Here’s some interesting math in case you want to geek-out on the sales and margin impact of UAA’s over dependence on off-price channels. Because of off-price sales last year 1Q & 2Q topline compares at UAA are more difficult than what consensus thinks and that is why it will be near impossible for Under Armour to stop selling to off-price retailers -- at least in the first half of 2019. Off-price is a drug and UAA can’t quit cold turkey -- it has to be wound down slowly. Yet we know off-price is also very margin dilutive, upwards of 2000bps in merch margin, so there is a clear trade off between sales and margins with the channel. UAA needs to show as much revenue growth as it can, so we think the drugs keep flowing for now – which is likely to keep gross margin gains capped over the near term (keeping in mind that nearly 100% of the bull case here is around UAA reverting to a ‘normalized’ margin).
Here’s the details:
1Q18
- On the 1Q18 conference call management said that gross margin was negatively impacted by 130bps due to an off-price channel shift.
- Management disclosed the channel shift had a ~6% impact on inventory levels which equates to COGS being inflated by ~$70mm.
- Gross margin contraction of -130bps is the plug which requires a $102mm adjustment to the sales line in 1Q18.
- So we believe that in 1Q18 $102mm of inventory was cleared through the off-price channel at ~30% gross margin. ($70/$102).
2Q18
- On the 2Q18 conference call management said that gross margin was negatively impacted by 240bps due to channel mix.
- If we extrapolate the same incremental ~30% gross margin realized in Q1, Q2 would have realized ~$160mm through the off price channel in sales and $112mm of COGS. These calculations are illustrated in Table 2 below.
- Without the off-price sales in Q2 sales growth would have been -6.7% instead of +8% reported.
Off-Price will have to continue to operate as a clearance channel for UAA vs being an ongoing outlet since it would be very difficult to deconstruct the product into a customized offering to make margins work in this channel. We expect UAA would start to undo the channel shift in 2019 by continuing to sell into the channel albeit at a lesser rate. The commentary on the Q4 conference call strongly suggests this may be the case. UAA guided 1Q19 gross margins to be up 20-30bps “with benefits from regional mix and product cost improvements being primarily offset by channel mix due to an expected lower percent of DTC as well as higher sales to the off-price channel as our more aggressive inventory efforts begin to normalize.” In 4Q gross margins benefited by 80bps due to channel and regional mix compared to a 60bps headwind from channel and footwear mix in 4Q17.
In addition, in 1Q18 Under Armour added $106mm to its customer refund liability balance. In 2Q18 the balance fell by $49mm to $304mm. In 3Q and 4Q the balance remained roughly the same. One possible explanation is that sales to a wholesale customer (let’s say DKS) in 1Q needed to be reserved against and cleared through off-price customers (TJX) in 2Q.
The longer Under Armour continues to sell into the off-price channel the more the consumer is being conditioned to expect discounts. Perhaps more importantly, the decision to continue to allocate product to the off-price channel will continue to impact its full price wholesale relationships i.e. DKS.
Table 1 - Removing all off price sales from 1H ’18 and ’19 makes the underlying growth of consensus numbers look difficult to achieve, hence we’re likely to see more off price sales.
Table 2 – Math around margins based on management commentary.
