Investment Conclusion. This beat, and subsequent rally, does not come as a surprise to us, and is in line with our multiple comments over the past week to back off the short headed into the print. Unlike what we saw with TGT and KSS, however, this was a genuinely upbeat growth algorithm, with 7% comp leveraging to growth of 14% and 36% in Revenue and EBIT, respectively. LULU definitely gets a ‘golf clap’ there, and yes, this probably buys Potdevin another couple of quarters on the job. But to be clear, despite the upside ‘surprise’ this story is no less troubled. In fact, there was absolutely nothing that came from this print that alters our TAIL call that unless major investments are made in branding/product tiering, absence of a clearance channel in the face of a historically ‘full price’ business that is starting to go the promo route, and absence of the ability/talent/investment to build a wholesale model (which is critical to the next stage of LULU’s growth), we’re likely to see sales roll, (increasingly higher) occupancy delevered, share erosion, and ultimately – a management shakeup. We still contend that there’s $4.00 in earnings power in this company, but this management team will simply never unearth it. Going forward, our estimates are below where the consensus is likely to end up after this print. Compares are still ‘easy’ into 2Q. As either a) we de-risk duration by moving closer to that time, b) the street extrapolates this quarter into 4Q/1Q and we prove to be well below the Street over the near term, or c) the stock pushes through $75 – then we’ll get much heavier on this position.
DETAILS
This quarter from LULU was certainly a bridge over trouble water. As poor as the quarter LULU reported three months ago was, this was the inverse of that. Especially in light of the move from $80 to the mid-$50s. The sheer power of the earnings algorithm – 14% sales growth leveraging into 34% earnings growth – shows the leverage the company has in the tank over the next 9 months as it recaptures the low hanging gross margin fruit due to mis-execution on the logistics side. That alone should provide enough kindling to keep the bulls excited over the interim, and was the sole factor which led us to back away from the short into this week’s earnings. Don’t get us wrong we still think we’ll see think we’ll see C-Suite shake up before the books close on 2017, and that a clear and concise investment plan needs to be laid out in order for LULU to double its revenue base over the next 5 years. That’ll likely take margins down to the mid-teens before an ultimate recovery to consensus numbers pushing 20%.
The question from our vantage point is timing. Over a shorter duration, the margin compares continue to be easy, and the company’s 3Q performance on the GM and comp (+7%) line provide little shorting material. Yea traffic was negative, and the company’s response to questions about the metric were puzzling to say the least. So too were the comments on athleisure being a crowded space. International commentary was mixed – caution on the European rollout and full-tilt expansion into China without a real proof of concept. But that likely won’t drag numbers down over the near term. That’s our way of saying we wouldn’t get heavy into a LULU short given the comparison tailwinds into 2Q17 at this price.
Over a longer duration we get to an incremental margin of 11% on an incremental $1bn and change in revenue. That assumes an EBIT margin rate just shy of 16%. The factors in that are centered on LULU’s growth vehicles – mainly men’s, international, and ivivva which are all dilutive to margins and capital intensive. That will ultimately understate margin recapture in the core business. And LULU is fully committed to non-core as its growth vehicle going forward.
So at what price would we look to get heavier? Around $75. How we get there…generally we like the 3/1 upside down side in any of our calls. Currently we are modeling earnings of $2.60 in 2018, good for a HSD earnings CAGR. On that we’d argue 20x earnings and 10x EBITDA = a stock in the low-$50s. Best case we’d argue $3bn in sales on a mid-50% GM, EBIT margins approaching 20%, and earnings number starting with a $3 handle. We don’t think we’ll see peak multiples on that, 30x is completely justified. That gets us to a $90 stock. At $80 we get to 10% upside and 30% down.
