Lululemon: Can Lulu Return to its Former Glory?

LULU Cover 2.jpg

Lululemon was at one point on top of the world. The company's yoga pants became a huge hit - not just with hardcore yoga practitioners, but also with a more casual audience. The stock grew from ~$4 in 2009 to its peak of $82 in June 2013. However, that year, the company ran into a slew of quality-control issues (see-through pants, pilling), increased competition (Nike, Under Armour, and a bunch of copycats), and supply chain problems. And more recently, just as the company was beginning to return to a solid state of revenue growth and margin expansion, the company again ran into execution-related issues in 1Q17. As a result, the company now sits 34% off of its 2013 peak, which it had recently approached in August of last year.

The key issue to the stock going forward can be summed up as:

Comparable sales trajectory: will it grow to the mid-single to the high-single digits, or will it taper off as new trends emerge?

Source: Company filings, brokerage estimates

Source: Company filings, brokerage estimates

Margins: will operating margin get to the low 20's and continue higher, or will it decline amid struggling top line trends?

Source: Company filings, brokerage estimates

Source: Company filings, brokerage estimates

Both questions will depend on the growth of the athleisure industry and Lululemon's ability to withstand growing competition.


Bulls: Lulu is in a class of its own

Athleisure is here to stay

There is a belief among bears and some of the general public that the athleisure trend is a fad that will likely taper off and be replaced by the next emerging trend (such as the reemergence of denim, for example). However, Lululemon bulls would argue that the athleisure trend will be here longer-term because it's more than just a fashion trend - it's a lifestyle. People are becoming increasingly health-conscious, and the effects of this consumer shift can be seen everywhere from consumer packaged goods companies such as Coca Cola and General Mills, to wearables such as FitBit and Apple, to food retailers such as Whole Foods and Trader Joes.  And just as people are not very likely to go back to unhealthy choices, they are also not likely to stop buying clothing that is technically supportive of that lifestyle.

This is perhaps a well-known trend that does not need much support. However, just to hammer the point home, one can see the trend in US gym memberships and gym growth, in the growing popularity of yoga, and ultimately, in athleisure apparel sales. NPD estimates that athleisure has grown to a $45.9 billion market, up 11% in 2016.

However, what's truly important for the stock going forward is whether athleisure will continue to grow in the future. Bulls would argue that the category still has lots of room to grow. While the trend has been ongoing for some time now, it can still take share within one's wardrobe, growing in categories such as bras and tops (which Lululemon is focused on, as I'll discuss later), and it could further penetrate work clothing as employers loosen their workplace standards. 


Lulu has a strong brand and pricing power

What about the competition within the athleisure space? Lulu's competition can be split into two segments - the larger, established athletic brands like Nike, Under Armour, and Adidas, and the smaller stores that are largely focused on the yoga pant.

Against the smaller players, bulls would argue that the competition Lulu faces is overblown. While the quantity of these competitors is high, many have yet to show evidence of meaningful traction that could take share from Lulu. Kit & Ace is especially of note as it was started by the Lululemon founder, but recently was forced to close all U.S. stores and lay off a portion of its staff. Few of these competitors are able to effectively compete against Lululemon's scale and brand.

Against the larger athletic giants, bulls would argue that Lululemon's brand is strong enough to withstand the competition and maintain pricing power. As the creator of the original yoga pant, Lululemon's brand is one of the strongest in the athleisure category. And beyond the yoga pant, the company has a history of innovating and addressing people's clothing pain points. For example, the men's ABC (short for anti-ball crushing) pant was made to be more flexible while maintaining the pant look. Additionally, the company recently released the Enlite bra (shown in the picture below), a premium sports bra that provides support while not compromising on comfort levels (so I've heard). These innovations should support higher prices over the long-term in the face of higher athleisure competition. And recent quarters demonstrate this pricing power, as the company has driven higher Average Unit Retail (AUR) without significant consumer pushback. 


Other growth drivers: Men's apparel is a growing piece of Lulu's sales and is a $1B opportunity

Lululemon is increasingly focused on men's apparel. Management has focused specifically on solving issues unique to men, and the consumer reaction has so far been strong. As an example, the company's ABC pant has been one of its most successful products, and has received positive press. Men's apparel now makes up 20% of sales (~$400 million in revenue), and the category has comped in the teens for multiple quarters. In the latest quarter, the category comped in the high-single digits, but management noted that it had accelerated to the double digits with the release of their new training top in 1Q. 

Going forward, the company will continue to focus on tops such as t-shirts, tank tops, and hoodies. Additionally, the company is carrying an assortment of men's apparel in their larger format stores that are opening in select locations. Furthermore, management will likely continue to focus on driving male traffic to stores and to the site. While the category represents 20% of sales, men make up only 30% of the company's traffic. Management expects these initiatives to help drive strong comps in the category and eventually approach $1 billion in sales by 2020.


Other growth drivers: International another $1B opportunity

Management sees international as another $1 billion opportunity. With just 15% of stores outside of North America, international is a major source of growth going forward. The company has a strategy of "seeding" international markets with showrooms that display a limited selection of products. Once the showroom generates sufficient interest, the company opens a full-line store at least a year later. 

For the year, management has a target of opening 50 Lulu stores globally in 2017, 15 of which will be international stores. Investors anticipate that this could accelerate beyond 2017 and become a larger portion of its unit growth going forward; while international made up 30% of new stores in 2017, consensus estimates suggest analysts expect international to grow to 50% of new stores in 2018. The company has noted that they will focus primarily on Asia, and specifically in China, where stores are generating $1,600 in sales per square foot (compared to the 2016 chain average of ~$1,500). The company has also seen a similarly strong reaction in other markets, including London (growing at 50%+ in constant currency) and a shop-in-shop concept in Dublin (also trending at $1,600 sales per square foot). While the results are still early, the customer reaction shows that the Lululemon brand cachet carries beyond the US and Canadian markets and could be a major driver of top line growth longer-term.

Source: Company filings, brokerage estimates

Source: Company filings, brokerage estimates


Operating margin to recover to above 20%

Lululemon's margin trends have deteriorated significantly over the last several years from a peak of 28% in 2011 to 18% in 2016. However, management has charted a long-term plan to get operating margin back to the low 20's by 2020. Bulls believe this is not only achievable, but even has upside should sales outperform. 

The pathway back to the low 20's is primarily a gross-margin led improvement. Specifically, within gross margin, management had outlined 300 basis points of product margin improvement that they believed they could attain through higher AUR and lower product costs from supply chain and logistic investments. The bulk of this has been achieved by management over the last year (see chart below). However, during the most recent 1Q17, management achieved 216 basis points of total gross margin improvement vs. their guidance for 50 basis points with product margin expanding 380 basis points, suggesting that product margin has further room to expand. 

Source: Company filings

Source: Company filings

Outside of product margin, the company has further upside for gross margin improvement through better inventory management (which should translate into lower markdowns). As shown below, the company has gotten better at managing its inventory levels. 

Source: Company filings

Source: Company filings

In total, investors are expecting gross margin to expand by roughly 50-100 basis points this year (in line with management's guidance) and moderate expansion thereafter.

Source: Company filings, brokerage estimates

Source: Company filings, brokerage estimates

Management also expects moderate gains to come from SG&A. The company has had some issues here recently in light of the 1Q execution-related issues, and management has noted that they will now not see SG&A leverage until 4Q. For the year, they expect 50-100 basis points of deleverage, offsetting any gains from gross margin. However, beyond this year, they have noted that with low- to mid-teen revenue growth (which they believe their business model can support over the next 5 years), they should see SG&A leverage. As a result, investors expect modest gains from SG&A as well longer-term.

Source: Company filings

Source: Company filings

In total, the combination of gross margin and SG&A gains should drive operating margin back to the low 20's by 2020. Bulls believe this is achievable and has upside should the company outperform on their comparable sales assumptions. Current consensus estimates have the company approaching 19% by the end of 2018.

Source: Company filings, brokerage estimates

Source: Company filings, brokerage estimates


Near-term hiccups behind them; returning to prior trajectory

In 1Q, Lululemon saw trends decelerate sharply. Comparable sales (including FX) declined 1% compared to the prior mid-single digit trend. And direct-to-consumer sales were flat compared to the prior double-digit growth trends. Management attributed the decline to a lack of color in their spring merchandise as well as issues with their visual merchandise. Of note was the fact that online traffic was not affected, signaling that consumers remain interested in the brand. The company has since corrected these issues and has noted that comparable sales are back to the low- to mid-single digit range, and that e-commerce is back up to the low-double digits quarter-to-date. These near-term data points give bulls increased confidence that the sales slowdown was due primarily to temporary execution issues, and that the company can return back to its prior growth trends. Consensus estimates currently show that analysts expect the company to gradually get back to the mid-single digit range by the end of the year.

Source: Company filings, brokerage estimates

Source: Company filings, brokerage estimates

Bull-case scenario and long-term trajectory

So what is the exact scenario, in financial terms, that bulls envision Lululemon's stock surges higher? The path was essentially laid out by management during their 2014 Analyst Day. The plan primarily involves low double digit revenue growth, driven by:

- Mid-to-high single digit comparable sales growth with low-single digit within women's and mid-teen growth within men's, or low-single digit growth at store and mid-teen growth online

- Low-double digit square footage growth driven by modest growth in North America and stronger growth internationally


Low double digit revenue growth would then generate the following by 2020:

- Revenue of ~$3.6 billion

- Margin expansion to 20%

- EPS of ~$2.80 by 2018 and ~$3.70 by 2020

- Multiple of 27x, in line with its multiple prior to the 1Q17 issues, and in line with a Lululemon that has fewer competitive concerns given its dominance in the space and strong brand equity, as well as a pathway towards future growth primarily through international expansion


In such a scenario, Lululemon stock is worth ~$75 by 2018, representing ~44% upside from current levels.


Bears: Athleisure has peaked, competition will grow

Athleisure slowing?

The industry has grown significantly driven by two factors: 1) the customer set of people wearing athleisure broadened significantly, and 2) each customer has replaced more and more of their wardrobe with athleisure gear. While it's difficult to pinpoint the exact start of the athleisure trend, we're now at least 5 years into it. Bears are now starting to wonder just how big the remaining opportunity is within each of those categories. How much athleisure can people possibly wear? And while there is some lifestyle element to this, there is also a fashion element, and that can work both for and against companies such as Lululemon. Should something like denim come back in style (of which there is some evidence that this is occurring), consumers may move away from athleisure. So at some point, growth will begin to taper off, and could turn negative. And with most athleisure companies off stock price highs (mostly achieved in 2015) save for Adidas, bears wonder if that time is happening now.

Source: Google Finance

Source: Google Finance

Lululemon has had several periods in which sales have slowed, with the most recent hiccup occurring in 1Q. While management has cited a number of compelling reasons for why this slowdown was likely execution-related and not due to a broader slowdown in the industry, there is still some uncertainty on this point. Perhaps the slowdown was 60% execution-related, and 40% related to consumer fatigue, bears might speculate. Consensus estimates for comps shows that analysts are also not fully convinced yet that it was entirely execution-related, as consensus estimates are expecting a modest recovery at the low end of the mid-single digit range.


Lululemon facing increased competition

Competition from the smaller players is essentially death by a thousand cuts. While none of these smaller players have become significant enough to move the needle significantly, it is the aggregation of them all that may be taking share from Lululemon. It's not just the small players like TNA or Sweaty Betty; it's also competition from established companies such as Victoria's Secret (with their new Victoria Sport brand) and Dick's Sporting Goods (with their private label Calia). Even if Lululemon is able to maintain its share within this now crowded space, bears believe that Lululemon will not be able to raise prices. 

Source:  Victoria's Secret, Dick's Sporting Goods, ADAY, Nike, Adidas, Under Armour

Source:  Victoria's Secret, Dick's Sporting Goods, ADAY, Nike, Adidas, Under Armour

There is some evidence that Lululemon may not be holding its own in the space. As mentioned previously, bulls would point to the 8% comparable sales performance in 4Q16. However, bears would point to slightly declining traffic at stores as well as the subsequent -1% comparable sales performance in 1Q17. As noted previously, management gave several reasons for the underperformance, and that they have been fixed. However, bears could just as easily point to the sensitivity of the customer as evidence that the competitive pressures have heightened. 


Margins could face tough road ahead

The plan charted by management is to get operating margin to the low 20's from 18% in 2016. However, bears see the company struggling to get back to this level for a few reasons.

- The company's core women's merchandise, which is likely higher-margin than other categories, is slowing.

- Future opportunities are all lower margin. While the men's category is growing rapidly, it will likely require more marketing spend to continue its growth rates since men's merchandise are not carried in most of the stores. Additionally, international growth is also lower-margin. Even the most mature stores with the highest sales volume were noted by management to have margins that are 300-500 basis points lower than North America margins. International will require further investment to build infrastructure and mature before margins are no longer dilutive to the company.

- With the category slowing and with continued execution issues, Lululemon will likely need to invest more heavily in the business to get the level of sales they want. The level of investments will likely pressure margins further. As an example, management had previously expected 2017 SG&A to be flat, but has since lowered that outlook as the company has had to invest more heavily in e-commerce.


Bear-case scenario and long-term trajectory 

The bear case is one in which the athleisure trend peaks and goes out of style. In financial terms, that means mid-single digit revenue growth driven by:

- Flat comparable sales growth with negative comparable store sales and DTC sales growth of mid- to high-single digits as athleisure slows and competition within the space heightens

- High-single digit unit growth as management slows store openings amid slowing top-line trends and increased competition


High-single digit revenue growth would then lead to:

- Revenue of $2.9B in 2020

- Declining margins as Lulu gross margin is pressured by continued negative traffic at stores and SG&A is elevated due to increased marketing and international growth

- EPS of $2.33 by 2018 and $2.37 by 2020

- Multiple of 16x, which is below the low-end of its historical trading range and several turns lower than its current PE given growth concerns and declining margins


These inputs would suggest a target price of $37, representing 30% downside from current levels.


Wrap Up

In sum, there are two possible scenarios in which the stock will move significantly higher or lower. In the bull scenario, athleisure will continue to grow and become a bigger part of our wardrobes, and Lulu's strong brand and evolving merchandise will sustain pricing power amid a competitive landscape. In the bear scenario, athleisure will fade off as a new fashion trend, potentially denim, emerges. Lulu may then have to fight for a shrinking pie, which will likely hurt sales, margins, and the stock.