Under Armour: Nobody Left To Protect The House

Summary

• The sales slump is not the only problem to worry about.
• Margins are in a downward spiral.
• Estimates, while revised down significantly, are still too high.
• Shares are set to drift into the single digits.

Under Armour’s (NYSE:UA)(NYSE:UAA) 3Q17 report, and more importantly, its 4Q17 outlook was a complete unmitigated disaster. Before the release, I was expecting 4Q EPS of about $0.10 ($0.21 consensus), FY18 EPS of $0.30 (consensus was $0.43) and viewed a fair value of $9-$13. The new UAA guidance was worse than I expected and implies 4Q adjusted EPS of just ($0.01)-$0.01, about a dime short of my estimate and ~$0.20 shy of the street. This warrants a valuation in the mid-high single digit range.

Everyone seems to agree that there is more pain to be had and no one is quick to catch this proverbial falling knife (last quarter there seemed to be more optimists bopping around). Although it seems fairly consensus, I still like the UAA short trade (especially paired with a Nike (NKE) long) and here’s why:

1. The sales growth has slowed and signs of a recovery aren’t in sight. This is the most obvious bear case point, and popular to discuss so I’ll just stop there. I will point out, however, that North American wholesale accounts for 63% of UAA sales vs. NKE’s 30% exposure. This is one of my key points on advocating the pair trade.
2. Gross margins are bad and getting worse. 4Q guidance implies gross margins of about 41.2%, a ~350bps decline from last year's 44.7% and 10% below the 4Q13 GM of 51.3%. With inventories growing 22% and a sluggish sales outlook, I expect margin deterioration to continue into the first half of 2018 as well (maybe not at a 300+bps clip, but deterioration nonetheless). Given the wholesale distribution point expansion we saw this year, I would expect this lower margin profile to be a new normal.
3. Inventories are a disaster. Inventories up 22% vs. sales down 4.5% is not a ratio that leads to margin recovery. One big issue here is UAA’s current lead time of 18-22 months. Management spoke to shortening the time from design to shelf to 12 months, but Nike is still one step ahead, with initiatives to reduce that process to under 6 months as part of its triple double strategy (2x speed).
4. Recent upper management changes cause a culture of inconsistency. Earlier this month Kip Fulks, co-founder and long thought of as second-in-command officially took a sabbatical. Fulks previously transitioned out of the COO role to a “President of Product” role in March of 2015 at which time Brad Dickerson, the residing CFO took over the COO responsibilities. When Dickerson moved to another opportunity (CFO of Blue Apron), Chip Molloy became CFO, lasted one year and resigned this last January. The former VP of Finance now sits in the CFO seat and Patrick Frisk was hired as COO. My question here isn’t on the competency of the new executives but in the longevity expectation of their roles there at Under Armour. While I’m sure CEO Kevin Plank sees himself as a Tom Brady of athletic apparel, the business units seem to have the quarterback consistency of the Cleveland Browns.
5. Estimates are still too high. The street cratered FY18 estimates to $0.24 from $0.43. I argue they didn’t go down far enough. There is no sign of gross margin recovery next year which is what $0.24 implies (assuming SG&A $ growth will outpace sales, which I view as a fair assumption). $0.24 seems rather optimistic given what we know now. I see a base case scenario where UAA earns $0.13-$0.17, and a bear case where they can earn only a dime next year. Only when I apply rather optimistic assumptions of sales and gross margin recovery happening pretty early in the year can I see exceeding the current estimates of $0.24. It’s possible, but definitely not probable.
6. Last but certainly not least; valuation. Using my estimates for valuation parameters, UAA is trading at 83x earnings and 20x EBITDA for a company with declining financials. This, under no circumstances, screams to me “value opportunity”. Essentially, this stock could get cut in half, again, and I would still need to see signs of operational improvement to become more constructive. Applying 15x my FY18 EBITDA estimate of $327 equates to a $8 share price, 10x would result in $4.50 per share.

In short, the stock still has a far way to go before it’s interesting on the long side. I think we would need to see clean inventories, sales acceleration in the double digits, and a clear pathway to significant margin recovery. We also need to see sell-side estimates more realistic, in order to avoid a series of guide downs. Multi-year visibility is hard here, but remaining negative on the story is not.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.