Canada Goose: Lululemon Parallels But Nosebleed Valuation

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About: Canada Goose Holdings (GOOS)
by: Detroit Bear
Summary

Canada Goose reminds me of Lululemon, as a fast-growing Canadian apparel company with technical expertise and a booming DTC business.

Revenue and margin expansion has been impressive with presumably a ways to go in terms of market geographic penetration.

Still, the market is pricing the company at over 45x free cash flow - the definition of being priced for perfection.

I am avoiding shares at current prices.

Shares of Canada Goose (GOOS) are down significantly from their 52-week high of $72.27, down 34% to $47.82 per share. The 52-week high was spurred by a blowout second quarter, with the decline driven by the broader market decline. Overall, I see striking similarities in the model to Canadian peer Lululemon (LULU), particularly with the rapidly growing DTC business and strong reputation for innovation and quality.

Nevertheless, I believe the market is far too optimistic about Canada Goose’s prospects, and I think shares are significantly overvalued at over 45x free cash flow. I fundamentally like the company, and its business model, but there is a chance that Canada Goose either loses its cache as market saturation increases or is unable to expand into enough adjacencies to grow revenue beyond jackets. As a result, I would avoid the stock at current levels.

Canada Goose – Strong Core Revenue Driven By Jackets And Premium Positioning

Canada Goose is not a luxury brand. Luxury brands have limited availability, a focus on very niche customer segments, and focus on conspicuous consumption over utilitarianism. Canada Goose, on the other hand, is a premium company that has best-in-class products available at a premium price point. Though the company has pursued a limited distribution model in the past, Canada Goose’s model has become less about creating brand cache and more about satiating excess demand.

Since Bain Capital invested in the brand in 2013, Canada Goose has focused on adding distribution via increased direct selling online and in-store, as well as further wholesale penetration. Since FY15, revenue has more than doubled to $591 million CAD from $281 million CAD, with revenue likely to grow another 30% y/y in FY19. The company seemingly exploded overnight from a niche jacket manufacturer for arctic expeditions to a leading cold weather fashion brand in the United States, Canada, and abroad. Canada Goose truly started as a high-end coat that was the leader in category performance (staying warm in arctic climates), but it has gained mainstream traction as both a premium brand as well as a functionally superior product.

Transition From Wholesale To Direct Highly Profitable

At the end of FY15, Canada Goose did less than $8 million CAD in direct sales compared to $210 million CAD in wholesale revenue. As this came prior to the fairly rapid increase in growth, gross margin at the time sat at 40.6% at a consolidated basis with a 73.4% gross margin from the direct business compared to a gross margin of just 39.3% from the wholesale business. Canada Goose’s strategy here was simple but brilliant. In order to get brand exposure, the company expanded within key partners like Nordstrom (JWN), Barney’s, Neiman Marcus, and Bloomingdale’s (M) to get exposure.

This led to a huge payoff as demand for the brand surged, and wholesale revenue jumped to $336 million CAD at the end of FY18. I believe the initial increase in wholesale did a great job of bringing attention to the brand, and bringing it from the fringes of high fashion to the mainstream.

Concurrently, Canada Goose invested heavily in its direct-to-consumer business via online sales as well as opening its own retail outlets. Unlike Lululemon, which opened up a significant number of retail outlets, Canada Goose has primarily built brand experiences, with just two stores in Canada, three in the United States, one store in London, and two showrooms in continental Europe at the end of FY18. This has helped keep capex spending relatively low, though the company has increased capex spending to over $70 million CAD in FY19, with new stores in New Jersey, Toronto, Tokyo, Hong Kong, and Beijing to help drive brand awareness and sales growth, particularly in the Chinese market.

As a result, the majority of business is online, and it is demonstrated in the profitability. The direct business generated a 74.4% gross margin in FY18, and with relatively light SG&A spending; it delivered a contribution margin of 52.8%. This compares very favorably to the wholesale business that while requiring little SG&A, delivers a gross margin of 46.9% with a contribution margin of 35.9%. Obviously, the direct-to-consumer business will continue to outperform as it receives a great share of investment capital. However, it should be noted that the profitability of the wholesale business has remained relatively robust, far exceeding the profitability that most companies with a wholesale business are able to achieve.

Overall, this plan to grow the retail business will continue to benefit the overall profitability. Importantly, I believe the combination of owned stores and wholesale partners will allow the company to introduce more products and leverage partners as showrooms for new product introductions. In essence, having a robust wholesale business acts as a strong conduit to advertise products. If advertising costs are simply less accretive sales, then I think Canada Goose has found a great model.

Geographic Penetration Remains Relatively Low

It is incredibly difficult for a part-time analyst like myself to completely estimate the market potential for Canada Goose, but the company makes an attempt to quantify jacket potential relative to Canada-based location above the 37th parallel and a household income greater than $100,00. Based on the company’s estimates, achieving 35% of Canadian penetration would equate to a tripling of demand. This is conservative in the sense that Canadian penetration appears to be growing, though the 35% penetration rate is fairly arbitrary.

Source: Canada Goose 2018 IR Deck

The upside is ultimately quite clear, as Canada remains the largest geography at $229 million CAD, followed by the United States ($184 million CAD), and the rest of the world ($178 million CAD). Without question, Canada Goose is relatively underpenetrated outside of Canada, which itself is not fully penetrated. Canadian revenue grew 47.5% y/y in FY18, faster than the 39.7% growth in the United States, and only a touch slower than the rest of the world, which is significantly smaller. Geographic penetration will be a continuing growth driver for several years to come, and in many respects, Canada Goose may be an ultra premium version of the North Face (VFC) in its infancy.

What The Market Is Currently Pricing In

At current prices, the market is valuing Canada Goose at over 45x free cash flow. To justify the current market price, one can assume essentially the next five years experience revenue growth at a CAGR of ~25% with flat to increasing operating margin. This is bold, and I believe there is significant risk to this sort of growth. For one, unlike North Face, which has jackets in the $200-400 range, Canada Goose is selling its jackets for $800-1,500 - a significant price premium. While this is an aspirational product, it may limit overall market potential as well the rate of penetration.

As a resident of a location that greatly benefits from Canada Goose ownership, I can attest to the utility. However, people in urban demographics spend a significant amount of time outside commuting and moving between places. This will be a high utility product for residents of cities in Europe and Asia that have to spend time outside. Suburban commuters, who may be great target customers for the product, spend a significant time in their cars during the winter, and thus may not receive the same level of utility. Therefore, to get more suburban customers, Canada Goose will have to rely more on signaling or targeting those who enjoy outdoor activities.

Secondly, there is risk in expansion beyond jackets. I live in a very robust Canada Goose jacket market, and I have not seen much in terms of hats, jackets, or other outerwear. While the company has a terrific reputation for coats, I am not sure they have been able to extend that reputation into other areas. The Canada Goose leather gloves have a relatively bad rating on Canada Goose's website (below).

The foray into other product adjacencies will be difficult. Canada Goose acquired a footwear company, Baffin boots, which fits with the company’s core heritage as a high performance, high-quality brand. However, I am not sure if it fits Canada Goose’s new model as an aspirational, fashion brand. It is a natural adjacency, but the boot market is rather crowded, and it is tough to envision an innovation on par with the Canada Goose down jacket.

In my view, the market is currently pricing in perfect execution on both of these fronts, with Canada Goose essentially becoming the new North Face. I do believe this is in the realm of possibility, but the current valuation of over 45x does not provide a sufficient margin of safety. Overall, I think Canada Goose has fantastic sales growth potential and the ability to improve its operating margin from an already impressive adjusted EBITDA margin of 25.2%.

There is significant execution risk in scaling a brand – just ask Under Armour (UA) – Canada Goose is not immune from these same issues, and in many ways, will have to follow a strategy of moving beyond its core product. I am staying away from shares, but I could be compelled to go long at a much lower price – $25-30 per share. However, if the stock gets to those levels without a larger macro concern, there could be more pertinent issues at the Canadian jacket giant.

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.