“Consumers’ fickle preferences for branded apparel and footwear product has always made it challenging to find compelling long-term investment opportunities in the industry.” – Jenny Hubbard, CFA

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-to-consumer (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 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 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.

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.

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 mid-tier 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 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.

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.

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 margin-dilutive 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.

1 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.

Originally published on May 18, 2016

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.

© Diamond Hill Capital Management

© Diamond Hill Capital Management

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