Short Treasuries: Natural disasters should cause rates to rise, not fall

 

Can Hurricane Harvey trigger a financial crisis? Probably not. But it may spark some unexpected inflation.  

I came back to Houston last Sunday after vacationing in Montevideo for 2 weeks. Houston seems unchanged in many parts, but certain highways were still under water and many traffic lights aren’t working. Traffic is terrible. Many are still living in temporary shelters in the stadiums and it will take a long time for life to come back to normal for them.  

Moody’s puts Harvey losses at about $80 billion, Warren Buffett threw out a rough estimate at $150 billion, and Governor About announced damages were expected to be $180 billion. These figures are about 0.4%, 0.8%, and 1% of GDP, respectively. For scale, the San Francisco Earthquake of 1906, which set off a chain of events leading to the Panic of 1907, resulted in damage estimated at 1.3-1.8% of GNP at that time. The losses from Hurricane Irma have yet to be tallied.  

Losses from a natural disaster don’t always lead to financial panic. Hurricane Andrew in 1992 led to losses around 1% of GDP, but no crisis followed – in fact, the economy began to recover from a recession immediately after the hurricane struck.  

But the hurricanes are still big enough to tighten money. Affected areas will need loans to rebuild, and this ought to drive interest rates higher.  

Inflation ought to go up as well. Affected areas will demand more materials to rebuild, and this demand ought to drive prices higher.

The majority of losses in Houston are estimated to be uninsured, so a lot of the rebuilding will have to be funded by the Federal Government. FEMA is running low on funds and the Trump Administration has authorized more funds on an emergency basis. All of these funds will come from issuing more treasuries.  

The Fed is likely to start shrinking its balance sheet this fall. This also will directly increase the supply of treasuries in the market.  

I think treasuries are setting up to be a good short. And yet, treasuries have rallied after the hurricane, on the logic that Harvey and Irma have reduced the odds for the Fed to hike rates or shrink its balance sheet.  

Consider the Fed’s response to Hurricane Katrina. Immediately after the hurricane, the market expected the Fed to “pause” its rate hiking cycle to make funds available for the rebuilding effort. However, the Fed continued with its 11th consecutive rate hike in September 2005 

This is appropriate. The standard Taylor rule response to a natural disaster is to increase rates. This is because with a Taylor framework, inflation is more important than output in determining the appropriate rate. And inflation ought to go up.  

If anything, the odds that the Fed will hike this year have gone up since the hurricane, not down. The treasury market is getting this wrong. I went short a treasury position at about 30% of my account equity. I’ll keep adding to this position until the yield breaches its 2016 low, at which point I would cut my losses. I’ll also add to the position if the yield exceeds the post-election high.

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Staying the Course with a Core Labs Short

One of my ongoing shorts has been Core Labs. I took on the position after reading David Einhorn’s thesis. One of the blogs I like to read is csinvesting, by “John Chew”, a treasure trove of value investing knowledge. John posted the Einhorn thesis for discussion back in May. I initially disagreed with Einhorn but after researching some of the points Einhorn brought up, I came around to his idea and went short the stock. I discussed the Core labs presentation in a comment on that blog, so I’ll repost my thoughts here:

I did my own work on this, and came to an analysis that it wasn’t an easy short because it could be trough earnings, and that reinvestment at its high ROIC would make the upside scenario too dangerous.

I did analyze the two business segments, but mistakenly thought that Production Enhancement was the area that would suffer going forward, because, like many analysts, I thought the Reservoir Description business would benefit from secular growth. I thought that this would provide a floor for earnings going forward, and that any upside from Production Enhancement revenues might make the earnings meet analyst guidance.

Einhorn did a fantastic job here of highlighting the precarious nature of their core business, Reservoir Description, because of its dependence on international offshore revenues. Furthermore, he made a great point that these complicated projects are planned out years ahead, so the revenues in Reservoir Description would not show any decline from the drop-off in Offshore until a few years after the drop in oil prices. This is particularly deceptive if you look at numbers from the 2008-2009 oil price drop, or even the drop-off in revenues 2014-2015, because it takes a while for all the pre-existing offshore projects to roll off.

It pains me a bit to say it, because I was a shareholder in Core Labs in the early 2010’s – I talked to David Demshur before and he was a great guy, and I really believed in the bull argument for this stock – but I do happen to agree with Einhorn after reading through his presentation. If the crown jewel of Reservoir Description is truly correlated to international and offshore, it might be more vulnerable than most analysts expect. Since the growth path forward will be dependent on Production Enhancement, which ought to have a lower ROIC than Reservoir Description, the upside risk may not be as high as I originally thought.

On a side note, I disagree a bit on his characterization of Demshur – while he may be promotional at times, I don’t think he intentionally was seeking to mislead investors.

As PW noted, one of the important things I learned is that ROIC is only as good as your reinvestment opportunities. After all the Buffett quote is that the best business is one that employs LARGE AMOUNTS of incremental capital at very high rates of return, not one that uses all of its incremental capital (and then some) to pay a dividend.

I shorted at $102. Since then, Core Labs has declined significantly in price, but I’m still holding the short position.

I believe Core Labs is priced as if earnings were about to accelerate back to 2012-2014 levels. Earnings are running in the $60-70 million range, with FCF in the $100 million range. The stock currently has a P/E multiple of 55 (minimal net debt, so P/E is probably fine to use). Even if you believe Core Labs is an incredible business with a high ROIC, if the company cannot reinvest and cannot grow, an appropriate multiple is probably around 30.

I think Core Labs will have trouble growing earnings because the major shale basins are running into production problems. They are reaching natural limits on lateral length and suffering from a phenomenon called “frac hits” which is dropping production and impacting the economics of infill drilling in shale wells. Core Labs is pivoting to Enhanced Oil Recovery techniques, but these techniques have really only been tested in the Eagle Ford reservoir, so it will take some time to prove this technology in the Permian. In the meantime, E&P’s still aren’t investing in major offshore projects, so the Reservoir Description segment ought to continue to suffer or remain stagnant.

Rig count growth is moderating and may actually decline in the latter half of this year, especially if E&P’s continue to suffer from frac hits in infill wells. This ought to keep Production Enhancement revenues steady at best, or declining at worst. Unless there is rapid adoption of EOR in the Permian and other basins, I don’t think Core Labs can increase earnings.

If earnings don’t increase quickly, then the stock will have to reprice. At 30X earnings, the stock should trade in the low $50’s. I will continue to hold until I see signs of rapid adoption of Enhanced Oil Recovery techniques, a pickup in deepwater drilling, or the stock hits my target.

Retail Woes

Impinj -a Boom-Bust Process in the Making

I have been wrong on many fronts with regards to the retail sector. I got it wrong with my short of Impinj, which appreciated over 50% since my article. I tend to invest first and investigate later, so as I was doing due diligence, I realized my argument was for a short on Impinj was weak for the precise reason that commenters had mentioned on my article: strained apparel retailers were willing to invest in a technology that could optimize their inventory. The commenters were right and I was wrong.

I do think in the longer run, Impinj might have to come to earth in regards to its valuation, and its continuing rise in inventory is worrisome. The company currently trades for 8X revenue and makes continuous losses. Inventory turnover has gone from 3.59 in 2015 to 1.96, draining cash. However, as I should have seen from my prior experience with boom-bust cycles, the company is able to fund its cash losses by issuing stock at inflated prices. This sets it up to be a reflexive boom-bust process that is capable of running for a long time.

Value bets on Retailers were Misguided

At the same time, my bet on retailers that were optimizing their inventory has also failed. I invested in Express (EXPR) and Buckle (BKE). The entire sector sold off massively on a bad report from Macy’s (M). This is not what I would expect to see at a bottom. In a bottoming sector, I would expect minor sell-offs on negative news and rallies on any news that’s mildly positive. I sold EXPR on the break below $8, and in hindsight, the move was fortuitous. BKE is showing more share price strength so I’m holding for now.

Bottom Fishing is a Dangerous Hobby

On a separate note, I have been reviewing my results, and I noticed a distressing tendency. I tend to invest in companies that I believe are bottoming well before they bottom. I tried many times to catch the bottom in 3D Systems (DDD), a stock which I got right on the long and short side, but I caught a falling knife multiple times, and missed the eventual bottom at around $6 a share (it now trades above $20).

Again I got caught in the oil patch, investing far too early in an oil turnaround, however when it eventually came, I was able to hold out long enough to make a profit.

So the lesson I take away from all this is that I ought to wait a lot longer than I feel like waiting for a turnaround in a sector. As Larry Livingston from Reminiscences of a Stock Operator might say, “If a man never made mistakes, he would own the world in a month. If he never learned from his mistakes, he wouldn’t own a blessed thing”.

The Path Forward for Retail

Retail should prove no different. If I feel that I should invest now, when multiples seem absurdly compressed, there are probably at least 2-3 more big moves downward that ought to come before the bottom.

This is a sector that is littered with the corpses of companies that failed to adapt. I was looking at the quarterly letters from Kerrisdale Capital in 2011 (the year they made 200% while the market was flat), and the following struck me:

It is clear that we need to be more careful investing in struggling retailers with same-store declines and deteriorating margins. Sometimes they turn around, but usually they don’t. The hidden leverage of operating leases continually catches us unaware.

Kerrisdale lost on two separate retailers that unexpectedly went BK. I would note that the most recent Kerrisdale letters, during the current retail crisis, have neglected to mention any retail investments.

Changes to FASB Will Mean Re-ratings of Several Retailers

The “hidden leverage” of operating leases is not going to stay hidden any longer. Changes to lease accounting are coming. This will mean all the leverage implicit in an operating lease is about to be made explicit. The explicit statement of the operating lease liability on the balance sheet is bound to end up with winners and losers. Retailers that have the worst terms (i.e. long term leases that were signed > 2 years ago when leasing rates were much stronger) will suffer when these liabilities are made explicit. Many of the retailers will go from showing net cash to showing net debt. Companies have until January 2018 to comply. I would imagine those with the worst positions will delay filing until the last minute.

Short Retail REITs – Federal Realty Trust (FRT)

Federal Realty Trust is a REIT focused on retail properties – generally strip malls in relatively affluent areas. It trades at 21X FFO, while commercial REIT peers trade at 16X FFO. While it has a low payout ratio (dividends are only 61% of FFO) and a low MCX ($16-17 million), it does have a need to refinance in the next twelve months because of rising interest costs and principal repayments. There are $210 million in principal due in the next 12 months, $280 million of dividends to be paid, $17-18 million in MCX, and only $434 million in FFO.

The CEO is very confident the company can refinance at a property level, and I think this is true, but I think the company ought to get worse interest rates going forward, given multiple hikes at the Fed, and the levered nature of the company. Moreover, I think lease rates will go down as all the retailers race to shut down stores. Finally, I think the growth engine of a REIT that has been powered entirely by retail sector strength will stall out, which ought to cause the company to trade in line with peers. Multiple re-rating would imply 20-25% downside from here, and any further weakness in leasing rates going forward ought to mean a further 10% or so decline. My target is $90-95 per share. I have momentum in my favor, and I will seek to limit losses if the stock spikes.

I am actively looking through all the REITs with real estate exposure that I can get my hands on. I think these are some of the best shorts in the current environment where bond proxies ought to suffer and a secular decline in retail ought to hurt renewal rates on the underlying leases.

 

A change of heart on apparel retailers

Lately, I have been putting 80+ hours per week at the hospital, so it has been difficult to get time to write. However, I have managed to stay abreast of my positions and current events more or less.

I closed the Impinj position last week. One piece of evidence for closing the short was simply the fact that the stock rose above $30. I wrote in my article that the technicals looked “awful”, and wrote the following, ” …the stock fell through $30, tried to break back above and failed to push through.” Well, it did end up pushing through. And then some. This rendered one support for my thesis invalid.

I generally use some kind of loss-limiting mechanism on my shorts. Usually it’s a system of halving my short if it goes the wrong way and I don’t know why. I also think of the process as thesis invalidation, which is a broad term that encompasses both price stops and discovering new arguments that might weaken the thesis.

As part of my due diligence on Impinj, I started reading conference calls of apparel retailers (Impinj’s largest customer base), and I was surprised to find myself liking what a lot of these management teams were saying. Many of them mentioned improving inventory management as an initiative. Furthermore, several mentioned initiatives to ship from store and buy online and pick up in store. Such moves ought to increase the turnover of inventory by turning mall stores into miniature distribution centers.

Such inventory focused initiatives ought to be tailwinds for Impinj, both by improving the health of the retail sector and by increased sales to more inventory focused businesses. There may be a lagging effect of 2016’s retail weakness that shows up in Impinj’s next quarter or two, but I bet it will probably guide a little higher and bounce after the next quarter.

I managed to close my short with minimal losses by concentrating on the key price level at $30. I closed around $31, and the stock took off afterward. I still wouldn’t go long the stock as I find it far too expensive and I can buy growth more cheaply elsewhere. And I may go short again if the valuation starts to get really ridiculous.

I am instead turning around and calling a bottom in the mall retailers. These stocks trade at absurdly low valuations. I can pick up some of the fast fashion brands, like Express, for nearly 5X free cash flow (EV/FCF).

Express has had a tough time competing with Zara and H+M, however has worked over the past year to speed up their time to design and now stands on better ground to compete. They are working on ship from store and buy online, pick up in store initiatives. They have 25% of sales online and are working actively to increase this. They have tons of cash and are buying back stock aggressively. They think there is still room to cut down on costs to minimize losses from same store sales declines. 50% of stores are up for lease within the next 2-3 years, giving management an opportunity to close loss-making stores and boost earnings.

Express has a track record of pretty conservative guidance. The best scenario management presents is a flat to low single-digit same-store sales environment. I can envision scenarios (like a broad based recovery in consumer spending) where Express has positive same store sales. Even if they hit guidance, the stock will still be cheap.

There are macro drivers for the mall-based retailers too. Nearly all of these companies pay the absolute highest corporate rate and would be direct beneficiaries of tax reform. While there may or may not be an eventual tariff placed on importers, one thing I know for sure is that the dollar is higher since the election, especially against the yuan, and the president is no longer committed to calling China a currency manipulator. Currency moves are mitigating any eventual tariffs that the new administration might place on imports from Asia.

I put on a very large position in Express, and it is now the largest single equity position I hold. I obviously have a lot of additional research to do in the name, but Thursday’s 7% move in high volume (for a really insignificant piece of news) indicates to me that a big move might be about to start in retail, and that I’m not the only one looking at this.

I also think there are perhaps better retailers out there that I don’t know yet. The entire sector might be due for a turnaround. It is the one sector out of all U.S. stocks that seems to be universally trashed, and the thesis behind the short is obvious and well-known: malls are dying and Amazon is taking over the world. But a new thesis is emerging – A malls will survive, C malls will die. As the market shifts from the idea that all malls will die to some malls may survive I think there will be a revaluation of PE multiples across the sector.

I’ll probably spend a lot of my precious free time digging in the retail sector for the next few weeks to see if I can invalidate this thesis.

For profit education rally is just beginning

I have a current working theory that the rally in for profit education stocks is just beginning.

The Obama administration was critical of the for profit education industry. The Department of Education proposed various regulations on the industry, like the 90/10 rule, which states that a proprietary education company cannot receive more than 90% of its revenue from Title IV loan programs, and the gainful employment regulation, which mandates loan repayment be less than 20% of discretionary income after graduation or 8% of total earnings.

Trump appears intent on rolling back many regulations placed under the previous administration. Newly appointed head of the Department of Education Betsy DeVos appears very unlikely to pursue further regulation of for-profit colleges, and I think there’s a good chance that the gainful employment regulation and the 90/10 rule are both rolled back.

In the meantime, the industry has been working hard to fix its problems. The industry has invested to lower dropout rates and increase employment post-graduation. Moreover, in a strong economy, more of these students can count on finding jobs when they graduate. Tuition has actually come down across the industry while tuitions at non-profits continue to rise. The schools seem to offer a better value proposition now.

And there may be more demand than ever for the types of technical degrees and certification programs that for-profit colleges excel in offering. I have read a number of reports that there is a “skills gap” that is partially to blame for the slow hiring in manufacturing, for example, this report from the manufacturing institute. Manufacturing companies are automating their processes, and new workers will have to certified in the technical skills necessary to operate in these highly automated factories. This is a secular trend in favor of companies that offer technical certifications.

Despite an impressive rally since the election, the companies still appear to trade at reasonable multiples, especially if you expect growth to pick up under the new administration.

I bought in a little cheaper than current prices in early March. Here are the multiples as they stand today:

Company P/Sales EV/Sales P/E EV/EBITDA EV/EBIT EV/FCF 5-yr Revenue Growth
DV 1.16 1.08 26.34 12.38 27.01 14.14 -3.1%
STRA 1.98 1.69 25.08 9.81 12.94 23.72 -5.7%
LOPE 3.75 3.74 22.05 11.53 13.76 N/A 14.3%

 

DeVry Education (DV)

DeVry Education looks interesting. It may be a good turnaround situation. It appears to have a similar P/E to the rest of the group, but it has one-time charges of a large asset write-down in the year ended June 2016, and a fine imposed on it by the Obama-era FTC in the current fiscal year. Adjusted for the fine and the asset write down, the company earned $176 million in operating income in the TTM period, as compared to the unadjusted figure of $74 million. The EV/EBIT goes from 26.05 to 10.94.

DeVry also has large restructuring charges. I am not sure whether the entire amount of restructuring charges can be added back as a one-time expense, but the restructuring charges do appear to be declining year over year, so I think its reasonable to expect that these expenses might continue to shrink.

Meanwhile, DeVry has been cutting down on administrative and overhead costs as well. SG&A is down from 37.8% of revenue to 34.4% in the TTM period.

That means, even with a slightly negative top line, DeVry can experience significant bottom line growth as restructuring charges shrink. Adjusted for a 50% reduction in restructuring expenses, the operating income at DeVry would be $200 million, putting the EV/EBIT at 9.64.

The risk with DeVry is that the reputation of the company has been tarnished after the FTC’s investigation. In the meantime, numerous competitors have sprung up without the baggage of a federal investigation, fines, and litigation. Management hasn’t had the attention or resources to defend against this competition, and has been cutting costs to get by, so it may be falling behind in its offerings.

I read gradreports.com, and I was surprised to see the amount of positive feedback on DeVry. It seems that students aren’t particularly deterred by federal investigations or general stigma against the industry. It was among the highest rated undegraduate experiences.

DeVry has a focus on healthcare education that puts it in enviable position. Healthcare has been one of the strongest areas of the economy in recent years

Strayer (STRA)

Strayer has finally managed to turn around a multi-year streak of negative revenue growth, eking out a 3% gain last year. However the operating margin has deteriorated, dropping from 18.3% in 2014 to 13.0% in 2016. I don’t think the drop in margins has been all bad news – 3% of the drop can be explained by increased marketing expenses. This was probably a big factor in turning around those revenues, and the investments in marketing may pay dividends for years down the road.

The rest is mostly made up of “Instruction and educational support costs”, but again, these costs may pay off longer term. Strayer appeared to have the worst reviews overall of the for-profit group, with many complaints that they are overly promotional and place pressure to sign up for classes, but abandon students once they have signed up. The increase in instruction and educational support costs as a percent of revenues seems to indicate that management is trying to address the problem.

The risk here is that the investments in educational resources and marketing don’t pay off. However, mitigating this risk is the low capital requirement of the company. It has a much lower invested capital, and thus, a higher ROIC, than the other for-profit colleges. Capital expenditures are also rising at Strayer, up from $6.9 million in 2014 to $13.1 million in 2016. If this capital has a return similar to the past, one might expect rising earnings in coming years.

Grand Canyon Education (LOPE)

Grand Canyon Education is probably the for-profit college that most resembles a traditional non-profit college. It ran as a private, non-profit, Christian university for 55 years, but transitioned to a for-profit college in 2004 to get additional investor funding. In the same year, it began to offer online courses. In 2008, it went public to get more funds.

The company is an exception to the rule in the for-profit industry. It has continued to grow enrollment and revenues and it reinvests a huge amount of capital back into the university. It has Division I NCAA sports teams for its campus. And, rather than refocusing on associates degrees and certification programs, it has doubled down on its full undergraduate offerings and graduate degrees.

In 2014, it was actually mulling over the decision to go back to a non-profit status, to avoid the stigma and regulations associated with the for-profit label. The stock price languished for 2 years despite consistently growing revenue and earnings. However, the election finally unleashed the stock and it rocketed up 50% over a short period of time.

It formed a base around $60 and has recently broken out again. I don’t think there is any telling how far this goes.

The company has no free cash flow, as it is continually reinvesting in its campus and its offerings. This currently doesn’t appear to be a problem as it is getting a pretty good return on its investments and growth shows no signs of slowing. If you own a stock that reinvests at a high rate, your investment can compound for several years until the company hits saturation or runs into competition issues.

I had figured that Grand Canyon would get good reviews because of its large investments, and overall, it seems to rank about the same as most average non-profit colleges.

I put the largest stakes of my investment in DeVry and Grand Canyon, and a small stake in Strayer. The group is up broadly since I invested about a week and a half ago. I plan to hold until I see reversal of the trend. I expect that we ought to hear some news announcements about DeVos rolling back regulations that will be positive near-term catalysts for this group.

Under Armour – Closing the Short, Taking a Victory Lap

Sometimes you nail it. I think it’s important to be objective and analytical regarding wins as well as losses – you have to see what you did right and attempt to replicate this in the future.

I started getting bearish in May of 2016 and looking for shorts. Unfortunately, we have been in a downright bull market ever since, and the economy is roaring. Luckily, I decided to focus on individual stocks to short, which worked out much better than if I had just gone short the whole S&P.

My original rationale

In June I got short Under Armour. At the time I wrote:

Under Armour is running into issues with its distribution channels, and I think its trying to cover it up. They announced a new inventory management system – I think the channels are stuffed and they can’t move the inventory. Inventories and Accounts Receivable are both rising faster than revenues – a huge red flag. Sports Authority went BK, a sign of the troubles at its distributors. It’s biggest customer is Dick’s Sporting Goods, which hasn’t run into trouble yet, but Dick’s is also launching its own athletic wear line to compete with UA. Oh yeah, and the Steph Curry’s are probably the worst reviewed shoe of all time, plus the Warriors lost.

My main motivation centered on inventory management. I felt like something fishy was going on when the company announced a new inventory management system at the same time GAAP financial statements were throwing out tons of red flags. Moreover, I could easily see an alternative rational for rising inventories – awful sales at the major retailers. 2016 saw some of the worst same store figures in years for all the major department stores. These department stores were huge holders of Under Armour inventory. I reasoned the trouble down the channel ought to affect Under Armour eventually.

I also cited the high valuation – 70X trailing earnings at the time – as a huge motivation for the short. I knew that a PE of 70 was generally expensive compared to a PE for Lululemon of 37, and a PE for Nike in the mid-20’s. I felt that Under Armour’s growth was going to decelerate to the rate of growth for the general athleisure industry. This is a problem of a) growing too large, b) increasing competition, and c) fewer channels of distribution to expand to. If Under Armour’s growth was slowing to the rate of the industry, then it deserved the same PE as the rest of the industry. I knew the high valuation gave the short room to run on the downside if things started to work out.

It’s tough shorting a market darling in a bull market

It wasn’t easy to hold the short. Here’s what I wrote in September:

UA is starting to stress me out. The latest quarterly earnings really bore out core points of my short thesis – the accounts receivable continue to rise, and inventories continue to climb, with management making a mountain of excuses. But I was troubled by one comment they made on the call. Management compared the number of distribution outlets UA has to the number that Nike has, with the argument they still had substantial room to expand distribution.
A big chunk of my thesis was that UA had benefitted for years from growth in distribution channels. But I figured that it was running out of new channels to grow into, and would start to suffer lower growth. I also postulated that the recent Sports Authority’s bankruptcy and weak same-store sales from the department stores were contributing to the bigger charge-offs and inventory build-up, and I thought that management was trying to obfuscate this by announcing they were changing their inventory management system.
The problem with this thesis is that if UA can still expand distribution – like they just announced with Kohl’s – there may be a while left before the negative fundamentals start to catch up.

I also was stressing out because my rationale on valuation wasn’t working out. Instead of the valuation of Under Armour going lower, Lululemon and Nike went up. I was also stressed because I saw David Einhorn covered his short in UA and thought most of the downside was already in. In retrospect, one of the cardinal traits of good investors is the ability to be able to bet against investors you respect when your thesis remains intact. This will be a lesson going forward to focus on doing my own work, and not rely too heavily on off-hand comments in a hedge fund’s latest quarterly letter.

But there were signs things might work out after all

There were a few things that strengthened my short thesis in the fall of 2016. Competitive pressures started to intensify. With Lululemon doing so well, it was bound to take athleisure market share. I saw more and more athleisure coming out from generic lines and smaller market share brands, like Gap’s Athletica.

The other piece that added to the short for me was the investment in connected fitness. I think in the long run, these investments may be a great way of differentiating Under Armour, and may establish the brand as a stand out from its competitors. But it may take years for these investments to pay off, and in the short run, it sucks out capital and pushes profit margins lower.

Pushback often helps clarify your thesis

My articles on betterstockideas.com get cross-published to Seeking Alpha. On SA I got some pushback on the international growth at UA. But here was my argument on why the fast international growth at UA didn’t matter… yet:

“Thanks for the insight. I may be getting myopic based on my focus on my home market, and I may be rationalizing here, but here’s my argument on that point.
International makes up 15% of UA’s revenue as of the Q2 2016. When UA was growing in a nascent market in North America, it grew revenues at about 30% a year, and I’d assume it will expand in International markets at approximately the same rate.
N.A., in the meantime, will probably grow at a maximum of 10% (and more likely in the mid single digits) because of the constraints of 1) lack of new distributors to expand to, and 2) an increase in the number of competing products.
That means overall growth will be stuck at approximately 13% for the next two years, as opposed to the 25% that management has been projecting. If the market is believing management, then the growth will be half of what’s expected currently, and the P/E ought to contract correspondingly. Moreover, the hits to gross profit from possible accounts receivable write-downs and inventory liquidations mean that the damage on the bottom line ought to be magnified.
I’m not saying UA won’t succeed in its goal of grabbing market share globally, and in the long run it may be a great investment. I just think that any meaningful impact to operating profits from the international and connected fitness business lines are at least 3 years out. In the meantime, I think it will take a hit to earnings, and it’s already at a high P/E. Some of the macroeconomic variables look negative and I think it’s a good time to hold some shorts. UA seems to fit the bill.”

And,

[30% international growth] may be an underestimate. You could also argue that management has learned lessons from the U.S. rollout that allow it to expand faster internationally.
I hadn’t yet looked at trailing International growth, which was 69% for 2015. I don’t think 100% is reasonable, but it could be something like 60% for 2016-17 and 50% for 2018.
That gives overall revenue growth of about 18-19% for the next two years. If UA gets back to its historic high of 11% operating margin, at current interest and tax rates, we get $1.10 in EPS.
Is UA really worth 35X 2018 earnings? I don’t think so. I don’t actually think margins can get back to 11% and there is a substantial risk of operational missteps that give a lot of downside potential and limited upside.

The above was my rationale on valuation. I built out my own messy excel model, and came to maximum reasonable EPS of 87 cents, based on more reasonable international growth figures (50% slowing to 40%), North America growth around 10%, and operating margins coming down figures closer to the more recent 8-9%. At 30X earnings, I figured a price target of $26 was a good target for the short.

A first victory

Under Armour dropped big in early November 2016. The inventory issue I had focused on started to become difficult to ignore, as inventory started piling up faster and faster. Connected fitness continued to pressure operating margins. Management dropped the forecast for operating margins. I put together some of my thoughts at the time:

“My downside target based on a 30 PE of 2018 earnings gave me a stock price of $25-26. The upside was $50-51 based on a 40 PE of 2018 earnings if margins ever come back to historic highs. Is the short still worth it?

One thing I’m working on is holding my winners. I’ve noticed a consistent pattern of getting out of my positions months before the trend ends. I think there is a realistic possibility that Under Armour overshoots to the downside. After all, the company still has write-offs of inventory and accounts receivable that will pressure margins for the foreseeable future.

I recently went to an Academy near my apartment, and half of the (nearly empty) floor was covered in Under Armour merchandise. The channels are full. The company says it can expand the number of channels, but I have doubts regarding the potential sales of these channels. Kohl’s (NYSE:KSS) isn’t going to sell as much Under Armour as Macy’s (NYSE:M).

UA is constrained until international and DTC grow big enough to overcome the relatively weaker North America sales.”

I closed part of my short immediately after the fall, and I regretted it. However, I might do the same thing again in a similar situation. Right after a big fall it may be prudent to take some off the table. The problem is, the more times you “take some off the table”, you are left with nothing on the table when the big win comes. Luckily, I had already noticed my tendency to close my positions too early. I was re-reading one of the Market Wizards books at the time and I noticed one of the consistent themes was getting comfortable holding winners and cutting losers. The ability to hold winners as long as your thesis stands is another trait of great investors, and will be another take-away from this experience.

Sleuthing pays off

I did a bit of sleuthing in October, visiting sporting goods stores. I was inspired by a book called the Sleuth Investor, recommended by a friend, Nick Bodnar. I was really surprised by a visit to Academy, where half the floor was Under Armour. There were entire walls of $30 Under Armour baseball caps. Who the heck buys this stuff? Moreover, who buys this stuff from Academy? The visit made a huge impression on me.

Watching Under Armour investments – the new headquarters

I also found a new reason to short Under Armour in the fall of 2016. I started developing a new theory on shorting. A stock’s earnings multiple ought to be related to the amount of capital it can easily reinvest into its business and the kind of return it can get on that reinvested capital. A choice Warren Buffett quote:”The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.

If a company is worth more if it is employing a lot of capital at high rates of return, the reverse should also be true: a company is worth less if it employs a lot of capital at a low rate of return. Moreover, if a company changes from a high rate of return on capital to a lower one, the multiple ought to change as well.

Under Armour has been reinvesting a lot of its capital. In the early years, it was reinvesting capital directly into making more t-shirts, shoes, socks, and other high margin products. These investments had a very high return on capital. In 2016, the reinvestment rate started to go up dramatically. What were these investments for? They were massive investments into Under Armour’s new headquarters in Baltimore.

Now, my brother lives in Baltimore, and Kevin Plank is a demi-god in that town. I’ve heard a lot of hoopla about the things Kevin Plank is doing in Port Covington. I have a ton of respect for the man. His plans for the development and rebuilding of old parts of Baltimore are wonderful, and the fact that he’s using tons of his own money in the project makes me pretty hopeful that Baltimore may be revitalized from the huge investment.

But I heard a story that made me wince. From the Washington Post:

Under Amour was taking in well over $1 billion in annual revenue when Plank went to the board of directors in 2012 and said that, in addition to building a new headquarters to accommodate the company’s growth, he wanted to buy and develop a much larger section of Baltimore.

The answer was: Under Armour isn’t a real estate developer, stick to shirts and shoes.

The fact that Plank would go to the board to develop real estate, for what is essentially a charitable endeavor, makes me question a lot of things. I think he may be conflating his personal desires with the business at this point. I think he has been taking his eye off the ball if he is not sticking to “shirts and shoes”. It is clear that he has been spending a ton of time on the Port Covington developments, lobbying politicians and selling it to investors. How much time has he devoted to the future direction of Under Armour in America? Has he noticed the accounting changes over the past several quarters?

Moreover, what is he really hoping to gain from the new HQ? Is it really being built to maximize profits for Under Armour? Or to maximize employment in Baltimore?

In any case, an investment in a new building for the company’s headquarters is likely going to have a lower rate of return than investing in a new factory to make clothes, Under Armour’s primary business.

The latest developments

The departure of the CFO Chip Mallow confirms my suspicions that there was something funky going on with the inventory management system that the company was touting in mid-2016.

Inventory write downs tanked gross margins this quarter, dropping to 44.8% from 48% a year earlier. Kevin Plank had this official statement: “We are incredibly proud that in 2016, we once again posted record revenue and earnings, however, numerous challenges and disruptions in North American retail tempered our fourth quarter results”.

The disruptions in North American retail did not start in the 4th quarter. On the contrary, the 4th quarter has been much stronger down the channel. What Under Armour is experiencing now is the delayed effect of the pseudo-recession that occurred in Q1 2016.

Revenue growth slowed down – approximately 12% growth, close to my calculations of about 13%. I think this is a rate that is more sustainable long term. With a good margin and reinvestment at a decent rate, the company could support a 30-40 multiple in this market.

The long run view for Under Armour

I think the bulls and bears for Under Armour both make a lot of good points. While I have obviously been a bear, I think a lot of it comes down to time frame. In the future, International is only going to be a growing slice of the pie. The great thing about a fast growing division is that the division starts to affect the overall revenue growth exponentially as it becomes a bigger and bigger share of revenues. International revenue came in at a strong 55% year on year growth, but they are still only 16% of revenues. In a couple of years, we will hit an inflection point where international is more important to overall growth than North America, and at that point, the overall revenue growth rate should pick up.

If management is willing to take the hit on inventory in one quick and painful write-off, and discounts at the retailers can clear the channel, the company will have a lot of productive growth ahead of it.

The HQ, while perhaps of dubious return to shareholders, will eventually be finished, freeing up the free cash flow to go to more productive uses. Given the timeline of large construction projects, this should probably happen about the same time that overall growth hits an inflection point.

The investments in connected fitness will likely help differentiate Under Armour from the pack of knock-offs and competitors. Smart clothing is an upcoming trend, but we are still at least a few years away from widespread use. The investment in MyFitnessPal has probably helped establish the brand, and increased the mindshare of Under Armour. They now have a platform to easily integrate smart clothing if and when this becomes a viable business line.

In a time when few companies are actually reinvesting, and most are simply focused on buying back shares and cutting costs, a company that is willing to invest in its brand and future products stands out. But valuation has to come to terms with the fact that North American growth is slowing.

The price has surpassed my original target of $25-26 a share, closing at $21.44 per A share today. Like I said in November, I think stocks often overshoot to the downside. There is no telling how far the stock can go to the downside, because even a 30 multiple, close to the overall market multiple, puts the stock price at $13-14 a share.

I am closing because I don’t think the stock is grossly overvalued at this point. I am still not willing to turn around and go long, because I demand a lot of margin of safety on my longs, and I’d need to see a lower valuation to get comfortable with owning Under Armour. But I think long investors can be reasonably hopeful in the longer term. I am certainly no longer a stolid bear on the company. More like an inconstant bull.

Under Armour (UA)

I thought I’d put together a quick overview on my thoughts at this point. The short has worked out pretty nicely.  I covered a small part of the position immediately after the earnings call, but now I’m regretting it. I didn’t believe the weakness in the price would be this pronounced.

The inventory buildup was extraordinarily bad this quarter. Accounts receivable continue to build – write off is looking more and more likely. Connected fitness continues to suck money out of profitable businesses for an uncertain payoff. And perhaps worst of all, the capex is going through the roof as UA builds out its massive new HQ. I respect Kevin Plank for what he’s doing for Baltimore in Port Covington, but I have to wonder if he isn’t taking his eye off the ball a bit.

My downside target based on a 30 PE of 2018 earnings gave me a stock price of $25-26. The upside was $50-51 based on a 40 PE of 2018 earnings if margins ever come back to historic highs. Is the short still worth it?

One thing I’m working on is holding my winners. I’ve noticed a consistent pattern of getting out of my positions months before the trend ends. I think there is a realistic possibility that Under Armour overshoots to the downside. After all, the company still has write-offs of inventory and accounts receivable that will pressure margins for the foreseeable future.

I recently went to an Academy near my apartment, and half of the (nearly empty) floor was covered in Under Armour merchandise. The channels are full. The company says it can expand the number of channels, but I have doubts regarding the potential sales of these channels. Kohl’s isn’t going to sell as much Under Armour as Macy’s.

UA is constrained until international and DTC grow big enough to overcome the relatively weaker North America sales.

As for the buyout rumors, I am pretty confident these are floated by traders with long positions looking to offload. 1) I really really don’t think Kevin Plank would ever want to sell. He has a specific vision and almost certainly wouldn’t trust someone else to execute this. 2) Who would buy? I really doubt Nike would be interested, especially at these prices. No one else is big enough. Maybe a PE firm would be crazy enough to do it, but again, I think Kevin Plank would fight like hell before being subjected to the oversight of a PE manager.

I think there’s a good chance that UA breaks technical resistance at $30, and then who knows where it stops? So I’m holding, although at a slightly smaller position.