There are many reasons to invest in a company, all boiling down to purchasing something at a discount to its intrinsic value. In "Value Investing: From Graham to Buffett and Beyond," author (Columbia Business School professor) Bruce Greenwald succinctly explains the possible components of intrinsic value, beginning with the value of the company’s assets, then layering in a no-growth earnings power valuation, and ultimately adding in franchise (and growth) value. As you move up through the layers, valuation becomes more nebulous and consequently more risky (i.e., it is easier to ascertain a discount to the company’s NCAV than it is to have confidence in potential future growth which may or may not materialize).
Let’s look at the case of Under Armour Inc (UA, Financial) the branded apparel company.
First we’ll start with assets. The company derives value almost purely from its brand, in that it outsources virtually all of its manufacturing and sells through a retail network of 23,000 locations worldwide (just 54 of which it owns). (One scary consequence is that the company relies on just two retailers, Dick’s Sporting Goods and The Sports Authority, for more than one quarter of its sales!). As a result of this strategy, one might expect a relatively greater emphasis on working capital rather than PP&E and other long-lived tangible assets. Not to disappoint, UA reports just $90.7 million in PP&E versus total assets of $766.2 million. The bulk of the company’s assets are cash, accounts receivable and inventories. This is a good thing, as these assets are easier to value than something like “Intangible Assets” or “Goodwill.” Speaking of intangibles, it is nice to see that UA has developed its brands in-house rather than through acquisitions, as the company reports a paltry $3.45 million of intangibles, or less than a half a percent of total assets (compare to Nike (NKE, Financial), which has 10x as high a proportion of total assets in the form of intangibles!).
Unfortunately, on an asset basis alone the company’s current valuation is difficult to justify. The company reports book value of equity at $538.5 million versus a market capitalization of $3.8 billion. As mentioned, the company appears to develop its brands in-house, so the full value of these brands is not accounted for in the current book value. However, if you assume for argument’s sake that ALL of the company’s SG&A for the last seven years went toward developing the brands, this would still only amount to an additional $1.567 billion, meaning that you would only be 55% of the way to the current market cap. Surely there has to be something more to justify the premium.
A company can trade at many times its book value if it is able to generate earnings from its assets far in excess of what others can. Imagine the only cold water dispenser in the middle of the desert. You would expect shareholders of that asset to be enjoying returns far in excess of what the same asset would earn in say, a suburban Florida mall, thus a premium to book value would be justified (Combine returns and book value by completing a Residual Income Valuation).
Let’s look at UA’s returns.
Under Armour Inc. - Returns, 2004 - 2Q 2011
These returns are ok, but I’ve shown many other companies on this site that have earned far better returns for far longer. In fact, on a residual income valuation, one would have to assume that future returns would far exceed historical returns (and do so consistently) in order to justify the current price.
Where a company trades at a high premium to book value and earns reasonable returns on its assets, there can be only one other justification – future growth expectations. Let’s first look at the company’s past growth.
Under Armour, Inc. - Revenues and Margins, 2004 - 2Q 2011
UA certainly has enjoyed significant revenue growth, without so much as a stumble despite the recession. Thanks to a relatively stable net margin, the company’s earnings have also grown substantially, increasing nearly six times from 2004!
Unfortunately, there may be more to this than meets the eye. While the company’s earnings have grown dramatically, its free cash flows have lagged behind by a spectacular amount.
Under Armour, Inc. - Free Cash Flows, 2004 - 2Q 2011
This chart stands in stark contrast to the uninterrupted growth shown in the previous chart. I have included both Cash Flows from Operations and Free Cash Flows to show that the scarcity of FCFs is not the result of major capital expenditures (remember, the company outsources production and owns very few retail locations, allowing for few capital demands). Given the company’s operating strategy, one would expect free cash flows to grow relatively in line with earnings. This has not been the case. In fact, while the company has reported $292.15 million in cumulative net income available to common shareholders since 2004, it has generated negative free cash flows equal to ($30.8 million).
How has this happened? One word: Accruals.
Where cash flows and earnings deviate, the difference is accruals, and academic studies have shown that large and increasing amounts of accruals tend to be correlated with poorer future performance. Let’s look at UA’s accruals over time, and in relation to net operating assets.
Under Armour Inc. - Accruals, 2004 - 2010
Yikes. These are high accruals, to say the least. This study [PDF] discusses how extreme accruals predictably reverse and impact future earnings, particularly with respect to inventory (emphasis added).
Under Armour Inc. - Cash Conversion Cycle, 2004 - 2Q 2011
Another Yikes! First, take note of the sheer magnitude of the company’s cash conversion cycle. Though the figure came down in the recent two years, so far in the first two quarters of 2011 it has exploded to nearly 160 days. The driving force? You guessed it – massive inventory growth. The company now has 180 days worth of inventories on hand. In other words, if the company had all of its manufacturing in one plant, and an earthquake leveled the plant, the company would have six months before it needed to start generating new inventory. This is a staggering amount.
But is this definitely a “bad” thing? Does it necessarily imply something nefarious? Are the academics correct, and the company will have to take massive write-downs in the future? No. The company could simply be gearing up for massive growth ahead.
Hence the title of this article; an investment in UA today is an investment in growth that you better believe in. It certainly isn’t justified on assets or free cash flows. It would be growth, and growth alone (the riskiest source of value). Good luck, and remember Protect Yourself First.
What do you think of Under Armour?
Author Disclosure: No position.
Talk to Frank about Under Armour.
Let’s look at the case of Under Armour Inc (UA, Financial) the branded apparel company.
First we’ll start with assets. The company derives value almost purely from its brand, in that it outsources virtually all of its manufacturing and sells through a retail network of 23,000 locations worldwide (just 54 of which it owns). (One scary consequence is that the company relies on just two retailers, Dick’s Sporting Goods and The Sports Authority, for more than one quarter of its sales!). As a result of this strategy, one might expect a relatively greater emphasis on working capital rather than PP&E and other long-lived tangible assets. Not to disappoint, UA reports just $90.7 million in PP&E versus total assets of $766.2 million. The bulk of the company’s assets are cash, accounts receivable and inventories. This is a good thing, as these assets are easier to value than something like “Intangible Assets” or “Goodwill.” Speaking of intangibles, it is nice to see that UA has developed its brands in-house rather than through acquisitions, as the company reports a paltry $3.45 million of intangibles, or less than a half a percent of total assets (compare to Nike (NKE, Financial), which has 10x as high a proportion of total assets in the form of intangibles!).
Unfortunately, on an asset basis alone the company’s current valuation is difficult to justify. The company reports book value of equity at $538.5 million versus a market capitalization of $3.8 billion. As mentioned, the company appears to develop its brands in-house, so the full value of these brands is not accounted for in the current book value. However, if you assume for argument’s sake that ALL of the company’s SG&A for the last seven years went toward developing the brands, this would still only amount to an additional $1.567 billion, meaning that you would only be 55% of the way to the current market cap. Surely there has to be something more to justify the premium.
A company can trade at many times its book value if it is able to generate earnings from its assets far in excess of what others can. Imagine the only cold water dispenser in the middle of the desert. You would expect shareholders of that asset to be enjoying returns far in excess of what the same asset would earn in say, a suburban Florida mall, thus a premium to book value would be justified (Combine returns and book value by completing a Residual Income Valuation).
Let’s look at UA’s returns.
Under Armour Inc. - Returns, 2004 - 2Q 2011These returns are ok, but I’ve shown many other companies on this site that have earned far better returns for far longer. In fact, on a residual income valuation, one would have to assume that future returns would far exceed historical returns (and do so consistently) in order to justify the current price.
Where a company trades at a high premium to book value and earns reasonable returns on its assets, there can be only one other justification – future growth expectations. Let’s first look at the company’s past growth.
Under Armour, Inc. - Revenues and Margins, 2004 - 2Q 2011UA certainly has enjoyed significant revenue growth, without so much as a stumble despite the recession. Thanks to a relatively stable net margin, the company’s earnings have also grown substantially, increasing nearly six times from 2004!
Unfortunately, there may be more to this than meets the eye. While the company’s earnings have grown dramatically, its free cash flows have lagged behind by a spectacular amount.
Under Armour, Inc. - Free Cash Flows, 2004 - 2Q 2011This chart stands in stark contrast to the uninterrupted growth shown in the previous chart. I have included both Cash Flows from Operations and Free Cash Flows to show that the scarcity of FCFs is not the result of major capital expenditures (remember, the company outsources production and owns very few retail locations, allowing for few capital demands). Given the company’s operating strategy, one would expect free cash flows to grow relatively in line with earnings. This has not been the case. In fact, while the company has reported $292.15 million in cumulative net income available to common shareholders since 2004, it has generated negative free cash flows equal to ($30.8 million).
How has this happened? One word: Accruals.
Where cash flows and earnings deviate, the difference is accruals, and academic studies have shown that large and increasing amounts of accruals tend to be correlated with poorer future performance. Let’s look at UA’s accruals over time, and in relation to net operating assets.
Under Armour Inc. - Accruals, 2004 - 2010Yikes. These are high accruals, to say the least. This study [PDF] discusses how extreme accruals predictably reverse and impact future earnings, particularly with respect to inventory (emphasis added).
Finally, we conduct a detailed examination of inventory accruals to corroborate and extend our analysis of aggregate working capital accruals. Thomas and Zhang (2002) find that inventory accruals have a particularly strong negative association with future stock returns. Consistent with our reversal story, we show that extremely positive inventory accruals are particularly prone to extreme reversals and that these reversals explain their strong negative association with future earnings changes and stock returns. We also conduct a detailed analysis of inventory write-downs, because inventory write-downs represent a common way in which measurement errors in inventory accruals are reversed. We show that inventory write-downs are concentrated in firms with extremely positive inventory accruals in recent prior periods.Let’s look at the company’s inventory, scaled to operations, in the form of Days of Inventory (which makes up a key component of the Cash Conversion Cycle, which I have discussed in these articles).
Under Armour Inc. - Cash Conversion Cycle, 2004 - 2Q 2011Another Yikes! First, take note of the sheer magnitude of the company’s cash conversion cycle. Though the figure came down in the recent two years, so far in the first two quarters of 2011 it has exploded to nearly 160 days. The driving force? You guessed it – massive inventory growth. The company now has 180 days worth of inventories on hand. In other words, if the company had all of its manufacturing in one plant, and an earthquake leveled the plant, the company would have six months before it needed to start generating new inventory. This is a staggering amount.
But is this definitely a “bad” thing? Does it necessarily imply something nefarious? Are the academics correct, and the company will have to take massive write-downs in the future? No. The company could simply be gearing up for massive growth ahead.
Hence the title of this article; an investment in UA today is an investment in growth that you better believe in. It certainly isn’t justified on assets or free cash flows. It would be growth, and growth alone (the riskiest source of value). Good luck, and remember Protect Yourself First.
What do you think of Under Armour?
Author Disclosure: No position.
Talk to Frank about Under Armour.
