today." Christine M. Day, 2012 Q2
Earnings Call.
Source
.
Real Estate Strategy And Future Store Metrics
Our analysis indicates that LULU's management has remained very
disciplined in regards to store locations, and has for the most
part only opened stores in premiere retail locations. This
disciplined strategy has been a key to its success and in part
explains its industry leading sales / s.f. metrics. In other words,
it has focused on the best locations in the best markets for its
products. This is not surprising. In the words of Christina Day,
CEO, on the company's second quarter earnings call:
"So the strength of our real estate strategy drives the
strength of our business."
Source
.
We applaud the company for its disciplined strategy, however, we
must note that the best locations in the best markets eventually
dry up. Management believes that North America will support 350
stores. We believe that store 300 will likely have less attractive
sales metrics than store 150. This question was asked directly on
the company's Q4 2011 earnings call. Management danced around the
direct question, but effectively confirmed this (and our next
point) in their response. To paraphrase their response, management
essentially said that new store sales may look a bit different or
be in different formats to what the company offers today, but when
you look at the additional impact of online sales, the economics
are still attractive.
Online Sales Growth Intimately Tied to Store Growth
The success of lululemon, and its continued ability to sell at a
premium to competitors, is largely attributable to its unique
branding efforts which involve community based marketing. The
company has eschewed traditional advertising outlets. For this
reason, we believe that the company's online sales are really an
extension of the store front given that customers find lululemon
through word of mouth and brand recognition is critical. In
addition, store employees play an important role in communicating
the benefits of its products.
Summing These Points Up
None of these issues represent fundamental issues, but they do
limit the company's ability to scale its growth. That is not the
same as saying that growth is slowing dramatically. What it does
mean is that when we are assessing the future, we must account for
the following:
- It is unlikely the company will materially increase the
number of stores it opens per year from current rates.
- The company is not likely to expand meaningfully beyond its
core customer segment and core yoga and running apparel -
frankly, current store sizes do allow the company to expand
meaningfully outside these categories. We believe same store
sales growth must moderate from current mid-teen levels as
product mix is optimized.
- Expect sales per s.f. to moderate somewhat for new stores as
lululemon approaches its target size of 350 stores in North
America.
- Online sales will likely cap out at some % of actual store
sales. While it is very difficult to predict what this point will
be, we believe 35% of store sales seems like a reasonable target.
Recognizing that this is, at best, a guess, we still believe some
form of this limitation should be reflected in forecasts of the
future.
- New competitors, trying to copy lululemon's format
completely, will face similar difficulties scaling its business.
This should provide lululemon some flexibility to continue growth
over the next several years with limited competitive
pressure.
Assessing Financial Performance
We have assessed LULU's historical performance in terms of
margins, growth and earnings quality.
Margins
lululemon has experienced significant margin expansion over last
three years driven by same store sales growth and fixed store
expenses such as D&A, as well as corporate overhead costs not
growing as quickly as revenues. This has led to over 5 points of
gross margin benefit and 5 points of SG&A decrease as a
percentage of sales. This can be seen below in the common size
income statement:
(click to enlarge)
Source: Company Financials and Road Less Invested analysis.
However, 2012 has shown a reversal of these trends and this is
additionally reflected in management's guidance. Gross margin for
the year is expected to be a hair under 55%, which is the company's
long-term stated target but a bit lower than 2011 levels. In fact,
company guidance for EPS of $1.79 and revenues of $1,352 mm (both
midpoint estimates) suggest profit margin of 19.2%, somewhat better
than 18.4% in 2011. However, EPS guidance of $1.79 includes the
impact of a one-time change in the tax-rate from roughly 36.5% to
29.5%. Excluding the impact of this tax benefit, net profit margin
was estimated to decrease to 17.2% this year. The reasons for this
include increased costs associated with international expansion, IT
development costs and others changes. CFO John E. Currie made the
following statement on LULU's Q2 earnings call:
"[W]e expect operating margin to deleverage slightly from the
peak levels seen in 2011."
Source
.
We note that he refers to 2011 as peak margins and that the
company in fact targets long-term gross margins slightly lower than
2011 levels.
Growth
The company has grown its top line revenues over the past five
years at a 46.6% CAGR, which, coupled with the margin expansion
described above has produced over 70% CAGR in earnings during the
same period. The chart below illustrates LULU's annual revenue
growth, as well as the implied revenue growth embedded in
management's guidance for 2012.
(click to enlarge)
Source: Company financials and Road Less Invested analysis.
While revenue growth has been somewhat volatile, this is not
surprising given the small size of the company and the financial
crisis in 2008 and 2009. However, we cannot help but note the
slowdown in growth between 2010 and 2012 guidance from 57.1% in
2010, to 40.6% in 2011 to an implied 35.1% in 2012. Top line growth
has slowed materially, a trend to watch going forward.
Taking the analysis one step further, we have broken down
corporate owned store revenues by source over the last several
years. This information is shown below:
(click to enlarge)
Source: Company financials and Road Less Invested analysis.
As shown, approximately 10% of the store revenue increases from
2007 to 2011 came from unsustainable sources including changes in
foreign currency exchange and the re-acquisition of outstanding
franchises. Of the remaining "sustainable" growth, approximately
50% came from increases in comparable store sales and 50% from new
store openings. This is an important consideration. As the store
base grows, the impact of opening new stores will moderate over
time since. As we have already discussed, it will be difficult to
scale up the number of store openings per year. Therefore, over
time we would expect comparable store sales growth to become
increasingly more important. However, this is a metric that becomes
increasingly hard to drive higher with the company's own success
(not to mention the natural limitation of store size, limited
ability to carry more products, and limitations on the target
market).
Earnings Quality
We believe that earnings quality has deteriorated over the past
few years, however, there are no definitive red flags. Perhaps the
biggest consideration involves the growth of inventories. As shown
below, inventory has grown faster than revenues in each of the last
four quarters. This is a typical warning sign for a slowing
environment and coming inventory markdowns, however management has
stated that increased inventory is a result of growth, in
particular very rapid online sales growth that is requiring the
company to hold more inventory.
Source: Company financials and Road Less Invested analysis.
While we have no reason to doubt management's rationale, we do
note that accruals for inventory obsolescence declined during the
same period inventories began growing. This is a very
counterintuitive result. Presented below is the company's provision
for Shrink and Obsolescence as a percentage of gross inventory.
Source: Company financials and Road Less Invested analysis.
What we find interesting is that this decline in accrual came
during a period when the gross margin of the company came under
inflationary pressures. This change would have helped offset these
pressures. Also note, the current accrual levels are similar to
levels seen in 2007 and 2008, prior to the impact of the recession,
and are not new levels for the company.
Another earnings quality consideration is what we are calling
the "Curious Case of lululemon's Corporate Headquarters." In March
2011, the company acquired the building that housed its Global
Store Support Centre for $65.1 million, which represented 53%(!) of
their capital expenditures in 2011 despite opening stores
equivalent to 30% of its store base. What we found most interesting
is that the company attributed $60 million of the purchase to land
and approximately $5.1 million to the building. As a result, this
$65 million capital expenditure likely only results in a $150,000
annual depreciation expense assuming a 30 year useful life for the
building. We believe the company was likely paying significantly
more to lease the approximately 70,000 s.f. of this building it was
already occupying. And because the value is primarily attributed to
land, lululemon will not get a tax deduction for depreciation of
$60 mm of the purchase. We believe the accounting for this
transaction is EPS driven and not shareholder friendly.
You might be wondering why we have delved into the building
purchase. Two reasons. First, in 2011, same store comparable sales
grew an outstanding 22% and net profit margins improved from 17.1%
to 18.4%. Despite this good news, return on average capital
employed actually declined by over 30 percentage points. These are
striking opposites! Second, the company recently acquired one of
its store locations in Boston. Our quick analysis suggests that
again the company has allocated more than 80% of the purchase to
land. This practice will benefit operating margins over time as
depreciation will be less than lease expense, and depreciation will
be fixed (i.e. not reflect inflation). Management's rationale for
the purchase was that it was a "permanent location." While we do
not doubt the rationale for the purchase or that it was the right
decision, we do caution long-term investors to consider whether the
financials going forward fully reflect the cost of these purchases.
We expect management to make similar acquisitions going
forward.
Finally, we note that depreciation as a % of gross PP&E,
excluding land, declined significantly from 2010 to 2011. That
said, this trend appears to have reversed itself in 2012 and may
represent a timing issue of when expenditures were made. We look
forward to assessing full year 2012 financials. These PP&E
issues are all relatively minor and may be readily explained by
changes made in good faith by management due to business
conditions. We are not accusing the management of wrong doing, just
observing the record with a healthy dose of skepticism.
However, growth in inventories outpacing growth revenues is a
classic sign of problems to come. We remain cautious on this
point.
Valuation
Valuing a company with a stock price as lofty as lululemon's is
always a challenging exercise. A vast majority of the value is
dependent on future growth expectations. In the case of lululemon,
current book value equates to about $5.00 per share and current
earnings support a $15 to $20 valuation (10 to 13 times LTM
earnings). The remaining value gap is explained by growth
expectations.
We have assessed LULU's value under five separate earnings
forecast scenarios. In each case, we value lululemon at the end of
our six year forecast using a 20.0x LTM price to earnings multiple,
equivalent to where Nike trades today on a LTM basis. We add to
this valuation excess cash we forecast to be on LULU's balance
sheet at the time. We then discount the value back to the present
at 12%.
We believe a 20.0x LTM P/E multiple at the end of 2017 is more
than adequate. First, by this time, growth will have slowed and the
five year outlook will likely be less than a 20% CAGR. This means a
20.0x multiple will represent a 1.0x PEG ratio or higher. While
certainly Nike's PEG ratio is considerably higher today, we will
caution that interest rates are very low. As interest rates rise in
the future, we believe what has been the historical standard of
1.0x or a slightly higher PEG ratio will again make good economic
sense. Second, we must believe that a 20.0x multiple is still a
"big time" multiple that incorporates the assumption of future
growth. We see little incentive as an investor to be aggressive on
valuation assumptions.
Note, all financial cases and figures shown below are based on
Road Less Invested analysis.
Case 1: Everything Goes Right
Case 1 assumes the company opens 30 to 40 stores per year. Same
store sales growth continues in the mid-teens range experienced in
2012 throughout the forecast period. Online revenues grow at a CAGR
of nearly 50% over the six year period from 2011 to 2017. The
company experiences moderate operating leverage, with net profit
margin improving from 18.4% in 2011 to 22.4% in 2017. Resulting
earnings grow at a 30% compound annual growth rate.
(click to enlarge)
In this case, we value the company today at $77.00 per
share.
Case 2: Operating Margins Remain At 2012 Levels
Case 2 presents identical assumptions to Case 1 except that
operating margins remain fixed going forward (i.e. the company no
longer benefits from operating leverage), consistent with the
company's experience in 2012.
(click to enlarge)
In Case 2, we value the company at $66.00.
Case 3: Same Store Sales Growth Moderates Over Time
This case is identical to Case 2, except rather than assume
comparable same store sales grow at 15% indefinitely, we assume
growth moderates over time. Specifically, we assume that same store
sales growth remains at mid-teen levels from 2012 through the end
of 2014, then moderates down 2.5% per year to a level of 7.5% in
2017. Given our analysis above regarding store sizes, this is not a
draconian assumption. The company itself has noted that more mature
stores in Canada have experienced a similar slow down.
(click to enlarge)
In Case 3, we value the company at $60.00 per share.
Case 4: New Store Economics Moderately Decline, Online
Revenues Capped
This case is identical to Case 3, except that we now assume that
new store sales / s.f. trend down to around $650 / s.f. in 2017
from approximately $900 / s.f. in 2011. In addition, we cap online
revenues at 35% of store revenues. This trending down of sales /
s.f. at new stores is meant to reflect more marginal locations as
the company approaches its 350-store target in North America.
Capping online revenues reflects our view that given the company's
marketing approach, online revenues are really an extension of
store sales. Note, that the impact of this cap slows the CAGR of
online revenues from approximately 48.8% to 40.7%, still a
meaningful growth rate over the period.
(click to enlarge)
In Case 4, we value the company at $53.00 per share.
Case 5: Modest Decline in Gross Margin Over Time
Case 5 is identical to Case 4, except that we assume that modest
competitive pressure causes gross margin to retreat to 2008 / 2009
levels. As a result, net profit margins decline from 18.4% in 2011
to 15.4% in 2017. Note, these profitability levels remain firmly
above Nike's LTM profit margin of approximately 9% and the Gap
Inc.'s profit margin of approximately 7%. In addition, this
forecast still assumes LULU retains industry leading $ / s.f.
sales, margins and return on capital metrics.
(click to enlarge)
In Case 5, we value the company at $44.00 per share.
Valuation Summary
We believe all five cases presented are plausible. However, only
cases 4 and 5 reflect our judgment based on the competitive
dynamics of the industry and the company's business model. We
believe the fair value for the company is at the low end of the
range of scenarios presented.
(click to enlarge)
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
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