[Investing Research] Lululemon - LULU
How to start…. maybe with a sigh of disappointment?
There were a couple things that got me intrigued about Lululemon (LULU). It didn’t do stock splits… as of today the stock price is north of $300 and I generally like seeing businesses that have a high stock price. Classic Berkshire bias? I’m also a fan of their shorts. I splurged on myself and got myself 2 of their shorts.
Having grown up in Vancouver you also want to cheer a bit for the hometown company. And there’s the thought of finding a compounding business in ‘athleisure’ wear. I’ll get to more throughout but there were many things that got me interested and furthermore… excited to read through the annual report and proxies this morning.
Let’s revisit with Phil Fisher’s 15 points.
1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
The “Are they solving an important problem in a large enough market” factor. Arguably, LULU is the company that made yoga pants a fashionable clothing item. When I think of ‘athleisure’ I think of LULU. I must really thank them for that because now less people look at me weirdly when I walk into fancy places in financial district with my gym shorts and dry fit shirts.
I think many would equate LULU as the company that changed social perception of athleisure wear. They made it mainstream enough for people to not be socially judged by it. Maybe they made being healthy trendy enough by making their brand a bit of a status symbol for someone who spends money on health?
The company was founded in 1998 by Chip Wilson in Vancouver. From what I gather, it was born inside a yoga studio. According to Wilson: "Ultimately, Lululemon was formed because female education levels, breast cancer, yoga/athletics and the desire to dress feminine came together all at one time.” Something about power women of the 80s and 90s getting tired of trying to fit into the boy’s club.
Even the origin of the name is weird: "It was thought that a Japanese marketing firm would not try to create a North American sounding brand with the letter "L" because the sound does not exist in Japanese phonetics. By including an "L" in the name it was thought the Japanese consumer would find the name innately North American and authentic. In essence, the name “lululemon” has no roots and means nothing other than it has 3 "L's" in it. Nothing more and nothing less.” I wonder if the large Japanese community and the wealth of Japan during the 90s made them a key target for Wilson. As he said in a New York Times interview, the target customer for LULU is "a 32-year-old professional single woman named Ocean who makes $100,000 a year.”
That target market accurately describes most people I know who are obsessed with the brand. Some deny it but c’mon.
So that’s kind of the history. How does the company make money then? Well, LULU’s evolved form just yoga pants to “designer, distributor, and retailer of healthy lifestyle inspired athletic apparel and accessories".
It makes money in 3 segments:
Though it has 491 stores in 17 countries, LULU makes most of its money in North America as ~75% of their stores are based in the continent.
According to Allied Market Research, the sports apparel market was valued at ~$167bn in 2018. The large players are Nike and Adidas. Though it’s 1/10 the market cap of LULU.. Under Armour is probably a competitor too.
LULU carved out a small niche for itself but as they’ve expanded their product line from women’s yoga pants to all kinds of apparel for men and women, they’ve certainly widened their market. Management has noted their expansion to APAC and EMEA as key parts to their growth strategy and I could imagine LULU succeeding in taking mindshare from the incumbents.
LULU has been able to grow revenue over the last 10 year at a CAGR of 24% and I think a key element to that is the shift in consumer behaviour where LULU’s products aren’t just limited to sports apparel but to every-day fashion. Most folks in my network, myself included, where LULU clothing for “going out”. LULU clothes are actually too expensive for me to wear for powerlifting training because I don’t want to get it ripped on the bar or have it smeared in chalk so I don’t even wear it for ‘sports’.
All these persona anecdotes aside, the company has had a strong run over the last decade. I do see various opportunities where LULU can evolve from being just an apparel company to tackling various parts of the fitness industry. They’ve already incorporated yoga studios to some of their experimental stores so that’s one obvious one.
I do believe that LULU has captured a kind of ‘image’ for the person that wears their product. As Wilson put it with the target customer of “Ocean”.... I truly believe that the person wearing LULU isn’t in it for the performance or comfort. I think there is an element to wearing clothes that show off your body to hit the lust nerve. It also hits the ego to signal your possible income status and who you are and what you stand for. It’s like why someone will buy Victoria’s Secret or YSL. Apparently, Korean fitness Youtubers call LULU the Chanel of yoga pants.
The further LULU separates itself from ‘sports apparel’ like Nike and the more it goes down the luxury path (like Apple did), I could see its growth potential blossoming. But… at the most fundamental level… it sells clothes. They don’t solve any key problems. They are a nice to have….
2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
They might. But it’s weak. The vision for LULU is: to be the experiential brand that ignites a community of people through sweat, grow, and connect, which we call "living the sweatlife.”
As far as management’s commitment to a mission/purpose… to a particular ‘why’... I don’t think they have one. When Wilson started LULU, it seems like his philosophy was heavily rooted in Ayn Rand’s Atlas Shrugged. A potential belief system that built a culture around: “the naked pursuit of self-interest should be society's highest ambition”.... Something the main character of the book believed.
Wilson is no longer involved with the business. Though he still owns 8.2% of the business, he left the company in 2015. Selling a portion of his then 14.2% of the business with it.
Wilson’s views brought controversy even in the earlier years. There are numerous articles that float the internet on his many interviews. Basically, he wasn’t politically correct. He had an opinions and views that didn’t ‘fit’ with what the West Coast Left-Wingers deemed ‘right’.. You know the type. Anyway, after long fights with the board, Wilson was ousted as the Chairman in 2015.
Not only that, LULU is on it’s 3rd CEO in 6 years. Christine Day (ex-Starbucks exec) took over CEO in 2007, then it was Laurent Potdevin (who ran TOMS) and in 2018 Calvin MacDonald took over. Oh, and the CFO quit in 2020. Also, all directors and execs combined own less than 1% of the business.
Given my bias for insider ownership, owner-operators…. I find it hard to believe anyone in management will dedicate their life for this company.
3. How effective are the company's research-and-development efforts in relation to its size?
It’s hard to say. LULU doesn’t break down how much they actually invest to ‘product innovation’. They have 2 expense items: COGS and SG&A. SG&A was about $1.3bn in 2019. If I were to use the YOY expense distribution as a proxy, I’d estimate about 20% (~$260M) is invested in employees in head office… which includes the product innovation team. If I assumed about 50% of the staff in head office were on the product innovation team…. And I also take out the $23M paid to the c-suite… about ~$120M is dedicated to hiring top talent for R&D. That’s ~3% of sales. Not a big amount.
4. Does the company have an above-average sales organization? Do they need a sales org to peddle products?
This I think LULU does well. I don’t think I’d be out of line to say there is a cult fan base for LULU products. I may have eluded to this earlier. But it’s this same cult base that twisted my arm into buying my first LULU products and I ‘get it’.
I just walk around the store now because I like the experience in the store. But there really is something to how once someone gets hooked on LULU products, their entire wardrobe becomes LULU. That’s been the case for a few of my friends and my mother too. She is a strong LULU advocate in the Lee home.
This is also by design. LULU has a ‘grassroots community-based marketing approach’ where they have events for various communities and partner up with athletes, influencer and aficionados to market the products. The best products are sold by loyal fans and LULU has a fair share of them. Not only that but the ‘luxury’ tag (their high prices are part of it I assume) will also sell to the human heart.
5. Does the company have a worthwhile profit margin?
As far as the business model goes… It’s a retailer at the core. 60%+ of sales come from in-store and unit economics of their store matters. I wasn’t able to figure that out from their annual report.. And the company has hit enough red flags for me to move on from that information searching crusade.
As far as their gross margins (GM) go, it’s been quite stable over the last 10 years. The 10 year average is 54% and except for once in 2016, it hasn’t moved drastically away from it. 2019 was at 55%.
LULU doesn’t own or operate any of its manufacturing facilities so they have to outsource all of the production. Though they have 39 vendors, 56% of their products are produced by 5 vendors. They also buy raw materials from 76 supplies and 5 provide for 59%. Furthermore, 1 supplier provides 32% of their raw materials.
None of the suppliers are in North America with most in SE Asia or China. LULU doesn’t have long-term contracts in place with them either.
Whatever costs they incur from suppliers, changes in raw material prices, distribution costs etc… all hit COGS. Given the relative stability of the COGS…. Without the need of long-term contracts… it makes me think LULU either has great relationships with their suppliers or they’ve been extremely lucky. Don’t get me wrong, the concentration risk to suppliers is there… and geography can pose a risk to supply chain as well.
The business is also seasonal as 47% of 2019 and 2018’s operating profit came in the fourth quarter. An operating margin that has a 10 year average of 22%, with no major deviations.
It’s a business that has gross and operating margins closer to LVMH than Nike. It’s ability to have stability in its margins over the years speaks to its brand value.
6. What is the company doing to maintain or improve profit margins?
It’s the brand. They have no IP with fabrics or material. I think it’s entirely the mindshare they have of being LULU. The cult following they’ve built compounds this and it has led to the company generating returns on capital of ~30%. They are the company that made ‘athleisure’ a thing. It’s also possible that I think that’s a bigger deal than most because of my personal biases.
7. Does the company have outstanding labor and personnel relations?
Knowing a few folks at LULU, I’ve heard some great things about working there. Glassdoor seems to agree as well as it has 4.2 out of 5 with 2K+ reviews. This is significant.
I’m not sure if it’s the chill nature of Vancouverites… but we are also demanding...so I doubt LULU is getting off easy with just providing fee yoga classes and amazing wellness perks.
What I found unique in their annual report was their reference to culture: "distinctive corporate culture; we promote a set of core values in our business which include taking personal responsibility, nurturing entrepreneurial spirit, acting with honesty and courage, valuing connection, and choosing to have fun". They went further to note how they wanted to instill purpose in their people "to elevate the world by unleashing the full potential within every one of us."
Without going any deeper with scuttlebutt, it seems they care.
8. Does the company have outstanding executive relations?
Nope. No insider ownership. Too many CEO turnovers. CFO quits suddenly and management looks external for a replacement.
There is no ‘depth’ to the ‘mercenary’ executive team:
And they measure both short-term and long-term compensation with operating income and net revenue. Long-term compensation looks at the 3-year CAGR with thresholds that are so low that it makes me wonder if there even is a point.
The CEO also makes 2-3x everyone else in the C-suite… and that doesn’t sit right with me.
9. Does the company have depth to its management?
Combined with above
10. How good are the company's cost analysis and accounting controls?
The CFO left. That’s one sign to be skeptical.
11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
It’s luxury sports apparel. It could even be in a category of it’s own. I could actually see LULU becoming a kind of ‘lifestyle’ brand…. It’s no coincidence Equinox gyms sell LULU gear….
But I really doubt management has much of a vision for it.
12. Does the company have a short-range or long-range outlook in regard to profits?
Short. They measure growth plans and compensation in 3 year increments. Maybe that’s because their long-term equity vests in 3 years and CEOs leave within 3 years.
13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth?
Nope. Plenty of cash. No debt. Some lease obligations but cash will cover it.
14. Does management talk freely to investors about its affairs when things are going well but "clam up" when troubles and disappointments occur?
Oh yeah they clam up. All the ‘controversial’ writings from Wilson were on LULU’s blog. Well, they used to be. The company deleted everything. Even articles written by past employees that were deemed controversial… like naked yogas for employees. They definitely hide the bad.
When Wilson was ousted, he wrote a letter to shareholders 2 years later (some legal requirement for the time gap). He wanted to address the shareholders for 10 minutes in the annual meeting but was denied. So he published the letter publicly.
I read the letter, which is public, and I think that letter should’ve showed shareholders that Wilson was not fit to run the business. He complained about poor share price performance since his departure and focusing on worthless metrics like net income. The fact that management was so afraid to let Wilson even speak just rubs me the wrong way. This management team is too afraid and just want cushy paycheques.
15. Does the company have a management of unquestionable integrity?
Note at all.
16. Valuation & Future.
At 1% yield.. I’m staying away. I really want to see this become a lifestyle brand and it very well could… but I hate the management situation at the moment.
Disclaimer - I’m writing this for myself. For my past, present and future self. Much of what I write is my opinion. If it somehow ignites agreement in you then great, I’d love to hear about it. If it sparks disagreement in you, don’t reach out because I don’t care for it. There always are obvious exceptions and the flawed person in me hasn’t considered them all.