Course Correction for Lululemon

No-moat

Although first-quarter total comparable sales declined 1% (with flat direct to consumer revenue), order-to-date trends online are now comping in the positive low-double digits and management expects a comparable sales percentage increase in the low- to mid-single digits on a constant dollar basis in the second quarter. Moreover, investments in the supply chain appear to be paying off with first-quarter adjusted gross margin increasing 210 basis points to 50.4% driven by product margin improvement.

We are encouraged by management’s quick response to flagging sales (including introducing more color and print) and the results achieved by initiatives. Therefore, we see little change to our $59 fair value estimate or our belief that the company can achieve high-single-digit top-line growth, on average annually, over the next five years and adjusted operating margin expansion to the low 20% range (versus 18% in fiscal 2016).

We think many of the actions that management is taking will continue to drive sales upside and margin improvement. The decision to mostly transition ivivva to an e-commerce offering makes strategic sense, in our opinion, given the lower profitability level of the brand. We believe that the store closures and restructuring should be completed by the end of the third quarter and drive $50 to $60 million in additional costs in fiscal 2017.

We are also encouraged by the results of digital initiatives (about 20% of business) given secular channel shifts although we disagree with management’s belief that some of the costs associated with this are one-time in nature. We note that this is already accounted for in our model, with adjusted operating margin reaching only the low 20% range in five years versus historic mid-20% levels.

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