Lululemon: Warning Signs & Stretched Valuation
Few would argue with the returns that Lululemon Athletica (LULU) has given shareholders this year. And, few would assert that their financial metrics are anything but excellent. Yet, with the stock hitting all-time highs, it’s worth asking whether the current stock price is justified. Given that the apparel industry is incredibly trendy, subject to boom and bust, Lululemon would only be able to defend its current stock price relative to its peers by maintaining both its margins and growth. However, there are a few warning signs the company may not perform well in the future, as well as is overvalued at current levels.
Profitability
One of the potential problems facing Lululemon is the rise in its SG&A costs. While gross margin continues to climb, the ratio of SG&A to revenues has slowly climbed from a low of 28.2% in 2014 to 24.03%, the highest of the decade. If you only looked at the margins, you would likely miss this piece as the increases in gross margin have outpaced the climb in SG&A, which has also led to an increase in operating margin.
It’s worth taking a moment to discuss the tax rate percentages. The company realized a one-time expense of $59.3M related to the reforms in the US tax code. However, executives still expect to have a 30% effective tax rate in 2018, which is a full percent higher than they originally forecasted. In part, this is why the net margin appears so poor for 2018 and TTM.
Lastly, two items, in particular, stand out that show the company may not be as effective as it once was. Both the ROIC/ROE and ROA measurements sit at some of their worst levels in a decade. On top of that, in the last 5 years, revenues have grown $1.3B or 93%, and the lease expense has increased by $84M or 100%. When you consider this in tandem with the climbing SG&A costs, it gives the impression that with the company focused on their ivviva business, they may be slipping on maintaining their efficiency.
Efficiency
There isn’t any denying that Lululemon has been growing at a marvelous pace and beating out many of their competitors. However, the growth of its underlying stores is being masked by the growth in the online sales. The below chart shows how the increase in same-store sales excluding e-commerce is a paltry 1% in 2017. In fact, outside of a decent year in 2016, the sales growth at the stores has been pretty abysmal.
Digging a bit deeper, this becomes more apparent in the average sales per store and square foot. Only when the e-commerce business started really taking off and becoming a much larger portion of revenues did the sales per square foot and store begin to increase. Strip away the e-commerce growth and the company isn’t actually growing as well as it should be.
The inefficiency also has begun to appear in what was their solid inventory controls. Notably, the days of inventory has climbed each year, as inventory turnover has declined. These indications may not necessarily mean anything other than the company expanding the list with the economic conditions. However, in the context of what we’ve discussed here, it should be taken as a concern.
Overextended Valuation
Beyond the warning signs that exist for potential problems for Lululemon, the current valuation relative to its peers suggest the stock is way overvalued. While clothing and retail companies can often garner high P/E ratios in the 20s or 30s, Lululemon is at 51.12x current earnings, and still 42x forecasted earnings. It’s price to sales sits at 6.65x, which is over twice it’s closest peer. With the exception of Under Armor (UAA), Lululemon’s price to cash flow is over twice its peers.
What’s more striking is the price relative to earnings growth. Even with the outstanding growth Lululemon is experiencing, they sit at 3.08x earnings growth compared to most peers who are between 2–2.5x. Given the possible trends that exist in the efficiency of how the company operates, investors aren’t pricing in much in the way of risk.
Lack of Debt Isn’t A Good Thing
When investors look at Lululemon, they’ll notice that their ROE and ROI are the same. Lululemon currently only has equity and no debt. Compared to their peers, it’s a bit of an unusual step given the company’s investment in its ivivva business as well as its general expansion. While this is obviously a deliberate choice of management, it comes at the expense of shareholder value.
Most of the peers in the fashion industry do utilize long-term debt, and often offer shareholders a dividend. Lululemon has chosen not to, and as such, has a much higher cost of capital than its competitors. Given the company’s need to fuel growth, management would be more efficient by taking advantage of the still low interest rates to balance their WACC and return more value to shareholders.
Stay Away and Keep a Wary Eye
First, it’s worth stating that the company currently is performing remarkably well and much better than many of its peers. Yet, there exists considerable evidence that management isn’t maintaining control of their efficiencies and effectiveness they once had, and likely are becoming a bit too narrowly focused at the moment. The price for the stock has gotten way ahead of itself, and there exists some considerable risk in the prospects, especially in an industry like fashion. It’s not worth buying the company at the current moment. Should the stretched valuation stay as it is and the concerning trends begin to take hold, the stock could set up for a shorting opportunity.
