Lululemon (NASDAQ:LULU) presents a potentially compelling near-term value opportunity, driven by a negative inflection point in its future growth rate expectations, which has created moderate undervaluation. With the potential for growth in China to exceed current consensus estimates, I'm moderately bullish on the investment for a near-term allocation to generate alpha. However, medium- to long-term above-market returns will become more challenging due to market saturation and execution risks.
Operational and financial analysisLululemon is a global athletic apparel company renowned for its high-performance, stylish products, including yoga wear, running gear, and accessories. Its vertically integrated business modelspanning design, manufacturing, and retailoperates through over 700 stores and a rapidly growing direct-to-consumer channel. The company's unique marketing strategy leverages local fitness ambassadors and events to foster brand loyalty. Robust international expansion into markets like China, Australia, and Europe positions the company for strong returns.
Despite this, Lululemon's growth has been slowing. While the company achieved a five-year annualized revenue growth rate of 26.4%, growth in the past year was just 14.3%. Consensus estimates predict annual revenue growth of around 8% over the next three to five years. This deceleration has contributed to diminished investor sentiment, evidenced by a nearly 25% decline in the stock price over the past year.
Nonetheless, Lululemon remains a unique and well-managed business. In Q2 2024, revenue from China grew 34% year-over-year, as the company expanded from around 10 stores in 2018 to over 130 by 2024, generating $1 billion in sales. China is now Lululemon's second-largest market after the U.S. This success suggests the potential for sustained growth in China, especially if management prioritizes this high-growth international opportunity. In contrast, U.S. revenue grew by just 1% year-over-year in Q2 2024 and still accounts for 68% of total revenue, compared to 13% from China.
While China presents significant growth potentialgiven Lululemon's 2% market share and relatively limited presence of 132 storespivoting away from its dependence on U.S. revenues will require strategic execution. This transition will take time, making the consensus 8% annual revenue growth projection seem reasonable for now. However, Lululemon's strong history of moderate margin expansion could enhance its overall value proposition in the medium term. Such strong margins are largely driven by the company's emphasis on high-value clothing that is inexpensive to produce relative to its premium pricing. Like luxury brands, Lululemon's reputation for quality and unique materials appeals to affluent customers willing to pay for the brand's prestige.
Valuation analysisThe company is reasonably valued against its peers due to strong EBITDA growth. Due to the expected growth slowdown, its EV-to-EBITDA multiple is the lowest compared to Nike (NYSE:NKE) and Adidas (ETR:ADSGN) (ADDYY). Both Nike and Adidas have exhibited EBITDA declines in recent years. Therefore, in conjunction with my valuation model below, Lululemon is attractively valued right now.
Lululemon is a valid long-term holding, but its greatest value proposition is likely to materialize within one to two years. For this reason, my valuation model adopts a two-year timeframe. Although long-term investors may consider holding the stock, I find it unlikely that Lululemon will outperform the S&P 500 (SPY (NYSE:SPY)) over the long run. Therefore, I use January 2027, the end of the Fiscal Year, as the terminal date in my model.
Consensus estimates forecast January 2027 annual revenue of $12.16 billion, with a high estimate of $13 billion. Although stagnation in U.S. revenue growth may continue, potential macroeconomic tailwinds from lower interest rates in 2025 and 2026 lead me to estimate Fiscal 2027 revenue at $12.5 billion.
While the current EBITDA margin is 26.9%, I conservatively project a terminal EBITDA margin of 26.5% due to historical volatility. This results in a Fiscal 2027 EBITDA estimate of $3.31 billion.
Lululemon's current EV-to-EBITDA ratio is 14.5, well below its 10-year median of 22. This discount reflects slower near-term growth expectations. However, I believe 14.5 undervalues the company, as management's growth initiatives are likely to bear fruit. Using a terminal multiple of 17.5, my Fiscal 2027 enterprise value estimate for Lululemon is $57.99 billion. Compared to its current enterprise value of $39.14 billion, this represents a 19.85% CAGR from November 2024 to January 2027.
Discounting this future enterprise value back to November 2024 using Lululemon's weighted average cost of capital of 9% gives a current intrinsic enterprise value of $48.09 billion. With a current enterprise value of $39.14 billion, this provides an 18.6% margin of safety for investment.
Risk analysisThe primary risk to this near-term value thesis is that the market may not accept an EV-to-EBITDA ratio above the current 14.5 unless Lululemon demonstrates improved growth in Fiscal 2028 and beyond. This introduces some uncertainty to the thesis and explains my buy' rating instead of a strong buy.' Nonetheless, even without significant growth rate expansion, the stock appears fairly valued, minimizing downside risk.
Moreover, while China offers significant growth opportunities, the country's consumption downgrade trend could challenge Lululemon's premium pricing strategy. Geopolitical tensions and regulatory risks further complicate its expansion in the region. Given that Trump has outlined a heavy tariff policy against China, it is not unlikely that China could respond with a similar policy, significantly repricing imported goods from the West. Lululemon may be heavily affected by such a trade war if de minimis thresholds are made low, affecting lower-value goods like those the company produces.
In addition, the value thesis relies on impeccable execution from management. Strategic missteps, such as the failed $500 million acquisition of Mirror in 2020, would significantly harm the company's stock, especially amid already dampened sentiment. Management must focus on its core competencies and prioritize leveraging these in high-growth international markets. The Mirror acquisition, which targeted the at-home fitness market, ultimately diverted resources rather than enhancing operational efficiency.
Q3 earnings expectationsLululemon is set to release its Q3 2024 results on 11/29/2024, with a consensus normalized EPS estimate of $2.72, indicating a 7.66% year-over-year growth rate. Additionally, the consensus revenue estimate is $2.36 billion, reflecting a modest quarter-over-quarter reduction from the $2.37 billion reported in Q2. The company has consistently beaten consensus estimates since, and including, Q3 2023, making it likely that this trend will continue, especially given the current depressed market sentiment around the company's medium-term growth prospects.
During the earnings call, it will be crucial to observe how management addresses opportunities in China and its efforts to reinvigorate women's product offerings. Management attributed the 3% decline in U.S. comparable-store sales in Q2 to earlier product decisions that resulted in fewer seasonal updates, particularly in women's products. As such, I'm eager to see how the strategy of revitalizing newness will impact the company in the near term, with management aiming to restore historical levels of newness by spring 2025.
ConclusionLululemon is a solid investment at this time, with my valuation model indicating a 19.85% CAGR over the next two years and an 18.61% margin of safety in its current enterprise value. While the thesis carries moderate risk due to execution challenges, particularly in China, the downside risk is limited, making the stock a buy.'
This content was originally published on Gurufocus.com
