Description

Scribd Link: http://www.scribd.com/doc/130563184/Lulu-Writeup

LULU is no stranger to VIC (see write-up from January 2010 which outlines a short thesis based on overvaluation and competitive threats).  Today, LULU stock is significantly higher and the competition has increased dramatically.  We believe the valuation is unsustainable and consensus earnings will not be met.  Our view is that slowing comp sales, low new store productivity, unlikely success outside of North America (specifically, Hong Kong), and increasing competition (by many deep pocketed players) will put a major dent in the momentum driven investor base.  We believe that earnings will be underwhelming and the stock will be in the mid $40s or lower by year-end.

Slowing sales growth a concern

LULU has had one the highest top-line growth rates in the consumer sector over the past 5-plus years. For perspective, from 2007 to 2012, the company generated revenue CAGR of over 35% driven by mid-teens comparable sales, double-digit square footage growth, and the build out of its e-commerce business.

However, same-store-sales have slowed over the past several years from 30% in 2010, to 20% in 2011, and to around 16% in 2012 (Table 1). Importantly, same-store-sales are now expected to slow to under 10% in LULU’s January year end quarter.  We believe the slowing in the core business, combined with extremely challenging comparable sales figures the company is facing in early 2013, is likely to drive further slowing in same-store-sales over the course of 2013.

In addition to a muted macro environment and increased competition broadly, LULU is facing same-store-sales growth headwinds from its maturing store base (Table 2). LULU’s mature store base, defined as stores open for more than 5-years, is increasing significantly as a percent of their overall store base. In 2008, stores 5-years and older comprised 18% of LULU’s total store count. By year end 2012, LULU’s mature store base will be over 50%. The maturation of LULU’s store base puts significant pressure on the company’s new stores to generate very high growth to offset the much lower growth in the mature store base. To compound the issue of the maturation of the store base, is the fact that LULU’s mature store sales growth is slowing. Canada (50 stores) comped up mid-teens early in the year, but has now slowed to low-single digit as of 3Q12. This highlights the challenges in driving incremental sales in many of LULU’s highly productive mature stores and makes it unlikely LULU will sustain 10%-plus comps going forward, in our view.

Table 1: See Scribd document

Table 2: See Scribd document

Sustained productivity declines

We estimate the new store productivity is set to be below 60% for a third consecutive year. This is one of the lowest figures we have seen from a growth retailer, and we believe sub-60% is concerning – and, will result in sustained margin pressure going forward. 

LULU faces inherent margin headwinds over the next several years due to a combination of less leverage on its mature store base as sales slow and lower new store productivity. For perspective, we estimate LULU’s current store base has operating margins of around 34%-35%, running sales per store annually of $6mn. The issue for LULU revolves around lower new store productivity, where sales/store for new stores is about $3mn. Based on our understanding of LULU’s current fixed cost structure, it implies new store margins of around 25%. So, as LULU continues to aggressively expand the new store base at margins well below the older store base, margins will remain under pressure.

The street currently forecasts LULU’s margins to remain stable to growing. In our view, LULU faces the classic catch-22. LULU can either continue to drive aggressive store expansion which will drive margins lower faster as management tries to sustain total sales growth. Or, LULU will be forced to slow store expansions as new store productivity slows as less attractive locations are available. In which case, total reported sales growth could slow meaningfully.

I believe there is sizeable risk to LULU earnings in 2013 and 2014 (Table 4). Based on comps that that are already slowing and increasing competition broadly, we believe comps will slow to 7% in 2013 and mid-single digits in 2014 and 25%-30% growth in the ecommerce business. We assume LULU remains aggressive in building out square footage growth, with 20% square footage growth over the next two years. From a margin perspective, LULU likely faces two headwinds. First, as comps decline to 7% there is limited to no margin leverage, while 5% comps result in margin deleverage. Second, LULU new store margins run around 25% and as the mature store base continues to slow, the margin dilution from new store will drive more visible dilution in LULU company store margin. We believe LULU total company margins could see 300bps of margin compression over the next two years based off of slow comps, dilution from new stores at lower productivity, and a continued ramp in cost associated with ecommerce and the international rollout. We  believe LULU is unlikely to earn $2 in earnings in either 2013 or 2014, well below street estimates of $2.26 and $2.80 respectively.

I believe the market, and especially LULU bulls, are grossly underappreciating the “perfect storm” LULU faces in regards to margin pressure. LULU has largely been able to compensate for below average new store productivity and 20%ish margins on the new store base because LULU’s current (i.e. open more than one-year) store base has been comping double-digit over the past two years, which has resulted in enough margin leverage at the current stores to mask the margin dilution from new stores. As comps continue to slow on current stores and margin leverage evaporates from those stores, the dilution from the new stores will becoming increasingly visible. While comps slow, LULU is ramping investment internationally. However, we believe these costs are going to continue to increase well beyond the top-line benefit from new international stores – this dynamic will only compound margin pressures LULU faces in the domestic business and ecommerce mix benefits cannot feasibly offset margin pressure. Lastly, we believe LULU is likely to face on-going cost pressure from China labor costs, which will put pressure on the company’s cost structure as well.

Table 3: See Scribd document

Table 4: See Scribd document

International expansion unlikely to be successful

As sales in North America have decelerated, LULU’s management team is focused on building out the business more internationally. LULU plans to begin pre-seeding activities in up to 15 countries over a two-year period, including further penetration of these markets through the build-out of showrooms. The two larger markets that LULU attempts to grow in near-term are London and Hong Kong. We have skepticism that LULU will be successful in these markets.

Hong Kong is not an entirely new market to LULU. LULU opened up its first showroom in Hong Kong over 4 years ago in October 2008. The showroom operated as a retail shop Thursday to Saturdays and also offered complimentary yoga classes. We believe the length of time from LULU’s first showroom (over 4-years) to its more aggressive expansion efforts currently, highlights the significant risk around the success of LULU in the Asian market. (http://www.info.gov.hk/gia/general/200810/25/P200810240141.htm)

In addition, yoga shops in Hong Kong continue to struggle. Yoga shops throughout 2010 to present have shut down due to financial problems. As highlighted in the article embedded below, the combination of bad customer experience and lack of industry standards and the passing of a “fad” led to distress for many yoga companies throughout Hong Kong. (http://www.travelwireasia.com/2011/01/yoga-and-hong-kong-now-thats-stretching-it/)

 Based on our research and the fact LULU has operated a showroom in Hong Kong for already over 4-years, seems to suggest to us that a market such as Hong Kong being a huge growth driver is unlikely.

Competition is not going away

The competitive pressures surrounding LULU continue to mount. It is well known that LULU will continue to face significant pressure from retail heavyweights such as Nike, Under Amour, and Adidas. However, there is an increasing threat from small niche yoga apparel companies, many offering similar products at a lower price point. Recent new comers, include Ellie, a LA company that received capital. Australian active wear retailer, Lorna Jane, opened its first store in CA last and has continued to see success. The company is considering opening up to another 16 stores in 2013, on top of the 9 stores opened last year. In addition, GAP continues to make headway with its Athleta brand, and expected to open 50 U.S. stores by the end of 2013.

The table below highlights the number of competitors LULU is now facing. Many of these competitors continue to expand aggressively. We believe LULU is facing now facing the most competitive operating environment it has ever witnessed.

Table 4: See Scribd document

Valuation

We think the slowing comp sales, low new store productivity, margin risk, and increased competition do not support LULU’s current valuation of north of 35x P/E. We believe comps are set to slow to 7% this year and 5% in 2014 which put substantial pressure on lower EPS and multiple. We believe LULU is likely to earn around $2 per share in FY2014, well below consensus of $2.80. Assuming a P/E of 20x-25x, it would imply a value in the mid $40’s – 35% downside from current levels.

Risks: The largest risk is LULU’s short interest at nearly 20%, success expansion in international markets, and a more robust macro recovery.

 * Historical financial data from LULU financial filings, consensus numbers from Bloomberg

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