Lululemon (LULU) Stock: A Buying Opportunity (Rating Upgrade)

Lululemon Athletica Inc. (NASDAQ:LULU) released an earnings and revenue update premarket on the 9th of January, and as a result, the stock price dropped by close to 10% during trading hours, pushing the stock price to under $300 per share. I believe this is offering investors a nice opportunity to increase their existing position in Lululemon or initiate one, as the risk-reward profile is more attractive than it has been for a while now.

Back at the beginning of December, I warned investors to be careful with buying Lululemon stock, as the share price had risen close to $400 per share and the stock looked like it was priced for perfection while estimates for 3Q22 results looked challenging. As a result, I rated Lululemon a hold, as the long-term potential for the company continued to be impressive. Since then, the share price has fallen by over 20% as, indeed, analysts’ forward expectations turned out to be slightly higher than the outlook given off by Lululemon and the company is feeling the results of an economic slowdown.

The revenue and earnings update

Management now guides for net revenue to be in the range of $2.660 billion to $2.700 billion, representing a 25% to 27% increase compared to the fourth quarter of fiscal 2021. Back at the 3Q22 earnings release in December, management guided for $2.605 billion to $2.655 billion in revenue. This means that net revenue is expected to come in higher than previously projected by management, although only by a slight margin. It does again indicate that growth for Lululemon is expected to remain strong, despite a difficult macroeconomic environment. This is a positive signal, but there is also some negativity.

EPS has been revised down slightly. This is mainly the result of a lower expected gross margin. Lululemon expects gross margin to decline by 90-110 bps compared to an expected increase of 10-20 bps. The decline in margins will most likely be caused by higher promotions and discounts during the holiday quarter to get rid of inventory and boost sales. The result is that EPS is now expected to be in the range of $4.22 to $4.27 for 4Q22 compared to the company’s previous guidance of $4.20 to $4.30, which back then was already below expectations. While this is not a major downward revision, it is showing the first cracks in the business, and this brings on worries surrounding margins going forward.

Still, margins for Lululemon Athletica remain excellent, even with this decline in mind. Also, these issues should only be temporary and, therefore, be of no worry for any long-term investor. CEO Calvin McDonald added the following to the news release:

We are pleased with our continued revenue growth and momentum in the business, as our teams navigate a dynamic macro-backdrop. In Q4, traffic remains strong across both physical and digital channels, and we anticipate delivering another quarter of solid earnings growth consistent with our updated EPS forecast. 2022 has been a strong year for Lululemon, and we remain focused on the significant opportunities ahead as we continue to deliver on our Power of Three x2 growth plan.

I believe his statement is spot on and that this is what investors should focus on. There are no significant changes in the business and the growth outlook remains unchanged. I do believe that Lululemon will likely continue to feel the impact of less consumer spending over the next couple of quarters and therefore experience some margin compression. Yet, once the economy recovers, growth will yet again be strong for Lululemon driven by its brand recognition and growth plans.

For a more in-depth analysis of the growth drivers, I would highly recommend reading my previous article on Lululemon, which can be found here.

Current valuation

Analysts are currently projecting revenue of $2.69 billion for 4Q22 and EPS of $4.28. This means current estimates are slightly above the estimates made by management and might have to come down ever so slightly. For the next fiscal year, analysts project revenue growth of 14% and EPS to grow by close to 15%. It is important to keep in mind that Lululemon will have to lap the very strong results from 2022, but continued product innovation and company expansion should support strong continued growth. I believe current analysts’ estimates for FY23 look fair, and we should expect Lululemon to report FY23 revenue of $9.00 billion to $9.35 billion with EPS of $11.55 as margins will be pressured by high inflation and lower demand. I do expect Lululemon to keep growing by double digits over the next few years, with EPS outpacing revenue growth from the second half of 2023 onwards. I will personally be very interested in the FY outlook management will give during their next earnings call.

Based on current estimates, I believe Lululemon is a buy. For reference, based on current EPS estimates for FY23, Lululemon is currently valued at 26x P/E. Yet, I believe a 28x P/E is fair for Lululemon while it grows by strong double digits. As a result, I believe Lululemon has a fair value of around $324 per share at the moment, though it could easily jump to over $340 based on higher multiples.

Conclusion

In my eyes, the 10% drop of Lululemon Athletica Inc. on the 9th of January was simply an overreaction by the market, and this has created a nice buying opportunity for long-term investors. The company continues to be a dominant force in the athletic apparel industry, driven by a strong brand. With plenty of growth and expansion potential left in other parts of the world besides North America, Lululemon looks very well-positioned to continue on its growth trajectory. Of course, we should keep in mind that the company might face some near-term headwinds, but management has been acting carefully so far and, therefore, has not (yet) faced the same issues as other apparel companies have, and I do not expect them to.

As the share price has come down by over 20% since my previous coverage, I change my rating on Lululemon Athletica Inc. to a buy. The long-term fundamentals remain strong and short-term pressure on margins and, possibly, sales growth are only temporary.