Investment Thesis:
Lululemon Athletica Inc. (NASDAQ:LULU) is a designer, distributor, and retailer of athletic apparel across the globe, with their most well-known product being the classic Lululemon yoga pants. Lululemon has long been renowned as a growth stock trading at high multiples, yet the price has fallen close to 40% YTD as a result of stagnant growth in North America which has raised concerns about Lululemon’s growth prospects and led to multiple contraction.
I believe that Lululemon is an extremely high-quality business that has created a strong brand around quality/luxury athletic wear, which allows them to flex their pricing power to sustain industry-leading margins and make it difficult for new businesses to compete within the sector. Although Lululemon’s domestic growth has slowed down in the short term, Lulu’s international expansion is undergoing massive success, while Lulu’s expansion into new product segments for men has also created another growth avenue. Lululemon appears to be an attractive investment due to the sustained growth prospects it has guided towards as well as the strong moat and brand established around the business which justifies paying a higher multiple. Overall, I believe concerns about growth deceleration in North America as well as competitive threats are overblown, which creates an opportunity to buy this phenomenal business at a fair price.
High-Quality Business:
One of the highlights of Lulu’s business and the reason it has traded at a premium multiple in the past is the strong brand and competitive advantage that the business has sustained. First, if you’re at all familiar with Lululemon’s products, you know that they are not cheap. Their classic women’s leggings are often $100+ on the low end, the men’s shorts are at least $60, and virtually all of their other items would be viewed as expensive by most buyers.
However, Lulu’s products encourage consumers to view their prices differently. The image and reality of high-quality Lulu products which will last consumers for years shifts the consumer mindset from simply trying to buy a cheaper product to understanding that even if they pay over $100 for leggings or $60 for shorts, the purchase is worth it if they wear the product for years without it wearing out. Lulu’s ability to charge high prices while having established a strong image of their product in the consumer’s mind is what makes the business amazing for numerous reasons. First, the higher prices they charge mean that their consumer demographic is often skewed towards higher income individuals. A skew towards individuals of higher income is preferable, as they tend to be less prone to economic downturns. Furthermore, Lulu’s pricing power has allowed them to garner industry-leading margins within the athletic wear space that have only grown over time. For instance, LULU had a 58% gross margin and 23% operating margin in the TTM, while Nike had a 44% gross margin and 12% operating margin in the same period of time.
Both Lululemon and Nike are renowned for their strong brands, yet Lululemon can further capitalize on it, which is reflected in their strong margins. Another important element of Lululemon’s business is their ability to outsource manufacturing. Lululemon does not manufacture any of their products in-house, rather, similar to Nike, they outsource manufacturing to factories in Thailand, China, etc. Lululemon’s ability to outsource manufacturing ensures the business is capital-light to continue operating, and the capital they do use is often for expansion in the form of new stores. This business structure has allowed Lululemon to achieve phenomenal levels of ROIC, being 30%+ during the past 5 years, outside of COVID. Businesses that invest their capital at high rates of return are the businesses I want to be invested in.
The late Charlie Munger had a great quote about how he views ROIC for businesses, “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years, and you hold it for that 40 years, you’re not going to make much difference than a 6% return-even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”
Right now, not only does Lululemon fit the criteria of a business that may be a little expensive but produces high returns on capital, but it also falls under the criteria of “a wonderful business at a great price” which we all know is what Warren Buffett prefers.
Competitive Threats:
Lululemon’s establishment of their superior brand paired with high prices makes it hard for other businesses to compete in the same space. Cheaper alternatives to their products such as Nike, Under Armour, Unique Lo, etc. are not valid competitors to Lululemon. When understanding the Lululemon consumer, it is important to note that they are not looking for a cheap product. If they were looking for a cheaper product, they wouldn’t be buying from Lululemon in the first place. Therefore, when cheaper alternatives flow into the market, there should be very low attrition from Lulu’s business towards those alternatives. The valid competitive threats are those who sustain similar prices and aim to achieve the same brand quality image as Lululemon, such as Alo and Vuori. Although Alo and Vuori have made progress towards becoming significant competitors to Lululemon, it is still very difficult for them to become a formidable competitor.
To compete with Lulu, Alo and Vuori have to ensure that they build up the same brand image as Lululemon in terms of the quality of their products. Unfortunately for them, Alo and Vuori are nowhere close to sustaining the same image relative to Lulu. Then, typically businesses in their position would lower prices to effectively compete with Lulu, but, by lowering prices, it would harm their brand. Therefore, they need to compete with prices very similar to Lululemon. Ultimately, this creates a scenario that makes it very difficult to compete with Lululemon, as consumers see comparable prices among those brands, yet they have a significantly higher perception of Lululemon relative to the others. Evidently, Alo and Vuori are likely to continue gaining market share, but it will take them a significant amount of time to scale their business to the size of Lululemon.
Growth Levers:
Lululemon’s plan to continue growing at a fast pace is shown through their power of three growth plans. In their analyst day in 2022, Lulu presented a plan to double their $6.25 billion in revenue at the time to $12.5 billion in revenue by 2027. The power of three plan focuses on three segments, their men’s, digital, and international business.
Lulu wants to double the men’s and digital business while quadrupling the international business, while so far, it appears they are on track to do so. Although I will discuss the financials on a more granular level in the next section, so far, Lulu is doing well in the execution of their plan. In their latest quarter reported June 5th, they grew men’s revenue by 15%, digital revenues by 8%, and international revenues by 35% YoY.
More importantly, in the TTM they have already done $9.8 billion in revenue, therefore the goal of $12.5 billion is not far from their grasp. I am less confident about their ability to grow their digital revenues, but Lulu continues to drive steady comparable sales growth (7% in their latest quarter) as well as continuing to open new stores across the world.
Financial Breakdown:
Lululemon has pristine financials. Beginning with their income statement, they’ve grown revenue over 4x since 2016 while their gross margin has expanded from 48% to 58% during the same period of time. Similarly, their operating margin also increased from 17% to 22.78%. Essentially, Lulu’s progression of revenue growth and margin expansion over the past 8 years demonstrates the operating leverage they possess as well as their ability to drive top-line growth. When looking at their balance sheet, they have $1.9 billion in cash & ST investments, while they have $0 in long-term debt. Although Lulu does have $1.3 billion in operating leases which are typically considered debt because businesses don’t pay an “interest” expense on leases, I will not classify the operating leases as debt when I value the business. Furthermore, Lululemon has also slowly bought back shares over the past 10 years, with a current $1.7 billion share buyback program in place that represents roughly 4.5% of their current market cap. The share buyback program is great as Lulu can focus the excess cash they have towards buying back shares of a great business that is fairly valued. Lastly, Lululemon’s free cash flow is roughly in line with their net income over the TTM with free cash flow being $1.733 billion compared to $1.581 billion in net income, meaning that Lulu has a strong cash conversion rate. Overall, Lululemon is in a phenomenal financial position where they generate lots of cash at expanding margins and a well-capitalized balance sheet.
Valuation:
To value Lululemon, I used a basic DCF model to try and come up with an intrinsic value for the business. I inputted Lulu’s TTM of free cash flow, and their net debt (excludes leases), and inputted a discount rate of 13% which is above the market average of 10% because I want to beat the market. Furthermore, I assigned a multiple of 20 to Lulu due to the quality of the business and growth prospects while I assigned growth rates of 15%, 12.5%, and 10%, for the next 10 years, which is roughly in line with management’s guidance for bottom-line growth in the short term as well as my belief in Lulu’s ability to continue growing the business over the long term.
As we can see, Lulu appears roughly fairly valued, with a 25% margin of safety to its intrinsic value. Most businesses I cover have a close to 100% discount to its intrinsic value but considering the quality of Lulu’s business, I believe it still presents a compelling investment case.
Risks:
Lululemon does possess some risks to the underlying investment thesis. First, although an economic downturn wouldn’t have a crippling impact on their performance due to the skew towards higher income consumers, it is likely that their growth plan will be impacted due to the discretionary nature of their products. Such an impact is seen in their North American sales, which have slowed down to just 3% growth in the latest quarter. Then, the competitive threats such as the legacy players in the space (Nike, Adidas, Under Armour) and newer players (Vuori and Alo) are likely to slow down Lulu’s market share gains within the sector as a whole. Lastly, a large part of the investment thesis lies in the fact that Lulu has a strong brand. If a high-profile scandal were to break out at the company which heavily damages consumers’ perception of the brand and product, it could severely harm performance. Overall, I don’t view any of these risks as very likely or substantial, yet they are important to note.
Final Thoughts:
Lululemon is an extremely high-quality business that possesses large growth prospects. Although the stock has historically traded at high multiples relative to their free cash flow and net income, their current multiple has contracted to a more reasonable level.
Overall, the opportunity to buy such a great business at a fair price does not come around often. I believe that Lululemon can produce market-beating returns over the next few years, while it represents an equity that can be held in my portfolio for a very long period of time.
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