Digging deeper into Lululemon Athletica

Today, I'll pick up where I left off yesterday with an analysis of Lululemon Athletica (LULU)...

In yesterday's e-mail, I shared my "first look" at the apparel company – focusing on its 20-year financial history. As I concluded:

In summary, Lululemon's financials paint a beautiful picture: exceptional top- and bottom-line growth... steady, high margins... robust [free cash flow ("FCF")]... a pristine balance sheet... and solid capital allocation.

So why has the stock been nearly cut in half since late last year? And could it be a buy at these levels?

Here's the chart I shared yesterday showing the stock's recent steep decline:

But let's take it a step further by taking a look at the stock chart since the company went public in July 2007 at $18 per share...

After briefly touching $30 in October of that year, LULU shares fell more than 90% to a low of $2.24 during the tail end of the global financial crisis. From there, it rose 230 times to its all-time peak of $516 this past December. But as I said yesterday, the stock is now down nearly 50% from its all-time high.

You can see the moves in the chart below:

This recent steep fall happened for a variety of reasons – the single biggest of which is that Lululemon simply became extremely richly valued.

I discussed this topic in my August 13 e-mail about the "quality bubble" – showing how companies like Costco Wholesale (COST) and Apple (AAPL), as great as they are, are trading at valuations far above their historical norms... making them vulnerable to sharp pullbacks (and explaining why Warren Buffett cut his stake in the latter by nearly half).

To see examples, look no further than three beaten-down growth stocks I've written about over the past month: Five Below (FIVE) on July 22 and July 23, Nike (NKE) on August 9 and August 12, and Starbucks (SBUX) on August 14.

As you can see from the next chart of the forward price-to-earnings (P/E) ratio, Lululemon traded around 30 times forward (next 12-month expected) earnings for most of the past two years. But then the stock spiked near the end of last year, taking it to 38 times forward earnings – a level from which there's a long way to fall if there's any misstep or slowdown.

And sure enough, a steep fall is exactly what happened. Take a look at the recent big drop in the forward P/E ratio after all that time in higher territory:

This Wall Street Journal (WSJ) article from June 6, the day after Lululemon reported first-quarter earnings (it reports second-quarter earnings next Thursday), does a good job of capturing what happened: Why Lululemon's Stock Is Going Out of Fashion. As the article explains, investors were concerned about slowing growth in its largest market:

Its results, though, only confirmed fears that Lululemon's growth is slowing in the Americas. In the quarter ended April 28, Lululemon's comparable sales growth in the region was flat, compared with the 1% increase analysts were expecting. That is a notable slowdown from the double-digit growth investors were used to.

And Lululemon's response didn't appease investors. As the article continues:

The company played down the significance of the recent sales trend: Chief Executive Officer Calvin McDonald said the company missed some sales because it didn't carry as many colors of its leggings as consumers wanted, and because it ran out of some sizes. He also said the company missed out on sales of newer bag styles, which sold out quickly, because of a lack of inventory. McDonald said the inventory issues should be fixed in the second half of its fiscal year.

Investors are also concerned about the company expanding outside of its core yoga market and new competitors nipping at its heels. Here's more from the WSJ article:

But the misstep could imply that Lululemon is losing touch with its customer base as it expands from a yoga-focused brand to one that sells everything from footwear to bags to golf apparel. The North American sportswear market itself is growing at a slower pace, according to Jefferies, and smaller competitors with well-defined niches have been nipping at its heels.

Fashion-forward Alo Yoga, and Vuori, a men's focused brand backed by SoftBank, have been opening stores close to Lululemon...

Alo and Vuori aren't so small that Lululemon can ignore them: Their combined women's U.S. business has annual revenue of about $1.5 billion, representing about 38% of Lululemon's size in that market, according to Jefferies. And Gap Inc.'s Athleta, a larger company that had been losing market share over the past two years, recently returned to growth.

The article concludes with a reminder that this is still a great company:

All of this has to be put in context, of course. Lululemon is still expecting revenue growth of about 11-12% this fiscal year, helped by rapid growth elsewhere in the world. Its operating margin, at about 20%, is almost unmatched in the nonluxury apparel space. Its sales productivity – measured per square foot – may fall short of Apple or Tiffany, which sell much pricier products, but far exceeds retail peers, valuation per BTIG.

Still, Lululemon's premium will be harder to justify if it can't prove that it is unequivocally dominating its core U.S. market. Its new creative leader has a lot to prove.

But with a stock that began the year trading at nearly 40 times expected 2024 earnings, results that were a bit short of perfection have led to a big crash.

To better understand the business, I recommend reading this recent blog post by Analyzing Good Businesses, which highlights Lululemon's small share of the markets in which it competes, and its growth opportunities. Excerpt:

According to the company's estimate at its analyst day in 2022, the global sports apparel market was $115B, of which $83B is in North America. This would imply using 2022 financials, that Lululemon commanded 6%-7% of the market. The company's expansion into other product categories like accessories, shoes, etc. increases the addressable market to $630B.

Lululemon has two main growth vectors going forward, international expansion and increasing brand awareness. In 2014, the company generated 6% of its revenues outside of North America. This compares to over 21% in 2023. China has been the highest growth region, increasing from 6 stores in 2016 (first year opened) to 127 stores in 2023. China is now the region with the highest number of stores outside of the U.S. at 367. The stores are predominantly located in tier 1 and tier 2 cities, split roughly 50/50. The target for 2026 in China is 220 stores.

As the post continues, regarding the other opportunity of increasing brand awareness:

At its 2022 analyst day, the company stated that the brand only has 25% brand awareness in the U.S. (38% women's and 11% men's). And in China, brand awareness was only 7%. This compares to other long established fitness brands like Nike/Adidas with 80+%. And even by product category, there are opportunities to improve awareness. Lululemon is known for yoga and had 68% brand awareness in this category, followed by train at 49% and run at 43%.

I also suggest listening to this 46-minute podcast episode on Lululemon from July 2023 with my friend John Zolidis of registered investment adviser ("RIA") Quo Vadis Capital.

I always like to consider the bear case as well, which was laid out in an April 4 post on my favorite stock idea website, Value Investors Club, by someone using the handle TrojansFightOn – who concluded:

Lululemon started to explore products in subsectors other than Yoga since 2022, such as running shoes, tennis, golf, and athleisure. If we compare Lululemon's strategy with other brands, we can notice that product line expansion is a typical practice when the company's major product line faces slow-down.

Take Under Armour as an example – UAA was the leader in indoor fitness segment, but later was overtaken by Lululemon. It enjoyed high growth before 2013 as the segment lacks competition. The brand was first focused on men's series, and have brought up the strategy of "female focus" in 2013, and conducted multiple marketing campaign in 2013-14. The strategy saved its revenue growth for 1-2 years. However, the company's female strategy wasn't very successful due to its product design and competition from Lululemon. Starting 2017, the company's revenue growth dropped to low single digit, and management entered into multiple subsectors, such as yoga, ski, and golf, but again wasn't very successful. Other examples [include] Adidas and Allbirds.

And as the post continued:

It's hard to say whether Lululemon's growth has peaked out here, but it's a clear signal that the management believes the growth should be supported by a second curve. After my visit to Lululemon stores, I personally think that Lululemon's tennis and golf trial will be good, but running shoes and athleisure likely to be lukewarm.

So with Lululemon's stock roughly cut in half and trading at around 18.5 times consensus analysts' estimates over the next 12 months, does that mean it's time to buy?

I still need to do more work on this to be sure, but I'm inclined to say yes.

That said, given the slowing economy and difficult year-over-year comparisons, I think there might be another quarter of flat growth in the Americas... So it wouldn't surprise me to see the stock take one more leg down after the company reports earnings next Thursday.

And that's what I'm hoping for... That way, the price would be even more attractive if my team and I decide that Lululemon looks compelling enough to officially recommend buying in our flagship Stansberry's Investment Advisory newsletter. (If you aren't already a subscriber, you can find out how to become one right here.)

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.