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    The Call @ Hedgeye Plus

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Yes, you heard it right. McGough, believer in the UA brand, but perennial bear on UA’s margin structure, is warming to the fundamental story. I’m buying on bad numbers. Here’s why…

First off, let me say that I still think that gross margin expectations in 2H are still too high, and I do not think that 2H numbers are doable. With 45% of the float short the stock, that may or may not matter. Nonetheless, I’m not here to game near-term sentiment. Let me hit on some fundamental factors…

This is really all about footwear. I’m increasingly of the view that UA will rival New Balance as the #2 footwear brand in the US after Nike (NB has 9% share to Nike Inc’s 42% and UA’s 1.2%). This is a $600 million delta. This is more than just a ‘the brand is hot’ call, but rather increased confidence on my part that the right financial levers are being pulled to drive growth in this space.

We all know the narrative. First establish the brand with apparel. Then come out with football cleats, then baseball – both low margin, but brand authenticators. Then step into the cross-training footwear market, and then running – both of which have mass appeal at a higher margin. Makes sense to me.

But when I heard about basketball, and that UA was beginning to endorse basketball athletes, my immediate thought was that it was entering a fight it could not win (with 1/20th the financial resources as its competition). In fact, as soon as I saw that UA endorsed High-School star Brandon Jennings – who skipped college to ‘incubate’ in Europe for two years before a planned comeback to the US. First I chuckled, but then I stepped back and analyzed the trend in UA’s athlete endorsement commitments, and was surprised with what I found. (Reference Exhibit below).

1. UA’s forward commitments to athletes is running at 8.8% of sales, compared to Nike at 20.5%. You can argue both sides of this one. Either a) UA’s cost of entry has to head meaningfully higher, or b) that it is doing more with less. Both are valid, but brand momentum leads me to put more weight on the latter.

2. UA’s endorsement payments are largely front-end loaded. For example, 99% of its contractual obligations need to be paid in the coming 4 years. In the case of Nike, 29% of endorsements are guaranteed after year 5. I have a pretty darn good feel as to how Nike strikes its sports endorsement deals, and do not think that its approach is aggressive by any means. But based on what I see at UA, I’m increasingly of the view that its approach is downright conservative. That was a shocker to me.

3. Supporting that view, 79% of what UA is contractually obligated to spend is due within 2 years. Does that mean that near-term SG&A pressure is looming? Nope. In ’06, UA’s next 1-2 year obligations stood at $18mm, but in ’07 it paid close to $15mm alone. That emphasizes the strong variable component that UA has in its endorsements. Whether we’re talking athlete endorsements, or retail operating leases – it is the long-tailed deferred arrangements that have historically gotten brands and retailers in trouble. UA seems to have a winning strategy thus far. Note to UA management – don’t veer off course!

4. Another important point as it relates to footwear is capacity procurement. Anyone reading my work over the past year knows that I think that both availability of and pricing for footwear capacity in Asia is radically shifting out of favor for the brands. We know Nike will end up winning. Adidas too. Here, size matters. But I also know that factory space previously earmarked for private label product, as well as smaller US brands (incl SKX) is converting to UA – with 2 notable capacity transfers over the past two months. Simply put, Asian manufacturers want brands that they know will be growing.

5. Lastly, in a perverse way, UA’s inability to grow aggressively outside the US gives me more confidence in the stability of its earnings power due to less FX impact relative to competitors. This is not a positive, but it is certainly a lack of a negative faced by 90%+ of apparel companies.

The bottom line with this one is that it is definitely not out of the woods yet. GM expectations are too high, and inventories still need to head lower. But the company executed flawlessly on its cross trainer launch, and I think we’ll see the same from its running initiative (despite competition from Nike, New Balance, Asics and K Swiss – which can’t be ignored). I’m gaining respect for the company’s financial approach to driving growth, and clearing out inventories and taking the GM hit would seal the deal for me.

If UA feels pressure in the weeks ahead as numbers come down, I’m likely there to support it. If the stock holds in despite weak numbers, then that’s bullish too. If I’m wrong and numbers don’t need to come down, then this thing is off to the races. Either way, I think you get my point…