Lululemon athletica inc. (NGS: LULU) and raising our price target to $400 from $380. With substantial opportunities to expand outside North America, particularly in China, a strong brand, and growing direct-to-consumer sales, we think lululemon’s prospects are among the best in the apparel sector. We expect a transition to higher margin direct-to-consumer sales and favorable operating leverage to result in higher operating margins over the next several years. With relatively few stores outside North America, prospects for growth in international markets appear significant. Expansion of the company’s men’s line should also fuel revenue growth. As such, we are maintaining our long-term BUY rating.
The company recently reported fiscal third-quarter results. On December 10 after the close, lululemon reported 3Q adjusted EPS of $1.16, up from $0.96 in the prior-year quarter. Results surpassed the consensus estimate by $0.30. Net revenue of $1.12 billion increased 22%, and 21% in constant currency. The consensus estimate had called for revenue of $1.01 billion. Revenue increased 19% in North America and 45% internationally.
Comparable-store sales rose 19%, well above the consensus estimate of 5%. Direct-to-consumer revenue increased 94% (93% in constant currencies), and represented 43% of revenue.
The improvement was driven by new products and an increase in traffic to the company’s ecommerce sites.
As discussed in a previous note, hoping to benefit from the fitness-at-home trend, LULU paid $500 million to acquire MIRROR. The company now expects MIRROR to add $150 million in annual revenue, driven by additional marketing, up from a prior $100 million annually.
In the press release, management said that it could not provide FY21 guidance because of COVID-19.
In FY20, revenue increased 21% to $4.0 billion and EPS rose to $4.93 from $3.85. Due to the negative impact of the coronavirus, the company withheld its FY21 guidance.
EARNINGS & GROWTH ANALYSIS
Gross profit totaled $627 million, up 24% year-over-year. The 3Q gross margin fell 100 basis points to 56.1% of sales, due to higher transportation costs and promotional pricing. The consensus estimate had called for a gross margin of 54.8%. SG&A rose nearly 25% to $411 million, or 36.8% of revenue, below the consensus estimate of 39% of revenue. Income from operations rose 17% to $205 million. On an adjusted basis, the 3Q20 operating margin was 19.1%, down from 19.2% in the prior-year quarter and 350 basis points above consensus.
For FY22, we expect a recovery following the launch of a vaccine and are raising our estimate to $6.50 from $6.24.
Our five-year compound annual EPS growth rate forecast is 15%. We still see significant growth opportunities in the domestic, international and men’s businesses. Sector-wide demand appears strong, but LULU’s leadership position is being challenged as competitors seek new, lower-priced distribution channels (as Under Armour did in choosing to sell merchandise through Kohl’s).
FINANCIAL STRENGTH & DIVIDEND
Our rating also reflects the company’s available line of credit of nearly $400 million. The company does have fixed obligations in the form of operating leases. Treating the approximately $635 million present value of these leases as debt shows that adjusted debt. This is relatively low; the average for retailers under Argus coverage is approximately 50%.
Reflecting the company’s position as a leader in the athleisure industry, we expect the operating margin to increase slightly in FY21 and FY22. Total inventory rose 23% in 3Q21 to $771 million from $627 million in 3Q20.
On December 1, 2020, the company announced that it had raised its share repurchase authorization to $500 million from $264 million. We think that the company’s strong earnings will enable it to repurchase $450 million worth of its shares.
MANGEMENT & RISKS
Calvin McDonald became the company’s CEO in 2018. Patrick Guido has also served as CFO since 2018.
Lululemon faces competition from much larger companies such as Nike, Reebok, Adidas and the Gap’s Athleta, which have attempted to replicate its success selling women’s athletic apparel. Under Armour is more focused on men, and on team and competitive sports, but UA’s management is working to attract more women customers. Lucy Activewear focuses on workout clothes for women that aim to be functional, stylish, and flattering.
Lulu’s success and the tremendous sales productivity of more than $2,500/SF has also drawn the attention of Victoria’s Secret, Express, Macy’s, J.C. Penney, Nordstrom, Dick’s, the entrepreneurial actress Kate Hudson’s Fabletics, and long-respected outdoor brands such as Patagonia. Even New Balance, whose shoes seem to emphasize fit over glitz, has a line of athleisure gear for women. Alo is a California-based brand that seems to have won a following among yoga enthusiasts.
While the company’s growth, sales productivity and margins are likely to attract more entrants, we like lulu’s focused position as a provider of functional, high-end apparel for affluent, educated enthusiasts.
The company could see sales slip if yoga becomes less popular or if activewear becomes less popular attire for mainstream pursuits. In addition, while lulu’s merchandise has loyal shoppers, some may treat it as a discretionary purchase, especially when economic conditions are difficult. The company’s overseas suppliers and international store locations also make it vulnerable to foreign exchange risk. The company also has exposure to higher raw material costs, particularly for cotton and for petroleum-based products that are used in synthetic materials.
Founded in 1998, lululemon athletica is based in Vancouver, Canada, though it is incorporated in Delaware and its financial results are reported in U.S. dollars. Sales in FY19 were $3.3 billion, up 25% in constant currency.
The fiscal year ends on the Sunday closest to January 31.
Despite better-than-expected 3Q21 revenue, margin and earnings, LULU shares fell nearly 5% on December 10. We believe that the selling was attributable to some investors’ concerns about higher inventory and profit-taking following a year-to-date gain of 56%.
We believe that they deserve to trade at higher multiples given the company’s increasing comp sales, strong brands, and prospects for continued growth. Our revised price target of $400 implies a multiple of 61.5-times our revised FY22 earnings estimate.
On December 11, BUY-rated LULU closed at $344.32, down $24.75.