Lululemon (LULU): 2023 Could Be Challenging Even As Momentum Continues

Investment thesis

With the release of the 3Q22 results, this article aims to look deeper into the results to determine how the company is doing.

In my view, the company remains to be fairly valued as its valuation has incorporated all the positives and good news. The company is a great long-term investment given that it has strong brand equity in the athleisure market and the company has a growth story, as evident from the management’s plans to grow the business through the targets it highlighted. That said, the company needs to execute well and achieve these targets in order for the valuation of the company to make sense. Even then, the market is pricing in these targets that management has set for its growth strategy, and it does not offer any outsized returns, in my view.

I have written previous article son Lululemon (NASDAQ:LULU), which can be found here.

Slight beat despite margins coming in weak

Lululemon’s EPS came in at $2.00 for the third quarter of 2022, beating expectations by $0.03 and guidance of $1.90 to $1.95. Revenues grew 28% year on year to $1.9 billion, which was 3 percentage points above consensus. Growth in revenues were largely contributed by the strong international revenue growth of 41% year on year growth while North America revenue increased 26% year on year. The strong revenue growth illustrates the strong performance of the company in a difficult operating environment for most retail players, in my view.

However, gross margins were down 130 basis points, 60 basis points worse than consensus expectations of a drop of 70 basis points in the quarter. In terms of the breakdown of the 130 basis points drop in gross margins, higher investments in distribution centers and supply chain investments led to 70 basis point fall in gross margins, while 40 basis points drop was due to the higher markdowns and inventory provisions and foreign exchange led to 60 basis points drop in gross margins. There was an incremental benefit to gross margins by 40 basis points from fixed cost leverage. SG&A expenses was up 25% year on year, somewhat in line with consensus expectations as management continues to be prudent in managing expenses but also strategically investing in the company’s long-term growth opportunities.

Guidance aligned with expectations

As for guidance, Lululemon expects that EPS in 4Q22 be around $4.20-$4.30, which is somewhat in line with consensus expectations at $4.30. Revenues for the quarter are expected to grow between 22% to 25%, compared to consensus expectations of 25%.

Gross margins are expected to improve by 10 to 20 basis points as a result of lower air freight, although higher promos and foreign exchange headwinds are expected to offset some of the increase. For SG&A, management expects to be able to leverage 30 to 50 basis points.

For the full fiscal year of 2022, management expects EPS range of $9.87 to $9.97. This is higher than the previous guidance of $9.75 to 9.90 and the consensus estimates of $9.92 are somewhat in the middle of the range. Gross margins are expected to be down 100 to 140 basis points, slightly worse than the previous guidance of being down 100 to 130 basis points.

Based on what management said in their earnings call, I think that freight could be the tailwind in 2023 for gross margins, but the team expects to continue to reinvest in the business. This comes in the form of reinvestment in new stores, distribution centers and supply chain. With increasing uncertainty globally, management looks to plan for different scenarios and have contingency plans if a global recession materializes.

Inventory remains elevated

As I have stated in previous article, I continue to look at Lululemon’s inventory position as an elevated inventory position could leave the company vulnerable given full price business model. The inventory levels were up 83% year on year in 3Q22 while sales were up 28% year on year. When comparing to 3Q19 levels, inventory is up +178% relative to sales that were up 103% during the period.

Looking forward, management expects that inventory growth at the end of 4Q22 will gradually moderate to about 60% growth rate year on year relative to 2021. They expect that inventory growth will continue to gradually slow down through 2023.

China weakness

Revenue growth in China was weaker than management expected as a result of covid-19 measures. In the last week of November specifically, 22 stores were closed in China, compared to the conference call date, when only 2 stores were closed. That said, at the last week of November, 99% of Lululemon’s stores were open despite those in China being closed.

As a result of more store closures, this led to the lower sales from the region in the third quarter of 2022 despite the strong performance of stores that remained open. The lower growth in China resulted in the lower gross margins for the quarter, along with the foreign exchange movements related to the Chinese Yuan.

Some further thoughts on Lululemon

While I think that the beat in expectations for 3Q22 may bring joy to some investors, the company continues to have tough hurdles to beat. The company’s 3-year revenue CAGR decreased to 27%, down 1 percentage point and the guidance does imply a further 1 percentage point deceleration in the 3-year revenue CAGR.

The missed gross margins bring some near-term pressure to the company while the higher inventory growth of 83% in 3Q22 was similar to the level of 2Q22 inventory growth.

Valuation

Lululemon is trading at 32x FY2023 P/E and 28x FY2024 P/E. As I expect that the company will have a 5-year EPS CAGR of 15%, this makes Lululemon relatively expensive compared to the growth it is expected to deliver. In my opinion, there is a lack of multiple expansion with the current multiple the company is trading at and there is a lack of catalyst in 2023 that would make it more compelling to own the stock. In addition, I think this is a classic example of a company with valuations reflecting the optimism and strong growth that would materialize if it were able to achieve its Power of Three x2 targets. As a result, I think that the risk reward opportunity is fairly balanced for Lululemon at current levels.

In addition, my 1-year price target for Lululemon is at $325, based on my forecast for the company’s 2023 and 2024 fiscal year EPS and assuming a PEG ratio of 1.3x. This implies 2% downside from current levels and as a result, I will maintain my neutral rating for Lululemon. Again, most of the positive news has already been reflected in the stock price and the valuation of the company is rich, implying low potential for outsized returns in the near-term.

Risks

Macroeconomic environment

The macroeconomic environment remains weak and uncertain today. With an elevated inventory position, this implies that there is a risk that demand may fall for its products as consumer sentiment worsens if a recession occurs.

International expansion risk

As the company has set its target to quadruple its international business by 2026, there is a risk that Lululemon may not be able to replicate its strong brand image and expansion strategy in international markets outside of North America.

Expansion into men’s category

As Lululemon looks to expand into the men’s category, this initiative has not yet proven to be successful, and it might pose a risk for the business if the men’s business does not take off.

Competition

While Lululemon has a strong brand image, athleisure continues to be one of the fast-growing spots in the market and it is attracting new entrants and large established players like NIKE (NKE). As a result, the company needs to continue to build its brand and bring new innovation to the market to continue to stay relevant in a competitive environment.

Conclusion

I think that Lululemon continues to look fairly valued as its rich valuation is one of the highest in the industry, reflecting and pricing in the fact that management will achieve its ambitious Power of 3 targets. That said, the company faces risks in the near-term and the execution towards the targets poses a risk in the current uncertain macroeconomic climate. I think that the elevated inventory position does bring additional risk to the company in the current environment, although the business continued to see strong momentum in the recent quarter that suggests that demand is still holding up for now. My 1-year price target for Lululemon is at $325, which implies the stock is fairly valued and the risk reward is balanced. I maintain my neutral rating for the stock and look to enter at more reasonable, discounted valuations.

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