Shares of lululemon athletica (NASDAQ:LULU) have outperformed the broader market this year, even though stores have not been operating at peak performance levels during the pandemic. Despite that weakness, investors are high on the company's digital prospects, as e-commerce sales have soared.
At some point, however, Lululemon needs to get its stores back to full strength -- its expensive-looking share price depends on it. On that front, Pfizer and BioNTech together as well as and Moderna recently reported good news, each announcing a highly effective vaccine for COVID-19 is nearing full readiness.
Here's what this vaccine news means for Lululemon.
Why investors are bullish on the stock
Lululemon has been a tale of two businesses lately. In the most recent quarter, total revenue increased just 2% year over year, as reopened stores operated at limited guest occupancy levels. Lululemon made up for the low sales volume at stores with tremendous demand online, where e-commerce revenue surged 155% year over year.
The stock is up 45% year to date due to the digital sales growth. Investors are shrugging off the weak store performance and focusing more on the digital side of the business for a few reasons.
First, digital is the future of retail, and Lululemon has one of the best digital operations in apparel right now. While Lululemon hasn't been able to fully offset the loss of store sales with online demand, it's doing a lot better than other apparel stores that have reported sales declines.
Second, Lululemon's direct-to-consumer (DTC) business generates a much higher operating profit margin than its physical store fleet. Last year, when things were normal, the DTC segment produced a 42% operating margin compared to 27% for company-operated stores.
So far this year, the DTC segment has been the only source of profit for the company. While physical stores reported an operating loss of $5.3 million in the fiscal second quarter, the DTC business generated $237 million of operating profit.
Still, digital sales will carry Lululemon's business only so far in the short term.
Stores are a strategic asset for Lululemon
Given that digital sales generate a significantly higher profit margin than physical stores, some investors might have been hopeful that Lululemon had reached a new plateau with the digital business and therefore would see higher margins down the road.
On the flip side, a vaccine would make more people feel comfortable shopping in stores again. That would likely take away Lululemon's digital sales momentum, but regardless of that outcome, Lululemon needs its stores to get back to full productivity levels.
Lululemon operates more than 500 stores worldwide and continued to open new stores, especially in Asia, this year. Those stores require maintenance and other investments that need to be replenished with revenue growth. That's why Lululemon's net profit plummeted more than 30% year over year in the last quarter, despite digital sales comprising 61% of total revenue.
Lululemon is investing heavily in its omnichannel strategy. In the future customers will connect with the brand through several channels: stores, e-commerce, and Mirror, an interactive fitness platform that the company recently acquired.
Moreover, Lululemon uses its stores as test labs to gather feedback from customers about products and test new services, such as the loyalty program, which is currently being tested in four cities. Lululemon plans to sell Mirror devices in select stores starting this quarter, which will become a crucial asset in helping the Mirror business grow.
The spotlight will be on store performance
Even if the availability of a vaccine causes Lululemon's digital momentum to moderate, it is a positive development for Lululemon. Guests were lining up to get in reopened stores in the last quarter, a sign that there could be pent-up demand when stores fully recover.
While management is remaining cautious over the fluid state of the coronavirus, the outlook issued during the Sept. 8 earnings report called for revenue growth to improve sequentially throughout the remainder of the year. Analysts currently expect Lululemon to report year-over-year growth in revenue of 13% for the fiscal fourth quarter, which would be a significant improvement but still down from the 21% reported in fiscal 2019.
Most importantly, Lululemon needs to accelerate revenue growth to justify the high valuation investors are paying for this growth stock right now. It's almost a given that Lululemon will continue to report robust digital sales growth, so investors should start monitoring the pace of recovery with store-level sales. With shares trading at a P/E of 82, Lululemon needs to be firing on all cylinders to justify that valuation.