Lululemon Stock: Balancing Risk With Reward, A Hold For Now (NASDAQ:LULU)

Executive Summary

Lululemon’s (NASDAQ:LULU) share price held relatively steady after reporting a miss in Q2-24 revenue by $40 million. Furthermore, management also expects both Q3 revenue and full year 2024 revenue to be below consensus, with Q3 revenue coming in between $2.34 billion to $2.365 billion against $2.41 billion and full-year revenue coming in between $10.375 billion to $10.475 billion against $10.62 billion. While GAAP EPS beats by $0.23, it is still surprising to see a momentary rally in share price post earnings considering the bearish outlook that management has painted. This really speaks volume of the negativity surrounding Lululemon, which sent the share price plummeting nearly 50% since the beginning of 2024.

For anyone who is interested in yoga, gym or working out, Lululemon has become almost impossible to miss. After all, it has become a ubiquitous athleisure brand that has ~236x its revenue since 2005. Its success has been grounded on premium brand positioning, high-quality products and unique community engagement tactics that focuses on word-of-mouth marketing and local fitness ambassadors. This stands in stark contrast to athletic brands like Nike (NKE), Under Armour (UAA), adidas (OTCQX:ADDYY) that relied on world-class athletes like Tom Brady, LeBron James and Tiger Woods to market their products.

Business Overview

For the less physically active ones like myself, here is a broader overview of Lululemon’s business. Since its founding in 1988 in Canada, Lululemon has become one of the leading players in the $358 billion activewear and athleisure market. It started out making yoga pants for women and gradually expanded into a wide range of workout accessories, backpacks and a growing collection of men’s athletic products. That said, the majority of Lululemon’s revenue still comes from women products today (62% of Q2-24 revenue), followed by men (25%) and other accessories (13%). Geographically, Lululemon operates in 4 major regions: Americas, China Mainland, Asia-Pacific, and Europe and the Middle East.

So What Could Have Caused Lululemon To Fall From Grace?

In the most recent quarter, Lululemon’s sales growth slowed to 7% YoY, compared to the 30+% CAGR it averaged since 2005. Notwithstanding the Law of Large Numbers, investors are clearly not used to this kind of slowdown and have bailed on the stock, making Lululemon one of the worst performers in the entire S&P500 in 2024. I believe the decline can be attributed to a few key reasons

1. A sharp deceleration in its Americas business – Lululemon’s home turf, which makes up >70% of total revenue today

2. Recent strategy missteps and departure of Sun Choe, Lululemon’s ex Chief Product Officer who has been credited for being the “brain” behind Lululemon’s innovation since 2018

3. Growing competition from existing incumbents like Nike, adidas and newer entrants like Vuori and Alo Yoga

In this article, I wanted to deep dive into Lululemon’s recent successes and woes and evaluate if Lululemon is a screaming buy at today’s prices or something I would park for another day.

The Positives

Industry-leading Profitability

The most glaring positive takeaway I had is the strong profitability picture at Lululemon. At 23% operating margin in Q2-24, Lululemon is head and shoulders above its peers like Nike, adidas and Under Armour. Remarkably, it has also managed to grow its operating margins from 22% 1 year ago and 20% last quarter. The improvement in operating margins is primarily due to an increase in gross margins and prudent management of SG&A expenses.

The profitability story is fairly consistent across all profitability metrics, with Seeking Alpha assigning an “A” rating to Lululemon. What stood out to me most is its 43% return on equity and 24% return on assets, which are significantly better than most names in the retail and apparel industry.

Looking ahead, the real question here is whether Lululemon is able to maintain its operating margins. With growing competitive intensity and price-pressured consumers, many retailers, including Nike, have resorted to slashing prices to preserve market share. While there is no financial evidence so far that suggests Lululemon is going down the same route, I am concerned that Lululemon might eventually succumb to investor pressure due to its dwindling sales prospects, especially in the Americas.

Strong Brand Positioning

I believe that Lululemon is still holding on to its strong brand influence. I arrived at this hypothesis by looking at Google search trends and website traffic to Lululemon.com. We can see that search interest in Lululemon remained strong and trending upwards over the past 5 years. Traffic also remained relatively stable and has averaged ~12m visits per month. This is from Lululemon’s CEO in its recent earnings release:

Our brand remains strong in the U.S. market. Traffic was up across both channels and Google search queries remain positive. Guests are looking for our product, coming into our stores and visiting our e-commerce sites”. I liked looking at these clues as they tend to be more forward looking than financial data and also shares how consumers are thinking about the brand, irrespective of the cyclicality of the current business cycle.”

Share Buybacks

Lululemon is also stepping up on its share repurchase program as a way to return capital back to investors. In Q2-24, Lululemon repurchased $590 million of shares (1.9 million shares at an average price of $310). Year-to-date, Lululemon has repurchased $1.2 billion of stock and has ~$1 billion left on their repurchase program. This is a positive sign because if Lululemon were to continue its share buyback trajectory from 1H-24, it would easily surpass its annual share buybacks in the last 5 years.

The Negatives

Serious Slowdown In The Americas Growth

With the exception of the pandemic period, Lululemon’s sales in the Americas have always grown at a healthy rate of ~20% YoY. While the pandemic has caused physical store and gym closures, it has ignited a new wave of athleisure enthusiasts and followers. It was so fanatic that some have described Lululemon as a “cult” that has created a fervent fan base on the back of its high-quality activewear products. However, as the pandemic eased and things returned to normalcy, Lululemon started having difficulties finding new people to sell its $150 yoga pants to. In the last couple of quarters, sales growth has been declining at a rapid clip, with Americas revenue only up 1% YoY in the most recent quarter. Until the international segment becomes a true behemoth, a re-acceleration in Lululemon’s Americas business is needed for any meaningful re-rating of the stock.

Recent Strategy Missteps And Failed Product Launches

After a recent outpouring of negative feedback and embarrassing reviews about its fit, Lululemon has decided to pull its “Breezethrough” leggings off its shelves. While management has reassured investors that the pause of sales had a negligible impact on revenue and gross margins this quarter, I am concerned that this might be more of a one-off incident following the restructuring of their product and marketing teams. While there were past product recalls for Lululemon, they were fairly rare and hardly due to poor fit or aesthetics reasons. In 2013, Lululemon recalled their Luon Yoga Pants because it was too revealing when wearers bent over. In 2015, Lululemon recalled their drawstring hoodie due to injury concerns. I hope that I am reading too much into it, but this has strangely coincided with the departure of their Chief Product Officer Sun Choe. When it comes to brand innovation, I prefer to be on the err side as it has precipitated the decline of many famous brands, including American Apparel and Gap (GAP).

Along the same lines of product innovation, management has also stepped out and acknowledged that a major reason for its revenue slowdown is due to the lack of sufficient colors and sizes to cater to its female audience. According to Lululemon’s CEO Calvin Mcdonald:

As we have learned more, it’s become clear to us that this reduced newness which is below our historical levels and stems from earlier product decisions, has impacted conversion rates given the fewer new options available to our female guests. While this reduction was seen across our women’s assortment, it had a more pronounced impact in bottoms and in our online channel. The newness that we had performed well, we simply did not have enough to inspire her to purchase.

While I appreciate Lululemon’s management efforts for acknowledging and rectifying the above issues, I need to see more traction and evidence to be comfortable that we are not at the start of the dearth of innovation at Lululemon.

Consumers Are Looking For “Value For The Money”

Amid economic uncertainty and a higher cost of living, consumers are increasingly prioritising value and cutting back on their discretionary spending. According to a poll conducted by KPMG, American consumers are trading down and reducing their spend on apparels by 7% in the summer of 2024. Given Lululemon’s premium positioning and hefty price tag, this pivot in consumers’ attitude would likely hurt Lululemon disproportionately in the short term.

Increasing Competitive Intensity

The apparel space has always been a competitive and cut-throat market, and Lululemon was up against well-established titans like Nike and adidas from day 1. However, with creative marketing tactics and a superior product offering, Lululemon has managed to beat the crowd and carved out a new niche in the active & athleisure space for itself. However, in recent years, two new entrants (Vuori and Alo Yoga) are starting to threaten Lululemon’s dominance. In terms of design, focus and pricing, there are quite a few similarities between the 3 brands.

In terms of monthly sales, both Vuori and Alo Yoga are growing market share rapidly. Since Apr-23, both Vuori and Alo Yoga gained ~1% market share and are currently at a similar size to Athleta, adidas, Under Armour and Fabletics in the activewear space. More than any other brands, Vuori and Alo Yoga also shared a similar audience with Lululemon. 52% of Vuori shoppers and 63% of Alo Yoga shoppers also shopped at Lululemon. Both brands also adopt a similar store expansion strategy by operating 85-90% of their stores within half a mile of a Lululemon store. With restructuring currently underway for Lululemon, there is no better time for both these fast-growing brands to gain ground in this competitive space.

Other Areas Of Concern

Overdependence on China to offset revenue slowdown: Mainland China remains to be Lululemon’s hottest market and saw a 34% YoY revenue increase compared to other international markets that clocked a 24% YoY increase. While this is a deceleration from Q1-24 45% YoY increase, the outcome is still very positive considering China’s sluggish economy. Management’s goal is to expand China’s current footprint to over 220 stores at the end of 2026 and grow it to be the 2nd largest market behind Americas. While China has a large populous market, I am concerned that Lululemon’s growing reliance on China might present a series of strategic risks due to ongoing geopolitical tensions between China-US and regulatory risks in the form of tariffs and unfavourable policies from the Chinese government to protect its domestic retailers.

Failed acquisition of Mirror: M&As are not a common sight for Lululemon. When Lululemon finally decided to pull the trigger in 2020 with the acquisition of MIRROR for $500 million, the outcome could not have been more disastrous. Mirror is a fitness technology company that offers interactive fitness classes through a mirror-like device. What started as a promising and synergistic acquisition quickly turned into a concerning and divisive piece within Lululemon’s core operations. As the home fitness market waned post pandemic, it became increasingly difficult for Lululemon to integrate Mirror into its suite of products. Consequently, it had to write off almost everything for Mirror and discontinue its sales. As the activewear and athleisure market becomes more saturated, M&A will become an increasingly important method for market leaders to grow. This negative experience has undermined my confidence in Lululemon’s ability to execute M&A effectively as a growth lever.

Inventory levels remain elevated: Inventory for Q2-24 came in at $1.4bn (+6% QoQ, – 14% YoY). From an inventory turnover ratio (Average inventory divided TTM COGS) perspective, Lululemon’s ratio of 2.9x puts it in the middle of the pack when compared to Nike at 3.8x, Under Armour at 2.7x, Gap at 3.7x and adidas at 2.5x. While this is in line with management expectations so far, I am not confident if Lululemon is able to trim its inventory levels effectively in the upcoming quarters as management likes to run a full-price business with markdowns used very selectively.

Valuation

From a P/E perspective, Lululemon certainly looks attractive at current prices. It is currently trading at ~19x forward P/E as compared to Nike at 27x, GAP at 12x and Under Armour at 33x. It is also at its 10-year lows when benchmarked against its own historical forward P/E ratios.

However, when we look at the PEG ratio, which, I believe, is more representative since it accounts for future EPS growth, Lululemon looks less attractive at 1.8x PEG as compared to adidas at 1.0x, Gap at 0.3x and Nike at 1.4x.

I also ran a discounted cash flow analysis on Lululemon, and below is a summary of my output and key assumptions.

• % revenue growth: I followed management’s guidance as much as possible, with some downwards revisions to reflect the miss in top-line for Q2-24

  • In 2024, management expects revenue to come in between $10.375 billion to $10.475 billion

  • Per Lululemon’s Power of Three x 2 growth strategy, management targets to quadruple its international revenue and double its overall revenue in 2026 vs 2021

  • Assume growth to flatten after 2026. Note that I did not adopt Seeking Alpha’s analysts’ growth estimates due to the lack of clarity around why growth would re-accelerate after 2026

• % operating margins: Assumed flat vs 2023. I understand that Lululemon has achieved a 23% operating margin % in Q2-24 and the company has done a good job in cost controls. However, I believe it is prudent to bake in some room for price markups in view of increasing competitive intensity

• WACC of 9.5%: Based on latest market inputs. Lululemon does not have debt, so this is effectively their cost of equity

• Beta of 1.26: 5-year average Beta of Lululemon from Finbox

• Long-term growth rate of 3%: Based on US average GDP growth rate from 1960 to 2023 from Worldbank

• Other assumptions like working capital, D&A, CAPEX, tax: Assumed flat vs 2023

With the above DCF, I arrived at an implied share price of $278 per share for Lululemon, implying a 7% upside from its current price of $259. Beyond the qualitative risks I have outlined in earlier sections, the crux here is whether management can execute effectively against its Power of Three x 2 plan by 2026 and whether an upcoming cut in interest rates can boost consumer confidence and reduce its cost of equity sufficiently. As such, I have also run a sensitivity analysis to see what it looks like with different permutations of long-term growth rates and WACC.

In my view, an increase in long-term growth rates is quite unlikely since Lululemon has already grown at sub 3% YoY in the past 2 quarters. With the upcoming reduction in interest rates, a reduction in WACC is possible but unlikely to be very significant. As such, I believe that the upside % for Lululemon in the next 12-18 months is realistically in the range of 7-15%. In the investments I hold, I typically look for a margin of safety of at least 20-30%. As such, I would prefer to stay on the sidelines for now.

Conclusion

Lululemon is one of the leading players in the activewear and athleisure space, with a proven track record of success and a loyal customer base. Furthermore, it has industry leading operating margins and no debt on its balance sheet. However, recent strategy missteps, organisational changes and slowdown in revenue growth has made it difficult for me to consider it a compelling buy. While the current share price and P/E ratio might look attractive to some investors, I am less convinced from a PEG ratio perspective. My DCF that is anchored on management guidance projected an upside of 7-15% for Lululemon’s shares, which is below my preferred margin of safety of at least 20-30%.

While I am still confident in Lululemon in the long term, I am still somewhat uncertain about its short-term (12-18 months) performance for reasons I cited above. In order for me to rate Lululemon as a BUY at current prices, I would need to see a re-acceleration of Lululemon’s Americas growth, more traction in its overseas markets and a series of successful product launches in the wake of Sun Choe’s departures. Otherwise, I would prefer to wait for the share price to dip to my preferred margin safety ($200-$220 per share) before scooping up some shares.