Lululemon Athletica: The Athleisure Leader - [Business Breakdowns, EP.120]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. and we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. This is Zach Fuss, an investor at Irenic Capital. And today we're breaking down Lululemon Athletica. The Canadian company founded by Chip Wilson in 1998 has grown from a pop -up store in a yoga class to a $45 billion apparel business. Along the way, it pioneered the trend of athleisure and forever changed what women and men wear to work out in. To break down the business, I'm joined by John Zolidis, president and founder of Quo Vadis Capital. We explore the origins of Lululemon's direct consumer growth strategy, how it has remained relevant in an industry known for fleeting success, and how its business model compares to the apparel giants like Nike, Adidas, and Under Armour.

1:35Please enjoy this breakdown of Lululemon. All right, John, thank you for joining us to tell the story of Lululemon. And when we were talking about the business at a high level, there are a lot of things about Lulu that make it just beyond an apparel brand. And maybe just to start, if someone is not familiar with the business, what is it? How big is it? How does it make money? Lulu Lemon is a athletic apparel and now footwear brand and accessories brand that has a global reach. They're going to do close to $10 billion in revenues in the current year. And that's split through a couple of different channels.

2:13They operate their own stores. They have a direct -to -consumer business, which mostly goes over the internet. And then they also have a smaller wholesale channel. They sell men's apparel and women's apparel, but it's majority women's apparel. And it's majority North America with about 16%, 17 % of the business being outside the US. But with the outside North American business growing much faster than the North American business. $10 billion apparel business is not built overnight. How did they get from where they were 15, 20 years ago to where they are today. Growth does not seem to be slowing whatsoever, but just curious some of the chapters in their evolution.

2:51So it started in Canada as a yoga apparel specialist for women, and it expanded to more of an assortment business and then went public with the intention, I believe, to add men's, which originally was quite small. They continued to open up stores. You also simultaneously grew a internet business. And this business, Lululemon, grew up within the rise of internet and omnichannel retailing overall. But I think the key thing about Lululemon and what makes it most interesting is how they pursued a growth and branding strategy that's very different from what we've seen or what others have seen with the likes of Nike and Adidas.

3:34So if you think about Nike and Adidas, these are brands that utilize marquee athletes to create excitement and align them with the sports fan and excellence in sports performance. And Lululemon has never really done that. They've been a grassroots community -based branding mechanism that sought out local, not celebrities, but well -known people within the yoga or other sports businesses and enlisted these ambassadors, they call them, to help introduce their respective markets to the Lulu brand. And in this way, they grew stealthily and created a lot of excitement and attracted particularly the female customer before expanding more aggressively into men's and accessories.

4:30But that's been the secret of their success, in my opinion, is this combination of community grassroots approach from a branding standpoint, together with product innovation and solving for problems and creating very attractive, beautiful garments to use with a technical athletic approach that didn't really exist in the marketplace prior to Lululemon coming in and finding a way to help women feel fantastic while also giving them technically performing product. Because this is a company that you've been thinking about and evaluating since 2007. I'd love to hear just a little bit of your history studying the business and the tact you were taking and covering it in 15 years ago versus kind of the debates today around the investment case.

5:20So when this came public, it was a hot stock and business was incredibly strong. And so a hot stock plus incredibly strong business leads to pretty extreme valuation in most cases. But just to rewind a little bit, my history following this sector, which at this point, I would call this a specialty apparel retailer, extends back to about 1999. And a number of the companies that I followed initially in the specialty apparel sector were very streaky. So in some cases, they would do well for a period of time, but then collapsed spectacularly. And so when I looked at Lulu, my first thought was, how do we know that this company isn't like all of these previous other specialty retailers that have come before and ended up in tears?

6:06So as I was looking at it, those are the things that I'm guarding against. Because as an analyst, that's kind of the most embarrassing thing that you can do is get sucked into a growth story at a very high multiple and then get embarrassed when it falls apart. So I think my first approach was, can this company really be different from other companies in the space? What's so special about them? Do they have the operating structure? Do they have the management team? Are there other structural influences in the business? Why is this more sustainable than other previous examples of perhaps fashion companies?

6:39That's how I was looking at or framing at the time that have not been successful. And what's the most likely or probabilistic outcome relative to the valuation investors were paying for the stock? But at that time, this was a business trading, presumably at an incredibly aggressive multiple. You were able to frame an investment case with which you were comfortable with the estimates being below your expectations. What were some of the key questions you were considering at that time and how'd you go about addressing them? There were two things I was looking at. One was the shift from a Canadian business to a US business.

7:11Now, that's obviously changed in the ensuing years. But back when it originally came public, the majority of the business was in Canada and the majority of the growth was in the US. And the Canadian market and the US market have some very different dynamics from a retail standpoint. So most important of which is that the Canadian market has dramatically lower retail per capita, retail square footage per capita. So when you look at retail productivity and sales per square foot performance in Canada compared to the US, almost all concepts generate much higher sales productivity north of the border than they do south of the border.

7:44There are some other differences like the rents are higher, the Canadian consumer is a little bit different, the seasonality is a little bit different. But the most important thing is the difference in retail square footage per capita. And in a lot of cases, what we look for is, is there some reason why investors are misunderstanding the growth opportunity? And so I think if you take the business and you don't understand the difference between Canada and the US, and you look at the productivity in Canada, you think that, hey, this is going to be amazing in the US, but it's actually seeing a dilution in some of its metrics as it moves from this high productivity, high margin market to a lower productivity, lower margin market.

8:26And that dogged the stock, I think, for a little bit over several years. But simultaneously, you had this incredibly strong growth. So what we'd be looking for is to try to understand why is it generating such powerful same -store sales. And to do that, I visited stores a lot. I talked to the company. I looked at the customers. I visited trade shows. I tried to understand what's from a competitive standpoint? Are there new competitors coming into the market that are knocking off Lulu that are going to steal away the company's source of differentiation? Are they really going to be successful in all these new markets and try to wrap all that up in the context of a financial model, which tells us whether they're going to make or miss numbers?

9:06We can't really break down Lululemon, I don't think, without talking about its colorful founder, Chip Wilson. In many ways, he created an industry with athleisure, but he's definitely a divisive figure. He's said some things publicly, which have gotten the business in some hot water and probably has gotten himself in a fair amount of trouble as well. Walk us through Chip's founding story, the influence he had on the business over the past decades, or whatever timeline you think is most relevant to the story. We'll rewind to his first business, which he created prior to founding Lululemon, which was a company he called West Beach, which he started around 1980.

9:45And originally it was just men's shorts and expanded into a skate surf look, which he rightly was able to anticipate was going to grow quite large. And then after a period of time, pivoted into the snowboard area, which was much more attractive in terms of the length of the season, the average price point of the items that were involved, the size of the total market. This, he eventually sold off. He ran West Beach for about 18 years. His total compensation for it, after all the work he put into the taxes, paying off his partners, etc., left him with a small amount of cash, but certainly nothing exciting in terms of, let's go and retire on a desert island or what have you.

10:33And so in a yoga class, which he attended, he got the same sense that the yoga market might trend in the way that he had previously anticipated the skate, surf, and snowboard markets. And this together with his own personal frustration about finding athletic apparel that would be functional and attractive led him to think about how he could solve that problem specifically for women who are the majority participants in this new sport yoga. About that same time, he learned that there were these manufacturing machines developed in Japan that could create a flat seam, which is to say could combine two pieces of fabric without any pieces adding to the sides, which would create friction or would rub when you were wearing them, especially during athletic activities, such as running, triathlons, or in this case, yoga.

11:37And so he traveled to Japan and he spent nearly all of his money to purchase four of these machines for $40 ,000 each so that he could try to manufacture a yoga pant designed specifically for women using this new manufacturing technique. So I would say that this was actually his first innovation or the company's first innovation was trying to find a way to solve this problem. And he felt that he was also one of the few people that was trying to make technical athletic wear with a eye towards it also being attractive. And previous to this point, most athletic wear was worn by men and it was generally worn just to sweat in and throw into the washer dryer.

12:26And so the idea was that people generally wore their least attractive, oldest t -shirts, sweatshirts, old college, high school wear, what have you. The idea that athletic wear could be attractive, functional, and you might want to continue to wear it after you were done working out was pretty revolutionary. So that was really the birth of the athleisure, which at that point didn't really exist. And it coincided with the nascent yoga participation craze, which he saw or he thought would become something much, much bigger than it was. Of course, he was right. I don't know that he would claim that he had that visibility, but he certainly was able to notice that there was a trend and then find a way to capitalize on it.

13:14I'm going to ask you to speak to some of the statements he's made because they became a pretty big news story. And I'm unsure if they've made an impact on the business's performance itself. I don't think he intended to be as controversially as he ended up being. When he went out and spoke in the public, he didn't speak in a guarded, polished, managed, manicured way to a broad audience. He shot from the hip. He repeated whatever he was thinking. And so it was easy to take a lot of his comments out of context. If we want to get a little bit more specific, the most controversial comment, the one that's repeated the most frequently, was around a product call that happened in 2013, where the business had grown quite fast.

14:02It only had one supplier for its Luan fabric, which was a company called Eclat based off Taiwan. And based on the volumes they were trying to order and the needs that they had, some of the quality started to not meet their standards. This together with some customers buying perhaps smaller sizes, because they were trying to make Lululemon do something that Spanx at that time, which was also coming out, was known to do shapewear. Lululemon was not shapewear, but sometimes in cases, at least Chip alluded to this idea, that customers might want to wear this product for purposes other than just their athletic activities or looking good in the grocery store, if you will.

14:46And so he made the comment that when it's being worn for these purposes, which is not what it was intended for, it could become sheer and a see -through, and it was the customer's fault he intimidated for wearing this. Or he said, I think more accurately, customers' bodies weren't made for the product, something of that nature. So this was, of course, interpreted very negatively as if he was blaming his customer for his product's defects, which is something that you never want to do. And also that he was saying unfavorable things about women and women customers in general, which is obviously the polar opposite of the idea you want to get across for a brand such as Lululemon, which was probably 80 % women's product at that time.

15:30That was the biggest gaffe, if you will. And I know that he would have preferred to take that back. It did precipitate a lot of changes in the company that led to him eventually taking a lower profile role. But ultimately, I think he was really a visionary in terms of anticipating what people wanted, being relentless on innovation with product, and finding a way to create a brand that was using a strategy quite different from his competition. Since Chip has stepped down, there's definitely been a number of changes to management and presumably issues that have come of that. Can you highlight the transition?

16:13What ensued in those following years? And then where leadership of the company is today, in your view? The company went public in 2007. And at that time, I was already in the works to bring on Christine Day as CEO in 2008. She came from Starbucks, where she had a very good reputation for managing the expansion of many stores, which was one of Lululemon's strategies to grow. And the CFO at that time was a gentleman by the name of John Curry. So they ran the business together with Chip on the board until this 2013 event that I mentioned around the product recall. And this event was really the transformational moment in the business when it went from being a fast -growing but smaller, somewhat entrepreneurial business to a professionally run company.

17:05But that transition didn't happen overnight. The first thing that happened after 2013, after this product recall, is that Christine Day resigned from the board. She quit, I would call it, somewhat in a huff over what was happening. on over having to work with Chip and not getting the control that she wanted. And so she left. And then they brought in a gentleman by the name of Laurent Faudet -Vin, a French guy who came from Tom's, which was a footwear company. And I think that Laurent was in over his head. They were looking for somebody who could take this to the next level. I think they wanted to go outside the traditional management within retail and they found Laurent.

17:44But I think this was just a bit too much for him. Simultaneously, Advent, a private equity firm, came in and made a second investment in the business. Advent had been the original partner in 2005 when Chip sold about half of his ownership in the company that helped him get some outside advisors and ultimately led to the company going public. They exited in 2009 at an eight times profit. So this was actually unusual for them to come back in 2014. They bought half of Chip's remaining stake, which reduced him to about 15 % ownership in the business at that time. And they were, in my opinion, instrumental in finding the new professional management team, which is what we see with the company today.

18:29So in particular, they put Glenn Murphy, the former CEO of Gap on the board. And they found Stuart Hasselden, who was the former CFO of J .Crew, which had been a very successful company at that time. And then lastly, they brought on Calvin McDonald to replace Laurent Pau de Vont, who left after some issues internally at the company. Calvin came from Sephora. So now, this is really the first time, in my opinion, that now we've got a real professional, established management team that has a track record of history with a board structure, outside investors looking at the business correctly. And really, this set up the significant improvement in the business that we see continuing today.

19:10And so they successfully navigated what I'll call the see -through pants saga. They put in a management team to manage it to the expectations of a public company. And then presumably, after going after their core, you always worry about these fashion businesses. I think we've talked about Abercrombie & Fitch in the past being one of those where there's a ton of growth and all of a sudden, for whatever reason, the brand loses its panache and growth becomes more challenged. How are they able to continue to find new pockets of growth and areas of the market to expand into? So Abercrombie & Fitch is a perfect counterexample.

19:44But another one that I would talk about maybe listeners are less familiar with is Chico's, which was a hot growth women's apparel company for many years, which ultimately outgrew its potential store base and saw margins and sales collapse. In the case of Abercrombie & Fitch, It was riding something, what I would call the distressed, allegiant look and hyper -sexualized branding that was very successful for a long period of time. And what happens with these companies is that they kind of come public when things are going well. Investors assign a high multiple, but initially they're skeptical. And then after a few years of doing well, investors start to change their tune and they start to believe that the company is run by merchandising geniuses.

20:28the multiples expand, the store base continues to expand, and then competitors move in, they knock off the look, it becomes ubiquitous, the customer gets bored, the innovation doesn't really happen, and sales start to slow down, which normally is accompanied by inventories getting too high and thus sales slow, comps turn negative, margins collapse, everyone hates the company, stock gets destroyed. What's challenging about this is that this cycle can last 6, seven years. So it really takes a long time for it to be proven out whether something can be sustainable or not. I think what's different about Lulu is twofold.

21:10One, it's really a functional product. So it's less fashion than Abercrombie & Fitch or American Eagle or Aeropostale, which is bankrupt now, or Chico's Fast. And it's more about solving a need from a functional standpoint for the customer, which continues. And that is to look good and feel good while participating in athletic activities. And the second piece that I think's different or differentiates Lulu versus the other class of business that we just mentioned is that it really stands for something from a brand standpoint. If I think about Abercrombie or Aeropostale or Chico's, I think these are pure fashion brands and they may have stood for a particular lifestyle or a way of looking or way of feeling.

21:58But I think Lulu has a deeper brand value and message. And that is about self -empowerment. And I think the message of self -empowerment and community is a deeper, more resonating message and feeling that it conveys to its customers. And I think that's helped it to retain its allure together with innovation around the product. And then I guess a logical extension of that question is how you consider competition. So at the one end, you have these multinational, massive businesses like Nike, Adidas, to an extent Under Armour, although I know they've struggled. And then you've got a series of upstarts, which I'd call copycats, like Athleta, Biori on the men's side, Roan, Sweaty Betty on the women's side.

22:48I mean, people saw this opportunity and the growth. And despite that, Lululemon has sustained that 20, 30, 40 % top line. How is it that they're finding the ability to fend off the competition? Let's run through these different groups of competitors. So you have the established core athletic brands, which you mentioned already, Nike, Adidas, and Under Armour. And then there were a series of specialty apparel brands focused on women or women's yoga. And when I say specialty apparel, I mean companies that sell their own brand in a small store. And so you mentioned a few of those, Sweaty Betty. But there were also some like Lucy and Lorna Jane, which have disappeared or haven't really been able to take off.

23:36And then the third class of competitors would be wholesale brands that have a heritage in the women's performance athletic wear category like aloe yoga. And you mentioned Rhone for Men. That's one as well. And so each of these compete in a slightly different way and in a different channel and engage with the customer in a different way. If we go back to the first category, Nike, Audi, and Under Armour, the first thing to note about those brands is they're dominated by men's product. So I believe Nike, which again, also is dominated by footwear versus apparel, but certainly has a huge developed apparel business is about two thirds men's product versus Lulu, which is the mere opposite at two thirds women's product.

24:21And I also think that Adidas and Under Armour are very masculine in their branding and really about sports and achievement at a very high level, which I would contrast with the self -empowerment message and community message of Lululemon. That's not the reason why Lululemon is taking share from them, but they come to the market with a very different approach from a consumer standpoint. The other specialty apparel retailers that haven't done as well, for example, Lucy, Athleta, Lorna, Jane, Sweaty Betty, there, I think it's a question of merchandising. Are they being as successful, innovating, and bringing new styles to the customer, and then managing their inventory levels, promotions, and execution in the store versus Lulu?

25:14And then the third piece, the aloe or the wholesale brands that are selling through high -end department stores or in other specialty retail stores, those brands have grown. But I think Lulu, through its combination of community activations and store openings and community outreach, has really been able to capture the consumer in a much more significant and deeper way. And so I think you highlight an important facet of their business mix being woman -led versus male. How is that mix shift starting to evolve as they go after the male category? And how are they finding success in doing so? Well, I think they know that they need men to achieve their long -term goals.

25:58And they've stated outright that I believe that they're wanting to double men's and they're going to grow women's at a low double -digit rate. So the women's business is much bigger. As I mentioned, it's about two -thirds. and it's more mature, but they need men to round out their brand ambitions. And so they have a number of ways that they're doing that. One is by remodeling the stores or opening up new stores with a greater percentage of the store dedicated to men's product. Second is by introducing new men's items and innovating around the product franchises that they have with poor men. And then they'll also be pursuing their marketing strategy, which revolves around working with local fitness influencers and people who are really important within the community to get the message out that men's product is there.

26:49A very interesting stat that the company provided in its 2022 analyst day was the business's unaided awareness within different groups. And in 2022, according to the data that they had, Lululemon only had an 11 % unaided awareness with men in North America. I think that's really low. I think it must be higher than that. But this is data coming from an external source. And so even if it's double that, I still think it's pretty low. So there's a lot of opportunity for the company to increase awareness with men, expand its product assortment, open new stores, engage with men, and grow that business.

27:29Can you just give us a sense of how big that store footprint is and how quickly it's growing on a unit basis? Sure. They had 655 stores at the end of 2022. And the guidance for this year, the plan for this year is to open approximately 50 stores. And what that would mean is about 18 % to 20 % square footage growth. The new stores tend to be a bit larger than their legacy stores, many of which were quite small. So if they're successful in transitioning the mix towards men, I guess the other question I have is internationally, they successfully took what was a Canadian business and transferred it to the US.

28:07Then presumably they went after Europe and Asia. I know they've had success in Asia. What does the global opportunity look like for a business like this, given the cultural differences in the clothing that we wear? So the most interesting market to talk about is China. They do break out China versus rest of world, Canada and the United States. And I think in 2023 is going to be the first year where China is bigger than Canada. That said, it's still probably only going to be close to a billion dollars versus Canada in 2022 was $1 .1 billion. So maybe they will surpass Canada in 2023. Maybe it will take another year, but it's certainly growing much faster than Canada, which is a more mature market.

28:53And that also means it's much larger than all of the other international markets put together. That's the key place. The question is, can they continue to be successful growing in China? One thing I wondered when they originally went in is that I've seen other businesses go into China, and I think Nike had this issue, where there were fit problems, which is to say that the fit that's appropriate for the customer there isn't exactly the same fit that should be sold to the range of customers that live in the United States or North America. And it doesn't seem like Lula has had any problem whatsoever transitioning into that market from a fit standpoint, which is pretty impressive.