Lululemon ($LULU) - Comfort Meets Performance ?

Table of Contents

1. Summary

2. Why is now the time to buy $LULU?

3. Lululemon Q2CY24 Highlights:

4. Sales Growth

5. Store Performance

6. Gross Margin and Pricing Power

7. Operating Margin

8. Earnings Per Share(EPS)

9. Cash Is King

10. Return on Invested Capital(ROIC)

11. Balance Sheet Assessment

12. Final Thoughts

Summary

• Surging same-store sales and aggressive expansion of new locations reflect an offensive push to reach more customers and capitalize on its popularity

• Revenue growth was exceptional over the last five years, indicating it’s winning significant market share

• Estimated revenue growth for the next 12 months is robust and implies its market share will rise

Why is now the time to buy $LULU?

At $320.05 per share, Lululemon trades at a 22.2x forward price-to-earnings ratio. This valuation is fair - even cheap depending on how much you like the story - for the quality you get.

By definition, where you buy a stock impacts returns. Compared to entry price, business quality matters much more for long-term market outperformance. Buying in at a great price helps, nevertheless.

Lululemon Q2CY24 Highlights:

• Revenue: $2.37 billion vs analyst estimates of $2.41 billion (1.5% miss)

• Adjusted Operating Income: $540.2 million vs analyst estimates of $507.9 million (6.4% beat)

• EPS: $3.15 vs analyst estimates of $2.92 (7.9% beat)

• The company dropped its revenue guidance for the full year to $10.43 billion at the midpoint from $10.75 billion, a 3% decrease

• EPS (GAAP) guidance for the full year is $14.05 at the midpoint, roughly in line with what analysts were expecting

• Gross Margin (GAAP): 59.6%, in line with the same quarter last year

• EBITDA Margin: 27.2%, up from 25.9% in the same quarter last year

• Free Cash Flow Margin: 12.6%, down from 15% in the same quarter last year

• Locations: 721 at quarter end, up from 672 in the same quarter last year

• Same-Store Sales rose 2% year on year (11% in the same quarter last year)

• Market Capitalization: $32.57 billion

Sales Growth

A company’s long-term performance can indicate its business quality. Any business can put up a good quarter or two, but many enduring ones grow for years.

Lululemon is a mid-sized retailer, which sometimes brings disadvantages compared to larger competitors benefiting from better economies of scale. On the other hand, it has an edge over smaller competitors with fewer resources and can still flex high growth rates because it’s working from a smaller revenue base.

As you can see below, Lululemon grew its sales at an incredible 22.8% compounded annual growth rate over the last five years (we compare to 2019 to normalize for COVID-19 impacts) as it opened new stores and increased sales at existing, established locations.

This quarter, Lululemon’s revenue grew 7.3% year on year to $2.37 billion, missing Wall Street’s estimates. Management is currently guiding for a 6.7% year-on-year increase next quarter. Looking further ahead, sell-side analysts expect sales to grow 10.4% over the next 12 months, a deceleration versus the last five years. This projection is still healthy and illustrates the market is baking in continued success for its products.

Store Performance

A retailer’s store count often determines how much revenue it can generate.

Lululemon operated 721 locations in the latest quarter. It has opened new stores at a rapid clip over the last two years and averaged 10.8% annual growth, much faster than the broader consumer retail sector. This gives it a chance to become a large, scaled business over time.

When a retailer opens new stores, it usually means it’s investing for growth because demand is greater than supply, especially in areas where consumers may not have a store within reasonable driving distance.

Same Store Sales

A company's store base only paints one part of the picture. When demand is high, it makes sense to open more. But when demand is low, it’s prudent to close some locations and use the money in other ways. Same-store sales is an industry measure of whether revenue is growing at those existing stores and is driven by customer visits (often called traffic) and the average spending per customer (ticket).

Lululemon has been one of the most successful retailers over the last two years thanks to skyrocketing demand within its existing locations. On average, the company has posted exceptional year-on-year same-store sales growth of 13.4%. This performance along with its meaningful buildout of new stores suggest it’s playing some aggressive offense.

In the latest quarter, Lululemon’s same-store sales rose 2% annually. By the company’s standards, this growth was a meaningful deceleration from the 11% year-on-year increase it posted 12 months ago. We’ll be watching Lululemon closely to see if it can reaccelerate growth.

Gross Margin and Pricing Power

Lululemon has best-in-class unit economics for a retailer, enabling it to invest in areas such as marketing and talent to stay ahead of the competition. As you can see below, it averaged an exceptional 57.7% gross margin over the last two years. That means for every $100 in revenue, only $42.30 went towards paying for inventory, transportation, and distribution.

Lululemon produced a 59.6% gross profit margin in Q2, in line with the same quarter last year and exceeding analysts’ estimates by 3.2%. Zooming out, Lululemon’s full-year margin has been trending up over the past 12 months, increasing by 1.8 percentage points. If this move continues, it could suggest better unit economics due to more leverage from its growing sales on the fixed portion of its cost of goods sold.

Operating Margin

Lululemon has been a well-oiled machine over the last two years. It demonstrated elite profitability for a consumer retail business, boasting an average operating margin of 20%. This result isn’t surprising as its high gross margin gives it a favorable starting point.

Looking at the trend in its profitability, Lululemon’s annual operating margin rose by 4.8 percentage points over the last two years, as its sales growth gave it immense operating leverage.

This quarter, Lululemon generated an operating profit margin of 22.8%, up 1.1 percentage points year on year. This increase was encouraging, and since the company’s operating margin rose more than its gross margin, we can infer it was recently more efficient with expenses such as sales, marketing, and administrative overhead.

Earnings Per Share(EPS)

We track the long-term growth in earnings per share (EPS) for the same reason as long-term revenue growth. Compared to revenue, however, EPS highlights whether a company’s growth was profitable.

Lululemon’s EPS grew at a remarkable 26.2% compounded annual growth rate over the last five years, higher than its 22.8% annualized revenue growth. This tells us the company became more profitable as it expanded.

We can take a deeper look into Lululemon’s earnings quality to better understand the drivers of its performance. Lululemon’s operating margin has expanded 3.8 percentage points over the last five years while its share count has shrunk 4.5%. These are positive signs for shareholders because improving profitability and share buybacks turbocharge EPS growth relative to revenue growth.

Cash Is King

Although earnings are undoubtedly valuable for assessing company performance, we believe cash is king because you can’t use accounting profits to pay the bills.

Lululemon has shown terrific cash profitability, driven by its lucrative business model that enables it to reinvest, return capital to investors, and stay ahead of the competition. The company’s free cash flow margin was among the best in the consumer retail sector, averaging 14.2% over the last two years.

Taking a step back, we can see that Lululemon’s margin expanded by 6 percentage points during that time. This is encouraging because its free cash flow profitability rose more than its operating profitability, suggesting it’s becoming a less capital-intensive business.

Lululemon’s free cash flow clocked in at $298.1 million in Q2, equivalent to a 12.6% margin. The company’s cash profitability regressed as it was 2.4 percentage points lower than in the same quarter last year, but we wouldn’t read too much into it because capital expenditures can be seasonal and companies often stockpile inventory in anticipation of higher demand, leading to quarter-to-quarter swings. Long-term trends carry greater meaning.

Return on Invested Capital(ROIC)

EPS and free cash flow tell us whether a company was profitable while growing its revenue. But was it capital-efficient? A company’s ROIC explains this by showing how much operating profit a company makes compared to how much money it has raised (debt and equity).

Lululemon’s five-year average ROIC was 45.4%, placing it among the best consumer retail companies. Just as you’d like your investment dollars to generate returns, Lululemon’s invested capital has produced excellent profits.

The trend in its ROIC, however, is often what surprises the market and moves the stock price. Unfortunately, Lululemon’s ROIC averaged 5.7 percentage point decreases each year over the last few years. The company has shown the ability to generate good returns in the past, but they have not been as strong recently.

Balance Sheet Assessment

As long-term investors, the risk we care most about is the permanent loss of capital. This can happen when a company goes bankrupt or raises money from a disadvantaged position and is separate from short-term stock price volatility, which we are much less bothered by.

Lululemon is a profitable, well-capitalized company with $1.61 billion of cash and $1.46 billion of debt, meaning it could pay back all its debt tomorrow and still have $151.2 million of cash on its balance sheet. This net cash position gives it the freedom to raise more debt, return capital to shareholders, or invest in growth initiatives.

Final Thoughts

Are you wondering whether to buy Lululemon or pass? We urge investors to not only consider the latest earnings results but also longer-term business quality and valuation as well.

There are multiple reasons why we think Lululemon is an elite consumer retail company. For starters, its revenue growth has been exceptional over the last five years. On top of that, its marvelous same-store sales growth is on another level, and its new store openings have increased its brand equity.

Lululemon’s price-to-earnings ratio based on the next 12 months is 22.2x. Analyzing the consumer retail landscape today, Lululemon’s positive attributes shine bright. We think it’s one of the best businesses in our coverage and like the stock at this price.

Wall Street analysts have a consensus one-year price target of $334.46 on the company (compared to the current share price of $320.05), implying they see upside in buying Lululemon in the short term.