May 30, 2012

Under Armour earnings come under fire

by Sridharan Raman

When specialty retailers reported their first quarter earnings recently, most of them (as reported in this article) posted results that exceeded analysts’ estimates. Among the ranks of those beating expectations was Under Armour Inc (UA.N ), which makes an array of sports clothing and accessories – but the company’s poor StarMine Earnings Quality (EQ) model score of 7 offer investors an early-warning signal that those earnings may not be sustainable over the coming quarters.

To generate its proprietary Earnings Quality (EQ) scores, StarMine uses computer-driven models to analyze the financial statements of more than 33,000 companies and to calculate a ranking for each. These scores have proven to be reliable predictors of the extent to which a company generates earnings that are sustainable over the coming quarters. Expressed on a scale of 1 to 100, with a lower score indicating lower-quality earnings, the StarMine EQ model enables investors to compare a company’s earnings quality against that of its peers, companies in the same region or across the entire universe of stocks. Companies with low StarMine EQ scores are likely to have difficulty in sustaining past earnings, while a high StarMine EQ score is a sign that a company is generating its profits from solid business fundamentals. With this look at Under Armour, we begin a new series of stories in which we will examine a selection of companies across North America that rank either especially high or low by our quantitative earnings quality measure.

Given the cyclical nature of retailing, it is important to compare a company’s quarterly results with the same quarter a year ago. When evaluating the financial health of a retailer, some of the key metrics to keep an eye on are the accounts receivable (A/R) days, the inventory days and the accounts payable (A/P) days. Together, these three metrics form the cash conversion cycle (calculated as A/R days + inventory days – A/P days) for the company, and measure the number of days that elapse between a company disbursing cash and collecting it. In Under Armour’s case, the three metrics tell a downbeat story: the A/R days and the Inventory days have increased from a year ago, while the A/P days have decreased. Thus, all three factors contribute to the cash conversion cycle increasing to 143 days from 122 days a year ago – a warning sign for any retailer.

Looking more deeply into A/R reveals that total receivables increased by 20% over 12 months that wrapped up at the end of the first quarter, hitting $196 million, up from $163 million in the year earlier period. The allowance for doubtful accounts (ADA), also referred to as the “bad debt allowance” – the portion of A/R that management estimates may not be collected – has been steadily decreasing, as a percentage of A/R. Why is that the case? In general, ADA levels tend to be stable but given that more than a third of the 70 retailers in our database with a market capitalization of more than $500 million have reported increasing the percentage of A/R that they view as ADA, it’s worth raising the question about whether the company’s view of ADA might be overly optimistic. Another reason to consider what might have happened had ADA simply remained unchanged as a percentage of A/R is the fact that this figure has a significant impact on the company’s net income and its earnings per share. Had ADA remained unchanged at 3.1% of A/R – the level that the company estimated in its quarter ended December 2011 — Under Armour would not have reported a positive earning surprise for the period. Indeed, net income would have been $1.4 million less than the company announced ($14.7 million). It may be that the company actually has been able to increase the number of creditworthy clients in just a few months, and winnow out those who it sees as unlikely to pay promptly or in full, but this is one metric that may repay further study. (Also of interest is the fact that the company used a lower effective tax rate in calculating its first-quarter results; had it used the fourth-quarter level of 39.5% or the 39.6% from the year-earlier quarter, its earnings would have fallen two cents per share below market expectations. Applying a tax rate of 36.6% enabled it to beat those expectations.)

Under Armour’s inventory days also have been rising, on a year-over-year basis, in each of the last five quarters. That is another warning signal for retailers, as it may be an indicator that the company isn’t managing inventories as efficiently as possible.

Source: Thomson ONE / StarMine

Source: Thomson ONE / StarMine

In the chart below, the red bars indicate quarters during which cash flow from operations (CFFO) lagged net income at Under Armour. Conversely, the green bars represent periods during which cash flow exceeded net income. In the quarter ended March 31, 2012, cash flow from operations at Under Armour lagged net income by $88 million; this figure has been negative for three of the last five quarters. Since earnings backed by cash are typically more sustainable than earnings from non-cash sources, this is another cause for concern for anyone trying to understand how sustainable the company’s profits may be.

Source: Thomson ONE / StarMine

While retailers as a whole appeared to be winners during the just-ended first quarter earnings season, posting results that generally were better than expected, not all companies within this group performed equally well. J.C. Penney’s stock plunged after the company announced it was suspending dividend payments to shareholders and reported quarterly results that were far worse than analysts and investors had been expecting. Although Under Armour beat estimates in the March 2012 quarter, the weak EQ score indicates that these earnings may not be sustainable in the coming months. Investors may want to take the time and effort to dig more deeply into the sources of the risks to the company’s earnings stream.

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