A day after Under Armour reported disappointing fourth-quarter earnings and forecast slower growth for 2017, Standard & Poor’s cut the company’s credit rating one notch to “junk” status. Moody’s Investors Service changed Under Armour’s rating outlook to negative from stable but all ratings were affirmed.
According to an S&P press release, Under Armour’s revenue growth has slowed as a result of challenging industry outlook because of strong competition leading to pricing pressure and a weak retail environment in its core North American market and weak operational execution by the company. The company also is facing increasing costs to support growth.
S&P said, “We have revised our forecast downward for the company and believe sales growth will slow over the next year or two and that margins will weaken due to intense competition in North America, a shift in growth toward less-profitable international markets and the athletic footwear segment, and high operational spending to support the company’s growth plans.”
As a result, the rating agency lowered its corporate credit rating to ‘BB+’ from ‘BBB-‘. The outlook is negative. In addition, it also downgraded the company’s $600 million in senior unsecured bonds to the same speculative-grade level, “BB+” from ‘BBB-‘ and assigned a ‘3’ recovery rating to this debt instrument.
“The rating action reflects our downward revision of our forecast and deterioration in credit metrics. We now believe the company will generate about 10 percent sales growth annually and margins will be in the 12% range, which results in leverage slightly below 3.0x. The company recently reported a weaker-than-expected operating performance during its important fourth quarter,” said credit analyst Mariola Borysiak. “This was attributable to weaker-than-expected execution on the company’s growth plan, increasing competition and a poor retail environment in North America, leading to price pressure as well as rising costs to support growth that erode margins and profitability. We believe Under Armour’s weak operating execution under its aggressive growth strategy weigh on our assessment on its business risk profile.”
The negative outlook reflects the risk the company could miss S&P’s revised forecast, which could mainly stem from an increasingly promotional industry environment in North America leading to further margin erosion, slower growth than expected as a result of stiff competition from industry leaders Nike and Adidas, slower category growth, or higher than expected spending to fund growth. Under such a scenario, S&P believes the company’s leverage could weaken to around 3x or above over its forecast horizon, which could lead to a downgrade. S&P forecasts that only about 8 percent EBITDA decline from its forecasted level for 2017 would lead to debt leverage increasing over this threshold.
S&P concluded, “A revision of the outlook to stable would be predicated on our belief that the company can demonstrate profitable sales growth, stabilize or improve operating margins, and execute successfully on its growth plan. In addition, for a revision of the outlook to stable, we would expect the company to maintain financial leverage well below 3x.”
In changing Under Armour’s rating outlook to negative from stable, Under Armour cited weaker-than-expected fourth quarter 2016 operating performance and significant downward revision in guidance for 2017.
Stated Moody’s Analyst, Mike Zuccaro. “The revised guidance reflects the challenges the company faces with balancing aggressive global growth while navigating a challenging North American apparel retail environment; a market in which it remains significantly concentrated. The affirmation reflects our expectation that the company will make appropriate adjustments to its cost structure in order to contain earnings declines and maintain appropriate credit metrics. We also believe that ongoing investments to drive growth in key areas make strategic sense and will further strengthen the company’s brand and competitive position in the market over the longer term.”
While Under Armour’s 2017 revenue growth is expected to be in the 11-12 percent range, operating profit is now expected to decline over 20 percent to $320 million due to a continuation of investments in key high growth businesses and ongoing revenue mix shift toward the lower margined footwear and international businesses. The company is evaluating its overall cost structure, which could provide some upside to its earnings and cash flow over time, although the size and nature of these benefits are yet to be determined. With the expected decline in profitability and modest debt increase to fund growth spending in 2017, Moody’s expects lease-adjusted leverage to increase to around 2.8x, up from around 2.3x at the end of fiscal 2016. Liquidity is good, supported by ample availability under the company’s $1.25 billion unsecured revolving credit facility due 2021.
Moody’s affirmed Under Armour’s senior unsecured notes rating at Baa2 and Senior unsecured shelf rating at Baa2.
Under Armour’s Baa2 rating reflects the company’s strong competitive position as one of the leading sports apparel brands in the U.S. and internationally. The rating also considers the company’s track record of innovation, which has driven strong revenue and earnings growth for an extended period of time, as well as Moody’s generally positive view of the global sporting goods market, including apparel and footwear, which provides credible organic growth opportunities for Under Armour in both the U.S. and international markets where the company is significantly underpenetrated. In addition, through its “Connected Fitness” platform, the company has developed the world’s largest digital health and fitness community. While being a relatively modest revenue contributor, Connected Fitness should be a strong catalyst for growth and consumer engagement over time. The company’s conservative financial policy is a key rating consideration, given that it has maintained a solid investment grade quantitative profile in the face of rapid growth. Moody’s expects this to remain the case going forward.
The rating is constrained by Under Armour’s reliance on a single brand and limited product diversity, along with nascent, but expanding, geographic reach. These risks expose the company to economic cyclicality and inherent changes in consumer preferences in a concentrated region. The rating also considers the high level of execution risk associated with continued rapid growth. This will require significant ongoing investment that will pressure free cash flow and suppress operating margins over the next several years.
The negative outlook reflects Moody’s expectation for declining operating profit and weaker metrics in 2017, as well as the risks inherent in maintaining high levels of investment to drive long-term global growth while navigating a very challenging North American apparel retail environment. Any meaningful decline in operating profitability or gross cash flow levels while driving growth could lead to a ratings downgrade, according to Moody’s. Quantitative metrics include lease-adjusted debt/EBITDA sustained above 3.0 times and interest coverage falling below 5.0 times.
Given the negative ratings outlook, a ratings upgrade is unlikely at this time, according to Moody’s. To stabilize the outlook, Under Armour would need to resume operating profit growth such that operating margins improve to the high single digit range. An upgrade would require successful expansion of its product and geographic reach, which would be evidenced by continued solid organic growth rates that exceed its peers (indicating that the company is gaining market share), and if operating margins expanded to the mid-teens. Moody’s said quantitatively ratings could be upgraded if lease-adjusted debt/EBITDA was sustained below 2.0 times, interest coverage remained near current levels, and FFO/Net Debt approached 50% while maintaining strong liquidity.
Photo courtesy Under Armour
