In our Office Hours on February 25, the topic of discussion was Under Armour. We spent a good deal of time delving into the details behind UA’s numbers, but it’s worth taking a step back to look at the problem from a 30,000-foot level.
We focused on revenue growth and investment spending, both of which are critical in understanding the value of the firm. Revenues represent the rain on a field of crops; if you don’t have enough rain, your harvest will be poor. Investments are like fertilizer on a field of crops; if applied correctly, future growth will be quick and strong.
In the discussion below, keep in mind that there is a reason for this detailed look at the specific numbers. Without properly quantifying the inputs, we will have no way of accurately assessing the likely value of the firm. It may seem pedantic, but without a detailed framework for quantifying our inputs, our decisions will be based on simple anecdotes.
There are two main trains of thought about Under Armour’s International segment revenue growth. Joe and Kyle are bullish on the International segment’s growth prospects; I am more cautious.
In order to get an idea of how fast Under Armour’s foreign sales might grow, I decided to take a look at the increase of its domestic revenues early in its history. Before the office hour sessions, I downloaded aggregate revenues from YCharts back to 200x, then deducted International revenues (which I had collected from UA’s 10-Ks) and calculated the year-over-year change. A graph of the year-over-year change of Under Armour’s domestic-only sales looks like this.
I noticed the two humps in the graph – one in 2006 and the other in 2011. From the reading I had done about Under Armour, 2006 sounded familiar as the first full year of the company being publicly traded.
I thought that 2011 was the year that Under Armour started marketing shoes, but that product launch was, in fact, in 2008. According to the 2011 financial statement (“Management’s Discussion and Analysis of Financial Condition and Results of Operations” section), the bump in 2011 was due to three factors:
- A large increase in direct-to-customer sales through expanded outlet locations and a new ecommerce website.
- New product offerings in numerous categories (“Charged Cotton”, golf, tennis, basketball and running shoes).
- An increase in accessories sales booked by the company as the firm took these items “in-house” (i.e., did the production and distribution itself) rather than receiving a licensing fee.
Jumps in revenue growth during these years are sensible – a cash influx from taking the firm public likely allowed Under Armour to expand its retail footprint, with an attendant jump in sales. The introduction of new products is usually good for a bump in revenues as well.
Other than these two bumps, my eyes, and those of Walter’s, focused in on the straight stretches on either side – representing consistent revenue increases of from 20%-30%. Keying off this, I tried plugging in best- and worst-case scenarios for Under Armour’s International segment that would, in five years’ time, see the company generating sales increases just on either side of the 20% mark. Here is a screen shot of that section of the model:
Joe and Kyle were unconvinced. Joe points out that the decay curve shown in figure 1 above will repeat in many countries as the company expands – he pointed out his recent conversations with some of our new Asian clients, who report that Under Armour is considered the go-to brand for cross-training activities. To him, the most important milestone will be the time at which international sales overtake domestic ones at UAA, and he suggested looking back at the Nike example to get a feel for that in comparison.
Joe and Kyle are tasked with coming back with a good argument for higher growth numbers by the next time we meet.
Why this Matters
We spend most of our analysis time thinking about the demand environment and how a company’s positioning to that demand environment will affect sales in the future. As we discuss in the 102 course on valuation, there is good reason to believe that the best directional investors are also closely focused on revenues.
Before we calculate a fair value, we want to come to a good enough understanding of the demand environment that we can provide testable best- and worst-case revenue growth forecasts that will be proven correct over time.
Expansionary Cash Flow
Joe brought up the point that in order to increase revenues, Under Armour would need to increase its investment spending – what we call “Expansionary Cash Flow”. He suggested that we take a look at how much Nike is spending on its investments to get an idea of a likely “normalized” level of investment spending as a percentage of profits.
Great minds think alike, because that is exactly what I had been thinking of before the Office Hour session. I had started a new Nike model and opened up the most recent Nike Form 10-K (annual financial statement) to see what the company was spending on investments.
We first started looking at the Statement of Cash Flows – in the “Cash used by investing activities” section, shown below.
The first four lines – Purchases of short-term investments, Maturities of short-term investments, Sales of short-term investments, and Investments in reverse repurchase agreements – all represent simple treasury functions. The company has generated cash and puts that cash in short-term bonds to earn a little more yield on it.
The next two lines are important to our model, so we entered them in, as shown below:
You can see the value of ($1,143) input into the “Gross Spending on PP&E” line and the $10 value input into the “Plus: Cash in-flow from Asset Sales” line.
Note that using the IOI framework, we do not view all of the spending made on new property, plant and equipment (PP&E) to be “expansionary”. Some portion of that spending is Nike’s use of funds to maintain its operations in good operating condition. We had already made an estimate for the amount of money spent on the “Maintenance Capex” portion when we calculated Owners’ Cash Profits in an earlier step. You can see that calculation here:
The ($669) value insert into the “Less: Estimate of Maintenance Capital” line is based on an accounting line called “Total Depreciation and Amortization.” If you’re unclear of why this is true, please send me an email or ask during office hours.
What these two diagrams are saying is that of the $1,143 Nike spent on PP&E, an estimated $669 of it went just to maintain the business as a going concern, and the remaining $474 was an investment designed to generate future profit growth.
As we can see from figure 3, Nike did not spend anything on acquisitions or joint ventures (JVs), so we entered zeros in those rows (figure 4).
There are a few more rows in the investment section, and for those, we have to look at another section of the Statement of Cash Flows and another statement altogether. Let’s fill in the numbers from the “Cash used by financing activities” part of the Statement of Cash Flows first.
Most of this data, we will not need. However, there is a very small amount associated with the line item “Payments on capital lease obligations” and that is a form of investment that we need to enter into our spreadsheet. The absolute value of this line item is low ($7), so even if you miss this, it’s probably not a big deal. Some companies (like Amazon) spend a lot on capital leases, but Nike does not.
Also, there are two line items that relate to the issuance of stock and options to executives and managers at the company. These are “Proceeds from exercise of stock options and other stock issuances” and “Excess tax benefits from share-based payment arrangements), with values of $507 and $281, respectively. We fill out our spreadsheet with those numbers, as seen below.
You can see the ($7) associated with capital leases and the $788 associated with the line “Cash Received from Stock Issuance” are just the numbers $507 and $281 added together.
The Average Stock Price data we have in row 24 is a number we pulled from YCharts, and price data is easy to get on Yahoo!Finance and similar sites as well.
The final row, “No. of Shares Issued” is already filled in with a figure of 27. That came from what I call the “fifth statement” the Consolidated Statement of Shareholders’ Equity.
This statement is set up in a slightly different way than other financial statements in that time flows from top to bottom on this one rather than from right to left on others. For more information about this statement, take the complementary Mini-Course on the Language of Business or see the IOI Guide to Financial Statements.
On this statement, we want to look at the “Shares” column rather than the “Amount” column. Nike has two classes of shares, but we want the Class B, because that is the share class traded on the open market.
When we looked at this during Office Hours, I was conscious we were running short on time and ended up skipping one important number, so my calculations on the call were wrong, but this summary is correct and the numbers listed in figure 7 are correct.
We want to find out how many shares the company issued to its employees. This number includes the 22 shares issued because of option exercise, the 2 shares that were converted from Class A, and the 3 shares issued to employees – a total of 27 shares.
The (55) shares the company bought back (see figure 8) are good for owners. Any purchases of shares the company makes concentrates the ownership stakes of the remaining shareholders. However, the 27 shares the company issued is bad for owners since it dilutes their stake in the company. In essence, Nike took 55 steps forward and 27 steps backwards (almost exactly “two steps forward and one step back”).
Our valuation framework assumes that the company will have to buy back those issued shares at the average price recorded over the year ($59.46 in this case). The company issued 27 million shares that had an assumed value of $59.46, for an aggregate value of $1.6 billion! Offsetting this, the company generated $788 million of cash inflow from these transactions, so had a net “Anti-dilutive Stock Buyback” cost of $817 million.
If you are a Nike shareholder, take a look back at the OCP number in figure 5. You may be surprised to find that management paid out a third of your profits to themselves and their buddies. This is not atypical for a large firm.
All expansionary cash flow items considered, the firm spent $1,289 million on investments in fiscal year 2016, representing 53% of Owners’ Cash Profits that year.
Why this Matters
Any money that a company spends on investments cannot flow through to its owners as dividends or stock buybacks. As such, it’s important to understand how much of the owners’ profits the company is spending and on what projects it is spending the profits.
From this, we know that Nike, a mature company, is spending about half its profits on investments, and of that amount, most of it is going out in the form of stock compensation to managers. We may be able to extrapolate this level of spending to the case of Under Armour as well, though in the short-term, UA’s spending is likely to be higher because its business is less mature.
Is this level of spending and executive compensation good or bad? We cannot tell by just looking at these numbers; we must look at how the company’s profits have grown over time and how likely the profits are to grow quickly in the future. We did not talk about that in our Office Hours session on Saturday, but surely, this topic will come up in a future conversation.