New Coverage Launch: $40 Estimate For Lululemon Athletica

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LULU: lululemon athletica logo
LULU
lululemon athletica

Lululemon(NASDAQ: LULU) is a manufacturer and seller of yoga-inspired athletic apparel and performance apparel and accessories for men and women. The company also runs a subsidiary under the brand name iviva athletica which manufactures dance-inspired apparel for girls aged 6-12. Founded in 1998, the company went public in July 2007. The company opened its first store in Vancouver, Canada. The store included a design studio, a retail store and shared space with a yoga studio. It was intended only to serve as a center for people interested in yoga but the company has since expanded, and operated 254 stores by the end of January 2014. The company also has showrooms in Hong Kong and United Kingdom. Additionally, Lululemon’s products are sold at various fitness studios in North America.

We have a price estimate of $39.87 for Lululemon, which is about 9% below the current market price.

We have broken down the company  into three divisions:

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a) Retail Stores

Retail Stores, which constitute around 70% of the company’s valuation, is the most important division for Lululemon.

Over the last five fiscal years, the company has booked an average retail stores revenue per square feet (RSRPSF) of $1,615, which is nearly three times as high as the average RSRPSF for other apparel firms. Infact, Lululemon’s retail store productivity ranks only behind that of Apple and Tiffany’s in the United States. In order to understand the reasons behind this stellar performance, we need to take a closer look at how Lululemon’s store operations differ from those of other retailers:

  • Instead of gathering customer data using software, rapidly expanding store count and offering aggressive discounts and gift coupons to boost sales Lululemon runs exclusive small stores with low inventory and introduces colors and prints for limited time-periods only. This strategy ensures that loyal customers buy items that they like as and when they see them, aware that these items might not be there the next time they come to the store.
  • Instead of relying on analytics based on data gathered from software, the company trains its store employees to keep their ears open to customers. Lululemon has folding stations adjacent to the dressing rooms, instead of in the storage room, so that employees can overhear customer complaints. The company management uses this feedback in order to tweak its products and also for future products.
  • The company also has core items which don’t change from season-to-season to keep sales ticking when limited-time items are out of stock. Moreover, it never puts its core items on sale and has a very strict return policy.

The company ended fiscal 2013 with 254 stores, up from 211 stores a year ago. Additionally, the company also operates 69 showrooms, 17 of which are located outside North America, including six in Asia and nine in Europe. In the Q4F13 earnings call, the company’s new CEO, Laurent Potdevin, hinted that the company has plans of expanding into new markets beside U.S, Canada and Australia. Lululemon just opened its second store in London last week. The company plans to follow the same process it followed in North America- open new showrooms to build brand awareness and then hire local ambassadors to help drive sales. Lulu has been organizing similar community events in Hong Kong as well.

The company’s EBITDA margin declined from 45% to 33% in FY13. This decline was due to high replacement costs which the company had to incur in order to replace a defected line of black luon pants. In the long run, we expect the EBITDA margin to improve gradually and settle at around 43% by the end of our forecast period.

b) Direct-to-Consumer business

This refers to revenues generated by LULU by selling its products straight to consumers without having to go through a distributor or dealer network, either through its e-commerce channel or company owned stores. Consequently, it is a higher margin segment. This division only contributes about 15% of the company’s revenues, but is responsible for ~19% of its valuation, owing to its higher margin. Moreover, as companies slowly continue to move away from the highly competitive retail space and more people begin to shop online, the contribution of DTC to the company’s revenues is only expected to increase.

However, there is a caveat here: in the past, the company has faced problems due to the absence of quality filters at its distribution centers, resulting in faulty products making their way to stores. Moreover, in the absence of an efficient and streamlined supply-chain network the company hasn’t been able to make certain on time delivery of products. The DTC channel requires a highly streamlined supply-chain network as delivery of faulty products and lack of on time delivery can deter consumers from shopping for the same products again.

c) Wholesale, Franchise and Other

The Wholesale division contributes only about 3.5% to the total stock valuation  of Lululemon. Even though the company’s wholesale business revenue has increased considerably -from $41 million in 2009 to ~$100 million in 2013- on the back of increased consumer spending on retail products following the recession, its overall contribution to the company’s revenues is still quite small. Also, given that the operating margin for this division is lower than that of retail and the direct-to-consumer businesses, we don’t expect this division to be a major contributor to the company’s valuation.

What Will Drive Lululemon’s Stock Price

In the fiscal year 2013, Lululemon recorded $1.6 billion in revenues. Since, 75% of Lululemon’s stores are based in the United States, and most of the revenues come from the sale of yoga pants, assuming an average unit price of $80, we arrive at 20 million as the number of units sold by the company each year. Based on a 2010 census, the population aged 18-44 in the United States is 112.9 million, of which approximately 57.4 million are women. Assuming an average spend of $300 per customer per year, we arrive at a figure of 5.3 million customers, or approximately 10% of women aged 18-44. Therefore, we can see that one way for Lululemon to increase its revenue base is by increasing the customer reach of its products. Another way is to develop products for men. For example, if the company can reach 10% of men in the same demographic segment and get them to spend $150 per customer, they can increase their revenue base by 50%.

The main trend that can drive increased spending on yoga products is the increasing drift towards fitness related activities and health-conscious lifestyles. With the decline of social security in the U.S. following the recession, the private sector has increased its spending on healthcare. The introduction of products like Apple’s iWatch, Samsung’s Galaxy Gear and apps like Nike+ and Under Armour’s MapMyFitness, can be seen as complementary to the increased supply of fitness and training apparel. As the costs of healthcare have been outsourced from the state to the private sector, individuals are likely to find treatments much more expensive than they did in the past. The result might be a much more health conscious society, taking precautionary steps far in advance to avoid those prohibitive and potentially fatal costs. These trends are driving the growing interest of urban-dwellers in training, running and other such activities. If these trends continue, consumer spending on such products is likely to rise and in that environment a company with a unique retailing strategy and a loyal customer base like Lululemon is likely to benefit.

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