2023-12-19 03:02:43 ET
Summary
- Lululemon's stock has surged by 18% due to the November-December market rally, prompting a reevaluation of its valuation.
- Q3 results show impressive sales growth and international expansion, but sustainability of growth is uncertain.
- The management incentives are well-designed, and, in my view, the CEO has skin in the game.
- Valuation is tricky; the current price suggests a 20% CAGR for the following years, which is a challenging task.
- Downgrading from buy to hold.
My thesis and article update
Two months ago, I conducted an in-depth analysis of Lululemon's ( LULU ) growth, business, and valuation. Since then, the stock has surged by 18%, attributed to the November-December market rally. Upon reflection, I believe my initial valuation may have been overly optimistic.
In the forthcoming article, I will provide an updated valuation, incorporating recent developments. Additionally, I will share crucial information about the company, including Q3 results, my assessment of management, and insights into their incentives.
As a preview, I want to disclose that I am downgrading my rating from "buy" to "hold." In my opinion, considering the recent rally, it might be prudent to capitalize on some profits.
Q3
Lululemon delivered an impressive performance in Q3. Sales witnessed a robust YoY growth of 19%, accompanied by a remarkable 27% increase in earnings per share. The notable 9% growth in comparable sales underscores the brand's resilience, demonstrating strong consumer demand even in challenging economic conditions.
International expansion was a standout, with a staggering 49% increase. These figures are truly outstanding. However, the crux of the matter lies in the sustainability of this growth over the next few years. While I don't consider it impossible, I do find it unlikely. As the company continues to grow and expand its market share, a natural deceleration in growth becomes expected.
Management incentives
Calvin McDonald has been at the helm of Lululemon since 2018, delivering remarkable results with over 200% growth in the top line. With approximately 260,000 shares in various equity forms, I bet this constitutes a significant portion of his total net worth, making it a major incentive. Notably, McDonald's background includes serving as the head of Sephora, a business within the LVMH group (LVMHF), showcasing his expertise in managing successful ventures.
Examining his executive compensation, it's positive to note that more than 90% is performance-based, with over 60% tied to equity. However, the performance metrics primarily focus on top-line and EBIT growth. While appreciating the emphasis on these factors, the inclusion of metrics such as ROC (Return on Capital) and free cash flow could enhance the overall evaluation.
compensation structure (LULU proxy)
Other key executives, including the CFO and CPO, receive over 50% of their compensation in equity. Share-based compensation ((SBC)) expenses, at around 7% of operating cash flow, are acceptable, especially if they contribute to the long-term perspective of shareholders.
Dennis Wilson, the founder, holds an 8% stake in the company but currently doesn't play a significant role in the business or on the board.
Moreover, it's worth investigating if there's any insider buying beyond stock awards. The last purchase occurred in June by one of the directors, albeit at a considerably lower price.
Updated Valuation
I am reassessing the discount rate and adjusting it from 8% to 10%. It's important to note the dynamic and potentially inaccurate nature of calculating the cost of capital, which is subject to change. Anticipating a potential reduction in interest rates next year will change the picture.
wacc (author)
I maintain a terminal growth rate of 3% to account for international expansion. I input a free cash flow margin of 12% based on the trailing twelve months margin.
The current stock price of $490 tells us that the stock will need to grow at a 20% rate in the following years. Before I continue with this valuation, I want to note that I'm not a fan of discounted cash flows as it's full of assumptions, which might be realized and might not. I prefer just to pay a reasonable price for a high-quality company, and you can simply determine if a price is reasonable or not by multiples in one form or another. Combining those multiples with a sober DCF will give you a safe range. Moreover, I'm sure that five years ago there were plenty of DCFs concluding that Lululemon was too expensive, and since then, the stock is up 300%.
DCF (finology)
The company's past success in achieving a 20% CAGR in the top line over the last five years is a positive indicator. However, I doubt that it is sustainable for the long term, particularly as the business matures and captures more global market share. Analysts' projections for the next couple of years are lower than 20% growth in earnings per share ((EPS)), but Lulu does have a track record of surprising analysts' estimates.
If we assume a 20% annual growth in the first five years, and after that, 15% as the firm continues to mature, we get an overvalued stock by 22%, and those assumptions are not particularly conservative.
DCF (finology)
In terms of multiples, paying a 39 forward earnings is always hard, and you need to be sure of the business path forward and the risks it has. Now, unlike other high-multiple businesses, Lululemon has the risk of losing relevance or going out of fashion, and, of course, it has immense competition from other new brands and also giants like Nike ( NKE ). However, it does trade under its five-year multiple average, but it's also important to note that these averages were impacted by the zero-interest-rate policy (ZIRP) era, and now the economic environment is a bit different and affects those averages downward.
In terms of FCF, paying a 2% FCF yield is a bit higher for me.
Conclusions and Risks
The important thing to monitor going forward for Lululemon, in my view, is the strength of its brand. I want to see it firmly established in the minds of consumers and expanding globally. Bottom-line growth below 20% will make me cautious. Another crucial factor to keep an eye on is the increasing influence of other brands. Despite Lulu's longstanding brand power, the landscape is evolving. I'll continue to monitor polls on brand awareness to gauge Lulu's position. A drawdown in these polls would be a warning sign for me.
After the price surge, I'm downgrading from BUY to HOLD. I believe prices around $400 will be fair value if the stock ever drops there again.
What are your thoughts on Lululemon right now?
For further details see:
Lululemon: After An 18% Surge, Updated Valuation Suggests A Hold