We wouldn’t touch this stock for all the Goji Berries in the world. Yes, the comp was great at +8%, but the company still managed to leverage a great top-line algorithm -- 8% comp and 17% sales growth – into a -12% EPS decline. How we look at it, comparisons on the top line begin to get tougher immediately, LULU just showed us that the cost of its growth is getting much more challenging, and it all but assured the investment community that gross margins will start to inflect – even though it lacks the operational excellence to make such a statement. Again, not for all the Goji Berries in the world. All in, at 30x earnings and 15x EBITDA, LULU is in the top 1% of retail as it relates to being expensive. We’d flat out short this name. While our estimates are not wildly outside of the Street, they carry – by a country mile – the greatest likelihood of any of any retailer/brand to completely blow a quarter, year and reshape investors’ view materially to the downside.
Comps – The 8% constant currency comp puts LULU in the 97th percentile during the 1Q16 earnings season. That’s nothing to scoff at – especially in this environment. Though, if we peel back the onion a few layers on the LULU comp trends – especially at the store level – the underlying trends paint a much less bullish picture. Specifically, the 3yr trend which eliminates all of the quarterly noise, hit an all-time low at 0% in the quarter (see exhibit below). That type of trend doesn’t add up to a growth stock.
Now comps get more difficult, going from a -1% compare this quarter to +5-6% comps, as the company laps Chip’s “our customers are fat” tailwind which benefited LULU in final 3 quarters of FY15.
Gross Margin – Definitely the highlight for LULU in the quarter, beating expectations by 130bps. Add on the better inventory balance, and LULU appears to be on track to reach its gross margin goals for the year. Guidance of 120bps of leverage in 2Q16 reflects that. Yet, despite the positive tailwinds from the sourcing side, product margins still were pressured by markdowns and discounts. LULU may very well get the gross margin lift this year (it’ll more or less give it back in SG&A), but that requires a level of operational excellence that this company has never proven it can deliver sustainably – if not momentarily. And…at this price the market absolutely demands it.
Up at 30,000 ft., the 35bps of deleverage in the quarter caps off a 5 year stretch in which margins have declined by a cumulative 10.5 percentage points. 2Q16, according to the company, will be the inflection point in the GM slide. That may be true, but we still think a mid-50’s gross margin is a pipe dream. Keep in mind that the bulk of this deleverage came at the same time LULU should have experienced its most profitable growth period – as it built out its store network in the US. Now growth becomes more expensive (Intl, ivivva, men’s) at the same time the DD comps dry up.
Also keep in mind that while inventory levels improved on the margin, we’re still looking at five quarters in a row – including this one – where inventory grew faster than sales. The only time we’ll give credence to a management team’s assertion that gross margins will turn around imminently is when it makes that statement with only a few weeks left in the quarter, or if inventory is exceptionally clean (i.e. there is a significant sales/inventory spread). We’re looking at neither here.
SG&A – Let’s ignore for a second the 100bps of SG&A deleverage caused by a strengthening of the CAD in the quarter. SG&A still delevered by 300bps in the quarter, or 75bps higher than street models called for. Yes, the cost of growth is growing.
Now on to currency, the headwind experienced in the quarter is part of doing business when the corporate headquarters are stationed in Vancouver. Over the past 3 years – LULU has recognized a $12.7 million benefit from currency revaluations. Now that’s going the other way, as are the cost savings associated with paying employees in Toonies, but there is an equal benefit to the top line.
We know that there’s supply chain investments underneath the SG&A hood, but let’s not forget where LULU’s growth is coming from. In this year alone, the combination of ivivva and Int’l accounts for more new doors (23) than North American LULU (17). That’s a meaningful margin headwind in light of the profitability characteristics of the two vs. the core business. The punchline = growth is more expensive.
International – the store growth plans for the Int’l markets remain on track (the reduction in store additions for the year came in the US market) at 11 new openings in FY16. That will put LULU at 22 locations in Europe and Asia by the end of the year, meaning a minimum of 18 openings in FY17 to hit guidance for 20 doors in Europe and Asia by the end of that year. Commentary was again mixed on the success of the International operation. With the positive being the store in Hong Kong putting up monster productivity of $5700/sq.ft. on a 1,300 sq. ft. box for a grand total of $7.4m. About 7% higher than an average 2.5k-3k sq. ft. US door at the peak. The rest of the doors in that region are tracking at or above $1,500-$1,600/sq. ft. Not shabby, but far below where LULU needs to be if it wants to hit its $1bn Intl sales goal (more below).
Europe appears to be a different story all together, with the case study being the London Market. The company has 5 doors in the country now and the hit rate is sitting at 60% in terms of winners – with 3 doors tracking at plan, and 2 doors lacking the community ‘vibrancy’ to be effective. To be clear, 60% winners equals 40% losers. Shouldn’t it have more success in a nascent market like the UK? Heck, maybe that’ll change with some nice therapeutic Brexit. No, not really.
We give LULU credit however, for looking at additional alternatives like shop-in-shops to broaden the International reach, but for International to work according to plan and meet the $1bn sales target which we will assume will get it to its ROI targets, it needs to average productivity of $4,500/sq.ft. The initial reads are not even close, and as LULU steps on the accelerator outside of NA, the company will move into lower tier markets. Zurich ≠ London or Hong Kong.
The Loonie Bump
LULU was explicit in calling out the SG&A impact caused by a 6% appreciation in the Canadian Dollar vs the US Dollar in the quarter (about 2x what the company expected). However, management failed to highlight the top line benefit created by the same currency move. Assuming 20% of sales are in Canada, the change in currency value caused a $6mm bump in revenue or 140 bps of growth in the quarter. On a full year basis, the currency change implied in guidance gives LULU about a $12mm (+0.5%) benefit from the Loonie appreciation. Meaning nearly all of the full year upward revenue revision can be explained by changes in the FX rate and not in a material improvement in the underlying health of the brand.