The athletic apparel industry has been one of the best places to invest in recent years, given the rise of athleisure and the investments leading brands have made in improving supply chains, e-commerce operations, and product innovation.
Some of the demand for athletic apparel has spilled over to growth in the interactive fitness market, where Peloton is playing the role of disruptor by bringing the gym to your home and offering live workouts through a potentially lucrative subscription model.
Here's a look at key drivers impacting both businesses before we determine which stock offers the best value for investors today.
E-commerce has been awesome for Lululemon
After suffering soft sales performance through much of the year due to store closures, Lululemon is revving back up again. Total revenue showed a significant sequential improvement in the fiscal third quarter, climbing 22% year over year compared to just 2% in the previous quarter. The highlight was once again the strength in the direct-to-consumer channel, including e-commerce sales, which grew 93% year over year excluding currency changes.
Most importantly, direct-to-consumer revenue made up 52% of Lululemon's total revenue and 88% of operating profit through the first three quarters of the year. Online sales generate a much higher operating margin than physical stores, which is a catalyst for a higher overall profit margin going forward. That's perhaps why the stock price has continued to outperform this year despite the store closures.
Even with the impact of COVID-19, Lululemon has nearly doubled its revenue over the last five years. At $4 billion in annual revenue, and with the sportswear market valued at $115 billion, Lululemon is just getting started.
Lululemon has had success expanding internationally, where revenue grew 45% last quarter. The brand is clearly resonating around the world, putting the company on track to emerge as a global athletic apparel giant.
It's noteworthy that Lululemon maintained a steady release schedule of new products during the disruptions caused by the coronavirus. This is a testament to the demand underpinning the business. The company seems to be hitting a stride, highlighted by the improved selection over the last few years, especially within the men's category, which represents a significant growth opportunity for the brand.
However, Lululemon sees incremental growth opportunities that could see its addressable market stretch much higher. A good example is Lululemon's recent acquisition of Mirror, which competes with Peloton in the $500 billion global market for physical activity. Mirror is on pace to generate $150 million in revenue in fiscal 2020, but it could grow into a much larger business and provide Lululemon a recurring revenue stream from subscriptions.
The growth of Peloton helps explain why Lululemon was interested to spend $500 million for Mirror earlier this year.
Peloton spins faster
Peloton benefited enormously from the stay-at-home dynamic in 2020, but it was already delivering the goods for investors. Between fiscal 2017 through fiscal 2020, revenue rocketed from $186 million to $1.4 billion, thanks to heavy spending on marketing.
All those TV commercials and the appeal of an engaging workout experience from the comfort of home have driven higher sales of Peloton's Bike and Tread connected fitness products. But the heavy marketing spending also explains why Peloton hasn't produced much profit over the last few years.
However, management's strategy is starting to bear fruit. The company uses the gross profit from selling connected fitness products to offset customer acquisition costs for new subscribers, and this strategy is starting to lead to improving margins.
Peloton's subscription contribution margin has improved from 13.5% to 63.8% over the last three fiscal years through June 2020. While the company is still reporting a net loss, Peloton is beginning to produce a healthy amount of free cash flow, which shows the actual amount of cash that a business produces from operations.
During the most recent earnings report, management referenced high demand trends continuing as we enter the holiday quarter. There is a backlog of orders waiting to be fulfilled, and management reported strong demand for the new Bike+. The introduction of the new model allowed for a price reduction on the original Bike model, which could create new interest from people waiting to take the plunge.
Peloton ended the most recent quarter with 3.6 million members, across connected fitness products and app memberships, but there's enormous potential for more growth. Management is targeting 100 million subscriptions over the long term, which comprises half of the estimated number of global gym memberships.
Moreover, Peloton recently announced a multi-year partnership with music artist Beyonce to create special workout content for members. As part of the partnership, Peloton will also offer a free two-year Peloton digital app membership to students at historically Black colleges and universities. This is a great opportunity to build brand awareness, given the 157 million people who follow Beyonce on Instagram.
Which is the better buy?
Peloton is growing much faster than Lululemon. The former expects connected fitness subscribers and revenue to double again in fiscal 2021, reaching 2.17 million and $3.9 billion, respectively. The yoga enthusiast is not offering specific guidance for revenue growth, but the consensus analyst estimate has Lululemon growing revenue by 8.6% this year and 24% next year.
Looking at the big picture, there's a lot going for both growth stocks, but if I had to select one to buy today, I would favor Peloton based on its lower price-to-free cash flow valuation.
On a price-to-free cash flow basis, Peloton stock trades at 69 times free cash flow, whereas Lululemon shares trade at a much higher multiple of 112 times.
Peloton has maintained a high subscriber retention rate of 92% on a trailing-12-month basis, which is only down a few points from the year-ago quarter. Customers are clearly enjoying the platform Peloton is building, and this should lead to a growing source of recurring revenue as Peloton continues to grow its subscriber base.
For these reasons, I would buy Peloton at current price levels.