The Pros And Cons Of Investing In Lululemon Now

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Lululemon Athletica (NASDAQ:LULU) has lost more than 30% of its market cap since the start of the year, while its fundamentals have remained strong compared to its peers. The company also has impressive growth figures on both the top- and bottom line. In this writing, we will take a look at LULU’s business and why it could be an attractive choice for investors, while also pointing out some of the main risks and headwinds.

Data by YCharts

Let us start with the cons, focusing on primarily on macroeconomic factors.

Cons

While many firms that have reported earnings and quarterly results in the month of May have seen a top-line growth of their business, they have also experienced contractions of both their gross- and net margins. These contractions were driven mainly by increasing shipping costs, increasing input costs, supply chain disruptions and a tight labor market.

In our view, these factors are likely to influence LULU’s results and margins in the near term as well. Let us take a look at some of the economic indicators that are signaling a support for this thesis.

Increasing gasoline prices

Since the start of the conflict between Russia and Ukraine in February, gasoline prices have skyrocketed.

Gasoline prices (Tradingeconomics.com)

This increase in prices will likely result in elevated shipping costs, creating a downward pressure on the firm’s margins. Although the gasoline prices seem to have peaked in March, they have remained significantly above the levels seen during last year. In our opinion, the prices are likely to remain elevated for the rest of 2022, creating temporary headwinds not only for LULU’s business, but for others as well.

Inflation

It is not only the gasoline prices that have skyrocketed, but also inflation has increased significantly.

U.S. consumer price index (Tradingeconomics.com)

Rising inflation eventually leads to increased input costs for manufacturing products, again creating a downward pressure on the firms’ margins. Whether a firm can successfully navigate through such times, highly depends on how successful the firm is with passing on the increased costs to its customers. In our view, the competition in the apparel space is very tense and significant brand recognition and customer loyalty is needed to retain customers, while increasing prices. At this point, we would recommend to stay cautious and wait to see, whether LULU is well enough positioned to keep its market share, while increasing prices.

Tight labor market

We have chosen two indicators to present a picture of the tight labor market. One of them the U.S quits rate, the other U.S. average hourly earnings year over year.

U.S. quits rate (Tradingeconomics.com)

U.S. average hourly earnings year over year (Tradingeconomics.com)

Both quits rates and average hourly earnings growth have risen significantly above the levels observed in the past decade. These factors are also creating headwinds from the supply side by creating a shortage of workers on one hand, and increasing the price of labor on the other hand. We think, just like inflation and increasing shipping costs, the tight labor market and rising wages are also likely to create significant headwinds for the firm in the near term.

Consumer confidence

Consumer confidence has been on a continuous decline this year, reaching 10-year lows and even approaching levels last seen in 2008-2009. So far we have not seen the negative impact of this decline in the sales of other retailers. Although consumer spending has remained strong despite the drop in confidence, we recommend to keep this indicator in mind, because low confidence can eventually result in lower spending, leading potentially to demand side challenges.

U.S. consumer confidence (Tradingeconomics.com)

Increasing inventory and receivables

LULU’s inventory and receivables have been consistently increasing over the last few years. Increasing inventory indicates that the efficiency of the firm may be declining by potentially overestimating demand for their products. On the other hand, increasing receivables indicate that the firm is having trouble collecting revenue, which could be a result of less strict credit terms in order to boost sales. Before you consider taking a position in the firm, make sure that you understand the drivers of these developments and that you are comfortable with them.

A comprehensive list of risks can be found in the annual report of the firm.

However, apart from the current macroeconomic and geopolitical trends, LULU’s business appears healthy and has exhibited excellent growth not only in the first quarter, but also in the last couple of years. It has also lost more than 30% of its market cap year to date, making it more appealing from a value perspective than six months ago.

Valuation

According to traditional price multiples, LULU seems to be overvalued even after the sharp drop in the share price. It has a price to earnings ratio of about 28x, which is almost three times higher than the sector median of 11x, however significantly below its own 5 year historic average of 46x. The same trends can be seen in terms of EV/EBITDA and P/CF.

Although LULU is trading at a significant premium compared to its peers, it also exhibits much faster growth than its peers. In our opinion, a premium is justified based on growth, however in combination with the potential macroeconomic headwinds, we believe it is not yet the right price level to start a new position, because further decline in the stock price may be expected.

Pros

Financials and growth

In the first quarter LULU had a YoY sales growth of 23% reaching $2.1 billion in sales. Not only revenue, but also diluted EPS increased YoY, reaching $3.36. The double digit growth figures in the 20s are well above the sector median of approximately 14, making LULU an attractive choice from a growth point of view.

Further, LULU also has more than $1 billion in cash, while has debt of about $0.9 billion. In our view, this liquidity could provide certain flexibility for the firm in the near term, if the headwinds materialize.

Looking forward, the firm maintains its high expectations for fiscal 2022, forecasting revenue in the range of $7.49 billion to $7.615 billion. This would represent a growth of about 20% to 22% year over year. Diluted earnings per share is also forecasted to reach $9.15 to $9.35, without taking into account the announced repurchase program.

In our view, LULU has successfully delivered on its promises on growth so far, while it keeps setting itself new ambitious targets. Their growth ambition, named “Power of Three x2” foresees the doubling of their business within the next five years, reaching $12.5 billion in sales. This initiative involves, doubling the men’s segment, doubling the digital segment, and quadrupling the international segment by expanding into new markets.

We believe LULU can be a potential addition to a growth portfolio.

Share repurchase program

In 2021 and over the last decade the firm has proven its commitment to return value to shareholders by buying back shares. In 2021 and 2022, so far LULU has bought back share worth of $1 billion, while in March the board has approved a new repurchase program up to another $1 billion.

Shares outstanding and change in shares outstanding (Macrotrends.net)

When making investment decisions, we usually like to see the firms consistently buying back their own shares and therefore increasing the earnings per share over time, which is the case for LULU.

All in all, we believe that LULU is a solid business, with a promising growth potential and a strong track record of successfully expanding. Our main concern with starting a new position now are the potential macroeconomic headwinds. Therefore, we rate LULU as “hold” now.

Our takeaways

Over the last few years LULU managed to rapidly expand its business and achieve impressive growth figures, while maintaining high margins. They also have a strong balance sheet with more than $1 billion in cash.

LULU has been creating value for its shareholders by consistently buying back shares, which we expect to continue in the near future.

Macroeconomic headwinds, particularly rising input costs, a tight labor market and increased shipping costs may create margins contraction in the near term.

Due to the potential macroeconomic headwinds and the valuation we rate the stock as “hold”.