Shares of athletic retailer Lululemon Athletic inc. (NASDAQ:LULU) are rising sharply on Wednesday after the company reported yet another double beat and raise quarter that included a huge comparable sales beat.
LULU stock is up more than 10% as of this writing. That brings LULU’s trailing twelve-month gains to above 35%. That is far better than the S&P 500 (up 12%), and also above the returns posted by athletic retail peers Nike Inc (NYSE:NKE), Under Armour Inc (NYSE:UAA), and adidas AG (OTCMKTS:ADDYY).
Broadly speaking, LULU stock has its groove back. Comparable sales growth is consistently positive. Margins are bouncing back thanks to a focus on full-price sales and strong unit performance. Earnings are roaring higher.
All is well in the LULU kingdom.
Except for valuation. At this price, LULU stock is priced for perfection. But, perfection isn’t going to happen because competition from Nike, Adidas, and small pop-up yoga shops is only rising. Thus, LULU stock will struggle to head higher from these elevated levels.
Here’s a deeper look.
Strong Quarter, But Growth Will Slow
The fourth quarter report was very good, and showed a continuation of positive trends in the underlying business.
Comparable sales rose a strong 12%, well above consensus estimates calling for an 8.6% increase. The e-commerce business is accelerating in its growth track (up 42% in the fourth quarter versus up 25% in the third quarter). Meanwhile, the brick-and-mortar business is stabilizing and even growing some (3 consecutive quarters of positive same-store sales growth). Gross margins continue to rebound from 2015 lows. Operating margins are also racing higher.
But, the growth trajectory isn’t going to improve from here.
Since 2013, comparable sales growth has averaged around 7% per year. Granted, that number includes e-commerce sales, but its still pretty healthy considering the shrinking that has been happening essentially everywhere else in retail. That 7% number speaks to the strength of the LULU brand.
Despite that strength, it is very unlikely that LULU replicates on its trailing multi-year success over the next several years.
For one, Adidas is making a huge push in the North American market. The European based athletic retailer wants to grow its North American business by 50% by 2020. This is a threat that didn’t really exist over the past several years. If Adidas capitalizes on that goal (and all signs point to the thesis that they are), then that means less market share for everyone else, Lululemon included.
For another, athletic retail king Nike is aware of Adidas’ surging popularity. They are fighting back with the Consumer Direct Offense initiative. Again, all signs point to the thesis that this initiative is working (management said on a recent earnings call that the North American business, which has been in decline, is nearing a critical inflection point).
Intense Competition Is a Legitimate Threat
Granted, Nike and Adidas focus mostly on footwear, whereas Lululemon is famous for their yoga pants and athletic shorts. But Nike and Adidas also make yoga pants and athletic shorts of comparable quality and price to Lululemon product. Thus, more intense competition from Nike and Adidas is a legitimate threat to the current Lululemon business.
Moreover, from my understanding of the Men’s athletic retail market, Nike and Adidas are the top two players in that space. Thus, increased competition from Nike and Adidas also means less growth potential from Lululemon’s rising Men’s business.
But competition doesn’t end with Nike and Adidas. There are a ton of small, indie pop-up yoga shops that are rising threats to LULU’s dominance. Look at Alo Yoga, Onzie, and many more. Over the next several years, I expect the popularity of these pop-up yoga shops to steadily rise, and LULU’s dominance in the yoga market to gradually erode.
Numbers Don’t Add Up For Lululemon Stock
Putting it all together, LULU should be subject to slower comparable sales growth and slower overall revenue growth over the next several years. Revenues have grown at a 13-14% annualized pace over the past several years. Over the next several years, that number will likely fall towards 10%.
Meanwhile, gross margins are tracking higher, but they will run up against some barriers now that they are close to all-time highs and that the business has higher fulfillment expenses thanks to burgeoning digital sales. Operating margins, likewise, have some (but not a lot) more room to expand. Consequently, 10% revenue growth plus good (but not great) margin drivers should create a 15% earnings growth backdrop for LULU stock over the next several years.
Lululemon stock is trading at nearly 28-times forward earnings for that 15% earnings growth backdrop. The market has similar long-term earnings growth prospects (~15%) but trades at a much cheaper 17-times forward earnings. As such, it looks like LULU is much more risk than reward at these levels.
Bottom Line on LULU Stock
It’s priced for perfection. But perfection isn’t going to happen. Instead, competition is going to pick up over the next several years, and LULU’s growth and dominance will erode.
That erosion will cause this richly valued stock to fall, much like it did in mid-2015, mid-2016, and early-2017.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
