LULU – We’re Out

Takeaway: Mgmt gave us zero comfort that this can be a ‘big idea’ in the $60s. It needs to shake the etch-a-sketch on its business model.

On Tuesday we took LULU off Hedgeye’s Best Ideas list, and today we’re taking it off our Retail Long list altogether. We’re out.

In our BlackBook on Tuesday (Link: CLICK HERE) we said that there’s $4.00 in earnings power hidden in there, but we need the conviction that management could find it. After today’s call, we we’re far from convinced – even farther than we thought we’d be just a few days ago. In order to justify a 30x p/e and give anyone hope of something in the $70s or $80s (presumably what you’re playing for in buying it today) we think that the company needs to completely reset its business model.

By ‘reset’ we think it has to stop focusing so much on a) improving gross margin and b) building out its North American real estate market.

a) First off, we’re hard pressed to think we’ll get much pushback from people saying that they’ll pay up for a higher margin. That might be the case for KATE (6% on its way to 19%) and RH (9% going to 16%), but not for LULU, which is 21% down from 29% -- and probably belongs in the high teens – which is NOT a bad thing. Management made it clear that a key area of focus remains driving Gross Margins. That’s a #mistake – from both a tactical and a communications standpoint. Laurent noted how “we don’t drive our business with markdowns.” Well, unfortunately he competes with brands that do. As long as this team hangs onto this mentality, there’s a greater risk of an unexpected slowdown in quarterly revenue.

b) As for real estate, we outlined in our Black Book on Tuesday why moving into so many new markets in the US will prove to be dilutive to both productivity and comps.  But that’s exactly what LULU double downed on. Management discussed adding another 100 stores in NA (US, mostly), some of which will be larger-format stores that will deleverage occupancy costs (and are untested)

Is Lululemon a great global brand? Absolutely. But Lululemon Athletica, Inc is not a great global company. It’s not even a good global company.  Let’s be clear, it absolutely can get there. But it has to break out of this North American owned retail-centric model and follow companies like Kate Spade, Kors, Nike, Ralph Lauren, and Under Armour (KATE AND UA are the most appropriate comps for many reasons). That means aggressively building out its international model – not by adding a token store in Dubai or ‘doubling’ its presence in Singapore by adding one more store. It needs to own the customer relationship by producing different product for different customers at multiple price points and distribute where the consumers shop. It’s not enough anymore to build up stores in new markets (or fill-in markets) and expect consumers to come shop. They need to be where the consumer shops. That means selling at Retail (which they do), e-tail (they’re getting there), and importantly – wholesale (zero presence).

It was pretty clear that this team collectively is focused on doing the same thing it’s done all along – just better. That’s not enough for us. We need it to think bigger. The brand can handle it, and stockholders deserve it.

The other key factor was new CFO Stuart Haselden, who has only been on the job for about six weeks. There are a lot of puts and takes here.

  1. The guy sounded like he’s been at the company for six years, not six weeks. He had an extremely strong control of the numbers for someone who was put in front of shareholders for the first time.
  2. As he reviewed the numbers, I scratched my head wondering how he could sound so comfortable in such a short time. Then it hit me…he was literally reading the script that former ‘cfo’ John Currie used for years.
  3. He sounded more convincing than Currie, which is a plus. But we wonder what kind of mandate he has to illicit change and build a finance culture inside a company that was built specifically to box out any kind of ‘finance culture’. (NOTE, both UA and KATE have one).
  4. The Q&A was a bit redeeming, in that Stuart answered 75% of the questions. He literally took over from Laurent, and it was difficult to tell who was running the show. Either a) he’s the more dominant personality, b) Laurent – who is naturally uncomfortable with analysts after his disastrous first outing last year – asked Haselden to take the lead, or c) The Board – who we think is Haselden’s REAL boss, told him to dominate the call.
  5. Either way, the dynamic was very notable. We can only hope that this results in a material change in the decision making at LULU. That has yet to happen. But in fairness, it is way too soon to happen. We’re inclined to think we’ll be looking at more meaningful changes in the functionality of this leadership team later this year. But again – we need draconian changes in the model as outlined above to make this a great stock. We’re comfortable revisiting it when the research suggests that’s happening.