Lululemon Stock: Now is not the time to take a position (NASDAQ: LULU)

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Investment thesis

Lululemon (LULU) is an activewear company based in Vancouver, Canada, which sells activewear such as pants, sweatshirts, jackets, shorts, etc. through their direct-to-consumer (e-commerce) and in-store channels. The company has enjoyed a decade of incredible success expanding its brand and shareholder value. Over the past 12 years, management has been able to secure a revenue CAGR of approximately 25% and an EPS CAGR of approximately 30%, representing more than adequate value creation over the long term. . Additionally, the company appears to be in the early stages of its secular growth strategy with estimated fiscal profits of 48% and 22% in 2022 and 2023 respectively. That being said, although Lululemon is a big company, I will have to classify their stock as a reserve depending on market conditions and the company’s rich valuation creates headwinds for their stock price. To begin, we’ll look at some of the factors that I believe will hinder Lululemon’s growth in 2022, such as declining economic activity, inflation, and intense competition. Second, we’ll look at the slowing growth in the company’s direct-to-consumer sales as people return to their pre-pandemic shopping habits. Next, we will also dive into the risk/reward ratio of the business by providing scenario analysis on a discount cash flow model. Finally, looking at Lululemon’s historical P/E multiples, we see that there is still some mean reversion risk in the company’s stock. Overall, Lululemon is a great company, but I think it’s best to wait on the sidelines as a further drop seems highly likely.

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Data by YCharts

Revenue growth faces clouds on the horizon

Lululemon has successfully implemented an incredible revenue growth strategy over the past decade and has the ability to maintain momentum through brand equity, enabling it to gain additional market share in the sportswear industry. That being said, while I believe Lululemon’s long-term growth should remain robust, there are two short-term factors that could temporarily put Lululemon’s growth efforts on hold. The first factor is the decline in economic activity. According to the Atlanta Federal Reserve, its forecast for US real GDP growth in the first quarter is between -0.5% and 1.7%, down significantly from the 7% growth we saw in the fourth. quarter of 2021. In addition, month-over-month retail sales are expected to increase only 0.4%, compared to a 3.5% increase the previous month. These numbers would concern me if I were a shareholder of Lululemon given that the company operates in a fairly cyclical industry in which it depends on a strong economy to meet their guidance. The second factor affecting Lululemon’s near-term growth efforts is increased competition. The company already has to compete with behemoths such as adidas (OTCQX:ADDYY) and Nike (NYSE:NKE), but Lululemon also faces up-and-coming competitors such as Peloton (PTON) which recently entered the apparel industry. sport. Lululemon unfortunately has a bad mix of headwinds facing them in the near future. Growing competition mixed with declining economic activity creates a huge hurdle for them in 2022. While I applaud Lululemon’s go-to-market strategy and brand recognition, unfortunately the companies’ growth strategies don’t follow. not always a continuum, and there are always economic and trade issues. factors that can temporarily disrupt a company’s growth cycle.

Slower direct-to-consumer growth

In addition to the headwinds facing the company’s revenue growth, Lululemon could also see its bottom line decline slightly in 2022. store. Lululemon’s e-commerce segment exploded in growth during the height of the pandemic, to the point that more than 60% of its total sales came from e-commerce. However, that has slowly started to change as Lululemon’s revenue proportions slowly return to pre-pandemic levels. The following data was gathered by reviewing Lululemon’s 10 Questions on its Investor Relations page.

Sales' repartition

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Looking at my chart, you can see that the revenue proportions are slowly approaching the pre-pandemic situation when sales were generated in-store. This impacts Lululemon’s margins as their direct-to-consumer segment has higher EBIT margins than their in-store segment. Using Lululemon’s Q2 2021 EBIT margins by segment, here is the company’s total unadjusted operating margin using Q4 2020 weighting. the company faces as a whole, such as business expenses, and is only the weighted operating margin of each segment.

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Sales' repartition

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Adjusting the revenue weighting by segment to the last quarter, we get an unadjusted total operating margin of 32%.

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This represents a change of around 12.5% ​​in the operating margin. Additionally, if Lululemon’s revenue weighting reverts to approximately 51% in-store sales and 35% e-commerce, that margin is reduced by an additional 4%. In addition to the pandemic disrupting the company’s revenue generation, the company also has to deal with rising inflation and labor costs. In a fierce new job market created by extended unemployment benefits, Lululemon may have to raise the wages of store workers to compete with other large retailers, another variable in which could weigh on the company’s results.

Valuation: the DCF model proves that the risk/reward ratio is negative

Using a discounted cash flow model, I was able to prove that even in Lululemon’s best-case scenario for its operations over the next 4-5 years, there isn’t enough upside to compensate investors for the mean reversion risks as well as company risk does not meet their guidelines. Using several factors such as sales breakdown, CapEx, and product innovation spend, I calculated my best-case scenario for Lululemon for the next 5 years.

Expectations

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Then, using a perpetual growth rate of 4% and a discount rate of 10%, I will calculate the intrinsic value of Lululemon stock given this scenario.

DCF model

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As you can see, in my most optimistic scenario, Lululemon only offers investors a 16% upside. The following is Lululemon’s advantage if my revenue growth rate were to be adjusted to 25% using the same DCF model.

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We can see that based on my estimates and baseline scenario analysis, Lululemon management has a small margin of error if it is to continue to drive shareholder value in 2022 and beyond. Finally, when you also look at Lululemon’s historical annual P/E ratios, you realize that Lululemon’s rich valuation poses a risk of mean reversion. The following chart shows Lululemon’s P/E ratios from 2009 to 2019, leaving 2020 and 2021 as outliers since the market roared during that time.

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Now, assuming the US market starts trading at a cheaper multiple due to expected economic uncertainty, interest rate hikes and inflation, Lululemon could see itself trading at a P/ E of 33 in 2022 taking into account market conditions and mean reversion. Here is my worst case scenario for Lululemon in 2022.

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To conclude talking about valuation, using a DCF model and a historical multiple model, we arrive at a best-case scenario of around 16% upside, while the worst-case scenario gives us a return of -25%. Therefore, we conclude that Lululemon is trading at a premium, while also generating a negative net risk/reward.

Conclusion: Lululemon is a great company, but a dodgy game for now

To conclude my holding note for Lululemon, management has done a fantastic job of creating shareholder value in the past, and I think it will continue for the long term. That being said, there are currently too many concerns about adjusting their sales mix to pre-pandemic levels, its premium valuation and current market conditions to consider adding to your portfolio at this time. In my opinion, if you’re looking to add to your Lululemon stance, or considering taking a stance, you might want to expect another 20-25% downside. Shareholders may also consider selling call options on Lululemon shares. Ultimately, Lululemon is a great company right now, but a mediocre stock.

James T. Quintero