Canadian yoga retailer Lululemon (Nasdaq:LULU) recently announced tremendous third-quarter earnings, which sent shares up to an all-time high. While the specifics of the announcement have already been discussed by many, I'd like to discuss where the company may go from where it currently stands - at its highest peak in the firm's history. (For background reading, see Lululemon Masters The Upward Profits Pose.)
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Lululemon's Third-Quarter Karma
To begin the analysis, it would only be prudent to touch upon some of the highlights of Lulu's third-quarter report. At the top line, revenues increased 56% to $175.8 million from just under $113 million in 2009, with comps improving 29% on a dollar-constant basis. Net profits also jumped sharply to $25.7 million, an 82% increase from 2009. More importantly perhaps, margins improved markedly across the board, with gross margin rising to 55% from 50%, operating margin up 5% to 24% and net profits improving by 2% to 14.6% of sales. The bottom line was also suppressed by an increase in the effective tax rate from 33% to 39% to account for a deferred tax liability. Analysts' estimates, along with company guidance, didn't even come close to predicting these sorts of numbers. Needless to say, what Lulu achieved this past quarter was incredible.
What's more is that management pegged fourth-quarter guidance at $210 million - $215 million, which I feel is well within reach. My biggest reason for believing this (and I'm sure management's as well): Oprah. As you may be aware, in late November Lululemon's drawstring women's yoga pant was featured as one of Oprah Winfrey's "Favorite Things", a title that in the past has equated to a sizable sales increase for other retailers. Since the airing of the episode came after the end of Lulu's third quarter, the proceeds from the publicity won't be recognized until Q4, which is already by far the company's busiest quarter thanks to holiday sales. But this is by no means groundbreaking news. In the week following the Favorite Things designation, shares popped 12%, so the "Oprah Effect" is presumably already priced into the stock.
But I'm not convinced this is the case; taking the high-end of fourth-quarter guidance, management is expecting a 23% sequential increase in sales. However, fourth-quarter revenue growth last year was more than 40% higher than the previous quarter. While it's unrealistic to expect the company to repeat that kind of growth at this stage in its growth cycle, 25-30% is not out of the question. Assuming sequential sales growth of 25%, Q4 revenues should be just under $220 million. Going forward, Lulu may have a hard time maintaining its margins; with three quarters of its production coming from China, the threat of increasing labor costs is always an operational risk. However, I would still expect Lulu to come in at the high end of guidance (and probably better) at year end.
Stretching Ecommerce Revenues
One key driver that could substantially push sales is the company's ever-growing ecommerce business. Reported as its "direct to consumer" segment, online sales have increased gradually since the online store's inception, from less than 1% of total revenues in fiscal 2008, to 4% last year, and currently 7% through the first nine months of fiscal 2010. One has to believe that the recent excitement surrounding the brand will lead to greater pageviews for the company's online catalog and subsequently an increase in online sales. I would expect the next quarter's direct-to-consumer sales to make up at least 10% of total revenues, as brand awareness has grown so much as of late and the increase in overall online consumer purchases expected for this holiday season. Add to this that of 78 U.S.-based stores, 41 are in California, New York, Illinois and Texas - that equates to a lot of interested shoppers that do not have a Lululemon store nearby. Expect online sales to surge.
Are the Bulls Ready to Relax?
While some will question whether the bulls have gotten ahead of themselves with Lululemon's current price point, I still see value here. The growth is there and so is the cash flow. Investopedia's Will Ashworth wrote a great article recently justifying Lululemon's valuation (see Making The Case For Lululemon's Rich Valuation), and while that was before its recent run-up, the fundamentals have not changed much when substituting forward estimates. Lulu's EV/EBITDA is roughly 30 and forward P/E comes in at over 40, but when compared to a similar growth retailer such as Under Armour (NYSE:UA), which sports EV/EBITDA and forward PE of 20 and 35 respectively, the valuations aren't really much of a stretch, especially considering the expected growth. For the coming quarter, I would put an upward limit of $76 on the stock, or a 10% appreciation level.
That's not to say, however, that Lululemon doesn't have some issues that may slow down the gravy train, the biggest of which may be its competitors, namely sports apparel giants Nike (NYSE:NKE) and Adidas (OTC:ADDYY), which can use their world-wide brand recognition and considerable pricing power to undercut Lulu in price while offering products of similar quality. This could be a huge issue going forward, as the still relatively new "yoga" market has really no barriers to entry and larger rivals will have little problem taking market share from Lulu on the basis of price.
Lulu's Future Pose
While Lululemon will continue to grow revenues in the coming year and to open new stores across the country, I think the company has an incredible opportunity to take advantage of its growing brand recognition and enter into a similarly hot and expanding market - shapewear. It's well known that Lulu pants can make anyone's butt look good, so why not take that one step further and provide consumers with items that they can use when they may not be able to slip into their favorite pair of yoga pants. The market for shapewear has grown to become a near $1 billion industry, with Maidenform (NYSE:MFB) and privately held Spanx being the dominant players. I believe the Lulu has a huge opportunity here to pick up a small market share, even if it's 1-2%, which would translate to over $10 million in additional revenue. With more and more traditional undergarment companies like Limited Brands' Victoria's Secret (NYSE:LTD) getting into the shapewear business, Lulu won't be able to make a huge splash, but I have no doubt the company would find some traction here. Let's see if management is thinking the same thing.
The Bottom Line
Lululemon's third-quarter results were a big eye-opener for retail analysts and investors alike, and many are wondering if Lulu can continue to build on the momentum it has gained in the past year or so. I am of the belief that growth on the top line will continue well into the next few quarters and, as previously mentioned, opportunities in less traditional areas could help increase growth for the foreseeable future. (To learn more, see Analyzing Retail Stocks.)
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