1. Lululemon Athletica (LULU) -- New Position
This week, I started a position in Lululemon and it will be the topic of my next deep dive after PayPal is published. For this issue, I wanted to provide a condensed (I promise) view of Lulu’s compelling characteristics and my path for building the position. For my Shopify overview, there was pushback regarding the length and I’m going to do my absolute best to keep this overview short, sweet and still packed with information.
a) Basics
Lululemon is an athleisure apparel company with roots in Canada. The vast majority of its sales come from direct-to-consumer (DTC) e-commerce and owned-stores, both of which provide key company benefits such as holistic access to its 1st party user data to guide product releases. In my view, Lulu has a chance to join Nike and Adidas in terms of ubiquitous global clout and presence with a more luxury niche. This won’t be overnight -- far from it -- but if that process plays out it could provide compelling incremental shareholder value.
b) Performance
I view this company as a high probability 15% revenue compounder for the long term -- which is where management has guided revenue growth for 2021-2026. In 2018, Lulu offered long term 5-year targets and eclipsed them ahead of schedule to offer evidence of its ability to under-promise and over-deliver. And the runway is still quite long. Lulu estimates its total global addressable market opportunity at $650 billion with its 2021 annual revenue representing around 1% of that. Since 2019, it has shown a keen ability to take more market share within adult active apparel than any other company. So the opportunity is immense and Lulu has taken advantage (since inception).
The Canadian firm has excellent brand awareness across North America, but carries very little influence internationally to date. That's changing via international sales compounding comfortably above 30% for the last several years and 30% annualized growth expected to continue through 2026 as it gains brisk traction. There’s a large cohort of customers especially in Europe and China that should naturally be drawn to a brand like this -- so far, so good with much more work to be done.
In terms of margins, performance here has been largely positive as well. Lulu’s selling channels are inherently higher-margin than traditional wholesale to re-sellers, so it boasts a lofty gross margin for a retailer. Specifically, this metric eclipsed 58% during the heat of pandemic tailwinds but has since cooled back off towards 53% -- still strong and better than most in its space. Just 11% of its sales are through “other” channels which include lower margin wholesale with its more profitable endeavors making up the rest.
Since Lulu’s 2018, the company has compounded earnings and revenue at 27% and 24% respectively. As a result, operating margins have reached a robust 22% -- and modest expansion is expected to continue through 2026 with profit growth outpacing the top line.
Interestingly, company owned stores have the best margins out of any selling channel as its complete vertical integration allows it to command a larger chunk of the profit pie. These owned stores possess an operating margin pushing 26%, and as brick and mortar shopping returns, that could push unit economics higher. Impressively, comparable store sales soared 24% YoY this last quarter on the heels of some difficult comps with store productivity surpassing pre-pandemic levels. That was wildly impressive to me in light of China -- representing 15% of its total stores – remaining shuttered during the period.
Furthermore, in-store and e-commerce shopping both effectively raise a customer’s engagement with the other Lulu selling avenues. For example, its e-commerce conversion rate has risen 10% over the last few years with credit given to its omni-channel proliferation. The engagement juicing also comes with no additional customer acquisition costs, thus increasing margins still further. I’d just like to point out here that Lulu’s margins are already comparatively excellent. There still may be a tad more expansion to come, but that's not needed to make my thesis work. Just margin maintenance.
In terms of capitalization, the balance sheet is a strength for Lululemon:
- $1.3 billion in cash with another $400 million in current liquid assets
- Zero debt with a recent mixed shelf offering which could eventually add some debt to the balance sheet.
- Bought back $813 million, or a little over 2%, of its shares in 2021 which represents a doubling pace vs. the previous 3 years.
c) Future Opportunities
- Global expansion where increased brand awareness creates opportunities.
- Expansion into sports like tennis and golf. It recently signed the 15th ranked female tennis player in the world (Canadian Leylah Fernandez) as its first ambassador for the sport. There's a large demographic overlap here.
- Partnerships with the Canadian Olympic Committee help as well.
- Experiential stores & pop-up shops creating service-oriented use cases. This contributes an added benefit of juicing revenue per user by 15% when a Lulu customer sweats more.
- Membership programs launched in fall 2021 to drive loyalty and engagement. For example, its Pinnacle membership involving “MIRROR” offers access to bountiful on-demand remote fitness content and early access to new gear.
- Footwear! Inning 1 here.
- Collaborations with iconic brands like the University of Michigan to create a dedicated apparel line for its half-million living alumni and 100,000+ students. Go Blue!
- Differentiation through new material creation. Its “Science of Feel” platform is a key focus for creating utility building, proprietary fabrics for its apparel.
- Depending on the legitimacy of these claims, this could provide rare differentiation within a commoditized industry. For example, its air support bra is the culmination of 5 years of research to help women with yoga poses.
d) Leadership and Hiring Trends
The company’s founder is no longer involved with Lululemon and has a somewhat colorful history. I’ll cover that in the deep dive but for the sake of brevity let’s focus on current leaders.
- CEO Calvin McDonald: Disney Board member; Former Sephora and Sears Canada President; 85% Glassdoor rating.
- CFO Megan Frank: Sachs Board Member; Former Finance VP at Ross and J Crew.
- CTO Julie Averill: Former CIO at REI; Former VP at Nordstrom.
Hiring Trends Via LinkedIn:
- Headcount is up 25% over the last 2 years with engineering headcount growth leading the pack by a wide margin at 32% growth.
- It has hired around 2,000 new employees since the start of the year but headcount growth has recently slowed.
- Average tenure is 2.5 years -- not great or terrible.
e) Risks
The main risk for Lululemon is shorter term macroeconomic volatility. Today’s economic cocktail of record low consumer confidence, generational high inflation and tanking savings rates will all inevitably weigh on discretionary spending. For a firm like this one which caters to a more affluent shopper, it will be relatively insulated from this pain, but certainly not immune. Macro creating more fragile customers also could present another possible issue: Shoppers flocking to cheaper brands. There are countless companies playing in Lulu’s space and most come at a lower price point. So as wallets are stretched, those fringe customers who can just barely afford a Lulu shirt may gravitate to a Gymshark shirt at half the price. I think Lulu’s superior quality will allow them to be somewhat overcome that phenomenon, but we’ll see.
We also must consider chaotic supply chains as a risk for retailers in trying to match dynamic supply and demand on a real-time basis. Many of the largest have struggled to do so, but Lululemon’s vertical integration surely provides some support here. Again, it’s resistant, but not immune.
This management team has also not done all that well with M&A. The MIRROR acquisition could very well eventually be written all the way down as it jumped into a faddish trend at the heat of the pandemic. Thank goodness it didn’t try to buy Peloton. I still think MIRROR can enhance Lulu’s overall omni-channel value proposition, but this deal is not off to a great start and it surely overpaid with the luxury of hindsight.
Finally, athleisure got a large boost from stay-at-home orders. No longer did employees have to wear a suit to work, and many embraced Lulu’s apparel niche as a result. Was that the reason it was able to reach its long term targets so soon? Or will the momentum be more sustainable than that? Work from home is not totally going away and Lulu had been compounding long before Covid-19 entered society’s vocabulary -- so I’m optimistic, but we will have to see. This also goes into the overall risk of a retailer needing to stay on-trend and in vogue to continue garnering market share. Lulu has years and years of demonstrating an ability to do so, but continuation is never a guarantee -- see L.A. Gear in the late 80s.
f) Expectations and Plan
At just under 27X next 12-month (NTM) earnings, Lulu trades right at its 5-year earnings multiple average. At these prices, I think a few things are true. The valuation is compelling enough to start a position and also there could very well be more downside (buying opportunities) ahead. Specifically, 21X forward earnings looks like it will offer Lulu’s stock with significant support and I’ll use the 21X to 27X multiple range paired with macro climate as a guide to filling out my position. With this in mind, I started VERY small with just 18% of a full position. It’s always a marathon and never a sprint, but today that may be even more true. Furthermore, the earnings estimates for Lulu and public companies could be coming down over the year as the economy weakens. I would point out that Lulu has a wonderfully consistent track record of beat and raise, just boosted its own estimates last month and has seen analyst estimates rise accordingly, but these are unprecedented times.
Based on my research into the company and historical results, I think the following 5 scenarios encapsulate where Lulu could be in the next 5 years. I would point out that estimates like these include several rough projections making accuracy a rarity. Please take this with a large grain of salt. Results could surely vary and I do try to lean pessimistic whenever possible when building these models.
2. Meta Platforms (META) -- TikTok and Various News
a) TikTok
The Federal Communications Commission (FCC) has requested that Apple and Google remove TikTok from their app stores. According the head of the agency -- Brendan Carr -- a recent investigation uncovered “serious national security threats posed by TikTok.” Per the report, based on leaked recordings from BuzzFeed, TikTok is actively sharing sensitive American consumer data with the Chinese government.
It’s not likely that this request alone will lead to a ban of TikTok in the Western World, but it is still a sign that governments are starting to work that way. And if TikTok were to lose access to these markets, it’s hard to think of a larger beneficiary than Meta Platforms and its Family of Apps. The Chinese App is already banned in India -- and across many U.S. federal agencies -- where Meta and especially WhatsApp dominate. Later in the week, it was announced that TikTok was working on safeguards to ensure U.S. compliance.
There was also a note out of Truist this week that sees Instagram and Facebook together overtaking TikTok’s short form video market share globally sometime next year. It sees signs of this beginning to play out. Quite the positive surprise if accurate.
b) Various News
- Zuck revealed Meta’s plans to hire around 6,500 engineers this year vs. previous plans for 10,000. Zuck was quoted saying “realistically, there are probably people at this company who shouldn’t be… part of my hope of having more aggressive goals is that I think some of you will decide this isn’t for you.” The belt tightening continues as Zuck calls this downturn “the most significant” in the company’s history that includes the Great Financial Recession.
- Meta recently uncovered its three latest Metaverse AI models within "Visual-Acoustic Matching, Visually-Informed Dereveberation and VisualVoice.” Visual acoustic matching specifically will eventually pave the way for re-living fond memories.
- J.P. Morgan and RBC cut financial estimates for Meta and the rest of the ad-tech space in its coverage network for 2022 amid worsening macro.
- Instagram is testing a full screen feed with more of a video-content emphasis. If this sounds like TikTok, that’s the point.
- The crypto wallet (“Novi”) that Meta has been working on has been delayed from its planned September WhatsApp launch.
3. CrowdStrike (CRWD) -- AV Comparatives
CrowdStrike’s Falcon product for Mac delivered 100% Malware protection in the May 2022 AV Comparatives Mac Security Test. In the blog post, CrowdStrike highlighted that it continues to test its software with more 3rd party organizations than any other vendor and continues to perform the best among disruptors as well.
The test compared 10 different vendors and their ability to detect and counteract thousands of malicious code blocks, malware and “potentially unwanted applications” (PUAs) most relevant to current hack trends. 5 received perfect scores in the Mac section but CrowdStrike performed worse than most in the PUA and windows-focused sections. Still, it received its 5th straight Mac Security Product award from the research organization.
4. PayPal Holdings (PYPL) -- New Merchant Credit Offering & A Schulman Interview
a) New Merchant Credit Offering
PayPal debuted a new merchant credit card through its WebBank partnership and issued through the Mastercard rail. The card offers 2% cash back with no rewards caps which makes it among the most compelling cash back cards for merchants in the market. It has no annual fees, and APRs ranging from 13.99%-29.99%. Interestingly, the card comes with a digital twin that is immediately eligible for use within app upon business approval. These businesses are also free to print new cards with separate account information for employees under the same umbrella account. With credit cards being the 2nd most common means of business financing this year per the Small Business Credit Survey, this launch is well-timed.
The debut is merely one of countless PayPal initiatives to build its two-sided network. The more value it can provide to merchants, the more merchants will join the platform and then the better, more targeted promotions PayPal can offer to its consumers. This builds consumer growth and spins the flywheel round and round. But this lucrative phenomenon requires providing more value to its stakeholders than its substitutes can which is why incentive-laced PayPal products like this continue to launch.
b) Schulman Interviews with Women’s Wear Daily
This was a short conversation with the following highlights:
- Schulman called PayPal’s Pay Later a “top 3” vendor in the space while previously calling it “top 4.” Schulman reiterated that PayPal’s loss rates are lowest in class with approvals best in class.
- Supply chains haven’t improved much as China ports re-open with still “a tremendous amount of dislocation.”
“We offer the best availability, authorization and loss rates to our merchants.” — PayPal CEO Dan Schulman