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Lululemon (NASDAQ: LULU) continues to demonstrate that they are entitled to a high valuation multiple. Growth continues to impress, coming out at 12% for revenues in Q3 of FY-17, and 16% for adjusted earnings before interest and taxes. The company has also embarked on initiatives to save cost, and to strengthen the platform for additional growth in 2020 and beyond. We are also encouraged by the level of production innovation, the company's China strategy,and its intension to its accessories product portfolio.
Since our report on Lululemon on September 11, 2017, the company has not disappointed at all. The stock price moved from US$60 per share to US$78-- a gain of around 27%. In our first report, we outlined why we felt that the commons were undervalued even if we assumed that the company remained in autopilot mode forever. Our readers can view the full report here, but to summarize the gist of our arguments are that the company has: a track record of meeting growth expectations with a huge run way ahead, added top talent at the board and management levels, excellent product innovation and initiatives to drive top line growth, a lead shareholder that has skin in the game, and a strong brand. In this article, we want to discuss a little more about what the company is doing to set themselves up for either accelerated growth in the near term, or above average growth beyond FY-20. Before we begin as is customary let us briefly recap the Q3 of FY-17 financials.
According to the company's 8-K filing, in Q3 revenue grew by 14% relative to the same period a year earlier, aided somewhat by exchange rate tailwinds. Adjusted for the benefit that the exchange rate provided, revenues grew 12%. Even more impressive is the fact that comparable store revenues--revenues from stores opened for at least 12 months --came in at 8%, reflecting a miniscule 2% growth from the brick and mortar channel, and a significant 25% growth from the online channel. As a side note we like to point out here the importance of product innovation in driving this growth, as there were several product launches in the quarter. The power of the Lululemon brand was put on full display again as, to our surprise, the company was able to eke out a 52% gross margin in the quarter (and an average of around 50% over the previous 2 quarters). In the financial models used in the previous report, we felt comfortable assuming that gross margin would normalise to around Nike's 10-year average of 46% (more on this later). While earnings before interest and taxes declined 8%, earnings before interest and taxes increased 16% after removing one-off costs associated with the iviva restructuring.
The positive momentum seems to be continuing in Q4 of FY-17, as management has signalled on several occasions expectation for strong numbers. First, after revising the revenue and profitability guidance upward in the Q3 conference call, the company gave further upward guidance at the 20th Annual ICR Investor Conference. This time comparable store sales expectations moved up from low single digits to high single digits. Second, the management team increased the stock re-purchase program to US$ 200Mn. In our view, given the sophistication of the lead shareholder -- Advent International -- this act reflects confidence in the company's ability to hit growth expectations that would lead to a higher valuation in the future.
To set stage for a discussion about growth we would like to re-iterate management's 2020 targets. Management expects to hit US$4Bn in revenues by FY 2020, with 25% of that due to Men's, 25% due to E-commerce, and International 25%. Today the company expects FY-17 revenues to be closer to US$ 2.6Bn, the E-commerce segment accounts for 20% of revenues, Men's 19%, and International 10% -- see investor presentation below. Obviously, we believe that these targets are achievable, and we explain why in the previous article. In the previous article, however, we didn't speak much about the quality of the brand, the international market opportunity, and the impact of a more efficiently operated company.
We believe that Lululemon is one of the most engaged brands in the athletic apparel space today, owing to the company's superb execution in both the digital and physical worlds. We have been impressed with the changes made to the company's website. It is now way easier for Lululemon's guests to buy buy buy, and the layout of the site forces the user to appreciate the design and innovation in the company's clothing and accessories down to the smallest detail. In early December-2017, we personally experience the use of chatbots in assisting us to make a purchase through Facebook messenger -- as a shareholder I must admit I felt a sense of pride.
Part of the problem for the slow start to the year was the lack of colours in its clothing, a fact pointed by the CEO in Q4 of FY-16, and confirmed by our checks of comments on social media throughout the period.
The slowing sales trend early Q1 has most acutely impacted eCommerce. We have clearly identified the issues, an assortment lacking depth and color for spring compounded with visual merchandising that did not powerfully translate our design vision. With focused urgency our teams have been cross correcting the issues, with early indications reflecting an immediate and positive impact on performance. We will see more color in selected style as early as next week.
There has been remarkable turnaround in the company's inventory, as checks online and in store now shows that today, there are much more colours in the company's inventory assortment. This highlight a couple of things in our minds. 1) the company is highly attuned to the experiences of its guests in real time, 2) the quasi-vertically integrated nature of the company (it designs its own products, leases its own it stores, and has a strong online presence) allows it to react with speed in rolling out new designs, and fabrics in its distribution channels, and 3) the responsiveness of its supply chain to changes in demand is top class as the company uses thrid party manufactures.
The company has been highly attuned to the comments of its guests on social media, with a response rate of over 65% to comments made on Instagram, Twitter, Facebook, and others. Almost all of these responses have an angle that would qualify as a soft sales pitch, which we think contributes to the bottom line. Nevertheless, the greatest evidence of a pleased customer, is a positive review to friends. In today's digital world, what millennials say on social media counts, so just use our bot icon to observe for a few seconds what #lululemon brings up. Our personal experience is that a significant portion of these comments reflect a fan base who can't have enough #lulu.
Many investors are concerned that the company may not be able to replicate its brand power in Western Europe, and Asia, but there is early evidence of the company gaining momentum. Initially, we had that fear because we saw a slowdown of business in Europe in FY-15, despite the company having a low store penetration in that region (6 stores). Today, we believe that the slowdown in sales that we saw reflects a slowdown after the initial hype, as the company had not yet established itself as a serious athletic brand in that region. Furthermore, Europe was in a multi-year economic slowdown, and only recently began to emerge. We believe that going forward, there will still be challenges in Europe, but business should be better. The company embarked on a global marketing campaign earlier in 2017 and it seems to be having great success. In Q3, sales from the European business grew 40%, despite adding only 1 store in Germany, and in Ireland, and none in the UK (see 10-Q filings here). Asia has been nothing short of remarkable, as growth in the Q3 went up 100% fuelled by growth in China, which increased 450%. Keep in mind that the store count in China doubled from 3 to 6 over the period.
We think that management's desire to bring the international segment from 10% of revenues today to 25% (which happens to be the largest contributor to growth going forward) is achievable. The size of the addressable market in China is larger than in the USA, just judging by the number of people within the age group 14 to 35, a rising middle class, and the drive to a more consumption led economy (in fact Laurent Potdevin mentioned 450 million mellenials in China and 130 million Chinese traveling outside of china). Additionally, there is evidence that the brand is respected as comments from the CEO in Q3 conference call highlight how lululemon's guests did an "apple-like" que up to purchase. On Q3 FY-17 conference call the CEO said:
And so without saying too much I mean, we think that we've got tremendous opportunities to enhance and amplify that possibility in China right now. We've got an opportunity to really enhance the connection between our guests, our ambassadors and our educators. And I think that one really good example of that is - an O2O, what they refer to as O2O in China is an offline to online event that we did with Alibaba where we sold 250 tickets on Tmall (for an offline yoga event). They (tickets) sold down in 30 seconds. It was pouring rain and (hundereds) of people came out. It (the event) was live streamed, where 225,000 people (watched) and I think that day we did about $700,000 in sales as a result of that. I mean that's where you can really see our ability to amplify what we do so well at the community levels, on a global scale. So that and again when we talk about creating transformational experience for our guest it goes beyond product, the way product today.
Don't forget that Western Europe is still an under penetrated market. The company has in total 9 stores across all of Europe. Compare this 9-store count to 6 in New Zealand and 23 in Australia (emphasis added here). Additionally, there are "low hanging fruits" to pick that can drive additional growth, particularly in apparels, which can not only drive growth internationally, but also in North America. According to Laurent Podevin:
On the accessory, I mean we've - our penetration right now I think is around like 7% or 8% and I've said before that for the brand that is as strong and as inspirational as we are. I mean, we have the potential to be in the 12% to 15%, so certainly we have a lot of runway. We've seen a nice acceleration in the latter part of Q3 probably as a result of the assortment that you are referring to, and we've seen the bulk of the opportunity really in bags, socks, yoga mat and head veil. I mean obviously we've got sort of other accessories on the side but that's where you are going to see the bulk of the business coming from, so a nice, a nice opportunity for us which is a great guest acquisition strategy and it's a high margin category.
A significant point that we overlooked in our previous report, is the impact that a higher scale in the business can have on growth in free cash flow. As pointed out before, in doing our valuation we assumed that company would see business profitability normalise to that of Nike's over the medium term. We assumed therefore, that gross margin will decline to 46%, contributing to operating margin leveling off at 17.5%. This led us to valuation in mid 70s with most of the upside beyond that coming from the company's ability to push growth above 14%. On the Q3 of FY-17 conference call, the CFO went to great lengths to explain how he believes Lululemon will reach a +20% operating margin by FY-20.
Okay. Brian, let me try to answer your question on SG&A. So, as we've talked about previously we are calling for SG&A leverage to help us achieve the EBIT margin rate in the low 20s and as we've talked about previously Q4 was an important period for us, its begin delivering on SG&A leverage. As we look forward and I'll give you a little more color on Q4 in a second, but as we look for beyond the fourth quarter we're going to plan a modest degree of leverage in our five-year plan. And the rationale there being at a mid-teens total revenue growth, we want to ensure that we are providing the dollars to fund our growth initiatives each year so that we're - we're not harvesting the business, we're continuing to reinvest at a healthy pace that will help sustain that topline trajectory, but also very disciplined manner allow those topline increases to flow through to earnings. So that is definitely how we've drawn up the plan. We think that Q4 and I would also point to Q3 as well an important evidence of achieving that plan.
The short version of the story is that he expects efficiencies in the supply chain to flow through gross margin, but the bulk of the savings will come from SG&A economies of scale, and a normalisation of investment in the company's digital infrastructure. Given Lululemon's track record under the current management team--for one, they have taken the difficult decision to restructure the iviva business to increase efficiency, and they kept gross margin above 50% -- we take their comments seriously. Consequently, we are evaluating whether to change our assumptions accordingly, albeit with a degree of caution still embedded.
In our view, #lululemon has a significant run away ahead to meet its growth targets, and strong brand to keep customer engaged. There are also early indications that our assumptions regarding free cash flow growth might be too conservative. If indeed the company can execute and bring operating margin in the 20% region, the company would deserve an even higher valuation than we anticipated without having to push growth to the 20% region. We continue to hold our position in the company as we wait to see how much better management can do.