RGA Investment Advisors commentary for the first quarter ended March 31, 2017.

Also see 2017 Hedge Fund Letters:

Many of the themes from the end of 2016 persisted into the early first quarter of 2017. Around the second week of February, the so-called “Trump Trade” reached its crescendo with many of the politically driven ascents fully faded into the end of the quarter. The market’s overall levels largely held up with a shift in strength towards technology and some of the other “high quality” laggards of late last year at the expense of cyclicals.

RGA Investment Advisors

RGA Investment Advisors

Underlying economic strength continued into the quarter and helped push the acceleration of expectations for the first Federal Reserve rate hike of 2017. Coming into the year, markets expected less than a 50/50 chance of a March hike, but during a spate of voting member talks in the month of February, these expectations shifted to near certainty. This coincided with the Trump trade’s inflection point.

We took advantage of the strength in cyclicals to shed some positions where we felt the pendulum swing in sentiment did not correspond to a shift in fundamentals—we sold both our auto manufacturer and car dealer (while maintaining our entire exposure to the financial sector). Below, we expand on two other notable portfolio changes during the quarter.

In which we realized our mistake quickly, though not soon enough:

In our 2016 year-end commentary we shared our thesis on Under Armour (NYSE: UA). [1] Shortly after publishing our thoughts, the company issued a trifecta of bad news when their earnings missed the mark, they abandoned what had been issued as longer-term guidance only three months prior, and their CFO resigned. Any one of these may have been indicative of a short-term problem, but together they compounded the woes. While our quick about-face may appear surprising, we think it is essential to remain flexible in our views despite our long-term bias and believe it is important to learn the right lessons from our mistakes. One of the foremost mistakes with UA was our under-appreciation for how much this company on the apparel side resembles a “fashion” company more so than a pure sports play. These quotes from their Q4 2016 conference call make this point stark:

  • “We need to become more fashionable with the products that we have out there. And one of the things we found is that some of the core basics were some of the challenges that we saw, is that we are counting on core basics as we have in years past to do more work for us. But the consumer today frankly has more options, and frankly most of those options are from good brands that we compete with, that are heavily discounting as well.” – Kevin Plank[2]
  • “So what you’ll see is that I don’t think it’s one shift of abandoning one for the other. Obviously, with things like the investment we’re making in UAS (31:30) in sport lifestyle in general, but we need to become more fashion. The consumer wants it all. They want product that looks great, that wears great, that you can wear at night with a pair of jeans, but that also does perform for them. But the performance has just become a bit of a given information. And so I think you’ll see us continue to react to that, and hopefully I think you’ll see us continue to lead in that.”[3]

We cannot help but ask, what is the company’s edge if “performance just become a bit of a given.”

Further, was growth demand-pull or supply-push? That is, did the company grow because consumers kept buying more and more, or because UA kept putting out more and more product. Obviously to some extent there is a symbiotic relationship between the two, but in hindsight it appears certain that the growth emphasis from leadership despite the reset in expectations during the Fall was a sign that the growth had inflected from a balance between the two to a more dominant supply-push. Supply-push is far less certain because it comes with increasing the capital base of the business ahead of the top line and requires growing inventory to the point where if something goes wrong, it will go very wrong. This is evident in the gross margin miss and the inventory build.

While Plank deserves admiration and is a worthy subject to study for how successfully he built UA, there was a warning sign that we did not consider until after-the-fact. Plank had been touting UA’s “26 straight quarters of 20% or more YoY top line growth.” This is a great accomplishment, but it is also an overt risk. When a streak becomes too important a corporate imperative, the incentive to continue the streak can outweigh the incentive to do the right thing because no one wants to be responsible for it ending.

UA’s goal in hindsight seems like it was kept up with pulling growth forward (creating way too much product and discounting heavily. Further, Q3 guidance for 2017 was shaped far too much by attempting to maintain the “above 20%” as an important threshold, instead of being realistic about what already was acknowledge as slowing but robust growth. Accounts receivable was a tell we should have noticed. Whereas inventory only grew 11.9% vs sales growth of 22.1% year-over-year in Q3 of 2017, receivables grew 29.5%. This inventory was sold through the channel to wholesalers who had not paid for the product. This helped boost sales and reach growth targets, when in fact it should have been a big red flag.

  • “a larger increase in accounts receivable of $53.7 million in the current period compared to the prior period, due to the timing of shipments driven by current period sales being more heavily weighted to the end of the period.”[4]

Perhaps the key takeaway here is as simple as the “capital cycle.” We were first introduced to this idea in “Capital Account: A Fund Manager Reports on a Turbulent Decade.”[5] The book featured the letters of Marathon Asset Management and its focus on the capital investment cycle at both the micro and macro levels and the impact it would have on valuations. We no longer own any other investments in companies which are simultaneously sacrificing margin & investing in capex at such a voluminous rate. We do have some investments in which out-year margins will be greater due to the investment that flows through; however, these businesses are very capital light and the investment through margin should be long-lived. UA is basically the reverse.

It’s very hard not to write off the big investments of the past year given how badly the company missed on both top line and margins, and what the outlook into next year is like for both as well as free cash flow. On the plus side, the company is lowering CAPEX spend, but this seems more out of necessity and leads us to wonder why it didn’t happen sooner. This does not strike us as a “capacity to suffer” (Tom Russo’s definition) problem right now.[6] This more realistically strikes us as a company

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