Lululemon's Core Business Shines, Whilst Connected Fitness Wilts
(Lululemon Q3 2021 Earnings)
Lululemon’s third-quarter exemplified the strength of the core brand. Despite marking down full-year revenue guidance for Mirror, their connected fitness venture, by more than 50% (a figure which will see a net decline in sales YoY), management upgraded consolidated revenue guidance for FY21 for the second successive quarter.
My initial hesitance to hold overweighted exposure to connected fitness (discussed in “Portfolio Update 08/30/2021”) resulted in me dissolving my Peloton position (a pure-play) in favour of Lululemon (where connected fitness accounts for just 3% of top-line). As time has elapsed, the softness in connected fitness (across both Peloton and Lululemon) has vindicated my decision.
Today’s memo will focus on three key areas: (1) The Core Lululemon Business; (2) Lululemon International and; (3) Mirror and Connected Fitness. For additional company-related commentary, please review my previous Lululemon memos (Lululemon: "Finishing Two Years Early", Elastic Growth).
(1) The Core Lululemon Business
Before I discuss the sombre revelations of connected fitness, it makes sense to focus on Lululemon’s primary operations, which are performing well. Net revenues of $1.45B (+30%) came in just above the upper range of last quarter’s guidance, with women’s (+24%), men’s (+29%) and accessories (+40%) each showing strength.
With 99% of stores open (averaged 96% throughout the quarter), company-operated revenues (+38%) continue to recover, accounting for 44%, 48% and 49% of total revenues across the trailing three quarters. Direct to consumer (+23%) also continues to do well in the face of ever-increasingly difficult YoY comps, potentially demonstrating that Lululemon’s customer base meaningfully increased during 2020, as opposed to existing customers purely shifting their consumption channels. Management cited Thanksgiving as the strongest volume e-commerce day to date. McDonald (CEO) would also remark that they are “seeing more of our store only shift into omni” and that they “are seeing our omni-guest spend more".
With a further $2.1B to $2.2B in revenue expected in Q4, LULU upgraded their FY21 guidance for a second successive quarter to a range of between $6.25B and $6.3B (original guidance was $5.8B to $5.9B in Q1). Demand is strong, but the reality of the logistics outlook will see LULU struggle to capture the full extent of its seasonal sales leverage in the coming quarter. As such gross margin is expected to come in ~flat compared to the fourth quarter of 2019 (58%) on account of additional airfreight costs resulting from congestion and capacity constraints. Together these constraints are expected to exert 450bps of pressure in Q4 relative to 2019 and between 200bps to 250bps relative to 2020 for the full year.
On the upside, gross margin is expected to increase between 100bps to 150bps YoY by the conclusion of 2021, despite the inflationary and supply chain environment. This is only down ~50bps from prior guidance and furthers the goal of annual margin expansion set forth in the Power of Three plan. Meghan Frank (CFO) acknowledged that Q4 will likely see the ‘peak’ of airfreight pressure whilst conceding that it may continue to linger throughout the first half of 2022.
(2) Lululemon International
Lululemon’s power of three plan (2018→2023) outlined the desire to multiply the international business by 4x and the men’s and DTC business by 2x, as well as a number of other metrics (gross margin, EPS growth) that will continue to be monitored through 2023. The DTC business has demonstrated that the customer base has expanded and that digital was not a one-and-done phenomenon from 2020. Physical stores are an important part of male customer acquisition and with 99% capacity and McDonald explicitly stating “we will double our men's business this year” back in Q2 (discussed in “Lululemon: "Finishing Two Years Early"), its a matter of edging past the finishing line in that department too.
The international segment (which is profitable ex-Europe) requires inherently lower ROI reinvestments. Expanding the breadth of male customers in a mature market, like Canada for instance, would require some SG&A spending to get those consumers into stores and trying on the merchandise. Anecdotally, a number of males may discover Lululemon through their partners. In a market where; (a) the physical store infrastructure doesn’t exist (or is nascent) and; (b) the brand does not have nationwide recognition, acquiring customers becomes more difficult (for both sexes). Not wishing to be a digital-only brand in these marketplaces, LULU has followed a dual-pronged approach of building brand awareness through stores and DTC.
It takes time to build stores, but the gradual compounding of presence in these areas should bear fruit in time. If you think back to 2018, just 20% of Lulu’s 440 stores were based internationally. Today (552 stores), that composition stands at 30% and international store openings continue to outpace that of domestic. Across that period, LULU has opened 77 international stores and 35 North American stores, growing at 85% and 10% respectively. Just this quarter, 14 of the 18 stores opened were based in Asia (12) or Europe (2) and the rest (4) in North America.
Growing revenues at 40% this quarter (relative to 28% in North America), each segment of the international business boasted double-digit growth sales growth on a 2-year stack, with markets like China (22 stores→62 stores from 2018 to now) breaking away with a 70% 2-year CAGR on sales.
Assuming the international business matches last year’s seasonal QoQ sales growth, it should conclude the year at close to $1B in sales on a TTM basis. Following that, two fiscal years of conservative growth in the mid-20s (well below historic averages) would take LULU across the finish line. I imagine the international business compounds far in excess of 25% across 2022 and 2023, so am comfortable assuming they hit their goal.
(3) Mirror and Connected Fitness
Given that the core Lululemon business is so strong, it allows management to leverage that strength and explore new areas; Mirror was certainly one of them. After acquiring the business for $500M last year, and guiding for $100M in 2020 revenues, it seemed like things got off to a great start when LULU reported $175M by year-end with a $250M to $275M guide for 2021.
However, reality has since crept back into the frame and LULU opted to revise their original estimate to $125M to $130M, for a truly dismal 27% YoY decline in sales at the mid-point, and a mark-down of 50%+ from prior guidance.
Highlighting the challenging environment for digital fitness in 2021 (AKA, waning demand), McDonald noted that LULU began to see customer acquisition costs (CAC) rise above the customer lifetime (LTV) to CAC ratio. In plain English, the cost of acquiring a customer was becoming more expensive relative to their perceived lifetime value. This actually caused management to reduce SG&A spending in the Mirror segment, with McDonald citing a reluctance to chase growth at any cost; “We will not chase growth at any cost. We simply don't need to”. I am happy he said this. Unlike Peloton, whose core business hinges on the growth of connected fitness, LULU does not have to worry about remaining a going concern should their product fall through.
Peloton’s management has been making some questionable moves lately. Telling investors they don’t need capital, before raising it a few weeks later and lowering the cost of their bikes to juice demand are two that spring to mind that reek of desperation.
Thankfully, Mirror represents <3% of LULU’s top-line and despite the abysmal guidance, management asserts that the 3% to 5% earning dilution expectation has not changed. Dilution is expected to improve next year. Remember here that Mirror is supposed to “assist in building and extending our lululemon community and helping us drive both retention and spend” acting as “an evolution of our membership program to propel our core business at lululemon, for lululemon” with management seeing a “clear path to engage with the more than 10 million lululemon guests who live the sweat life”. I am not certain whether McDonald means 10M connected fitness subs (audacious goal) or simply to reach 10M shoppers in stores (more likely), so I won’t speculate on that.
Now featured in over 200 stores, in-store demonstrations are said to have a 6% conversion to sale ratio, which is promising. Total subscribers are anticipated to grow 40% YoY in 2021. In August, during the LULU deep dive, I wrote:
“It may turn out to be a zero but my feeling is that Lulu is likely to recoup their investment within the next few years either way, which would mean the risk is somewhat mitigated. Whatever happens, this was the first time Lulu truly flexed their acquisitive muscle.” - Elastic Growth, Lululemon
Perhaps a naive statement at the time, but I stand by my assumption that Mirror is not dead yet. At the very least, I am thankful that LULU only paid $500M for this business. If nothing else, it will prove to be a useful lesson in opportunistic M&A for the c-suite. The most pleasing takeaway is that management is not willing to throw everything at an injured horse.
Overall, a pretty loud quarter for LULU. Loud in the sense that they demonstrated how powerful their core brand is, despite the failings of Mirror. As a reminder to readers, the Power of Three plan (which excludes Mirror) is due to be revised next year on account of the accelerated progress LULU has made on those goals so early into their lifespan. I look forward to that, as well as the impending shoe line launch in Spring.
I will be waiting to see (like I will be for most consumer-facing businesses) how much pull-forward in demand was created during Q3 and whether or not this depressed Q4 sales volumes. Management’s track record for raising and beating has been consistent, however, so I assume this was announced prudently. Inventory levels grew 22% QoQ, above estimates of 15% to 20%, which is reassuring. In this case, LULU wants to have stock on hand for every line to support demand.
Until then, this may be the last research memo I send out for 2021. As noted, Market Talk will be taking a hiatus for this coming Sunday, and I am unsure if I will be sharing anything until then. January’s company spotlight is almost ready, but I plan to release it post-new-year as I respect people are with family at this time of the year.
I have a lot of things planned for the turn of the year, including some discussion about another year on Substack and what is next for 2022, my reflections on my portfolio, and some new company spotlights.
If we don’t speak until then, Merry Christmas to those who celebrate, and a happy new year.
Author of Investment Talk