Lululemon: "Finishing Two Years Early"
(Lululemon Q2 FY21 Earnings Review)
The reaction to Lululemon’s second-quarter earnings (announced September 8th) caused the company’s share price to soar ~14% the following morning, ending the day up ~12% at $420 per share.
Whilst price action is not something I look to for validation of a great quarter, the reaction certainly seemed just.
Revenues for the quarter came in ~$150M over guidance ($1.45B), having grown 61% YoY, with the stronger than anticipated sales causing management to hike FY revenue guidance from between $5.83B to $5.91B to $6.19B to $6.26B. Equally impressive were the sales from Lulu’s e-commerce segment which, after guiding for a slight decline YoY, came in at a modest 4% increase from the monstrous 157% increase witnessed during the same period last year.
This, in conjunction with the apparent haste with which Lulu is completing their FY23 roadmap goals, has investors feeling confident. Impressed with the success of their progress in the Power of Three plan CEO, Cavin McDonald, has stated that he will “come back to [investors] next year with an updated view” on the 5Y plan, given that by the conclusion of the year, the revenue target and the doubling of the men’s and DTC businesses, will be completed two/three years early. Thus, leaving just the quadrupling of the international business, as well as targets for earnings and margin expansion, on the table.
The second quarter showed a resurgance in the company-operated store revenues in tandem with 11 net new stores opened during the period, bringing Lulu’s total store count up to 534 (95% of which are now open).
Today, I will be breaking down the important takeaways from Lulu’s earnings, as well as casting some of my own commentary on those results.
For context, I recently wrote about Lululemon in the company spotlight segment of this newsletter, which you can find here.
For continuity, I must state that Lululemon is a position I currently hold in my portfolio (weighted at ~4%).
Key Takeaways from Q2
Revenues of $1.45B came in at ~10% above the upper range of guidance.
FY21 revenue guidance has been upgraded by ~6% to highs of $6.26B.
Doubling of the Men’s business is set to be complete in FY21, two years ahead of schedule. Quadrupling of the international business set to be complete before FY23.
In light of progress on the FY23 roadmap, McDonald has suggested they will revise the plan in 2022.
Company-operated store revenues are back, now accounting for the lion’s share of the revenue base once again (48%), up from 44% last quarter, and 38% in 2020.
Lulu guiding for attractive margin expansion, despite a 150bps to 200bps headwind from additional supply chain expenditure.
Lulu is expected to accelerate store openings heading into H2 with a further 25 to 30 international stores (10 thus far) and 10 to 15 North American stores (3 thus far) to be opened over the remainder of FY21
Finishing Two Years Early
Lululemon’s second quarter was plagued with supply chain constrictions, particularly in Vietnam (the largest source of manufacturing) where ~33% of Lulu’s products were manufactured last year. As a result of factory closures, port stagnation and reduced airfreight capacity, around one-third of Lulu’s finished goods inventory are incurring higher costs to mobilise.
Meghan Frank (CFO) remarked that Lulu’s supply chain and product teams are working to “mitigate these risks by shifting production out of Vietnam, where possible with our vendors who operate in multiple countries, prioritizing production to ensure key fall holiday styles are produced first and strategically increasing our use of airfreight”
Despite these supply chain issues, Lulu managed to accelerate past their own guidance of $1.3B and reported $1.45B in revenues with McDonald citing both TAM expansion and market share acquisition as the key drivers for growth both in the current moment and in the future. The newly revised guidance for FY21 revenues ($6.26B) means that Lulu is on track to surpass their FY23 revenue target (laid out in their power of three plan) two years early.
Whilst on the topic of finishing things early, McDonald would remark in the call that the goal of doubling the men’s business will likely be complete this year (two years ahead of schedule) as well as stating they are on track to quadruple the international business before FY23. This comes after the company checked off the goal of doubling the DTC business during FY20. More on that momentarily.
After the composition of company-operated store revenues plummeted from 63% to 38% of revenues from 2019 to 2020 with the wave of store closures, the DTC business stepped in to pick up the slack, allowing Lulu to continue to grow their sales base, despite the drop in footfall.
These store revenues are now bouncing back with 95% of stores now open, with Lulu reporting $695M in revenues for the second quarter, up 142% from $287M last year.
Store revenues have generated $1.23B in sales thus far in FY21, now surpassing the DTC business ($1.14B) with a 48% share of the fiscal year’s revenues.
Other revenues ($158.1M) increased 157% YoY, largely bolstered by the inclusion of Mirror revenues, and have generated $302M so far this year.
The setup for DTC revenue comps was tough heading into the second quarter. This time last year the segment demonstrated 157% in growth and included an online warehouse sale which juiced revenues to the tune of $43.3M. Initial guidance from Q1 suggested a modest YoY decline for DTC revenues in Q2, followed by two-quarters of growth over the remainder of Q3 and Q4.
As it happens, the DTC business expanded by a further 4% (constant dollar basis) in Q2, reaching $597.4M in revenues.
I suggested back in August (here) that “managing to equal the revenue base from 2020 for FY21 would be an impressive feat” for the DTC business. Currently at $1.14B in sales for the 6 months of FY21, this is essentially 50% of the $2.28B generated in FY20, with the holiday season ahead of them. With management holding strong on their suggestion that Q3 and Q4 will see modest YoY growth, it feels likely they match or beat last year’s DTC revenue figure. Over H2 in FY20, Lululemon generated $1.38B in DTC revenues, and with 65% of that ($900M) coming in Q4, the guide for YoY growth is particularly strong, if it occurs.
Assuming Lulu meet the upper range of FY21 revenue guidance, and that DTC revenues come in flat YoY (which feels unlikely), with a 10% share from ‘other revenues’, this would leave the year’s composition of sales to show 53% from company-operated stores, 37% from DTC, and 10% from other.
However, the actual end result is hard to estimate. DTC was already growing as a percentage of sales pre-covid (18% in 2015 to 29% in 2019) and after this last year of exponential digital exposure for Lulu consumers, I would imagine that the DTC business settles well above pre-covid norms.
Long term, this stands to benefit Lulu’s margins and scalability of their brand. Despite not breaking out the gross margin profiles of each segment, it is assumed that the DTC business boasts the superior margin profile of each of the three segments.
Gross profit ($842.7M) grew 72% in Q2, demonstrating a 390bps expansion (58.1%) largely driven by the reduction in the cost of goods sold relative to the larger sales base (sales leverage) as well as ~60bps of favourable currency exchange rates. It was remarked that additional airfreight costs offset this expansion by ~20bps.
Lulu’s FY23 goals include both modest gross margin expansion (each year) as well as modest leverage in SG&A. Whilst I suspect the eventual launch of Lululemon footwear will negatively impact gross margins ever so slightly (see Nike’s gross margin relative to Lulu’s), it remains the case that increasing e-commerce penetration is the gold standard which their ability to attain this goal is weighed upon.
For the FY21, gross margin is expected to come in at between 57.5% and 58% (150 to 200 basis points improvement on last year). This guidance includes a 150 to 200bps offset from additional airfreight costs. As such, Lulu is partially constrained this year with respect to expansion and still providing a healthy guide. This leaves me feeling confident that they can continue to expand in the following year (FY22) provided there are no significant setbacks.
A similar story is present with respect to operating income ($291M), whereby the benefit of sales leverage propped margins up back up to pre-covid levels, at 20%. Margins have been particularly bolstered by the return of store revenues and subsequent operating incomes. Earnings ($208M) too, are up ~140% from the second quarter of 2020.
Over the last 18 months, the DTC business has maintained an operating margin (ex-cost) in the low to mid-40s, whilst the company-operated and other segments have continued to retrace the disruption caused by store closures in 2020.
Thus, it goes without saying that a significant portion of the expansion we see now, is due to the revitalised strength of the company-operated store segment.
Whatsmore, Lulu’s operating efficiencies appear to have improved sequentially, cutting 7 days from the cash conversion cycle thanks to a reduction in the days of inventory and sales outstanding.
With respect to the Power of Three plan, we have established that margins continue to expand, SG&A leverage is present and ongoing, and that the digital business has doubled already in FY20.
I will touch on the remaining items of the FY23 plan (below), as well as the Mirror business before moving on to discuss the balance sheet, guidance, and my concluding remarks for the quarter.
Double the Men’s Revenue Base (Complete by FY21)
Quadruple the International Revenue Base (Complete by FY23)
Have Revenue Growth (CAGR) in the Low Teens (Ongoing)
Have EPS Growth > Revenue Growth (Ongoing)
The Men’s Business
Calvin McDonald was so frank to state that “we will double our men's business this year”. For that goal to materialise, that means Lulu will earn $1.38B from their men’s business by the end of this fiscal year.
After reporting $363M in sales in Q2, Lulu has generated $637M in men’s sales so far this year, leaving a further ~$743M to be generated over the course of Q3 and Q4, representing a YoY comp of ~45%.
In the past, management has cited the stores as being the primary acquisition vehicle for male customers, which could explain the decline in growth from 2019 to 2020 (3% vs 34% in the previous year) as stores lay dormant. Perhaps, whilst brand recognition amongst males is weaker, the digital arm of Lululemon is less of an acquisition vehicle, but more so a repeat custom vehicle for males who already know the brand.
With stores now “generating productivity in line with 2019”, most of which are now open, and the holiday season upon us, management clearly believe men’s sales will show strength heading into H2. For me, the promise of beating this target two years early is certainly pleasing, but not something that is all too important.
To me, Calvin has been a CEO that rarely overpromises. Suggesting that men’s attire reaches $1.38B in sales this year opens up a window to underdeliver. This feels like an unnecessary claim if one doesn’t have a strong conviction that it will materialise. As such, I trust the guidance, but won’t be upset if it does not come to fruition.
The International Business
Calvin would also remark that Lulu “remain on track to quadruple our international business by 2023, if not sooner.” For that to happen, they would need to report ~$1.43B in international sales by FY23.
So far this year that figure stands at $446M (+77%), and we could see the FY21 figure land anywhere between $850M to $950, on a conservative basis.
Taking the middle of that range (~$900M) it would only take Lululemon two years of mid to high 20s growth to achieve that target. This seems achievable, given the pace of international growth in tandem with the aggressive store openings.
In Q2, Lulu would open 11 (net) new stores, 8 of which (7 Asia, 1 EU) are located internationally, and 3 within the US.
Store openings are the primary method of customer acquisition and revenue expansion for the international base. The opening of a new store, or the expansion of a store count in a particular region also has the added benefit of acting as a ramp to the international DTC business on account of brand exposure. This appears to be particularly important for the men’s business.
Based on guidance, Lulu is expected to accelerate store openings heading into H2 with a further 25 to 30 international stores (10 thus far) and 10 to 15 North American stores (3 thus far) to be opened over the remainder of FY21.
Revenue CAGR and EPS Growth
McDonald would cite, back in 2018, that the objective for revenue would be to grow it at a low-teen CAGR over the course of FY18 to FY23, whilst having EPS outpace the growth of sales.
Whilst it’s still too early to really determine whether or not that goal is being met, the current FY21 revenue guide would imply a CAGR in the mid-20s from FY18 to FY21, well above estimates. As such, there is considerable wiggle room should revenue growth slow down somewhat over the following two years.
With respect to EPS growth, it has surpassed revenue growth in 2018 and 2019, with the allowable hiccup in 2020 (10.6% revenue growth vs an 8.7% decline in EPS).
With an anticipated ~42% growth in the revenue base this year, Lulu would need to report an EPS of $6.40 (or more) to surpass it.
Despite citing that Mirror is contributing to an ever-growing share of other revenues, there was not a great deal of discussion surrounding Mirror other than Calvin stating the company “continue to see the members use of MIRROR, number of sweats, number of members per household sweating increase and hold very high numbers”.
I suspect, whilst Mirror is an incremental portion of revenues, we only get updates on the metrics annually, or sporadically. I am most interested in seeing whether or not Mirror attains the $250M to $275M revenue guidance for FY21, which goes some way to offsetting the $500M they paid for the business.
The Mirror product has been rolled out across 50 more stores (150 in total) in the US, and is expected to be placed in a further 50 by the end of the year, which includes the expansion into Canada later this year.
The business also opened a second studio in New York during the quarter, allowing them to double the number of live classes they offer.
McDonald would also announce the proposal of an e-commerce site for Mirror which is expected to be launched “in time for the holidays”. There were no comments on what exactly would be sold on this site, but I imagine this will be part of the infrastructure to expand the Mirror business into new verticals, perhaps additional equipment, apparel, and accessories.
Most interesting to me were McDonald’s comments about how the experimentation of Lulu’s rewards program led to the eventual acquisition of Mirror.
“The learnings from our membership tests are considerable. Some examples include digital sweat classes and community events were top drivers of overall program engagement. Guests want to engage deeper with us in each other, and they are willing to shift into the digital space to do so, and the program was embraced by men at a higher rate than we were expecting.
These learnings were integral to our decision to complete the MIRROR acquisition and hold true today. We look forward to sharing more with you on the evolution of our loyalty programs at a later date.” - Calvin McDonald, CEO of Lululemon
The original Lulu membership program (which was experimental and restricted to small samples of consumers) has now been officially terminated, and those learnings will be applied to Mirror, which will now serve as the “vehicle through which we offer long-term benefits to our guests”.
This could be something as simple as discounts on Lulu apparel for Mirror subscribers, access to member-only classes and workshops, or perhaps a more gamified approach, which is something I would implore.
When looking at Peloton, which recently launched a private apparel brand to rival Lululemon’s dominance, the resources required to gamify the relationship between exercise and apparel feels like low hanging fruit. Unlocking limited edition pieces of apparel for completing exercise milestones or tasks could go a long way in encouraging brand loyalty and retention for both Peloton and Lulu. I guess we have to wait and find out.
Liquidity and Cash Flow
Lulu’s balance sheet remains solid with just shy of $1.2B in cash, a bounty that is superior to their current obligations ($981M).
Much of the discussion concerning the balance sheet surrounded the levels of inventory that Lululemon is experiencing, currently standing at $789M, up 17% from last year.
This figure came in below the expectations of management (who assumed a 25% to 30% increase) on account of the impressive sales performance during the quarter, as well as some broader disruptions to the supply chain.
Simply put, for Lulu to support their extended revenue guidance, they require a healthy crop of inventory. Meghan suggests that inventory should increase 15% to 20% from Q3 FY20 levels (~$900M) and asserts that this will be sufficient to manage the demand heading into H2.
This comes at a crucial period in the year, as the holiday season approaches, and Lulu’s inventory turnover begins to reaccelerate.
Elsewhere, management repurchased ~506K shares during the second quarter (average price of $338) for a total cost of $171.1M, with a further $245M left in the share repurchase program.
During the quarter Lulu produced $286M in operational cash flow, 72% of which was converted to free cash flow ($205M) after $80M in CapEx.
Based on guidance, we should expect to see a further $220M to $230M in CapEx over the remainder of the year ($145M in H1), with the acceleration due to the increased velocity of store openings over that period.
This should be offset somewhat with the guided acceleration in revenues over that period.
Guidance for Q3 FY21 and FY21
The revised guidance, as well as McDonald’s assertion that the Power of Three plan will be revisited next year, are were two of the core components to the strong market reaction from the second quarter.
Q3 Fiscal 2021 Guidance
Net revenue to be in the range of $1.4B to $1.43B, or 55% to 58% YoY.
Gross margin to increase 50 to 100 bps versus Q3 2019. This guidance includes ~200bps of negative impact from airfreight.
SG&A deleverage of between 300 to 350 basis points relative to 2019. Core drivers are the presence of Mirror results (not included in 2019), as well as increased investments in brand building.
Diluted earnings per share are expected to be between $1.28 and $1.33 with adjusted diluted earnings per share to be between $1.33 and $1.38.
Full Year Fiscal 2021 Guidance
FY21 revenue guidance was raised from $5.83B to $5.91B to $6.19B to $6.26B.
Continue to expect between 45 to 55 new company-operated store openings, which includes between 35 to 40 international stores.
Continue to expect gross margin to expand 150 to 200bps, or 57.5% to 58% by year-end (Includes 150 to 200bps impact from airfreight).
Diluted earnings per share are expected to be between $7.16 to $7.26 and adjusted diluted earnings per share to be in the range of $7.38 to $7.48. Adjusted diluted earnings were raised from $6.73 to $6.86.
Continue to expect CapEx of ~$365 million to $375 million for 2021.
An upgrade to FY21 guidance, after a better than expected second quarter, as well as demonstrating an ability to maintain healthy margins during a period of inflationary costs to distribution and manufacturing. Great stuff.
Most interesting to me was McDonald’s comment that, come 2022, they will revise the Power of Three plan, given that the higher-level goals will mostly be complete by FY21/FY22. This is evidence of brand adoption, at a faster than anticipated rate.
By the end of this year, we could see Lulu (a $54B business) generate $6.26B in TTM revenues with a healthy $3.6B in TTM gross profit. This would put Lulu at ~8.6x FY21 revenues as things stand.
Whilst apparel businesses are tough (they tend to experience fad-like cycles) history has shown that brands that evolve with their consumers stay in the limelight. Nike has become the epitome of this ideal.
I think it’s clear that Lululemon is not in the bracket of fad-like businesses. One need only look back at headlines (a quick google search will suffice) from the early 2010s to confirm this. The business has quietly ticked away with each year, reaching an ever-growing population of consumers.
That journey still feels relatively young, with the company yet to fully crack the men’s market, as well as their international ambitions.
Whilst I remain confident in their ability to do so, the threat of competition is always present. Peloton, the connected fitness company, has recently launched a private label apparel brand to rival the likes of Nike and Lululemon.
Despite having sold apparel since 2014, the new line represents a dramatic step-up in terms of quality (and price). I struggle to see why a consumer, not present within the Peloton ecosystem, would be interested in apparel possessing large Peloton branded clothing items. However, consumers are a strange sort, so time will tell if the venture proves to be successful. As of their most recent quarter, Peloton only sold ~$8M in apparel.
For Peloton, this offers up an attractive tertiary form of revenue (after connected fitnesses hardware and subscriptions) that presents a superior margin profile to their primary source of revenue, their hardware.
In my mind, I see Lululemon as a great technical apparel business with an embedded call option in connected fitness (Mirror), whilst Peloton is a great connected fitness business with an embedded call option in technical apparel.
The two businesses look to be slowly converging paths, and I guess it’s a matter of which model/industry you feel most comfortable underwriting. Whilst I am bullish on connected fitness, I am not certain pure-play is the best way to gain exposure. On the reverse, if you want direct exposure, then Peloton (the outright leaders in the space) are certainly the best business to study.
After acquiring a position in Lululemon, I asked myself how I wanted to position the connected fitness exposure and concluded that it makes little sense (for me) to own Lululemon in size whilst also owning Peloton. Should connected fitness not reach the heights some think it will, Lululemon is shielded by the success of their high-margin apparel business. For Peloton, under those circumstances, the opposite is true.
On the contrary, the spoils of a thriving connected fitness market, led by Peloton, will certainly be given to those who own the stock. So, there are puts and takes.
Each is fine, but the path I chose is applicable to my own reasonings. Objectively, when assessing both businesses, I view Lululemon as a superior business to Peloton.
Over the course of the next 3Y to 5Y, the opportunity for expansion is more clear cut in my own perception. This is despite understanding the bull case for Peloton.
Should I be proven wrong, then so be it. That is the nature of this game we all participate in.
Great quarter, great guidance, and promising effort in spite of the headwinds which have faced Lululemon this year. Onto the next quarter.
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