Lululemon Stock: Things Could Turn Sour In The Near Term (NASDAQ:LULU)

With the recent strong quarter showed by Lululemon (NASDAQ:LULU), I think that it is apt to relook into my investment thesis for the company to see firstly how is it faring and whether there are opportunities for investment in the company.

Investment thesis

I have previously written about Lululemon, which can be found here. While I am maintaining my neutral rating on Lululemon due to the rich valuation and risks highlighted below, I think that while in the near term there is no opportunity to add to the company, I remain watchful for any drawdowns on the stock where valuations could become more favorable.

That said, I continue to like Lululemon as a brand and I think that the management executes well and are able to bring innovation in the athleisure market. With its strong market positioning and premium profile, the superior margins it earns is one of the highest in the industry. As the company executes on its plans to double revenues by 2026, there are several areas of growth that the company can leverage on to achieve this.

Solid 2Q22 results

The 2Q22 print was a solid beat in multiple ways, showing the strength of the brand in more challenging times. Net revenues were up +29% year on year to $1.9 billion in 2Q22. Earnings per share grew +33% year on year in 2Q22 to $2.20. The strong beat came as expectations were lowered as the macro backdrop seemed challenging.

While strong quarterly results are a good indication of how well things went in the past quarter, an important piece of information from the results was the outlook and guidance given for 2022. Management revised guidance upwards by 4% for the year, indicating that they expect the strong momentum in 2Q22 to continue in the second half of the year. I think that this upward revision in guidance is rather telling in that the company is able to beat expectations and guidance in a tough environment where the macroeconomic backdrop is worsening and other retail players are suffering in the difficult operating environment.

The new forward revenue guidance translates to a 26% 3-year CAGR, which is 7 percentage points higher than the 3-year revenue CAGR that the company saw in 2020. This is also above the target that management set for their Power of Three x2 growth plan, which was at a 15% 3-year CAGR for revenues.

In addition, the company also slightly revised the number of net new company operated stores to 75 in 2022, increasing by 5 from their previous guidance. Of these, 45 will be in the international markets, thereby further growing its international footprint.

Power of Three x2 strategy

The Power of Three x2 strategy is rather similar to its earlier achieved Power of Three strategy. The recently launched Power of Three x2 strategy plans to achieve a doubling of revenues to $12.5 billion by 2026, implying a 3-year revenue CAGR of 15%. Similar to the earlier version, management plans to continue to double its digital business and men’s business and quadruple the international business. Along with the strong growth in these 3 segments, the company still expects double digit growth in the North America, traditional brick and mortar stores and women’s business.

Based on the recent results, the company remains to be on track to achieving these long term goals. For its international expansion goals, the company managed to grow the international markets by 40% 3-year CAGR in the current quarter. More importantly, China continues to grow at a 3-year CAGR at 70% although the company had a slow start to 2022 due to the COVID lockdowns in the country. China continues to be a major growth driver for the company and, in my view, could be a key pillar to achieving its 2026 goals. While the company is showing good initial progress in China, I think that Lululemon is still in the early stages of growth in China. In Europe, it saw a 22% 3-year CAGR and for the first time in 3 years, it is entering a new market in Europe. It is entering Spain in an exciting new opportunity to grow its penetration in Europe.

For e-commerce, the company saw e-commerce traffic grow 40% year on year and also launched a new digital store on JD.com (JD). As JD.com has a larger male client base, this may be a useful client acquisition tool for Lululemon in China to convert more males into customers. For the men’s business, there were not many encouraging signs that I can point out. While the men’s business did grow at a slightly faster 3-year CAGR of 30%, this is only 5 percentage points higher than the women’s business, which is growing at 25% 3-year CAGR. I do not think that this shows any material acceleration in the men’s business in the near term although the women’s business is still showing good momentum.

Elevated inventory poses risk

Inventory levels rose 85% year on year as compared to the 29% increase in revenue in 2Q22. The increase in inventory was a result of having a shortage of inventory one year before that resulted in management not being able to maximize its business. While management mentioned that the elevated inventory levels are as a result of deliberate increase in and stocking up of inventory to ensure sufficient inventory to meet high demand, I think that this poses a new risk to the company. This is because as global demand softens and the macroeconomic backdrop worsens, this elevated inventory is no longer necessary and instead, brings about a further drag to the company.

In the scenario where the weakness in the macroeconomic environment causes a downturn and a recession, this may be detrimental to Lululemon since it is a full price business and is unable to use discounts to clear inventory. Furthermore, in such an environment, customers would naturally reduce spending on discretionary spend and focus more resources on staples and essentials. As such, I am cautious about management’s enthusiasm in raising inventory levels at a time like today.

Cautiously confident about outlook

It was mentioned in the 2Q22 earnings call that the management team tracks key spending behaviors and consumer habits. Despite signs of macroeconomic weakness, the company has not seen any variation to the usual consumer spending habits.

In fact, the company is seeing key metrics grow as it continues to acquire 20% more new guests, seeing 40% increase in e-commerce traffic and 30% increase in store traffic. All these was done without any need for price promotions or discounts, as mentioned above, because the company maintains a full price business.

Valuation

While Lululemon’s forward P/E has dropped to 27x 2023 P/E, I think that it is still difficult to justify the high price tag for Lululemon. At this multiple that is one of the highest in the industry, I think that this already priced in a successful Power of Three x2 strategy. However, I think that there are both risks to execution for the Power of Three x2 strategy and at the same time, the macroeconomic environment suggests that there are further risks coming up in terms of weakness in consumer sentiment affecting discretionary spending like that of Lululemon.

For a company growing at an EPS CAGR of 15% in the near term with risk that its 2026 goals may not be achieved and external factors like macroeconomic weakness affecting future growth, I think that the current forward multiple of 27x 2023 P/E implies that there is limited room for further P/E expansion, so most of the upside will come from the revenues and earnings upside. However, at the present moment, for at least the near term, I think that there is more of a negative skew towards revenues and earnings upside.

Based on a PEG ratio of 1.3x and taking the average of my 2023F and 2024F forecasted EPS, I derived a target price of $310 for Lululemon. I maintain my neutral rating for the stock given my view that based on the implied target price for the company, most of the upside has already been priced in and I would prefer to enter a position into the company at a lower level.

Risks

Weakness in macroeconomic environment

This is the biggest risk for Lululemon. Given that the company is a full price business and having elevated inventory levels compared to what they usually have, any sudden change in consumer sentiment may cause a drop in demand for the company’s products and lead to difficulty in selling off the elevated inventory levels that was accumulated in the year. This would also imply lower growth in the near term and if consumer sentiment remains negative for a longer period of time, this could hamper growth in its key markets and potentially mean that its Power of Three x2 goals may not work.

Difficulty in international expansion

While management shows confidence in being able to quadruple the international business by 2026, this could prove challenging if the company is unable to replicate its strategy or brand equity in other international markets. In particular, China is an important market for future growth for Lululemon and if the response to its products is less than lukewarm, this could be a huge risk to international expansion.

Risks in expanding into men’s business

While the strategy of focusing on men’s business may seem to be successful in the previous version of the Power of Three strategy, that growth may have been due to a low base. However, there is a risk that the management may not be able to grow its men’s business to the scale that it hopes to achieve. Furthermore, there may be further margin dilution in the business if management pursues this strategy as the men’s business may see lower margins due to lower brand equity.

Competition

Rivalry in athleisure may increase as incumbents and startups come into the space and bring new innovation and products that may cause downward pressure to Lululemon’s margins.

Conclusion

While the company’s 2Q22 results were solid and the forward guidance was revised up, I continue to take the view that the stock is currently fair valued. With a 27x 2023F P/E multiple, I think that most of the growth expected in its Power of Three strategy has been priced in and thus, there is relatively small room for P/E multiple expansion. With most of the upside to come from revenues and earnings beat, I am cautious on this as well due to the weak macroeconomic environment and the possibility of slip in execution or expansion risks that could dampen growth and cause a rerating in its high multiple. As such, I maintain my neutral rating for Lululemon and have a target price of $310, implying a 2% downside from current levels.