- Chinese growth will be crucial to the market sentiment. Will recent volatility in this market affect top line growth?
- Inventories are too high which means the company can't roll over products fast enough. The end result here if the trend continues is the product being sold off cheap which again will hurt margins.
- Under Armour stock is likely to remain volatile going into the earnings.
Under Armour (NYSE:UA) is expected to announce its fourth quarter earnings on the 28th of January before the bell and analysts are expecting revenues of $1.12 billion and an EPS of $0.46. Under Armour stock is already down a whopping 16%+ year to date (see chart) and investors should be cautious about upcoming earnings in my opinion. Why? Well, the company has beaten EPS expectations for the past 27 quarters and many of those earnings "beats" catapulted the stock price to over $100 a share last September. However, Q3 earnings last October was the first time the market didn't respond well to a beat on earnings as Under Armour stock sold off after the announcement. Why? Well, the cost of sales metric on the balance sheet ballooned to $616 million which meant gross margin fell to 48.8% from 49.6% in the corresponding quarter in 2014.
Third quarter earnings definitely changed sentiment as the company up to that point was enjoying strong revenue growth along with stable operating margins. Nevertheless recent weakness has meant that the company's trailing 12 month operating margin metric is currently 10.2% which is a good 1.3% lower than operating margins in 2014.
If this trend continues, you are going to see the market becoming more bearish on Under Armour stock as a lot of future growth has already been priced in. Under Armour stock presently has a price to earnings ratio of just under 70 and the recent stock price collapse has dropped the forward price to earnings ratio to just over 50. Earnings need to convince the market that the company's long term growth path is intact. Here are some things to watch out for.
The obvious metric to watch when the company announces its earnings is revenue growth in international markets and specifically China. Whereas North American sales grew by 25% last quarter, it is the international markets which reported 52% revenue growth and are still basically untapped that are really giving this company a high valuation at present.
In fact, CEO Kevin Plank is stating that his company will reach $8 billion in sales in China by 2018 which indeed seems optimistic. The company is projecting 200 new stores in 2016 and up to 75% of them are expected to be earmarked for the Chinese market. Furthermore, Under Armour opened its first international brand house in Shanghai last September when NBA star Stephen Curry accompanied the CEO on a trip across 5 different cities in Asia promoting his new Under Armour shoe. Interest among fans was obviously huge and sales should have received a meaningful boost here.
The top line will undoubtedly increase in China but will the risk of currency devaluation seriously impair the company's operating margins in the region? The Chinese stock market is down over 20% since the start of the year and investors are worried about future demand as well as currency risks going forward so management's language here must be carefully worded to convince investors.
There are also some worrying trends on the balance sheet that need to be addressed if this company is going to fulfil its potential. First of all receivables (which are shown on the balance sheet as an asset) totalled $551 million at the end of the third quarter which was a 22% increase over Q3-2014. Inventory levels grew by 36% in the third quarter of last year to $867 million.
The problem Under Armour has with these metric is that its top line growth is not keeping up with these two metrics which explains why its cash conversion cycle is higher than its competitors in this sector. When the cash conversion cycle gets too high, more often than not the company in question sells off its inventory at lower prices in order to raise cash. Therefore, Under Armour has targeted higher excess footwear division for liquidation in its fourth quarter. Operating margins will suffer somewhat which is a risk when you consider what happened to earnings in the third quarter.
Looking at stock price, the chart looks ugly in the sense that 30% of the company's market cap has been wiped out since last September. The expected move is around $6 in either direction. Implied volatility rank (Implied volatility measured against itself over a 12 month period) is high at 97 meaning option sellers can take advantage of rich premium if they want to trade Under Armour over earnings. Personally, I wouldn't trade this due to low liquidity but if I did, I would be looking at a 2 dollar wide call spread 3 or 4 strikes above the share price. This way your risk is defined if indeed the Under Armour stock rallies hard to the upside through your strikes.
To sum up, Under Armour stock has had a horrible few months since September and its Q4 earnings needs to stop the rout. Investors will be looking to see the breakdown in sales of the product mix, growth rates in Asia and specifically China and hopefully a rebound in operating margins. It has to deliver on these items if its is going to keep its current valuation. Robust top line growth will not be enough anymore especially when you see increasing receivables and inventories.