Lululemon: Making The Lemonade

| About: Lululemon Athletica (LULU)

Summary

LULU appears to be on the road to recovery with improved supply chain efficiency and new product launch.

Women's top could be a potential catalyst after the success of the pants category.

Current valuation of 25x next year's earnings is reasonable.

Lululemon (NASDAQ:LULU) reported a solid quarter with strong revenue growth on the back of same-store comps. Guidance of mid-single digits was also in line with expectations, implying that the investment from the supply chain initiative is playing out. Notably, demand was strong across all the key categories, particularly women's and men's pants that saw double-digit growth. Clearly, LULU is executing its new product strategies and investors could see steady increase in traffic comps and margins. At this level, the stock looks attractive with 25x next year's consensus earnings. Although the stock had a great run since the beginning of the year, up 34% vs. S&P 500's +2.5%, I think there is still upside potential, and if the company manages to execute on the women's tops category, that could have material upside to traffic and comps.

I have been bearish on LULU given the competitive outlook and potential margin contraction, but the company has certainly shifted its focus and appears to be executing on refining its supply chain that is driving a better-than-expected margin profile. More importantly, product catalysts are driving consumers back to LULU's retail outlets and this is certainly a positive for comps and revenue growth.

This quarter's results were exceptional with revenue of $496M above company guidance and consensus, while EPS was largely in line. Total comp of +8% was driven by +3% retail comp and +18% direct-to-consumer, suggesting that LULU was able to maintain customer demand momentum despite the increasingly competitive market. As I mentioned earlier, both women's and men's categories were strong, highlighting the exceptional brand value associated with LULU. Notably, women's pants were up double digits vs. the prior year and men's were up more than 20%. While the outsized gain from "Other channels" saw +52% y/y growth, I expect the sell-through to outlets as part of inventory clearance sales to deliver incremental brand equity to LULU, thereby further differentiating itself from the competition.

Going forward, women's top, which is expected to be introduced for the summer, could be another driver. This will be critical for LULU to reach out to the lapsed consumers who have migrated to other brands last year. The bar is certainly high given the success of the pants category. Successful execution will be a key catalyst to drive LULU shares higher in the second half of the year.

In terms of financials, gross margin of 48.3% was ahead of consensus of 47.1% on lower shipping cost and reduction of material cost. On the other hand, SG&A continues to deleverage and that resulted in a +4% increase in expenses. The consulting cost also did not help while marketing cost remained elevated to maintain brand awareness. Management believes that consulting cost will come down in the second half and this is a positive for the margin, but I do not expect it to move the needle that much.

Finally, e-commerce remains a focus area, with the company committed to building a comprehensive e-commerce experience with a newly redesigned website and mobile site. The company is targeting a 20% digital penetration, which I see to be aggressive but not unreachable given the recent rollout of RFID technology that will allow the company to better track its inventory and targeted advertisement strategy that I see as critical to its digital growth.

LULU appears to be on the right track, and I would be a buyer of the stock at this level.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.