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Why Lululemon’s Digital Business Is So Profitable

John Ballard, The Motley Fool

Lululemon Athletica (NASDAQ: LULU) has been on fire lately, and one area of the company that investors are most impressed with is the performance of the direct-to-consumer channel (which includes online sales). Lululemon's digital business grew 49% last year, and management believes they are at the beginning of a long runway of digital growth. 

Management shared an important insight on the last conference call that explains partly why Lululemon's digital business is performing so well, particularly how the company is generating significantly higher margins from the direct channel compared to its physical stores. Here's what they had to say.

A group of men and women practicing yoga during a yoga class.

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Lower online returns

The company's operating margin for digital sales is more than 50% higher than physical stores (41% vs 27%, respectively). One analyst on the fourth-quarter conference call was "extremely impressed" with the margins in the digital business and pointed out that Lululemon's digital margin is as good as it gets in the retail industry. 

The response by COO Stuart Haselden says more about customer satisfaction with the product than anything special the company is doing operationally to drive a high margin rate:

Our return rates, in particular, are very low, which helps explain why we enjoy a better rate -- margin rate online than other companies.

Haselden didn't mention any other factor except the low return rate which implies that returns for online orders are a major cost burden for a retailer.

The average return rate for online orders in the retail industry is three times higher than purchases made in-store. That's not surprising given that it's difficult to gauge how something will fit until you have the item in hand. It's worth pointing out that Lululemon's clothes are not for the faint of wallet, so customers must be very satisfied with the quality of the product.

A low return rate is a huge cost saver, as companies take a hit for the costs required to process an online order like picking, packing, shipping, and other overhead costs when an order is returned.

Standing out from the crowd

Contrary to conventional wisdom, not all companies generate higher margins from digital sales. Different stores use digital sales in different ways and have different cost structures. For example, some department stores use physical stores as mini-distribution hubs to process and ship online orders direct to customers. 

One study by AlixPartners found that this omnichannel approach can lead to a lower profit margin as opposed to selling the item to a customer in the store. The reason is that when a product is ordered online and processed by a local store, the company is, in effect, doubling the cost of processing the order, since there is a cost being incurred to operate the website, distribution, and the overhead of the store. This can lead to no accretive profit falling to the bottom line for an online order.

This likely explains why, for example, Nordstrom has not been able to improve its operating margin despite digital sales increasing from 18% of sales to 30% over the last five years. Only recently has Nordstrom's digital business reached the same contribution margin as physical stores. 

However, Lululemon has earned an operating margin of 40% or better from its direct-to-consumer channel for years and has seen its companywide margin improve in the process. 

One way Lululemon keeps costs down is by owning and operating only one distribution center in Ohio and leasing others. Instead of opening capital-intensive distribution centers, the company focuses on investing in website improvements, such as better search, improved speed, and better order processing, as well as providing the customer a lot of information, including high-resolution photography and other details on the product page. These investments paid off last year with accelerating digital growth, and Lululemon is planning to launch new websites in France, Germany, China, Japan, and Korea this year. 

During the last call, Haselden remarked that they still haven't mastered the digital side of things despite what their superior margin rate would lead you to believe:

We don't feel like we're world champions yet in digital e-commerce, and there's a lot of opportunities we see with the website, with social media, with digital marketing, where we can do much better. And so the upside there is a nice runway of revenue growth in our digital business.

Haselden's comment on top of the company's recent stellar performance makes it seem the growth story has legs. The improving profitability, partly as a result of increasing digital penetration, is one reason why investors continue to love the stock.

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John Ballard owns shares of Lululemon Athletica. The Motley Fool owns shares of and recommends Lululemon Athletica. The Motley Fool recommends Nordstrom. The Motley Fool has a disclosure policy.