Under Armour's Under Investigation

In this episode of MarketFoolery, host Chris Hill talks with senior analyst Jason Moser about some of the market's biggest news. The SEC and the Department of Justice are investigating Under Armour's (UA 0.95%) (UAA 0.92%) financials. Things don't look great for the apparel company, which has been struggling for years. Meanwhile, McDonald's (MCD 0.38%) suddenly has a new CEO, and he has quite an act to follow in Steve Easterbrook's wake. Plus, some speculation on what Berkshire Hathaway (BRK.A 0.64%) (BRK.B 0.54%) might want to do with its exorbitant cash hoard. Tune in to hear more! 

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This video was recorded on Nov. 4, 2019.

[Law and Order theme plays]

Chris Hill: It's Monday, November 4th. Welcome to MarketFoolery! I'm Chris Hill. Joining me in studio today, the one and only Jason Moser. Thanks for being here!

Jason Moser: Thank you for having me!

Hill: The news fairy showed up over the weekend. 

Moser: [laughs] It did!

Hill: You and I were trading messages on Sunday. McDonald's has a new CEO. Berkshire Hathaway has a record amount of cash. We're not going to start there. We're going to start here -- the U.S. Department of Justice. That's always good news anytime you're a publicly traded company. The U.S. Department of Justice has teamed up with the Securities and Exchange Commission to investigate Under Armour's accounting practices. At issue is whether Under Armour moved sales from quarter to quarter to appear healthier than the company actually is. This is a criminal investigation. Shares of Under Armour are down 15% this morning. I'm a little surprised they're not down more. Not that it was trading at some sky-high valuation.

Moser: Yeah, I was going to say, it's been not that great of a time for Under Armour anyway. I think the funniest part, if you could say there's a funny part about this, it did strike me, if there's any veracity to these allegations whatsoever, [laughs] they were doing this to make their financials look better. Why not just go all out? We could argue -- I think you and I would probably fall on the same side of this story -- their financials don't look so hot right now as it is. And if these are somewhat manufactured, then you have to start asking yourself, if there's really a problem here, why didn't they really just go whole hog, as they say, and just do it up right? 

To that point, let's acknowledge that Under Armour management believes, and they said the word firmly, they do believe firmly, they've done nothing inappropriate. That's what they said in the call this morning. This is an investigation that's been going on for two and a half years. I'm still not quite sure what takes so long. Who knows? The length of the investigation makes me wonder a little bit if this something that they did. If they are seen to have done something inappropriate, this is not fatal to the business, but it is just one more problem that they have to deal with at a time when they really don't need any more problems. 

Hill: By the way, they also issued their third quarter report, which came in better than expected both in terms of profit and revenue -- and nobody cares. Nor should they.

Moser: Nor should they, because how can we trust them? Are those numbers that they're throwing out there a figment of their imagination, or are they real? 

Hill: You and I had the same thought. Once I started to read more about this story, it reminded me of years ago, when there was a steroids scandal in Major League Baseball. A list came out of players who either admitted or it was provable that they were using steroids. And there were some players on that list who were big guys who were hitting lots of home runs, that kind of thing; but there were also a few names on that list that were kind of like Under Armour, like a small second baseman who was batting 265 and had 11 home runs. And it's like, "Wait a minute, you took steroids to get those numbers? What would you have been without the steroids?" That was one of the thoughts I had. Like, wait a minute. If you're actually cooking the books, these are the numbers you're coming up with?! Come up with better numbers! 

Now, on the one hand, as an Under Armour shareholder, I like to think that anytime lawyers are involved, and they are approving written statements, and they are saying things like, "We firmly believe we did nothing wrong," that there is veracity of that. On the other hand, the SEC is involved. And the SEC is a regulatory body that is not exactly swimming in money and resources. 

Moser: That's a very good point.

Hill: So I sort of feel like, anytime the SEC is actually significantly involved in an investigation, I'm inclined to believe that at least the people inside that building believe, "This is worth our time because we don't have a lot of time or money or resources."

Moser: You would figure. Anytime you get the SEC involved with anything, you'd better pack a lunch because it is going to be a while. To your point, two and a half years does sound like a long time. Clearly, they think they have something here. Whatever may have been done, we'll get more light shed on this as time goes on. There was very limited information they could release on the conference call. That's understandable. It's an ongoing investigation. 

And, listen, we can pile on Under Armour, make fun of them and everything, and that's fine, that's part of our job and we have fun with that. This is not unique to them. We see companies go through these types of investigations often, more often than probably we'd like to. I mean, remember, it wasn't all that long ago, Markel was under investigation for some reserve issues regarding their CATCo side of the business. That was a very small side of the business. But it's an investigation nonetheless. That's not been resolved yet, either. They, believe it or not firmly believe that they did nothing wrong, Chris. [laughs] Again, we'll learn more about this as time goes on. I think it is important to recognize this is not something that would be fatal to the business, but it is a problem at a time when they don't need it. 

Now, to go to the actual results for the quarter -- and I'm going to give them the benefit of the doubt and trust that the numbers that they're releasing are actually the numbers, because, again, they weren't that great to begin with, but they could have been worse. I think that for Under Armour, they're doing a very good job with this turnaround plan in achieving the goals, for the most part, that they're trying to achieve. The balance sheet is getting healthier. Inventory levels are coming down. Margins are improving. But they've got to figure out how to light a fire under those sales numbers. That's really the problem. That's the source of the problem. If they could figure out how to reaccelerate that sales growth, man, we'd be singing a different tune today, I think. Right now, we're three years into this, and they still cannot get those North American sales back in the right direction. They fell 4% for this quarter. Direct-to-consumer, again, not very impressive. Inventory, on the other hand, inventory's down 23%. In their case, that's a good thing. And margins are improving, which means they're getting back to that premium product offering, as opposed to really just trying to appeal to all of the masses. So I think there are signs that they're doing some good things, but man, oh, man, we know the headlines are about today. 

Hill: McDonald's has a new CEO. Steve Easterbrook is out after four and a half years after admitting to a consensual relationship with an employee. Chris Kempczinski is the new CEO. He's been the president of McDonald's USA for the past couple of years. Boy, this moved quickly. I think you and I were chatting a little bit about this this morning. I'm not a McDonald's shareholder, but it struck me how quickly these announcements came -- the combination of, "Easterbrook is out, this is why. Here's the new CEO. Here's who's going to take Kempczinski's place." The board of directors at McDonald's, maybe they've been working on this for weeks, if not months, but they really took care of business in this situation. 

Moser: It didn't sound like it was something that happened at just the snap of a finger. There were board votes involved. There were attorneys involved. I think they were trying to make this exit as clean as possible without trying to ruin everybody's lives in the process. 

I think the good thing for McDonald's is that Kempczinski should be able to essentially pick up right where Easterbrook left off. Easterbrook's been there since 2015. I think that for the most part, he's done a very good job at reigniting what was a difficult situation there with McDonald's. Talk about challenges on the top line, getting those sales back in the right direction. That was really a big problem with McDonald's back in 2015, 2014. Don Thompson, who was the CEO before Easterbrook, and he had been the COO, we thought he was the guy for the job and he didn't really have a solution there. But Easterbrook's North Star was that phrase he always uttered, progressive modern burger company. That brought McDonald's, it seems like, into this new century with a little bit of a different brand awareness. It's no longer just this fast food burger place, but a place where they offered a lot of other things. You look at the way the numbers of have worked out for them. This past quarter they just reported, U.S. comps up 4.8%. Now, traffic is still a bit of a problem. But by the same token, in the face of weak traffic, they still brought those 4.8% comps, which means they're realizing a little bit of something on the pricing side, and continue to innovate on the menu side as well. 

This is a tough personal thing. He did what he did. It was something that was clearly against company policy. I admire the company for taking the stance that they take here. He seems like he's in agreement with for the most part as well. It's always difficult to really understand exactly what went on here. It is what it is, I guess.

Hill: Yeah. It's going to be interesting to see what, if any, additional details come out about this. On the surface -- look, this may have been as simple as, you're the CEO, and therefore, every employee at this company reports up to you. So, a consensual relationship with any employee is against our policies, and that's that. It may just be as simple as that. To this point, anyway, it doesn't appear to be what we saw a few years back at HP with Mark Hurd, where there was a relationship with a contractor and there was money involved, where he was paying for her to go to different events and that sort of thing. So, there were corporate dollars involved, as well. Hurd resurfaced at Oracle. It'll be interesting to see where Steve Easterbrook goes from here. He has a non-compete. Very smart of the board of directors. I just stopped reading the non-compete because it was basically a list of every restaurant in America that has more than one. It'll be interesting to see, in a couple of years, if he does resurface at another business. To your point, it's interesting, you said Kempczinski has got the blueprint. I agree with you. In some ways, the new CEO has it easy, because he's got this blueprint he can follow. His early communications to the McDonald's employees was essentially, "No, no, we're on a path. I'm going to follow that path. I'm not looking to do anything new." 

From the standpoint of the stock, I think it's tougher for him. I think it was the reverse for Easterbrook. Easterbrook had it easy because under Don Thompson, this was a stagnant business and a very stagnant stock. Easterbrook was able to come in, spend a few months listening, talking to a lot of different people, and then going from there. The stock up more than 90% in the time that Easterbrook has been CEO.

Moser: Yeah. Very good point there. Just want to remember that Easterbrook came in at a time when McDonald's was in the doldrums. Executing his vision, it only made sense to see the stock -- the stock has essentially doubled over the last five years. He's done what he promised he would do in regard to returning value to shareholders. He's targeted $25 billion for a three-year period ending in 2019, and he's at about $22.5 billion between share repurchases and dividends. So my suspicion is, Kempczinski, I read where he referred to Easterbrook as a mentor. They worked very closely together. The relationship this made me think of immediately was that of Alan Mulally and Mark Fields at Ford. It's important to remember, Mulally came in at a time where Ford was just knocking at desperation's door, brought things back around, and everything was hunky dory. You figured, when Mark Fields stepped in there, he could just keep on executing because he'd been working so closely with Alan Mulally to begin with. It's a lot easier said than done. So, I think that for Mr. Kempczinski, he's going to come in here thinking, "OK, this is nice. At least I've got an easy way to keep this ball rolling as it is now," but we're at a point where McDonald's is going to have to figure out that that next act. They're going to run into more competitive headwinds. Where you go from here, it's a big company. It's not like they can just keep on opening McDonald's. They've pretty much saturated the market with McDonald's. It was neat to read in the call how Steve Easterbrook had spoken with so many franchisees with the company, and generational franchisees, trying to get an understanding of their history and where they feel like the company should be going. He really did seem to be interested in learning more from the people who are actually really doing that work on a daily basis. My suspicion is that Mr. Kempczinski will probably take that information to heart. Listen, you have to be in touch with the people. It's a restaurant, you're selling food to people. But yeah, I feel like he's at least got a good entryway here, but I do not envy the task he has ahead, because we're going to hold him to the standard. How is he going to make this stock double over the course of the next five years?

Hill: You just reminded me of the letter from a few months back, that an independent board of franchisees sent to Easterbrook about the premium chicken sandwich. How long do you think it's going to take before they're in touch with Kempczinski? The first quarterly conference call after they sent that letter -- and, to my memory, it wasn't a particularly pointed letter. It didn't have a lot of attitude attached to it, or accusatory language. It was just, "Hey, look, this is what we want. This is why we want it. What are you going to do?" And on the first quarterly conference call, Easterbrook was asked about it, and basically said, "Yeah, no. I'm not talking about that." So, it'll be interesting to see if they go public. I'm sure, in the next week, they're going to at least have placed a phone call to the new CEO.

Moser: I feel like that's a great opportunity, particularly where you see Chick-fil-A, obviously, picking up a lot of market share in that space. The noise that Popeye's has created has been, I think, pretty fascinating, considering Popeye's isn't probably the biggest known franchise in the world. But even this past weekend, what was it, the Shawn Watson with the Houston Texans? He credited the Popeye's spicy chicken sandwich for healing his eye. You need people singing your praises like that. So I bet you that Mr. Kempczinski would love to hear someone talking about their future chicken sandwich in such accolades. 

Hill: Chick-fil-A is not public, but Popeye's is part of Restaurant Brands International. I believe the last quarter, Popeye's was the jewel of that crown.

Moser: It moved the needle.

Hill: Let's move onto Berkshire Hathaway. As is Warren Buffett's wont, they issued their quarterly report closing business on Fridays. Third quarter profits came in higher than expected for Berkshire Hathaway. They operate more than 90 businesses. It's not like there was one particular division, or business, for that matter, that was really moving the needle on this. So the headline that we have been given is the increasing pile of cash that Berkshire Hathaway now has, which sits at $128 billion. I was thinking this morning about how, when Apple's cash hoard was $50 billion, and then $100 billion, the conversation around that business was, "Oh, my gosh, look at all the cash they have! What are they going to do with that?" Here's Berkshire Hathaway. They have $128 billion. What are they going to do with it? Here's what we know. They're not going to overpay for something, because Warren Buffett won't let that happen. So if they're not going to acquire something, what are they going to do with this cash?

Moser: I don't know. Personally, I have a little bit of an opinion here. I'm sure you're surprised to hear that. I feel like it's time for Buffett to you-know-what or get off the pot. 

What I mean by that is, we've been talking a lot about a Berkshire Hathaway dividend. People have argued they should pay it, they shouldn't pay it. Berkshire Hathaway continues to say they're not going to pay one because they feel like they can do more with their investment dollars than cash in the pocket of the investor. And that's fine. But clearly, you don't really feel like you have many avenues right now. Listen, it's not like you're going to be running up on a shortage of cash. Like you said, they've got 90 businesses. They've got a lot of cash-producing machines. They're not going to really be worried about capital from any perspective whatsoever. Again, this is a big company, and growing is going to become more and more difficult for them, because it's not a tech company. This is a good cross-section of the American economy. Book value was up 6.5% from a year ago. That's nice. I do appreciate the fact that they continue to repurchase shares. And I like the fact that they basically eliminated that 20% premium over book value stipulation. And now they can just do it whenever they feel like it's a good value. I'm not arguing with them about businesses and valuations, either. I don't want them out there overpaying for something. Unless, of course, it was for something like McCormick, Chris, because McCormick, that's just like a little dividend in your pantry.

Hill: [laughs] I mean, come on. 

Moser: But, really, it does feel like he's trying to have his cake and eat it too. I think that this is an ideal time for him, particularly with the way the stock is performed this year --

Hill: It's basically flat over the past 12 months. 

Moser: Yeah. The, market, obviously, is outperforming it by a lot. You stretch that timeline out three, five, 10 years, it becomes a little bit more of like a market-matching type of a stock. I just think that the goodwill that shareholders would take from even just a modest dividend, because then that dividend can grow over time, I just feel like it's the right time in Berkshire Hathaway's life to start paying a dividend. I think shareholders would appreciate it.

Hill: You think, maybe instead of that, they just send a box of See's Candy to all the shareholders?

Moser: Listen, it would be better than nothing. You can assign a dollar value to it, and most people love See's Candy. The peanut brittle is top notch, as you know, Chris. Top notch. And I say all of this, I am not a Berkshire Hathaway shareholder. I used to be a number of years back. I just decided that at some point or another, I had places where I felt like the money would be more productive. But, hey, if they were paying a dividend, I might have left those shares alone, Chris.

Hill: That cash hoard is only going up. Three months from now, we're going to be talking about this as being $140 billion.

Moser: Something like that.

Hill: Thanks for being here!

Moser: Thank you!

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of MarketFoolery! The show's mixed by Dan Boyd. I'm Chris Hill. Thanks for listening! We'll see you tomorrow!