What If Under Armour Is Not In Big Trouble?

| About: Under Armour, (UA)

Summary

Under Armour's Q4 was bad and 2017 will be a reset year.

That said, profitability in 2016 wasn't as bad as it looks on the surface and incremental international revenue is highly profitable.

International growth has a terrific runway ahead of it.

I am long shares and think they can rally to $30 in the next two years.

Shares of Under Armour (NYSE:UA) (NYSE:UAA) tumbled after a fourth quarter that fell well short of consensus expectations combined with weak guidance, and the departure of the company's relatively new CFO. However, I do not believe the sky is falling. In fact, I believe CEO Kevin Plank is simply managing Street expectations to set up for a rest in 2017 followed by a strong year in 2018.

I have been long shares on and off as the gap between C shares and A shares converged, and I once again find myself long the stock. I believe the stock will trade back to the $30 level over the next two years, though I admit my November outlook was not nearly skeptical enough.

International: Not just a revenue story

When investors think of Under Armour's international growth, I believe they are primarily fixated on the revenue figure. This makes sense, as the business did grow a whopping 63% in 2016 on top of 69% growth in 2015. However, I think increasing profitability is the very intriguing story.

2016

2015

2014

Revenue

$740,984

$454,161

$268,771

Op Income

$45,867

$8,887

-$5,190

Margin

6.2%

2.0%

-1.9%

Inc. Rev

$286,823

$185,390

Inc. Op Inc.

$36,980

$14,077

Inc. Margin

12.9%

7.6%

Source: UA Filings

As we can see in the above chart, Under Armour's incremental margin on sales in its International division are increasing dramatically. Profit was up more than four-fold in 2016, and I think the International business will remain a source of growth for many years to come. Under Armour remains highly underpenetrated in Europe, AsiaPac, and Latin America. I believe the company is currently doing a fantastic job of leveraging significant investment costs to drive highly profitable incremental dollars of sales.

The Curry growth story in China remains tremendous, in my view. Though basketball shoe sales growth has stalled out globally, Under Armour has the opportunity to take share from Nike (NYSE:NKE). Nike's most popular athlete in China, Kobe Bryant, retired. Steph Curry resonates with consumers across the globe, and I believe the brand could gain significant momentum as the Warriors advance in the NBA playoffs.

Connected Fitness is obscuring company-wide profitability

We will focus on the terrible guidance shortly, but I want to point out an interesting dynamic in Under Armour's reporting that obscures the profitability of its core business in 2016.

2016

2015

Revenue

North America

$4,008,165

$3,455,737

International

$740,984

$454,161

Connected Fitness

$80,447

$53,415

Total

$4,829,596

$3,963,313

Operating Income

North America

$411,275

$460,961

International

$45,687

$8,887

Connected Fitness

-$36,820

-$61,301

Total

$420,142

$408,547

Op Margin

North America

10.3%

13.3%

International

6.2%

2.0%

Connected Fitness

-45.8%

-114.8%

Total

8.7%

10.3%

Source: UA Filings

As we can see in the above chart, Under Armour's North American business is dragging down the profitability of the broader business in 2016, as is the highly unprofitable Connected Fitness segment. Plank will tell you the investment rationale for the Connected Fitness segment is pull-through, but I am skeptical. Alas, if we remove the segment entirely from Under Armour, the performance looks slightly better:

2016

2015

Rev - Ex CF

$4,749,149

$3,909,898

Op Inc - Ex CF

$448,095

$522,262

Op Margin Ex CF

9.4%

13.4%

Source: Detroit Bear

The operating margin decline still looked pretty dramatic, so I searched for explanations and found two from 2016. The first "one-off" factor was the $25 million impairment related to The Sports Authority's bankruptcy. Another interesting factor was $5.4 million in reallocation of expenses from 'Connected Fitness' to 'North America'.

As a long-time follower of founder-run companies, I suspect this was mostly to avoid layoffs rather than to provide a productive use of SG&A spending. Adjusting for these two items as well as the Connected Fitness business, we can see that operating income still fell, but the erosion in the core business was not as dramatic as 2016 earnings would suggest:

Op Inc Ex- 1 time

$488,595.00

Ex-1 time margin

10.3%

Source: Detroit Bear

If underlying earnings weren't that bad, why are 2017 earnings declining so rapidly?

In my view, management's guidance for 2017 implies North American growth in the mid-single digits. Additionally, management's notion that inventory growth will outpace revenue growth in 2017 suggests that the North American channel has a lot of inventory that needs to be cleared. As a result, I see a significant amount of incremental cost as additional athletic sponsorships hit the P&L without a corresponding boost in sales. Although I believe sponsorships can be a compelling long-term investment, earnings will undoubtedly be diluted in the near term.

Altogether, the combination of lower gross margins from clearing inventory and higher investment costs will have an incredibly negative impact on Under Armour in 2017. I do not think the company did an adequate job planning for the increasing cost structure, which may explain why the CFO departed.

Expect a reset and easy comparisons for 2018

2017 will very much be a reset year for Under Armour. The company has a lot of excess inventory to clear from the North American channel, and it must determine the best way to replace The Sports Authority among the many other retail vendors that went bankrupt in 2016. Retro footwear product is also currently on fire, which, unfortunately, Under Armour simply does not have exposure to due to its relatively young age. As a result, I expect North American footwear in particular to slow in 2017.

That being said, I believe Under Armour will use 2017 to reset expectations. Under Armour may become more of a 12-15% revenue growth company rather than a 20%+ growth company. And, if it comes with higher levels of profitability, I think this is the right decision.

Under Armour has a lot of whitespace to grow in women's apparel, footwear, and internationally. As well, its North American retail business continues to grow, and it could lead to a superior margin profile for its apparel and footwear.

Overall, Under Armour's valuation may still look a bit stretched as the company experiences a significant reduction in 2017 earnings guidance. That said, like Nike, Under Armour is one of the few retail investments that is relatively insulated from Amazon (NASDAQ:AMZN). When it comes to retail exposure, I would much rather own high quality brands like Nike, Under Armour, and adidas (OTCQX:ADDYY) rather than retailers that must go toe-to-toe with Amazon. I believe shares will trade to $30 within the next two years as the company recovers and returns to profitable growth.

Disclosure: I am/we are long UA, AMZN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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