Valuation: Overvalued

Investment Thesis:

Lululemon represents a great investment opportunity as they continue their expansion into Asia, Europe, and China.
- If done successfully, this can help Lululemon launch their business to the next level, and drastically improve on their financial reports.
Furthermore, Lululemon’s desire to grow is also exhibited through their acquisition of MIRROR, which they believe is an extension of their brands principals/image.
- If Lululemon can make changes to this business and scale it, there is another fantastic opportunity for future growth there.
However, the valuation techniques used in this report argue that Lululemon’s Stock - $LULU, is currently overvalued. My models predict that $LULU price target is $362/share (implying a 9.4% drop).
- There are risks and catalysts that could potentially have large impacts on the share price, and my opinions on them as a company. These risks/catalysts are listed at the end of this report.

Company Overview:

$LULU – Lululemon Athletica Inc. designs and distributes their athletic apparel, and accessories to their customers worldwide. Lululemon’s goal is to continue to grow their cult-like following around the principals of exercise and health.

Lululemon is actively chasing this goal, which Is evident through their recent purchase of MIRROR, which is an in-home fitness company with an interactive workout platform with live & pre-recorded classes.

Recently, Lululemon has set their eyes on further expansion into China, Europe, and Asia, which could be very lucrative if done correctly, as these countries/continents have large markets.

Investment Information:

Business Segments:

Lululemon has split their business into 2 main segments in their sec filings for reporting purposes. These two segments include their Company-Operated Stores, and their Direct-to-Consumer segment (DTC).

In 2020, their DTC segment represented 52% of their total revenues. This increased drastically from 2019, as in 2019 only 29% of Lululemon’s revenue came from their DTC sales channel. This increase is good to see as an investor as the DTC sales model tends to have better margins, which can help Lululemon’s profitability and help them report better financials.

In 2020, Lululemon’s Company-Operated segment represented 38% of their total revenues. This is a large decrease from their 2019 figure of 63%. Once again this is good to see as DTC tends to be favourable for companies.

This drastic shift away from Company-Operated stores, and to their DTC sales channel can be attributed to COVID-19. Many companies (including Lululemon) were forced to close their stores at the start of the pandemic, these companies were forced to either adapt or be left behind. Luckily for Lululemon, they already had an established DTC model, which helped them to adapt quickly and capture the online market very quickly. As a result of this, Lululemon was able to generate record revenues and increase their margins.

The rest of the revenues not accounted for belong to their “other” segment. This “other” segment includes their revenues from MIRROR, outlet stores, and pop-up stores.

Company-Operated Stores:

Despite the pandemic still raging on Lululemon was able to net an increase of 30 stores in 2020. Out of these 30 stores, 10 came from the USA, 17 came from China, 2 came from the UK, 2 came from South Korea, and 1 came from Germany.

If you did the math, you will have noticed that I just listed off 32 new stores, this is because I have not factored in the 2 stores that were closed down over the past year, 1 store in Canada closed, and 1 store in Japan closed.

As we can see from their Company-Operated Stores data, Lululemon is currently expanding into Europe and China. It is likely that we see this expansion continue in China and Europe, as well as a focus on starting to expand into Asia.

Seasonality:

Lululemon has acknowledged that their revenues are very seasonal, and that they tend to generate the most revenue in the fourth quarter. This is very common among multiple industries (especially retail) as it is the holiday season. However, Lululemon’s business is much more seasonal than most. This can be observed through their revenues in 2019 and 2020, in which $LULU earnings reported that 47% and 56% of their revenues in these respective years came in the fourth quarter alone.

This is important to know as an investor and is noteworthy especially as we approach $LULU stock earnings for Q4 (likely to be on January 31^st, 2022). This jump in revenues is already somewhat priced in, however if we assume that 56% of their revenues comes in Q4 this year than we ca make our own estimate.

Using this 56% figure, we can estimate Lululemon’s Q4 EPS to be $2.74 [(sum of Q1-Q3)/ (0.44)] – (Sum of Q1-Q3). This implies that Lululemon will beat their earnings report in Q4 by 10.93% (Q4 EPS estimated to be $2.47 by taking the average of 8 analyst estimates) which may serve to be a catalyst in the future.

MIRROR Acquisition:

On July 7^th, 2020, Lululemon purchased all of the outstanding shares of MIRROR, which is an in-home fitness company with both live and on-demand classes. It has been reported that this purchase was $500M. Of this $500M, Lululemon has reported that $360M of it is “goodwill”.

For those of you that do not know, “goodwill” is the difference between the purchase price of a business, and that businesses fair value of assets [= (assets acquired) – (liabilities assumed)]. In this case, Lululemon paid $350M over the “fair value” of MIRROR, this goodwill is valuable due to the reputation and the brand that the purchased company built.

In their SEC 10-K filing, Lululemon stated that they purchased MIRROR based off of growth, discount, and royalty rates that they believe the can make in the future. This is important as Lululemon believes that they can generate revenues and profits in the future.

Financial Information:

Financial Performance (Good): In 2020, Lululemon was able to increase their revenues by 11%, increase their gross profit by 11%, increase their gross margin by 0.1 percentage point, and increase their DTC revenues by 101%.
Financial Performance (Bad): In 2020, Lululemon increased their cost of revenue by 10% (which is good because the increase in cost of revenue is less than the increase in revenues), their income from operations decreased by 8% (decreased operating margin), their revenues from company-operated stores fell by 34%, and their net income fell by 9%.
Overall Financial Performance: It is rather difficult to give an opinion on whether Lululemon’s financial performance was good or bad in 2020. This is because there were economic factors (ie. COVID-19) that had adverse effects on businesses, which made some companies report “bad” earnings. However, the pandemic also helped many companies transform to digital, or helped companies (ie. Zoom) to have quicker adoption and report very good earnings. This dilemma is very prevalent with Lululemon as many retail and mall stores did horribly through COVID (Lululemon was no exception), however companies that adopted a social media presence and a DTC model were able to perform rather well (ie. Lululemon). Overall, I think that Lululemon had a slightly worse financial performance (as opposed to better). I think this because their DTC model should have helped them to achieve better margins and be more profitable, however the opposite happened and Lululemon’s net income fell.
Options Exercised: In 2020, Lululemon issued 182,000 shares through the exercise of stock options. This issuance had a dilutionary effect of around 1%
Performance Stock units (PSU’s): In 2020, Lululemon offered 171,000 shares through the vesting of performance-based stock units (PRU’s). These shares are given out to employees based on their performances and goals that they met. The issuance of these shares had a dilutionary effect on Lululemon’s existing common shares of approximately 0.1%
Restricted Stock (and shares) Units (RSU’s): In 2020, Lululemon issued a total of 196,000 common shares as a result of the vesting of their Restricted Stock Units. This issuance had a dilutionary effect on existing shares of approximately 0.2%
Share Repurchases: in 2020, Lululemon reported that they repurchased a total of 400,000 shares in 2020 alone. This repurchase offset the majority of Lululemon’s dilution for the year 2020, netting a total of 149,000 shares issued during the year. This brings the total dilution for 2020 down to 0.1%, which is essentially negligible. The fact that Lululemon has little to no share dilution even after acquiring MIRROR is a very good sign for investors and potential investors alike.

Competition:

In order to undergo my comparable analyses, I needed to find 4 companies that are comparable/similar to Lululemon.

These companies need to exhibit the following characteristics to be considered: be publicly listed, have valid financial ratios/multiples, have similar operations to Lululemon, and be of similar market cap.

By narrowing down the companies based off of the above criteria, I ended up with the following 4 comparable companies:

$GOOS Stock – Canada Goose Inc: Canada Goose designs, manufactures, and sells their performance and luxury apparel for men and women. Canada Goose sells their products primarily in Canada but also in the USA, Asia, Europe, and Internationally. Canada Goose also sells their apparel in both physical retail stores as well as through their online store (DTC model).
$LEVI Stock – Levi Strauss & Co: Levi Strauss designs, markets, and sells their jeans, shirts, other forms of apparel, and accessories in the Americas, Europe, and Asia. Levi’s sells through 3^rd party retailers, 3^rd party e-Commerce stores, company-operated stores, and their company website (DTC).
$UA Stock – Under Armour Inc: Under Armour develops, markets, and distributes their apparel, footwear, and accessories to their customers in North America, Europe, Asia, Middle East, and Latin America. Under Armour sells their products through wholesale channels, distributors, and through their DTC channel (e-Commerce store).
$AEO – American Eagle Outfitters Inc: American Eagle is a specialty retailer that provides clothing and accessories to their customers in USA, Canada, Mexico, and Hong Kong. Furthermore, American Eagle is able to ship to 81 countries around the world through their online store (DTC).

Valuation Information:

WACC:

I was able to calculate the WACC through my own models. These models can be found in the DCF model. My WACC model estimated that Lululemon’s WACC is approximately 7.75%, which I used in my DCF model.

CAGR (2021-2025):

I used a CAGR that was between Lululemon’s gross profit growth rate over the past 5 years, and the average forecasted CAGR over the next 5 years. By doing this I arrived at a CAGR of 19.26% over the next 5 years.

CAGR (2029+):

I estimated lululemon’s CAGR for 2029 and 2030 to be 10 as it seems like a reasonable number given Lululemon’s growth. In the years between 2025 and 2029, I slowly tapered down the growth rate from 19.26% to 10%.

Operating Expense Increase Rate (2021-2025):

In order to achieve this figure, I used the same approach as the CAGR. By doing this I arrived t an Operating Expense Increase Rate of 19%.

Operating Expense Increase Rate (2029+):

To predict Lululemon’s operating expense growth rate for 2029 and beyond, I decided to use 9%. I did this because the operating expense increase rate has always been relatively close to their CAGR.

Depreciation and Amortization Increase Rate:

Over the past couple of years, Lululemon’s average yearly Depreciation and Amortization growth is 15.47%. I used this historic growth rate to forecast the future growth in my DCF model.

Tax Rate:

I was able to find Lululemon’s tax rate to be 28.10% through their SEC 10-K filings.

Capital Expenditure Growth Rate:

Over the past couple of years Lululemon’s CAPEX has grown at an average of 2.2% per year. I used this historic rate to forecast their future growth rate.

Risk Free Rate:

I was able to find Lululemon’s risk free rate through a website called Finbox. Finbox estimated that Lululemon’s risk free rate was 2.25%.

Investment Valuation:

DCF:

In order to arrive at a $LULU stock price target, I decided to undergo a discounted cash flow (DCF) model. In order to compete my DCF model, I used the information found above in the “valuation information” section of this report. By doing this, I found Lululemon’s fair value to be $459/share, which implies an upside of 15%. This is quite reasonable; however, it may be a little high and as a result of this I decided to undergo 3 comparable analyses to gather more information.

Comparable Analyses:

EV/EBITDA:

Through comparing Lululemon’s EV/EBITDA multiple to that of their competitors (listed above in the “competitors” section of this report), I found that $LULU stock price target should be $311/share. If this were the case, there would be an implied downside to this investment of 22%. This is vastly different from the results achieved through the DCF model, so I underwent another comparable.

EV/Revenue:

By comparing Lululemon’s EV/Revenue multiple to that of their competitors, I found that Lululemon should have a fair value around $160/share. If this were to come to fruition, there would be an implied downside to this investment of 60%. This is vastly different from the DCF valuation and is even very different from the previous comparable. As a result of this inconsistency, I decided to undergo one final comparable.

P/E:

By comparing Lululemon’s P/E ratio to their public competitors, I found them to have a fair value of $324/share, which would imply a downside risk of 19%. This result is somewhat consistent of that achieved through the EV/EBITDA comparable, however as a result of the general inconsistency among comparable analyses, I decided to take the average result from each of them.

Average Comparable:

By taking the average result of the 3 comparable analyses, I arrived at one, all-encompassing comparable valuation of $265/share, which implies a downside risk of 34%

Plan:

Due to the inconsistency between the comparable valuation and the DCF valuation, I decided to take the average result in order to draw one price target for Lululemon. By doing this I arrived at an overall $LULU price target of $362/share, which implies a downside risk of 9.4%.

My plan would be to wait for Lululemon to drop 9.4% (or to the $362 price target) before buying in.

I prefer this plan over shorting $LULU because I believe in the long-term prospect of Lululemon, and Lululemon has big reactions to news and is very volatile in the shorter time frames.

Catalysts:

International Expansion: We know that Lululemon is looking to expand further in China, Europe, and Asia. These markets are huge and can be very lucrative for Lululemon if they are able to capture this market. If Lululemon does this successfully, their future financial reports should reflect a large increase in revenues due to this expansion, which should excite investors.
Financial Performance: Overall, in 2020 Lululemon had a subpar financial performance. However, if they are able to fic this and report good earnings for the year 2021, they will get investors excited about the future growth prospect of Lululemon, which should help their price.
Q4 Earnings: Based off of their seasonality I have estimated that Lululemon will beat their expected Q4 earnings. Obviously, I very well could be wrong here, however, if I am right their stock price should be benefitted by beating their earnings estimates.

Risks:

Financial Performance: Overall, in 2020 Lululemon did not have the best financial performance. Although there were some good aspects of it, I felt that the bad outweighed the good and resulted in an overall poor financial performance in 2020. If Lululemon continues on this path of poor financial performances in 2021 then investors may lose faith in Lululemon’s ability to continue their growth, and consequently exit their positions.
Seasonality: As we know, Lululemon has historically experienced seasonality especially in their Q4 financial reports. This kind of seasonality has already been priced in, to a certain extent, however if the seasonality starts to fade and Starbucks misses estimates, their stock could be negatively affected.