The Great Retail Slaughter
One of the big investing themes of the last 6 months has been what I have dubbed “The Great Retail Slaughter.” Consumer/Retail stocks – especially the legacy mall retailers – have been destroyed in the market. A weak Holiday season was followed by an even weaker first quarter and a sense of impending doom has taken over the group.
Several companies have either gone out of business or are against the ropes – Coldwater Creek (BK), Wet Seal (on its way), Body Central (going going gone), American Apparel (there’s nothing left to save there, Dov), JC Penney (ew), etc. Those retailers lucky enough to have survived the Holiday season are doing so by the skin of their teeth. See this performance comparison in Finviz.
I have spent many hours thinking about this phenomenon – the Great Retail Slaughter, that is. The cause of the slowdown in retail performance remains a mystery. There are many questions:
1) Is the economy bad and folks just can’t spend like they used to? Maybe.
2) Are new internet retailers like Gilte Group, Bonobos, Chubbies, etc. changing the retail paradigm? Probably, but how do we measure their impact on traditional retail?
3) Is the mall as a retail intermediating concept in decline or already dead? DeadMalls.com sure thinks so. As a part of a larger theme, suburban America appears to be in decline (per this TIME article), which is no doubt correlated with the success/failure of traditional mall retailers.
4) Or was it just a really cold Winter season (Who wants to shop in -30 degree weather?) and the activity will pick up with warmer weather? I know that I had no motivation to go shopping in the bitter cold this Winter.
The uncertainties facing the retail industry have caused investors to begin doubting the ability of many retailers to earn the way they have historically. This doubt has manifested itself in indiscriminant multiple compression in the group (see the Finviz performance chart again). Even the best retailers with the strongest brands have been thrown out with the bathwater.
Enter Lululemon Athletica (LULU)
LULU is one of the retailers that has been thrown out with the bathwater.
LULU is a retailer of “healthy lifestyle inspired athletic apparel.” LULU is best known for its yoga apparel, especially its yoga pants, which have become a fashion staple among female millennials.
Since going public in 2007, LULU has had a meteoric rise in the United States and Canada growing from 52 stores in 2007 to over 260 as of the most recent quarter end. Revenues have ballooned from $41M in 2004 to $1.6B in 2013. Cash on the balance sheet – once just $3.8M in the year 2006 – now stands at $752M. Cash from operations – a paltry -$1.7M in 2004 – totaled $50M in what was considered a very weak first quarter 2014.
Given its blistering growth in North America, LULU has been afforded a very strong valuation in the public markets for most of its time as a publicly traded company. It was not at all uncommon to see LULU trading for 25-50x trailing EBITDA. With the company growing EBITDA 50% a year, these valuations are understandable.
With great growth and a lofty multiple comes a lot of expectation from the markets. LULU at 25+x LTM EBITDA is priced for perfection. That is to say, everything in the growth plan needs to go correctly for an investor to make money and to participate in the theoretical upside potential of the company. Since 2006, everything has gone more or less right for LULU. They’ve opened a couple hundred new stores; the yoga fad has really grown nicely in the United States; Same-store sales growth has been in the mid-teens to low 20s range for several years; and the brand image has grown immeasurably among young people.
As often happens with Icarus-type high flying fad retailers/companies, a chink appears in the corporate armor. In this case, LULU was involved in a relatively minor controversy when it rolled out a series of yoga pants that became unintentionally see-through if worn too snugly (early 2013).
LULU founder Chip Wilson was then involved in a related public relations snafu when on the talk show circuit attempting to dispel fears about see-through pants (ironically enough). Mr. Wilson made a comment about some potential LULU customers that eventually became a PR nightmare. He said:
“The thing is that women will wear seatbelts that don’t work [with the pants], or they’ll wear a purse that doesn’t work, or quite frankly some women’s bodies just actually don’t work for it.”
Although Mr. Wilson’s commentary is mostly innocuous, it is thought to be emblematic of LULU’s concurrent derailment from the path of perfection.
See-through-pants-gate led to the dismissal of CEO Christine Day in June. 2013 went on to be a troublesome year for the retailer and midway through the 4th quarter (which ended up being the worst Holiday quarter in the company’s history), Mr. Wilson himself (I remind you, he is the founder of the brand) resigned from his position as Chairman of the Board.
And the CFO just announced he is going to retire at the end of the year. It was a full house cleaning.
Falling From Grace:
Before pants-gate, LULU traded at $80/share or roughly 25x LTM EV/EBITDA. Following the dismissal of Christine Day, Mr. Wilson’s commentary on yoga pants, his departure from the company, and a weak Holiday season, the shares found themselves under $40.
You can see investor expectations deflating in a stock price graph since June 2013. LULU now trades in the 10-15x EBITDA context – a massive change of expectation with regard to future earnings power. The last time one had an opportunity to buy LULU at 15x LTM EBITDA was in 2010 following the Great Recession.
Not only are the forces behind the Great Retail Slaughter driving pessimistic investor expectations, but competitive threats have emerged in an attempt to steal market share from LULU – the yoga market leader. Gap has introduced its Athleta brand. Moreover, Dicks Sporting Goods has a new yoga line in its stores and has introduced True Runner, a fitness/lifestyle brand that operates in a similar niche.
In this context it makes sense that investors have begun to doubt the previously impervious yoga retailer.
The Night is Darkest Just Before the Dawn
LULU is coming off of two of its worst quarters as a public company. 4th Quarter 2013 saw LULU’s first ever same-store sales deceleration. LULU missed revenue and SSS guidance pretty badly.
Sales, operating income, and EBITDA per store were the lowest that they have been in the last 3 years.
To top it off, management guided revenue expectations to the lower half of its previous guidance.
When it rains it pours.
What do I think? I think this is the new management team coming in and using the poor retail backdrop to reset expectations. Instead of guiding for SSS growth in the mid-teens to low 20s per year, a new regime of single digit SSS is being instituted. Margin expectations have been reduced by several hundred basis points. Everything you don’t want to hear a retailer say and do is being said and done under the new management team led by CEO Laurent Potdevin.
I think it is simply a reset of expectations. I’m calling peak negativity at LULU.
Laurent Potdevin is setting the bar low by bringing in expectations. It is much easier for him to please his Board of Directors (the same BOD that sent Christine Day, Chip Wilson, and CFO John Currie packing in the last year) if expectations aren’t too high.
I think Laurent is setting himself up to be a “beat and raise” type manager in 2014 and beyond.
Management and the sellside have begun to classify 2014 as a “transition” year for LULU – one in which margins and earning power are reduced in lieu of growth initiatives and investments.
However, I think Street expectations are way too low. For instance, the CS analyst has LULU doing $409M EBITDA in 2014 despite having done $440M in 2013 and having 45 new stores on deck for 2014. I find it hard to imagine the company will see negative EBITDA growth absent alarming SSS declines. The sellside has bought management’s manufactured reset of expectations hook, line, and sinker. I think the CS analyst will be surprised when Laurent beats expectations later in the year.
Assuming the stores perform just as poorly in terms of margin in 2014 as they did in 2013, I have LULU doing just over $500M EBITDA. If you assume the margins improve to the management target of mid 50s gross margins, LULU could do $525-$540M EBITDA this year.
The Growth Path
Going out to 2017, LULU management has suggested a desire to grow to 350 stores in North America and 20 stores in both Europe and Asia. Again, LULU will add another 45 stores in North America in 2014, which should get them to 299 stores by the end of the year.
(Aside: On the last call, management said that their first store in London is doing $7M of sales at an annual run rate, which is higher than the average North American store. So we can assume there is similar demand for yoga apparel in those markets as there is in North America.)
The average store in 2011 did $2M EBITDA; in 2012 $2.1M EBITDA; and in 2013 $1.8M EBITDA (big fall off).
If we assume the forward EBITDA run-rate per store is $1.8M, these stores would theoretically do over $700M EBITDA. That’s a realistic goal within 3 year’s time in my mind.
What’s LULU Worth?
I assume LULU will do $500M in 2014 EBITDA based on “normalized” (same margins by quarter as 2013) margins and 45 new stores coming online. The company has no debt and $750M cash in its balance sheet. I assume the core business is worth 15x EBITDA in a base case given its market leading position and defined international growth plan for the next several years.
($500M * 15x EV/EBITDA + 750M Cash)/145M Shares Outstanding = $57/share
If the company is able to execute a successful international expansion, the shares have considerable upside in a 2-3 year timeframe.
($700M * 15x EV/EBITDA + 750M Cash)/145M Shares Outstanding = $77/share.
This valuation obviously assumes no further cash accumulation and no share repurchases, which together are unlikely as there is a $450M share repurchase program underway.
Enter Chip Wilson
Chip Wilson, unceremoniously dumped from the company he founded in December, is back. He allegedly wants to take the company private once more.
Chip owns something like 30M of the 145M shares outstanding and has allegedly had talks with private equity firms to take the company private – much in the same way Mickey Drexler teamed with TPG and Leonard Green in 2010 to take J.Crew private.
I have a feeling there is a good chance Chip tenders for the company before the end of the year. If I were in his position, I know what I would do.
o LULU is a best of breed retailer that has been beaten down in The Great Retail Slaughter
o Expectations have come in considerably over the last half year
o Despite the negative expectations, the company is still wildly profitable with a clear growth trajectory
o Valuation is attractive given historical valuation
o Outside chance the estranged founder reenters the scene with a takeover bid