Last month, I wrote about how I believed a 20% drop from recent highs presented a buying opportunity in Under Armour (NYSE:UAA) (NYSE:UA) shares. With 24 consecutive quarters of 20%-plus revenue growth, a founder-CEO at the helm, and an aggressive move into Connected Fitness, its digital technology suite of health trackers and mobile applications, I believe Under Armour is in a position to provide shareholders plenty to cheer about over the long-term.
However, no investment is without risk, and Under Armour is no exception. Let's take a look at some of the biggest risks to its business.
Departure of Kevin Plank
Much of Under Armour's recent stock decline can be attributed to the departure of two key executives. The chief merchandising officer position is temporarily being backfilled by the current chief marketing officer, Kip Fulks, while the chief digital officer role will be taken over by MyFitnessPal co-founder Michael Lee. There will likely be some bumps in the road as the leadership team works through the transition. However, in the long run, the moves are unlikely to have a large impact on the company as both positions can be filled by experienced and competent leaders. However, if founder and CEO Kevin Plank were to leave the company, that bump in the road would be more like a mountain.
In 1995, CEO Kevin Plank created a T-shirt that wicked away moisture for his former football team at the University of Maryland. After perfecting the design, he began selling those T-shirts out of the back of his trunk, and 20 years later, he has led Under Armour in developing a $17 billion business.
A recent study by Harvard Business Review found that returns to shareholders of companies that are currently led by their founders are three times higher than those of other companies. The top performers have a founder's mentality, which management consulting firm Bain & Company defines as "behaviors typically embodied by a bold, ambitious founder -- to restore the speed, focus, and connection to customers."
Since its IPO in 2005, shares in Under Armour are up over 1,120%. To safeguard Plank's ability to maintain a founder-led culture, the company recently split its stock in a way that will ensure majority voting power remains with its dynamic CEO. If for some reason Kevin Plank were no longer leading the company he founded, investors would be wise to consider parking their investing dollars elsewhere.
Connected Fitness flops
Since 2013, Under Armour has spent nearly $1 billion acquiring three fitness and activity apps. The purchases of MapMyFitness, MyFitnessPal, and Endomondo are a part of Under Armour's strategy of connecting with customers and increasing awareness and sales through its wholesale and direct-to-consumer channels.
Under Armour intends to leverage the data from its 160 million registered Connected Fitness users to boost engagement and monetize these apps. The company is off to a good start in terms of growing its digital business. In its most recent quarter, revenue in its Connected Fitness category grew 119% to $18.5 million. Still, while Connected Fitness makes up less than 2% of the overall business, its absence would have resulted in an increase of 47% in overall operating income. In the first quarter of 2016, Connected Fitness' contribution to operating income was a loss of $16.5 million.
Under Armour is still in the early innings of its investment in digital fitness. As the business matures, investors should look for increasing returns. If the business continues to shrink company margins, investors may need to think twice about this strategy.
Supply chain doesn't improve
Under Armour's inventory growth for the first quarter of 2016 came in at 44%, well above revenue growth of 30%. This marked the third consecutive quarter that inventory grew faster than revenue. This is a concern, particularly for retailers, as excess inventory is typically followed by deeper discounting to clear shelves for newer products.
In Under Armour's defense, management did put investors on alert that inventory levels will increase. In a presentation to investors in September 2015, COO Brad Dickerson had this to say about increasing inventory:
First, on the near-term -- over the course of the rest of this year and through 2016, we are focused on delivering our products to our consumers more timely, specifically on key seasonal floor set dates. This focus specifically in comparison to some prior years' challenges will result in elevated inventory growth rates over this time frame to flow product earlier.
Longer term beyond 2016, many initiatives are under way which should bring added efficiencies to how we manage our inventory. These initiatives are focused on how we plan and deliver our seasonal products.
I do give Under Armour a pass on consistently growing inventory faster than revenue for the remainder of this year. Management is making a strategic decision to improve service levels. However, the words "prior years' challenges" should be heeded. Under Armour has had inventory issues in the past, which have led to lower operating margins. Over the last 12 months, the leaner and more efficient Nike has delivered profit margins of 11.8% versus Under Armour's 5.7%.
To help improve its supply chain, Under Armour announced that it is working with software maker SAP over the next three years to provide an integrated enterprise resource planning solution across all of its business lines. This investment should lead to "getting the right product in the right place at the right time."
If management unable to improve inventory management, the investment thesis in Under Armour may be at risk. Today, the story at Under Armour is revenue growth. However, over the long run, that revenue growth must translate to the bottom line.
Under Armour has been a tremendous investment over the past decade. It is very easy to think that its past performance will carry forward. This may very well be the case, but investors would be well-served by keeping tabs on these risk factors.
Palbir Nijjar owns shares of Nike and Under Armour (A Shares). The Motley Fool owns shares of and recommends Nike and Under Armour (A Shares). The Motley Fool owns shares of Under Armour (C Shares). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.