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Lululemon has a number of pros that put the "currents" in favour of a higher valuation. One of the key tailwinds is that they have an active shareholder that has board seats and who needs a price of at least US$82 per share to meet Internal rate of return requirements. The management team is also laser-focused on accelerating growth above the trajectory that has been priced-in by analysts, as they work towards meeting their fiscal year 2020 targets. The company's unique marketing strategy and product quality has allowed the copmany to build a strong brand with enormous pricing power. In our view, a valuation in the mid 70s is justifiable even if the company goes into "autopilot".
In FY-14, Lululemon (NYSE:LULU) suffered a major setback. With 17% of its women's bottoms plagued with a design flaw, the company had to do a major product recall. As a result, earnings declined precipitously, and the stock price plummeted from US$81 to US$39 per share. In our view, these product quality issues unmasked an under investment in the company's quality assurance infrastructure. Since then however, there have been fundamental changes to the business, and solid growth in earnings power. Over the period, the CEO: Christine Day was replaced with Laurent Potevin, improvements were made to the company's supply chain, inventory management, and its online capabilities (Source: Lululemon form 10Ks). Earnings per share increased by 33.4%, and operating margins increased to what are now industry leading levels. Yet the stock still trades range bound between a low US$45 and a high US$81 per share, and today it sits at US$61 per share.
Why then haven't we not seen sustained positive momentum in the stock price? In our view, there are a couple of reasons for this: execution risks associated with Lululemon's growth, soft Canadian business, perceived sustainability of the industry, and perceived threat of competition.
In our view, as time progressed execution fears surfaced occasionally, which led investors to question whether the implied growth in earnings is realistic. As outlined, Lululemon was trading in the US$80s before quality control issues surfaced. At those prices, the stock would have been trading at a 1-year forward EBITDA multiple in excess of 20.0 times the value of the enterprise, which implies an earnings growth of 11% to 13% for 6 -8 years into the future, before normalizing to 3%. As the company recovered post product recall, there were a few occasions where management's guidance implied less than anticipated growth in earnings, and consequently the stock price declined. The company's track record, however, shows that they are largely on track with anticipated growth rates, which led investor sentiment to swing back to the positive side occasionally.
Since FY-14, the Canadian segment of the business has had YoY (Year over Year) declines of approximately -1.6%, -4.4%, and -4.1% respectively. The Canadian segment represents approximately 20% of systems sales for Lululemon, and as such a decline in this segment has a significant impact on realized growth in earnings. Some investors believe that this is a secular trend, because they feel that the market is now saturated. After all the Canadian addressable market is a fraction of the US market, and there have been new Canadian based brands such as Lole that have been growing in the segment. Nevertheless, given the strength of the Lululemon brand, we are of the view this trend is transitory. It is more likely that the decline in the Canadian segment is a result of a downturn in demand from Western Canada--due to the decline in oil price-- and currency headwinds, as the US dollar appreciated against the Loonie.
There is a large segment of the investing public that still holds the view that Lululemon will remain an athleisure company. A large portion of this segment also holds the view that athleisure is a fad that will go out of style in a few years, and therefore so will Lululemon. It seems that the jury is out on this one, as one can also find an equal number of consultants, and analysts that seem to believe the opposite. In my view, the idea that Lululemon is athleisure and athleisure is Lululemon is becoming outdated. In the near future, athleisure will become irrelevant to the company's destiny. Looking at the actions that management has taken thus far, we are inclined to believe that the company is redefining its DNA to become an athletic apparel company (more on this later).
For this section I refer to the boilerplate text written in the "Risk and Uncertainties" section of most 10-Ks.
We face intense competition. If we do not continue to innovate and provide products and services that are useful to users, we may not remain competitive, and our revenues and operating results could be adversely affected.
This text was taken from Google's 10-K, a company known to have a commanding market position on search. The point here is that Lululemon has many competitors-- Nike (NYSE: NKE), UnderArmour (NYSE: UAA), Adidas (OTCQX:ADDYY), Sweaty Betty, Yoga Smoga, etc-- but only a handful of these competitors have the pricing-power that Lululemon commands (more on this later).
In our view, the concerns of the market about the growth trajectory of Lululemon is overdone. There is tangible evidence that the company has made, and continues to make decisions that will at a minimum lead the company to grow earnings by 11% to 12% CAGR over the next several years. Our DCF model shows that the company should trade in the mid $70s if this growth rate holds true for the next 5 years, with 3% growth as the steady state in year 6 and beyond. So lets look at what the company has done, for as the saying goes "actions speak louder than words".
Between FY-13 to FY-16, the company grew gross profits (we focus on gross profits because management has made several investments in SG&A to transform the business) by a CAGR of approximately 12.6%. With that track record, the occasional weak management guidance appears to be nothing more than evidence of management conservatism, which is fine. Additionally, this was done while the Canadian side of the business declined for 3 consecutive years, a phenomenon we do not expect to continue. The size of the addressable market for athleisure (... and we don't believe Lululemon will remain an athleisure brand) in the USA alone is estimated at approximately US$44Bn by NPD Group. Lululemon, as the category founder, can attain a market share close to 10%, which would allow them to easily grow their gross profits by a CAGR in excess of 12% for a few more years, and hit their target of US$4Bn in revenues by 2020. The only effort needed here is to maintain brand strength, build more stores in the USA, improve the men's business, and maintain their online capabilities.
The company added Glenn Murphy as Co-Chairman of the board in April 2017. In our view, the addition of this talent to the board was partly influenced by Advent international, which is a private equity investor that hold Lululemon commons. We believe management, the lead shareholder, and the board are committed to strengthening the position of Lululemon in the Canadian market, and growing the brand internationally. According to the press release:
As Head of FIS Holdings, Mr. Murphy is responsible for leading the high-impact consumer-focused investment firm deploying a combination of operating guidance and capital flexibility. Prior to founding FIS Holdings, he served as Chairman and CEO of The Gap, Inc. for seven years. Mr. Murphy has also successfully led diverse retail businesses and brands across grocery, pharma, health and beauty, books and lifestyle; having previously served as CEO of Shoppers Drug Mart Corporation, and CEO and President for the Retail Division of Chapters Inc. Mr. Murphy began his career at Loblaws where he spent 14 successful years.
According to the FIS Holdings website, Mr. Murphy's firm focuses on:
Attracting and Developing Talent
Strong track record of identifying and retaining incumbent talent, and skilled at recruiting key executives from the best companies.
We have over 15 years of deeply rooted, top-tier PE Firm relationships to draw on.
Broad international experience in Asia, Europe, South America and Middle East.
Established reputation for driving market share in low growth industries, including retail footprint expansion and optimization, digital/omni-channel, brand extension and international launches.
Glenn Murphy also has significant skin in the game. According to the Barron's website:
Glenn Murphy, who was named to the post in April, bought a whopping $5.55 million in Lululemon shares, the largest on the open market since the company went public in 2007 and only the third insider purchase since 2009. Murphy paid an average of $55.50 each for 100,000 shares over June 26 and 27
Added to this development is the fact that the Canadian dollar has been appreciating against the US dollar, and discretionary spending in western Canada has been strengthening, as expressed by other companies that sell discretionary products in the region such as BRP Inc in Q2 of FY-18.
We believe that the 12% CAGR that Lululemon has managed to obtain is viewed as insufficient by Advent International (more on this later), and so management has been pulling levers to accelerate growth. News releases show that they have been focused on several growth inducement strategies namely, greater product innovation, expansion into new athletic categories, expansion into new geographies, and leadership changes at the Board and management level of the company.
Perhaps the most recent evidence of product innovation is the Enlite Sports Bra which have been performing excellent, according to Lululemon, in spite of a US$98 price tag. The company also branched out of traditional yoga wear into sportswear for running, swimming, the gym, volley ball, and training. Recently, the company made a minority investment in 7mesh of Vancouver, British Columbia. 7mesh is a leading apparel manufacturer for cycling enthusiasts. On August 8, 2017, Lululemon announced expanded offering into shoes. The company partnered with Athletic Propulsion Labs to offer an assortment of male and female footwear styles in 23 stores across North America. As outlined in Q1 of FY-17, the company is also accelerating its store footprint in China, a market that is estimated to generate US$1Bn in additional revenues. Products are already being sold on Tmall and sales is growing at double digit rates. The company had 11 stores in Europe as a January 2017, and plans to build more in the future with specific focus in Germany, and Switzerland. Perhaps of even greater significance is the number of leadership changes that have taken place.
According to a press release on August 31, 2017:
We are excited to add Tricia Patrick to the Board," said Laurent Potdevin, Chief Executive Officer of lululemon. "Her global experience across consumer sectors will bring further insight and operational expertise to lululemon at a time of significant growth for the Company.
At Advent, Ms. Patrick focuses on buyouts and growth equity investments in the retail, consumer and leisure sector. Prior to joining Advent in 2016, Ms. Patrick spent 12 years as an investment professional with Bain Capital Private Equity and before that, was with the Private Equity Group of Goldman, Sachs & Co.
Ms. Patrick was designated for appointment to the Board of Directors by Advent International in accordance with the terms of a support agreement between lululemon athletica and certain entities affiliated with Advent International under which Advent has a right to designate two people for nomination to serve on the Board of Directors for so long as Advent beneficially owns at least 10% of the voting securities of lululemon.
Additionally, Scott (Duke) Stump, who served as Executive Vice President, Brand and Community, will be leaving the company effective October 1, 2017. As Executive Vice President Duke was originally appointed to lead the growth of the brand internationally (Source: Lululemon 8-K filing).``
Apart from the action taken by management, there are other forces at play that puts the "currents" in favor an acceleration of earnings growth. One of those is position and capabilities of the lead investor--Advent International-- and the other is lululemon's strong brand equity.
Advent International is private equity firm with assets of $39Bn as of March 2017-- according to the company's website. The firm targets investments in North America, Europe, Asia, and Latin America. Advent seeks transactions valued between $50Mn and $3.5Bn and can commit up to $1Bn of equity per investment. The firm's sector expertise includes business & financial services, retail & consumer, technology, media, & telecoms, healthcare & life sciences.
According to Advent's website, the company adds value through a variety of growth initiatives, including:
Advent's first foray with Lululemon came in December 8, 2005 when they purchased a minority stake in partnership with Highland Capital at an implied enterprise value Cdn$225Mn. The deal was to support the company's growth strategy in the US and internationally. Some of Advent's holdings were sold in the IPO of 2007, with the remainder sold over the ensuing years. Fast forward to August 2014, Advent decided to do a double dip, and they re-invested in Lululemon by acquiring approximately 50% of Chip Wilson's (Founder) ownership in lululemon--approximately 13.85% of the Company's outstanding shares-- for approximately US$845Mn. At the time, Chip Wilson owned 40.2Mn shares of lululemon common, and so Advent attained 20.1Mn shares at a price of approximately US$42 per share.
If we assume that Advent International requires an internal rate of return on capital deployed that is similar to most private equity shops, their required internal rate of return should be between 20% and 30%. Assume also that the US$845Mn minority investment is unlevered. For a 20% required Internal rate of return, Lululemon's stock price should have been on a run rate of US$72 per share in August 2017. At an internal rate of return of 25% the run rate should have been US$82 per share, and at an internal rate of return of 30% the run rate should have been US$92 per share. Today, the stock sits at US$61.2 per share, and given its trading dynamics, and the time value of money, we believe that Advent requires a run rate in the mid 80s to unload their minority stake at a success today. Furthermore as time lapses the required run rate gets higher. Lululemon's adjusted operating margin is already above industry average, and so the firmest way to achieve this is through acceleration of earnings growth over time. Our discount cash flow model show that Lululemon would need to grow earnings in the region of 20% to 25% for the next 3-4 years to justify a valuation in the 90s.
Investors should be convinced by now that the Lululemon brand is among the best in the athletic apparel industry. Some of the more recent evidence of this is the fact that the company was able to increase product prices in Q3 of FY-16, with little to no reduction in volume. In Q2 of FY-17 the company had a warehouse sale which contributed 15% comparable store sale growth while having de-minimis impact on gross margins. With this level of pricing power Lululemon can continue to grow aggressively in the athletic apparel space, in-spite of the strength of its competitors.
In summary, we believe lululemon can grow earnings at around 12% for the next 5 years just by remaining in autopilot. An earnings growth of around 12% is enough to justify valuation at US$75 per share. Nevertheless, given what management has done thus far, the position of Advent international as an active sophisticated shareholder, and the market opportunities available to Lululemon, we believe the company can significantly exceed that growth rate. At an earnings growth of about 20% for 3 - 4 years, a valuation in the 90s is justifiable.