Under Armour's Earnings Quality Improvement

Under Armour (NYSE:UA) has appreciated over 100% within the past year. The large increase is contributed to its earnings quality improvement relative to prior years and competitor's such as Nike (NYSE:NKE) and Lululemon (NasdaqGS:LULU).

Earnings quality issues

Earnings quality refers to reliability in the numbers provided in the financial statements. Due to financial reporting subjectivity, it is possible for companies to overstate their earnings. Foolish investors always desire a company that reports earnings conservatively.

Monitoring earnings quality for growth stocks such as Under Armour is imperative because they are highly volatile on Wall Street's earnings expectations. This creates an incentive for aggressive accounting since executive pay is correlated to stock price movement. Consistently low earnings quality indicates a decreased probability to reach expectations priced into the stock, because aggressive accounting cannot be perpetually maintained.

Under Armour's accounting was a concern for investors in the past. In 2011, the company booked a $3.3 million fair value gain on real estate in its selling, general & administrative expenses. The effect was a lower SG&A, and increased operating income. Concerned investors believed that a company selling athletic apparel should book this gain as extraordinary, since it fit GAAP standards of unusual in nature and infrequent in occurrence.

Earnings quality test

UA's earnings quality has improved significantly. Earnings quality can be estimated by comparing operating cash flows (OCF) and net income. OCF is the actual cash generated by operating activities, and has less room for "window dressing" than net income. Comparing against previous years, and mature (i.e. Nike) and younger (i.e. Lululemon) competitors guards against life-cycle sample error. This is important because mature companies have different capital expenditure and cost structures than younger companies. Below are the results:

 

2008

2009

2010

2011

2012

Under Armour

         

OCF

 $69,516

 $119,041

 $50,114

 $15,218

 $199,761

Net Income

 $38,229

 $46,785

 $68,477

 $96,919

 $128,778

OCF/Net Income

1.82

2.54

0.73

0.16

1.55

           

Nike

         

OCF

 $1,936,000

 $1,736,000

 $3,164,000

 $1,812,000

 $1,899,000

Net Income

 $1,883,000

 $1,487,000

 $1,907,000

 $2,133,000

 $2,223,000

OCF/Net Income

1.03

1.17

1.66

0.85

0.85

           

Lululemon

         

OCF

 

 $46,438

 $117,960

 $179,995

 $203,615

Net Income

 

 $39,363

 $58,281

 $121,847

 $184,063

OCF/Net Income

 

1.18

2.02

1.48

1.11

Under Armour achieved a OCF/net income greater than 1 in the 2012 fiscal year. This is a large improvement from the 2011 fiscal year. OCF/net income will vary from industry and age of company, but it is always desirable to be greater than 1 because it lends itself toward conservative financial reporting. 

On a competitive basis, Under Armour's OCF/net income is greater than Nike and Lululemon. In the 2012 fiscal year, Nike and Lululemon had OCF/net income of .85 and 1.11 respectively. It is a good sign for Under Armour to beat both competitors. Furthermore, it should be noted that earnings quality of Under Armour has increased during the time Nike and Lululemon have not.

Conclusion

Under Armour's improvement in earnings quality has furthered its stock movement. This provides comfort that the earnings are from organic demand of its products. Foolish investors should continue to review earnings quality as the company releases earnings.


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