Description

Lululemon Athletica - Short - (COMP:LULU)

1.25.2010 / $29.14

Lululemon Athletica ("LULU" or "Lululemon") is priced for perfection at current levels (16x FYE 1/31/2012 EBIT, 24x EPS).  The market believes that current metrics and margins will apply through full penetration, which is increasingly unlikely given (i) new competitors in the yoga space and (ii) sustained gaps in US store productivity (due partly to (i) today's economic climate and (ii) the presence of new competitors).  The biggest risk here relates to timing and the stock's technicals (17% of float is sold short / 10 days to cover).  I think ~$20 (30%+ return) is a reasonable target price, as the market realizes that current metrics and margins are unsustainable and the equity is repriced.  I would not be surprised to see sizable insider selling after Q409 earnings (Advent International, a 7% shareholder, could sell their remaining stake given the stock's performance and valuation, and the fact that they are approaching a five year hold on this investment).

Investment Thesis

• Operating Metrics are Unsustainable - LULU is a best-in-breed retailer, with industry-leading metrics and returns across the board (50% gross margin, $1,450 in comp sales per square foot, high 20% ROE).  I believe these metrics are unsustainable as they grow their store base into the smaller markets needed to reach ~300 North American stores, or ~250+ in the US.  Retailers & apparel makers are entering the yoga market through (i) tuck-in acquisitions (Athleta, Lucy) or (ii) new brand extensions (Addidas).  Competitors' products are good and getting better, and are usually priced at meaningful discounts (for those not familiar with LULU, the Company's core product is the $98 Groove Pant).  A few notes on competitors are listed below (please note that I am still digging for new info relating to competition). 
  • Lucy - a high-end retailer focused on women's yogawear, operating 60 stores in the US.  Lucy generates ~$65mm in revenue and plans to grow revenue at a 30% CAGR (VF plans to increase the store base to ~200).  Lucy stores have a similar feel when compared with LULU, although products are priced at a discount and do not have the same cachet.  VF's backing and expertise in brand development suggest Lucy could become a formidable competitor over time.
  • Addidas / Nike / UnderArmour - Addidas owns two brands through (i) Addidas by Stella McCartney, a new line launched in 2005, and (ii) Addidas' house yoga brand.  Stella is focused on high-end technical products, leveraging technical expertise from Addidas' Clima365.  Stella's products are marketed to very high-end customers (who associate the Stella brand with Tracy Anderson, a personal trainer for the stars who also promotes Stella products), at price points generally above LULU products.  Addidas' house brand offers the same Clima365 technology as the Stella line, but at a lower price point.  Nike has not made such a concerted effort, but has developed yogawear under the Nike brand.  These two competitors are important in that they are the two largest athletic apparel manufacturers / retailers in the world; although they are much less focused on creating a community (and therefore differ somewhat in focus and strategy from LULU; this is also why a NKE acquisition of LULU is so unlikely).  UnderArmour is more sports / performance-focused than LULU (they made a major hire in 2008 to ramp up their women's apparel, but I don't have too much hard backup here).  I'd view UA's role in the yoga market as similar to NKE, in that they are more focused on products and wholesaling.
  • Athleta - Gap purchased Athleta for ~$150mm in 2008; a catalogue / online business selling third party and private label products (private label are the vast majority of sales) to athletic women.  Athleta's products are priced at meaningful discounts, although they get good reviews and seem to be high quality.  Athleta products are sold across all Gap websites (Gap, Old Navy, Banana Republic), allowing Gap to leverage its existing online distribution with a new product set.  It is unclear if Athleta will build out a meaningful retail presence.
  • Smaller Players - Victoria's Secret, Eddie Bauer, Bebe Sport, J Crew, PrAna, Lotuswear are all vying for a piece of the yoga market.  Eddie Bauer's yoga brand has ambitions to grow to 200 stores, as does Bebe Sport.  Private label is not considered here.
  • The table below details key operating metrics for several of LULU's purest comps.  I believe that Victoria's Secret is the best long-term comp, given the brand and focus.  There are no perfect comparisons, but the table below, coupled with competitor pricing data suggest that LULU's operating metrics and margins are unsustainable.

• US Store Base is Less Productive - LULU's growth has been and will be driven by US expansion.  LULU's domestic stores are about 50% as productive as their legacy Canadian stores (LULU is based in Vancouver).  Some drop-off is to be expected given a normal productivity curve for new retail locations; however, there are several notable differences between the Canadian stores and the newly launched / future US stores.  
  • LULU was really the "first one there" with a high-end yoga offering in the early part of the decade.  Store growth has been impacted by the recession (5 openings this CY, 40 planned in 2010), impacting LULU's brand awareness and ultimate reach.  The longer it takes to roll out new stores, the less attractive these new markets are due to the presence of incremental competition.
  • Their Canadian stores were launched during a different economic era, when consumers were less cost conscious.  In addition to this macro shift in consumer behavior, the US market is increasingly competitive, with competitors' products priced at meaningful discounts.  Competitors may not have to (or may not want to) recreate LULU's "communities", and can effectively backfill yoga products into their portfolio and leverage their existing distribution.
  • The table below details comp store productivity for the Canadian and US stores.  Sustained gaps in productivity suggest that the US market opportunity is not as big as some might think.  If management makes it to 300 stores, is it reasonable to think that they will be generating ~$1,450 in sales per square foot?

• Valuation - At $31 LULU trades at 26x FYE 2012 EPS. This is a very rich valuation for a young retailer in an increasingly competitive yoga market. The assumptions below use management's long-term stated goals, or apply status quo metrics going forward. Under these "blue sky" assumptions the stock is fairly valued using a 10% discount rate. The stock is priced for perfection and I see downside to ~$20, or 20.0x my 2012 EPS of $1.00 (or about a 1.00x PEG).

Risks

• Short Squeeze - 7mm shares are sold short as of 12/31/09, or ~17% of the float.  The shares have been extremely volatile since coming public in July 2007, and will likely continue to exhibit sustained volatility (valuation, float, etc.).  LULU is up 600%+ from a 52 week low.
• M&A - LULU has been periodically mentioned as an acquisition target, for an acquirer who would look to gain entry into the growing yoga market.  Reports claim that Nike and Addidas were interested in buying LULU at the time of the 2005 financing.  Someone could theoretically buy LULU, but given the (i) size ($2bn + control premium), (ii) valuation, and (iii) store base I don't see this happening, or at least not anywhere near these levels.
  • I do not doubt that Nike / Addidas were interested in 2005, but these claims do not make sense today.  At the time LULU had a ~$200mm enterprise value, today it is $2bn.  The Company has grown and outperformed expectations but the brand and strategy are effectively established.  Further, a sale to a "big corporate" buyer would be completely inconsistent with LULU's goals & ideals, and could dilute the brand value.
  • LULU is a standalone brand, with 119 stores and plans for many more.  Comparisons with Gap's acquisition of Athleta (done at ~3 /4x current year sales) are misleading.  Any buyer would assume LULU's store base and leases, making this a less attractive acquisition (someone can't strip out the SG&A; they simply need to think they can run the business better than the current management).

Summary

• LULU needs to grow their store base another 150% to reach their long-term target; so assuming 40 new stores per year and no showroom closings (typically closed after 18 months), they will be fully penetrated by mid 2014.  Sales per square foot will be diluted down as they expand into new, smaller markets, and gross margins will compress given fierce competition.  The shares are priced for perfection and I'd think about covering in the $20 range.

Catalysts

• Increased competition / margin compression
• Re-pricing of the equity
• Insider Sales - As briefly noted, Advent owns 7% of the stock through a 2005 PE financing.  My rough estimates suggest they have already realized a ~5.3x COC return.  Advent's actions here will be very interesting.
  • This investment has been a huge success, given the sector and vintage year.  In fact, it has already been such a success that Advent may be taking a "house money" view towards this last 7%.
  • Alternatively, Advent (who has several representatives on LULU's board) could just take the incremental ~1.5x COC and juice their IRR (all else equal).  With the shares near a 52 week high and approaching the five year mark, my guess would be that they sell.
  • As a more general note, insider buying has been non-existent since the IPO and insiders (aside from founder Chip Wilson) own a minimal amount of stock.

Catalyst

Increased competition / margin compression

Insider sales