Under Armour may be running a different race than the market thinks. Image source: Getty Images.
When Under Armour Inc. (UAA 1.81%) (UA 1.73%) reported earnings for the third quarter on Oct. 25, there was a lot to like. The company delivered its 26th consecutive quarter of 20%-plus revenue growth, double-digit operating income and net income growth that exceeded most pre-earnings estimates, and management committed to continuing to invest in growth.
But a few things stood out in Under Armour's earnings presentation, including a drop in gross margin percent, a slowing of growth in North American apparel sales, and a big reduction in the company's guidance for operating income growth over the next several years. The result? Multiple Wall Street analyst downgrades, and a big sell-off of its stock, which has fallen more than 17% since the earnings release.
What should investors make of this quarter, as well as the change in guidance for near-term profits? Let's take a closer look at Under Armour's results and what management had to say about what it is doing.
The numbers
| Metric | Q3 2016 | Q3 2015 | Change (YOY) |
|---|---|---|---|
| Revenue | $1,472 | $1,204 | 22.3% |
| Net income | $128.23 | $100.47 | 27.6% |
| Earnings per share | $0.29 | $0.23 | 26.1% |
| Operating income | $199 | $171 | 16.4% |
| Gross margin % | 47.5% | 48.8% | -130 BPS |
Revenue, net income, and operating income in millions. Data source: Under Armour. YOY = year over year.
What happened in the quarter
As the numbers above show, Under Armour continued growing at a fast clip, but margin compression meant operating income grew at a slower rate than revenue. Here's a closer look at how Under Armour performed in key categories:
- Apparel -- which accounted for 69% of sales -- increased 18% to $1.02 billion.
- Footwear increased 42% to $278.9 million. Footwear was 18.9% of sales in the quarter, up from 16.3% in the year-ago quarter. Year to date, footwear is 22.3% of sales, versus 18.3% in the year-ago period.
- International revenue increased 73.7% to $226.2 million. International sales were 15.4% of revenue in the quarter and 14.9% year to date, up from 10.8% in the year-ago quarter and 11.3% nine months into 2015.
- Essentially all of Under Armour's operating income growth this year has occurred in its international business. To date, international operating income is up 471% while it has fallen nearly 8% in North America. In the quarter, North American operating income was roughly flat year over year, while international operating income was up 34%.
- Connected Fitness revenue and operating income both continue to improve. Revenue was up 39.8% to $20.2 million, and an operating loss of $8.5 million was roughly half of the operating loss of $16.6 million the segment reported in the year-ago quarter.
What management said
There has been growing concern in the investor community in recent months that the North American market continues to soften. And while that is happening, Under Armour founder and CEO Kevin Plank offered up some important context, as well as pointing out how footwear remains a huge growth opportunity not only in North America but around the world:
Consider this: Our two largest competitors generated approximately $18 billion in revenue in North America over just the past 12 months. So, while we recognize that our trailing 12 month North American revenue of $3.95 billion is 85% of our business, it is just a fraction of the opportunity that we believe exists for our brand. Whether it's through share gains, market growth, new distribution or sheer brand heat, we know we have tremendous runway in our home market. ... A large part of that growth in North America will come from footwear, as we firmly believe that we are at a tipping point in terms of opportunities to gain market share. In the back-to-school window of July through September, our overall footwear market share nearly doubled according to industry data.
... So, we'll continue to invest meaningfully in our footwear business with a focus on talent as well as infrastructure that will help improve the profitability in our business as we scale. We believe we are at a moment in time where we can gain share in footwear and we are prepared to make investments that will drive long-term profitable growth.
Plank also highlighted the importance of China to Under Armour's international growth:
[O]ur Greater China market remains the biggest growth story for our international business, posting revenue in the third quarter equal to the entire first half of the year, and firmly on a path to more than double the business from $80 million just a year ago. We are making incredible inroads in China that we believe will drive our position in this critical market.
He also emphasized the company's investments in expanding its presence in multiple international markets, and how it was part of the long-term strategy that would mean higher spending in the short term in order to achieve long-term goals:
We've rolled out e-commerce platforms in four new markets this year including Mexico, Australia, New Zealand and Chile -- and that's after doing the same in 14 new markets in 2015, bringing our total global e-commerce sites to 30; we're building a global organization for the long-haul. As I said earlier, funding these growing international markets may require additional investment in the short-term. However, we believe they are essential to our long-term goal of market leadership.
Lastly, Plank described why the company would continue to prioritize Connected Fitness:
The third key where we will continue to over-invest in the near-term is Connected Fitness. We're doing so because we believe strongly that it will prove an important differentiator in our relationship with the consumer. With nearly 190 million registered users in our community, we continue to gather critical information to help us change the way athletes live.
Looking ahead: Under Armour is running a marathon; Mr. Market thinks it's a sprint
Pardon the bad sports analogy above, but it's fitting. Under Armour operates in a very competitive industry, and against some behemoths in Nike and Adidas with much greater resources and long track records of historical success. Factor in what's looking like a cyclical decline in demand for athletic apparel in the West in the near term -- a shift that could increase price competition and further squeeze margins and profitability, and Under Armour management acknowledged that its operating income isn't likely to grow over the next few years at the rate the company had projected at last year's analyst day.
However, Plank and his team aren't going to back down on investing in innovation -- both product development and Connected Fitness -- nor are they going to back off investing aggressively to grow the brand's retail presence and distribution partnerships outside North America.
And while a nonplussed market has voted against this strategy in recent days, Under Armour's track record of success -- by doing exactly what it's choosing to do now -- should make long-term investors think twice about following the herd.
