Valuentum Exclusive Analysis for the Discerning Investor

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Image Source: Lululemon Athletica Inc – Third Quarter Fiscal 2019 Earnings Infographic

By Callum Turcan

On June 11, Lululemon Athletica Inc (LULU) reported first quarter fiscal 2020 earnings (period ended May 3, 2020) that missed consensus top- and bottom-line estimates. The company’s strong digital sales were offset by the negative impact of containment efforts to stop the spread of coronavirus (‘COVID-19’), namely store closures (both company-owned and third-party retail locations). Shares of LULU are still up comfortably year-to-date as of this writing, in large part due to its pristine balance sheet and past investments in its digital infrastructure and digital sales channels. We covered these two aspects of its business model and why that would be a source of strength during these challenging times back in March 2020 (link here).

Digital Sales Provide Support

Store closures due to pandemic containment efforts played a key role in Lululemon reporting a 17% year-over-year drop in its GAAP revenues during the fiscal first quarter. Its GAAP gross margins dropped by ~260 basis points during this period largely due to its diminishing scale (declining total revenues) and logistical hurdles (rise of e-commerce). However, there were some bright spots in terms of a favorable product mix shift. Management had this to say during Lululemon’s latest quarterly conference call (emphasis added):

“The gross margin decline of 260 basis points include[s] a 180 basis point increase in overall product margins, resulting from lower product costs and favorability of product mix. We did not take any significant inventory write-downs in the quarter. This was offset by 330 basis points of deleverage on occupancy and depreciation, 100 basis points of deleverage on products and supply team costs and 20 basis points of negative impact from foreign exchange.” --- Calvin McDonald, CEO of Lululemon

Digital sales represented over half of Lululemon’s revenues last fiscal quarter (~54% according to management), in part due to store closures but the company has made a concerted effort to bolster its online presence. That strategy included launching a digital educator service that enables consumers to talk with an “educator” about Lululemon products, allowing the company to direct the consumer to new products, gift ideas, and how certain products fit. In the month of April, e-commerce sales were up 125% year-over-year on a comparable store basis, and that momentum is expected to carry on into the fiscal second quarter according to management.

All of Lululemon’s distribution centers are now operational (as of mid-June), which is essential to maintaining its momentum in the e-commerce space. 295 of Lululemon’s company-operated stores were open, as of June 10, and the firm ended the fiscal first quarter with 489 stores. When the remaining company-owned stores reopen, Lululemon should find it easier to move inventory. A lot of Lululemon’s products have “shelf life[s] beyond the current season and with limited markdown risk” which helped prevent the firm from building up inventory that would have had to be heavily discounted to get rid of.

Lululemon also sells its products via third-parties, meaning the reopening process at those stores will play a key role in its sales trajectory going forward. Most retail firms are in the process of reopening their physical stores and adjusting to the “new normal” (requiring masks to be worn by customers, enforcing social distancing measures, greater sanitation efforts), which should improve Lululemon’s operational and financial performance going forward.

As China emerged from its COVID-19 induced lockdown, Lululemon noticed that “our overall business in China accelerated further as guests began to feel more comfortable returning to the stores. Our total comps in China increased in the low-teens in April and have further improved into quarter two.” Management appeared to be communicating to investors that its performance started showing meaningful signs of improvement during the last several weeks of fiscal first quarter (both in China and in the global e-commerce world), indicating a bottom may be in as it relates to its financial performance. 

The strong performance of Lululemon’s digital sales during the fiscal first quarter was essential in supporting its revenues. Going forward, management expects sales through digital channels will continue to play a bigger role in consumer’s lives when compared to the pre-pandemic environment.

Financial Update

Lululemon exited the fiscal first quarter with $0.8 billon in cash and cash equivalents on hand and no debt, which we really appreciate. Having a pristine balance sheet during these difficult times is an enormous source of strength. Due to unfavorable working capital movements, including a large build in its inventories, Lululemon generated negative free cash flow in the fiscal first quarter. As its physical stores and other retail outlets that sell its products reopen, that should help improve its cash flow profile in the near- to medium-term by allowing the firm to convert its inventory into cash at a faster pace.

Please note Lululemon decreased its capital-expenditure expectations for fiscal 2020 due to the pandemic to better adjust to the new environment. Additionally, the firm removed $130 million in spending from its original SG&A budget for fiscal 2020 and that should go a long way in improving Lululemon’s cash flow profile and overall cost structure. Management has targeted other potential sources of savings should the expected rebound in its business not materialize.

The company is not providing forward guidance for fiscal 2020 given the forecasting complexities created by the ongoing pandemic. Lululemon noted in its earnings press release it had access to an additional ~$0.4 billion in liquidity through the undrawn portion of its $0.4 billion revolving credit line due June 2023 (only a marginal amount of letters or credit were posted against the facility as of May 3, 2020). In our view, Lululemon possess the financial strength and flexibility to ride out the storm intact.

Concluding Thoughts

Lululemon set out a five-year plan in 2019 that aims to double its digital sales (a process made easier due to changing consumer dynamics of late), double its men’s sales, and quadruple its international revenues by 2023. Particularly on the digital side of things, Lululemon is well on its way to achieving those goals. With that being said, shares of LULU are trading well over the top end of our fair value estimate range of $263 per share. Considering Lululemon’s recent share price performance indicates its technicals are turning against it, shares of LULU may come under fire in the near-term though its long-term growth trajectory appears sound.

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Callum Turcan does not own shares in any of the securities mentioned above. Both the Best Ideas Newsletter and Dividend Growth Newsletter portfolios include a SPDR S&P 500 ETF Trust (SPY) put option holding with a $295 per share strike price that expire on August 21, 2020. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.