TIVP033: Lululemon (LULU): Still the King of Athleisure? w/ Shawn O’Malley & Daniel Mahncke

28:49And now it could be further negatively affected by tariffs and the economic strife brought on by trade conflicts, where not only are you maybe having less cross-border trade, but maybe you have people protesting American brands, that kind of stuff. None of that's going to help Lululemon's international plans. And at the same time, Lululemon is expanding aggressively in countries in which awareness of its brand is relatively low. So it may not have as much success in these regions as it had in North America, where at least there may not be as big of a runway to grow internationally without spending a ton of money on marketing to get their reach to similar rates of market penetration as in North America, if that's even possible.

29:33So I have trouble believing it, but management claims that Lulu's brand awareness and its core market of the US and Canada is still only 40%. So if you think that's possible, that does imply that there's still considerable room for growth, even just in the US, as they get more and more people familiar with the brand. So I would love to know the threshold they use for how they define that brand awareness. Because to me, I feel like everyone I know, of course, knows Lululemon, but maybe I'm living in a bubble. I'm the worst, worst judge of it. But for whatever you tell me, this just couldn't be.

30:09I mean, sometimes you read these statistics and feel like this just can't be true. Reminds me a bit of Peter Thiel's strategy for undermining your market power when you're a monopoly. Just expand the market size so far that your share looks small. And in this case, it might just be talking to investors and saying the U.S. target audience is actually not as saturated as you would think. This suggests that there's still a huge untapped market, which of course would be interesting for all possible investors. But I personally doubt anyone would give up their Harley Davidson leather jacket to put on a Lululemon sweater.

30:45But something else I wanted to ask you about, and we talked about this with Nike a bit, is their DTC strategy, DTC versus wholesale. How does Lululemon primarily sell its product? Is it mainly in their own retail stores, online? How do they rely on chains like, I don't know, Dick's Sporting Goods to sell much of their apparel to the end customer? It's a great question. And I can't emphasize enough how important it is to think about product distribution and retail. As you know, Daniel, it matters so much more than you might think for people who have not invested in retail before, but it really does matter.

31:25And unlike many of its competitors with large wholesale operations, Lululemon generates less than 10 % of its sales through third-party retailers, which are mostly these specialty yoga shops and similar kind of stores. So the company mainly sells its merchandise through these company-owned, full-price, physical stores and then also with e-commerce directly through their website. And you can contrast that with Nike, which wanted to go more DTC, but that ended up completely derailing the business. And now they're retreating back to selling wholesale to retailers. And in part, the difference is that Nike is more of a ubiquitous brand like a Coca-Cola that customers have been conditioned to expect to be able to purchase everywhere.

32:07You don't think that you have to go to a Nike store to buy Nike, Whereas Lulu has historically been seen as this very specialized and even aspirational lifestyle brand where if you want their products, you got to go directly to the source. It's so hard, you know, to go from being a mass market product to being a premium DTC product. It just it doesn't work. And Nike, unfortunately, has been one of those companies that has to learn that the hard way. They learned it the hard way. And it's a discussion for another day and people can go listen to our episode on Nike. but they're trying to turn that around.

32:42But if we look at Lulu, I mean, they've always been DTC focused and they have been building the brand status to be able to draw people specifically to their stores rather than, I don't want to say cheating, but relying on the Dick's Sporting Goods of the world to handle selling for them. It's a very tempting way to quickly grow sales at the long-term cost of the brand. And so this DTC model where they're selling directly from their own stores, that gives them so much more control over pricing, discounting their own expenses, product assortment and marketing. And these touch points people have with the brand, whereas Lulu's competitors, if they're selling wholesale through these diversified retailers, they lack the same level of control over the customer experience, which shapes their brand perception.

33:27And then also they, of course, just have to share some of their margins with retailers too, which makes the business less profitable. And as we've seen with Nike, to some extent, A wholesale strategy can put brands at a greater risk of losing control of customer perceptions over time. And I mentioned earlier the paradox of retail and how popular things go mainstream and they lose their luster. And then they have to rely on discounting as a brand kind of stagnates, fades away, or needs to be rejuvenated in some way. And the pressure to discount is even greater when you're competing for shelf space at a place like Foot Locker or Dick's.

34:00If they can't move your inventory, then they're not going to carry it. And that incentive structure is partly why I say that relying on wholesale can be at odds with having total brand control, especially in contrast with Lululemon, which can afford to be a bit more long term minded in their brand because they have such control over their distribution. And so not to say that in all cases, one is better than the other. Nike clearly had success with wholesale for a very, very long time. Junior had very impressive excess returns on capital. So it really just depends on the brand strategy and whether you're trying to be a premium brand or not.

34:33For more premium brands like Lulu, which does command a premium, literally, to Nike products, I think it's just much more important to control all your products' touchpoints with customers. Point being, competing brands may lose their status if their product is discounted or sold through struggling diversified retail stores. Totally. I agree on the advantages, but going DTC, just as we said, takes a lot of brand power and consumers need to be used to it. you just mentioned it, I believe part of what caused Nike's DTC failure is that consumers were conditioned over decades to get Nike at pretty much every retailer they can visit.

35:12And on the point of brand power and pull, what makes me a bit nervous about Lulu is this big question mark of whether they will lose a bit of social status, which seems inevitable eventually because of how competitive retail is and especially has become in the last probably decade or maybe two decades. So it's a question of whether that's already happening or is it two years out, five years out, or even more than a decade out, which would be probably a bull scenario in this case. But once that pricing power cracks, it could be really devastating for the business. For example, on Slack just the other day, you showed me that by just quickly Googling women's running shorts for sale.

35:52You found what looked to me basically to be the same product, just basic running shorts and yet at Nike they were on sale for like 18 bucks while the Lulu pair was listed at 78 bucks. I'm amazed that they have been able to command such a high premium for so long but again I just don't know how long that can sustain. If something else arises that is being seen as cooler or anything like that. So my question for you is how much of that price difference is just paying for a brand with more status and how much of it is due to Lulu actually being a functionally better product. There are some folks who really drink the Kool-Aid, as I say, about how great Lulu's product quality is.

36:41And don't get me wrong, it's very good. But if I'm being honest, I would think that maybe 90 % of that price differential is purely from brand status. And just anecdotally, I know I would pay a premium to wear the same shorts with a Lulu logo over a Nike logo. But it's a great point you raise about whether the differential has gotten too extreme. Maybe Lulu will always be a premium brand versus Nike. But if they have to lower prices to$15 to drive someone to buy Lulu shorts over Nike, which is selling for$20, then that's going to be a big problem for their profit margins and for returns going forward.

37:18And I should say, though, Lulu's fabric quality, this is not all fluff. I mean, this is not just a marketing gimmick. Its signature Luan fabric was developed two decades ago and was trademarked in 2005. And it consists of a greater amount of nylon microfibers than a traditional polyester brand, making it a much higher quality product. And Lulu has produced several other very impressive performance fabrics, some of which are also trademarked. And it's apparel really is designed to be bacteria and smell resistant, feel great, and also to be able to survive many washes. And again, I can attest to that.

37:54I mean, this is good quality stuff and there's something genuinely special about the quality. I should say, I don't think I've ever had any other clothes like my Lululemon clothes. There really is something differentiated about it, but correspondingly the material in its apparel is significantly more expensive than in traditional athletic shirts and pants. So those Lululemon shorts that we looked at were probably dramatically more expensive to produce than the equivalent Nike ones. And I think this higher price at Lulu, of course, partially accounts for the fact that there are higher input costs.

38:30The reality is that Lulu's competitors broadly sell apparel with cheaper materials at lower price points, but in a weaker economy, maybe that stuff is good enough. Maybe people are fine with Nike shorts instead of paying that extra price for some Lulu ones that might last five years instead of two years. So I would summarize my view as saying that I simultaneously think that Lulu's brand is durable enough to continue commanding pricing power. And also at the same time, the products are literally higher quality and on their own should command some sort of premium, even if the Lulu brand for some reason was seen as being less cool than it currently is.

39:12You know, I would hope that in a recession, people are okay with wearing Nike if it still puts food on the table instead of Lululemon. Now, I still got to feel like I got to try this stuff for myself. Maybe you can advise me on, you know, what piece of clothing I should get to try Lululemon. But my next question then is about their marketing strategy. It's not enough to have a better product. You also need to market it to customers. So how did they go about it? How are they communicating this superior quality to the world? Is it mostly word of mouth? Are they spending a lot of money on marketing?

39:45How are they doing it? They've pretty consistently shown that they can sell merchandise in high volumes, even though the company only spends about four to five percent of its sales on advertising. And for comparison, most of its competitors spend eight to 13 percent of their annual revenue on marketing, which is structurally why a brand like Lulu can be much more profitable. And in contrast to Nike and Adidas, Lululemon's online and TV advertising is pretty limited, clearly. So it's fair to say that they've relied much more heavily on word of mouth because their athletic sponsorships are a very small but modestly growing part of the advertising strategy.

40:26And instead, they've chosen to engage in much more personal forms of marketing, such as their seemingly ubiquitous reusable shopping bags, which I swear I see every time I leave the house, I see somebody carrying a Lululemon shopping bag or by even offering yoga and fitness classes directly within their stores, which brings people in. You come in for Sunday morning yoga and then you leave with$120 pair of yoga pants. So the classes are popular And I think they increase customer goodwill and encourage loyal customer visits to the store more frequently. And that's just a win-win for people to feel like they truly are a part of a community when they wear your brand.

41:09It's not just something with a logo, but it's the place I do yoga at every week. And somewhat famously, they have focused more on sponsoring local yoga and fitness instructors who they call ambassadors that then go about promoting the brand. That's been part of the word of mouth strategy. They embrace this influencer model pretty early on. And these are mostly smaller scale influencers. So they're not paying Kim Kardashian for a promo like Nike's doing. And our colleague Kyle, in a past life working in the fitness industry, he was actually an ambassador for Lulu. And so the idea here is being if you see your instructor at the gym wearing Lulu, you might be even more likely to admire the product and buy it than if some celebrity endorses it.

41:51because obviously the connection is even more personal and it's not the deepest moat I've ever seen, but I do believe the firm has local connections to its customer base that aren't just promotional gimmicks and they're actually legitimate and give them some loyalty that other apparel retailers simply do not have. And that's why they're able to pull so many people directly to their stores to drive sales. And as such, I tend to view its physical stores as a strength for the brand and necessary for the brand, as opposed to being weak points that generate a lot of costs, which is usually what we would say for a brand that has a lot of DTC physical locations.

42:31It's kind of a point of fragility and vulnerability for the company. I would be interesting in seeing how this develops over time, because as long as you're a niche brand, I think this form of marketing is pretty much the best thing that you can do. But when you also go and try to sell sneakers to people, right? And just go out of your way and expand your business, you just have to speak to different people. I mean, if you look at the story or the history of Nike, they at some point was a niche and they went to track fields, sponsoring people there, giving away their shoes, kind of like that. And over time, the spectrum of customers just widens so much that you have to advertise just wherever you are.

43:08And perhaps that's how Lululemon will do it at some point, but probably that's bullish because it would mean that the brand is getting significantly larger than it is today. But you just mentioned modes. So let's talk about modes. What mode does Lululemon have? If any, how wide are they beyond just the marketing you just mentioned? It's hard to say that Lululemon has any modes in the classic sense beyond just the intangible value of its brand. And I don't think they, for example, have a low cost of production advantage, nor does it even really have a ton of sway over their suppliers. Products are sourced from about 52 manufacturers and 67 fabric suppliers, nearly all of which are in Asia and susceptible to tariffs.

43:52And they also supply competitors as well. They don't have exclusive production relationships with these companies. So Lulu is probably an important customer for them. But I would guess that Nike has much more leverage in being able to push suppliers to absorb costs from tariffs because Nike is a much bigger part of their business. And the thesis here, though, doesn't require Lulu to have extremely deep moats beyond just their brand. I mean, brand strength plus continued operational excellence. I think that's all that's really needed here to drive great returns from what is a really, really low valuation for a company of Lululemon's quality.

44:30And so the stock has recently lingered in this$230 to$250 $50 range, where its decline on the year is 30 % to 40%. And management is now lowering its full year earnings per share outlook by about 2.5%. And that hasn't helped. But also, you're revising down expectations, which then makes it easier to beat expectations down the road. And so, the market has not digested what I would say is this modest cut to the outlook very well. And I think this has brought the bears out of the woodwork who love to express their longer term fear that Lulu is something of a fad and its popularity will fade with time, like the American Eagles or the Abercrombie and Fitches of the world.

45:12And creating this dreaded flywheel of retail brand destruction that leads to flat or declining sales, excess inventory and price cuts that ultimately destroy margins. And that's how many people see the end state, the terminal value being for most retail brands. And there is certainly more examples of that happening than not. But I do think that to some extent, this ignores that Lululemon's products are genuinely better quality and more functional than most others in the market. So it's less a stylistic fad and more the highest quality producer and athleisure. I mean, Lululemon has been, every time I've gone to the gym for the last decade, Lululemon has been an enduring part of the apparel that I see.

45:56So it's hard for me to call it a fad. A lot of these fears started to emerge for the stock in 2024. And that's when it really began to plummet due really to the worry that its business in North America at about 70 % of sales at the time was going to be adversely affected by rising competition. And then these possible changes in consumer tastes where maybe people are moving away from athleisure or they're moving to more niche athleisure brands. Brands like Aloe have unequivocally put pressure on their sales. There's just no doubt about that. Before 2024, I had never heard of Aloe. And now I actually own some Aloe stuff myself and I feel like I see it everywhere.

46:35So it has emerged as almost the new Lulu in some ways. And that gives me pause. It does sound though, rather than being a story of Lulu's brand collapsing, this is more about the stock being priced for perfection previously. While the underlying business is actually from a high level held firm, Mr. Market's narrative has shifted and the stock has swung from being clearly overvalued in hindsight to now trading. It was almost a distressed level, I would say for a company of Luluz quality at least. Yet there has been this huge pendulum swing, the stock's PE ratio, and it seems all the more crazy when you realize the earnings per share have grown by more than 20 % since the stock first began hitting air pockets.

47:22It's not like the fundamentals have totally fallen apart. So there's a pretty good case to be made that sentiment has gone from one extreme to the other over the last 18 months. I agree with you, Daniel. And something that gets me bullish on the underlying business is the fact that Lululemon has arguably one of the most loyal customer bases in all of retail, with its percentage of repeat customers being 13 percentage points higher than peers like Aloe after eight quarters. And within a year of first buying a LULU product, 44.7 % of those customers will return and buy another versus an average of 32.6 % for the broader industry here, which includes companies like Athleta, Viore, Abercrombie, Old Navy, Hollister, Banana Republic, Urban Outfitters, and a handful more.

48:13And 10 quarters from an initial purchase, almost 60 % of shoppers returned to Lulu to buy more. So again, that really epitomizes why I say this brand truly resonates better with people and people genuinely find it to be more high quality. And that's why they're willing to come back and continue to pay a high price for new stuff after having owned it for a year, two, three years previously. These numbers sound incredibly promising, but to play some more devil's advocate here, and I think that's kind of what I'm here for, are these numbers kind of looking like the numbers of a brand that is at somewhat the pinnacle or maybe the highest point of demand?

48:56If you want to say that, you could perhaps also call it a hype. If I look at the second and the third place on this list, and actually fourth is Abercrombie, which you just mentioned two minutes ago. They also have fantastic repeat purchase numbers. They have a very similar profile. They are very young, athleisure-focused companies. The brands that have been successful over many, many decades, Nike, Adidas, and H &M, naturally have lower scores here, but they are on these lists for the longest time. But again, I might also think like this because I haven't experienced the superior product of Lulu.

49:31perhaps this case is very easy and they are just better. Another bullish argument is that right now isn't the first time that the markets have lost faith in Lulu. Only for the stock to pull off an even greater comeback later on. It happened at least twice before if I'm not mistaken. In 2013 something like one-fifth of Lulu's pants had to be recalled for being too see-through. That sent the stock down 50 % from peak to throth and ultimately led to the CEO and founder stepping down. But after admitting the mistake, swapping management and of course fixing the problems, growth resumed within a year and trust was reestablished with its core customers.

50:14And then again, in 2017, Lulu reported a small decline in same store sales because its core assortment of products had gone a bit stale and it just wasn't resonating well with much of the target audience. The stock dropped 35 % from its peak and Lulu just continued to focus on investing significantly into new innovative styles. And it also began pushing hard into men's products, which is also part of the strategy now. And by late 2017, early 2018, growth had surged again and the stock has obviously kept chugging along. So just with that track record, it's hard not to be impressed by Lululemon's resilience.

50:58And wonder if this is not also just a passing market freak out or something more chronic. What really powered the stock higher was in 2019 when CEO Calvin McDonald unveiled what they called the power of three growth plan. And that aimed to double men's, double digital, and quadruple international revenues over five years. And as McDonald proudly pointed out, the company hit all of those targets early. So just four years later. And then that's why they released this revised power of three times two strategy that I alluded to earlier. And this time it looks like Lou's going to fall a little short.

51:36So they kind of shot themselves in the foot, but I respect the ambition. If you zoom out, that is that's pretty good stuff. And so they set expectations really, really high. And when they delivered, the market fell in love with the stock and push it up to 50, 60 times earnings. And that has, I think, contributed to this really harsh overreaction, in my opinion, given the outlook that they've now delivered being a little bit more conservative. I like ambitious management, but just from a market perspective, it's probably not smart to set guidance so high, or at least expectations that at some point you just have to disappoint them, right?

52:15And if I'm not wrong, McDonald actually came from Sephora, right? A company that we know because of your LVMH deep dive. He did. And he said though, that running Lulu is his dream job because fitness and health are passions of his. So I don't know, maybe that's true, but it is interesting to have a man at the helm of a female led brand and beyond his qualifications for the job. I do think, especially given the timing of when he joined, it does reflect that the board really is looking for someone to turn Lulu into as much of a menswear brand as it is a women's wear one. And in one interview, McDonald did say, our men's business is 25 % of our sales in the US and awareness is in the mid 30 % range.

52:59As the brand grows, as the assortment grows, we're growing away from a yoga brand for her. So in the US, the opportunity is to continue to drive awareness as a brand for him. And so I'm trying to think of when I first got Lululemon, probably 2021, 2022. So I fell exactly into their strategy around that time of appealing to more men. And from what I can tell, that has largely meant a push into footwear, where I feel much less confident in any advantages that Lulu may or may not have. But it's created a new opportunity in resonating with women too. And looking at footwear for men, they discovered that women's athletic shoe designs are historically based on a man's foot.

53:44And so as McDonald put it, other shoemakers assume that the feet are the same. And because we're obsessed with science and feel, we know that the feet are not the same. There are significant differences between the width and forefront of the foot, heel, pitch, and angle, and the narrowness of the back heel. And because of that, we delayed the launch of men's so that we could launch and be the first lineup of women's performance footwear designed on her foot. Wow. I didn't know that. I would be kind of surprised if all of these bigger brands like Nike, who, you know, create shoes for the best athletes in the world, have not yet figured out that they should create women shoes differently.

54:26But you never know. I won't hold my breath waiting for Lulu to displace Nike or Adidas in footwear. but I appreciate the ambition, right? All in all, I think it's a pretty interesting thesis that you're outlining here. I might sound a bit more skeptical at times than I actually am. I just want to make sure that this isn't too good to be true, that we're not missing any alarm bells that better explain why the market has soured so dramatically on Lulu because if you just look at the numbers, they're insane and they're almost too good to be true. It's so important to not just take narratives at face value, which is the one thing we try not to do on this show.

55:04So I appreciate you mentioning that. And it would be really, really easy, but also lazy to just think, oh, I'm sure Lulu is this really well-run company that will continue to do well for reasons I don't totally understand because it's such a popular brand and the results have been great historically and we're just going to draw a straight line and extrapolate for it. And that's just not what we want to do. We need to actually dig in a bit behind the scenes and see what the numbers are like truly to best understand reality. Otherwise, it's so tempting to get mesmerized by gut feelings and these stories from charismatic management teams or borrowing conviction from other people, which can be dangerous.

55:44So as I was looking to understand the picture of the business over the last few years, one of the things that I looked at, which is especially important to do for a retailer, is their cash to sales ratio. And basically, as the business has grown, you're wondering, is the company generating and keeping more or less cash on hand as a percentage of their total sales? And cash is, of course, the lifeblood of the business. That's what they teach you in any finance 101 class. So if a company is growing unsustainably or unprofitably, one thing you might see is its cash as a percentage of sales falling significantly over time.

56:18And that is actually what we've seen with Lulu. Their cash to sales ratio has declined from a peak of 37 % in 2017 to just over 12 % today. That is a massive swing. And other than this one-year blip in 2023, it's basically been a straight line down over the last eight years, which you can see we're showing the chart on screen right now if you're watching this on Spotify or YouTube. And like I said, it's a straight line down after having previously risen very consistently for a long period of time. So that's the kind of thing you see when you're trying to validate your assumptions about a company that does give you some pause.

56:54And it's not necessarily damning, but when I see that, I definitely want to make sure I understand why that is happening and has happened before I go any further. But this doesn't have to be an entirely bad thing, right? It could also mean that they've ramped up their share repurchases or investments in the business over that time. And actually, if you map it out, it does sort of look like there's an inverse correlation between increases in the buyback yield, so the amount of share repurchases they are doing and the amount of cash they have relative to sale. It's another question as to whether those share repurchases are being done in a way that enhances intrinsic value by making the buybacks at reasonable prices below fair value.

57:39But yeah, it could just show that as the company has matured, they're returning more capital to shareholders and were maybe overcapitalized in the past. You're a great example of the importance of second and third order thinking, Daniel, because yeah, I mean, none of these things, there's a story behind every number. And that's a great illustration of not just taking the numbers for what they are, but again, actually trying to understand what the numbers mean and what's going on. And like you said, it's not objectively a bad thing. There's definitely truth to the fact that some of the decline in cash is coming from a bigger buyback program, but that's also not the entire picture.

58:18It doesn't explain everything. And so I also dug into their inventory and cash conversion cycle to get more context. And as Lulu's cash to sales ratio has declined considerably, the company's cash conversion cycle has increased by roughly a third since 2019, which is a bad thing. And then it was about 82 days. And now over the last 12 months, the cash conversion cycle is closer to 109 days. And for anyone who doesn't know what the cash conversion cycle basically measures is from when you first purchased your inventory. So maybe a new shipment of likings for Lulu. How long does it take for that inventory to then get sold on average?

58:58And on top of that, since most of these purchases are usually made on credit with credit cards, how long does it take for the cash from those transactions to end up in the company's bank account. And so you don't need to have an MBA from Warden to see this chart that we're showing on screen right now and think, okay, well, that's not very good. If it's taking the company 33 % longer to get paid, that is probably contributing to the decrease in cash on hand as a percentage of sales. Again, you're going to want to understand why, because that's at a minimum hurting their cashflow, but it could also show that they're not handling inventory as efficiently.

59:33Maybe they're stocking up on stuff too quickly, or maybe as they've expanded to offer more products beyond their original yoga pants, that is tying up capital and inventory for longer periods of time, which can be capital inefficient and just have a real impact on the company's operating results over time. It's sort of a canary in the coal mine, as you might say. One of the risks of this being when you're keeping more cash tied up in larger inventories, if a product flops or the company misses the mark on this season's styles, Now you're stuck with these units that you cannot sell and you're taking up space on the shelves.

1:00:11And you face the dilemma of either having to discount those products to liquidate them, which helps in the short term, but it undermines the quality of your brand long term. If customers learn that they can just wait and get your product at a lower price eventually. Apple, for example, famously almost never has sales because that would just dilute the brand's perception. Typically, high quality premium brands don't have to discount. So when you suddenly start discounting a bunch, that's why I say it can slowly shift how the brand is perceived over time and destroy some pricing power over the long term.

1:00:47That's really what we are talking about here when we mention the costs and the risks of having too much inventory. And it has been a characteristic of many foreign angels we covered on this show recently, like Estee Lauder, but also Nike that had a similar problem. And it's probably the biggest, at least yellow flag that has hung over the stock. It doesn't sound like much, but over the last five years, the size of Lulu's inventories have compounded at a growth rate that is 1 % more a year on average than sales. So that does add up to be a fairly significant amount over time, with the point being that total inventories have risen faster than sales.

1:01:29And that is a yellow flag based on everything you just said, Daniel. And the other thing weighing on Lulu on the actual cash collection and payout side of the cash conversion cycle equation is that they tend to have arrangements with suppliers where Lulu pays them in cash after 30 or 45 days. whereas the Nikes and the Adidas of the world typically don't pay out suppliers until 60 or 90 days. And that extra time holding onto cash before paying it out comes directly at supplier's expense and finances those businesses. So the TLDR is that as a business, you generally want to collect cash as quickly as possible from your customers and pay out your cash to suppliers at as long of a delay as possible because you get to hold that cash, use it, or just earn interest on it in the meantime.

1:02:19It sounds like Lulu has expanded into new product areas, new stores that are probably marginally less successful than previous ones. They've just generally taken on more inventory. And then at the same time, between COVID era supply chain disruptions and disruptions related to the war in Ukraine, I'm sure that has all only complicated their efforts where maybe you're being a bit more aggressive in ordering inventory when you can because you don't know when the next crisis will come and make fried or production costs just much higher. For example, we saw imports at retailers in the US surge in the first quarter of this year as companies raced to stock up on supplies before tariffs actually went into effect.

1:03:02And that, of course, is going to contribute to higher inventories and also worse cash conversion. That doesn't explain the entire picture over the last five years, but we have had an abnormal amount of these major disruptions since 2020 that are very different from anything that we've seen in the years leading up to 2020, honestly, which is just to say, to be fair, comparing the cash conversion cycle for Lulu in 2025 versus say 2018 is not an apples to apples comparison for a few reasons. And then on top of that, Lulu doesn't have favorable payment terms with its suppliers. so I did just want to quickly ask you about why you think that is.

1:03:42I check it up to a few reasons and we talked about this briefly earlier but Lulu's suppliers have a good bit of supplier power from a Porter's Five Forces perspective to get a little academic for a moment and Nike ships probably an order of magnitude more products than Lulu's unit volume and the same for Adidas to a lesser extent. That scale lets some meaningful market share loss if vendors refuse to go along with the extended terms that these huge companies demand. And this was a big part of the story for anybody who listened to our AutoZone episode, which is another company that has a lot of buyer power over suppliers.

1:04:16And that has enabled them to have negative working capital, which has been pretty material for their free cash flows and share buyback strategy. So Lulu's smaller order book gives suppliers more leverage to insist on quicker payment, especially because they use these very niche technical fabrics. And that brings us to the point that Lulu doesn't have any patents around for its fabrics. And they have trademarks, but a trademark isn't quite the same protection as a patent. And so in theory, anyone else could produce the same fabric as Lulu. And so I actually think that increases supplier power as well.

1:04:54It's pretty subtle stuff, but nothing happens in a vacuum. And given the prices Lulu can charge and the high margins they have as a result. I think management has historically viewed missing out on a few hundred million dollars in faster payables as an acceptable cost for having a secure, high quality supply chain. I think that all makes a whole lot of sense. And the only other thing we have mentioned yet was Lulu's botched acquisition of a company called Mirror. They've basically written off that acquisition entirely at this point. That consumed a good bit of cash and also left a whole lot of wasted inventory to be disposed of.

1:05:32That definitely didn't help the trends in cash conversion and cash on hand that we've been discussing just recently. Maybe you can just tell the audience more about this acquisition or what should have been a successful acquisition. It was not an inspiring move. And it's the company's only ever external investment that I'm aware of. And it came in mid-2020 when Lulu bought Mirror for$450 million, as you said. And it just proved to be a huge mistake. During the pandemic, there was all this excitement about socially connected fitness and being able to bond with people digitally all over the world while working out.

1:06:06There's this kumbaya feeling. And that was just one of the big visions that made a lot of sense when we were all stuck at home and we were thinking about the world very differently. And the idea was that Lulu supplied the clothes and really the fitness lifestyle, the image that people wanted to project themselves to the world and embrace. While mirror was sort of like Peloton. It was a way to do classes from home where you could have, in theory, this virtuous cycle where people paid high margin monthly subscription fees for workout classes at home, which made working out more convenient and enabled them to do more of it, which then drove them to need more exercise apparel that they would then go buy from Lululemon.

1:06:47And I don't think it was a bad idea at all. I mean, it's so easy to be critical of things in hindsight, but I get what they were trying to do. I see why it made sense during the pandemic. And I just think if you have, as a clothing brand, a legitimate chance to capitalize on a potential SaaS business model, I don't blame them for taking it. It was a cost of mistake. It was well beyond their circle of competency, but they rolled the dice and it didn't work. That happens. So it really is what it sounds like, though. These mirrors are these big smart TV mirrors that you might install in your home, and they guide you through classes.

1:07:23And the reality is that we found out nobody wants to buy these, especially in a post-pandemic world. And Peloton has had enough trouble selling their bikes, which are actually functional products, right? It's a bike. Whereas a mirror like this, I mean, it could really just be replaced by a computer or an iPad propped on a chair or an even actual smart TV. I know my mom, she airplays her workout classes from YouTube on her phone onto the TV. And so there's this question of, do I actually need a devoted, smart mirror to guide me? And so again, it kind of feels more like an idealistic gimmick in hindsight.

1:08:03And as a result, Lulu has rebranded these offerings as their Lululemon studio, as they call it. And they're focusing more on the app and accessing workout content through there, as opposed to selling the hardware, which they don't sell anymore. So I think that's for the best. It reminds me a bit of the Roku model, and we saw there just how much unprofitable tech hardware sales can weigh on a business, even though the rest of the business might be great. And without having looked much at the function of these black mirrors, it doesn't strike me as a huge value add, even if you're doing home workouts.

1:08:40Exactly. And so now Lulu has moved away from hardware entirely and is just doing the bare minimum to honor the mirror purchases and subscriptions that its customers had bought by entering this five-year strategic partnership with Peloton. And now they have something of a co-branded product together. And it has not been a smooth transition by any means. As a 2023 Forbes article put it, quote, the shift in the workout vibe from a fitness club atmosphere to a dance club ambiance has not resonated well with the mirror community. Complaints about trainers singing along to music and particularly about excessive foul language highlight the disconnect between the expectations of mirror users and the Peloton content.

1:09:25So you're merging these co-branded products together and you're merging these brands and they're realizing the people who go to Lululemon are not exactly the same people who want to have a Peloton. There are some differences in the workout experiences that those people expect. And one of the big differentiators with Mirror before was the ability to join a class live and actually receive call outs from your instructor who could see you and see what you were doing through a camera on the Mirror device. And that was kind of the value add. And when you move to these pre-taped Peloton classes or classes where you're adjoining to watch but can't be seen, then there's this question of, hey, why am I paying for this and not just watching a workout class on YouTube for free?

1:10:07And I tried to sign up through Lulu, but everything is just truly being directed to the Peloton app. So instead of a partnership where Lulu is trying to build any kind of enduring SaaS business, it looks like they're really just offloading the accounts for everyone who had bought a mirror to Peloton. And after five years, I bet they'll step away entirely. But that's just my guess. So it's too far outside of their core focus on apparel. And unfortunately, it's done more harm than good. Given how the mirror experience has worked out for them, I suspect we won't see any more big acquisitions coming out of Lulu for some time.

1:10:42But on that note, how about we kind of bring it all together, as we always try to do by talking about devaluation. We've both hinted at how we think just from a PE perspective, Lulu seems very cheap. But as you try to think about the company's intrinsic value and attractive price to buy these shares at, I'm curious where exactly you landed with it. So where I started was by first segmenting out the North American business from China and then looking at their sales across the rest of the globe just to see what kind of growth rates we're working with here. And I was presently surprised to say it over the last five years, despite being Lulu's most mature market, sales in North America have grown by 14 % a year on average.

1:11:27While the average growth rate in China has been closer to 45 % and 35 % for the rest of the world, which are great numbers. So when I look at my base case where I have Lulu sales growing at just 4 % a year in the Americas and 18 % a year internationally, I don't feel like I'm being overly aggressive. If anything, it's maybe a little conservative on the international front. And then I looked at the trends and their operating margins, which have gone up as the business has scaled. But I also try to account for the reality that tariffs at a minimum will limit any further margin expansion for the time being.

1:11:59And more realistically, we'll probably eat into their margins a bit, or at least if we want to be conservative, we need to account for that. So yeah, I have their operating margins averaging about 21.8 % over the next five years, which is exactly in line with their average margins over the last five years, but down two percentage points from 2024. Presumably, at least to me, I expect that would come from these tariffs or maybe higher marketing costs to fend off competition or a combination of those two factors. And I have to say for Lulu to have expanded margins through the pandemic and all the supply chain disruptions that came with it, it makes me feel a lot better about their ability to handle this tariff pressure.

1:12:40And when I do all of that in my model, and I also account for Lulu's share count continuing to decline as they keep pretty aggressively buying back shares as they've done for several years now, you can get a pretty decent approximation of what their earnings per share can look like in 2029. And then from there, it's just a question of thinking about what a fair exit multiple would be and really what PE will the market be willing to pay for this company down the road. And of course, we can't know that. But assuming Lulu comes out on the other side of this rough patch intact and maybe tariffs fall off at some point or just things don't go as badly as the market currently fears, this stock, even as the company matures, should be trading at much more than 15 times earnings, in my opinion.

1:13:25So this is one of those rare cases where I don't mind betting on the PE multiple appreciating as part of my base case expected return projections. And I suspect as sentiment normalizes and Lulu keeps executing on its playbook, the PE could easily rise from what is one of the most depressed levels it's ever been at to something much more reasonable, like 20 times earnings. That's what we call mean reversion. And this is, I think, a pretty fair expectation when you consider that the S &P 500's average PE is around 20, but Lulu is an above average company in terms of growth and profitability. So it should at least be in line with the market average.

1:14:04So with all of those assumptions, I get a present fair value for Lulu of about$300 per share with a target buy price of approximately$240 per share, which would give us a 20 % margin of safety from that fair value estimate. And well, that is about exactly where the stock has been trading at, at the time of recording, actually a little below that. So to jump to the punchline, I would be keen to add Lululemon to the portfolio at current prices, but I'm getting a little bit ahead of myself. From current prices, I do think a 13 % or higher expected annual return is plausible, though it's just back in the napkin math, really.

1:14:41So it's not a guarantee at all of what will actually happen over the next five years. I don't think there's anything I would have to jump in and say that's too optimistic. Of course, the investment case relies on international expansion. But looking at the actual growth rates versus what you assume, this feels like there is already a margin of safety in those assumptions. And if it achieves this growth and margin profile, the stock is certainly too cheap to trade at 15 times earnings. Having said that, before we commit to a decision, how about we linger on the bear case a little longer and just think more about the risks we would be taking on if we invest?

1:15:19Thank you for reining in my optimism. Yeah, when I tried to imagine the bear case for Lulu, I looked at some case studies on other brands that had some sort of premium positioning and or functional superiority where the brand then lost its status to see how that would ripple across sales trends, gross margins and operating margins in the hopes that would give me a better idea of what it might look like if in the coming years, Lulu's saturation of the US market leads to them losing market share and pricing power. And maybe you have some other suggestions in mind to look at, but I looked at Under Armour, Coach, Michael Kors, and Victoria's Secret for this little case study I did.

1:16:01And we don't have time to discuss each one and why I picked them for too long. But in short, these were all very popular brands that saw sentiment around them on social media peak, which you can actually measure with Google search trends. And that led them to do a bunch of things from offering more discounts and flash sales to lean more heavily on wholesale until these brands became pretty significantly diluted over time. And that is ultimately the concern with Lulu, right? That is what is keeping the bulls up at night is this notion that the brand will take a significant hit and then the business's flywheel will start to slow or spin in reverse, that we're at a peak.

1:16:38And what I found was that in these other examples from peak to trough, gross margins contracted by about five or six percentage points on average, typically. So that was what I went with in a worst case scenario for Lulu. And of course, that ripples down to affect their other profitability metrics. And the warning signs you'd look for would be something like their inventory turnover ratio declining, which is how long it takes them to clear out their inventory. And actually, like I said, that ratio has been declining for a few years now. They used to cycle through inventory more than four times a year, and now it's less than three, but that has stabilized in the last three years.

1:17:14So it doesn't appear that inventory bloat has continued to worsen. And as we know, this hasn't actually resulted in worse gross margins for them. Lulu's gross margins have actually risen in recent years during this time. And we talked about this earlier with the cash conversion cycle too. So it's not a huge surprise and we have some plausible explanations for why this has happened. So my conclusion is that at least among the examples I looked at, Lulu does not have a perfect comp, mainly because they are uniquely D2C driven. A lot of these brands seem to really fall apart on the wholesale side.

1:17:50And Lulu has been able to control its destiny in a way that many others haven't been. And I came away still fearful of what a worst case scenario could look like, but I don't think it's quite as ugly as what has happened to Under Armour, for example. And so that impacts just how pessimistic I'm willing to be in mapping out my bear case. The long story short of it being, I set a floor price of about$159 per share for Lulu's fair value looking out over the next five years. And that to me is what the stock would be worth today if margins fall off a cliff and sales in North America flatline, while growth internationally is much, much slower than what most analysts expect.

1:18:30And at around$230 per share, we actually aren't all that far from the stock being priced to already account for a significant possibility of that worst case scenario occurring. And there could realistically be 30 % more downside. But again, this is to me a low likelihood outcome where things would have to take a turn for the worst over the next five years. And I can deal with that kind of downside risk to own a great brand like Lulu that I think continues to have really compelling prospects ahead of it as my baseline scenario. And the caveat being that, of course, things could always be worse than I imagined, but still, this all actually makes me feel a bit better about how bad sentiment is around Lulu, since this is a company that is, after all, still growing very quickly and probably has pricing power to protect its margins, at least in response to tariffs.

1:19:23So when I think about everything that could go wrong compared to these peer companies, I don't think the worst case for Lulu is as bad for some of these other names that I mentioned. And at the same time, it's almost already priced there. At least if you look at the valuation and everything, it doesn't have the numbers to trade at 15 times PE. And I think that's basically almost the entire pitch here. But maybe we should also indulge into the bull case a bit more then. How good could things be if the brand outperforms expectations? I imagine that sales in North America continue to chug along at a mid to high single digit percentage, while international growth compounds at more than 20 % a year.

1:20:05Gross margins stay relatively flat at the high levels they've hit the last few years. And then operating margins also remain relatively resilient to tariffs in competition. That's my crazy bull case. And then since it's the bull scenario, I accounted for some further mean reversion and Lulu's PE multiple since we keep saying it's at the lowest multiple it's ever traded at. And I just don't think that would be likely to continue, especially not in a bull case, of course. Of course, if everything goes right, the multiple is going to jump a lot and be a tail end too. So I went in with an exit multiple of about 22 times earnings for my bull case model, which I think is still somewhat conservative when you consider that the company's average PE ratio since 2022 is 37 times earnings and 26 times earnings since the start of 2024 when that sentiment first started to sour.

1:20:55And so with all these assumptions and a conservatively optimistic bull scenario, I could easily envision a fair value for Lulu of about$390 per share, which would imply roughly 70 % upside. And so when I see more plausible upside potential than downside risk, and I already feel pretty good about the valuation relative to my base estimates combined with everything qualitatively we've already talked about on the show today, about how great the brand is and the loyalty. That's how I start to feel really comfortable about recommending it to be an addition to the portfolio at current prices. What sells me on Luna is devaluation.

1:21:34Of course, in combination with the excellent economics of the business that they have shown now for almost a decade. And we first look at the numbers offline when you started researching for your pitch and we looked at return on invested capital margins and all of that, we barely believed what we saw. When a company is consumer facing, it's always easier to get on board of the ideas when you've made a good experience with the brand yourself or you're a loyal customer for a long time as you are with Lululemon. That's why I think more highly of, for example, PayPal or Nike than you do. And perhaps you like Reddit or Lulu more than me, but there are companies where the investment case is just so strong that you just see this makes sense.

1:22:16So while I naturally can't have the same conviction in the product that you have, I'm excited when I see these numbers. And I guess the only question that is so outstanding here is how big do you want the position to be? I would probably be inclined to make it at least a 5 % portfolio weight. I don't think this is one where I think the valuation hedge is sufficient here. The margin of safety is wide enough that we don't need to tiptoe into a 2 % to 3 % position here, as we've done with some of the more speculative companies that we invested in that have since taken off, right? I think Reddit was a 2 % position and now it's almost 5 % because the stock has more than doubled since we first entered it.

1:23:02And with Lululemon, I mean, I think that there's real potential for upside here. And the downside seems to be capped in a way that I don't have any hesitations about making it what we might call a core position of at least 5%. We've talked about targeting 20 portfolio holdings total for the portfolio over time. And it's taken us six months to get to where we are. So I don't know if we're going to reach 20 anytime soon, but of course that implies on average a 5 % weighting. So I think Lulu fits, I think this is an opportunity where we can call it, it's an above average opportunity, but it's an average opportunity in our portfolio, which is in theory, a composition of all above average opportunities.

1:23:46So yeah, and we get a better price on it. I think we could make it a bigger position, but that's my two cents. I totally agree. I think what I also liked, and you mentioned that in your pitches, that we've already seen Lululemon drop in price and stock price significantly before, but it got not only back on its feet in terms of how the business performed, the stock also got back on its feet. So I think there's even a lot more potential than, I mean, in your bold case scenario, you have multiple expansions to 22 as a multiple, but we've seen 37 even after Lululemon dropped before. So I think there's a lot of potential there.

1:24:20And as you just pointed out, by now our smallest positions have been the best performers. And we just recently had a fund manager talk to our community and call. And he also said that most of the time people don't really have an idea of what positions will actually be the best performers. I would add to this that our smallest positions just have the most downside risk. So we technically know that the upside risk is probably higher than in some other positions, but we want to cap the downside. And I think Lululemon combines both. We have a pretty cap downside risk and still also pretty high upside potential.

1:24:53So because of that, I'm totally inclined to have a 5 % position at Little Lemon. And when the price drops, we could buy even more. Well, I think this is a testament to Daniel why you're a better investor than me, because you're more open-minded to owning companies that you don't tangibly relate to. For me, I have such a tangible element to like, if I haven't worn the products, I have trouble truly understanding why they're superior, of course, which makes sense. But I think you're very open-minded about companies and brands that are maybe not big in Germany. And maybe you're kind of more used to that on the other side of the pond.

1:25:30But I certainly admire that you are willing to take a risk on a company that I probably have, I won't say probably objectively have more conviction in than you do just as a long-time user. Let's hope it works out that I'm flexible here. Anything else we should add on Lulu, Daniel? Or should we look ahead to next week? I think it's time now to look ahead and give just some hints for the next episode. And honestly, we will stay in the retail business. I've chosen a company that has come up multiple times now in our comment sections whenever we discuss the hints for the next episode. As I said, it's also a retail brand.

1:26:08And I would say it's famous for mostly one specific product. And I was surprised to see how fast the company is growing, despite only being focused on really one major product. And it is still trading at very cheap multiples. And since you all guessed this company again and again anyway in the comments, I guess that's where I will stop with the hints and we will just see and find out in the next week. Should be a good one. Yeah, maybe we'll get another addition to the portfolio two weeks in a row. That would be fun. We've definitely had more rejections than additions. And I just want to say this one last caveat here.

1:26:44We always like to mention when we own a stock personally ahead of having pitched it on the show. So I'll just say I have owned Lulu for a period of time before I went and pitched Daniel on it. So yeah, I am a shareholder in Lulu. So with that, I will leave us with a quote to close out today's episode. As Starbucks's Howard Schultz has put it, if people believe they share values with a company, they will stay loyal to the brand. In my words here, Lulu has done a pretty incredible job building on their shared values with customers. And that has fostered a uniquely loyal culture that underpins our bullishness or at least my bullishness on the brand.

1:27:27So with that, we'll see you back again here next week.