Industry Perspectives: A Monthly Research Analyst Series
Industry Perspectives: A Monthly Research Analyst SerieMay 2016
Long and Short Opportunities in Branded
Apparel and Footwear
Jenny Hubbard, CFA
Research Analyst
Consumer Discretionary Sector
The past few years have witnessed a substantial shift in the way
products are sold and purchased. Retail companies used to be
the primary point of distribution for their apparel and footwear
vendors. Today, most brands have dramatically increased their
distribution channels, bringing product to market through
owned retail stores, websites and—as indicated by the roughly
30% share of North American retail sales growth recently claimed
by Amazon1—third-party websites. Consumers have responded
to this development by conducting more purchases online. This
trend is reflected in the widening disparity between direct-toconsumer (DTC) and wholesale revenue growth for brands that
sell into both channels. This transformation has clear negative
implications for retailers and has been central to our short theses
for aggregators of branded product such as Macy’s, Cabela’s, and
Best Buy (BBY). However, we believe the impact to vendors will
be more balanced; it creates the potential for structural margin
improvement and broadens access to the consumer, but it also
lowers barriers to entry and alters the competitive landscape of
the industry. This piece addresses our view of how these factors
are affecting branded footwear and apparel companies and
where we are finding investment opportunities in the industry.
Reducing the amount of goods sold through traditional retail
channels allows brands to capture a larger percentage of product
mark-up, so more mature apparel and wholesale companies
growing their exposure to DTC channels are realizing higher
gross margin levels. New entrants are using owned or third-party
online channels as a low cost, expeditious way to penetrate target
markets. The ease with which new companies can connect with
consumers has brought many new niche brands to the industry.
This, in turn, has intensified the competitive environment as
consumers have more choices available now than ever before.
Consumers’ fickle preferences for branded apparel and footwear
product have always made it challenging to find compelling
long-term investment opportunities in the industry. The
emergence of a dynamic that intensifies the competitive climate
makes this endeavor even more difficult. Brands with a fashion
element typically have a rapid—but often relatively short-lived—
growth cycle that the market tends to reward with a very high
multiple. When the brand reaches a point of saturation, or a new
enticing product enters the market and growth slows, it follows
“Consumers’ fickle preferences for branded apparel and
footwear product have always made it challenging to
find compelling long-term investment opportunities
in the industry.”
that the multiple and stock price drop in dramatic fashion. A
review of the stock charts for companies like Michael Kors,
Deckers, and Coach punctuates the frequency of this outcome.
One company we have owned for many years that is more
insulated from the volatile sales and earnings trends that
characterize many brand companies is V.F. Corp. (VFC). This
investment has performed well for us over the long term, and
we believe it has the potential to continue to deliver attractive
returns. We wrote extensively about V.F. Corp. in our October
2013 Industry Perspective and the key attributes cited in the
piece still support our favorable view of the company. The most
timeless feature is the benefit of maintaining diversified exposure
to brands and geographies. Owning multiple, global brands
minimizes the sales and margin volatility that accompanies
concentrated exposure to one brand or geography. A review
of V.F. Corp. sales and margin trends over the last 10 years
highlights the company’s relatively consistent performance
through all phases of the cycle. V.F. Corp. has also been growing
its DTC business for the last five to six years, so it already has
extensive experience managing the complexity of selling product
through multiple sales channels. This shift has been a source of
gross margin improvement, but with DTC at just around 30% of
V.F. Corp.’s total sales, there is room to grow sales from this more
profitable channel. V.F. Corp. also has an evolved manufacturing
and distribution infrastructure, long known as one of best in the
industry. The company is thus very capable of navigating the
rapid changes underway in the industry and integrating future
M&A opportunities that will likely surface in a more challenging
environment.
In the past, we have also been drawn to Nike, a company that
we owned in many of our long strategies. We were comfortable
with exposure to one brand because athletic footwear forms
the core of Nike’s business. This product has tended to have
more functional than fashion appeal and benefits from more
repeat buying patterns inherent in athletic footwear, both
characteristics that tend to support pricing. We also purchased
Nike following the recession, a period when expectations were
low and the stock price did not reflect some of the key attributes
we cite. In addition, the athleisure trend was just starting to
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Diamond Hill Industry Perspectives: A Monthly Research Analyst Series May 2016
resonate with consumers and the competitive environment was
relatively benign: Adidas had lost market share and was still
focused on recovering from an ill-timed and costly acquisition
of Reebok; Under Armour (UA) was just gaining share; and there
were far fewer niche companies in the industry. Nike’s stock
price eventually appreciated to our estimate of intrinsic value so
we adhered to our valuation discipline and exited our position.
least differentiated athletic product, yet it is the segment of the
market that has seen the largest influx of new brands. We believe
it is the most vulnerable to competitive pressures and pricing
declines. We have already seen decelerating growth metrics in
the North American apparel segments for both Lululemon and
Under Armour over the last year, and we expect this trend to
continue.
Nike is still an excellent company that remains the clear leader
in the industry; but in our opinion, the current valuation is not
overly attractive at this point. The high growth and return profile
of Nike’s product categories, coupled with the declining barriers
to entry we touched on, has invited many new entrants to the
market. There is more retail floor space devoted to athletic
product and more choices available from the industry leaders, as
well as several new niche providers, than ever before. A simple
search for workout pants on the Dick’s Sporting Goods website
sources 20 pages of products spanning 25 brands; a search for
athletic shoes displays an equally broad range of choices. A
maturing growth trend, coupled with a proliferation of suppliers,
is bringing the industry to a point of oversaturation.
Partially offsetting lower apparel growth is the strong sales
momentum both companies are realizing in international
markets, and in the case of Under Armour, very strong growth in
footwear on the introduction of new running footwear and the
Stephen Curry basketball shoes in 2015. The market’s reception
to the company’s running shoes has been mixed, but demand
for the Curry shoes has been exceptionally strong. What Under
Armour has done with the Curry shoes is very impressive.
Continued strong reception to the product and the potential for
the company to expand its presence in the basketball category
has the potential to catalyze upside to footwear revenue growth
expectations.
Our conclusion is supported by troublesome metrics that
surfaced across the industry in the summer of 2015. First,
inventory growth has exceeded sales growth for most names
in the industry for the last three quarters. In fact, this ratio for
the athleisure brands is the highest in the industry. We are also
starting to see pressure in average selling prices (ASP) for the
only companies in the industry that disclose these metrics: Nike
and Sketchers. After a period of realizing mid to low-double
digit ASP growth in most of its product segments over the last
few years, Nike’s North American ASP growth flattened in the
second quarter of fiscal year 2016, and dipped 3% in the third
quarter of fiscal year 2016. ASP growth in footwear followed a
similar trajectory. While Nike maintains some premium pricing
in footwear, pricing for its apparel product is at parity with other
leading brands and is thus a good barometer for the athletic
apparel industry. We have seen a similar degree of deceleration
in ASP metrics at Sketchers, which is priced in the lower to midtier of the athletic footwear market.
We don’t believe other names in the industry like Lululemon
Athletica (LULU) and Under Armour are immune to this trend,
but these stocks continue to trade at very high valuations relative
to our assessment of their long-term earnings potential. We
thus recently took an opportunity to establish a short position
in both companies. While it can be uncomfortable to short
companies that are delivering strong top-line growth, we believe
expectations are too high and don’t believe growth opportunities
in new geographies or new product segments will offset
decelerating growth in the companies’ core, high margin athletic
apparel segments. Apparel product represents all of Lululemon’s
revenue and profit, and represents 70% of total revenue and an
estimated 80% of total profit for Under Armour. Apparel is the
We should be reminded, though, that it took Nike 10 years to
grow the Jordan basketball product to the $2.5 billion range
that many view as the potential for the Curry shoes. And this
was at a time when there were no other competitors of size in
the market. Average peak revenue levels in the industry are
much smaller, with other top-selling Nike basketball shoe lines
featuring the names of iconic players generating annual sales
closer to $200-$250 million. We also realize that Under Armour
has the potential to drive growth in its premium running shoe
product, an area where it has yet to get much traction. However,
growth in these products and international markets will come
with a much lower margin profile. We estimate that international
operating margins run an average of 50% or less of North
American operating margins for Lululemon and Under Armour.
Margins will improve with scale, but this takes most companies
years to establish. In addition, for Under Armour, we estimate
that the spread between apparel gross margins and footwear
gross margins has to be at least as wide as the approximate 2,000
basis point difference between Nike’s footwear and apparel gross
margins.
Neither Lululemon nor Under Armour realized operating
margin growth before they started expanding into lower margin
geographies and product areas. In fact, Lululemon’s operating
margins have compressed every year since 2011, and this was
during a period of time when the industry was realizing strong
ASP growth. Now that ASP growth is slowing and margindilutive sources are contributing a greater percentage of revenue
growth, we believe the expectation for margin expansion at
Lululemon and margin stability for Under Armour is very
optimistic. And if we do eventually see the widespread pricing
pressure an oversupplied industry portends, we believe the
probability is very high that both companies’ earnings trends fall
well short of expectations.
Evercore ISI, April 2016
As of April 30, 2016, Diamond Hill owned shares of VFC.
As of April 30, 2016, Diamond Hill held short positions in BBY, LULU, and UA.
1
The views expressed are those of the research analyst as of May 2016, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a
forecast of future events, a guarantee of future results, or investment advice.
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