Lululemon Athletica Inc. (LULU, Financial) may be eating Nike’s lunch, but that does not necessarily mean it is worth investing in the stock at the current price. With credit card debt approaching $1 trillion nationwide and prices for all retail goods moving higher, it is only a matter of time before people cut back on unnecessary purchases like yoga pants and workout tops. I am not sure any retailer will be able to survive lower consumer spending, even one like Lululemon. At some point in the future, there will be a great buying opportunity for investors. Until then, I do not think it is wise to chase the herd on this one.
Latest quarter
At the end of March, Lululemon reported fourth-quarter financials that did not disappoint. Revenue increased 30% year over year, beating expectations by $100 million. Adjusted earnings per share were $4.40, topping estimates by 14 cents. The comparable store sales increased 15%, while the real growth was in the direct-to-consumer segment, which grew 37%. It was indeed another blowout year.
In a statement, CEO Calvin McDonald commented on the company's performance. He said:
"In 2022, we passed $8 billion in revenue for the first time driven by balanced growth across categories, channels and markets. Our product pipeline driven by innovation is very strong. More than 9 million guests signed up for our Essentials membership program in the first five months, which further strengthens the opportunity to keep building our community, strengthen our guest relationship and drive long-term value. Our market share gains show our brand is able to expand and attract new guests and yet our unaided awareness remains low, which demonstrates the runway in front of us. And we're seeing strong momentum in every market where we operate, and we continue to successfully expand into new geographies."
Solid financials
With that in mind, Lululemon has delivered again and again for shareholders. Despite generating approximately $25,000 in net profit on $238,000 in revenue per employee, the company produces a healthy profit. Gross margins have consistently averaged over 50%, with returns on equity and assets coming in at 39% and 16%. More importantly, in the last decade, every dollar in retained earnings has produced around $19 in market value.
That said, for a company to grow earnings at 15% a year over the course of a decade is no easy task. That is what some analysts expect from Lululemon, which is why I think it is nearly impossible to keep this valuation, especially in a market like retail. There are so few companies with economic moats in retail that can grow at those numbers. Granted, Lululemon has a great brand, fantastic products and should continue to grow. The company has already increased sales by more than 20,000% in the last 20 years, going from $41 million to over $8 billion. In hindsight, it might seem obvious, but reading annual reports paints a rosy picture for nearly every company.
Brand power
Lululemon's primary customer demographic has historically been affluent women, particularly those who are health-conscious, active and seeking high-quality, stylish athletic wear. The brand initially gained popularity for its yoga apparel strengthened by in-store yoga classes, and has since expanded to cater to a wider range of fitness activities and demographics. While no one is buying Lululemon shoes as collectors or for fashion, people are in love with the company’s clothing. As with most apparel manufacturers, the pressure to be a full one-stop shop for personal goods is strong. That may backfire on Lululemon over time by adding additional costs at a loss. Only time will tell, but for now the brand remains as strong as any other industry participant.
The company mainly sells through company-owned stores and e-commerce, which make up 45% and 46% of its revenue, respectively. The company’s control over pricing, discounting, expenses, product assortment and the sales process provides one advantage.
Lululemon's chain of retail stores provide another competitive advantage and more brand awareness through 650 locations. Even as the company shifts to direct to consumer, sales per square foot at the retail level remain the highest among large apparel retailers. Lululemon is getting around $1,580 per square foot. That will likely fall in the future as buying demographics change, but this brand is more luxury than most of its direct competition. If that is right, price increases over time will not impact its customers and only help the company continue to grow.
High valuation
Investors are paying 54 times current earnings and 31 times next year’s earnings estimates. To meet these expectations, Lululemon must increase earnings per share by 75% this year. I think that will be extremely hard to do. More importantly, despite inflation pushing valuations lower across the retail industry, Lululemon seems to defy gravity. Having a high price-earnings ratio is one thing, but being priced like a tech stock is another with the company trading at 6 times sales versus the sector median hovering around 1.
Brand power is huge, but it is also at the whims of the market. Lululemon understands this and deploys capital through 2,000 "ambassadors" around the world, which has led to a strong social media presence. If the company does not keep up with the changes, will it lose brand power? I think so. Maybe I am wrong and the company can continue to warrant increased market values that outperform the S&P 500, even at this level. It just seems like the shares are priced for perfection with obvious economic headwinds on the horizon.
