Few people would argue that UA is a tremendous story by almost any measure. Overcoming significant odds, it has drawn a line in the sand as the #2 Athletic brand in the US, it broke through the $3bn revenue mark faster than any Athletic brand in history (including Nike), it (Plank & Co) created $13.9bn in value for shareholders in just the past 3-years alone off of just a $5bn base, and now stands as one of the only companies with $3bn revenue base that is covered and owned by large-cap managers. #impressive. But the downside for UA is that when it is hovering at over 70x earnings with just 7% of the float short, it leaves extremely little room for error.
The good news is that UA has gotten extremely good at setting and managing quarterly expectations – even better than Nike, we’d argue (and guide/print numbers would support that), which says a lot. The punchline there is that the risk of UA missing numbers in 2015 is pretty low, at least how we’re doing the math.
The bad news is that the primary growth elements at UA are becoming more complex, more expensive, and more capital intensive – with what we think is a lengthier duration on payback. Again, when we consider UA’s multiple and lack of room for error in the model, we’d consider these factors ‘errors’, for lack of a better term. We’d love to own this name given the growth algorithm, but we simply don’t think that the risk-adjusted long-term upside offsets the severe pain of growth slowing, margins falling, returns declining (which is a near certainty), or market style-factors falling out of favor – even for a quarter.
Here are some things we’re referring to:
1) First off, let’s call a spade a spade…capex is going up this year – a lot. It should clock in at $330-$340mm, up from $141mm in 2014. That’s a 140% increase in capital spending – one of the biggest increases we’ve ever seen in this space. We’re not saying UA should not spend it. The fact of the matter is that the company probably should. We fundamentally believe that you need to spend money to make money (assuming it is well spent). But UA has proven to be a good steward of capital over time, and we don’t expect that to change. But with this level of spending, we need to see the company put up 27% growth in earnings this year, versus the Street’s expectation for 15% growth, in order to prevent dilution in ROIC.
2) Connected Fitness As a Business Driver. We struggle with this one. We understand the importance of assets like MapMyRun, Endomondo, and MyFitnessPal. But we don’t see how they are monetized. It doesn’t sound like the company does either, without significant capital spend. Is it possible that UA has a vision for how the different apps will be merged and integrated in a complimentary way years down the road? For sure. But ultimately it needs to drive consumers to the UA brand in a commercial way. Nike has been struggling with this for years in its digital businesses – most notably Nike+. And let’s not forget that Nike already has a seamless benefit of a digital platform that synchs perfectly with its product. We’re not saying that Nike will beat UA in this arena – this game is wide open. But if UA wants to play it’s going to have to spend.
3) SAP: A big part of the increase in capital spending is SAP-related. If there’s one thing we know about SAP, it is NEVER a 1-year spend, nor is it 2, 3 or even 4. The only companies who successfully implement SAP spend not only for the software (capex), but also for the service component (SG&A) as SAP staff immerse themselves in the company. UA said repeatedly that it has a ‘partnership with SAP.’ We need to get more color from the company on that one. That sounds to us like someone saying ‘I have a partnership with iOS8’. Unless there’s a profit sharing component (which is possible, by the way), this sounds more like a complex customer agreement.
4) Athlete Endorsements are Headed Higher. There was an unusual amount of real estate on the call dedicated to Jordan Spieth, Stephan Curry, Lindsay Vonn and Tom Brady. We understand that these athletes are winning, and it’s the job of the CEOs to be promotional regarding their assets. Heck, if I were in Plank’s position and had just notched some high-profile victories with athletes I pushed for from a business/endorsement perspective, I’d be just as loud. But what if these athletes lose?
What if Jordan Spieth is not ‘the new face of US Golf’? We’ve already seen the cost of endorsements head higher, and that before Nike lost some high profile events (starting with World Cup). UA and Nike duked it out over Kevin Durant, and Nike won by retaining him. Then Durant lost half his season to injury. The Masters was a shot in the jaw to Nike, who had a major Rory/Tiger campaign leading up to the event. Heck, Nike was sweating it out at the potential for Duke (Nike) to lose to Wisconsin (Adidas) in the NCAA finals. The sports marketing folks at Nike are nervous…and they should be. We think it’s going to go on a buying spree, which puts pressure on everyone. UA will play the game, and they’ll drive up prices for Nike. Nike will do the same for UA. Don’t forget about AdiBok, who is bowing out of its NBA deal to focus more in specific athletes.
Let’s put real numbers behind it. Last year Nike had $4.7bn in athletic sponsorship obligations sitting on (actually, off) its books. UA was at $393mm. Nike’s total obligations changed last year by $1.1bn. In other words, Nike’s endorsement purse changed last year by more than UA has in total. Again, this is not a nit-pick on UA, but stating the simple facts that the cost of growth is critical to consider with a stock trading at 70x earnings – no matter how good the story might be.