Lululemon: one of the greatest retailers of all time?

Lululemon has pre-tax returns on capital (well) above 70%.  This is pretty insane.  Imagine you could invest in bonds that yielded 70%/year- you would become filthy rich pretty quickly.

I don’t know enough about retail to do a good calculation of Lulu’s return on invested capital (ROIC).  The underlying business has the following as invested capital:

  1. Inventory.
  2. Plant, property & equipment.
  3. Working capital.  I don’t know how much working capital Lulu needs for its stores.  Lulu definitely has way too much cash on its balance sheet.

I will arbitrarily assume that #3 is equal to #2.  A quick calculation of pre-tax ROIC would be as follows:

pre-tax ROIC = operating income / (#1 + #2 + #2)

$376M /($215M + $155M+ $155M) = 71.6%

Lulu’s ROIC is at least 71.6%.  It’s actually a lot higher than that.  Over the years, Lulu has generated huge amounts of cash and hasn’t returned any of it to shareholders.  Because it can only expand so fast and can’t reinvest all of its capital, it has generated huge amounts of cash that is just sitting there.  It spent some of this cash buying real estate.  It probably isn’t generating 70%+ ROIC on its real estate.  It is likely generating less than 10% on its real estate.  If it did not put money into owning real estate, its actual ROIC would be much higher.  This company is disturbingly profitable.

Accounting tidbits (these mostly don’t matter)

I don’t think that Lulu has accounting that causes large distortions to its reported earnings.  Its earnings could be materially distorted if it is using inappropriate depreciation rates or overcapitalizing expenses.  I don’t believe that Lulu is doing either.

Taxes on repatriating earnings (aggressive)

From the latest YE2013  10-K:

We have not recorded deferred taxes on undistributed earnings and other temporary differences of our Canadian subsidiary which are considered to be indefinitely reinvested. If management’s intentions with respect to these undistributed earnings and other temporary differences were to change in the future, deferred taxes may need to be provided that could materially impact our financial results.

This is aggressive.  It is likely that Lululemon will eventually repatriate its Canadian earnings to the US and return it to shareholders.  (Lulu is incorporated in Delaware, US even though it started out in Vancouver Canada.)  I would prefer to see Lulu record a tax liability.

I could be wrong.  See this paper by PWC that explains these tax issues.  In most situations, recognizing the liability will understate true earnings.  Companies will almost always defer their US taxes and enjoy an interest-free loan from the US government; GAAP accounting doesn’t give any value to this loan.  On the other hand, not recognizing the liability will overstate earnings.  No matter what you do, GAAP accounting will distort true profitability.  Lulu chose the more aggressive option.

Stock options expense (conservative)

Lululemon seems to overstates their options expense (which reduces reported earnings).  Instead of using historical volatility, “expected volatilities are based on a review of a peer group of publicly traded apparel retailers.”  Lululemon uses an expected volatility of 64.65%.  Volatility in the last 3 years has been 46.08%.  The volatility implied by current options prices suggests that the market anticipates volatility around 34-41% (the high borrow cost causes put/call parity to break down so the market implied volatility is a little weird).  It would be more accurate for Lululemon is use an expected volatility figure in the range of 34-46%, not 64.65%.

Gift card accounting (conservative)

I don’t understand this area very well but it seems that Lululemon is becoming more conservative in this area.  Lululemon reports revenue on gift cards that it thinks won’t be redeemed.  As well, it reports its overall “Unredeemed gift card liability”.  Revenue divided by total liability should stay flat or go up slightly over time.  This is because more and more of the unredeemed cards will go lost or missing as time passes.

In the year ended 2012, there was $1,775k in revenue versus a liability of $22,773.  (7.8%)
In the year ended 2013, there was $1,351k in revenue versus a liability of $35,113.  (3.8%)

However, Lululemon has shifted its accounting estimates.  It assumed that gift cards suddenly stopped going missing/lost at a much lower rate (this is unlikely).  So, it has recognized less revenue from gift cards.

Here’s the bigger picture.  The slight difference in revenue has virtually no impact on Lululemon’s overall profitability.  Even if they are trying to hide/”cookie jar”* a few million in earnings, it will barely budge the needle.  Lululemon had $270,556k in after-tax income in 2003 (maybe 100X what hidden gift card earnings should be).

*Some companies will be overly conservative in their accounting so that they can save up earnings for later in the future.  If the company needs to beat analysts’ estimates, the company will reach into its “cookie jar” of earnings that it has saved up.  Some companies will do this to receive positive press.

Provision for obsolescence and shrink (conservative)

This seems like it might be another cookie jar area.  Inventory jumped 49% while this provision jumped 115%.  Maybe Lululemon has gotten a lot worse in having its inventory stolen and becoming obsolete.  But it’s probably not the case.

Capitalized software costs (more conservative than last year)

Capitalizing software costs will increase reported earnings (some companies do not capitalize any of their software costs).  Adjusting the amount of software capitalized can be used to manage earnings.  Earnings can be inflated by capitalizing as many costs as possible.

The amount of capitalized software went down in 2013 versus 2012.  It should be going up since Lulu is expanding its online stores and is presumably expanding its distribution infrastructure.  It is likely the case that the 2013 year’s accounting is more conservative than the prior year.

What Lululemon does

They make high-quality athletic apparel that is stylish and makes women look good.  They are the innovators in introducing style to high-quality athletic apparel (or “technical” apparel).  In my opinion, the main reason why Lulu’s customers buy their clothes is because of the combination of those two things.  They don’t have much competition that does both well.  Here are qualities of clothing that matter to Lulu’s customers:

  1. Does it make me look good?  Women want to feel attractive.  This might sound sexist but I believe that almost women are wired this way.  Human beings have certain behaviours that are wired into us.  We mirror the body positioning of people we are close to.  Kids bully each other at school even though it doesn’t make sense.  We have heuristics and shortcuts in our thinking.  Women want to feel attractive.  Even feminists want to feel attractive.  That’s just how most/all women are wired.  Lulu’s clothes highlight a woman’s curves.  It makes their butts look good.  Lulu gives women what they want.
    For social reasons, men and women don’t talk about this aspect too much even though it is important to Lulu’s customers.  I think that this quality is the most important quality for most of Lulu’s customers.  It is common for women to sacrifice comfort for fashion.  They wear uncomfortable heels, wear skimpy clothing during winter, etc.  Lulu’s customer base is less overt about how flattering their clothing is but it is still very important to them.
  2. Does it make me look like a slut?  Unfortunately, our society judges women.  Women want men to find them attractive.  But if they dress “sexy”, they may be labelled as a slut.  Nobody wants to be judged.  So, many women want to feel attractive without being slutty.  It’s a delicate dance because women sometimes feel like they have to compete against sluts or be a slut to get male attention.  Lulu’s clothing is aimed at the “beautiful but not slutty” market.  The clothing needs to push the envelope of sexiness/attractiveness (e.g. make those shorts shorter) without going into slutty territory.  (There is a market for slutty/risqué clothing but Lulu is not in that market.)
  3. “Sheerness”.  Sheer refers to how see-through a fabric is.  See-through pants are slutty (or risqué depending on how you look at it).  Lulu has had problems with sheer clothing for a long time.  While Lulu pretends that only its black luon pants are sheer, its customers know that some of its other pants have sheerness problems.
  4. Camel toe.  Nobody wants to see this.
  5. Durability.  Lulu’s clothing has been declining in this area.  Some of its clothes will pill quickly even when hand-washed and separated from cotton garments.
  6. Colorfastness.  Does sweat discolor the clothes, do the dyes rub off onto skin or other clothing?  Lulu has had problems with this in the past at a higher rate than its competitors.
  7. Cuteness.  Cute as in Hello Kitty cute, which is different than “does it make my butt look cute?”.  Lulu’s clothing is generally considered to be cute in a good way.
  8. Status.  There is an element of women competing with their peers in clothing.  If your clothes are “better” than somebody else’s, then it is a sign that you have more social status than them.  “Betterness” might be based on quality, brand, trendiness, cuteness, or some other completely arbitrary measure.
  9. Are other women wearing Lulu?  If you are wearing the same piece of Lulu clothing as somebody else in the same studio/gym, it’s embarrassing.  As Lulu sells more clothing, their clothing will hold slightly less appeal.  This is a good problem to have.
  10. Scarcity.  Originally, Lululemon clothing was limited in supply and difficult to come by.  This arguably made the brand more cult-like and trendier.
  11. Scarcity.  This increases the perception of value.
  12. Comfort.  Women do want to feel comfortable while engaging in athletic activities.  Lulu tends to be more comfortable than other clothes as the fabric wicks sweat, fits well, and feels comfortable overall.
  13. Price.  Obviously a very important factor.  High prices can create the perception of value, so high prices aren’t necessarily a bad thing.

Lululemon is becoming a very different company than what it used to be.  Starting somewhere in 2009ish, it has slowly let the quality of its clothing slip.  Maybe it did this knowing that its same-store sales would skyrocket anyways.  But as a consequence of letting its quality slip, Lululemon’s brand has changed.  Its fans used to be fanatical about its clothing.  This fanaticism is wearing off as Lulu no longer produces the highest quality clothing possible.  It seems that many of Lululemon’s most diehard fans (see blogs like Lululemon addict) are starting to add other brands to their wardrobe (e.g. Athleta, Under Armour) and are no longer spending thousands of dollars a year on Lulu.

Lulu arguably lags it competition in terms of quality control (sheerness, colorfastness) and in durability.  Its fabrics tend to be the highest quality in terms of comfort.  Its fashion/style is considered to be in the top tier.

Operating performance

Same store sales (SSS) increases used to be double digits and are now slowing down to “only” high single digits.  Very few retailers deliver high single digit improvements in SSS.  This is a sign that Lululemon’s operations are still getting a lot better.  Consumers are buying more Lululemon per store despite the drop in quality (prices have remained roughly flat).  They must be doing something right.

Margins have gone up slightly though this should be expected if you allow the quality of your product to decline.  As Lulu grows larger, it should theoretically enjoy economies of scale from its vertically integrated distribution network.  It may be losing operating efficiencies somewhere.

Hyper growth and growing pains

Lululemon’s extreme growth rate is very difficult to pull off.  Christine Day (its CEO) has worked at Starbucks so she should have experience in trying to grow really fast.  Sometimes it is not pretty.  I think that Lululemon has privately been struggling to meet demand for its clothing.  That is the reason why its quality control has been poor for years.  There is no reason for it to ship clothes with dye bleeding and sheerness problems.  Returns are expensive and shipping bad product hurts the brand.  Perhaps some executive at Lululemon decided to ship the clothes to stores anyways to hit his/her numbers.  Lululemon may have been increasing the number of its suppliers because its previous suppliers haven’t been able to keep up.  In any case, its quality control has been declining and it is not surprising to see Lululemon’s chief product officer leave the company (probably fired).

Online business

I think that the economics of selling clothes online is a wonderful business if you have customers who are willing to risk purchasing online.  Customers love Lululemon so much that there is an active market for used Lulu clothing on eBay (and other online venues).  Many of Lulu’s customers are buying their clothes online even though they don’t live remotely close to a physical store.  Lulu’s online store has seen rapid growth, almost doubling in revenue from 2012 to 2013.  I believe that the online business is a wonderful business since it can scale faster than having to start bricks and mortar stores (and hire staff, train them, deal with local regulations and laws, setup distribution logistics, etc.).  The online business also has higher margins than its store-based business.

Capital allocation

This has been ok/good.  Lulu has a wonderful problem- its business is insanely, insanely profitable.  It is making more money than it can reinvest.  Fortunately, they have been focusing on improving the underlying business (e.g. SSS has continued to climb).  To its credit, Lulu hasn’t done anything stupid with its money.  I would much rather Lulu sit on cash than to make some value-destroying merger or acquisition.  On the other hand, it is sitting on cash earning very low returns.  In the absence of good reinvestment opportunities, it might as well return profits to shareholders via dividends or share repurchases.

Integrity of management

I don’t see any problems with the related party transactions.

Insiders are selling stock but Lululemon hasn’t been getting more aggressive with its accounting.  As well, they do not play the non-GAAP earnings game where non-GAAP earnings are almost always higher than GAAP earnings (e.g. lots of “one-time” charges every year).

Management is likely managing earnings.  Overall, I would rank management’s integrity as somewhere between Warren Buffett and John Malone.  I don’t have problems with management’s integrity.

The short thesis

Lululemon is one of the most shorted stocks around.  Here are some writeups recommending Lululemon as a short:

valueinvestorsclub.com/value2/Idea/ViewIdea/93353

valueinvestorsclub.com/value2/Idea/ViewIdea/27795

Arguments made against Lululemon are:

#1- Yoga is a fad that will pass

I don’t think that yoga’s popularity in the West will die off very quickly.  But even if it does, I think that Lululemon has a very good chance of adapting and surviving.  Many of Lulu’s existing customers wear their clothes for other athletic activities (e.g. Lulu is very popular among runners).  It is likely that some women will continue to exercise because society teaches them that exercise will lead to a hotter body.  If it’s not yoga, they will be running, spinning, etc.  I think that women will continue to wear Lululemon for those activities due to comfort and fashion.

#2- Its margins are unsustainable

Lululemon’s margins have been pretty stable (and growing somewhat) over the past several years.  Gurufocus.com is a good way to quickly see historical metrics for a company.

EDIT:  A better way of looking at it is this.  Lululemon’s value proposition has been declining over the years due to declining quality.  Its competition has been increasing their value proposition.  Despite this, same store sales have gone up despite that.  It seems to me that Lululemon’s premium pricing is sustainable.

#3- Competition

I do think that Lululemon is seeing the gap between itself and its competitors close.  Lululemon is ahead in terms of delivering the combination of comfort and style.  They are lagging in terms of durability and quality control.

My guess is that Lululemon will continue to dominate its niche of high-priced/high-quality stylish athletic apparel.  Based on historical precedent, you always want to bet on the superstar CEOs in the retail field.  By most/all objective metrics, Christine Day is doing extremely well.  ROIC is over 70%.  Sales per square foot is over $2000/sqft.  Other great apparel retailers like Abercrombie, Aeropostale, etc. are only in the ballpark of $400-600/sqft.  The 55% gross margin is among the industry’s highest.

Day’s numbers would suggest that she is one of the greatest retail CEOs ever.  She will likely destroy her competition.

Valuation

I think that Lululemon is fairly valued at its current price of $76.88.  The P/E ratio is 41.45.  I would be more interested in buying LULU if its P/E ratio was 20 or lower.  I really do think that the short sellers are wrong to short this stock.

The call options are interesting.  Because this stock is heavily shorted and the borrow is expensive, put/call parity for the options has broken down.  The call options are cheap.

*Disclosure: No position.  I might be interested in the call options if the stock comes down in price but it doesn’t interest me at the moment.

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