Description

Investment Thesis

Under Armour is a retail short play on (1) the struggling retail sector as consumers are increasingly focused on “experiences” rather than “stuff”; (2) increased competition within the athletic apparel/footwear market; (3) the brand’s expanded distribution strategy into mass retail; and (4) the brand’s risky international expansion, which collectively are leading to lower margins. As a result, at more than 50x our F2017 EPS estimate, the risk-reward profile for shorting UAA is favorable.

Description

Under Armour designs, manufactures, markets, and distributes branded performance apparel, footwear, and accessories globally.

In 1996, Kevin Plank founded Under Armour, after graduating from the University of Maryland, where he played on its football team. The brand launched with moisture-wicking T-shirts, manufactured with synthetic fabrics that absorb sweat better than do cotton T-shirts. In the early years, Under Armour revolutionized the athletic apparel market with high performance products, positioning the brand as a niche player catering to a younger demographic, the millennials.  Even the company’s tagline “I Will” was created to appeal to millennials’ affinity for persistence and resilience. Thus, in its early years, and until the past few years, Under Armour was not directly competing against the industry titans, Nike and Adidas. Plank is a transformational business leader, known for his motivational speeches and competitive drive.  Over the course of the past 20 years, with Plank's visionary leadership, Under Armour has grown to 15,000 employees and approximately $4.5 billion in annual sales. However, Under Armour is now challenged to develop a strategy for sustainable double-digit growth.

Capital Structure

* Balance sheet data as of 10-Q for period ended March 31, 2017

**In addition to debt, UAA has $1.4 billion of lease obligations

Market Overview

The athletic apparel/footwear market continues to grow more competitive, as Under Armour, Nike, and Adidas engage in a slugfest for global dominance. With innovative, high performance gear, Under Armour has historically been able to differentiate its brand and be the brand of choice for youths and amateur athletes.  However, recently in its efforts to expand, management was confronted with a strategic turning point: maintain the brand for the CrossFit types or expand horizontally into mass retail. Management pursued the latter strategy, which removed the niche positioning and put the brand in more direct competition with Nike and Adidas. In addition, Under Armour is trying to expand internationally, where those competitors are more well-known and have significantly greater market shares.

The retail industry remains under significant pressure. The department store model, especially the mid-tier, is among the most structurally challenged in the industry and some specialty stores, such as The Sports Authority have recently filed for bankruptcy and liquidated. Store traffic has rapidly decreased, as online shopping is more convenient and teens no longer socialize at malls as they did in the 1980s and 1990s. Consumers are increasingly focused on buying “experiences” rather than “stuff”. Younger shoppers --- the millennials ---in particular when purchasing apparel prefer less expensive, fast-fashion items that can be worn a few times. As a result, the market for expensive sneakers may be tightening, as evidenced by softening sales of the Steph Curry 3. 

Our Perspective  

Growth Decelerating, Sputtering

In 1Q:2017, Under Armour recorded its fourth consecutive quarter of decelerating net sales growth. Further, UAA posted its sixth straight quarter of decelerating growth in apparel, which is a critical category, particularly with its recent entry into the crowded athleisure market.  In addition, footwear, sales after growing nearly 50% in 2016, increased just 2%. While management argues that this was due to a difficult year over year comparison (footwear grew 64% in 1Q:2016), this contention is more likely an inconvenient excuse, since in 4Q:2016 footwear grew 36% against 95% growth in 4Q:2015. Increased competition and resulting lost market share are more likely.

Exhibit 1: Quarterly Net Sales 

Exhibit 2: Quarterly Apparel Sales

Exhibit 3: Quarterly Footwear Sales 

Ominous First Quarterly Loss

In addition to slowing growth during the past year, UAA reported its first quarterly loss as a publicly traded company for 1Q:2017. In our view, Wall Street viewed the results through rose colored glasses, as UAA reported better-than-expected results yielding a loss of merely $0.01 per share, compared to the consensus estimate for a loss of $0.04 per share. However, we think the headline of a shocking (albeit expected) quarterly loss was largely lost by the expectations game. The fact that UAA reported (and Wall Street expected) a loss of any kind demonstrates how far UAA has fallen from its heyday (circa 2008).

Competition Growing Fiercer

The athletic apparel/footwear market is saturated with major players, as well as niche brands. Competition revolves primarily on brand image, performance (quality), and price. Nike and Adidas are UAA’s chief rivals. For example, in 1Q:2017, North America was the fastest growing region for Adidas, with revenue up 31% on a constant-currency basis. Yet, Under Armour witnessed its revenue drop in North America by 1% during this same period, effectively losing market share to Adidas.

However, as Under Armour shifts its focus to athleisure apparel, there is no shortage of competitors there, too, In addition to Nike and Adidas, Lululemon is a dominant player. Trendy niche brands include Yogasmoga, Calia by Carrie Underwood (Dick’s Sporting Goods), Sweaty Betty, Outdoor Voices, Athleta (Gap), and Gaiam. Soon Amazon will step up to the plate in this arena, as well.

From a marketing perspective, Nike and Adidas compete for contracts to outfit college athletic programs. In addition to receiving lucrative sponsorship contracts, we assume that athletic directors also base their decisions on the quality of athletic gear that each brand provides. In this context, we note that Under Armour had deals with only 12 of the 68 teams in the 2017 NCAA Men’s Basketball Tournament, compared to Nike with 40 and Adidas with 15. In our view, this is evidence that the performance premium for Under Armour is not as strong as the company’s marketing would suggest.

As we describe in the next section, strategic blunders in its retail distribution have caused the Under Armour brand image to sour, as pricing on some products has become more promotional to better compete.

Strategic Decisions Unraveling Brand Authenticity

Partly in reaction to recent bankruptcies of sporting goods brick-and-mortar retailers, such as The Sports Authority, as well as to fuel sustainable revenue growth, Under Armour has sought to broaden its distribution by entering mass retail outlets, such as Kohl’s. Unfortunately, two months into its much hyped debut at Kohl’s, the strategy is underperforming and could threaten the brand’s integrity.

Plank has argued that retailing at Kohl’s was a logical evolution for Under Armour, especially considering the retailer’s popularity with middle-class suburban mothers.  First, UAA’s core consumers are youths and amateur athletes and part of the allure of the Under Armour brand was the brand was seen as exclusive and cool. By going to the mass market, this exclusivity is lost, turning off its core consumers, losing its competitive advantage (i.e. brand image), and becoming just another athletic brand. Further, only because sales growth has decelerated so much has UAA needed to enter the mass market, indicative of a fading brand. Since Kohl’s is highly promotional with steep discounting, there is the risk that the Under Armour brand will be de-valued, as well. UAA is now also set to expand to other discounters, such as DSW and Famous Footwear. Will TJ Maxx and Marshall’s be next for Under Armour? Those stores are not exactly where the Crossfit types want to see their exclusive, cool brand. 

Further adding to UAA’s retail woes is its poor segmentation strategy, which has resulted in significant overlap in SKUs offered on its own website and at Dick’s Sporting Goods, Foot Locker, and to a lesser extent Kohl’s. With much overlap, the probability of price discounting is greater. There is already evidence that the highly promotional pricing cadence at Kohl’s is affecting sell-through at Dick’s Sporting Goods. Moreover, even if lower quality SKUs are being sold at Kohl’s (saving higher quality SKUs for “full price” retailers) this dichotomy will only further confuse consumers. In order to effectively segment the market by retail concept (mid-tier department store, upscale department store, specialty store, etc), the brand needs to have dozens of SKUs. However, Under Armour only has a limited assortment.

In summary, the mass retail strategy is likely to cause two major issues for Under Armour: (1) the weakening of its brand image and (2) lower margins.

Weak Corporate Governance, Undemocratic

Under Armour currently trades two publicly-traded classes of stock: UA (class C) and UAA (class A). UAA shares include voting rights, whereas UA shares do not. However, Plank owns a separate class of stock (class B) which enables him to control 65% of the voting rights, as the class B shares have 10x the voting rights as do class C shares. This convoluted share structure is undemocratic and below industry standard. Further, the UAA class with voting rights merely offers investors an illusion of voting power, given Plank’s control.

Focus on Risky Global Expansion, Distracts from North America Headwinds, Turnaround

At the same time that Under Armour is trying to turnaround --- yes, when a company reports its first quarterly loss in more than a decade as a publicly traded company, the business is in turnaround mode--- management has set its eyes on global expansion. However, international markets only accounted for 15% of net revenues in 2016, dwarfed by North America. As a result, despite impressive-sounding growth rates during 2016 in Europe (+62%), Asia (+86%), Latin America (+34%), these growth rates are bound to decelerate as well, given the relatively small numbers that they are based upon. Further, given the significant marketing expenses needed to generate revenue in global markets, the EBIT margin of International (6.2%) is 400 bps less than in North America (10.2%). Moreover, as UAA mounts a threat to Nike and Adidas in international markets, those stronger, more capitalized competitors will clearly flex their muscles to fend off this “new” competition. In addition, oftentimes, the winners of international market battles are the ones with the most recognizable brand names (i.e. McDonalds, Coca Cola, etc). In addition, we are concerned that UAA management may find its focus on international expansion a distraction from its turnaround efforts in its core North America market. Given the lower margins of the international segment, even if UAA is successful in growing revenue in those markets, the overall margins for UAA would decrease.

Nosebleed Valuation Unwarranted

Despite Under Armour’s rapidly decelerating revenue growth and expected earnings contraction in 2017, UAA trades at a steep valuation multiple, currently 50x consensus 2017E EPS of $0.43. However, trading at nosebleed, tech stock earnings multiples is nothing new for UAA, as Exhibit 4 below depicts. Looking back 7 years, UAA’s P/E multiple has fallen from 95x in early 2010 to as low as 37x in early 2016.

Exhibit 4: Historical Forward P/E Multiple  

Financials

As our earnings model in Exhibit 5 illustrates, we forecast below consensus EPS in 2017 ($0.40 vs $0.43) and 2018 ($0.44 vs $0.51), primarily from increased competition in both the North America and International segments, lower gross margins from mass retailing, lower EBIT margins from the International segment, and the commoditization of athletic apparel.

Exhibit 5: Earnings Model

As e-commerce is increasingly becoming a major force in apparel retailing, Under Armour is investing heavily in its digital commerce platform (direct to consumer). Unfortunately, this growth path has its own challenges: significant capital expenditures as well as higher expenses (i.e. free shipping). Given the expected capital expenditures, we do not forecast any meaningful free cash flow yield for UAA, even when excluding growth capex (which we estimate to be 50% of total capital expenditures).  

Exhibit 6: Free Cash Flow Model

Valuation

As we discussed earlier, UAA shares trade at a steep valuation multiple, more like that of a technology start-up than an apparel company. As Exhibit 4 depicts, during the past 7 years, the forward P/E multiple for UAA shares has diminished from 95x to 37x. Yet, despite posting its first quarterly loss since its IPO, a likely earnings decline in 2017, and management’s unrealistic full-year 2017 guidance which is loaded to the second half of the year, shares trade at 53x our F2017 EPS estimate of $0.40. Even if we were to assign the historical trough 37x multiple to UAA, the implied stock price would be $15, more than 25% lower than the current price. Yet, even 37x seems to be a rich valuation, given the headwinds, decelerating growth, and likely lower margins.  As Exhibit 7 illustrates below, utilizing a forward multiple between 25x and 40x and EPS between $0.40 and $0.50 (consensus is $0.43), yields a stock price between $10 and $20. As Exhibit 8 illustrates, these stock prices imply downside potential between 6% and 53%. As a comparison, Nike currently trades at 23x its consensus $2.40 F2017 EPS estimate.

Exhibit 7: Implied Stock Price 

Exhibit 8: Implied Stock Price Variance

Risks 

Stronger than expected sales growth – Sustainable double-digit sales growth (i.e. at least 15%) would imply that the 1Q:17 results were truly an anomaly and that the turnaround is working.

Stable or growing margins – This would demonstrate that the company’s growth initiatives are not margin crushing and that combined with double-digit sales growth, the stock may warrant a premium valuation multiple.

Increase in brand popularity – New endorsement deals from all-star athletes or product innovations that captivate the market would enhance the brand image.

Dividend or share repurchases – The issuance of dividends or repurchase of shares would indicate management’s confidence in near-term fundamentals.

Conclusion

Under Armour, a once high-flying momentum stock, is now facing (1) mounting headwinds from transformational shifts in the retail industry; and (2) the consequences of its growth strategy to enter mass retail and expand internationally. Unfortunately, both of these initiatives are margin busting, as mass retail requires near constant promotions and international expansion significant marketing expenses.  As a result, Under Armour may chase sustainable double-digit revenue growth while yielding lower margins for the foreseeable future.

However, Under Armour is not as popular as the brand was even 5 years ago, when the brand had its premium, high quality/performance image for serious athletes. Even amongst teen consumers, the brand has lost its luster. A recent Piper Jaffray survey about teen spending indicated that Under Armour was not among the top 10 favorite apparel or footwear brands (Nike was #1 for both categories). Moreover, the same survey found that that Under Armour is number one for brands that males no longer wear.

With the rapid deceleration in sales growth combined with lower margins from mass retailing and international expansion, we simply find that UAA shares at more than 50x our F2017 EPS estimate offers a favorable risk-reward profile as a short idea with continued multiple contraction likely.

Catalyst

Continued deceleration in sales growth in key product categories – This would provide further evidence that UAA’s strategy of mass retail distribution is tarnishing its brand image and competition is growing stiffer.

Continued gross margin erosion – This would be the result of continued weakness in retail apparel, necessitating promotions to clear inventory.

Loss of key management – In February, Under Armour’s CFO resigned due to “personal reasons” and the company is now actively searching for his replacement. We think additional senior management departures would indicate further fundamental weakness in the business.