Lululemon Athletica - Turnaround Might Be Sooner Than Expected, Go Long

| About: Lululemon Athletica (LULU)

Summary

2016 goal of product margin expansion seems achievable.

Decent 1H 2015 results.

The major improvement will be observed, once Go-To-Market calendar process is successfully reorganized.

Good entry point for investors, given attractive P/E multiples.

DCF valuation outlays 28% upside potential.

Lululemon Athletica Inc. (NASDAQ:LULU) has been trading at a significant discount to its historical averages, as investors continue to remain worried about the increasing inventory levels and shrinking profit margins. However, we believe that the company is undertaking dire steps to improve product margins, re-organize the Go-To-Market calendar process, improve efficiency of raw material management, reduce reliance on airfreight and renegotiate cost structure with factories. These efforts are expected to reap in significant returns for investors over the next 12 to 18 months.

Performance During 1H 2015

Investors, following the company's stock should take into account the fact that the Vancouver-based retailer of athletic apparel has made a decent turnaround during the current fiscal year, given the huge recalls undertaken in 2012. Since the recall, the market dynamics have changed significantly, as competitors continue to grab greater market share through offering more trendy and fashionable garments.

During the first quarter of FY15, the apparel retailer posted 10.1% YoY (year over year) higher revenues to $423.5 million, surpassing the Street's estimate of $421.02 million. The earnings per share (EPS) clocked in at 34 cents, in line with consensus estimate.

For the same period, the company reported inventories of $236.5 million, up by 33% YoY. The gross profit margin contracted by 230 bps (basis points) YoY to 48.6%, while the operating income margin shrank by 210 bps YoY to 16.1%.

During the second quarter of FY15, the apparel retailer posted 15.9% YoY higher revenues to $453 million, surpassing the Street's estimate of $444 million. The earnings per share clocked in at 34 cents, in line with consensus estimate.

For the same period, the company reported inventories of $280.6 million, up 55% YoY. The gross profit margin contracted by 370 bps YoY to 46.8%, while the operating income margin shrank by 270 bps YoY to 14.7%.

Following the release of better than expected second quarter earnings, the company's stock plunged by 18% as investors remained concerned regarding declining profit margins and rising inventory levels. Supply chain disruptions caused by long delays at the West Coast port has been highlighted as the major reason by LULU's management for increased inventory and lower margins.

The Problem Lies Here

In line with LULU's management, the current delay is being attributed to the design phase and production process delays. In my opinion, the initial delay has been caused by the flexible deadlines given to the design team, accompanied by delays in the approval, followed by delays in the production process. Significant delays in the production process have created excess liabilities for the company, given cancellation of raw material and designs. I believe that if LULU becomes successful in fixing delays, the subsequent problems of increased airfreight reliance and raw material management will automatically be resolved.

Expected Improvements

According to Stuart Haselden, the company's CFO, the company has identified the opportunity to improve product margins by 300 bps in 2016, as compared to 2014. The expansion in product margins will be undertaken through "improvements of our Go-To-Market calendar process, improvements that will deliver lower airfreight, improved raw material management and better costing."

In line with Mr. Haselden's comments, I believe that the company has been trying hard to reorganize its Go-To-Market calendar. The calendar sets a deadline for each department in order to ensure that all the deliveries are on time so that maximum benefit of full-price selling could be reaped. Late deliveries on the market floor have less time to sell at full price, before they are considered to be markdown (sold at a discount) in order to pave way for the next season's styles and products.

Along with reorganization, LULU's management should focus on ensuring accountability in the process so that employees, who are making decisions should be held answerable for any delays. Another significant improvement would be to introduce "style ownership." There should be more than one person to approve designs, in order to speed up the process of approval.

One of the most convenient ways to make up for delayed production time is to air deliveries to get back into the game, but this comes in with increased cost as compared to boating deliveries. As per the estimates provided by the company's management, almost 40% to 50% of the raw materials and finished goods are aired. This alone, accompanied with surcharges due to port delays have adversely impacted 1H 2015 margins by almost 150 bps. Once the calendar is reorganized, there will be more time available for raw materials and finished goods to be transported cheaply through boats, positively contributing towards profit margins.

Due to delays in the design phase, it is not possible for the production teams to commit to provision of fabric. Along with it, changes in the designs being made at a later stage also make it difficult for the production teams to manage raw material efficiently. However, the issues of raw material will automatically be resolved, once the calendar is reorganized and the overall process is managed efficiently.

Following the Luon pant recall, the company is committed towards enhancing quality control protocols. For the purpose, the fabric is checked before every factory receipt, garments are checked at various intervals in the production line and finally, the finished goods are checked again before being shipped to stores. Once the production timeline is improved, it would be easier for LULU to improve quality control processes, which is an essential step towards the long-term image establishment of the brand.

Outlook

As mentioned earlier, the company aims to have 300 bps product margin expansions in 2016. However, these estimates highlight that Lululemon would have to lower its airfreight reliance to 8% to 10% and reduce FOBs by almost 10% to 12% in order to achieve the said margin goal. I believe that the margin goal is realistic as the company is already taking steps to reorganize its Go-To-Market Calendar. Along with it, the company's senior management is traveling next month to renegotiate prices with factories and mills. Based upon the above mentioned factors, we rate the company's stock as Outperform with a target price of $64, translating into an upside potential of 28% from Monday's closing price of $50.17.

Attractive Price Earnings (P/E) Multiples

Lululemon's stock remains attractive based upon P/E multiple comparisons. As per my valuation, the company's stock is currently trading at a 12-month forward P/E multiple of 26x, representing a discount of almost 34% from its historical P/E multiple of 35x. The comparative valuation highlights a good opportunity for investors to go long on Lululemon's stock, given that the company is on track to fulfill its 2016 margin goal.

Financial Valuation

The following is an excerpt of Lululemon's past financial performance:

Metrics/Year

FY10

FY11

FY12

FY13

FY14

Rev ($ mn)

452.9

711.7

1,000.8

1,370.4

1,591.2

Adjusted EBITDA ($ mn)

86.9

182.2

299.4

376.4

391.4

Tax Rate

0.3

0.3

0.4

0.3

0.3

Depreciation ($ mn)

20.8

24.6

30.3

43.0

49.1

CapEx ($ mn)

15.5

30.4

116.7

93.2

106.4

Working Capital Investment ($ mn)

(16.8)

(10.5)

16.7

59.2

67.2

FCFF ($ mn)

66.5

109.8

68.9

127.9

116.4

Rev Growth

28.12%

57.14%

40.62%

36.93%

16.11%

EBITDA Margin

19.19%

25.60%

29.92%

27.47%

24.60%

Depreciation/Rev

4.59%

3.46%

3.03%

3.14%

3.09%

CapEx/Rev

3.42%

4.27%

11.66%

6.80%

6.69%

Working Capital Investment/Rev

-3.71%

-1.48%

1.67%

4.32%

4.22%

FCFF Growth

65.01%

-37.27%

85.73%

-8.94%

Source: Company 10-Ks

In order to forecast future trends of earnings, I have extrapolated the past averages. The table below summarizes my basis of valuation.

Metrics/Year

FY15

FY16

FY17

FY18

FY19

FY20

Rev Growth

16.11%

14.30%

14.80%

15.30%

16.00%

16.50%

EBITDA Margin

24.00%

25%

25%

26%

26%

27%

Depreciation/Rev

3.09%

3.16%

3.16%

3.16%

3.16%

3.16%

CapEx/Rev

3.42%

6.82%

6.82%

6.82%

6.82%

6.82%

Working Capital Investment/Rev

4.32%

4.32%

4.32%

4.47%

4.62%

4.77%

The company did not have any debt on its books till FY14. Based on terminal free cash flow to firm (FCFF) growth of 1.5% and WACC of 5.08%, the enterprise value turns out to be $7.36 billion through a discounted cash flow (DCF) valuation method. The enterprise value translates into intrinsic value of stock of $64, based upon 115.3 million outstanding shares.

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.

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