More Layoffs in Big Tech

In this podcast, Motley Fool senior analyst Asit Sharma discusses:

• The Producer Price Index falling 0.5%, much more than economists were expecting.
• Microsoft's layoffs.
• Why he's expecting more questions about layoffs this earnings season, but also more talk of where companies are investing.

Is Lululemon Athletica facing short-term headwinds or long-term challenges? Motley Fool contributors Ryan Henderson and Jamie Louko go head-to-head in a bull vs. bear debate.

The Motley Fool's flagship service, Stock Advisor, is open to new members for just $99 a year. To access this exclusive offer go to www.fool.com/intro.

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This video was recorded on Jan. 18, 2023.

Chris Hill: We've got another layoff announcement from Big Tech and a bull versus bear debate over Lululemon, Motley Fool Money starts now. I'm Chris Hill joining me today, Motley Fool Senior Analyst, Asit Sharma. Thanks for being here.

Asit Sharma: Chris. Thank you for having me.

Chris Hill: We're going to start with The Big Macro today because the Producer Price Index fell by half a percent, which is much more than the 0.1 percent that economists were expecting. I'm choosing to take this as good news. How are you taking this?

Asit Sharma: I also see this as positive, Chris. I mean, producer prices, wholesale prices have been falling since March of last year, that was the peak, so we've seen some deceleration in prices at the wholesale level. That's generally positive for the economy; of course, it's especially positive when you think about Uncle Fed, who's looking at these numbers and wants to make a decision on how much they should adjust interest rates. This means probably, potentially will help in the data points if you are one of those who's a proponent of smaller rate increases, and also you can point to energy and food as the propelling factors that pushed it down. I saw some reports today that said, well, this is due to energy prices decelerating more than expected. But that's good for the economy too, correct? If fuel prices are declining, that's helpful for the productivity, the economy, and it also is again, a counter data point to inflation.

Chris Hill: I don't want to poke the bearthat is Jay Powell, but this does seem like the thing that you alluded to where for those who are looking ahead to the next couple of interest rate announcements, data like this does seem to support the idea that we're going to see smaller rate hikes, and maybe it actually is going to be a quarter of a percent the next couple of times. Although, I feel like the more we talk about this thing, the greater the chance we're just jinxing it and Powell comes out with another big rate hike.

Asit Sharma: I know we shouldn't jinx it because after all, this is related to some volatile pieces of the index. We just talked about energy. Energy prices are actually a little bit up since December. Also, we've got the consumer price index still to come. Although in many cases, the PPI, Producer Price Index, can be an omen for the CPI, it can be forward-looking. So let's not talk about this anymore Chris, stop the jinx. We should move on to the next topic. How about that?

Chris Hill: I'm with you 100 percent. Microsoft became the latest big tech company to announce layoffs. It's going to be 10,000 employees, which is roughly five percent of the overall workforce, and this can't be a surprise to anyone who's been paying attention to this industry or anyone who was listening when earlier this month CEO Satya Nadella, talked about how tough the next two years are going to be.

Asit Sharma: Certainly, they're big tech layoffs all over the place. Salesforce had a big layoff. We've seen them from Amazon. Many other companies. So it shouldn't be a surprise there. I guess what's different here is that in the SEC filing, Microsoft put out on this layoff, they talk about how their demand areas are changing, so we know PC sales have slowed dramatically since the peak of the pandemic. Microsoft wants to follow demand. Its Cloud business is also slowing, so we can extrapolate a little bit from that, that the layoffs might be not hugely concentrated, but they're at least touching hardware and perhaps some parts of the cloud business, and they've already signaled how much they're looking to infuse their products with AI. 

They have an investment already in open AI, that's ChatGPT. They're going to bump that up potentially to $10 billion, and you'll see some of this technology in Outlook; you'll see it in Bing. So this is a forward-looking layoff in some ways. It's on the ground pointing to the realities of a post-pandemic world. But at the same time they're saying, look, we're going to shift some of our resources around and we'll be investing in things that we think are more productive, maybe have a high return on margin for us in the future.

Chris Hill: This is similar to what we've talked about recently with Amazon and Salesforce for that matter. This is against the backdrop of a lot of hiring overall that Microsoft has done over the last, call it two to three years. I am wondering though, since we've talked about Amazon, and Facebook has done this as well, and today it's Microsoft; Alphabet is on the clock, aren't they? If this were a sports draft of some type, I feel like this is where someone announces, Alphabet is on the clock. Isn't the next natural announcement here coming from Alphabet?

Asit Sharma: It's human nature for shareholders of all these companies to wonder if so much of big tech is optimizing operations and getting more efficient and siphoning off some of those excesses from 2020, 2021, 2022, those hiring excesses, we talk about Microsoft, I think they added like 75,000 employees over a three-year period. It's time Alphabet for you to show that you're also fiscally and operationally responsible. Now, I hate to say that. I hate for there to be any layoffs, but it does beg the question, when is their shoe going to drop? They have a very nice business in digital advertising, and they've always emphasized the priority of investing in big bets. But over the years I think we've seen a little bit less of enthusiasm for Alphabet to take huge risks, to funnel just money without question into their innovation centers, and I think we've seen a more practical and rigorous operations based approach to this company, so I think yeah, maybe that signal is there.

Chris Hill: But thank you for reminding me that period of time you just talked about. I'm pretty sure it coincided with Ruth Porat becoming the CFO at Alphabet, and it's entirely possible that what we get out of Alphabet if in fact there are layoffs coming later this year, it's maybe not to the degree that we're going to see out of the other big tech companies as well.

Chris Hill: The last thing before I let you go, we're at the beginning of earnings season. Is it safe to assume that in terms of earnings conference calls, this is a topic that's going to come up over and over again in the same way that interest rates and inflation were asked about constantly? Rightfully so throughout 2022. It seems like questions about layoffs, ''Rightsizing the business", it just seems like the environment is ripe for that.

Asit Sharma: I think so. I think analysts will be asking what companies are doing to improve their cash flow, how they're going to be allocating that capital for those companies which have announced layoffs, big ones. I think will be asking, where are the cuts? Which of your divisions are you pulling people off of? Because we want to know, is it something that will result in higher margin or is it just a broad across the board reduction for some of these companies. The more pointed the better when you can take the opportunity to cull a part of your operations that is not as profitable. You do that and you and I will see good managers saying, we're removing some of the excess from X part of our business.

But I think that the market also is very forward-looking, so I'm hoping that analysts also ask about the innovation component of these companies, not just where they're trimming, but where they're investing because cycles turn almost faster than we can predict. Chris, it wasn't too many weeks ago that I was saying, ''Hey, watch out for China, they're really not handling this COVID situation well. This lockdown situation is dragging on.'' They still aren't there. They're paying for some long defrayed or delayed decisions, but the government there did an about-face and now we see maybe China is going to grow at 5-6 percent, so the same way, suddenly, business conditions, can turn on a macro level, they can turn on a business level for these companies as well. I would like to see some talk of investment in 2023 when I listen to calls.

Chris Hill: Asit Sharma. Always great talking to you. Thanks for being here.

Asit Sharma: Same here. Thanks for having me, Chris.

Chris Hill: By the way, our city is one of the members on our investing team behind our flagship service Stock Advisor. When you join Stock Advisor, the team sends you two new stock picks every month, plus you get access to exclusive reports on fast-growing industries, and you get access to our brand new Stock Advisor round table podcast. The service is open to new members for just $99 a year. To learn more? That's easy to go to fool.com/intro. I put a link in the show notes, so just one click and you're on your way. Is Lululemon facing short-term headwinds, or does it have long-term problems? Ricky Mulvey hosts a Bull versus Bear debate, on the popular athletic apparel retailer.

Ricky Mulvey: Welcome to Bull versus Bear. We take a company, find a couple of Fools to talk about it, and then flip a coin to see which side they'll take. Today, the company is Lululemon, the multinational apparel retailer that also had some plays in connected fitness, footwear, that kind of thing. This company was brought to us by Twitter user, the Dwight Schrute, assuming that is Rain Wilson's burner account, but feel free at Motley Fool money. If there's a company you want to hear Bull versus Bear on, we'll see if we can make it happen. On the Bull side of Lululemon, we have Ryan Henderson. Ryan, thanks for playing.

Ryan Henderson: Looking forward to this.

Ricky Mulvey: On the Bear case, we have Jamie Louko.

Jamie Louko: I'm really excited to dive in.

Ricky Mulvey: Today, we're going to start with the Bear side first of Lululemon. Jamie, five minutes is yours.

Jamie Louko: Thank you, Ricky. Normally most of the time, I'm fine with investing in apparel companies like Lululemon, but I think there's a danger that some of these companies can fall into. It poses a considerable risk to investors and that danger is that their sole competitive edge comes from just their strong brand. Now, during the company's heyday, this could theoretically be a great thing. If their brand is strong and they have many loyal users that can create the ability for said apparel company to raise their prices to exorbitant levels and make very high margins. This is exactly what Lululemon has been doing over the past few years and it's doing today. Right now, its brand reputation is very strong and they're capitalizing on that by pricing its clothes at sky high prices. For example, it's women's yoga leggings are sometimes over $100 and this is leading to incredible margins for the company right now.

The problem with having your success rely on just one competitive advantage, however, which is your brand, is that it's not always sustainable, especially in the fashion and apparel industry. Fashion trends change, and that means that having a brand reputation as your primary competitive edge just isn't sustainable. Just take history, for example. It didn't matter if you were the strongest brand in the legwarmers industry in the '80s or the velvet tracksuit space in the 2000s, once those fashions trends dissolved, you were left empty handed. Of course, you might look at other competitors with strong brands and wonder how they've endured for centuries. Take Nike. What I just said about how brands shouldn't count for a lot, how has Nike succeeded? The company's edge eventually or inevitably comes down to not only its brand reputation, but it's cost advantages as well.

Because of how large Nike is, the company can get its way with suppliers far better than rivals like Under Armour or Adidas, which boosts its operating margins. Starbucks does the same thing. These companies don't rely solely on their brand reputation, while that's the only advantage that Lululemon has. Everything I've said so far assumes that Lululemon's brand is incredibly healthy right now, but that would be dangerous to make this assumption. In an environment where consumers are tightening their purse strings, Lululemon has certainly felt the pinch. Demand has slid over the past few quarters for its products, and this was made evident in two main ways. The first is that the company's inventory levels shot higher over the past year. In Q3, the company's inventory totaled $1.74 billion, which is 80 percent higher than the year ago quarter.

This signals that Lululemon was producing its goods far faster than people were actually buying them, which left unsold goods sitting on its shelves as demanded drastically slowed. In an effort to reverse this, the company has made massive cuts to its prices. The company expects its gross margin to drop a 90-110 basis points in the upcoming quarter, which shows that the company had to drastically cut its prices in order to sell enough goods during the holiday season. Of course, this puts the company's pricing power because of its strong brand into question. If Lululemon had such a strong brand and can charge whatever price they want, then why are they reducing prices? It likely means that their brand and their pricing power wasn't as strong as investors and management previously thought, and they have had to slash prices in order to see sufficient demand.

With all of this uncertainty about the future, the fact that shares of Lululemon are trading at a premium compared to other apparel companies is concerning. Lululemon is valued at 5.5 times sales, which is a 33 percent premium compared to Nike, which is arguably one of the strongest brands and has the strongest brand reputation in the entire apparel space. That's even six times higher than Under Armour in terms of their price-to-sales valuation. Since we're Fools, the only time frame that matters is the long term. While Lululemon looks like a strong company right now, the fact is that its long-term future is extremely unpredictable. Fashion trends can change on a dime and considering Lululemon doesn't have any other moat aside from its brand and its pricing power which is connected to its brand, the company's moat doesn't look sustainable for the long term. We are already starting to see the cracks in the foundation, which would leave investors concerned about how it could live up to its expensive valuation over the long haul.

Asit Sharma: Jamie Louko, thank you for the bear case Lululemon. Let's find out the bull case, Ryan Henderson, five minutes is yours.

Ryan Henderson: I think Jamie makes a good point. I'll start by saying I'm generally the investor that actually avoids the retail category in general. To me, it scares me and for a lot of the reasons that Jamie mentioned, which is oftentimes you're buying into a brand, and consumer purchasing habits can change really quickly. Not only what they're buying, but where they're buying. Very few brands are able to adapt to those changes. However, Lululemon has, and they've done this consistently since their genesis. They basically created the athleisure category. Since then they've successfully diversified into other markets. We've already alluded to it. The genesis was women's yoga pants. Today they sell men's winter jackets; they sell men's work clothing. People are probably familiar with their ABC pants, these are a premium price point, but I happily pay them because they're the most comfortable pants I've ever worn.

They have accessories. People are now wearing Lululemon handbags over their shoulders, which was never a thing before Lululemon. Well, but I'm seeing people do it that would've never worn something like that. They would have stuck things in their pockets or their purse, but now they're wearing these Lululemon handbags; hats, underwear, I think they have socks. They just released a women's shoes line which last I checked was impossible to buy anything in the size or color that I wanted online. Basically, this is just to say that Lululemon has, and I don't think this surprises a lot of people, a cult-like customer base where it has almost inverted the customer or brand relationship now where instead of the brand trying to adapt to customer changes, customers are now adapting to whatever Lululemon's brand changes are.

If Lululemon launches a new men's hoodie line, I basically just accept the premise that that's what's new and cool today. It really has inverted that situation. The other thing that's worth saying, they do focus on quality fit, quality products, and there is even a signaling as- like a social signaling aspect to it. Where if I'm wearing something in public that has the Lululemon logo, it's almost a signaling thing that says, I care about what I wear. I spend a lot on what I wear. It's almost like a class signaling thing. It's taboo to say that, but Jamie is making a face that it's true. It's very much true. They sell their products at a premium price point because they have attracted that affluent customer base, which in a recession, in a consumer environment, historically the affluent customer base or the luxury items, I'm going to call this complete luxury.

They tend to fare better than the discount retail partners, or appears. To simplify the bull case here, for me, they're going to succeed if they keep doing what they're doing currently. For reference, at an Investor Day in 2019, Lululemon laid out three different five-year goals. It wanted to double its online sales, it wanted to double its men's sales, and it wanted to quadruple its international revenue. Instead of, taking them five years to accomplish that, it took them three. At a recent Investor Day, they once again laid out the exact same goals. In other words, Lululemon is going to have to achieve 15 percent compound annual growth rate in its men's and digital sales. Then a 32 percent growth rate in its internationals, albeit international's coming from a lower base. For reference, on the international side, the biggest market here is China aside, they're also entering some European markets. But in second quarter in China, they reported 30 percent revenue growth.

That was when most Chinese stores or a big portion of their Chinese store base was actually closed and there were supply chain constraints. As that reopens, it's going to be a quick boost probably to the top line. But I imagine they can also grow store count quickly, much quicker than their domestic or North American side. Definitely, I think they can hit that international revenue guide which they're hoping to get to. I think all the things they mentioned, whether it's through expanded store count, same store sales growth, whether that's pricing power or revenue mix, higher ticket, just people buying more. I think both of those are achievable. I think they can sustain the margins they've had for reference over the last five years, margins, operating margins are, I think EBIT margins have gone from an EBIT. It's just earnings before interest and taxes has gone from about 16 percent to 21 percent. I believe they can sustain that 20-21 percent margin, if they're able to do that, and Lululemon gross revenue at 15 percent a year, they've grown at 26 percent per year over the last five.

They're going to be generating about $3 billion in earnings before interest and taxes. If you assume that what the market values those earnings at in five years is significantly lower than the current ones. Let's say they value that at 20 times, right now it's, they trade at about 26 times EBIT, and historically over the last five years, it's been 35 times EBIT. That would mean a $64 billion market cap. I believe today as we're speaking, are around $70 billion if you include the cash that would accrue over the next five years. It'd be about $70 billion worth of market value versus $40 billion today, I think I'm throwing conservative estimates out there; obviously, it means that the brand to stay relevant and be as influential in society as it is today. I think they can continue to do that. They have continued to skate where the puck is when it comes to consumer trends and adapted well. I think the future looks a lot like the past just a little bit longer and Lululemon is going to succeed as they continue to move forward.

Asit Sharma: Ryan Henderson, thank you for the bull case. Building valuation tables on air. How about that for a feat? ABC pants, also a great way to say I'm wearing khakis, but I'd rather be wearing sweatpants anyway, you guys can decide who made a better argument at Motley Fool Money on Twitter. We will have a pull-up there.

Chris Hill: Today's lucky winner will receive a complete VHS workout tape collection. It includes Jane Fonda's easygoing workout, Sit and Be Fit, and Tae Bo. It's a new year and you've got new fitness goals. Commit to your health journey right from your living room. Need some extra motivation, put a mirror behind your TV set. See every stage of your fitness journey and work out with a friend. You will never need a gym again when you can get ripped right from your couch. This fabulous prize package could be yours if you win Bull versus Bear. 

As always, people on the program may have interest in the stocks they talk about. The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.