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Protect This Stock: How Under Armour Drew SEC Scrutiny

Photo: Justin Sullivan/Getty Images

This week, the Wall Street Journal provided more color on what they originally reported last week: The Justice Department and the Securities and Exchange Commission are probing Under Armour’s revenue-recognition practices, which is to say, its practices for deciding which quarter its revenues occurred in.

The broad allegation seems to be that, as Under Armour started struggling to maintain its robust growth in 2016, it fudged the timing of its revenues so it could continue to show 20 percent year-on-year sales growth. If the company was about to fall short of that benchmark in a given quarter, it would find a way to move some sales up from the next quarter into the current quarter. Eventually, this strategy became impossible to sustain, and when Under Armour announced in January 2017 that it had fallen below the 20 percent benchmark, its stock price fell 23 percent, showing why executives were so focused on staying above it.

But a key question is whether the company fudged the numbers in a way that was illegal. And in this week’s story, the Journal describes a number of revenue-shifting tactics that experts said may have been perfectly legal. For example, Under Armour encouraged some retailers to take shipments of its products early. Or it sold products wholesale to third-party discounters instead of retailing them in its own outlet stores. When you sell to another retailer, you get to book revenue as soon as you’ve delivered to the store; when you sell in your own stores, the revenue can’t be recognized until the clothing is bought by an end consumer. The practices described in the Journal article may not be the sum total of what Under Armour did to smooth its sales, but the story provides an outline for what could be a legal and regulatory defense for the company.

Of course, just because a revenue practice is legal doesn’t make it good idea. If you could achieve a higher profit margin by selling in your own outlet stores, then selling to a third-party retailer instead just so you’ll be able to book the revenue earlier means making less profit in the long run. This is an unusually clean example of what people mean when they warn about short-termism: Corporate executives, whose compensation is closely tied to stock performance or quarterly results, may make decisions to goose either of those metrics, even against shareholders’ long-term interests.

But an odd thing about any possible short-termism at Under Armour is that founder Kevin Plank, who announced just weeks ago he will be stepping down at CEO, owns about 16 percent of the company’s equity. So a decision that boosts quarterly results now without generating true, long-run shareholder value does him little good; he primarily earns his income from the company as a shareholder, not as an executive.

This makes me wonder if there was some irrationality at play at Under Armour. If you shift some sales up from next quarter to hit the 20 percent growth threshold this quarter, that will make it even harder to hit the threshold next quarter, because some of the sales you should have been able to count on next quarter will have already been booked. If your true, long-run sales growth is far below 20 percent (as was the case at Under Armour), you obviously will not be able to keep this up. But if you believe you’re just having a temporary sales problem — that next season’s product line is going to be killer, and you’ll recapture your old growth trajectory and then some — then revenue smoothing could be a way to avoid temporarily spooking the markets.

Under Armour’s fundamental problem is that its product line apparently has not been so killer recently. The company’s trajectory has not been unlike Lululemon’s — one disruptive innovation (stretch yoga pants at Lulu, wicking athletic undergarments at UA) can take you a long way, but your established competitors will copy what you innovate, and eventually your blistering growth becomes impossible to maintain, as you become just another mature apparel company competing with Nike and Adidas. You definitely can’t fix that through sales smoothing.

Protect This Stock: How Under Armour Drew SEC Scrutiny