Lululemon Athletica: Great company, but overvalued stocks (NASDAQ: LULU)
Experiential lifestyle brands such as Tesla (TSLA), Starbucks (SBUX), Apple (AAPL) provided above-market returns across all sectors. For consumer discretionary products, brand equity is the key to winning multiple benefits such as pricing power, word of mouth marketing and sales volume. One of my favorite lifestyle brands, a company that is still in supercharged growth mode, is Lululemon (NASDAQ: LULU). Lululemon stock has generated a >250% return for shareholders in less than 5 years. That said, the stock has sold 22% since the start of the year as the market turned bearish towards growth assets. Is it time to buy?
In this article, I apply a residual earnings framework based on EPS analyst consensus estimates to value Lululemon. My calculation reveals that LULU is relatively well valued/slightly overvalued based on a target price of $238.31/share.
Lululemon Athletica is a leading experiential sports brand and retailer in Canada. The company designs and markets apparel and accessories for healthy lifestyle activities such as yoga, running and general fitness activities. Founded in 1998, Lululemon has quickly become one of the most valuable brands in the world. Most notably, Lululemon’s brand value of $17.9 billion in 2021 fell just $1 billion below what was needed to rank in the top 100 brands list. Specifically for apparel, Lululemon ranks 4th, behind Zara, adidas (OTCQX:ADDYY) and NIKE (NKE). Lululemon operates and serves customers worldwide, focusing on North America, Europe and the APAC region. As of early 2022, Lululemon operates over 600 stores globally, of which approximately 320 are located in the United States. In 2021, Lululemon generated approximately 85% of total sales in North America, but the company’s international market is growing rapidly, growing more than 50% year over year.
Ambitious growth targets
2021 was a banner year for Lululemon, with the company growing total revenue 42% year-over-year to $6.26 billion. Strong growth was, among other things, driven by direct-to-consumer digital sales, which accounted for more than 50% of revenue and a strong performance from Lululemon’s men’s business, which grew more than 100% year-on-year. year to year.
Additionally, in 2021, Lululemon introduced its Power of Three x2 growth strategy, which aims to double the company’s revenue through 2026, to $12.5 billion in sales. The strategy is supported by a focus on the company’s men’s business (1), international expansion (2) and digital sales (3). Additionally, the strategy is aided by a tailwind in the global sportswear market, which is expected to grow at a 5-year CAGR of 7% (Source Bloomberg). The tailwind is even stronger in China, where the activewear market is expected to grow >12% CAGR (Source Bloomberg). For reference, between 2018 and 2021, Lululemon grew its sales at a CAGR of 24%.
Additionally, Lululemon management expects profit margins to increase as the EBIT margin is expected to grow from 22.0% in 2021 to 25.8% by 2026. That said, EPS is expected to grow at a CAGR > 15%. In particular, the analysts’ consensus does not doubt management’s ability to achieve the company’s ambitious growth objective. In fact, consensus EPS in 2022, 2023, 2024 and 2025 are modeled at $9.33, $9.86, $12.86 and $14.86.
If management predictions and analyst consensus are correct, what should be a reasonable price target for Lululemon? To answer this question, I propose to value the LULU stock based on a residual earnings framework and anchor it on the following assumptions:
- Base my EPS estimates on analyst consensus through 2025.
- I apply a cost of capital of 9%, which is consistent with the WACC model and reflects Lululemon’s relatively low risk growth.
- For the terminal growth rate, I use a 1 percentage point premium to the estimated long-term nominal GDP growth of 3.5%, calculating 4.5%.
Given my assumptions and calculations, Lululemon seems slightly overpriced. My calculation returns a fair base target price of $238.31. However, I understand that investors may want to apply different valuation assumptions to LULU’s WACC and terminal value growth. That said, I have also attached a sensitivity chart. Feel free to select the scenario that best reflects your assumptions.
Investors are advised to note the following downside risks which could cause LULU stock to differ materially from my target price as calculated in the review section:
First, a slowing macroeconomic environment, caused by inflation, rising interest rates and supply chain challenges, among other things, could negatively affect the purchasing power of Lululemon’s customers. . If the challenges turn out to be more severe and/or last longer than expected, the company’s financial outlook should be adjusted accordingly. The economic slowdown in China will likely have a negative impact on the company’s operations. This is especially true for Lululemon’s exposure and growth aspirations to China, a country currently experiencing strong economic headwinds.
Second, Lululemon’s success and growth strategy is closely tied to the company’s strong brand image. Arguably, much of Lululemon’s success is attributable to a very specific focus in the company’s early days on “women + yoga.” However, as the business has gradually expanded into more diverse segments, including tennis, men’s business, etc., there is a risk that new business ventures will add to brand dilution and therefore reduction. of brand equity.
Third, in an environment of declining asset prices and caution around risky assets, much of Lululemon’s stock price volatility is currently driven not by company fundamentals, but by the investor sentiment. Thus, investors should expect price volatility even if Lululemon’s business outlook remains unchanged. In addition, inflation and rising real yields could add significant headwinds to Lululemon’s stock price from a technical/mathematical perspective, as higher discount rates affect the net present value of long-term cash flow.
While I like Lululemon as a company and while I think mainstream brands with lots of brand equity are poised to outperform in the long run, I’m not entirely convinced that LULU is a buy at the levels current of >$290/share. The reason is simple: even taking into account the achievement of the company’s ambitious growth targets until 2026, the fundamentals do not indicate a good deal. That said, I think the current market environment offers better opportunities. I conclude my article with a HOLD recommendation and a base target price of $238.31/share.