A typical discussion on lululemon athletica inc. (NASDAQ:LULU) is like a typical discussion on climate change. People are labeled "believers" or "skeptics," and little actual science is ever discussed. This article intends to present the science behind LULU as an investment today. Unfortunately, our findings suggest long-term holders will be disappointed, but not because the business model is broken. Long-term holders will be disappointed because LULU's stock price already discounts a best case scenario.
lululemon has achieved truly atmospheric returns on capital and growth due to its innovative business model. However, with limited barriers to entry, we believe the environment will get more competitive over time. In addition, lululemon's business model involves tradeoffs between operational efficiency and growth. Therefore, we do not see the underlying growth drivers accelerating from 2012 levels. In fact, same store sales growth and new store economics should naturally moderate over time.
We believe the company is fairly valued near $44.00 per share. While we believe there are plausible cases that present significant upside to this valuation, we have little reason to be aggressive considering margins appear to have peaked, growth is declining and earnings quality has deteriorated. We strongly caution against investing in LULU at current market prices and suggest looking for a margin of safety even on our $44 estimate.
Brief Company Overview
lululemon athletica inc. is a designer and retailer of yoga inspired, technical athletic apparel operating primarily in North America and Australia. The company's target customer is a sophisticated and educated woman who is engaged in an active, healthy lifestyle. The company has introduced some men's products as well. As of July 29, 2012, the company operated 189 store locations worldwide, and additionally sells its products online through its own website.
The company boasts the highest retail sales per square foot in the retail apparel industry with comparable store sales hovering around $2,004 / s.f., nearly 6 times Gap Inc.'s $337 in sales / s.f. across its portfolio in FY2011. The company has grown its revenues at over a 40% CAGR over the past five years and its earnings per share at over 70% per year. The company currently trades for approximately 45.8x trailing twelve month earnings per share (based on Friday's close of $68.02).
Industry Competitive Dynamics
The retail and athletic apparel markets can be characterized as highly competitive, with many well capitalized competitors such as athletic apparel maker Nike (NYSE:NKE) and traditional retail apparel companies such as Gap Inc. (NYSE:GPS) Firms compete on price and quality, with brand and perceived quality playing an important role. Fashion trends and changing consumer preferences are also important. We believe LULU has developed a unique strategy that has proven both successful and hard for existing competitors to replicate (to be described in more detail in the next section).
It is important to note that there are limited to no barriers to entering this industry. Manufacturing and distribution can be outsourced; real estate can be leased. For little more than the cost of opening a store, an idea can be tested. Several direct competitors, in fact, have emerged, such as lucy activewear, which was acquired by VF Corporation (NYSE:VFC), and Athletica, which was acquired by Gap Inc. We expect others to enter the market going forward.
Why These Competitive Dynamics Matter
lululemon's economics provide competitors a compelling rationale to compete with them. Below is our calculation of lululemon's return on average capital employed. Note that we have backed out capital tied to the company's $65 million purchase of its corporate headquarters building in March 2011 (this purchase converted a small operating lease into a fairly significant capital investment relative to other assets which we believe skews the metrics).
Source: Company Financials and Road Less Invested analysis.
LULU's return on invested capital is more than 100%. For every $1 million it invests in a new store, it is getting approximately $1.25 million back in earnings. If LULU had been turning out 30% ROEs, competitors might be less compelled to chase them because there would be less room to maneuver competitively (in terms of margins vs. asset turns). But in this case, competitors can pass meaningful economics on to customers and still earn a fair return on capital.
Bottom line: we expect the market to get more competitive going forward, not less.
Understanding LULU's Business Strategy
Michael Porter, the grandfather of competitive strategy, defines strategy as "deliberately choosing a different set of activities to deliver a unique mix of value." lululemon's innovative strategy is an excellent example. The core of LULU's business strategy is five self reinforcing activities that are challenging to replicate and offer unique value to customers. The key components are as follows:
- Focus on Underserved and Growing Customer Segment. lululemon's business is focused on sophisticated and educated women interested in an active and healthy lifestyle, particularly yoga and running. The "underserved" part of the story may no longer be true.
- Provide Innovative, High Quality Products Designed for this Target Audience. lululemon's products are highly technical and are designed to perform better for the intended activities and audience. Designed with its target customer segment in mind, products offer a "flattering fit" and intricate, "beautiful" design details.
- Community Based Marketing. LULU's grass roots marketing approach intertwines the lifestyle with the brand. LULU develops relationships with local "ambassadors," or local yoga and other fitness instructors. In addition, it sponsors and supports community boards and events, and even in-store yoga and running clubs.
- Store Locations Chosen to Support Brand. lululemon targets street and lifestyle center locations that are integral parts of its community, effectively helping to support community based marketing efforts noted in point 3.
- Highly Educated Employees. Store employees, referred to as "educators," are highly trained to understand benefits and features of products. Employees are encouraged to form personal relationships with customers.
Points 1 and 2 boil down to this: target a specific customer, then give that customer what they want. This is marketing 101, and a simple strategy that practically any competitor can follow. The key to appreciating LULU's success is to understand points 3 through 5. Fundamentally, these activities support and validate its customer's lifestyle: LULU helps its customers live the life that they desire and add unique value. Further, it is extremely challenging, if not impossible, for an existing competitor to mimic LULU in points 3 through 5. This has thus far given LULU a competitive advantage.
However, with limited barriers to entry, it should be expected that new competitors will enter the industry and that these new competitors will try to replicate part or all of lululemon's strategy. This explains why larger competitors, such as Gap and VF Corporation, have purchased smaller upstart brands in this space rather than directly competing with lululemon from within its existing platforms. The benefit from lululemon's perspective is that it will take these competitors considerable time to build out its own platforms to compete. Therefore, we believe the company has a fairly significant runway ahead of it, but should feel modest competitive pressure on its margins and asset turnover over time.
LULU's Business Model - Other Considerations
lululemon's business model and strategy requires tradeoffs between growth and what we will label operational effectiveness. It is important to realize that competitors attempting to copy the company will face similar tradeoffs.
Community Based Marketing Approach Slows Geographic Expansion
Community based, grass roots marketing is the most differentiating factor of lululemon. However, to successfully execute this strategy requires careful planning and maintenance. Prior to entering a market, lululemon often spends years cultivating relationships with local "ambassadors" and other stakeholders. While this strategy creates strong brand identity and loyalty, it takes considerable time to develop. Ultimately, this limits how quickly the company can expand geographically outside of its current footprint.
Employee Training Requirements Limit Ability to Open New Stores
Opening new stores requires that LULU find and train new employees. In addition, it must instill the company values and culture onto these new employees. This is a process that takes both time and resources, and you must have the resources in the market you are targeting. Maintaining this culture and control over the store environment ultimately limits how quickly it can open stores.
Store Size Limits Ability to Expand Into New Product Categories
Store size is an important component of LULU's strategy. LULU targets stores that are smaller than 4,000 s.f. in size. In fact, its stores average approximately 2,850 s.f.. Management has indicated that smaller size stores help keep the energy level of its store environment high, and prevents employees from having to chase customers around a seemingly empty store. However, small stores limit LULU's ability to expand into new product categories or target new customers. Don't take our word for it. When analysts asked the company whether it planned to expand the sizes it carries, here is its response:
"We are not planning on introducing larger sizes. If you took all of our colors and styles in our size of store and added additional sizes, we just physically cannot put the product in the size stores that we have today." Christine M. Day, 2012 Q2 Earnings Call. Source.
Real Estate Strategy And Future Store Metrics
Our analysis indicates that LULU's management has remained very disciplined in regards to store locations, and has for the most part only opened stores in premiere retail locations. This disciplined strategy has been a key to its success and in part explains its industry leading sales / s.f. metrics. In other words, it has focused on the best locations in the best markets for its products. This is not surprising. In the words of Christina Day, CEO, on the company's second quarter earnings call:
"So the strength of our real estate strategy drives the strength of our business." Source.
We applaud the company for its disciplined strategy, however, we must note that the best locations in the best markets eventually dry up. Management believes that North America will support 350 stores. We believe that store 300 will likely have less attractive sales metrics than store 150. This question was asked directly on the company's Q4 2011 earnings call. Management danced around the direct question, but effectively confirmed this (and our next point) in their response. To paraphrase their response, management essentially said that new store sales may look a bit different or be in different formats to what the company offers today, but when you look at the additional impact of online sales, the economics are still attractive.
Online Sales Growth Intimately Tied to Store Growth
The success of lululemon, and its continued ability to sell at a premium to competitors, is largely attributable to its unique branding efforts which involve community based marketing. The company has eschewed traditional advertising outlets. For this reason, we believe that the company's online sales are really an extension of the store front given that customers find lululemon through word of mouth and brand recognition is critical. In addition, store employees play an important role in communicating the benefits of its products.
Summing These Points Up
None of these issues represent fundamental issues, but they do limit the company's ability to scale its growth. That is not the same as saying that growth is slowing dramatically. What it does mean is that when we are assessing the future, we must account for the following:
- It is unlikely the company will materially increase the number of stores it opens per year from current rates.
- The company is not likely to expand meaningfully beyond its core customer segment and core yoga and running apparel - frankly, current store sizes do allow the company to expand meaningfully outside these categories. We believe same store sales growth must moderate from current mid-teen levels as product mix is optimized.
- Expect sales per s.f. to moderate somewhat for new stores as lululemon approaches its target size of 350 stores in North America.
- Online sales will likely cap out at some % of actual store sales. While it is very difficult to predict what this point will be, we believe 35% of store sales seems like a reasonable target. Recognizing that this is, at best, a guess, we still believe some form of this limitation should be reflected in forecasts of the future.
- New competitors, trying to copy lululemon's format completely, will face similar difficulties scaling its business. This should provide lululemon some flexibility to continue growth over the next several years with limited competitive pressure.
Assessing Financial Performance
We have assessed LULU's historical performance in terms of margins, growth and earnings quality.
lululemon has experienced significant margin expansion over last three years driven by same store sales growth and fixed store expenses such as D&A, as well as corporate overhead costs not growing as quickly as revenues. This has led to over 5 points of gross margin benefit and 5 points of SG&A decrease as a percentage of sales. This can be seen below in the common size income statement:
Source: Company Financials and Road Less Invested analysis.
However, 2012 has shown a reversal of these trends and this is additionally reflected in management's guidance. Gross margin for the year is expected to be a hair under 55%, which is the company's long-term stated target but a bit lower than 2011 levels. In fact, company guidance for EPS of $1.79 and revenues of $1,352 mm (both midpoint estimates) suggest profit margin of 19.2%, somewhat better than 18.4% in 2011. However, EPS guidance of $1.79 includes the impact of a one-time change in the tax-rate from roughly 36.5% to 29.5%. Excluding the impact of this tax benefit, net profit margin was estimated to decrease to 17.2% this year. The reasons for this include increased costs associated with international expansion, IT development costs and others changes. CFO John E. Currie made the following statement on LULU's Q2 earnings call:
"[W]e expect operating margin to deleverage slightly from the peak levels seen in 2011." Source.
We note that he refers to 2011 as peak margins and that the company in fact targets long-term gross margins slightly lower than 2011 levels.
The company has grown its top line revenues over the past five years at a 46.6% CAGR, which, coupled with the margin expansion described above has produced over 70% CAGR in earnings during the same period. The chart below illustrates LULU's annual revenue growth, as well as the implied revenue growth embedded in management's guidance for 2012.
(click to enlarge)
Source: Company financials and Road Less Invested analysis.
While revenue growth has been somewhat volatile, this is not surprising given the small size of the company and the financial crisis in 2008 and 2009. However, we cannot help but note the slowdown in growth between 2010 and 2012 guidance from 57.1% in 2010, to 40.6% in 2011 to an implied 35.1% in 2012. Top line growth has slowed materially, a trend to watch going forward.
Taking the analysis one step further, we have broken down corporate owned store revenues by source over the last several years. This information is shown below:
Source: Company financials and Road Less Invested analysis.
As shown, approximately 10% of the store revenue increases from 2007 to 2011 came from unsustainable sources including changes in foreign currency exchange and the re-acquisition of outstanding franchises. Of the remaining "sustainable" growth, approximately 50% came from increases in comparable store sales and 50% from new store openings. This is an important consideration. As the store base grows, the impact of opening new stores will moderate over time since. As we have already discussed, it will be difficult to scale up the number of store openings per year. Therefore, over time we would expect comparable store sales growth to become increasingly more important. However, this is a metric that becomes increasingly hard to drive higher with the company's own success (not to mention the natural limitation of store size, limited ability to carry more products, and limitations on the target market).
We believe that earnings quality has deteriorated over the past few years, however, there are no definitive red flags. Perhaps the biggest consideration involves the growth of inventories. As shown below, inventory has grown faster than revenues in each of the last four quarters. This is a typical warning sign for a slowing environment and coming inventory markdowns, however management has stated that increased inventory is a result of growth, in particular very rapid online sales growth that is requiring the company to hold more inventory.
Source: Company financials and Road Less Invested analysis.
While we have no reason to doubt management's rationale, we do note that accruals for inventory obsolescence declined during the same period inventories began growing. This is a very counterintuitive result. Presented below is the company's provision for Shrink and Obsolescence as a percentage of gross inventory.
Source: Company financials and Road Less Invested analysis.
What we find interesting is that this decline in accrual came during a period when the gross margin of the company came under inflationary pressures. This change would have helped offset these pressures. Also note, the current accrual levels are similar to levels seen in 2007 and 2008, prior to the impact of the recession, and are not new levels for the company.
Another earnings quality consideration is what we are calling the "Curious Case of lululemon's Corporate Headquarters." In March 2011, the company acquired the building that housed its Global Store Support Centre for $65.1 million, which represented 53%(!) of their capital expenditures in 2011 despite opening stores equivalent to 30% of its store base. What we found most interesting is that the company attributed $60 million of the purchase to land and approximately $5.1 million to the building. As a result, this $65 million capital expenditure likely only results in a $150,000 annual depreciation expense assuming a 30 year useful life for the building. We believe the company was likely paying significantly more to lease the approximately 70,000 s.f. of this building it was already occupying. And because the value is primarily attributed to land, lululemon will not get a tax deduction for depreciation of $60 mm of the purchase. We believe the accounting for this transaction is EPS driven and not shareholder friendly.
You might be wondering why we have delved into the building purchase. Two reasons. First, in 2011, same store comparable sales grew an outstanding 22% and net profit margins improved from 17.1% to 18.4%. Despite this good news, return on average capital employed actually declined by over 30 percentage points. These are striking opposites! Second, the company recently acquired one of its store locations in Boston. Our quick analysis suggests that again the company has allocated more than 80% of the purchase to land. This practice will benefit operating margins over time as depreciation will be less than lease expense, and depreciation will be fixed (i.e. not reflect inflation). Management's rationale for the purchase was that it was a "permanent location." While we do not doubt the rationale for the purchase or that it was the right decision, we do caution long-term investors to consider whether the financials going forward fully reflect the cost of these purchases. We expect management to make similar acquisitions going forward.
Finally, we note that depreciation as a % of gross PP&E, excluding land, declined significantly from 2010 to 2011. That said, this trend appears to have reversed itself in 2012 and may represent a timing issue of when expenditures were made. We look forward to assessing full year 2012 financials. These PP&E issues are all relatively minor and may be readily explained by changes made in good faith by management due to business conditions. We are not accusing the management of wrong doing, just observing the record with a healthy dose of skepticism.
However, growth in inventories outpacing growth revenues is a classic sign of problems to come. We remain cautious on this point.
Valuing a company with a stock price as lofty as lululemon's is always a challenging exercise. A vast majority of the value is dependent on future growth expectations. In the case of lululemon, current book value equates to about $5.00 per share and current earnings support a $15 to $20 valuation (10 to 13 times LTM earnings). The remaining value gap is explained by growth expectations.
We have assessed LULU's value under five separate earnings forecast scenarios. In each case, we value lululemon at the end of our six year forecast using a 20.0x LTM price to earnings multiple, equivalent to where Nike trades today on a LTM basis. We add to this valuation excess cash we forecast to be on LULU's balance sheet at the time. We then discount the value back to the present at 12%.
We believe a 20.0x LTM P/E multiple at the end of 2017 is more than adequate. First, by this time, growth will have slowed and the five year outlook will likely be less than a 20% CAGR. This means a 20.0x multiple will represent a 1.0x PEG ratio or higher. While certainly Nike's PEG ratio is considerably higher today, we will caution that interest rates are very low. As interest rates rise in the future, we believe what has been the historical standard of 1.0x or a slightly higher PEG ratio will again make good economic sense. Second, we must believe that a 20.0x multiple is still a "big time" multiple that incorporates the assumption of future growth. We see little incentive as an investor to be aggressive on valuation assumptions.
Note, all financial cases and figures shown below are based on Road Less Invested analysis.
Case 1: Everything Goes Right
Case 1 assumes the company opens 30 to 40 stores per year. Same store sales growth continues in the mid-teens range experienced in 2012 throughout the forecast period. Online revenues grow at a CAGR of nearly 50% over the six year period from 2011 to 2017. The company experiences moderate operating leverage, with net profit margin improving from 18.4% in 2011 to 22.4% in 2017. Resulting earnings grow at a 30% compound annual growth rate.
In this case, we value the company today at $77.00 per share.
Case 2: Operating Margins Remain At 2012 Levels
Case 2 presents identical assumptions to Case 1 except that operating margins remain fixed going forward (i.e. the company no longer benefits from operating leverage), consistent with the company's experience in 2012.
In Case 2, we value the company at $66.00.
Case 3: Same Store Sales Growth Moderates Over Time
This case is identical to Case 2, except rather than assume comparable same store sales grow at 15% indefinitely, we assume growth moderates over time. Specifically, we assume that same store sales growth remains at mid-teen levels from 2012 through the end of 2014, then moderates down 2.5% per year to a level of 7.5% in 2017. Given our analysis above regarding store sizes, this is not a draconian assumption. The company itself has noted that more mature stores in Canada have experienced a similar slow down.
In Case 3, we value the company at $60.00 per share.
Case 4: New Store Economics Moderately Decline, Online Revenues Capped
This case is identical to Case 3, except that we now assume that new store sales / s.f. trend down to around $650 / s.f. in 2017 from approximately $900 / s.f. in 2011. In addition, we cap online revenues at 35% of store revenues. This trending down of sales / s.f. at new stores is meant to reflect more marginal locations as the company approaches its 350-store target in North America. Capping online revenues reflects our view that given the company's marketing approach, online revenues are really an extension of store sales. Note, that the impact of this cap slows the CAGR of online revenues from approximately 48.8% to 40.7%, still a meaningful growth rate over the period.
In Case 4, we value the company at $53.00 per share.
Case 5: Modest Decline in Gross Margin Over Time
Case 5 is identical to Case 4, except that we assume that modest competitive pressure causes gross margin to retreat to 2008 / 2009 levels. As a result, net profit margins decline from 18.4% in 2011 to 15.4% in 2017. Note, these profitability levels remain firmly above Nike's LTM profit margin of approximately 9% and the Gap Inc.'s profit margin of approximately 7%. In addition, this forecast still assumes LULU retains industry leading $ / s.f. sales, margins and return on capital metrics.
In Case 5, we value the company at $44.00 per share.
We believe all five cases presented are plausible. However, only cases 4 and 5 reflect our judgment based on the competitive dynamics of the industry and the company's business model. We believe the fair value for the company is at the low end of the range of scenarios presented.