Value Investors Club / LULULEMON ATHLETICA INC (LULU)

Description

EXECUTIVE SUMMARY

Overview: LULU is an attractive long given management’s recent areas of investment, which will allow for sustainable double-digit to teens top-line growth at structurally higher margins over the next several years. The crux of the thesis is LULU’s e-commerce initiatives, as the go-forward benefits to sales growth and margins from the DTC channel reaccelerating have been underestimated by the Street. In addition, a greater push into China this year (also reinforced by digital growth given the large

installed base of “e-commerce first” consumers) is a key growth engine layered on top of the core women’s business, which continues to show strong momentum. Despite tough comparisons in H2 ‘17, I believe consensus estimates are too low and LULU has enough levers from product newness and international acceleration to beat near-term numbers. Longer-term, my estimates on all key metrics are well above Street, congruent with my view that the company’s new initiatives will bear fruit. For

a brand that has long suffered from a generic competition short thesis, Lululemon has evidenced clear market share gains over a multi-year period; top-line deceleration in FY ’17 appears to be a temporary lull as LULU goes through an “investment year”. Overall, a dominant full-price brand with a clear path to sustain superior earnings growth should garner a premium valuation in a broadly challenged retail sector. While I do not assume significant multiple expansion is required for a long to make money,

upward revisions to consensus should allow for long-term average multiples to hold.

Risk/Reward: 3.1x on the long side

• Downside (Risk): $49.00 (-15%); 22.0x FY ’17 EPS $2.25 (my downside estimate)

• Upside (Reward): $84.00 (+46%); 25.0x FY ’19 EPS $3.37 (my base case estimate)

BUSINESS

Business Model:

• Vertically integrated sourcing, marketing, and retailing of branded athletic apparel worldwide; outsourced production

• Relies on “healthy lifestyle” brand marketing to target primarily yoga and general fitness categories and female consumers

• No wholesale; controlled distribution means higher quality at better ASPs/margins and direct consumer relationships

Recent Developments: Post Q1 ’17, LULU announced the restructuring of Ivivva, its internally developed brand targeting girls 8-12 years old, as primarily an e-commerce brand and is closing 40 of 55 stores, with 50% of the remainder to be re-bannered as Lululemon stores (complete as of 8/20).

Segments (FY ’16 financials): Company-operated Stores (411 stores in Q1 including Ivivva, 1.2mm square feet; 73% of sales, 67% of EBIT), Direct to Consumer (e-commerce; 19% of sales, 30% of EBIT) , Other (showrooms, warehouse sales, etc.; 9% of sales, 4% of EBIT)

Revenue by Geography (FY ’16): US 74%, Canada 19% (CAD exposure), ROW 7%

Growth Algorithm (based on management’s FY ’20 targets):

• LDD square footage growth @ 60%+ new store productivity + MSD SSS = LDD-teens revenue growth

• Low 50% gross margins

• 20%+ operating margin (fixed cost leverage at low to mid-teens sales growth, but greater opportunity near-term)

• LDD-teens EPS growth (does not assume buybacks though LULU has repurchased shares regularly since Q2 ’14)

Key Vectors for $4bn FY ’20 Sales Target:

• Women’s $3bn + Men’s $1bn (~20% of sales today, or ~$500mm)

• International $1bn

• Digital > $1bn (on track for > $500mm in FY ’17)

LONG THESIS: KEY POINTS

1. Top-line Reacceleration to Sustainable LDD-Teens Growth

LULU’s growth algorithm is not broken. Revenue growth can reaccelerate from 2 particularly underappreciated avenues: continued DTC growth and international penetration, especially China, beginning in H2 ‘17. China will be fueled by continuedshare gains via Tmall, owned e-commerce, and greater square footage growth to reinforce the brand’s omnichannel presence. Meanwhile, the women’s business in North America should continue to comp up strongly. Despite these drivers, the Street has

written off the FY ’20 guidance for $4bn in sales as highly unlikely due to athleisure being past its peak, recent store traffic headwinds, and a DTC execution mishap post Q4 ’16. This has de-risked consensus revenue estimates; in the near term, this could lead to upside to FY ’17 guidance, offering a favorable setup for a long.

2. Investment Cycle Unlocks New, Permanent Margin Structure

The Street doubts LULU’s ability to ever achieve an EBIT margin of 20%. My work suggests that due to the brand’s pricing power and tailwinds from e-commerce investments, it is actually quite likely that this happens. Gross margins should slowly climb towards the mid 50% range over time due to greater DTC sales mix, continued inventory “right-sizing” (localization, ship-from-store, etc.), leverage from prior supply chain investments, and reducing the headwind from lower margin Ivivva revenue.

Outsized SG&A leverage can be achieved beyond FY ’17, as the biggest investment year in recent history (including the first ever global brand marketing campaign in Q2) will be behind the company. Management indicates that fixed cost leverage occurs with low to mid-teens revenue growth. Given that the Street is modeling lower out-year revenue growth, consensus also underestimates the total margin opportunity available. Incremental margins are what matter most; since e-commerce should

continue to out-comp stores at higher operating margins, the flow-through to EPS is sizable. Taken together with LDD-teens top-line growth, operating margins approaching 20% can drive EPS growth into the teens.

3. Capital Allocation Potential

The market is overlooking the optionality granted by LULU’s net cash balance. While this is ultimately a retailer with physical stores (and hence leases) and I would prefer that management reinvest to grow the business, I believe the recent hesitation to deploy more cash towards share buybacks is due to elevated, temporary near-term capex and opex needs. Since Q2 ’14, management has shown an appetite to support the stock price opportunistically. Over time, there could be unmodeled upside to

EPS growth from an acceleration or upsizing of a subsequent buyback authorization. In addition, longer-term there could also be optionality from some M&A scenarios, including a sale of the company.

THE OPPORTUNITY

The current opportunity in the stock arises from my view that recent issues, including a disastrous Q4 ’16 print with product assortment issues, choppy brick-and-mortar store traffic, and negative headlines on athleisure are missing the bigger picture. Investors can pay a reasonable valuation for a high-quality brand that continues to win market share and entirely controls its distribution, critical given never-ending department store traffic woes and discounting that competitors face, with an increasingly

international growth story that will diversify its future earnings power. Although athleisure’s popularity may be marginally declining, I think this is an overblown risk that is understood well by the market now. LULU’s women’s bottoms business, most prone to market saturation and athleisure weakness, continues to comp up strongly and innovation in areas like bras is fueling incremental growth, driving share gains versus competitive laggards like Victoria’s Secret. While LULU is not “cheap” on an

absolute basis, I believe there are meaningful company-specific levers, especially relative to peers who are currently combating structural top-line deceleration and large wholesale exposure, producing more attractive risk/reward.

WHY NOW?

• Management fixed the DTC execution issue from Q1 (lacking proper seasonal color in the online assortment), with new products more in-line with current consumer tastes. Digital acceleration as well as sequentially improving (less negative) store traffic trends have been noted into Q2, which my proprietary checks also confirmed.

• Q2 will include the expansion of ship-from-store to 145 stores (up from 85 in Q1) and the launch of “buy online, pick up in store”, which should allow digital strength to continue sequentially into H2 as the initiatives roll across more stores.

• Square footage growth will offset the drag from the Ivivva store wind-down, especially with international openings set to accelerate in H2.

• Enlite bras, the most expensive bras in LULU’s portfolio launched in May (beginning of Q2) with noted success; my checks suggest the strength continued throughout the quarter and should carry into H2, which will lift AURs. LULU is also launching a new fabric platform as part of its high intensity workout line in Q3, improving its assortment of tops, and has a slate of new outerwear SKUs planned, which should also drive pricing.

• My proprietary analysis of third-party credit card data indicates Q2 SSS well in excess of Street, which alone could drive a beat-and-raise to FY ’17 guide.

• New Co-Chairman Glenn Murphy bought 100k shares worth ~$5.6mm in late June.

BEAR CASE

LULU’s top-line deceleration is a sign that this is a fad-driven business in a hyper-competitive industry and has been too reliant on the multi-year popularity of athleisure, which is now declining. Store traffic headwinds will get much worse, and e-commerce cannot offset this. FY ’17 revenue growth guide of 8-10% y/y is the first sign of trouble and a permanent downshift in the growth algorithm is imminent. Tough comparisons in H2 ’17 will catalyze a miss and guide-down. Pricing and gross margins are

unsustainable in the face of the industry slowdown and competition that will exacerbate as more players chase fewer dollars being spent in LULU’s core categories. SG&A leverage is out of the question, as LULU faces the reality of slower top-line growth and has no choice but to continue investing to drive whatever revenue growth is left. EPS will shrink and multiples will collapse, driving significant downside to the stock.

VARIANT VIEWS & ESTIMATES

SSS: I believe consolidated SSS (stores + DTC) will handily beat consensus beginning in Q2, though I acknowledge the tough H2 comparisons and an overall cautious tone from management will likely result in reiterating FY guide. Q2 DTC SSS compares against a period last year with depressed growth given lapping an online warehouse sale from Q2 ’15. My work indicates that LULU ran an additional online warehouse sale this year and generally robust QTD trends noted by management on the Q1 call strengthened throughout the quarter, further corroborated by analysis of credit card data. Off of this above-consensus base, I believe H2 will see even higher e-commerce growth sequentially compared to 2016 on the back of incremental site optimization and digital marketing investments in Q2 (~$6mm) and continued share gains in the channel internationally. I think this leads to a significant y/y comp acceleration in 2018 with some subsequent moderation in 2019, whereas consensus believes SSS barely scratches the low end of management’s long-term MSD SSS guide in both years. I should note that the store SSS I am assuming is negative in FY ’17 (even with some benefit from FX in H2) and then LSD recovery in 2018 and 2019. The biggest source of variance to consensus is therefore driven by my DTC growth assumptions.

Revenue: The Street does not appreciate the white space unit growth opportunity overseas or the ability to hold productivity stable. Management believes square footage can grow in the LDD range for the next few years, fueled by international growth. Importantly, additional store growth in North America will increasingly utilize a “Local” format, with slightly smaller store sizes without sacrificing productivity, which should marginally drive up sales per square foot. The wind-down of Ivivva will see a net of

~80k square feet come out of the system in FY ’17, but given the guide for 50 new openings weighted towards H2, square footage growth will hit a bottom this year at ~8% y/y. I assume square footage continues to grow over the next two years within management’s guided range, as the international opportunity allows for a lot of white space. I assume new store productivity is stable at 65% going forward, as the Local format and international store openings both should generate higher average SPSF.

Taken together with my assumptions on SSS, my views on unit growth produce total revenue growth towards the high end of management’s FY ’17 guide, which then accelerates to the mid-teens in FY ’18 (aided by Q4, which will contain an extra week) before slightly slowing to the LDD level in FY ’19, which could ultimately prove conservative.

Gross Margins: Management highlighted that merchandise margins would improve approximately by a cumulative 300 bps vs. 2014 levels by the middle of 2017. This has led the Street to assume that there is an upper bound to how much gross margin opportunity is left, which I think is incorrect. Though H2 ’17 will see y/y improvement moderate given comparisons, the longer-term trajectory assumed by the Street ignores primarily the ongoing mix shift from higher DTC penetration, which also has implications for the brand’s ability to maintain superior pricing and fewer markdowns as tighter inventory levels are maintained. For FY ’17, I assume LULU can achieve the high end of guided gross margin improvement of 100 bps y/y. However, I am ahead of the Street for subsequent years given my research on the brand’s core pricing power, DTC mix, and inventory control, which should produce well north of 50 bps y/y improvement annually through FY ‘19.

SG&A: FY ’17 is an investment year, driving y/y SG&A deleverage, further exacerbated by slower near-term top-line growth. Q2 EPS guidance calls for $0.04-0.05 in incremental digital investments (~$5-7mm), which are all one-time but result in guide for SG&A deleverage of 350 bps in the quarter. The company believes this deleverage sequentially improves in Q3, with Q4 showing leverage, to yield a total of 50-100 bps deleverage for FY ’17. I have upside to this line given a higher FY ’17 revenue base. Beyond FY ’17, my research indicates that similar to gross margins, EBIT margins will also benefit from e-commerce given higher incremental operating margins on comps accretive to consolidated SSS. While store-level investments will be required with square footage growth as well as potentially additional one-off marketing spend, I believe the Street’s EBIT margin trajectory does not give the company credit for the increasingly omnichannel profile of incremental revenues (likely

requiring lower staffing expenses) and higher SPSF levels at international stores.

Overall: The above assumptions are the key drivers of my variance vs. consensus, although there are clearly several puts and takes. The key takeaway is that LULU’s EPS growth algorithm will be increasingly driven by higher-margin digital revenue both in North America and overseas, which the sell-side has largely ignored and has instead placed undue emphasis on near-term store traffic trends. An additional area of potential variance is if management decides to buy back a significant amount of stock,

which would drive additional EPS upside, though I only contemplate this in my upside case.

My Estimates:

	FY 2017E	FY 2018E	FY 2019
Consolidated SSS	4.7%	7.6%	6.7%
Net Revenue	$2,570.5	$2,964.6	$3.299.1
Adj EPS	$2.41	$2.96	$3.37

VALUATION

Entry Point & Setup: Given its growth profile, LULU has consistently traded with a P/E north of 20.0x over the last several years. I do not expect this to change absent a total miss/guide-down resulting in a multi-year cut to Street estimates, which I view as unlikely. Although the stock bounced following the Q1 ’17 print and significant insider buying in late June, valuation and the technical entry point remain appealing as the stock is down YTD and on a multi-year basis. The Street remains fairly

skeptical given the distribution of analyst ratings, but sentiment has improved somewhat lately. Overall, I view the setup as favorable due to my upside to Street estimates, a lowered bar for expectations, and historically cheap valuation.

What Is LULU Worth?:

• Base Case: 26.0x FY ’18 EPS of $2.96 = $76; 25.0x FY ’19 EPS of $3.37 = $84. The base case is driven by all of the key variances to consensus discussed earlier. Current FY ’17 P/E is assumed to roll forward in FY ’18 given significant variance to Street; the degree of multiple compression assumed in FY ’19 narrows from today’s y/y gap due to earnings growth compounding much faster than consensus contemplates.

• Downside Case: 22.0x FY ’17 EPS of $2.25 = $49. In this case, LULU misses earnings estimates and has to cut FY ’17 guidance (guided FY '17 EPS range $2.28-2.38). I expect management would buy back stock, but P/E will compress a few turns regardless.

• Upside Case: 26.5x FY ’18 EPS of $3.15 = $83; 25.5x FY ’19 EPS of $3.60 = $91. The upside case assumes fundamentals accelerate beyond the base case and management repurchases shares aggressively. Multiple expansion is assumed in this case in both years given the magnitude of variance to consensus and superior capital allocation.

RISKS/PUSHBACKS

• Continued Innovation Necessary: With athleisure past its peak, LULU must regularly introduce enough product newness to encourage repeat purchase rates and maintain pricing power. The brand cannot afford many more execution mishaps like in Q4 ’16. If bears are right and athleisure is the entire reason for the brand’s popularity, then I will effectively be wrong on the company’s competitive moat and structural growth deceleration and declines in profitability will become realities.

• Store Traffic Headwinds: Management continues to note soft and inconsistent foot traffic to stores, which I acknowledge could get worse. While I believe LULU is not “over-stored” and does not share the same mall-based exposure as many of its competitors, it is not immune to broader trends. This would render my store comp outlook, which bakes in flattish/down SSS in the near-term, too aggressive.

• Comp Growth, Gross Margin Compromise: LULU’s SSS may continue to accelerate in excess of expectations, but this may come at the expense of gross margins. This has happened with many retailers over time.

• “Bad Neighborhood”: Overall, athletic apparel retail has not been a good sub-sector for long exposure. Even an industry stalwart like NKE trades poorly on incessant fears around industry growth deceleration, distribution channel concerns, and broader macro issues. Owning a good house in a bad neighborhood is not suitable for everyone’s risk appetite, particularly given the volatility associated with retail today.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Earnings (Q2 ’17: 8/31 AMC), share repurchases, insider buying, potential M&A

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			2017	2018
Price:	57.61	EPS	0	0
Shares Out. (in M):	137	P/E	0	0
Market Cap (in $M):	7,904	P/FCF	0	0
Net Debt (in $M):	-698	EBIT	0	0
TEV (in $M):	7,205	TEV/EBIT	0	0