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Under Armour, Inc (NYSE:UA)

Q3 2007 Earnings Call

October 30, 2007 8:30 am ET

Executives

Alex Miyamoto - Director of IR

Kevin Plank - Chairman and CEO

Brad Dickerson - VP of Accounting and Finance

Wayne Marino - EVP and Chief Financial Officer

Analysts

Robby Ohmes - Banc of America Securities

Jim Duffy - Thomas Weisel

Omar Saad - Credit Suisse

Jeff Klinefelter - Piper Jaffray

Jeffrey Edelman - UBS

Operator

Good day, everyone and welcome to the Under Armour’s third-quarter 2007 earnings results conference call and webcast. Today's call is being recorded. At this time, I would like to turn the call over to Ms. Alex Miyamoto, Director of Investor Relations. Please go ahead.

Alex Miyamoto

Thank you and good morning, everyone. I'd like to start by welcoming you to Under Armour's third quarter 2007 earnings call. During the course of this conference call, we will be making projections or other forward-looking statements regarding future events or the future financial performance of the Company. The words estimates, intend, expect, plan, outlook or similar expressions are intended to identify forward-looking statements. We wish to caution that such statements are subject to risks and uncertainties that could cause actual events or results to differ materially.

Important factors relating to our business, including factors that could cause actual results to differ from our forward-looking statements, are described in our press release and in the ‘risk factors’ section of our filings with the SEC. The Company assumes no obligations to update forward-looking statements to reflect the events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events.

Before we continue, I'd like to direct you to our website, investor.underarmour.com. There you'll find this morning's press release and, on our webcast page, images of a number of the products and initiatives we will address on the call.

Now, I'd like to introduce the speakers and topics for this morning's call. Kevin Plank, Chairman and CEO, will address the drivers of our third-quarter results and our strategy for continued growth in 2007 and beyond. Brad Dickerson, Vice President of Accounting and Finance, will then discuss the Company's financial performance for the third quarter and provide an updated outlook for the balance of 2007. Wayne Marino, Executive Vice President and Chief Financial Officer, will conclude the prepared remarks with the preliminary outlook for 2008. After that, we will have a Q&A session that will end by 9:30. And with that, I will turn it over to Kevin Plank.

Kevin Plank

Thank you, Alex. Good morning, everyone, and thanks for joining us today. I'm proud to announce results from our third quarter, which proved to be our largest to date in both top and bottom line.

Let's start with a quick recap of the scoreboard. Under Armour net revenues increased 46.3% to $187 million in the third quarter of 2007. Operating income for the quarter increased to $33.8 million compared to $22 million just a year ago, an increase of 54%. For perspective, Under Armour's net income for just the third quarter of 2007, at $20 million, exceeds the Company's total net income for the entire year of 2005.

Wayne and Brad will provide more detail to the scoreboard in a few minutes, but it's the color behind the numbers that we believe further solidifies our position as “the athletic brand” of this generation. And considering what we have planned on the horizon, this is by far the most exciting time in our brand's history. With that, let's look at our key growth drivers and let me start with women's.

With the launch of our BoomBoom-TAP campaign in July, we staked our ground by authentically representing the female team athlete, something no other brand has done to date. The Team Girl athlete has been at the core of our brands since our beginning when female teams were buying smaller sized men's Compression base-layers. We believe it's our duty and our privilege to continually innovate our design, style offering and color palette to the Team Girl, while continuing to speak to her as we did with the BoomBoom-TAP, our largest campaign of 2007.

The results speak for themselves. Women's apparel growth checked in at 49% for the quarter, driven by Compression and Training, respectively. Our year-to-date growth in women's now stands at 39%. This is proof that the female team athlete can be a driver at retail for the women's category.

Another highlight is the youth category. Our youth business is not only a representation of our present brand strength, but a positive sign for the future. Youth apparel growth was up 51% over the same period last year. This is further evidence that we are this generation's athletic brand of choice, and we're making a pretty good case for the next generation as well. Our men's apparel business continues to grow and show strength, posting an increase of 43% over the third quarter last year. I'm proud to say that we continue to grow the core and find new, broader offerings that drive scalable growth for our men's business.

Fueling that men's business is Compression. It's the men's largest category, and it continues to grow at double-digit rates. Bolstered by our Good/Better/Best story, we've not yet found the ceiling for Compression and continue to see growth in this category. Meanwhile, men's training is growing faster than the overall Compression category at nearly 60% year-to-date. This can be attributed to our ability to expand our core business as we broaden our performance platform across categories and across sports.

One of these new categories showing fast growth is golf. Nonexistent two years ago for our brand, our golf business has grown more than 140% year-to-date on roughly ten styles. We also expanded our presence in Q3 in the outdoor mountain categories, with the launch of Under Armour outerwear. This program has just hit the floor and augments the core offering that this channel has already accepted from our brand.

The success we've seen across our men's, women's and youth businesses, allow us to invest in large, scalable businesses to support long-term, sustainable growth. So for example, at retail, our concept shops continue to elevate our presentation and tell a richer story about our product and fabric technology. With partners like Dick's Sporting Goods, The Sports Authority, Hibbett Sports and outsell outdoor retailer Cabela's, we're building new branded shops ranging in size from 500 to 1500 square feet across the men and women's footprints.

These shops serve as a home base of performance and anchor our many outposts throughout the sport and category-specific zones in the rest of their stores.

Before the kickoff of the holiday season, we will have more than 260 new concept shops installed in North America alone, adding to and reshaping almost a quarter million square feet across these marquis positions within our top retailers' top performing doors.

This storytelling of the Under Armour brand on the retail floor is naturally a global initiative for Under Armour. In Europe, for instances, we are mirroring this plan with shops in major cities like Stuttgart and Berlin, Paris, Dublin and Madrid. Our business in Europe remains on track and is poised to deliver as a long-term growth driver for our brand.

Peter Mahrer, President of Under Armour Europe, who joined us in July, is on the ground and driving our three-part strategy from Amsterdam, our headquarters; building the team, authenticating the brand on field, and finding the right distribution partners for Under Armour.

The goal in the United States and abroad is to tell a better branded story while educating the consumer on the benefits of performance. Our job as the originator of performance and the thought leaders of the category is to continue to lead the ship from cotton into performance. Cotton remains the enemy as well as our largest opportunity. We will continue to dedicate space on the retail floor precisely for this education.

Logistically, we're always looking to expand our footprint while continuing to improve our already strong productivity per square foot.

So, part of telling a better branded story comes to life this week with the opening of the very first Under Armour full-line retail store. We plan to cut the ribbon at the Annapolis Mall in Maryland this Thursday with a store that will be unlike anything you have seen before in a mall. We set out to create a branded shopping experience that will be the physical manifestation of the Under Armour brand and provide the feeling and emotion of being in an Under Armour commercial.

Our goal is to showcase the Under Armour brand by telling comprehensive product and brand stories.

At the same time this week, we will launch the latest version of www.underarmour.com. This new version will ease the navigation of the site for quick and easy purchases while providing our web visitors with the newly added visual content they have been asking for, including enhanced branded content, product education, and high-resolution product images with point-and-click zoom capability. I invite you all to come and visit and explore this branded visual experience.

Next, we will answer the latest top request from our brand fans; non-cleated footwear. As I stated last quarter, the big news for Under Armour in 2008 will be the launch of our first line of performance trainers. This first-ever version of Under Armour non-cleated footwear will be the cornerstone of Under Armour performance training, and it will complete the outfitting package for our athletes who spend nearly 95% of their time training for that very important 5% of competition on the field, court, ice or track.

You'll see this launch in the second quarter of 2008, but as with any Under Armour launch, you'll hear the buzz building much, much earlier.

With these launches on the horizon, both near and long-term, we will continue to bolster our future by remaining disciplined with our marketing investments. We will invest where necessary to give our brand and our retail partners the proper support for our major launches. At the same time, we will remain opportunistic with our marketing spends, allowing us to stay fast and nimble with our growing brand.

We are proud of the quarter we posted and the achievements we've had on both the top and bottom lines. We're confident of how we are committing resources today as we continue to invest in large, scalable businesses.

And lastly, we are excited about the growth opportunities that lie ahead in growing our men's core apparel offering, expanding our women's business, building our international business, and launching Under Armour performance trainers.

With that, I will hand it over to Brad to take you through more detail on the numbers.

Brad Dickerson

Thanks, Kevin. I am going to take a few minutes to provide information around our third-quarter income statement and balance sheet, and I will provide an updated outlook for the full year of 2007.

First, our income statement for the quarter; our consolidated net revenue growth in the third quarter, compared to the same period in the prior year, was 46%. This was driven by a 45% combined growth in our men's, women's and youth apparel sales. We are continuing to see benefits of an expanded product assortment in our Good/Better/Best strategy with average selling prices and apparel up approximately 11% compared to the third quarter in 2006.

Year-to-date, our consolidated net revenue grew 46% with our apparel sales growing 41%.We continue to see strong demand for our most mature business, our men's apparel. Growth in men's apparel for the quarter was 43%, compared to 2006, and was driven by our Compression, Training, Mountain and Golf products. Year-to-date, men's apparel growth was 40%.

Women's apparel growth for the quarter was 49%, compared to the prior year, and was primarily driven by our Compression, Training, and our new Mountain product offerings. This strong third-quarter showing helped boost our year-to-date women's apparel growth to 39%, an acceleration over the 31% growth we achieved for the first half of the year.

Our youth apparel growth for the quarter was 51%, compared to the prior year, driven by our Compression, Training and football products. Year-to-date, youth apparel growth was 58%.

Now, moving to our gross margins; for the quarter, gross margin was unchanged from the prior-year quarter at 50.6%. There are a few puts and takes impacting the margin for the quarter. First, as planned, beginning in 2007, we began to shift dollars previously given as customer discounts to in-store marketing and SG&A. Second, growth in our licensing and Direct-to-Consumer business, which includes our website, catalog and retail outlet stores, provided improvement in gross margin for the quarter.

These gains were offset by increased sales returns, allowance and inventory reserves in the third quarter on certain cleated footwear styles that will not carry forward to the next season. SG&A as a percentage of net revenues for the quarter was 32.5% compared to 33.4% in the prior year. On a dollar basis, SG&A for the third quarter totaled $60.7 million, an increase of $18 million compared to the same period in 2006.

Within SG&A, we continue to invest in our brands by increasing investments in marketing. Marketing costs represented 11.5% of net revenues in the quarter, compared to 10.3% during the same period last year, primarily driven by higher in-store marketing investments. We had previously indicated that marketing costs in the quarter would exceed the 10% to 12% range of net revenues. However, it is important to note approximately $2 million of marketing spend previously anticipated in the third quarter will shift to the fourth quarter of 2007.

This is mostly due to the timing of the installation of new concept shops and will not affect our total planned marketing spend for the year. The increase in marketing costs, combined with additional investments in our growth areas, represented approximately two-thirds of the year-over-year dollar growth in SG&A. Our operating income for the quarter increased to $33.8 million compared to $22 million in the prior year, an increase of 54%.

Operating margin for the third quarter was 18.1% compared to 17.2% in 2006.

The effective income tax rate for the quarter was 41.9% compared to 27.9% in the third quarter of the prior year. The lower rate in the prior-year quarter was a result of a $2.3 million benefit from a state tax credit earned. Our resulting net income for the quarter increased to $20 million from $16 million in the same period last year.

Third-quarter diluted earnings per share was $0.40 compared to $0.32 in the prior year.

Now, to the balance sheet; total cash and cash equivalents at the end of the quarter were $14.5 million compared to $44.3 million at the end of the third quarter in the prior year. This change was a result of investments in inventory and capital expenditures, which I will discuss shortly. Net accounts receivable increased 43% or $38.7 million on a year-over-year basis, continuing to grow at a pace below our top-line growth.

Now, I would like to discuss our inventory. As we have previously stated, our strategy is as follows; be in stock on core offerings to meet consumer demand while improving our inventory efficiencies over the long term; ship seasonal products at the start of the shipping window and earmark any seasonal access for our 15 outlet stores, and operate those stores at a profit.

Inventory increased $76.8 million or 102% on a year-over-year basis. Let me take you through the details of this increase. First, our year-over-year increase in core inventory was approximately $37 million or almost half the increase in total. Our core inventory represents inventory that we plan to have available for sale on a 12-month basis at full price. In the prior year, we did not meet all of the consumer demand for our products in the back half of the year. As a result, in 2007, we strategically increased our safety stock levels for core items to improve our service levels to meet the anticipated consumer demand, and increased productivity from our investment in fixtures and concept shops.

We believe our investment in core inventory is paying off, as we are seeing significantly higher percentage of demand for core items being filled today than one year ago.

Another portion of the year-over-year increase was in-transit inventory. Our in-transit inventory increased by $13.1 million or 110% from one year ago; this was primarily a result of our strategy to increase sourcing from Asia, resulting in more favorable product pricing.

Finally, the balance of the increase was driven by additional inventory needed to support our growth throughout all businesses and an 8% higher average cost per unit due to product mix.

As we move to capital expenditures, I need to continue to point out that we are building the foundation for large, scalable businesses. We continue to plan 2007 capital expenditures at $34 million to $36 million. Year-to-date, we've spent approximately $26.2 million. These expenses were consistent with what we have discussed in previous quarters and mostly related to infrastructure needs in our distribution facilities, in-store fixtures and concept shops, and other needs to support our continued growth.

Now, moving to our updated outlook for the full year 2007; we are raising our annual net revenue outlook to a range of $590 million to $600 million, an increase of 37% to 39% compared to last year and up from our previous outlook of $580 million to $590 million. This updated revenue outlook takes into affect our strong third-quarter results, current visibility that exists into our fourth quarter, and our inventory strategy which we believe positions us to fill seasonal demand for our core products at significantly higher levels than during the prior year.

We are also raising our full-your income from operations outlook to $81.5 million to $83 million, an increase of 42% to 45% compared to last year and up from $79 million to $81 million in our previous outlook.

Now, let me take you through some of the details of our outlook. First, our gross margin; we continue to believe our gross margin will improve 20 to 30 basis points for the full year compared to 2006. The puts and takes are consistent with what we have said in the past. First, we anticipate that our higher margin, Direct-to-Consumer business will grow at a faster rate than our overall business. Second, we will have a positive benefit to our gross margins from the shift in spending from discounts to in-store marketing, and finally, a portion of these improvements will be offset by our cleated footwear business, which carries margins lower than our existing apparel margins.

Related to SG&A, we believe our marketing has a direct impact on our top-line growth. As previously stated, for the full year, we're planning to invest at the high-end of the 10% to 12% range, and if top-line volumes exceed our outlook, we will be opportunistic with our marketing spend and invest more in planned campaigns to launch large, scalable businesses.

Given the increase in our expectations for our top-line, balances our continued investment in marketing, we now expect SG&A leverage of 20 to 30 basis points for the full year. We are forecasting our other income net, to be approximately $3.1 million for the year, including a year-to-date foreign currency gain of approximately $2.1 million.

We are projecting our effective tax rate for the year to increase to 41.5%.

Weighted average diluted share count in 2007 is expected to be approximately 50 million. Now, turning to our balance sheet for 2007, based on our current visibility, we anticipate inventory at the end of 2007 to increase between 5% and 10% from the levels at the end of the third quarter. Wayne will provide more insight into our longer-term inventory strategies in a moment.

Taking into account our strategic investments, including our expected investment in working capital, specifically inventory, and capital expenditures, we are expecting cash and cash equivalents to be approximately $25 million at the end of 2007. The $25 million takes into account our recent pay-down of the $10 million in borrowings we had at the end of the third quarter. As a result, we expect, at the end of the year, to have full availability of our $100 million line of credit facility.

Now, I would like to turn it over to Wayne, who will take you through a preliminary review of 2008.

Wayne Marino

Thank you, Brad. I will now provide you with the preliminary outlook on several key elements of our business for 2008. First, I'd like to remind you that our long-term targets remain at 20% to 25% for both our top and bottom lines. However, due to the strength of the brand, the capacity to expand across categories, and our ability to leverage our existing businesses, we believe our 2008 revenues and income from operations will exceed our 20% to 25% long-term growth targets.

For 2008, our long-term strategic growth initiatives remain the same; first, continue to grow our men's and women's apparel business; second, enter new categories of footwear while continuing to maintain a disciplined approach to gaining market share in existing categories; and third, build the Under Armour brand internationally.

Complementing these growth initiatives is the appropriate distribution for the Under Armour brand, including the opportunity we have in our Direct-to-Consumer business.

Now, let me provide you with some color around 2008. Apparel will continue to be a significant part of our business with strong growth in both men's and women's. This growth is planned to be driven by continued expansion of product offerings in the training, golf, football, and outdoor categories. Strong fulfillments within our core products, which represent approximately 50% of our business; increased consumer appetite to move into better performance products; increasing our ASPs; and higher productivity within in-store concept shops that are being installed within our larger strategic accounts.

In the second quarter of 2008, we're planning to launch our performance trainer. Similar to our first cleated footwear launch, this will be an allocated program in the first season. With the launch of performance trainers, we expect the year-over-year growth rate in our footwear category to outpace the Company's overall growth and position us to launch into other footwear categories in 2009 and beyond.

Internationally, we will continue to focus on Western Europe with particular emphasis on the UK, France and Germany. We continue to believe that the long-term opportunity for the Under Armour brands internationally is as large as the opportunity in the U.S., and we will make the appropriate investments in people, brands and infrastructure in 2008 and beyond to reach that goal.

We believe that our year-over-year rate of growth internationally for 2008 will outpace the Company's overall year-over-year growth rate.

For 2008, we believe that our Direct-to-Consumer business, which currently includes our website, catalog, outlet stores and full-priced test store, will be an important contributor to our year-over-year top-line dollar growth and an even greater contributor to our year-over-year operating income growth.

Our first full-priced retail store, located in the Annapolis Mall, will open in two days. We are excited about this opportunity to present our brand at retail as we explore how full-priced stores fit into our strategy going forward.

Our gross margin; based on the visibility that we have today, we believe that our gross margin for 2008 will continue to show improvement as a result of growth in our higher-margin Direct-to-Consumer business outpacing growth in our overall business, offset in part by our anticipated growth in footwear, specifically with the launch of our performance trainer, which will carry higher margins than our cleated footwear business but lower margins than our existing apparel margins.

Our SG&A -- we believe that our marketing has a direct impact on our top line. For 2008, we're planning to invest additional dollars in key growth initiatives to tell our story and support our major launches, specifically in training. Historically, we have invested between 10% and 12% of our net revenues in marketing, and as Brad said earlier, we're planning to be at the high end of that range for 2007.

From a financial perspective, our marketing philosophy remains the same; continue to make $1 spend like $3. From a strategic perspective, we will continue to create our marketing message internally, and cluster our initiatives in key parts of the year. Rather than trying to outspend the competition, we will continue to place our product on-field and in assorted media.

For 2008, we believe that investing between 12% and 13% of our net revenues will not only support our large scale of businesses like footwear and our international business, but will further strengthen our brand's position as the athletic brand of choice of this generation. In 2008, we believe our strong growth in revenues will allow us to leverage our fixed costs and partially fund this investment in marketing.

Now, I will walk you through our inventory strategy for 2008. As Brad said earlier, our inventory strategy is simple; first, be in stock on core offerings to meet consumer demand while improving our inventory efficiency over the long-term; second, ship seasonal product at the start of the shipping window; and third, earmark any seasonal access for our outlet stores, and operate those stores at a profit.

In 2007, we accomplished the first part of our strategy by doubling our level of safety stock in core replenishment items that we sell year-round, which resulted in improving our fill-rate percentages from the low 80’s to the mid 90’s on increased demand. This strategy significantly impacted our top-line growth.

For 2008, we will continue to hold our fill rates on core inventory at these levels while we reduce our safety stock levels and drive more aggressive inventory management initiatives. We believe that by the end of 2008; will see an improvement in our inventory efficiency whereby top-line growth should outpace inventory growth.

CapEx; taken as a whole, our CapEx investments for 2008, related to our distribution house, information technology, outlet stores, web business and office facilities, are planned similar to 2007 levels. At our year-end call, I plan to provide you with more color on our capital investments for 2008, as well as more detail around seasonality and quarterly initiatives.

Lastly, we expect our effective tax rate to increase to 41.6%, up from 41.5%, and weighted average diluted share count in 2008 is expected to be approximately 50.5 million to 51 million shares.

For 2008, our continued investment in infrastructure, research and development of new products, and marketing to support our growth initiatives is paramount to our long-term success.

At this time Kevin, Brad and I would like to open the call for your questions.

Question-and-Answer Session

Operator

Thank you. The question-and-answer session will be conducted electronically. (Operator Instructions)

We will take our first question from Robby Ohmes with Banc of America Securities.

Robby Ohmes - Banc of America Securities

Can you guys hear me okay?

Kevin Plank

Yeah, fine Robby.

Brad Dickerson

We hear you good.

Robby Ohmes - Banc of America Securities

Good morning. Hey, two questions, one, you've given a lot of detail on the inventory, but can you help us understand if weather has played an impact in the buildup of your inventory? Then also, can you help us understand the sort of way we should think about quarterly revenue growth, because your implied guidance is obviously a slowdown in the fourth quarter versus what have you put up for the third quarter.

Then your '08 guidance of exceeding that 20% to 25% implies a reacceleration. Can you just kind of walk us through how we should think about patterns of revenue growth for you guys?

Then the second question is, as we're looking at all of the things you are doing in Europe, new stores and sneakers. Is sneakers the big focus of '08 and we should think that Europe probably comes on the stronger, maybe more '09-'10? How meaningful could stores be? If you could help us rank where you see the opportunities as we are thinking about '08?

Wayne Marino

Sure, Robbie. This is Wayne. I'm going to take your inventory question first.

I think there's a couple of points I want to make on the inventory. First, we made a strategic decision in 2007 to bring our core inventory levels at a pace that would meet our demand. In 2006, specifically in November and December, one of the shortfalls we had was we could not keep pace with the demand for our product. So, we essentially went out and took core inventory, which is available for sale 12 months of the year, and this is the benefit of our business model. We increased those levels of safety stock. As a result, we filled demand at a much higher rate, and that was a big benefit to our top-line.

There's always an opportunity, and there will be as we go forward, to hold those fill rates constant as we start to improve our inventory efficiency. That's what we will be working on in 2008. So, I think the inventory itself that we have on hand represents a plan mostly around the core inventory. As far as the weather was concerned, ColdGear is a factor to us in the back half of the year as we all know. One of the things we did this year was we received our ColdGear, and the entire season of ColdGear, in by the end of October. The reason we did this is, once again last year specifically in November, we were very short on ColdGear. In fact, we missed some opportunities to fill that demand. So we wanted to be in a position by the end of October to have our entire ColdGear season in-house, knowing that the season itself would have to be a longer season, which it is; it typically end for us in February or March.

In addition to that, we didn't have to chase any inventory like we did last year. Now, the benefit of that, Robby, is that we are sitting here with ColdGear and we have been able to get some good duty rates on ColdGear, which we should start to see as an opportunity in our gross margins. So, a lot of plusses on that as well.

As far as '08 is concerned, you know, the inventory itself will start to get in line in '08; that's some of the initiatives that we talked about. As far as our top-line growth, one of the things we factored in for '07, we factored in the visibility we have currently today with October. So, our full-year outlook factors in an unseasonably warm October. Also, I look into November and December of last year. November was actually, as I said, not a month that we filled very highly and December was unseasonably warm. The good news is that we are in a great position with our inventory to fill demand in the back half of the year. We are also going to be in a great position to fill demand in the early part of the first quarter of next year.

Brad Dickerson

Robbie, this is Brad. I just wanted to add to that too, what Wayne is saying. Also, we tend to build our business on a seasonal basis versus a quarterly basis too. So we tend to look at the fall-winter season versus the fourth quarter in particular. Also, not really any significant new product launches in Q4 of '07, so from a year-over-year competitively basis, that factors in too. But obviously, our full-your outlook, our revenues are up 37% to 39% for '07, and as Wayne stated for '08, we are exceeding to 20% to 25% top and bottom line growth.

Kevin Plank

Robbie, this is Kevin. Let me jump on your second question there, which is how do we really rank I think the priorities for our business and what are the growth drivers that are going to really be impactful in 2008. I think, frankly, coming off a quarter where men's grew 43% and women's grew 49%, we still feel, first and foremost, great about those two core growth drivers. I mean, men's and women's apparel alone just continue to I think show that we have yet to find the ceiling. I gave a couple of call-outs in my script to things like Compression and how we are continuing to see the volume driving there, but even above that, the Good/Better/Best strategy, ASPs were up 11% in the quarter and were up nearly 9% year-to-date.

We still want to continue to drive that. We think that, with our brand, we have the ability to place consumers into better products, and we need to continue to take advantage of that, so building better product is something you'll see come out of us in 2008.

So, without question, the largest growth driver for us is our core existing U.S. business. Not far behind, from an excitement and a buzz factor though, is our opinion on footwear.

We've spent really the last two years and frankly the last three or four or five years planning for that footwear launch with getting into in starting with cleated footwear. We've taken our lumps with margin; we've taken our lumps with really building a business, building an infrastructure, and most importantly building the team of people. We are poised and we are ready to start harvesting some of investment that we've input into athletic footwear.

You're going to see that in the second quarter of this year when we reintroduce the category of training to the world. We believe that our athlete is training in a different way and that the story we're going to be telling them is something which is consistent with what athletes are doing today.

So, footwear, without question, is something that is going to be a big buzz and a big driver for us in 2008.

Europe, as we've stated all along, I think it's a long-term growth initiative for us. Peter Mahrer just got in there in July, and he's on the ground, and that strategy that we have is still the same. Peter's job is really localizing that strategy; number one, building the right team of people so he is over there, he's evaluating the team and he's building the out, he is making hires. It's authenticating ourselves on-field, of course and its finding and saying what are the right properties for us to attack? Thirdly, it's also finding and saying who are the right partners for us to be in Europe?

So, we've got some great doors opening and Europe, we continue to see traction. Again, we are on plan and it will grow, and as Wayne said, it will outpace our U.S. growth. But still it's a long-term investment for us.

Robby Ohmes - Banc of America Securities

Terrific. Thanks a lot, Kevin.

Kevin Plank

Thanks a lot Robby.

Operator

We will go next to Jim Duffy with Thomas Weisel.

Jim Duffy - Thomas Weisel

Thank you. Can you guys hear me?

Brad Dickerson

Yes, good morning Jim.

Jim Duffy - Thomas Weisel

Good morning; couple of questions. You mentioned some expenses in the fixturing program being pushed from the third quarter into the fourth quarter. Where are you with the fixturing program? How many store-in-stores do you have in place? Then related to that, do you have any further insights on the productivity enhancements that you're seeing from those fixtures?

Kevin Plank

Let me jump on it first then, Jim. Again, we are targeting about 260 of these soft/hard shops to be in by the end of the year. We are just over 200 right now that we have. Again, the impact of that will be roughly about quarter million total square feet that we will have out at retail. That will be in this new concept, this new look, which we think, something again, which is the manifestation of the Under Armour brand, when you walk into them. Not unlike what we're trying to do as we become better retailers and better wholesalers.

The goal that we have and what we've seen to date, again, it's early. But I think what we've seen consistently, when you put in concept shops, you're looking for about a 20% lift with product. And as that's been pretty consistent to the new fixtures and new concept shops that we have versus the stores that don't have shops. Right now, we are looking at about three per week, is what we're going to be installing. Again, this is just not a Q3 or Q4 initiatives for us, as much as this is something where, again, you're showing $20, $30, $40 T-shirts. You want to be able to tell great stories at retail. It's part of our three-part strategy which is the way that we are approaching the Web, the way that we are approaching concept shops, the way that we are approaching I think our own experience, our own direct touch points with the consumer. We want to make sure that we are explaining to them what is performance, what is technology, and what does the Under Armour brand stand for.

Jim Duffy - Thomas Weisel

Okay, great. And then Wayne, I want to drill down a little bit on some of the things to improve inventory efficiency. As you look into next year, what are some of the areas you'll be targeting to try to improve the turns?

Wayne Marino

Yes, the easiest one for us, again, maintaining that fill rate at that high mid 90s is important to us for the top-line. What we did, Jim, was we increased our safety stock probably two and half times to be able to meet that demand. What we see, going forward, we will be able to bring those safety stock levels down while holding our fill rate high. That's going to have a significant impact because approximately 50% of our inventory is in this core inventory. So, I don't see any risk at all in being able to do that; I believe that's a timing part, still maintaining the fill rate and bringing safety stock levels down. In addition to that, our Chief Supply Officer Jim Calo already begun to look at programs that we run 12 months out of the year where we can shorten our lead-time.

Right now, our lead-time is anywhere from 90 to 120 days. The opportunity here is to work with our suppliers and have them hold fabrications that will continue to run in our business going forward. Now, we've seen some benefits with cutting lead-time down almost on half on just certain key programs.

So, early indications from me are that we are in the right direction and we've accomplished that first goal of holding our fill rate.

The last piece I think is as important for me sitting in the CFO position, is that our obsolete inventory is relatively the same as a percentage of inventory as it was last year. And anything that we have that we would consider prior season, we've earmarked for our outlet stores. Our outlet stores operate at a very good profit. It's a good margin model and a good operating margin model.

So, we've got a pretty good containment on anything that is excess inventory. Again, that excess is minimal, mainly because we focused on that core inventory.

Jim Duffy - Thomas Weisel

Great, and the final question and I will let somebody else jump in; have you seen any resistance to higher average selling prices for your products?

Brad Dickerson

No. Jim, I think that the new categories that we have gone into, they really have a tendency of creating these halo effects. So, the consumer is looking at our brand and they are saying, we've got basic, it is sort of dumb-dumbs out there. What the Under Armour brand stands for is that we are about innovation. We are about bringing and building technical product for the marketplace, and we've found that our brand actually gives us license to go to places where other brands in the past have not. And that's the excitement that we've had from important partners like Dick's Sporting Goods or people who say “We can try higher price points, we can take this company and the brand to places where other brands have not been able to go to”. So, we need to be thoughtful about that; we need to make sure that we are careful about the products that we do decide to get into, the categories we decide to get into. Again, that's what gives us continuing confidence in what we can do in apparel, as well as what we believe gives us the ability to go after something like footwear, and particularly in the performance training category.

Jim Duffy - Thomas Weisel

That sounds great. Keep up the good work and good luck on the holidays.

Brad Dickerson

Thanks very much Jim.

Operator

We are going next to Omar Saad with Credit Suisse.

Omar Saad - Credit Suisse

Thanks, good morning.

Brad Dickerson

Good morming Omar.

Kevin Plank

Good morning Omar.

Omar Saad - Credit Suisse

I wanted to just follow up on the weather question. What are you guys seeing in markets where it has got colder or as the temperatures have dropped a little bit here in the East Coast? Are you guys seeing anything that can help us understand whether, there's a big kind of question mark out there. Is it macro issues impacting the consumer, that's kind of impacting the slowdown that generally is being seen across retail, not just athletic?

How much is the weather playing an impact? Are you seeing the demand for some of those seasonal products in some of the markets, or do you feel like the consumer is kind of pinching their purse strings a little bit?

Kevin Plank

Omar, this is Kevin. First and foremost, what we're seeing in the market is that our brand in particular, and I can't speak for the total market, but our brand is very strong out there. When we are seeing cold weather, and whether it's what happened in Utah three weeks ago, what happened in Denver two weeks ago, but we're starting to get some signs on the East Coast and 43 degrees this morning in Baltimore, Maryland and we are thrilled about it, scraping ice off my windshield. But the opportunity that we have I think is, when it gets cold, it continues to pace and to outpace.

So, it's just a matter of timing. It's not a matter of if; it's a matter of when. We remain confident, I think, in what we're seeing in our business; we remain confident in the way that we are positioned. And more importantly, we spent, a year ago, when it comes to the weather, really chasing it. In Q3 and Q4, we were out of stock; we were out of business. And since then, one of the things we made a decision this year that, with the weather comes, when it comes,we're going to be ready. We're going to have inventory and have the ability to service it.

There's a lot of competition out there that we are very aware of and that, frankly, they are pretty good at what they do and they are pretty cutthroat. So, our ability to have product, to have it to the store, to be able to react to the weather, I think is something which are these core basic products, things like our ColdGear items. You've got 10 or 15 styles from Under Armour doing 30% to 40% of the work for our company. We're making the right bets and we believe we're making prudent bets on inventory.

Wayne Marino

Omar, this is Wayne. Just kind of to add onto that, from my perspective, I never bet against the weather. So, I sit in that CFO's seat, I'd look at the brand and I say, we have gear for 12 months of business. And our ColdGear specifically is about the season; it is not just about the quarter. So, we've built our ColdGear for the season, and we believe that season in places where as Kevin said it started to get colder, we saw great results and we expect those results to continue as the weather turns seasonal for us.

Now, secondly, we are factored right now; we've factored the October unseasonably warm weather into our outlook. And in addition to that, we are well positioned. We've got some products that have been sold very well. I think our fleece product has been very powerful for us even in this weather today. So, we've got some great tops. In addition to that, we've got a new introduction of base layer which is doing very well in its early introduction.

Omar Saad - Credit Suisse

And just so I'm making sure I understand this; it sounded like you said you did the entire cold season by or fall-winter season by, it was done on your books by the end of October.

Wayne Marino

Yes.

Omar Saad - Credit Suisse

That was the rest of the season, not just through December but, last year it was freezing in February and March.

Wayne Marino

Omar, I positioned it with our inventory team to take advantage of having all of our productד in for the end of October, so that if we had the ability to reorder when we needed to, we could reorder. Last year, we did not have that ability, and we missed opportunity. You're right; the cold weather season goes beyond just the fourth quarter. For us, it's a season that falls right into January, February, and even sometimes parts of March.

So we've positioned ourselves for that. It's at full price; it's the right sizes; it's the right styles, and I see a minimal risk to us. I think ColdGear is about timing.

Omar Saad - Credit Suisse

Okay, and then if I could just switch gears a little bit, something was mentioned in the prepared remarks around gross margins. It sounded like you had some very positive impacts on the gross margin line, but it was offset by increased returns and reserves and allowances on some of the cleat offerings. It sounds like something was not working there; you're going to discontinue some of those lines. Could you just delve into that a little bit more and help us understand what's going on with the cleat side of the business, and what gross margins might have looked like, ex that impact?

Brad Dickerson

Hey Omar, this is Brad. It's important for us to innovate and update styles seasonally. Our goal is to create great performance products for the athlete. So the realities of that, with the seasonal styles are that we have a short selling season, a short selling window in these seasonal styles. So we kind of feel, not just in footwear but in apparel, normal course of business, we have to prepare to introduce new styles.

We kind of feel we should become better at this in footwear as we grow or business and learn from it. But really these are styles that we're going to update and bring new styles in, in the next season. The good news here is that we've factored this into our outlook going forward, not only for the 2007 quarter going forward but for 2008 also.

Omar Saad - Credit Suisse

Okay. Can you help us understand what gross margins might have looked like ex some of the impacts there on those certain footwear lines?

Brad Dickerson

Sure. The returns allowance and inventory reserves actually had a 130 basis point effect, negative effect on margins for the quarter.

Omar Saad - Credit Suisse

I got it. So, gross margins, ex that, up 130 bps on kind of the rest of the business?

Brad Dickerson

That's correct.

Omar Saad - Credit Suisse

Got it. All right, and then one last question for Kevin, you talk about scalable businesses, footwear, women's. You're starting a retail launch in a couple days of a full price. Where do you stand on leadership for some of these key businesses? Are you happy where you are now? Because I know you brought Peter in on the international side. How are you thinking about those going forward?

Kevin Plank

Look, for any great growth brand, I don't think you are ever happy with where you are, and that's part of what my number one job is. It's hiring and retaining great talent. So, you know, we are in a market today as we always are. Again, I spend about 25% of my time looking for great marquis talent, particularly around our growth initiatives. I think Peter was a great win for us in 2007. And we continue to look to bolster it, not only just the senior leadership but, a company like Under Armour that is positioned for not the next 2 or 3 years but the next 5, 10, 15 years is the way we think about our business, the way we think about the infrastructure that we've invested in. We're looking for those great managers, those great directors as well.

So, it's not just the premium talent that we get to send out the press releases about, but I think who our company, our brand is, we are in this fortunate position that we really can attract some great young talent that's going to be there for us going forward. But without question, we're still learning in some of these things. The question you just asked Brad about footwear, these are lessons that you go through it. It's hard to say and even when people have experience, until you have a group or a team of people that are working together, things don't run as smoothly until you just have time.

Our footwear team is now heading into its third year of fully operating and shipping product. Our forecasting, our sales team, the way that we interact, the expectation that we can have from the market, you just get better. The one thing that's always certain about a year or two from any product company is that it will be better than year one, right? It's not to say there is anything wrong with year one; it just means that it is constant improvement. And frankly, that's the way that we approach our business each and every day.

Omar Saad - Credit Suisse

Excellent, thank you.

Operator

We will go next to Jeff Klinefelter with Piper Jaffray.

Jeff Klinefelter - Piper Jaffray

Yes, just a couple of quick questions for you, one is on sourcing. Wayne, you mentioned that, or I think you mentioned that on the prepared comments, that part of your inventory increase was in-transit due to Asia sourcing.

We also know that recently you've discussed transitioning some of your sourcing back closer to home for a response time. Could you just give us an update on, like, for example, at the end of Q3, how much of your inventory was Asia-sourced versus last year, Q3, to get a sense for how the in-transit increased to that degree, and then also an update on that new sourcing strategy?

Brad Dickerson

Jeff, actually this is Brad. On the sourcing piece, right now sourcing through Asia is about 50%. That's compared to about 40% last year. So we are up 10% in our sourcing from Asia. Also, on the temporary shift, that was really more of a late Q4 '06, first half of '07 event, and we've pretty much worked our way through that right now. So as we speak right now, that temporary shift -- we are not seeing that.

Jeff Klinefelter - Piper Jaffray

Okay, so that was a temporary; now you'll go back to seeing Asia become a bigger and bigger part of your sourcing going forward? Do you think it will go above the 50% going forward?

Brad Dickerson

Correct. We should be right around 50%. We should see that. We will take opportunities to improve our margins through looking at sourcing it through Asia as we see fit.

Jeff Klinefelter - Piper Jaffray

Okay, great. Then just a couple of other quick questions; one would be on international. You clearly identified that as a long-term growth strategy. We know, in the U.K., you've had some early success in distribution. Maybe, Kevin, could you give us an update there on, generally speaking, where your door count is situated today? We know the U.K. has been probably your strongest and earliest market with JJB. But in terms of France and Germany, you are using some distributors in those markets. What's the margin implication of that versus the direct distribution in the U.S.?

Kevin Plank

Well, today, Jeff, we've got about, we are over 1,200 doors of distribution that we have in Europe right now. Again, I will go back to that three-part strategy that Peter is driving for us right now; find the right team of people, get us authentic on field, and find the right distribution partners.

So, speaking specifically to distribution, JJB has been an important partner to us, but not to be outdone I think by people like Innersport, which are the 4,000-store buying groups of the smaller mom-and-pop independents which really got us going in Europe. So, it's not a one-trick pony in Europe or frankly in any of the markets -- not unlike what we did here in the States, we've got a strong, independent foundation of dealers that are selling that authentic football shop, that authentic rugby shop, etc. They are talking directly to the athlete. Then we also have the relationships teed up right now for the more, larger chain stores, like the JJB.

The good news in Europe is that they are not having any of the weather issues that we've seen here in the U.S. Europe is actually very cold and that of course always looks favorably for our business. So, I think business is about where we expected it to be in Europe right now. I think, going forward, that's some of things that Peter, as he gets in there, he comes back after listening for three months and then starting to evaluate the team for three months, that is six-months plan of how are we going to reengage and attack Europe, country by country, focusing on really France, Germany and of course the UK.

Jeff Klinefelter - Piper Jaffray

Okay. Then how does the 1200 doors split between the U.K., France and Germany today, Kevin?

Kevin Plank

I think you can call it roughly half in the U.K., and then the balance over the other two countries. And then also spread in a few other places, Italy and Greece and a little bit in Spain as well.

Jeff Klinefelter - Piper Jaffray

Okay. Then the margin structure; we've heard from other brands that you can get favorable margin and pricing in those markets. Are you seeing the same trend?

Wayne Marino

This is Wayne. One of the things we did, we had the opportunity to learn. When we went to Europe, we set our pricing up, similar to the U.S. but also taking into account what it would take to do business in Europe. So, we've presented a fair margin. Our gross margins are good, but it wasn't by just the pricing. I think what we did with the power of the brand, we went to our retail partners there and were able to negotiate with them, what I would consider fair arrangements as our business grows.

So right now, we have a good gross margin structure and I think fair pricing at retail. In addition to that, we've built it so that we have strong operating margins as well, as that business continues to leverage.

Jeff Klinefelter - Piper Jaffray

Okay. So just to clarify, Wayne, are you looking for comparable op-margins out of the two businesses or; you are--

Wayne Marino

We've built the model right now to have comparable margins over the long-term as the business continues to grow, yes. That's how we modeled it.

Jeff Klinefelter - Piper Jaffray

Great, thank you. The last question; Kevin, you made it pretty clear in your point of differentiation is that the power of the brand, your opportunities to take pricing up and ASP mix up in the U.S., So, clearly your priority is not figuring out how to go downstream in pricing. But we've heard a lot over the last couple of quarters from the moderate channel of distribution about how important this performance category is, probably due largely to success in Dick's and other higher-end retailers.

What are your thoughts on that? Let the competitors come in and take that moderate price, or consider it diffusion or sub-brand for UA as some point?

Kevin Plank

Well, I think one of the themes that we've heard from the line of questions that have been coming from you guys this morning is how do you keep all of this stuff straight? You've got the retail component; you've got footwear; you've got your core business. But we do have a lot of balls in the air; there's no question about it. It sounds like a lot, but I think we've done a pretty good job of focusing and knowing what's important. It's like when I said, look, our core men's and women's business is going to be the most important thing for us. Footwear is number two; Europe is long-term.

We need to keep in perspective I think the areas that we're going to attack, and we see, frankly, so much opportunity with just providing better product out to the market that we are already serving. We still see the opportunity at Dick's Sporting Goods, at The Sports Authority, at Hibbett Sports, at the outdoor market in Cabela's and Bass Pro and these other just whole other channel that I don't think we're really speaking to. So, it would be easy for us to look and have conversations about other distribution. It would probably be detrimental to our brand, I believe.

Our focus, lives, needs should be on where we're doing business today, and I think driving that, and taking the consumer that we already speak to into higher and to better price points, and not just higher price points, but it's better product. We don't just charge more because it's Under Armour; we are introducing them something new. We are lifting their expectation of what should I expect when I wear a T-shirt? Right? So that is something that gives us our brand DNA.

Jeff Klinefelter - Piper Jaffray

Okay, great. Thank you.

Alex Miyamoto

We have time for one more question.

Operator

We will take our final question from Jeffrey Edelman with UBS.

Jeffrey Edelman - UBS

Thank you, good morning. Just two questions; one, Wayne, as we think about next year, you mentioned leveraging your fixed overhead, but when we think about the increased marketing spend, I suspect that will put some pressure on the SG&A, and maybe we start thinking about relatively flat operating margin for the new year.

Wayne Marino

Jeff, it is Wayne. What I wanted to do is, first, look at next year. One of the important factors for us is that we are a growth company, and we are going to continue to invest in areas that could become large, scalable businesses. One of the investments that we're going to make going forward is in people, in brands. Brand is very important for us.

As we launch into the training category, which we're currently in right now in apparel, and we will be in with performance trainers in Q2, it's important to send that message out, both in footwear and international and we believe that our marketing is that message. So, the ability to pay for that marketing is coming from our growth. Our growth is there because we have made the investments in the last couple of years. Part of that growth will help leverage our fixed costs.

So, one of the points I want to make is that our fixed costs will leverage. We will take those dollars and it will help offset some of the marketing.

In terms of doing the math, I think next year, when you look at it, we said first we will have growth in our top line and our bottom line. We're going to have additional investment in marketing and leverage to pay for some of that marketing. I haven't given out the exact financial projections for next year, but I think there are some natural offsets.

In addition to that, another factor that helps us pay for some of that marketing is increase in our gross margin, and that's the other factor that will happen next year as we continue to look at our direct businesses, as we continue to improve our footwear margins, as we continue to have strong apparel margins from our sourcing base in Asia.

Jeffrey Edelman - UBS

Great, thank you. And then, could you talk about your own retail? What kind of comp-store sales did those have in the quarter and roughly what are they now as a percentage of total?

Wayne Marino

Jeff, it is Wayne again. Yes, we typically do not talk about our comp stores and our outlet stores. What I can tell you, though, is, first, the gross margins in the outlet stores are as strong if not stronger than our wholesale margins. Secondly, we have about 15 stores, hopefully planning to have 17 outlet stores. They essentially take all of our excess inventory and turn it into profits; they are all operating at a profit.

Now, one of the key metrics that I use is looking at that direct business. Now, our direct business is a combination of our Web business and our outlet stores and our full-priced retail store that we're about to open in two days. Collectively, the direct business will contribute approximately 15% of our year-over-year top-line dollar growth and an even greater percentage of our operating income. So, it's a strong model. It's a material model to our dollar growth, and accretive to both our gross margins and operating margins.

Jeffrey Edelman - UBS

Great, thank you.

Wayne Marino

Okay.

Kevin Plank

Okay, operator. Thank you everyone; happy Halloween!

Operator

That does conclude today's call. We do appreciate your participation. You may disconnect at this time.

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Source: Under Armour Q3 2007 Earnings Call Transcript
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