Rebel Without a Cause

Rebel Without a Cause (Photo credit: Wikipedia)

Barbara Gray, CFA – June 11, 2012 – lululemon is rebelling against Wall Street’s myopia. Why does the company believe in investing precious time and capital to deepen relationships with its customers, employees, business partners, and communities? And how does it have the audacity to consciously sacrifice short-term profits for potential long-term gains? Isn’t the obligation of a corporation solely to maximize profit for its shareholders?

Given we are still in a weak economic environment and lululemon sells premium-priced apparel, you would expect investors would be joyous over a company that was able to grow its top-line by 53% (with comparable sales up 25% – on top of 16% growth a year ago) and its bottom-line by 39% (EPS came in at $0.32, up from $0.23). But instead, investors took the stock down by 10% as they started to panic over the 370bp decline in its gross margin and were disappointed the company maintained its guidance for the year of revenue of $1.32 to $1.34 billion and for EPS of $1.55 and $1.60. And the critics came out in full force – both in traditional and online media – warning of soaring inventory levels, increasing competition, and slowing growth…

Before I delve into the company’s quarterly results, I want to share with you the highlights from lululemon’s 2011 Video Annual Review, which the company showed during its AGM (Annual General Meeting) last week. I encourage you to watch it as I think it really captures the essence of lululemon’s greater purpose as well as it incredible culture and community. The video, which is set to the backdrop of beautiful Vancouver (my hometown!), is playful, fun, and inspirational. Christine Day, President & CEO, opens up the video talking about how lululemon is “…building a culture of personal development and accountability…building leaders around the world” and emphasizes “it’s our beliefs, our values, living the lives we love.” She then goes on to share “…it is the dreams of the people who work here, how we treat our guests everyday, how we work with our factories, our vendors, our ambassadors, and our communities to achieve these results that truly matters.”


As we enter the age of the Social Renaissance, companies like lululemon, which have established a strong level of trust and built up positive social capital with their customers, employees, and business partners, will be able to really leverage the higher level of connectedness and create new generative moats. The company’s unique ambassador program is the perfect example of this as “it’s a partnership, friendship, authentic relationship” as the ambassadors provide lululemon with insight into what products to make, what sports are cool and what is important in each community. This, combined with the time lululemon invests on getting feedback from athletes and guests, creates a very social collaborative environment. Although many companies will try to become more transparent, authentic, and engaging with their customers in their social media efforts, as Frank Eliason writes in “@ Your Service” “The creation of a relationship hub does not happen overnight, nor does it start with a social media campaign. It first begins with your own employees and your company culture.”

Back to the quarter – if the critics took the time to listen to the analyst conference call, they would have discovered the story behind the numbers and realized that the sky was not falling and in fact, the outlook for this company has never been better. The company’s reported gross margin of 55.0% is right in-line with the company’s long-term target and it was actually down only 230bp after you adjust for last year’s non-recurring tax benefit. The company benefited from leverage of fixed occupancy and depreciation costs but this was slightly offset by a bit of inflation and a more normalized level of markdowns. The primary culprit was higher raw material and labor costs resulting from management’s strategic decision to invest in product innovation in terms of new fabrics and blending fabrics on garments, which requires more complexity and construction. And yes, the inventory is up 67% from a year ago, but this is positive, as the company’s store base is up 30% (it ended the quarter with 180 stores) and it was highly under-inventoried a year ago.

What I find fascinating about lululemon is its conservative, yet innovative approach to growth in terms of seeding markets by launching showrooms to test out new store locations, capsules to test out new product lines, and E-Commerce to test out new geographic markets. I just finished reading Grant McCracken’s incredibly insightful book “Culturematic” in which he writes “If you want to innovate as Google, Apple…you should follow a couple of rules: Don’t look for big ideas. Seek small ideas that can grow. Fail fast. Fail often. Keep learning and never give up.” This describes lululemon’s capsule approach to product expansion. For example, last quarter, the company tried out its new swim and commuting lines and although it has decided to drop them for now, the company believes in this beta approach and is increasing the cadence of new capsule launches from 2 to 3 last year to 8 this year. As Christine Day explained in the conference call “So these are small controlled bets, onetime, where we take the learnings, always looking for that anchor piece that we can take forward.”

It is rare to find a President & CEO who will stand up and declare to analysts “Revenue upside opportunity is limited until Q4, as we have focused our product team on innovation for the future in favor of chasing near-term revenue dollars.” But as she explains “…longer term, making sure that we have the quality, that we have the right amount of scarcity, that we’re innovating what’s needed as a market leader from a brand and long-term growth story is a position we’d rather be in.” It’s interesting as lululemon is very similar to LinkedIn (see research report “LinkedIn: Disrupting By the “Power of We”” for more details), which cautions in its prospectus “Our core value of putting our members first may conflict with the short-term interests of our business”.

It is ironic how the critics warn that lululemon’s growth is slowing – as the reality is the company is on the verge of international expansion. In April, the company opened its first showroom in London, which is apparently performing better than its US showrooms, and it plans to open its Hong Kong showroom at the end of the third quarter. To help further seed these markets, lululemon will be launching country-specific e-Commerce sites for UK and Hong Kong later this year, following the May launch of its Australia e-Commerce site. The company is starting to reap the benefits from its strategic investment a year ago to bring its e-Commerce platform in-house. Its online revenue grew by 179% to $38 million and now represents 13.5% of total sales, nearly double from 7.4% a year ago. The company’s SG&A actually declined by 160bp to 25.6% as the lower cost structure of its online platform more than offset investments the company made to build its pipeline, infrastructure, and operational. As stated by Kathryn Henry, its Chief Information Officer, in the video “it’s about the global expansion – Ecommerce, showrooms, stores…the complexity in the supply chain in order to support bringing product into Europe, Asia, and these new markets we are going to bring lululemon into.”

Unlike James Dean, lululemon is a “Rebel with a Cause”.

Disclaimer: I have a LONG position in lululemon athletica, inc. (LULU-NASDAQ) and LinkedIn Corporation (LNKD-NYSE).

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