This note was originally published June 06, 2013 at 08:20 in Retail
Conclusion: UA exceeded our expectations at its Analyst meeting in Baltimore. We had UA on our Best Ideas list on the short side due to our concern that increasing capital costs to facilitate growth would erode margins in 2H. For reasons discussed below, we don't think we'll see that. We were wrong on the research here, and are not going to sit idle and hope it turns in our favor -- especially with a company where we believe so strongly that it will be a long-term share gainer. There are plenty of other lower-risk places we can look on the short side. UA officially off our list. We're taking up our EPS estimates by a dime this year, and $0.20 in 2014 to $1.46 and $1.72, respectively, due to lower SG&A spend and slightly higher gross margins. We definitely would not chase the stock here at 40x earnings. Even though some of our best ideas are expensive (and deserve to be), this valuation is stratospheric. But to be short UA here, you need either a revenue miss, which we don't think we'll see, or a pick-up in opex, which now seems increasingly less likely.
Anyone who cares about the story likely heard the headline already -- that UA endorsed a $4+bn top line forecast in 2016 (revenue CAGR of about 22%). By and large, that's consistent with what we're seen in recent years -- so no real shocker there. But it's not really the revenue story that we doubted. After all, this is one of the few 'power brands' in retail that has blue sky revenue growth opportunities.
Our concerns have been two-fold. First and foremost, it was the cost of the growth. We believed that UA would have to take up its level of SG&A and Capital Spending to support growth in areas (footwear and international) that have higher barriers to entry, more competitive pressure, and are inherently lower margin. Nike and Adidas, for example, have 90% of the global soccer/football market locked up, and they won't roll over and play dead in this space (a critical sport needed to reach every country except US). In other words, we thought that UA would succeed in growing, but would go the way of other brands that came before it like Reebok, which had to take down margins from 11% to a high-single-digit rate in order to achieve its lofty growth goals.
Secondly, we were concerned about the revolving door of talent that started with changes in the supply chain organization two years ago through the departure of Footwear SVP Gene McCarthy in January of this year. Rarely have we seen so many executive departures without some kind of adverse consequences.
But at the meeting yesterday, a few things became clear to us:
1) Finally The Right Team? The team Kevin Plank has in place to take the company to the next level is probably the right one. We were most surprised by what we saw coming out of the footwear team. The irony is that we're finally seeing the beginning of a sustainable business AFTER McCarthy departed, which is ironic because he is one of the most talented executives in the space (at least that's our opinion). But for whatever reason, those skills did not translate well to UA. Don't get us wrong, some of the footwear product on the display wall was downright ugly -- most notably on the basketball wall (think of a dozen unmatched colors poured into a blender and then molded into a shoe). But then again, I (McGough) am hardly the authority on what product is 'cool' vs not. I'm probably a good contra-indicator. Personal preference aside, what I can make an authoritative statement on is that I was impressed by the company's focus on new platforms of product.
2) Why do platforms matter? Think way back to Nike versus Reebok. What makes Nike so successful is that it invests R&D dollars to come up with new platforms which become new lines of business. This dates back to Nike Air, but also includes Shox, Free, Lunar and FlyKnit. In the Case of Reebok, they'd make a lot of noise about producing a new Iverson shoe -- which simply replaced the same shoe they sold at a different price point a year ago, but would rarely add new platforms. That's not a growth mentality. Under Armour is tearing a page out of Nike's playbook. It started with its Spine technology in Footwear, and is also doing it with the new Speed Form, which will be released en masse over the next 12 months. In apparel, we're seeing this with the Alter Ego line (think compression apparel meets superhero unitards). Sounds crazy, I know. But it was the best selling product in all of 1Q13 despite the fact that it only sold in March. We're seeing the same 'platform' development in apparel with things like Storm, InfraRed, ColdBlack, Scent Control, ArmourBra and a new men's underwear line. Products flop all the time, but platforms rarely fail in this business unless the R&D or the Marketing is severely botched.
We're doing further analysis on the specific areas of revenue growth potential for UA based on new information given at the analyst meeting (including international, retail and a deeper dive in footwear), and will return with more depth thereafter.