Octavio Jones
Investment thesis
With Lululemon’s (NASDAQ:LULU) results coming up, this article serves as a preview for the upcoming quarter based on the recent news, happenings and prior quarter results of the company. I have previously written about Lululemon, which can be found here.
I will first state that I think that Lululemon is a great investment for the long-term, with its strong brand equity one of the strongest competitive advantages that is hard to replicate. The company is poised for strong growth in the long-term as it has a strong market positioning. While I like the Lululemon story, most of the positives has been priced into the stock at the moment, in my view. Valuation of the company is rich and expensive given the near-term risks. As such, the risk/reward of the company skews to the negative and I maintain my neutral rating ahead of the 3Q22 print.
Brief analysis of the second quarter
I think we saw that Lululemon’s 29% sales growth in the second quarter as well as the $2.20 earnings per share for the quarter was one to remember. This is also despite the fact that Lululemon was operating in a tough environment with peers struggling in the current market conditions.
The icing on top of the cake was the upward revision of the FY2022 guidance from $9.35 to $9.50 to $9.75 to $9.90. This led to greater investor sentiment and confidence in the management’s visibility into the business as the outlook for Lululemon seems to remain resilient and somewhat stronger despite the weak macro backdrop.
On top of that, qualitatively speaking, the recent category launches of its new hiking, footwear categories did give the market an added confidence in Lululemon’s ability to execute in other sports categories and the demand and response from the launch of these gave investors the assurance they needed. With the Lululemon brand continuing to see increasing strength in a weaker athleisure market, this boded well for the future potential for the company.
China growth momentum is accelerating, and Europe remain solid
With the recent second quarter results, I think that we are beginning to see improving business momentum in one of Lululemon’s most important international markets. Due to the covid-19 related closures and restrictions that continued to be imposed in China due to the tough zero covid policy, Lululemon had a weaker start to 2022 in the region.
That said, in the second quarter, there was a rebound in China as revenue growth came in at 30% compared to the prior year and the 3-year CAGR for the region was almost 70%.
In the second quarter, the company opened 8 more stores in China, with a total of 79 stores in China. Most of these are in the tier 1 and 2 cities, with 40 and 25 stores in tier 1 and tier 2 cities respectively. This leaves room for further expansion as Lululemon can continue to strengthen its brand and gradually expand to more cities in China. Lululemon is using its direct-to-consumer model continue to grow its brand image and bring in new customers.
On the e-commerce front, the company launched on JD.com (JD) its digital flagship store. With JD’s customer base being relatively higher proportion in males, this does bring a new channel for customer acquisition for males in China.
Lululemon remains at the early stages of its growth in China and has thus far employed a similar strategy it has carried out in its other markets as it builds on branding to bring in the demand.
On the other part of the globe, Lululemon saw strong momentum in Europe, with revenues increasing 20% and 3-year CAGR of 22%. The company is entering its first new market in Europe in 3 years as it looks to enter Spain, with the launch of its Barcelona and Madrid stores to open soon and the local e-commerce site has already been set up. Lululemon has got 40 stores in Europe at the moment and 5 websites.
As part of its Power of Three x2 plans, Lululemon is targeting to grow their international business by 4 times from that of 2021 levels by end 2026. This current progress we have seen in 2022 for China and Europe puts this target within sights as the international business revenue grew 35% compared to the prior year and on a 3-year CAGR basis, it grew by 40%.
Product innovation to drive growth
One of the levers that Lululemon can pull to drive growth in its current and new markets is through product innovation.
For its core products, Lululemon launched SenseKnit, which is a new type of fabric technology that the company developed that helps offer runners with zone compression. Management commented that this was popular in its core products for both women and men.
In its play categories, Lululemon launched in the second quarter its hike collection. This is the company’s way to solve its customers’ needs for innovation in other sports activities to associate Lululemon with different sport categories and improve their credibility in other sports categories. Management commented that the response to the new hike collection has been rather positive thus far. The company plans to continue to expand its product portfolio in the hiking category to launch more products for heavier duty hiking where the weather may be harsher.
Lastly, Lululemon launched Blissfeel, a running shoe designed for technical performance and there has also been a rather strong response to the launch of the shoe and the company is looking to increase its inventory for the product to cater to the strong demand. Lululemon looks to continue to bring innovation into its products, and this includes apparel for running that includes retention of heat and reflective features for cold climates and dim light settings.
Inventory a potential weakness
In 2021, Lululemon was in an under-inventory position, and this led to a difficulty for management to maximize its business.
In the second quarter of 2022, what I think is more of a concern today is that the inventory levels are somewhat elevated. The inventory position is up +196% from the second quarter of 2019, while sales was only up +112%. While this risk may not materialize and the markdown levels are somewhat at the 2019 levels, this could be one of the weaknesses for Lululemon going forward
With where Lululemon is at currently, there is no doubt that the company is well placed for surges in demand if that occurs. With an elevated inventory level, this enables the company to be able to maximize its business, but it also brings the risk of markdowns if demand fails to materialize. This is what I hope to monitor in the coming 3Q22 report as demand needs to remain strong for the elevated inventory position to be relevant.
Valuation
Lululemon is trading at 38x FY2023 P/E and 33x FY2024 P/E. This makes the company one of the most expensive amongst peers and in my opinion, makes the company too expensive in my view. The company is growing at an earnings per share CAGR of 15% in the near-term and to place a more than 30x P/E multiple on this does not seem wise in the current economic climate. There are real risks to the company being able to achieve its Power of Three x2 targets and the potential weakening of the macroeconomic environment poses an additional risk.
As such, there is rather limited room for further P/E expansion for Lululemon and most of the upside would have to come from upside in earnings and revenues. With the risks highlighted above, this makes it harder to recommend Lululemon as there is a negative skew to the risk/reward perspective.
I apply a PEG ratio of 1.3x on the average of my 2023 and 2024 forecasted EPS for the company. With that, my 1-year price target for Lululemon is $325 for Lululemon. As a result, I maintain my neutral rating and I believe that much of the optimism and good news for Lululemon has already been priced into the stock.
Risks
Weak macro backdrop
As a result of Lululemon being a full price business and the current elevated inventory levels, this makes it challenging for Lululemon if the demand for their products falls when the macroeconomic environment worsens.
With a poorer consumer sentiment and confidence, the lower demand for consumer discretionary products like Lululemon might be a prolonged one especially if the macroeconomic environment does not improve quickly. This might prove to be a challenge to the company’s 2026 targets.
International expansion risk
The management has a goal to quadruple its international business by 2026. While the company remains on track to achieve this, there are risks involved for their international expansion. While its popularity and brand image are strong in North America, Lululemon may not be able to replicate this in its newer markets like China and Spain. If it is unable to build its brand equity to the level we see in North America, this could bring some weakness to its growth from these new markets.
Expansion into men’s category
For Lululemon, its expansion into the men’s category has been lukewarm at best. With its low and small base at the beginning, the growth may have appeared strong, but it needs an inflection point in the men’s business for this to take off. There is the risk that the brand reputation for Lululemon has titled too strongly to that of women and that might be a headwind for increasing penetration in the men’s category.
Competition
Athleisure remains to be an interesting product category with old large players like Nike (NKE) and newer entrants vying for market share. The space is undoubtedly competitive and Lululemon remains to be a leader in the space. That said, the company needs to continue product innovation and introduce new products to sustain and grow its market share in the space.
Conclusion
While Lululemon is showing that the business remains strong amidst a weak macro environment, the shares are fairly valued, in my opinion. With the shares trading at the most expensive amongst peers, I think that the risk/reward is balanced at current levels. I think that it was encouraging to see that the international business remains to be executing well in both China and Europe. China remains one of their largest growth opportunities, in my view, and the company is still rather early in the region, while management continues to focus on new levers it can pull in Europe that will be the new growth drivers for the business. Management is also executing well with beats in their second quarter and raising of guidance that helps improve investor sentiment. In addition, product innovation remains a priority as management showed that they are looking to increase the quality and quantity of both its core product and play product categories. My 1-year price target for Lululemon is $325 for Lululemon and I maintain my neutral rating for the company in the near-term.
Be the first to comment