Every headline out there today will talk about how UA is simply killing it – and it’s well-deserved. UA’s brand heat continues to roll full steam ahead, and the company is proving itself out to be one of the true generational growth stories in Consumer.
That said, we think it's more than fair to point out that Revenue growth is accelerating, but earnings growth is decelerating. In fact, this company has not grown earnings since 4Q14. When 2015 is said and done, we’re likely to see revenue, EBIT and EPS grow at 25%, 15%, and 10%, respectively. That’s not the kind of ‘World Class’ growth algorithm that we’d expect from a World Class Brand like UA.
We understand that the company is investing today in order to capitalize on (and create outright) growth opportunities tomorrow. We like when companies play offense like that. But at 75x earnings and 36x EBITDA, is it too much for us to expect that earnings grow faster than Wal-Mart? We don’t think so.
We’ve always said that the cost of growth in this space is headed higher. In fact, UA was fairly explicit on its call in saying that it would capitalize on brand heat in 2H by spending more on athletes and endorsements. While that makes sense academically, and probably financially if executed right (which UA probably will) the reality is that Nike will make this very difficult.
Keep in mind that this is the first time Nike and UA will truly be going toe to toe in a meaningful way since UA came along and created a space (compression apparel) that Nike arguably had the technology for first – but failed sorely to execute on. We got a little taste of the endorsement battle with Kevin Durant, which UA fortuitously lost to Nike to the tune of ~$30mm/yr.
As a point of reference, Durant represented 33% of UA’s existing endorsement obligations this year, but only 3% for Nike. UA ‘lost’ Durant, but stuck it to Nike with Spieth, Copeland, Curry. In other words…Nike is not happy right now. NKE’s Sports Marketing group is feeling heat it has not felt in over a decade. Do you think that just MAYBE Nike is going to step up its marketing spend by a couple hundred million to secure its dominance? You betcha.
We’re not saying that Nike will secure dominance – we’re just saying that it is going to spend in its attempt to get there. Also keep in mind it has a brand new CFO who comes from the brand side of the house, who is more likely than Don Blair (one of the best CFOs we’ve seen in all of Consumer Discretionary in 23 years) to rubber stamp spending that might be ROIC dilutive.
The bottom line on the stock is that as much as we like the multi-year top line growth potential, we’re reasonably certain that it will come at the expense of margins and ROIC. But that’s hardly a reason for us to be short a name that’s earned its spot as the clear #2 player in a global oligopoly where retailers are begging for an alternative to Nike. But even if we assume that UA continues to grow mid to high 20% EVERY year for five years resulting in $9bn in sales, AND overcomes near-term margin pressures and pops back up to 12% EBIT margins, we get to an even $3.00 in earnings. That’s a 32.5x p/e and 15.5x EBITDA multiple on a number 5-years out that takes a whole lot of positive assumptions to get to. We’re simply going to sit back until the research call suggests a more asymmetric setup – in either direction.
SOME HIGHLIGHTS FROM THE CALL
1) Top line continues to look very very strong accelerating on a 2yr basis. Int'l and footwear (the two categories where UA is still establishing a beachhead) ticked up on a 2yr basis and now both account for over 10% of revenue. The guidance raise of $60mm after a $20mm beat with no lift to margin dollars was enough for the bulls to get excited about.
2) On the margin front -- the company cited gross margin pressure from Fx, connected fitness dilution, and extra air freight cost for the 160bps whack in op margins, but that doesn’t explain the 70bps decline in the NA business. Brand Houses (ie the 30,000 sq. ft. store on Michigan Ave in Chicago) are significantly more expensive on a unit basis then the legacy Outlet locations, but we'd expect a little more leverage on 22% revenue growth in its biggest region.
3) The athletic footwear and apparel market in the US had a monster 2Q. NKE and UA grew at 13% and 22% respectively totaling $560mm in revenue. That’s good for at least 3 points of growth for the entire athletic footwear and apparel market alone which did about $16.75bil in LY's 2Q. DTC at UA kicked it up in a big way growing 33% in the quarter -- up 1200bps sequentially on the 1yr and 700bps on the 2yr trend line.
4) As noted above the investment cycle is no where near close to being over. On the call management talked a number of times about the fact that fulfillment rates and global infrastructure is not anywhere close to where it needs to be as evidenced by the 50bps hit or $4mm in incremental air freight expense during the quarter. That makes sense given the fact that Int'l penetration has grown by 5 percentage points on a TTM basis over the past 18 months. There is a lot of track that needs to be built in order to support this global network.
5) The last piece of the puzzle is the company's move to a sports/category focused org. structure rather than the simple 2 dimensional structure that exists today. UA has been hiring leadership talent to facilitate this transition, but if we use Nike as the model when it switched to the category offense -- we are looking at least 3 years of growing pains before the model is optimized – and that’s if it executes perfectly. Given UA’s impressive execution track record, management will probably get it right by hiring all the right people into the appropriate roles. But this takes time.