📍 TLDR

UAA has soared along with other apparel plays — despite posting a soft outlook in its most recent earnings report.
The optimism towards the sector looks overdone, which only adds to the sense the rally in UAA should reverse.
After the gains, UAA is pricing in growth from this point onward.
Given history and a volatile and difficult environment, betting against that growth seems wise.

During the second half of 2021, apparel stocks began to weaken as the market realized the group collectively had been a ‘pandemic winner’. When equities turned south in the spring of 2022, the sector saw even more pressure amid rising fears of a recession-driven, decline in consumer spending.

But the consumer has held up, at least so far. Third quarter results were strong across the sector. Combined with hopes that the Federal Reserve will pull back on rate hikes, potentially allowing for a “soft landing”, apparel stocks have bounced back:

source: Bloomberg

Under Armour has joined in the rally. Since Nov. 2, the day before its fiscal second quarter earnings release, UAA stock1 has risen 34%.

The rally is part of a big run for the space. As Bloomberg pointed out, Abercrombie & Fitch , American Eagle Outfitters , and Burlington Stores all gained at least 18% after recent earnings reports. Under Armour’s direct peers have performed well, too. adidas AG has bounced 32% since 11/2; Nike is up more than 30% since wiping out after FQ1 earnings in late September.

But what makes the rally in UAA distinctive is that Under Armour’s earnings actually looked quite disappointing. The quarter itself topped consensus estimates, but relative to peers still looks soft. More importantly, the full-year outlook was cut for the second time in as many quarters.

The combination of another soft earnings report from a serial disappointer and a stock price at the high end of a multi-month range creates an attractive short that can work in a number of ways. Betting against Under Armour has been a profitable trade for years, and it looks like a profitable trade again.

Betting Against Under Armour

It’s easy to forget how strong Under Armour once was, as both a stock and a business. At one point, UA was one of the “CULT stocks”, along with fellow ‘momo’ plays Chipotle Mexican Grill , Lululemon Athletica , and Tesla . (Quite clearly, at this point one of those stocks does not look like the others.) At its 2015 peak, Under Armour stock had gained 700% in almost exactly a decade since its initial public offering, a ~23% annualized return. The gains were driven by strong business performance. As of Q3 CY162, revenue had increased at least 20% year-over-year for 26 consecutive quarters.

But it’s also easy to forget how long it’s been since the business showed that kind of strength. Following a soft Q4 2016, the business simply stopped growing. Revenue rose ~3% annualized over the next three years; operating margins shrunk dramatically (8.65% to 4.49%).

Indeed, since 2016, the only strong year Under Armour has posted was in 2021. That year, revenue increased 27% (albeit against a -15% compare). Adjusted operating margins cleared 9%, thanks to adjusted gross margins above 50%.

Of course, every retailer3 posted a strong 2021. Promotional activity all but ended, consumers were flush, and spending was directed away from travel and experiences. But here in 2022, we're about right back where we started.

Through the first three quarters of calendar 2022 (which includes a transition quarter for CY22), adjusted operating profit was $184 million against $426 million in the year-prior period. Revenue did increase almost 4% excluding currency, which admittedly suggests some strength. But in an inflationary environment that performance is hardly spectacular. For full-year FY23, adjusted operating income now is guided to come in at $290 to $310 million, down by almost half from CY21 results.

Of course, that’s if guidance is hit. And there are some reasons to believe it won’t be. First, this is a company that has disappointed time and time again for most of the last six years. More recently, it’s a company that has disappointed in each of the last two quarters, with operating income guidance reduced after each quarter.

History aside, Under Armour expects profit to increase year-over-year in the back half of the fiscal year. The midpoint of adjusted operating income guidance suggests 2H profit of $127 million. That’s a 14% year-over-year increase. So revenue growth is expected to accelerate, if modestly so.

Even granting much easier comparisons, it’s difficult to see that scenario playing out. It’s not as if Under Armour is performing particularly well heading into the holidays. In fiscal Q2, its revenue increased 5% on a constant-currency basis, a two-year stack of 11%. Nike grew constant-currency sales 10% in its FQ1 (which ended a month earlier), with its two-year stack twice as high. Nike has a greater penetration of footwear, a stronger category, but of course that relative strength isn’t going to change in a matter of months. Lululemon now provides another significant competitor: its men’s business rose 28% year-over-year in fiscal Q3 (which ended a month later).

In that context, yet another guidance cut would not be a surprise, and almost certainly would not be so easily ignored by the market. And so a UAA short can win simply if the company does what it has does so often, and disappoints investors.

The Industry Catalyst

Even assuming Under Armour does hit its guidance, there are two additional possible catalysts to the downside.

The first is a reversal of the optimism toward the sector at the moment. A stronger-than-expected holiday season simply doesn’t change the mid-term outlook all that much. The environment is going to get more difficult regardless of how the macroeconomic picture changes over the next few weeks.

For the industry, normalcy simply hasn’t truly returned, and Under Armour’s own guidance shows the extent to which that is true. The company is guiding for gross margins to decline ~400 basis points year-over-year against 49.6% the year before. Per the Q2 call, only about 100 bps of that total is coming from increased promotions, with another quarter coming from increased freight. Currency and product and channel mix are doing the lion’s share.

Freight costs should moderate at some point, but that aside, the news is not going to get any better. Under Armour isn’t winning on the high end of the market (by management’s own admission) so product mix is likely a continuing headwind into CY23. The same is true for channel mix, as UA’s direct business continues to disappoint (while Nike’s continues to impress).

But the fact that promotional pressures in FY23 are only hitting gross margins by one percentage point against Q2 CY21 to Q1 CY22 (the least promotional period in recent memory) suggests that Under Armour’s margins remain at least somewhat elevated. 5%-plus EBIT margins don’t sound like much, but that would be well ahead of the late 2010s performance. And it’s coming with cost controls: selling, general and administrative expenses are guided down year-over-year. Assume the promotional environment truly normalizes, and UAA’s operating margins head back to the 4% range, and net profitability once again gets relatively thin.

Yet, like many retail executives of late, management after FQ2 talked up the “challenging near-term environment”. We’d argue strenuously that, taking the long view, the environment simply cannot be considered challenging. It’s not 2021, certainly, but it’s possible that no year in our lifetime will ever be like 2021 again. The promotional environment is still reasonable and consumers are still spending.

Source: YCharts

The Case For A Reversal

As we discussed two weeks ago, value has outperformed growth this year, particularly of late. We expect that fact has contributed to the rally in apparel plays, which look cheap on a headline basis and cheaper if full-year expectations rise (as seems likely following the raft of fiscal Q3 reports).

But we also expect that at some point investors will remember that apparel stocks underperformed before the pandemic for very good reason. The industry was under significant pressure, particularly in terms of margins. Heightened promotions and the rise of e-commerce — which added expense — led to compression across the industry, and Under Armour clearly was not immune.

At some point, and it may not take long, the market should realize that the post-pandemic environment is likely to look the same as that of the late 2010s. In that scenario, there may well be a more profitable short out there than UAA (honestly, how many times are people going to chase a rally in ANF?). But, as we’ll discuss in a moment, the price of UAA does not reflect the ongoing declines seen in other retailers and manufacturers within the sector.

It looks like Under Armour’s guidance is questionable. But even if the outlook is hit, there’s potential for a re-rating downward amid a reversal of the sector-wide rally that has sent UAA higher over the past six weeks. Those gains look more like investors reaching for value than a sign of a real change in the sector. That’s particularly true for a company like Under Armour that has shown little evidence of such a change.

Taking The Long View

After that long discussion, there’s a simpler way to make the short case here: UAA is still priced for growth. Based on the midpoint of guidance, and backing out our estimate of post-Q3 cash on the balance sheet, UAA trades at over 16x net earnings. Even looking at the cheaper UA, the multiple is just shy of 14x4.

Taking a bit of a longer view, trading in UAA comes down to the market’s belief in the potential for a turnaround to finally stick and some kind of turnaround is priced in. Again, the stock is pricing in growth that, based on guidance and excluding the pandemic-boosted FY21, would be the company’s best in seven years.

Under Armour hasn’t really put forth a plan that brings any confidence to that outlook. That may be because the company hasn’t had a permanent chief executive officer. Patrik Frisk stepped down in May. (Chief operating officer Colin Browne is the interim CEO.)

But it’s also because there isn’t an obvious strategy to take here. Under Armour’s historic strength was in performance. Since reaching scale, it’s struggled in athleisure.

As a result, Under Armour’s strategy going forward, as detailed on the Q2 call, implies little in the way of change. Browne talked up expanding the company’s assortment, adding “live” to a current product line focused on “train, compete and recover”. He added:

Yet, as we've observed meaningful changes in the market dynamics and consumer behavior over the past few years, it was clear that our consumer centric strategy needs to evolve. Consequently, we have refined our target audience, which is now centered on the 16 to 20-year-old team sport athlete.
This definitive group personifies our brand attitude and lives at the intersection of multi-generational influence from pushing the boundaries of what's possible in sport to seamlessly blending fitness, music, and street culture. This target audience will allow us to bring our product and storytelling into sharper intensity across the entire athlete experience influencing the larger target market.

This is, once again, Under Armour trying to move into fashion in large part because the core performance market isn’t large enough. And it seems an extraordinarily risky strategy. 16 to 20 year olds are notoriously fickle. More importantly, the oldest members of that cohort were thirteen years old the last time Under Armour was a ‘hot’ brand.

This strategy looks like more of the same. And that’s precisely what the short case for UAA is based on: the belief that more of the same will not be close to enough.

As of this writing, Vince Martin is short TSLA. He may initiate a short position in UAA this week.

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1

UAA stock is the Class A common, which includes one vote per share. UA is Class C, which is non-voting. In this piece, we’ll train our focus on UAA, which is more expensive, though we’ll later discuss valuation in the context of the surprisingly large difference in price between the two stocks.

2

Under Armour changed its fiscal calendar this year, moving from a December end date to March.

3

Except for GameStop .

4

A UAA short even has a potential, if modest, tailwind from a compression of the spread between UA and UAA. On average over the past year and past five years, UAA has traded at at a mid-12% premium; the figure is currently 14%. There’s roughly a percentage point of return to a UAA short simply if that spread reverts to the multi-year mean.

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