Lululemon (LULU) is a Wall Street darling. It should be. The company earns ridiculous returns on invested capital, operates as a cash cow that can internally fund its own expansion, and has some of the best profit margins around.
Oh, and it has a reputation for selling boatloads of merchandise through a single store. Revenue comes in above $1,900 per square foot. Only Apple and Tiffany & Co. match its sales on a square footage basis.
Can Lululemon's Success Last?
Any long-term investor knows that durability is much more important than growth. It’s all in the underlying mathematics.
When you calculate the value of any business, most of it will rest in the perpetuity calculation at the end. This perpetuity calculation makes a very dangerous assumption that the business will last forever. For established, wide moat companies like Coca-Cola, this assumption isn’t that much of a stretch. Coke owns the business of beverage distribution, so as long as we’re thirsty, we’ll likely buy what it has to sell.
Clothing is different. Trends, tastes, materials, and styles all change over time. This is especially true for women’s products. Look at Coach, which has a storied history, but is losing out to companies like Michael Kors, which have popped onto the scene as the new hot handbag. In a few years, Michael Kors will likely be replaced by the next designer product.
If 10 years ago you were to see a list of publicly-traded clothing and retail companies — Ralph Lauren, True Religion, Crocs, AERO, Rue21, Wet Seal, Express, Men’s Wearhouse, etc. — you might have a hard time picking out the winners and the losers. It’s much harder to look forward than it is to look back.
Let’s try to do just that: look into the future of Lululemon.
What’s Up with Lululemon
First of all, let’s throw out the discussion about see-through pants. If anything, Lululemon received hundreds of millions of dollars in free press. It isn’t as if Lululemon had planned to make see through pants, and whatever issues there were have been seemingly corrected. Controversy probably worked in their favor.
What I’m most interested in is determining whether or not Lululemon is:
- Building durable branding power — Customers respond well to its yoga-focused mostly female product lines, especially yoga pants. But is this a company that can sell everything from shirts to hats at a premium price point?
- Making yoga pants a new staple — Moisture-wicking, chafe-resistant material just doesn’t have the ring of denim, or . . . you know, cotton. Are yoga pants — by far the biggest sellers at Lululemon — a permanent staple in a woman’s closet?
- Isolating itself from competition — When you can turn your inventory five times per year at a net profit margin of 19 percent per trip, competition catches on. Lululemon is the leader in the premium space, but new entrants like Athleta (a Gap brand — GPS) challenge LULU’s price point with items at lower cost while touting the same or similar quality. Even tougher, the big-box retailer Target (TGT) is piloting an independent sportswear store based on its C9 brand of women's athletic apparel. Does Lululemon hold its place, or will it have to succumb to competing on price?
Thinking it Through
I’m not sure I need to try on a pair myself to test these three concerns. First, we know that Lululemon does not have claim to any proprietary input on yoga pants or athletic products, so it's certainly possible to build a better pant, but perhaps not market it as well. Second, yoga pants aren’t exactly a pair of blue jeans — so history probably isn’t the best predictor of the future.
I think what scares me most with this kind of fashion-based growth stock is that investors have to pay dearly to own it. An investor who buys today would pay for 35 times last year's earnings, meaning Lululemon has to 1) keep its position in yoga apparel, 2) grow its customer base, and 3) last for a decade or longer for investors who buy and hold to see any real returns on their investment.
Lululemon offers everything an investor could want in a stock except for a moat. It turns earnings into cash, it doesn’t need to constantly issue debt or equity to grow, and for every dollar it invests in inventory in a calendar year it claims another $1 in profits. The returns are incredible.
But is it durable? Is Lululemon now one of the premier brands of the world that can slap a label on something and charge substantially more than the competition? Is its product something that women will want to have in their closet for years, or is it just another pair of Crocs?
I really don’t know. That’s my best answer to the durability of the Lulu name. If I miss out on another meteoric rise in the stock . . . well, at least I’ll sleep well at night.
For me, this one goes in the “too hard” pile. I do know, though, that anyone who can see through this model for the next 10 years could make a killing on the trade. I think it’s binary — a multi-bagger or a 90 percent drop over time.
What do you think? Does yoga wear have legs? Are Lululemon shirts, socks, and other clothing products on a similar “must-have” scale as its pants?