Even though lululemon athletica ( LULU -2.79% ) has reported impressive results this year, it hasn't escaped the market's turbulence, with shares down 23% in the last three months. Wall Street is worried about a possible recession in the next few years, but I'm more concerned about where Lululemon is going to be in 10 years. I like the trends I'm seeing.
Lululemon has the right online strategy to win in tomorrow's retail landscape. Plus, I like that management still sees opportunities to expand margins over the next few years. The company is also winning over customers with everyday wear, which reveals an expanding market opportunity for the brand that goes beyond traditional workout wear. For these reasons, I decided to take advantage of the market's near-sightedness and start a small position in Lululemon stock.
E-commerce growth is driving higher margins
While some retailers have struggled to figure out how to connect with customers in a digital age, Lululemon has its online strategy down pat. In the first three quarters of fiscal 2019 (which ends in January 2019), direct-to-consumer revenue has surged 51% year over year. This represents an acceleration over last year's pace, when direct-to-consumer revenue increased 27%.
There are several reasons for the boost in the e-commerce segment. Other than robust demand for the product, management credits the company's effort to collect customer email addresses as well as digital marketing for generating higher traffic to the website. Also, the website has an updated, fresh look, and Lululemon offers convenient checkout options with Apple Pay. This makes it extremely fast and easy to add items to your cart and click or tap a button to complete payment.
Additionally, the company has an effective omnichannel strategy in place. If an item is out of stock on the website, you can check with any store in the country, and if a store has what you're looking for, that store can ship the item directly to you. Several top retailers are offering pickup in store and ship to store these days, and when executed properly, it's a powerful way to boost e-commerce sales and increase store productivity and returns on capital.
E-commerce was 25% of Lululemon's revenue in the third quarter, and management sees nothing in the way of that percentage moving higher. Direct-to-consumer revenue generates an operating margin of 40% compared to about 25% for store sales. That means there is still a margin expansion opportunity as e-commerce sales grow faster than the rest of the business.
Lululemon's management team are perfectionists
During the company's fiscal third-quarter 2018 conference call, management talked about the potential to raise prices on certain items, including increasing the fee on a new loyalty program they are currently testing. Lululemon's ability to raise prices in a heightened competitive environment for athletic wear shows just how much the brand is resonating right now.
Even after several years of making improvements to the company's supply chain, which has helped expand gross margin from the 40s range to the mid-50s, management continues to discuss opportunities to lower product costs and further expand margins.
During the earnings call, COO Stuart Haselden highlighted the areas of improvement management is focused on:
For the full year 2018, we are on track to deliver an annualized increase in product margin of over 700 basis points since 2015. Our strategic supply chain programs amplified by favorable product mix and strong full price selling have driven these increases, and investors should know that we are making important new investments across our distribution network that should enable us to capture additional gains in product margin over the next couple of years.
Expanding addressable market
Lululemon is already swimming in a $300 billion athletic apparel market that is expected to keep growing over time. However, with the company experiencing strong demand for non-athletic apparel, like jackets, shirts, and pants that are suitable for the office, Lululemon has significantly expanded its addressable market.
On the call, Haselden noted that the company is in the early innings of expanding its merchandise to everyday wear, where management already sees substantial growth taking place:
Outerwear was particularly strong for us on both the men's and women's side, with comps increasing over 150% and 40%, respectively. We've expanded the assortment relative to last year by offering more puffer and water-resistant styles also, including the Cloudscape Jacket for women and the Outpour Parka for men. We're still in the early stages with outerwear, and we're excited [about] the potential we see here.
A final word
You might have noticed that I haven't mentioned valuation among my reasons for investing in Lululemon. Some investors may shy away from the stock due to its high trailing P/E of 43, and I'm certainly not advocating that you go out and buy the stock just because of this article. However, I have followed Lululemon since I first tried the product in 2011, and I believe in the growth story.
Overall, what caused me to pull the trigger at this time is that the growth story is getting better, even while Nike and countless other retailers have expanded their athletic wear assortments. Lululemon has performed exceptionally well over the years with its core workout clothing, and now the company is demonstrating the ability to apply its design expertise to everyday wear.
Add it all up, and Lululemon looks like a long-term winner, in my view.