Lululemon ($LULU) — a High Risk Choice for the Recession

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In the long term, I am bullish on this steady-growing, increasingly profitable company with an expanding moat. But a recessionary environment could pose huge short term threats.

Revenue and Earnings: Past and Future

As seen above, revenues have consistently grown at around 15% per year. While this is a strong growth rate for a clothing company, it is worth noting that their revenue growth has been outpaced by tech stocks like Facebook and Google. Of course, it’s not fair to compare a clothing company to tech, because software is inherently more scalable than clothing. But, if we found that a great tech company was undervalued relative to LULU, the tech company would likely make a better investment. However, LULU is still worth considering as a means to diversify into consumer discretionaries as the sector has dipped given recent economic events (inflation, rate hikes, etc.)

Earnings growth has followed more of a see-saw pattern than revenues, which is not a surprise given that the growth of SG&A expenses have generally outpaced gross profit. I do not believe this is a concern, because the general trend is clearly strong upward earnings growth. However, we should not assume the stellar FY2021 performance (42% revenue growth, 65% earnings growth) will continue. In my opinion, there were two factors that contributed to their 2021 outperformance, one transient and one lasting: COVID stimulus and pricing power.

The COVID Bull Run

According to their most recent 10-K, about half of LULU’s revenue comes from e-commerce sales. So it is no surprise that they benefitted from the e-commerce boom during lockdown. This of course is not sustainable and has more to do with temporary macro conditions than the fundamentals of the business. We have already seen ecommerce platforms like Shopify suffer major losses in the market as enthusiasm has declined. Therefore, it is important to make sure the 2021 bull run is not being priced in. Based on it’s own history, it seems we are getting there. The current P/E for LULU is 33, compressed from a max of 73 in November 2021. The March 2020 COVID crash P/E was 28. So we have already seen significant correction on valuation. It is possible we will not reach 28 again if general sentiment has improved.

Pricing Power

Lululemon’s branding and reputation give it staying power as a high-growth clothing company. Long story short, there is a cult-like following around this company’s products. People know the products are overly expensive, yet they still want them. So the company does have a moat. They have also been wise to expand beyond yoga pants and other accessories into shoes, tops and pretty much any activewear one could imagine. They have also recently acquired a Peloton-style company called MIRROR, described below.

MIRROR Acquisition: Creating a Lifestyle Ecosystem

In Fiscal Year 2020, LULU acquired MIRROR.

MIRROR, unsurprisingly, is a mirror. Except it displays instructor-led workout routines overlaid on top of your reflection. To access these classes, one must purchase the device ($1500) as well as sign up to a monthly subscription service ($39.99/month). So, the thing isn’t cheap. But this could actually be a positive in my view. When customers have sunk so much upfront cost into buying the mirror itself, they will be more inclined to stay subscribed and get their money’s worth. I also think that in-home workouts are a secular growth trend that should continue with or without COVID. Many people new to working out feel uncomfortable in gyms, and even experienced people may enjoy the “presence” of a virtual coach guiding them through the workout. I also think it is generally wise of LULU to expand their product offerings beyond just clothing, and create a sort of “ecosystem” of fitness-related products. This is what other businesses like Nike have done with their running apps, for example.

Balance Sheet / Debt Position

The company has an excellent track record of financial discipline. Their debt has never exceeded cash for the last 10 years, meaning they could pay off all of their debt in full at any time. They didn’t even begin taking on debt until FY 2019 in preparation for the MIRROR acquisition and fueling digital expansion into ecommerce and online training apps like I mentioned above. There is really nothing to worry about debt-wise.

Buybacks

LULU is still growing at “growth stock” pace, yet they have a consistent record of share buybacks, a shareholder-friendly policy. Share buybacks are good for shareholders, because if the valuation (market cap) of the whole company remains the same, then each remaining share after a buyback is now worth more. So share buybacks can amplify shareholder’s returns in the long term. As we can see, shares outstanding has declined 11% in the last 10 years. This is a good pace for a growth stock like LULU. We would not want to see them spending too much on share buybacks, because their primary focus needs to be fueling future growth, product offerings, et cetera.

Cash Flow

As we can see, LULU has consistently grown free cash flow, and maintained a free cash flow margin around 10%. Free Cash Flow is cash flow that remains after capital expenditures. This means it is usable for things like share buybacks or dividends. In other words, it is cash that is returned to shareholders of the company. The growth pace of their FCF has outpaced that of revenue, suggesting that LULU is improving their efficiency, making the most of their expenses and keeping a greater percentage of cash flows for shareholders.

The above graph compares the Free Cash Flow margin of LULU to a few competitors, including Nike, Adidas and VF Corp (North Face). Free Cash Flow margin is Free Cash Flow / Revenue, expressed as a percentage. It answers the question “what percentage of revenue survives operating expenses and capital expenditures, and remains to be distributed to shareholders?” As we can see, their FCF margin has consistently rivalled and often outperformed that of their competitors.