Lululemon: The karma offensive

Thanks to near flawless execution of its business plan, Lululemon is poised to become the next great Canadian global brand. The only dark cloud is a stock that is priced for more than mere perfection.

Michael McCullough 0

During a conference call to discuss Lululemon Athletica’s fourth-quarter and 2009 annual results on March 25, several analysts prefaced their questions with “Congratulations on the great numbers.” Their queries were substantive – the company is plowing ahead with a rapid expansion in a recession, after all – but the tone of the conversation was as supportive as a girlfriends’ post-workout lunch.

After defying a grim outlook for the consumer discretionary sector, the designer and retailer of “yoga-inspired” sportswear is once again back to being a stock-market darling, testing its record highs and all but silencing the skeptics who once dismissed it, with no small whiff of macho market chauvinism, as a fluff stock – a women’s fad.

If Lululemon’s snap back from the $5 range a year ago proves anything, it’s that this corporate phenomenon, with a $2.5-billion-plus market capitalization and aiming for sales of between $570 million and $585 million this year, is for real. Indeed, it is poised to become the next great brand export from a country not known for its global brands – even if its shares are as overpriced as a hundred-dollar hoodie, leaving investors vulnerable to anything less than peak performance.

The company’s current media silence (it declined interview requests for this story, saying it planned to lay low for a few months) can perhaps be viewed as management’s tacit acknowledgement of that overvaluation. It wouldn’t be the first time the company was taken aback by its own popularity among investors. As it prepared for its IPO back in the summer of 2007, insiders intended to price the offering in the $10 to $12 range. But interest from the underwriters was such that the same shares were offered instead at $18 – and doubled in price over their first two weeks of trading.

Even then, the critics were vocal. “Wearing Lululemon is largely a fashion statement – one likely to become less so when everyone and her aunt wears it. My bet is that Lululemon either proves to be a flash in the pan, or else the company’s aggressive expansion plans will prove its undoing,” wrote columnist Sean Silcoff in the National Post. Such detractors scoffed at the projections of the more smitten analysts, that it would double the number of stores (then 59) in two years and triple earnings in three.

The naysayers held sway through the general market collapse of late 2008 and early 2009. Who was going to pay a premium for stretchy tops and pants when so many were worrying about losing their house?

A large enough number, it turned out. After a single-digit pullback in early 2009, comparable store sales grew 29% in the fourth quarter ended Jan. 31, 2010, compared to a year earlier. Results might have been better had the company been more aggressive with its factory orders: “Being in stock and in sizes two, four and six continues to be our biggest productivity expansion opportunity,” CEO Christine Day remarked in the conference call.

And those bullish projections from three years ago? Lululemon has pretty much met them. The chain added another four stores to its total of 124 in the first quarter, in Canada, the United States, Australia and Hong Kong. After generating net income of $58.3 million in 2009, its guidance calls for higher margins this year, with earnings per share upward of $1. Bullish as many analysts are, Lululemon’s earnings have topped the Street’s consensus for seven consecutive quarters.

Importantly, the company is moving toward bringing its U.S. stores to the same level of sales and productivity it sees in Canada, where the brand is ubiquitous after 12 years of grassroots brand-building. In the past few years, the major caveat to Lululemon’s stellar results has been the discrepancy between store performance in Canada and the U.S., where most of its expansion is slated to occur. The 44 stores in Canada (35% of the total) generated 60% of revenues last year.

However, the company is beginning to post better results at its U.S. stores with a new showroom strategy, where it opens a cozy retail space with a limited inventory and only part-time hours – the staff go into the community to teach yoga classes and participate in events – as a way to break into promising markets such as Malibu, Boca Raton and Fort Worth. With their lower sales and the extra investment in staff recruitment and training, the showrooms are at best a break-even proposition, but so far they’ve succeeded in driving brand awareness in new markets, which drives sales in subsequent store openings.

“For 2009, every store we opened had an incredibly strong opening because we deployed the showroom strategy against those markets, so we know this is a winning formula,” Day said in the conference call. “What we’ve learned about the guest is that how she discovers the brand creates an emotional attachment and loyalty, and what we’ve been able to do with the showrooms is recreate that special sense of discovery and attachment for every new guest.”

While it plans to open only 12 to 15 new stores this year, Lululemon aims for 25 new showrooms by June and another 20 by August. It launched an e-commerce channel in April 2009 that grew faster than expected and generated gross margins of 60% (compared to around 50% in stores); again, sales would have been brisker still if product had been available. Then, in August it rolled out a running line, all the while tinkering with its mall stores targeted at tween girls, known as Ivivva. CFO John Currie projects a possible 300 stores in North America, with Asian expansion likely into 2012.

Behind the near flawless execution of Lululemon’s business plan are some big-league attributes. It began with founder and chairman Chip Wilson’s sense of a market that even after 12 years defies explanation in an elevator pitch: clothing that is functional but also fashionable, designed for athletic use but often worn for other purposes, appealing to a New Age, anti-consumer aesthetic while occupying pricey real estate in shopping meccas, and all the while pushing a potpourri of empowering self-help messages. In its early years, Lululemon’s edge lay in the undeniably flattering effect its clothes had on women’s behinds, but clearly it has moved beyond that.

Staying true to that now instantly recognizable yet intangible brand required another of Wilson’s mantras: retail integration. Rather than sold in other stores, Lululemon merchandise is exclusive to its own outlets, only 13 of which are franchised (mostly in Australia).

Part of this came from Wilson’s trial and error with his previous creation, Westbeach, a maker and retailer of surf, skate and snowboard clothing. After a meteoric expansion into Europe and the U.S. in the 1980s and early 1990s, Westbeach became overextended and retrenched to a few retail locations in Canada, then sold out to Morrow Snowboards in 1997. Opened the year after he sold Westbeach and just up the hill from its flagship outlet in Vancouver’s Kitsilano neighbourhood, the first Lululemon store, alongside a yoga studio, was a calming refuge for Wilson after his wild ride as a globe-trotting stylemaker to the board culture. But once again his instincts for the zeitgeist were right on the money. He had by then also learned a thing or two about managing a global supply chain from Asian factories to North American storefronts. Part of the reason Lululemon experienced stock shortages this year is a just-in-time model that allows the company to carry scant inventory. It backfired when the recession caused buyers to underestimate sales.

But the most important thing Lululemon has got right so far is its seamless succession in both governance and ownership structures. It went from being owned and run by a second-time entrepreneur to a limited partnership that brought U.S. retail experience to the table – private equity funds Advent International and Highland Capital Partners acquired a 48% stake from Wilson in 2005 – and finally a public listing that has enabled the company to accelerate the pace of expansion.

The accumulation of expertise and financial wherewithal along the way has allowed Lululemon to shrug off things like the departure of CEO Robert Meers (the one-time Reebok International president was replaced by Day, a 20-year veteran of Starbucks and doubtless a better representative of the company’s core customer) and the seaweed scandal of 2007, when clothing touted for its supposedly skin-friendly properties was found to contain none of the marine ingredient.

People in the marketing community certainly believe the brand has what it takes to become a worldwide phenomenon. “I haven’t been in an airport in the last five years without seeing people wearing Lululemon,” says Kaileen Millard-Ruff, vice-president, retail at GfK Research Dynamics in Toronto. Getting the right staff who believe in the product is “the toughest part of retail,” says Millard-Ruff, a former national sales director of Hallmark Canada, and Lululemon has definitely cracked that nut, at least with its corporate-owned stores. It has also found a sweet spot in pricing: high enough that it feels like a luxury brand but within reach of most consumers.

Moreover, customers feel that the high price notwithstanding, they are getting good value, adds James Fraser, a partner with Hunter Straker Visual Brand Strategies in Toronto. Fraser often cites Lululemon’s attributes in his presentations, from its recruitment of real athletes and customers to test its products to its unobtrusive, wordless logo that is recognizable most for its placement on the back of the pants: “From 10 feet away this logo is just a white dot but people understand that that dot means quality.” It’s also aspirational; it subtly confers upon its wearer, like no women’s athletic brand before it, at least the desire to attain a state of holistic health and fitness.

There are two stories about Lululemon, though: a feel-good tale of growth in the real world, and a potentially scary one surrounding its stock. Lululemon has recently been trading at more than 30 times forward earnings, compared to around 22 times for the next comparable stock, fast-growing team sportswear maker Under Armour. That level of pricing doesn’t leave much room for a stumble.

The bloated valuation has attracted short sellers, though their arguments sound a lot like those voiced in Canada three years ago. “It looks like a fad to me – it’s yoga clothing!” hedge fund manager Whitney Tilson of T2 Partners wrote in a note in April.

What Lululemon still needs to do is maintain the pace of store openings and meet its company-wide sales averages in increasingly foreign territory. It also must fend off competition from behemoths Nike and Adidas, which have both recently introduced yoga lines. In fact, the greatest obstacle to the Canadian company’s becoming an internationally recognized brand on the level of BlackBerry or Four Seasons hotels is the threat of a takeover by one of these giants. Meeting with investors in New York earlier this month, Nike CEO Mark Parker let on Nike was on the lookout for high-growth brands to acquire. “Women’s [clothing] is definitely on our radar screen in terms of opportunity and potential,” he said. What’s stopping a takeover is likely the daunting stock price, and the continued tight control by Wilson and his partners.

Canadians can cheer on Lululemon for bringing home-grown design and market insight to the world, and learn from its strategy and staying power. Whether investors should buy into the story at today’s market value is another question.

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