The Zen Innovation Investor Volume 6

The purpose of this weekly is to sharpen my thinking by sharing thoughts about industries and companies that fit into powerful long-term investment themes. It is also a place to share insights into decision making, takeaways from the past week, and random thoughts that arise. Thank you for reading this piece! Feedback is welcomed.

This week:
➢ AI: Prosperity on the Way, Part 1
➢ Lululemon: Innovator of Lifestyle Products
➢ Lululemon: It is not just Yoga Pants; it is a Fantastic Business!

AI: Prosperity on the Way, Part 1

In the past few weeklies, I have discussed lessons learned from the 1990s PC Era and the Internet Era that ensued. We have officially entered the Data / AI Era and I am sharing some thoughts this week about what that means.

AI is the most powerful theme for the coming years, and I believe these years are going to be wild. What is sitting in front of us is economic prosperity driven by innovation. AI is the driver of more innovation, and it is coming at a faster pace than prior catalysts of transformational change.

Zooming out, a few things happened on our way to this point:

1. Technology (think smart phones, cloud computing, etc.) has slowly and steadily become part of the fabric of what we do and rely on every day, and it is here to stay.
2. People (corporations included) are comfortable with what they spend on technology because it makes their lives easier and better. For corporations, it makes their processes more efficient and cost effective.

3. Every new period of transformational change has resulted in more spending on technology goods and services because the added value of the newer technology (think PCs, software), the added value of the new way to communicate (think

smartphones) or distribute products etc. (think the internet) are superior to the old way of doing things.

It is important to stop and reflect on how we got here, because progress and change happens incrementally. Whether you are in favor of more technology in your life or not, it is here to stay and will continue to become more and more important in our daily lives. This not only has implications for what life will look like, but it will also affect how companies use technology and how investors evaluate corporations.

So, coming full circle to AI, yes, it will be BIG… A few things I feel strongly about relative to AI:

1. The pace of change will be faster than many anticipate because AI sits on top of mostly existing infrastructure.

➢ The information and data to run the models are already on the web or in the cloud.

2. New models and applications that run on top of them will require additional infrastructure, spurring a hardware capex increase.
3. The percentage of money spent on goods and services going toward technology will increase because of AI.

4. Those that get a disproportionate share of benefit from AI, either in revenue gains or expense reduction, will reap the most economic gains (i.e. prosperity). 5. The amount of prosperity afforded to the winners of AI will surprise many and create a whole host of other issues we will need to deal with. I plan to write about this in the coming weeks.

As with any period of transformational change, the path from rapid change today to more normal rates of change will be bumpy. There is and will be hype and there will be periods of concern and disappointment. This will manifest in the valuations of investments etc. But the rewards will surprise many when this is more mainstream.

One other thing I am thinking about in terms of what to expect by using the PC Era and Internet Era as a guide. I believe one large recognizable corporation will report around mid-year 2024 that they are seeing revenue increases and cost reductions driven using AI. This will make their equity value higher and create a call to action for other companies and their Boards of Directors. We will see, but I expect a wild and fun year ahead of us in 2024.

Next week, I will talk about thinking about how to benefit from this prosperity in a portfolio and asset allocation model.

Lululemon: Innovator of Lifestyle Products

Innovation doesn’t always have to be about technology. Technology is certainly important to innovation today, but there are companies that are part of the global economy that are innovators but are not categorized as a technology company.

Lululemon is one of those companies. What they have done over the last 17 years as a public company is nothing short of remarkable. Initially known for yoga-wear, the company has successfully transitioned into a lifestyle brand, and has been one of the creators of the athleisure category. The company had around 50 stores when they went public in 2007, and now have close to 700. Revenue was $149 million then and they are on track to post approximately $9.6 billion in Fiscal 2024 (January). That is a compound annual growth rate (CAGR) of 28%! Even more impressive is that the company has been profitable all that time, and they are on track to post more than $2 billion in operating profit for Fiscal Year 2024.

It isn’t easy to do as a consumer company, but Lululemon has done it by being innovative in a few ways:

Establishing and protecting the brand. Over the years, Lululemon has meticulously cultivated and safeguarded its brand, establishing itself as a leader in the wellness and lifestyle sector. Central to this has been their unwavering commitment to quality and innovation, consistently delivering products that blend style, comfort, and functionality. By fostering a unique community culture through in-store experiences and local events, they’ve created a loyal customer base that resonates deeply with the brand’s ethos. Additionally, Lululemon’s strategic marketing and smart expansions into diverse product lines and technology integration, through their app and other ways, have further fortified their brand identity, setting them apart in a competitive market.

Product innovation and expansion. Lululemon has skillfully used product innovation as a cornerstone of its growth strategy, continually introducing high- performance, proprietary fabrics that offer unmatched comfort and durability. This focus on innovative design has not only kept them at the forefront of athletic wear but also allowed them to expand into diverse product categories like men’s apparel, lifestyle accessories, and now footwear. By thoughtfully expanding their product set to cater to a wider range of lifestyle and wellness needs, Lululemon has adeptly

broadened its market appeal while maintaining the quality and distinctiveness that define their brand. This approach has proven vital in establishing Lululemon as a versatile and resilient leader in the competitive world of lifestyle and athletic apparel.

Building out e-commerce to distribute broadly and effectively. In the third quarter of 2023, the company’s digital channel revenues reached $908.1 million, accounting for 41% of their total revenue. This represents a significant 19% increase in digital sales compared to the same period in the previous year, highlighting the brand’s strong online presence and effective e-commerce strategies.

Utilization of technology to build community and enhance customer experience. Lululemon has done a great job of using technology to build a robust community and elevate the customer experience, setting a new standard in the retail industry. Their innovative use of social media and digital platforms has created interactive and engaging online spaces that foster a sense of community among their customers. Additionally, Lululemon’s in-store technology, like virtual fitting rooms and mobile apps, has streamlined the shopping experience, making it more convenient and personalized, further strengthening their customer relationships and community ties.

Lululemon’s innovation extends beyond their products; it’s ingrained in their business model, marketing strategies, and corporate ethos. This comprehensive approach to innovation has set them apart in the athletic apparel industry and established them as a leader in lifestyle branding.

Lululemon: It is Not Just Yoga Pants, It’s a Fantastic Business!

I have been investing in consumer companies for close to 30 years now. Consumers are famous for their fickleness. Barriers to entry in the consumer space tend to be lower than other industries, and the internet to market and distribute has made it even lower in my view. But many companies have left investors with heartache and losses from changes in consumer preferences, competition, and poor execution. So, how do you know if you have a good one that can last? It is the same formula as other industries and sectors, but there are three elements to me that stand out as being even more important in this space versus other industries:

1. Brand and brand management.
2. Customer friction levels – the lower the better.

3. Bullets then cannonballs.

For this example, I touched on the brand building, brand quality, and brand protection above. Lululemon has done an amazing job at this, and they have the affinity of a wide demographic, willing to pay a premium for their goods due to the brand.

Branding is a hard thing to analyze, it is one of the art forms of the job as an investor. A brand to me is mostly how consumers feel as they contemplate a purchase. What will that purchase do for me, say about myself and my taste, etc? It is more than that but to try and keep it on the simple side, that is how I think of it.

Lululemon has not been free of controversy, but the company has done a very good job of keeping the integrity of the brand, even while it expands its business into more than yoga pants. This to me is the most important thing to follow from here forward, will they stay true to the brand and not over expand to try and grow to make a quarter’s report.

The company has adopted a strategy of using multiple channels for growth, and they are growing stores at a steady pace, which is where missteps can happen. The company has focused on identifying key markets and locations that align with their brand ethos and customer demographics, ensuring a strong market presence and brand resonance. This measured approach to expanding store count, both domestically and internationally, has allowed Lululemon to maintain the quality of customer experience and community engagement that their stores are known for.

Today, retail stores represent more than a place to purchase products. It serves as a testing ground for the introduction of new products, a low friction way to return product, and a way to keep the brand from of mind. The brand’s international expansion, especially in markets like Europe and Asia, reflects a keen understanding of global consumer trends, further solidifying Lululemon’s position as a globally recognized and respected lifestyle and wellness brand.

Consumer companies that have a strong brand have a major advantage, if used properly. They can roll out new products to customers and due to brand affiliation, can often get increased business if the offering is good and it meets customer needs. Where it can go wrong is where a company tries a new product line as a big splash, only to have it fall flat. That damages the brand and sets the company back. Author Jim Collins uses a framework for measured growth that he calls bullets then cannonballs. Meaning, fire a few bullets to calibrate, then once the range is

found, then fire a cannonball. In consumer parlance, that would be a slow introduction to a new set of products, maybe to a new demographic than your customer is used to then go all in.

Lululemon has done this with men’s apparel and is doing it now with footwear. This type of behavior allows the company to protect the brand, with the ability to have it evolve and expand, and it allows for agility.

Great businesses have these characteristics:

▪ They grow revenue and grow it consistently.
▪ They earn a margin above similar products or services.
▪ They preserve financial flexibility and invest for future growth. ▪ They repeat this behavior.

Lululemon does all these things and has done it for a long time now, 17 years as a public company. Bravo!

To circle back to my earlier comments about AI, I see Lululemon being a big beneficiary of AI, as they have a unique dataset, combined with an innovative culture.

Next week, I will discuss Lululemon’s stock and how building this business has created tremendous wealth for shareholders.

Note to readers: Arrowside Capital has a position in Lululemon.

My story

I am an investor and entrepreneur, having started two investment companies. I am the Founder and CIO of Arrowside Capital, based in Boston. I have more than 30 years of experience in the investment business, investing in mostly small and mid- sized companies, all geared toward innovation and growth. The blog is named The Zen Innovation Investor because I believe it is so important to remain calm and focused during the rapid pace of change in the world today. I am keeping a view of the long term while also keeping abreast of developments in the world of innovative companies. I view this as a place to sharpen my thinking and provide some insights that are thought provoking.


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