UA: What Would Ray Lewis Do?

UA said all the right things at its analyst meeting – and it wasn’t smoke in mirrors. But growth isn’t linear, and we think that investment capital flows take the stock lower before it takes its next tear upward (as much as we disagree with Wall Street’s rational for doing so).



I’m sitting on an Amtrak from UA’s analyst meeting in Baltimore back up to New Haven, and have a mixed analytical read to say the least.  I’m trying to ignore the fact that I am sitting next to Ray Lewis…No joke.  The dude is completely decked out in UA from head to toe…and he wears it well. (Note to self…I gotta start working out). We’re sitting here eating our Caesar Salads, and I have the screen brightness on my mac as low as possible so he can’t see what I’m typing. If he sees me write anything negative about the brand he knows and loves, I am mildly concerned that he’ll snap my left arm like a pencil.  Heck, maybe I’ll roll the dice let him read this when I’m done.


The punchline out of the UA meeting was very poignant. These guys are going to grow, grow, grow. The reality is that this is not exactly a change from the plan all along. Remember that UA could have been printing an operating margin double its 10-11% over the past 8 years if it desired to do so. But instead, it has reinvested in growth. That’s why it’s growing organically today at 20-30%. It’s also why they’ll keep doing that for the next 5 years at a minimum.


The only new target thrown out today was that the company would double sales in 3 years – that’s a 28% top line CAGR. What I like here is that it is not just coming from US apparel. Consumer direct going from 6% of sales, to 10% (now)  to 23% by 2013 and ultimately 2030 is a massively ambitious goal. But that will help UA achieve these consumer-direct ratios that are double that of other brands.


It’s interesting to think about it, actually. Being such a young brand is a double edged sword. On one hand, they still have a lot of money to spend to get the size and scale to compete on a global cross-gender multi-sport basis with its rivals. But on the flip side, it is not hostage to the legacy processes that the traditional brands are married  to as it relates to building a business from scratch. They can shake the Etch a Sketch clean, and literally start fresh. This is particularly an opportunity for Gene McCarthy in building the footwear business, which we think already has a turn time that rivals Nike, and will only get better on the margin.


Despite the hyper top line, however, management made it clear that it will not be afraid to spend money to achieve its goals. That’s fine with me. This is a business where you need to spend money to make money. Also, despite what doubters may think, this company has proven to be an ardent steward of capital in recent years.


All that said, capital investment and realization of financial rewards are not simultaneous nor are they linear. Unfortunately, the former needs to come first.

We continue to contend that UA is in an investment period today – in SG&A (Tom Brady, Cam Newton – current charges plus off balance sheet liabilities), cape (building store count to 80 by end of year), and working capital (building a footwear business and filling retail stores with product.)


People focus on sales momentum and EPS growth with this name, but another key stock driver is the cadence of SG&A combined with Capex and Working Capital. When all are headed in the same direction, the stock almost always goes the other way.


Again, to say this brand is killer would be a massive understatement.  To say that the management  team has grown in breadth, depth and maturity is as well. My confidence level walking out of the meeting into the 100 degree Baltimore sun was quite high that this is one of those unique Consumer companies that will defy growth projections time and time again and will threaten Adidas as the #2 global athletic brand.


But we know that this is a punitive market. As working capital squeezes, our sense is that the stock will trade down on the margin.

The sentiment on the name is close to all time highs (78x), the stock is still peaky, and management stock sales have accelerated. (See our sentiment chart below).


When we put on our TAIL duration hat (3 years or less), we absolutely want to own this name. But holding true to our risk management framework, the TREND and TRADE don’t look compelling. We’ll hold on and look to buy this great company at a better price.


(I’ll leave it up to you to guess if Lewis read this note).


UA: What Would Ray Lewis Do? - 1


UA: What Would Ray Lewis Do? - 2


We caught up with CFO Mark Robinow for lunch today.  The obvious first issue on the table was the departure the CEO Mark Buehler.  Robinow was very straight forward in saying that the Buehler and the board decided that the company need to find a CEO that would reside in Phoenix.  Importantly, it had nothing to do with the operations; in fact, according to Robinow, the company is operationally stronger that it was 18 months ago. 


A couple of other key takeaways from lunch:

  1. Business trends remain on track - the Kona recovery story is alive and well.
  2. The remodel program is probably ahead of plan and we should see a positive impact to 4Q comps.  The remodeling of the seven stores should be completed in time for the holiday season.
  3. Commodity costs remain an issue, as for all restaurant companies, but the overriding message was that costs are manageable.
  4. From a growth perspective, the company is currently negotiating leases for 2012 and 2012.
  5. Management is looking to close under-performing stores.

Despite the recent price action in the stock (before today), I continue to see KONA as one of the better-positioned small cap names in the restaurant space.





Howard Penney

Managing Director

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China's TARP?

Conclusion: Rumors suggest China is on the verge of introducing a major bailout package for its reportedly ailing Local Government Financing Vehicles. Analysis of these loans, the Chinese banking industry, historical precedent, and recent moves throughout Chinese financial markets suggest at least some level of caution is warranted.


Over the last week, credit quality in China has once again been making (or at least trying to make) headline news. Per Reuters and a bevy of secondary reports, the latest unconfirmed speculation out of mainland China is that the central government is preparing to shift 2-3 trillion yuan of recently-extended debt off of local government balance sheets. The amount, equivalent to $309-$463 billion, is roughly 14-21% of the total outstanding debt of China’s Local Government Financing Vehicles (LGFVs) according to the PBOC’s 2010 Regional Financial Operations Report.


At an amount roughly equivalent to 5.2%-7.9% of China’s GDP, it’s clear to us that this bailout of sorts is a big deal. To put some context around the size of this rumored bailout package, TARP was “only” 4.9% of US GDP at the time of passage. Whether or not this winds up being “it” as it relates to financial crisis aversion in China remains to be seen.


One thing that is quite disconcerting is the strong denial of any bailout by Chinese officials. Wu Xiaoling, vice chairman of the National People’s Congress Financial Committee dismissed the rumors yesterday, saying that they had been confused with a telegraphed government investigation into LGFVs during the June-September period. As we have learned from the likes of Greece, Ireland, and the US for that matter, politicians’ denials of market rumors are typically anything but a sign of relief.


That said, we are in the unique position of waiting for more data before we jump ship on our Year of the Chinese Bull Thesis. As mentioned in our previous work on China, we’ve chosen to remain on the sidelines here, rather than expressing this idea in our Virtual Portfolio due to China-specific quantitative factors (Shanghai Composite broken TRADE & TREND) and broader Global Macro factors (our 27-factor risk management model continues to signal to us that equities should be underweight as an asset class within our Dynamic Asset Allocation Model). Separating research ideas from actual investments remains one of the hallmarks of modern-day risk management, as well as one of the best ways to practice Warren Buffet’s rule #1: don’t lose money.


China's TARP? - 1


 Shifting back to the Chinese bailout rumor specifically, let us dig into the background story and relevant components in an effort to get you up to speed.


In an unprecedented effort to avert a sharp recession for the Chinese economy, the central government via Chinese financial institutions oversaw a 17.6 trillion yuan ($2.7 trillion) expansion of credit from 2009-2010. During the rapid debt buildup, money supply (M2) growth peaked at +29.7% YoY in November ’09. It has since come down to more trend-line levels as the central bank ramped up its efforts to drain liquidity and curb property speculation over the last 18 months via a cumulative +550bps increase in bank reserve requirements, as well as four interest rate hikes since October ’10 totaling +100bps.


China's TARP? - 2


A great deal of the credit expansion over the last two years had been funneled through the aforementioned LGFVs. For background, current statutes in China prevent local governments from issuing debt to finance spending and investment; as a result, they have setup alternate arms-length entities through which debt financing is procured. It can be strongly argued that their obligation to implement the central government’s stimulus objectives over the last couple of years is perhaps what got them into the current situation. Moreover, as the Jim Chanos-es of the world would have you believe, rapid and perhaps reckless credit expansion is not without consequence.


According to the PBOC’s recent report, the total number of LGFVs grew +25% from 2008-2010 to over 10,000 and their collective debt burdens grew +50% in 2009 and +20% in 2010 to an estimated sum of 14 trillion yuan ($2.2 trillion) or 28% of total credit outstanding throughout the Chinese banking system as of April. Additionally, Premier Wen Jiabao’s push to build 36 million low-income housing units is estimated by some analysts to add another 1.9 trillion yuan ($296 billion) to the existing LGFV debt burden in this year alone and another 4.9 trillion yuan ($757 billion) through 2015.


Further, the PBOC profiles these loans as “mostly long term” and “linked to infrastructure projects” with about half of them coming due in 2014-15. An unverified leak from an unnamed Chinese official suggests that roughly 20% of the total LGFV debt burden would ultimately wind up in the non-performing loan category; Fitch Ratings assigns a 30% NPL rate in their worst-case scenario.


Using the aforementioned 20% or 30% NPL rate, that roughly equates to the Chinese banks having to charge-off 5.6%-8.4% of their total loan books over the long term, with roughly half of that occurring in the next 3-4 years based on the maturity schedule of the aggregate LGFV debt burden. That’s a pretty substantial amount of bad loans that will likely have to incrementally reserved for – which is perhaps why Chinese banks have been substantially underperforming the broader index of late.


China's TARP? - 3


Last year, Chinese banks sold a combined $70 billion of shares in a comprehensive effort which included cutting dividend payout ratios (an average of -200bps to 37% for the five largest banks) and expanding non-lending businesses to become compliant with higher capital requirements. Back in April, China’s banking regulator drafted rules forcing banks to have Tier 1 capital ratios of at least 8.5% by 2016; for reference, the nation’s lenders had an average Tier 1 capital ratio of 10.1% according to the same documents (that compares to an average of 12.3% of the world’s top 100 largest banks by market cap, per Bloomberg). Still, the rules assume average credit expansion to the tune of +15% YoY alongside economic growth of +8% YoY per year, which implies Chinese banks are likely to have to add another 1.26 trillion yuan ($195 billion) in supplementary capital over the next five years.


From a more immediate perspective, the same regulator has forced the nation’s five largest banks (combined holders of 26.8 trillion yuan of risk-weighted assets) to adhere to a minimum capital adequacy ratio of 11.5% throughout 2011. Should any of them fall below that threshold for any moment of time, they’ll be forced to raise capital, slow loan growth, delay acquisitions, and/or suspend new branch openings to become compliant in 90 days. As the chart below shows, each of the banks is well capitalized above the recently-implemented floor, but still well below the average capital adequacy ratio of the world’s 100 largest banks by market capitalization, per Bloomberg.


China's TARP? - 4


All told, it’s too early to tell whether or not China will actually implement drastic measures to avert or mitigate any potential credit crisis surrounding LGFV debt over the long term. History shows there is precedent for the Chinese government to undertake major intervention initiatives, having spent roughly $650 billion bailing out its banks from 1. Recent moves in China’s sovereign CDS and select bank CDS do, however, suggest that at least some level of incremental caution regarding China’s banking sector is merited.


China's TARP? - 5


At the bare minimum, we find that “doing nothing” is the best immediate-term plan of attack here. Waiting and watching from the sidelines will afford us a more objective interpretation of the data as it rolls in. Additionally, it’s important to keep in mind that we are potentially in the early days of a multi-year developing story, so there’s no sense in rushing for answers, as any you are likely to receive now may wind up far from the realities of tomorrow.


Unless of course you’ve have an “unnamed” Chinese bureaucrat on speed-dial.


Darius Dale



With the volatility in the commodity elevated and corn hitting record highs today the comments from CAKE management team highlight the risk to EPS this year.  I know they can’t update guidance weekly given the volatility in the commodity markets, but we can.  Coming into this year CAKE had 60% of their costs contracted for, leaving the balance to float for the balance of the year. 


As of the last update in April, they talked about 3.5% food cost inflation for the year.  The trends would be heavier in the first half (4.5%), which what it was in 1Q and looks like it will in 2Q, but falling to around 2.5% in the second half of the year.  The reason for the slower rate of change in 4Q primarily because 4Q10 had very high dairy prices last year and dairy is a commodity that is not contracted for.


CAKE is not expecting commodity costs to fall off a lot, rather as management stated today, “we're just not expecting them to be at the economically high levels that they were in the fourth quarter last year particularly with respect to the dairy component.” 


As the charts below illustrate, dairy costs are currently higher than they were in 4Q10.  Of course, there has been significant volatility of late and there is potential for a snap-back.  However, management may be forced to revise its expectations with respect to the dairy component of food costs if prices in cheese and milk markets remain anywhere close to where they are currently trending.  While there is still time for management to revise its view, we are watching this closely. 







Howard Penney

Managing Director

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