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The fact that the stock is trading down on a beat and guide-up shows exactly why we don’t like the stock now. UA guided down gross margins materially. They’re making up for it in SG&A – which is puzzling given that they are an investment cycle. While we love UA on a TAIL (3-year) duration, the fact is that first it has to get past the TREND (3 month) and TRADE (3 weeks). We like it lower.  Overall, no change to our negative thesis (see yesterday’s note – reprinted at the end of this note).

What we liked:

  • UA posted solid top-line growth driven primarily by apparel revenues up +36% on top of 34% growth last year. The addition of charged cotton (we estimate between $20-$25mm, or 9-12% of growth) was a key driver in the quarter and one of several launches the company has planned in the coming quarters. Next in line for Q3 is Storm Fleece in September along with the latest basketball footwear for BTS. UA’s product pipeline is loaded and likely to keep top-line growth rates well above 30% near-term.
  • Direct-to-Consumer growth was up 80% accounting for 27% of sales in the quarter up from 23% in 2010. With gross margins in excess of 10pts higher than the company’s core, DTC will be a key offset to escalating margin pressures.
  • UA took up guidance by more than the Q2 beat – again. In fact, the incremental raise was greater than in Q1. The company beat top-line expectations by ~$20mm in each of the last two quarters. In Q1 it raised full-year guidance by $40mm, for Q2 the company increased guidance by another $50mm reflecting greater confidence in the 2H revenue numbers.

What we didn’t like:

  • Inventories remain an overhang near-term up +75% on +42% revenue growth. Yes, the company communicated that Q2 would mark peak inventory growth due to bringing its hats and accessories business in-house and planned build ahead of BTS, but you can’t ignore the underlying trend turning negative here. If we strip out these two factors in each of the last two quarters, the sales/inventory spread over the last four quarters would were down -7%, -10%, -9%, and then down -15% here in Q2 (see SIGMA below). The yy changes in both Receivables and Payables remain negative as well.
  • This is the second quarter in a row where the company beat on revenue, missed on gross margin, and then made up for it in SG&A. In fact, the company lowered its gross margin expectations for the year by an incremental 50-80bps from down -100bps to -150bps-to-180bps. As an offset, it also reduced the outlook for marketing expenses by 50-80bps. You can’t knock the company for leveraging expenses, but the outlook implies a reduction in the absolute dollar spend – something you don’t want to see for a company growing revenues at 30%+.
  • Embedded in lighter than expected Q2 gross margin results was the impact of increased sales allowances. While the company has an active product pipeline for the 2H, more aggressive sales allowances with inventories at peak heightens concern over the company’s ability to maintain margin levels in the 2H. With half of the adjustment to gross margin outlook from pricing and the other half sales allowances at the same time we’re entering a period where price variability remains high, so too does the possibility for further adjustments again next quarter.

With the changes to working capital still negative and margin risk and uncertainty increasing as we head into the 2H, we remain bearish on the name over the Intermediate-term TREND (3-months or more).

UA: Big Duration Mismatch - UA 7 26 11

 

07/25/11 02:39PM EDT

UA: WE’RE STILL NEGATIVE

 

We don’t like UA around tomorrow’s print – either into it or out of it. Let me be crystal clear on duration…

TAIL (3 years): Luv you long time, UA. These guys are pulling one right out of Nike’s playbook. The growth profile is unquestionable to us. Though they have yet to get any ancilarry categories right – such as Women, Footwear, and International – they will. Of that, I am near certain. But that is also one of the reasons why the team and I don’t like this name on a TREND (3-month) duration.

TREND: The fact of the matter is that even through all the ebbs and flows of revenue, UA has been printing an operating margin of 10-11%. It could have easily been printing something in the mid-high teens. But no, instead it opted to plow the capital into the model to stimulate top line growth. I like that. But’s a double edged sword…

  1. On one hand , I am extremely confident in the top line trajectory. When Plank stands up there and says that the company will double in sales over 3-years, I believe him (and I’m a natural cynic).
  2. But the reality is that there have been several initiatives that simply have not panned out yet. Footwear has been a zero. Granted, the original structure of the company was insufficient for anything but failure in this category), and the current team will tread slowly (no pun intended). They probably won’t mess it up, but we’re very very close to the point where people won’t simply give the Gene McCarthy organization the benefit of the doubt. If footwear does not work, this company won’t double.
  3. Charged cotton was a good launch. Definitely better than footwear. But it was a shadow of its core performance product. This is not a savior for UA.
  4. UA is spending like a drunken sailor. That’s probably a bit dramatic. But with growth in retail stores accelerating, endorsing Michael Phelps, Lindsay Vonn, Kemba Walker, Derrick Williams (#2 NBA draft – ahead of Kemba at #9) and some dude named Tom Brady, the reality is that UA is in investment mode. They’ll play this like Nike in that they will make it work – but will spend more along the way to ensure their success.

If you have a 3-year+investment time horizon, then you have nothing to worry about. They’re doing the right thing.

But we’re paid to point out the potential landmines along the way.

With the stock at $78, 40x+ earnings, 16x+ EBITDA and very little controversy on the name, we’re simply wary – if not flat-out negative given that cash flow is headed the wrong way.