Under Armour's CEO Discusses Q2 2011 Results - Earnings Call Transcript

| About: Under Armour, (UA)

Under Armour (NYSE:UA)

Q2 2011 Earnings Call

July 26, 2011 8:30 am ET

Executives

Brad Dickerson - Chief Financial Officer and Principal Accounting Officer

Tom Shaw -

Unknown Executive -

Kevin Plank - Founder, Chairman, Chief Executive Officer and President

Analysts

Sharon Zackfia - William Blair & Company L.L.C.

Michelle Tan - Goldman Sachs Group Inc.

Kate McShane - Citigroup Inc

Mitchel Kummetz - Robert W. Baird & Co. Incorporated

Omar Saad - ISI Group Inc.

Robert Ohmes - BofA Merrill Lynch

Michael Binetti - UBS Investment Bank

Jim Duffy - Stifel, Nicolaus & Co., Inc.

Operator

Good day, ladies and gentlemen, and welcome to Under Armour, Inc. Second Quarter Earnings Webcast and Conference Call. [Operator Instructions] As a reminder, this webcast is being recorded. I would now like to introduce your host, Mr. Tom Shaw. Please go ahead.

Tom Shaw

Thanks, and good morning to everyone joining us on today's conference call.

During the course of this conference call, we'll be making projections or other forward-looking statements regarding future events or the future financial performance of the company. We wish to caution that such statements are subject to risks and uncertainties that could cause actual events or results to differ materially. These risks and uncertainties are described in our press release and in the Risk Factors section of our filings with the SEC. The company assumes no obligation to update forward-looking statements to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events.

Joining us in today's call will be Kevin Plank Chairman, CEO and President; followed by Brad Dickerson, our CFO, who will discuss the company's financial performance for the second quarter and provide an update to our 2011 outlook. After the prepared remarks, Kevin and Brad will be available for a Q&A session that will end at approximately 9:30 a.m. I will then close with a tentative date of our third quarter 2011 earnings call. Finally, a replay of this teleconference will be available at our website at approximately 11 a.m. Eastern Time today. And with that, I'll turn it over to Kevin Plank.

Kevin Plank

Thanks, Tom, and good morning, everyone. Last month, we held our Investor Day here in Baltimore and laid out our strategy to double revenues between 2010 and 2013. We identified the key growth drivers we'll need to execute on in order to deliver that growth. And today, we're providing our first update against those drivers. From a gross perspective, there are a number of highlights. direct consumer revenues grew 81% in Q2. Footwear revenues were up 31%, and our largest business, apparel, grew 36%, led by the strong introduction of Charged Cotton. These numbers are great evidence that we continue to deliver against the promise of the Under Armour brand, and are delivering the innovation our consumers expect from the thought leaders in performance.

For Under Armour, thought leadership means finding the answer to a simple question, "How do we create technical breakthroughs that change the way a product is used by athletes?" Our brand was founded on a single insight around athletic performance, and the innovation that grew out of that has taken us over the billion dollar mark. We set the bar, and athletes have come to expect us to take them to some place new. But our opportunity now is so much greater. With the strength of what we built so far, we can now take our brand to a whole new audience of athletes.

In March, we brought the next generation of Under Armour innovation to every athlete's closet with our introduction of Charged Cotton. We looked in the athlete's closet and saw that the overwhelming majority of their t-shirts were cotton. We had an incredibly high share of their non-cotton t-shirts, but understand that the broader opportunity in getting a disproportionate of share in cotton as well. But we could only accomplish that by bringing innovation to the cotton category and changing the way athletes use the product. With our entry into performance cotton, we are just beginning to tap into this broader audience of athletes. We see Charged Cotton as our path nearly quadrupling our 2010 addressable market in apparel from the previous $3 billion market side to the more than $11 billion active use market, while continuing to blur the lines of a much larger $58 billion activewear market over time.

Our strong launch of Charged Cotton and our continued strength across core apparel, such as baselayer in training, help drive the 36% increase in U.S. apparel revenues. We're especially proud of driving this level of revenue growth in apparel, considering it comes off of 34% growth in Q2 of last year. We see these quarterly results as continued evidence that performance apparel remains the key driver of industry strength, and Under Armour continues to drive that leadership, especially from a premium pricing perspective. We feel very good about the strength of our core business, and we continue to lead the industry in share ASPs and most importantly, innovation.

In an important core category like baselayer, we remain a full-price brand. We continue to widen the gap between UA and our competitors in the category from an average selling price perspective, and are doing so by raising consumers' expectations around products through innovation that changes how they use our apparel. We'll continue raising the bar with our recent introduction of the next chapter in our Charged Cotton story, Storm Fleece. It's a water-resistant cotton hoody made of a heavyweight and durable cotton, and we're bringing a new level of performance to one of the most basic pieces in the athletes' closet. This is what our consumers expect from Under Armour, and we will continue to deliver this level of innovation as we grow our addressable market well beyond compression.

We built our apparel business on a platform of authenticity. At Investor Day last month, we discussed how we are building that same authentic platform in our footwear business. So while we remain focused on the long-term opportunity in footwear, we are showing signs of solid growth both on field and at retail.

First, we continue to get our shoes on the feet of champions, as the University of South Carolina took home their second consecutive NCAA baseball championship wearing Under Armour head to toe, including fleece. And with the NFL about to get back on to the field, we will be on the feet of not only the lead MVP and Tom Brady, but on the league's most watched new player in Cam Newton.

At retail, we are seeing some positive developments in footwear as well. Our Assert running shoe had strong sell-through in the second quarter, as we look to build the same level of authenticity with runners as we have with football and baseball players. We know it takes time to build that credibility as we enter each new category, but we're going about it in an authentic and surgical way. We are building credibility with runners in the same way we did with football and baseball players, with great product that solves an athlete's needs and looks as good as it performs.

Our other key deliverable in footwear is to raise awareness levels to make more consumers know that we are an authentic and growing footwear brand. Our multimedia back-to-school footwear campaign will include many of our top athletes, including Tom Brady, Cam Newton, and UFC fighting champion, Georges St-Pierre, and will be our first brand campaign where footwear takes center stage. We'll be introducing our Micro G cushioning technology to consumers in the campaign that will feature 2 new running shoes: the Split and the Charge RC. We've begun to shift the momentum in footwear with a strong product like the Assert, the Split and the Charge RC. We're also working closely with our partners, Foot Locker and the Finish Line, to deliver exclusive products that will help differentiate the Under Armour brand in the mall.

In basketball, we're going to bring the Under Armour product DNA to our footwear and be laser-focused on fit. Brandon Jennings signature shoe, the Micro G Bloodline, will launch in Q4. And we'll also have our newest athletes, basketball players Kemba Walker of the Charlotte Bobcats and Derrick Williams of the Minnesota Timberwolves, both top 10 picks in the recent NBA draft, wearing Under Armour basketball footwear this season. We talked at Investor Day about building the platform for long-term growth. We are able to make the needed investments in footwear and international and still show the increase in operating leverage that Brad will discuss. Because in part, our growth in apparel and our direct consumer business continues to outpace even our own expectations.

With 81% revenue growth in direct consumer this quarter, we continue to reach new consumers both online and at our retail doors. And as our product mix continues to expand, we're able to offer a much wider breadth of products in our DTC sales channel as well. This allows us to build bigger footprints for our Factory House stores and begins to leverage the opportunities in both footwear and apparel as we go deeper into the athlete's closet. With our continued growth in direct consumer, we've learned to become better retailers, and this is helping us improve our retail presentation within our existing key wholesale partners. As we grow our presence in footwear and accessories, we will be able to tell more integrated product stories at retail. This summer, we are launching a new concept in Dick's Sporting Goods called All-American shops, featuring an enhanced shopping experience with more efficient fixtures and the capacity to tell great head to toe product stories. We will install 50 All-American shops by the end of 2011 with a more aggressive rollout in 2012. The very best of these shops, what we're calling blue-chip All-American, will feature interactive digital centers, larger floor space and what can be described as monumental storytelling. And the blue-chip All-American shop that is being installed at Dick's Roosevelt Field on Long Island upon completion will be the largest single retail presentation for our brand in the world.

With the Sports Authority, we're introducing Armour Build 2.0, which involves an all-new innovative and flexible fixture package for better storytelling and more productive floor space. Expect this expansion of Armour Build in 100 of their doors by the end of this year. In the improvement in our retail presentation, it doesn't stop there. In all, we will be enhancing our presentation in more than 700 new shops over our existing distribution over the next 12 months. Combined with the next generation of our e-commerce site, which debuts this fall and the improvements we're making to our own retail stores, we will be impacting the retail presentation of over 50% of our revenues.

We're also taking our first steps into retail outside of the United States this year. Through our distribution partners, we've opened a new UA store in South Korea, a second store in Japan and the first UA store in Madrid in just the last quarter. We also opened our first store in Shanghai and are learning as much about the operations required for a store in China as we are about the consumer. We're planting the seeds to tell the full Under Armour story globally, much like we did with football and baseball cleats in footwear more than 5 years ago. And these new doors help provide a great platform to do that.

In summary, our industry is in a very strong growth mode, and Under Armour continues to drive that growth through product and thought leadership. By bringing innovation through a new audience of athletes, we are growing the industry and bringing new consumers into the performance market. As a team, we are committed to getting our operational capabilities to the same level of execution and leadership as our brand and products, so that we can fully benefit from the demand of our consumers. We believe we will make our operational platform a world-class partner to our products and brand competencies. We will invest in the people, processes and systems to fully leverage the power of the Under Armour brand. We believe we will double revenues from 2010 to 2013 and show operating leverage as well. While our rate of growth may vary from quarter-to-quarter, it will always be driven by our ability to innovate, to continue finding new ways to improve the products that make all athletes perform better. With that as our number one goal, we will work as a team to fully realize the incredible financial opportunity provided by being the athletic brand of this generation and next. And with that, I'll turn it over to Brad.

Brad Dickerson

Thanks, Kevin. I would now like to spend some time discussing our second quarter and year-to-date financial results, as well as our updated 2011 guidance.

Our net revenues for the second quarter of 2011 increased 42% to $291 million. Year-to-date, net revenues are up 39% to $604 million. Apparel grew 36% to $205 million during the quarter, our highest quarterly growth rate for the category since the third quarter of 2007. Apparel was up 35% year-to-date and continues to see broad-based strength across each of our men's, women's and youth categories. As Kevin mentioned, we are pleased with our Charged Cotton launch, and the program remains on track to generate approximately $60 million of net revenues in 2011. And as we have discussed, we will launch the next chapter of our Charged Cotton story, Storm Fleece, this September.

Beyond the training category, which includes Charged Cotton, we are also seeing strong growth in our graphics business, which more than doubled during the quarter. Our direct-to-consumer net revenues increased 81% for the quarter and 67% year-to-date, representing approximately 27% and 24% of net revenues, respectively, as compared to 21% and 20% in the prior year period. We opened 9 new Factory House stores during the second quarter, increasing our Factory House store base to 72, up 60% from 45 locations at the end of last year's second quarter. We expect approximately 7 additional Factory House stores to open in 2011, bringing our total door count by year end to 79. In addition, we expect to open our first hybrid store model this October.

Growth in our e-commerce business, which remains strong from -- primarily by higher traffic and conversion rates year-over-year, and we expect our new web platform to go live this fall. Footwear net revenues during the second quarter increased 31% to $47 million from $36 million last year, representing 16% of net revenues. Growth was predominantly driven by our running products led by our Assert products and initial selling of some of our back-to-school products. We continue to see greater 2011 footwear growth concentrated in the second and third quarters. Accessories net revenues during the second quarter increased 266% to $32 million from $9 million last year, reflecting the addition of our hats and bags business, which we brought in-house in January and which has also received strong consumer acceptance. We now expect our hats and bags business to contribute an incremental $70 million of net revenue in 2011, up from our prior guidance of an incremental $60 million.

International net revenues increased 58% to $14 million in the second quarter and represent approximately 5% of total net revenues. Growth was driven primarily by results in the EMEA region. As expected, our licensing revenues in Japan through our partners at Dome Corporation were impacted in the quarter by the March earthquake and tsunami. We are starting to see some recovery in this market, and still expect our overall business there to be up meaningfully year-over-year in 2011. Licensing net revenues declined 27% to $7 million in the second quarter, driven primarily by the transition of our hats and bags business in-house and the year-over-year pressure with our licensing business in Japan that I just mentioned.

Second quarter gross margins were 46.3% compared with 48.8% in the prior year's quarter. We had 3 primary factors contributing to the 250 basis point gross margin contraction. First, in apparel, less favorable product mix, input costs and sales allowances negatively impacted margins by 160 basis points. Second, a lower mix of licensing net revenues negatively impacted margins by approximately 120 basis points. Both the hats and bags' transition to in-house and the recent challenges for our Japanese licensees were key factors. And finally, we continue to generate a higher percentage of net revenues from our higher margin direct-to-consumer business, which grew 81% during the period, positively impacting margins by approximately 45 basis points.

Selling, general and administrative expenses as a percentage of net revenues leveraged to 42.4% in the second quarter of 2011 from 45.4% in the prior year's period. Details around our 4 SG&A buckets are as follows. First, marketing costs declined to 11.7% of net revenues for the quarter from 13.4% in the prior year period. While we experienced some shifting of dollars from the first quarter into the second quarter, our strong top line growth allowed us to leverage marketing costs during the second quarter. Second, selling costs increased slightly to 10.5% of net revenues for the quarter from 10.4% in the prior year period, primarily driven by the continued expansion of our Factory House stores and investments in our e-commerce business. Third, product innovation and supply chain costs decreased slightly to 10.7% of net revenues from 10.8% last year. Similar to last quarter, we continue to invest in these areas to support our long-term growth. But we were able to show a modest leverage given the strength of our top line. Finally, corporate services decreased to 9.5% of net revenues, compared to 10.8% in the prior year period as we leveraged corporate personnel, IT and facility expenses.

Operating income during the second quarter grew nearly 65% to $11 million compared with $7 million in the prior year. Operating margin expanded 50 basis points to 3.9% from 3.4% in the prior year quarter. Our second quarter tax rate of 41.7% was favorable to the 43% rate in the prior year period. Our resulting net income in the second quarter increased 78% to $6.2 million, compared with $3.5 million in the prior year period. Second quarter diluted earnings per share increased 73% to $0.12, compared with $0.07 in the prior year.

Now on to the key balance sheet items. Total cash and cash equivalents at quarter end decreased to 23% to $120 million, compared with $156 million at June 30, 2010. We have no borrowings outstanding on our $300 million revolving credit facility. During the quarter, we did take out the $25 million term loan, and was included in the overall credit facility to finance part of our purchase of our corporate headquarters here in Baltimore. The closing for the purchase took place in early July 2011. In connection with the closing, we also assume a $38.6 million loan attached to the property. Inventory at quarter end increased 74% year-over-year to $311 million compared to $179 million at June 30, 2010. Similar to last quarter, 2 factors contributed to our inventory growth during the quarter. The transition of our hats and bags business in-house and an earlier plan build of our ColdGear apparel for the 2011 fall/winter season. Excluding these factors, inventory would have increased approximately 57%, compared to our net revenues growth of 42% and reflecting our ongoing efforts to better service anticipated demand. Our investment in capital expenditures was approximately $20 million in the second quarter and approximately $32 million year-to-date. We are now planning capital expenditures for 2011 toward the high end of our previously indicated range of $45 million to $50 million. In addition to our normal operating capital expenditure plans, we'll have approximately $65 million in total investments for 2011, related to the just completed purchase of our corporate headquarters along without other investments and improvements in the campus.

Now moving on to our updated outlook for 2011. Previously, we anticipated 2011 net revenues of $1.37 billion to $1.39 billion, an increase of 29% to 31% over 2010, and 2011 operating income of $149 million to $153 million, an increase of 33% to 36% over 2010. Given our current visibility, we are raising this full year 2011 outlook. We now anticipate 2011 net revenues in the range of $1.42 billion to $1.44 billion, an increase of 33% to 35% over 2010, and 2011 operating income in the range of $155 million to $160 million, an increase of 38% to 42% over 2010. Our current guidance implies full year operating margins of between 10.9% to 11.1%, leveraging 30 to 50 basis points from the 10.6% level achieved in 2010. We expect additional gross margin pressure for the year to be more than offset by improved SG&A leverage due to our top line strength. We'll provide more details on this shortly.

Below the operating line, we continue to expect to see an effective tax rate of approximately 40% in 2011. We are pursuing certain tax credits in the back half of the year similar to those obtained in 2010, which would enable us to improve on this rate. As a reminder, our full year effective tax rate in 2010 was 37.1%. Finally, we continue to anticipate fully diluted weighted average shares outstanding of approximately $52.5 million to $52.7 million for 2011.

Now we'd like to provide some additional color around our outlook for the remainder of 2011. First, with respect to gross margins. We had previously outlined some of the headwinds we faced in 2011, including the transition of our hats and bags business from a licensing model to in-house and near-term challenges around apparel and footwear sourcing costs. As expected, these specific challenges are still in place with the impact largely unchanged from our previous guidance, this previous guidance call for gross margins to climb approximately 100 basis points in 2011. Over the past 6 months, we have raised our top line guidance by approximately $90 million or nearly 7%. There's a balance between trying to service the strong demand for our brand with our ability to execute operationally. The level of efficiencies and planning for and executing on this demand are not where we need them to be. Because of this challenge to meet demand and the continued near-term pressures around sourcing costs, we currently expect gross margins in 2011 to decline approximately 160 to 180 basis points, compared to our previous guidance that's down approximately 100 basis points.

Let me walk you through the factors that have led us to this change from our prior guidance. The first major factor relates to higher sales allowances. As we continue to chase increasing demand this year, we have not optimally serviced our wholesale accounts, resulting in higher sales allowances. The other major factor relates to the profitability of our Factory House channel. While our direct-to-consumer gross margin dollars will be significantly higher in 2011, our gross margin percentage in this channel will be lower than initially planned due to a higher mix of sales from lower margin close out product. These 2 factors are the primary drivers contributing to the change in our guidance on gross margins for the full year. From a quarterly standpoint, we expect the greatest year-over-year gross margin pressure to occur in the third quarter, with declines expected to moderate for the fourth quarter.

As we have said on previous calls, we are building a long-term platform for growth and remain focus on investing in people, process and systems in order to gain efficiencies and leverage opportunities around gross margins. While servicing the strong demand for our product poses challenges to our operational platform, we are making important strides in building a team to make our supply chain a core competency. These included the hiring of a senior vice president of sourcing earlier this year who brings over 28 years of global sourcing expertise, and a senior vice president of planning hired earlier this month, who brings over 18 years of planning and supply chain experience. In addition to this leadership, we continue to add talent and are realigning our profits to help drive improvements in our supply chain.

Now to inventory, which as expected hit peak year-over-year growth levels during the second quarter. As we indicated last quarter, we expect the year-over-year inventory growth rate to move more in line with our net revenues growth in both the third and fourth quarters. Part of this movement will reflect our lacking of incremental inventory investments, which we commenced in last year's third quarter to better service demand. We will also be shipping the ColdGear Evo part that we have been carrying in the past few quarters. We continue to work toward our goal of delivering a forward inventory turn of 3x and a 90% to 95% fill rate. Despite the additional gross margin pressure, our top line upside is allowing us to better leverage our SG&A expenses this year. Marketing is an area where we now plan to be at approximately 11.3% to 11.5% of net revenues, down from our prior guidance of approximately 12% of net revenues. Importantly, this lower spending percentage in no way means that we are sacrificing our ability to tell compelling product stories. Our second half plans include a new footwear advertising campaign, expanded basketball investments, including a TV campaign and the addition of 2 first-round draft picks to our roster, Derrick Williams and Kemba Walker.

And finally, we will invest with our leading retail partners in developing compelling new shop and shops and co-branded holiday commercials. This spending is expected to be concentrated in the third quarter where we expect a similar year-over-year rate of spending as a percentage of net revenues before leveraging in the fourth quarter. With these puts and takes, we are able to raise our operating income guidance and the high-end of our implied operating margin target by 10 basis points. While the near-term components of our operating margin structure have changed, we believe the challenges driving this are largely operational and a byproduct of strong consumer demand. We are taking the prudent steps to address these challenges and believe key leadership is in place to enact the changes. Now we'd like to open the call to your questions. [Operator Instructions] Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from Omar Saad with ISI Group.

Omar Saad - ISI Group Inc.

One of the follow-ups in some of Brad's more recent comments at the end of the call there on the gross -- the change in the gross margin outlook, can you help me walk through the higher sales allowances piece? How does that -- does that tie into the inventory build that you've had? Help me understand, is there inventory that you're not happy with it, or is it really a servicing the accounts issue?

Brad Dickerson

Omar, it's really more of a servicing the accounts issue. This item obviously stems for our ability or maybe more probably our inability to achieve a 90% to 95% fill rate on our wholesale customer orders. So it's basically either incentive or penalty to take product or our fill rate issues fall below that fill rate threshold over their delays in the receipt of the product, and we're seeing a little bit of both of those right now. So we did see an escalation in these allowances or we sometimes call pricing incentives last year, as we ran into some fill rate challenges that we called out last year. In fact, we called out this as a -- in our Q4 margin explanations last year as a reason for margins being impacted year-over-year last year. We had assumed in our original plan that we would have improved on this item year-over-year, as we move towards a more desired 3x forward inventory turn rate compared to some turn rates that were higher last year. But as we closed out May and June of this year, we were continued to see some challenges to get to that 90%, 95% fill rate, specifically around some of the Chase products that we're talking about. So even though we called our top line up $90 million from our original estimate 6 months ago, some of that revenue has been a little bit difficult for us to chase. So when we saw May and June's trend relative to sales allowances and pricing incentives, combined with early sights of this item in Q3, we revised our forecast and kind of tempered our outlook on our ability to gain improvement here for the remainder of the year. So as you look at going forward, it's a slight opportunity for the back half of this year compared to our forecast although obviously, we're not planning for it to happen this year but obviously a much, much larger opportunity in the longer term.

Omar Saad - ISI Group Inc.

And then one quick question on the international side, I thought it was interesting that you guys are opening more Under Armour stores. You mentioned one in Europe and some stuff happening in Asia. Can you talk about the balance of wholesale, retail, what you're learning internationally, why you're kind of moving maybe away from the wholesale business -- a little bit more towards on retail?

Kevin Plank

No, we're not. I think what we're doing is we're empowering the local partners that we're putting on the ground. So in many cases, that's either distributor relationships or licensing relationships. So in Japan, probably our most mature international market, we've got a partner there who's -- they have a really vibrant -- and the majority of their business is wholesale. But they're also complementing where not unlike we find here in the states where they don't have the ability to reach all the consumers they want to, they're going to open up full-price retail. So that's what's happened again in Japan opening their second full-price store there. It's something that, a, it's a great brand presentation, and it really provides a vision for many of the wholesale accounts too of what the power of brand can be and frankly, the breadth of the product line that we now have to offer and their ability to localize and make that important to the consumer. So as we're moving into other markets, creative being a good example, I think having that, I wouldn't call it a flagship, but I'd have that aspirational view of what can the Under Armour brand look like. I think in creative it's a great place where it's painting a vision for many of the wholesale accounts of what our presentation can be and more traditional sporting goods or whatever that would that mean to a local market. So what's happening again, I think, that was a pretty big statement, in my script, of opening our second store in Japan, opening our first store in Shanghai directly as a company in China, then what's happening in Madrid with distributor, as well as we're just beginning to see and feel some growth from the international. But again, this is more like planting seeds for the future and something that we anticipate harvesting 2, 3, 4 and 5 years out.

Operator

Our next question is from Kate McShane of Citi Investment Research.

Kate McShane - Citigroup Inc

With the NBA lockout, and I know there's still some time here before the NBA season even starts. But with having the 2 new draft picks as endorsers of your brand, is there any possibility that you'll move your basketball offerings up from the beginning of the season to maybe earlier in the fall?

Kevin Plank

A couple of things that we're working on now is how can we be opportunistic with -- if there is any time for the athletes because one of the things we're contemplating, it's probably a script that's been played before as okay, let's put our athletes together, and as we start breaking into new markets like China, we should take these guys on a roadshow. And I think what we're coming back to is sort of the back to basics of we know want to take these guys on a roadshow through the United States, and what you'll see is the amount of exposure where the ability, I think, it's a real testament to our team, particularly to our product team, the type of product that we're putting out there. We didn't go out to these athletes and pay them more money, and that's why they're with our brand. We went after these athletes, and they believe that we can bring something compelling to themselves and most importantly, give them a great product that will help improve their game. And the ability for them to endorse that to tell that story and to provide the social credibility as much as anything with the fact that Under Armour is a basketball brand, it's not going to happen overnight. But as we sit here in our seventh or eighth month of basketball, I think we're pretty opportunistic about what that category can mean for us.

Kate McShane - Citigroup Inc

I wondered if you could give any inventory guidance for the rest of the year, where can we expect to see inventory levels at the end of 2011?

Brad Dickerson

Yes, Kate, I think as we called out in the previous call, we peaked our growth rate in inventory here in the second quarter at 74%. So we expect as we get into Q3 and Q4 to start to get that growth rate more in line with our net revenues as we get into Q3 and Q4. So as our net revenues grew 42% in Q2, inventory growth 74%, you're going to see the delta between those 2 growth numbers come down much more significantly towards Q3 and Q4.

Operator

Our next question is from Michael Binetti of UBS.

Michael Binetti - UBS Investment Bank

If I look at some of the comments, Brad, that you made about the direct-to-consumer gross margin update, and the related to the higher close-out product cost, does that imply to you that the made for factory strategy in that channel has started to level off, and we don't see that as an increasing driver going forward? Is that a fair assumption?

Brad Dickerson

Michael, I think some of the challenges that we're seeing around planning and execution in our wholesale channel we're also seeing in our direct-to-consumer channel. So obviously, growing our business 42% in the quarter and trying to plan and execute around that is a challenge in itself. And obviously, in the DTC business, which has grown 67% year-to-date, is also challenging. By adding 27 new doors this year, it's a lot of growth in the DTC channel. We're seeing some of the same pressures and challenges we see in the wholesale channel. So we originally planned for a benefit in gross margins for the year due to our DTC business and the plan levels of made for that we had in our original plans versus excess product. And we've been relatively satisfied with our made for strategy and the levels planned for this type of product. But we underestimated the capacity that we had to move excess product in addition to that made for. Our current guidance takes into account the capacity we have to move excess for the remainder of the year that we have this ability to now that we didn't a few months back. So although our Factory House margins in total are accretive to the overall company, this change from a more excess product being moved the back half of this year, is impacting the gross margin percentage. It's important, I think, to note even both the sales allowance, pricing incentives I mentioned before, and the change in the Factory House gross margin, both of these items involve adding incremental dollars to the top and bottom lines for 2011. So in the case of our wholesale business, our ability to meet, plan, demand is more specifically to this conversation. Chase on plan demand is a decision that although impacts gross margins negatively, it does add positive gross profit and operating income dollars to the bottom line. In the case of Factory House, identifying and planning for the appropriate optimum capacity resulted in us adding some additional revenue gross margin dollars, even though this mix attribute to a gross margin contraction from our previous guidance.

Michael Binetti - UBS Investment Bank

And then, you mentioned in your sourcing team and if I could just change directions for a minute, what are some obviously, question one, with that would be we're obviously looking at input costs -- commodity cost levels that are much lower than last time we talked to you guys, and I'm sure you guys are starting to look at what the cost outlook is for early 2012 at this point. Obviously, you're going to have prices in place, price increases in place as well with the potential for input costs to be much, much lower. So maybe just an early look at what you're seeing as far as sourcing goes, but then also maybe some things excluding cotton that the sourcing -- the new sourcing team isn't finding as they start peeling back the onion and start really looking through the chain would be helpful.

Kevin Plank

Michael, I think, similar to we talked about in the last few times we spoke on the sourcing side is continued pressure, obviously, the back half of this year and into the first half of next year. So although there's been some relief in commodity prices, you really won't see the impact of some of that relief until you get in the back half of next year based on the timing of commitments and purchase orders and so forth. So as we talked about continued pressure, spring/summer '12, and we'll obviously give more guidance around our 2012 outlook in the future calls, it's important to note also that obviously, although cotton is a part of our product now, still, we weight more towards the synthetic fabrics, and the price of oil is up higher year-over-year. When you look at last year at this time versus this year, so there's some added pressure there on the synthetic side even though cotton prices have somewhat started to be relieved year-over-year. But in addition to those data points, I think bringing the expertise in-house that we talked about and the talent can help us plan and execute better going forward, especially as we get into the back half of 2012. So even with some pricing pressures, we see tremendous opportunity with the additional expertise and talent we brought in to help mitigate some of those cost pressures.

Operator

Our next question is from Mitchel Kummetz of Robert Baird.

Mitchel Kummetz - Robert W. Baird & Co. Incorporated

First question on the gross margin outlook. Brad, you're not saying down 160 to 180 on the year, so how much of that -- can you be specific as to how much of that pressure is on the higher sales allowances and the weaker Factory House margins, and to what extent you think those margin pressures could potentially reverse themselves next year?

Brad Dickerson

Yes, Mitch. As far as the additional 60 to 80 basis points that were calling margins down, it's relatively even. Sales allowances and price incentives are a little bit more than the Factory House but pretty close as far as the call down. And as far as opportunities for next year, again, I think, planning and execution in supply chain are tremendous opportunities for us as we move forward. So the addition of some new leadership will take a little bit of time, but I think we should start to see some benefits there as get to the back half of next year.

Mitchel Kummetz - Robert W. Baird & Co. Incorporated

Was there any expected pressure from those 2 gross margin items in your prior guidance of down 100, or is this all just the incremental pieces all from this -- it wasn't -- there wasn't really something expected in the guidance previously?

Brad Dickerson

Yes, there wasn't anything in the previous guidance. This is really more of a change based on our outlook. In the sales allowance pricing incentives, we thought that would see less of that as we got to the back half of this year. And we thought we'd be able to service demand a little bit better than we're seeing. So maybe in our forecast, we have assumed that there won't be an improvement year-over-year in those line items, and that would be called down and the same thing in the Factory House side, it was just a change based on really getting better visibility around the capacity we have to move product, which drove more excess product.

Kevin Plank

Mitch, let me weigh in here too if I could, because I think it's important as I touched on at the end of my script as well. But at first and foremost, a lot of people know that, number one, we're not satisfied certainly with our operational execution, I think, that came through. The people, process and systems, we are committed to all 3 of them, and we've demonstrated that with some of the talent that we brought in, in 25 and 18 years type of experience in sourcing and planning aspects of the business, and we're going to continue to bring in talent around to support the operational side of our business. But first and foremost, our brand and products have never been stronger. And I think it's important to note managing 42% growth, I get questions all the time of how about this opportunity and that opportunity, I think we've got enough growth for the company right now, and we feel good about it. But managing 42% on $1 billion base, it's not going to be a straight line. And we've hired and we're going to continue to do so, and we've processed and we've implemented systems, and we'll continue to do that until our operational excellence is as strong as the product and the brand. And if anything, when we look at where we are -- I feel very proud of the quarter that we put up and most importantly, that $1 invested in Under Armour a year ago is making 38% to 42% more than it was as you look at the 2011 outlook. So within that, we absolutely have work to do, and we're going to continue to put the pieces in place and make sure that we are strong operationally as we are in the other aspects of our business.

Mitchel Kummetz - Robert W. Baird & Co. Incorporated

And then second question, you guys touched upon in terms of incremental revenues, the expectation of picking up $60 million on Charged Cotton and $70 million on the hats, bags transition. Can you say where you are in terms of incremental revenue that you've picked up on those 2 items year-to-date through the first half?

Brad Dickerson

As we called out in previous calls, the seasonality of those items on the Charged Cotton side is relatively even throughout the year as far as year-over-year Charged Cotton comping, obviously, no Charged Cotton last year. So you're going to see a relatively similar impact quarter-by-quarter on Charged Cotton. On the hats and bags business, much more in Q2 and Q3 impact year-over-year, also the higher quarters as we ship back-to-school and start to ship some pre-holiday shipments for hats and bags. So you'll see, I think, the first half versus second half of hats and bags probably relatively in the same impact year-over-year first half versus second half, but highlighted more in Q2 than Q3.

Operator

Our next question from Michelle Tan of Goldman Sachs.

Michelle Tan - Goldman Sachs Group Inc.

I was wondering if you could give us a little more color around the DTC growth? It accelerated pretty dramatically this quarter to that 80% growth rate. It doesn't seem like the year-over-year store growth accelerated from Q1 to Q2, so it looks like it's coming from either comps or online. Can you help us think about what's driving that, and how we think about the growth rate going forward?

Brad Dickerson

Michelle, I think, in Q2 obviously, it's our lowest volume quarter of the year, so some of the things that happen in DTC can be compounded a little bit to our overall growth rate. But we are opening Factory House stores earlier than we have usually done some in the past. For the fact that we're currently at 72 doors up from the -- at the end of the year which was 54, we already opened 18 to 27 doors in the front half of this year. So that somewhat contributed year-over-year especially in Q2 the high growth rate with the stores opening a little bit earlier. But the growth rate we saw in DTC was relatively similar on then the Factory House and website, so we've seen some good positive things in the website with some small tweaks we've made to the website, even prior to going ahead and doing the revitalization of the site towards the end of the year.

Michelle Tan - Goldman Sachs Group Inc.

So Brad, just to be clear, the web piece of the business did accelerate this quarter as you made those tweaks in terms of growth rate?

Brad Dickerson

Yes.

Michelle Tan - Goldman Sachs Group Inc.

And then just on the marketing spend, I know you're looking for a little more leverage on that line item this year than you previously thought. How do we think about leveraging marketing going forward? Is that a line item we should expect to kind of stay in that 11% to 12% of sales level, or is that something where you'd look for a longer-term leverage against the two?

Brad Dickerson

I think we've thought talked about in the last few years that the optimum target to be 12% to 13% of net revenues. But this obviously is an item where as we grow our top line significantly, we get additional significant dollars to spend in marketing. So even though our percentage is coming down, if you look at our guidance, we're talking about a $30 million to $35 million more spend in marketing year-over-year, which is enabling us to do things like support Charged Cotton, the sending of Tom Brady, Cam Newton, Derrick Williams, Kemba Walker and so forth, and operate some of our shop and shops. So I think it's an area where as our top line continues to grow and we get benefits to our top line expectations, it's an area we can see leverage. It doesn't change our long-term outlook of 12% to 13%. But in a year like this where our top line is growing compared to our expectations, it's an area where we can leverage.

Kevin Plank

Michelle, this is Kevin. I think you're saying is we're beginning to take chances where -- more certain chances on athletes and probably stepping out where in the past, we go with authentic grassroots athletes that can drive them, we're certainly doing that. But there's a time for refining the benefit of signing celebrities like Tom Brady, who's as authentic on the field and frankly, as much of a celebrity off the field as well, Cam Newton. And then also building our own celebrity, where is Lindsey Vonn, et cetera. So we've got a much bigger and broader staple of athletes today that give the stability to be and think a lot more. But that is one of the challenges we have as a team. We've got more money to allocate, and so that means making longer-term investments when we announced cotton a few months, and I think there may be some head scratches. But for us, we're thinking about the impact that can have for our business 2 and 3 years down the line as we start to prepare for things and frankly the impact that can have of a double banger for things like the Olympics next year in the summer, what cotton will be and then going forward of being an EPO and being in premiership football. So our spends are really broad-based, and if we can do it while leveraging some of those dollars and being broader in the way that we approach becoming a global business, I think you can see us continue to do that.

Operator

Our next question is from Robbie Ohmes of Bank of America Merrill Lynch.

Robert Ohmes - BofA Merrill Lynch

I was hoping you could talk a little bit more about Charged Cotton and a couple of things on that? Can you speak to how Charged Cotton is performing in the sporting goods channel versus the newer mall customers like Foot Locker and Finish Line, and then versus your factory stores and then maybe some insight into how you're going to grow that business in the next year? And also if you could clarify, the $60 million that you guys are expecting for this year for Charged Cotton, does that include Storm Fleece, and if you could sort of talk about that business as well and where you see that being distributed for fall, and then how you're planning Charged Cotton for next year?

Kevin Plank

Robbie, it's Kevin. First of all, Charged Cotton has done very, very well. I think everyone is very pleased about it. There's a couple of different indicators we are using for that. First and foremost, we're -- our tech tee program was sort of the entry price point in Under Armour in the past, and it's a 20-dollar option. And I think, there was some concern that we had from everybody of the -- is this going to mean cannibalization coming out with a $25 in addition to basic to $25. And what we found is that going into the market is that, number one, we didn't see as much cannibalization and more importantly, the effect, if you look at baselayer as a category, versus what is this going do to tech tees, or what is this going to do to Charged Cottons, we're effectively selling somewhere north of 70% more total units than we were a year ago, and we just had one solid $20, and we're doing it at a price point at $25. So taking consumers up, more importantly, taking retail or ASPs up as well, has been some of what we've seen with Charged Cotton. But just -- I think, again, I can still make that statement of nearly quadrupling the addressable market for Under Armour by going into a market like cotton is something which is very important to us. We've also learned we haven't been flawless in the launch. I think we've been more successful in the men's side than we have in the women's side, and we're taking strides with that, because we believe there's a great consumer on the female side as we begin to approach there's 2 markets that we look at or 2 consumers we target, women and one is called teen girl and one is called city girl. And we think that by being in cotton, we're going to have a lot more legs to really attack city girl, where we think there's obviously a big revenue opportunity as we find that more casual approach with that consumer. But all in all, it's been very successful. And yes, that Storm Cotton, it is a part of the $60 million that we have. And just a moment on Storm Cotton, I think we have the ability to do something really special there. I think, we, number one, have a great product, and it's going to give us legs, of course, into our existing big-box sporting goods partners. But we also think that Storm Cotton we've got some exclusives that we have out there with some of our partners like Foot Locker and some of the things you'll see with what we're doing in Finish Line, so really giving us access into the mall and activating some of our biggest assets as around Lindsey Vonn, Cam Newton and Brandon Jennings and putting them in the product and really activating them from a BOP standpoint. So cotton is, we believe, it's, of course, it's going to be here for a long time with us, and we think it's a story that we just kicked off in '11. It will only get bigger and bigger.

Robert Ohmes - BofA Merrill Lynch

And just a quick follow-up, Kevin, are you guys phasing in any price increases this fall or for spring of next year on existing items?

Kevin Plank

We're going to be opportunistic but nothing really large scale this fall. And then of course, we have the ability to come back in the spring and make appropriate price adjustments. But where we sold this a year ago is where Storm Cotton a $60 hooded fleece, which I think is an unbelievable value for the consumer, and I will note they are now available on our website, so please don't hesitate to buy one and give it a try.

Operator

Our next question is from Jim Duffy of Stifel, Nicolaus.

Jim Duffy - Stifel, Nicolaus & Co., Inc.

A couple of questions. You talked about enhancing the presentation at retail. Do you have any quantitative evidence of improved productivity from those investments, or is it too early yet?

Brad Dickerson

I think it's early. I think we're still making some of those investments right now, and the most important thing that we have as we continue to address and readdress our most important distribution. And as we've brought the point up when you look at the ability to control and impact a new direct consumer, a new website coming out this fall, the factory stores that we have opened controlling our presentation and then 2 of our biggest partners in Dick's and the Sports Authority, and being able to affect 50% of our revenues, I think, there's a new phase and there, frankly, is a much broader product line that Under Armour has today versus even just 2 years ago, the last time we really talked about refreshing some of our shops. And so this is a joint effort between ourselves and our partners that we believe we can be a lot more productive, and where we can take some chances and some products in frankly some product categories. And from a retail perspective, our brand is flat out in performing, and particularly on the men's side, where we are hands down the number one apparel brand just virtually everywhere we do business, and on the women's side, fast approaching. Towards that, I think that having the right ability to tell and communicate the right type of story is what we're hoping to accomplish with this and, of course, improve performance for our partners.

Jim Duffy - Stifel, Nicolaus & Co., Inc.

Brad, questions on the operational direction. What are the service levels now? What do you feel is the gap you need to close, and is there any way to quantify what that would mean to margin? And what are some of the key operational things that are important to closing that gap?

Brad Dickerson

Yes, Jim, I think we don't really disclose what our fill rates are. But obviously, they're not at that 90% to 95% sort of need. They've improved a little bit from last year, so we're seeing them headed in the right direction, but we're still below where you need to be, and obviously that's impacting with the sales allowances and the pricing incentives. Some of the things like just planning better, again, being able to appropriately and really plan your business and seeing the demand, so instead of having to chase some demand, being able to plan for that demand upfront would be a very, very important thing for us. So hiring a vice president of planning was a step in acknowledging that in trying to get better at the longer-term. Again, on the sourcing side, lead times and being able to position ourselves to meet some demand in the much more efficient ways are things that we're going to look at and will be important for us going forward.

Operator

Our final question is from Sharon Zackfia with William Blair.

Sharon Zackfia - William Blair & Company L.L.C.

Two quick questions. Just one on quarterly cadence, it sounds as if perhaps given some other color you gave us, margins might decline, and the third quarter before rebounding in the fourth on a year-over-year basis, just wondering if that's correct? And then secondly, on the Charged Cotton, I know it's still relatively early, but just wondering if you have any market research on whether or not that's bringing new consumers to the Under Armour brand?

Brad Dickerson

Sharon, this is Brad. On the quarterly cadence of margins. As I said in my script, you're going to see the greatest contraction in Q3, so we're down 250 basis points in Q2. A lot of the similar things we talked about in Q2 are going to be there for Q3 also. So I would expect that margins would be down in most year-over-year in Q3. And in Q4, that reduction in margins year-over-year would come down significantly from what we've seen in Q3 but still be down slightly.

Sharon Zackfia - William Blair & Company L.L.C.

Brad, I guess, that was taken out through the operating margin one?

Brad Dickerson

From an operating margin perspective, I think, what you're going to see is Q3 will leverage less in SG&A than Q4 will. So again, when you're looking at operating income, you have the highest pressure on gross margins in Q3 and also the lowest leverage in the back half of the year in Q3 compared to Q4. So from an operating margin perspective, you'll see more pressure there in Q3 than in Q4.

Unknown Executive

In terms of Charged Cotton, I think, that it's probably still anecdotal at this point, but the flat out performance if you look at t-shirts sold at Sporting Goods a year ago, versus t-shirts sold at Sporting Goods today, the increase in size and the lack of cannibalization, meaning, that we are growing those overall categories without question, I think, we'll bring in more consumers. But we'll continue to press that because we're finding out where the consumer wants us to take that product line, and away from just being on field and to, frankly, moving them off field and off court as much, which is again the big opportunity we see with Charged Cotton.

Kevin Plank

All right. Thanks for joining us on our call today. We look forward to reporting to you our third quarter 2011 results, which tentatively has been scheduled for Tuesday, October 25 at 8:30 a.m. Eastern Time. Thanks, again, and goodbye.

Operator

Ladies and gentlemen, thank you for your participation. That concludes the conference. You may disconnect, and have a wonderful day.

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