Lululemon Stock: David Vs Goliath (NASDAQ:LULU)

Can Lululemon Athletica Inc (NASDAQ:LULU) grow to become the largest athletic sportswear brand in the world in the future? The title of the largest sportswear brand in the world currently belongs to Nike (NKE), while Lululemon currently belongs somewhere in 6th place by worldwide sales. While Lululemon is currently seen as the underdog, the story of David vs Goliath is very apt for this investment case.

David, seen as a weaker and smaller opponent than Goliath, had his odds against him when he was to fight the larger and stronger Goliath. Instead of the usual single combat style of sword and spear, David hurls a stone using his sling that hit Goliath’s head and caused him to fall to the ground, bringing victory to the underdog, David.

Similar to David, Lululemon, in my view, could surprise us in ways we may not think of in its quest for growth. As a brand initially focused on yoga apparel and on women, Lululemon can leverage on its unique strengths and may claim the top global sportswear brand one day in the future.

Investment thesis

I think that Lululemon has a great brand, management team that executes well, and innovative products that customers like. Its premium product positioning as well as strong brand image has enabled the company to earn industry high margins even while it is growing its top line rapidly. Furthermore, there are many opportunities left untapped in the international markets and the men’s market that can continue to fuel industry leading growth for the years to come. Thus, I really like the prospects for growth and the business model and strategy of the company and think that it is a great company to invest in.

That said, I am initiating Lululemon with hold rating. The primary reason for this is that valuations are not compelling for me to enter Lululemon at this price, given that there are certain risks that I will highlight below.

Overview

Lululemon is a designer and retailer of premium athletic apparel, selling pants, shorts, tops, accessories and jackets designed for healthy lifestyle activities such as yoga, running, and general fitness.

It has a physical presence as well as e-commerce channel. It has stores globally, in the US, Canada, Australia, New Zealand, in the United Kingdom, Europe, Greater China, Singapore, South Korea and Japan.

Business segments

To understand Lululemon better as a business, we look deeper into its business segments.

First, it is important to note that North America, which comprises of Canada and the US, makes up 85% of total sales. In comparison, the sales contribution from areas outside North America is rather small at 15%. This sales from areas outside North America, which Lululemon calls international revenues, is an area of focus for the company in its past 5 year plan and there has been rather encouraging results, with the management recently announcing a 2 year CAGR of 60% in China. I think we will likely see management continue to have a strong focus on international sales as it continues to leverage on the Lululemon brand to expand into more markets.

Second, Lululemon’s sales from females account of the bulk of total sales, at 67% of total sales in 2021. The men’s business accounts for about 25% of the total sales. This is also an area of focus for Lululemon in its past 5 year plan and the company has seen some progress in this area. I think that this will continue to be a focus for the company in the next 5 years to come as the low mix in the men’s business leaves some low hanging fruits for further growth if executed well.

Excellent execution on “Power of 3” strategy

In 2018, Lululemon posted a 40% growth in EPS, which was one of its strongest results, pointing towards increased demand for Lululemon’s products. As such, with a solid growth seen in 2018, the company set a 5-year growth plan to be achieved in 2023. The strategy was to grow in the next 5 years through the power of 3. The goal of the power of 3 strategy is to continue to “drive product innovation, create integrated omni guest experiences and to expand deeper into key markets around the world“.

As such, Lululemon set 3 targets for its “Power of 3” strategy. It targets to:

1. Double the size of men’s revenues by 2023
2. Double digital revenues by 2023
3. Quadruple international revenues by 2023.

Currently, in 2022, the company has achieved 2 of these targets early and expects to achieve the 3rd by end 2022.

In particular, men’s revenues have more than doubled from $650 million in 2018 to $1,536 million in 2021, which equates to an 1.2x increase.

Digital or e-commerce revenues have doubled from $578 million in 2018 to $2,777 million in 2021, representing an 3.8x increase.

Lastly, Lululemon is on track to quadrupling international revenues, from $358 million in 2018 to $957 million in 2021. Management remains confident that it will achieve its target of $1,433 million international revenues in 2022.

What does this mean for Lululemon? In my view, to double men’s revenues when the brand has more of a female positioning was a rather bold and aggressive stance. In addition, the target to quadruple international revenues was also fraught with uncertainties given that Lululemon’s brand equity mostly resides within North America. Thus, I find it very encouraging for the results to show that there is strong demand for Lululemon’s products in both the men’s business as well as international business. This initial targets that were met plants the seeds for further expansion into these respective markets in the years to come.

Since the company will be having an analyst day on 20 April to announce their next 5 year plan, I am of the view that this will comprise of new, more aggressive targets for the men’s and international business, as well as a roadmap on how it intends to get there.

Industry high margins

Lululemon posted strong industry high margins in its 2021 report. Gross profit margin was at 57%, EBITDA margin at 26% and net profit margin at 16%. This is in comparison to Nike’s 2021 report, which posted gross profit margin of 45%, EBITDA margin at 18% and net profit margin at 14%. For the savvy readers who have followed Lululemon or Nike for some time, you would know that there are some reasons for the difference in margin profiles.

First, Lululemon’s positioning in the sportswear market is more premium, while Nike has more of a mass market positioning. As a result, Lululemon has been able to price its products at a higher end within its rather niche market as a result, earning higher margins per product sold. Second, Lululemon’s strong brand equity enables it to price at the high end despite competition within its own niche markets. Especially among its women customers, there is fierce brand loyalty and recognition for Lululemon’s products, which allows for Lululemon to continue to earn such enviable margins in the sportswear sector today.

However, I am cautious about Lululemon’s margins for a few reasons. This currently industry high and firm high margins means that there is limited upside potential in the future from a margin perspective. In fact, I think what is more likely, is that as the mix of men’s and International business grows, this may weigh down on margins as these segments has not yet shown a similar strong brand loyalty to Lululemon.

In fact, Lululemon’s historical numbers show that its current gross profit margins and EBITDA margins are looking relatively elevated as its average gross profit margins and EBITDA margin is 48% and 21% respectively.

I think we have to also bear in mind the cyclical nature of consumer discretionary companies, which to me, means that there is a certain risk for margins to normalize towards more industry or firm average levels.

That said, I think its highly uncertain to say for sure the timing of this margin normalization and earnings could still grow through faster revenue growth by having more aggressive expansion strategies.

Competitive analysis

When comparing Lululemon with its competitors, Nike is one that comes to mind given its similar strong brand recognition. In fact, there are some lessons we can learn from comparing Lululemon to Nike

First, it is important to note the size difference between the 2 companies. Lululemon’s market capitalization is currently at $50 billion while Nike has a market capitalization of $207 billion.

Second, it is important to note some differences in business mix. Lululemon, as noted earlier, has a rather high concentration of sales in North America (85% of total sales) compared to Nike (39% of total sales).

Of course, in my view, this brings international expansion opportunity for Lululemon, especially in China, given that China sales makes up 19% of Nike’s total sales mix.

That said, there is also geographical concentration risk in North America for Lululemon, while uncertainties remain over execution ability as well as brand equity in international markets. There is evidence that Lululemon is having some success in China. In 4Q21, management said that China saw a 2-year CAGR of 60%.

Also on the business mix front, Lululemon managed to grow its male business (33% average growth) at a pace faster than the female business (22% average growth), and at a pace faster than Nike’s male business (4% average growth) as well.

Third, on financials, it is worth highlighting again that Lululemon’s margins are higher than Nike’s due to its premium positioning and strong brand loyalty. That said, there are several sell-side analysts that have pointed out that given its industry high and firm high margins of 58% gross profit margin and 29% EBITDA margin, there is limited upside from the margin perspective. I have already explained this in detail above.

On the working capital and inventory front, there are some concerns that inventory days for Lululemon has not yet tapered off from Covid highs in 2020, and instead grew in 2021. In comparison, Nike managed to keep inventory leaner in 2021 as its inventory days were reduced from Covid highs.

This in my view could bring a valuable opportunity to Lululemon. Listening into the 4Q21 call, Lululemon’s CEO did reiterate that in order to prevent the situation in 2019 when it had an under-inventory situation limiting growth, the company has been implementing new strategies to keep proper levels of inventory to fuel its top line growth. The CEO also mentioned that 45% of these inventories are Lululemon’s core season-less products which has lower markdown risk.

The main concern for the elevated inventory days is that this is caused by lack of demand from its Men’s product line given recent push in 2018. Lululemon’s inventory days used to be in the 80s range before the increased focus on Men’s products, so there’s some concern on that front.

Valuation

However, on the valuations front, I find it difficult to justify the 41x forward P/E for Lululemon given certain risks:

1. On revenue mix front, it is less diversified and riskier than Nike from a geographical standpoint.
2. Although men’s and international sales business opportunity is huge and could bring higher growth in the long term, most of that upside has been priced into the valuations.
3. Apart from a potential top-line growth miss, the industry high and firm high margins might imply risks from a margin compression standpoint due to the cyclical nature of consumer names like Lululemon. This could come from multiple sources, including the increasing mix of international and men’s revenues’ whose margins profile are not yet disclosed.

As such, at the current moment, the risk reward perspective for Lululemon is fairly balanced and there could be opportunities down the road when the stock shows weakness.

Based on a more reasonable PEG of 1.4x, taking the average EPS for 2022F and 2023F, we could look to enter at $305 which implies 2023F P/E of 25x.

Conclusion

I think that the fact that Lululemon is able to achieve its 2023 targets ahead of schedule suggests strong execution from its management on its goals. This will also give the market more confidence in its next 5-year plan.

In addition, I like that Lululemon, given that it is only a quarter of the size of Nike, still has a decent runway to leverage on growth from:

1. International business, in particular, China if it succeeds in the region. Lululemon’s 15% international business mix compared to Nike’s 56% international business mix.
2. Men’s business: Lululemon’s Men’s sales mix of 25% half that of Nike’s 42%. Lululemon’s Men’s sales of $1.5 billion vs Nike’s $19 billion.
3. Continued growth in Women’s business through product innovation.

However, I believe that currently, the stock is fairly valued as the risk reward skew is fairly balanced right now. I think that much of the growth in men’s and international business has been priced in, and I prefer to look for opportunities to add into Lululemon down the road when the stock shows weakness. Will Lululemon succeed in taking down Nike like how David successfully took down Goliath? The green shoots are appearing and I think the odds are good for Lululemon, just that now is not the time.