Warren Buffett is renowned for his patient, long-term approach to investing in high-quality businesses with durable competitive advantages. While the Oracle of Omaha has historically shied away from retail stocks, athletic apparel maker Lululemon (NASDAQ: LULU) displays many characteristics that could potentially make it an attractive Buffett-style investment. Let’s analyze LULU through the lens of Validea’s quantitative model based on Buffett’s investing philosophy.
Understanding Buffett’s Investment Criteria
Before diving into Lululemon specifically, it’s important to understand the key tenets of Buffett’s approach as interpreted by Validea. Here are the key fundamental criteria he looks for:
Earnings Predictability: Buffett seeks companies with steady, consistent earnings growth over long periods of time.
Conservative Financing: Companies should have manageable debt levels that can be paid off from net income in 5 years or less.
Strong Return on Equity: Buffett looks for firms with 10-year average ROEs of at least 15%.
High Return on Total Capital: For non-financial companies, Buffett wants to see 10-year average return on total capital of at least 12%.
Efficient Use of Retained Earnings: Management should demonstrate the ability to effectively reinvest earnings to fuel future growth.
Limited Capital Expenditure Requirements: Buffett prefers companies that don’t require major ongoing investments to maintain competitiveness.
Attractive Initial Rate of Return: A stock’s earnings yield should be higher than the long-term Treasury bond yield.
Potential for Strong Future Returns: Buffett uses both a return on equity method and an EPS growth method to project potential 10-year returns.
Now, let’s examine how Lululemon stacks up against these criteria.
Lululemon’s Fundamental Strength
Consistent Earnings Growth
Lululemon passes Buffett’s earnings predictability test with flying colors. The company has demonstrated remarkably consistent earnings per share growth over the past decade, with EPS rising from $1.66 in 2014 to $12.20 in the most recent fiscal year. This steady upward trajectory, with only minor dips, would likely appeal to Buffett’s preference for predictable businesses.
Conservative Balance Sheet
LULU’s conservative financial position would almost certainly catch Buffett’s eye. The company carries no long-term debt, easily passing Buffett’s debt criteria. This gives Lululemon significant financial flexibility and reduces risk.
Impressive Returns on Equity and Capital
Lululemon’s profitability metrics are exceptional. The company boasts a 10-year average return on equity of 27.6%, well above Buffett’s 15% threshold. Its 10-year average return on total capital is equally impressive at 27.6%, far surpassing the 12% bar set in Validea’s Buffett model.
Effective Use of Retained Earnings
Management’s capital allocation skills appear strong. Validea’s model indicates that Lululemon has generated a 22.2% return on retained earnings over the past decade. This suggests the company is effectively reinvesting profits to drive future growth – a key Buffett consideration.
Positive Free Cash Flow
Lululemon passes the free cash flow test, generating $12.94 per share in free cash flow. This indicates the company isn’t burdened by excessive capital expenditure requirements to maintain its competitive position.
Share Repurchases
While not a primary factor, Buffett views share repurchases favorably when done at attractive valuations. Lululemon has reduced its share count from 130.4 million to 120 million over the past five years, potentially creating value for long-term shareholders.
Evaluating Lululemon’s Potential Returns
Validea’s Buffett model employs two methods to estimate future returns:
1. Return on Equity (ROE) Method
This approach projects Lululemon’s book value growth and potential earnings power 10 years into the future. Based on the company’s historical ROE and other factors, our model estimates a potential 23.9% average annual return using this method.
2. EPS Growth Method
This method uses Lululemon’s historical EPS growth rate to project future earnings. Using this approach, Validea’s model calculates a potential 11.54% average annual return.
Averaging these two methods yields an expected return of 17.7% annually over the next decade. This falls squarely within the range Buffett would find attractive (12-22% expected returns).
The Qualitative Case for Lululemon
While Validea’s quantitative model gives Lululemon a near-perfect score, Buffett’s investment philosophy goes beyond just the numbers. He seeks businesses with durable competitive advantages or “economic moats.”
Lululemon appears to possess several qualities Buffett prizes:
Strong Brand: The company has built a premium brand in the athletic apparel space, commanding customer loyalty and pricing power.
Innovation: Lululemon continually develops proprietary fabrics and designs, helping maintain its edge in a competitive market.
Growing Direct-to-Consumer Channel: The company’s e-commerce capabilities provide a valuable connection to customers and higher margins.
International Expansion Potential: While strong in North America, Lululemon has significant room for growth in international markets.
Conclusion: An Intriguing Buffett Prospect
Lululemon scores exceptionally well on Validea’s Warren Buffett-inspired investment model, achieving a 100% rating. The company’s consistent earnings growth, strong profitability metrics, conservative balance sheet, and projected returns all align closely with Buffett’s historically favored characteristics.
While Buffett himself has generally avoided retail investments, Lululemon’s powerful brand and growth trajectory make it an intriguing potential exception. The company’s ability to maintain high returns on capital over an extended period suggests it may possess the type of sustainable competitive advantage Buffett seeks.
Of course, valuation always plays a crucial role in Buffett’s investment decisions. At its current price-to-earnings ratio of 24.9, Lululemon isn’t exactly cheap. However, given the company’s growth prospects and financial strength, it’s conceivable that Buffett might view the current price as reasonable for such a high-quality business.
While we can’t predict if Lululemon will ever find its way into Berkshire Hathaway’s portfolio, the company’s fundamental characteristics make it a compelling case study in Buffett-style investing principles.
