Lululemon Athletica's (LULU -7.23%) stock dropped 9% on Jan. 9 after the yoga and athletic apparel maker updated its guidance for the fourth quarter of its fiscal 2022 (which ends on Jan. 29). It now expects revenue to rise 25% to 27% year over year, which is higher than its prior guidance for 22% to 25% growth. It expects adjusted EPS to increase 25% to 27%, which is slightly lower than its earlier forecast of 25% to 28%.
Those headline numbers looked stable, but Lululemon also warned that its gross margin would decline 90 to 110 basis points year over year in Q4, compared to its prior expectations for 10 to 20 basis points of growth. To offset that pressure, it plans to rein in its selling, general, and administrative expenses more aggressively to shield its operating margins.
That revised guidance was disappointing, but Lululemon's stock has already declined about 35% from its all-time high in November 2021. Should investors tune out the near-term noise and focus on its long-term growth prospects instead?
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Lululemon's core business is still growing
Between fiscal 2016 and 2021, Lululemon's revenue rose at a compound annual rate of 22% as its annual gross margin expanded from 51.2% to 57.7%. Its adjusted EPS grew at a rate of 29%.
Lululemon grew rapidly because it maintained its first mover's advantage in the premium yoga and athleisure apparel space. It retained its pricing power even as aggressive competitors like Gap's Athleta entered the market, and it locked in its customers with free yoga classes and other community events.
To reduce its dependence on third-party retailers, Lululemon grew its direct-to-consumer business by opening new brick-and-mortar stores and expanding its e-commerce platform. It ended the third quarter of fiscal 2022 with 623 stores, compared to just 406 stores at the end of fiscal 2016. Its digital sales also increased at a compound annual rate of 46% over the past three years and accounted for 41% of its Q3 revenues.
What near-term challenges does Lululemon face?
Lululemon's updated Q4 guidance suggests its revenue will rise about 28% in fiscal 2022 as its adjusted EPS only increases 11% to 12%. Its gross margin should decline nearly two percentage points for the full year as it grapples with higher supply chain costs and currency headwinds.
Yet, big markdowns weren't a major part of that equation in the first nine months of the year. During its latest conference call last month, CEO Calvin McDonald said Lululemon was still selling most of its products at a regular price even as other retailers implemented heavy discounting to counter inflation and clear out their excess inventories.
Instead, Lululemon says it's been intentionally growing its inventories, which rose 85% year over year in Q3, to satisfy the market's robust demand for its products. It expects its inventories to rise another 60% year over year in Q4 -- which could either be interpreted as a green flag for its near-term demand or a red flag for its gross margins.
Lululemon's gross margin reduction supports the latter because it suggests its inventories are rising too quickly and forcing it to implement more markdowns. But that all will remain speculation until Lululemon posts its Q4 report in March.
Its "Power of Three x2" Plan remains intact
Back in April 2019, Lululemon introduced its "Power of Three" plan to double its digital revenue, double its men's revenue, and quadruple its international revenue from fiscal 2018 to 2023. It achieved its digital and men's goals ahead of schedule in 2021, even as it dealt with temporary store closures throughout the pandemic, and it expects to quadruple its international revenues by the end of fiscal 2022.
Last April, Lululemon launched a new "Power of Three x2" plan with the same goals. Once again, it plans to double its digital and men's revenue as well as quadruple its international revenue, from 2021 to 2026. It expects those growth engines to nearly double its annual revenue from $6.3 billion in 2021 to $12.5 billion by 2026.
During Lululemon's latest holiday update, Calvin McDonald reiterated the company's commitment to those "Power of Three x2" targets. If it achieves those goals and its valuations hold steady, its stock could still easily double within the next four years.
Lululemon is still worth buying
At $310 a share, Lululemon looks reasonably valued at 28 times forward earnings. Nike, which is growing much slower than Lululemon, still trades at 39 times forward earnings. Gap, which has seen Athleta lose its momentum over the past year, trades at 16 times forward earnings -- but it faces much tougher near-term headwinds than Lululemon.
I believe Lululemon is still one of the best apparel stocks to own in this rough market. Its stock might remain out of favor until its gross margins stabilize, but investors who buy some shares now might be well rewarded in just a few years.
