Thursday, January 3, 2013

How Long Can Lululemon Keep Growing?

In a recent article I spilt some cyber ink on the subject of how investors could better achieve their aims. The central thesis of the post was that investors need to focus on ascertaining what is the key qualitative or quantitative factor that will drive share price. Your ability to discern these factors are what will separate a good investor from a bad one. Now we all rely on certain favored metrics in order to try and price out stocks, but sometimes it is the level of confidence in the numbers that governs the investment decision. In the case of yoga gear manufacturer Lululemon (NASDAQ: LULU) I think it's useful to invoke some insights from legendary investor George Soros.

Flexibility and Reflexivity

For some background on Soros’s theory of reflexivity I would refer readers to this article. Soros primarily talked of how favorable price movements attract investment, which then creates the fundamentals which encourage more investment, and so on. Ultimately these positive feedback loops lead to an unsustainable bubble which collapses into negative feedback loops on the way down. Note that this means you can make money for a long time on the way up and usually a lot of money within a shorter time frame on the way down.

Now think about this in terms of supplanting ‘price’ with the ‘feel good factor’ (FGF) of buying Lululemon yoga gear. Yogis invest in the brand by buying the gear, it then acquires a FGF, this then encourages more interest in the FGF, which buyers are willing to pay increasingly more for. This goes on until one day someone walks into a yoga class with some super cool looking yoga gear from Adidas (NasdaqOTH: ADDYY) , Puma, or Nike (NYSE: NKE). All three of these companies are chasing this marketplace with their own gear. And I think we can safely say that these companies know how to make athletic gear. The rest is investing history. Consumers will then start to ponder with the premium attached to Lululemon’s products adequately recompenses them for the FGF. The decline sets in.

Don’t Underestimate the Power of the Brand

With that said I would urge some hesitation before getting too negative here. I’ve known more than a few women who eulogize over the brand and they are willing to pay a premium for the product. I also know that yoga is a fast growing activity whose attraction is only being magnified by trends in modern life. The Lululemon story undoubtedly has legs and the company sells the idea of its products being part of a lifestyle choice. This is savvy stuff when you are trying to get consumers to part with money to buy your relatively expensive products.

For a flavor of the company’s presentations I would suggest looking at the 2011 annual review video accessed on the investor relations site of their website. It refers to developing a culture of personal development and aiming for brighter futures, which elevate the world into greatness from mediocrity. Bemusingly, management claims

 “to see what problems and what elegant solutions we are going to have for people that they are not asking for and that they don’t even know that they want yet”  

and they claim the ability to

“look into the future and require no evidence for where we are going.. … we know what the future looks like, because we are going to be wearing it”

They make yoga gear.

It’s easy to lampoon this, but again, I would caution against it. Yoga is a social activity and Lululemon’s strategy of grassroots involvement ensures it keeps focus on what its clients want. It is tapping into the whole lifestyle aspect of its customers, so we shouldn’t be surprised by this kind of approach.

My point is not to criticize this, but rather argue that this means a significant amount of pressure is going to be placed on its management to get fashions right on an ongoing basis. And predicting the future is fraught with uncertainty. The company may feel it is on top of things right now, but any drop in popularity or its FGF and the forward PE of 32x is going to look very expensive.

What to do With Lululemon?

It certainly has growth prospects. E-commerce sales are expanding rapidly. It’s significantly under-penetrated globally and its clientèle doesn’t tend to be short of money. For an insight into the latter, consider a similar sort of healthy lifestyle play like Whole Foods Market (NASDAQ: WFM), which recently claimed that the 80/20 rule applies in its sales. In other words, 20% of its customers can make up 80% of its sales. This may be normal in, say, industrial companies, but it is astonishing for a grocery store.  I see Lululemon in a similar vein.

My suspicion is that it is not a stock that is going to work well in terms of evaluating on its metrics alone. I think the market will keep buying while it stays hot and the short side needs to beware of being aggressive here. It’s a stock whose dynamics are more governed by thinking about reflexivity.

For now Lululemon is hot, and if you put a gun to my head I’d rather be long than short. However, when you put the gun down I’d tell you I had no interest in a position or any idea with guessing what the future was going to look like. Although it is highly unlikely to involve me dressing in spandex and making the shape of a tree while a duet of Olivia Netwon-John and Leroy from Fame sings 'Physical' in the background.

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