Under Armour: Beware Of The Possibility Of This Catastrophic Event

Under Armour, Inc. (UA) shares declined by more than 10% on May 11 as the company reported disappointing earnings for the first quarter, missing on both revenue and earnings estimates. The market reaction suggested investors were hoping for better numbers from this struggling retailer, which was surprising.

Our thesis for Under Armor is based on liquidity concerns, the expected revenue in the second quarter of this year, expectations for revenue once the economy reopens, and a CATASTROPHIC event that many investors are not factoring in. While the financial media has covered in detail the liquidity concerns and the expected drop in sales of around 50% in the second quarter, little has been said about this catastrophic event we have uncovered.

Under Armour might get kicked out of the S&P 500 index

Yes, you heard that right!

Beat Billions strives to uncover hidden truths in small-cap stocks, and in our search for attractive opportunities, we uncover devastating truths about some companies that could meaningfully impact their market value.

Under Armour is a constituent of the S&P 500 index, which is considered as the gold-standard listing for a U.S.-domiciled company. Under Armour joined the index on April 30, 2014, replacing Beam, Inc. (BEAM). At the time, UA stock was trading close to $50.

The eligibility to be included in the S&P 500 index depends on a few factors, and below are the latest eligibility requirements published by S&P Dow Jones Indices in March.

  • Common stock should be listed on a U.S. stock exchange.
  • The U.S. portion of fixed assets and revenues constitutes a plurality of the total, but need not exceed 50%.
  • Files 10-K annual reports.
  • Unadjusted company market capitalization of US$ 8.2 billion or more.

Changes to the S&P 500 index composition will be made on an as-needed basis, and the next quarterly rebalancing day falls on Friday, June 19.

Source: S&P Dow Jones Indices

At the time of writing this article, Under Armour had a market capitalization of $3.61 billion (May 12). However, it’s important to note that S&P uses float-adjusted market capitalization numbers in its eligibility criteria. This comes to just over $3 billion for Under Armour. This confirms that the company is in violation of the eligibility criteria to be included in the S&P 500 index.

This, however, does not mean that Under Armour will be kicked-off from the index during the next rebalancing.

It’s important to distinguish between the eligibility criteria to be included in the index and the eligibility criteria to remain as a constituent of the index once included. The latter is at the discretion of the board committee that decides which companies should be removed from the index. Even though there are no guidelines as such, consistently failing to meet the eligibility criteria can be seen as one of the reasons why committee members would decide to remove a company from this prestigious index.

Under Armour, in our opinion, will fail to meet the eligibility criteria on market capitalization for quite some time. The business is struggling, and the brand power the company once had on consumers seems to be fading away with every day that passes by. Even when mobility restrictions are eased, Under Armour will still struggle to gain traction as the company would be forced to sell its merchandise at a steep discount to its normal prices in a bid to revive sales.

The unemployment level in the country has surged to new highs as well, and the United States is well and truly in a recession, as confirmed by the Bloomberg recession prediction model. This puts another nail in the coffin for Under Armour as consumers are unlikely to shell money on its products when the going gets tough, which it will in the future.

Based on these assumptions, Beat Billions believes that Under Armour’s market capitalization will remain under the threshold required to be included in the S&P 500 index, eventually leading to the company getting kicked out from the index, paving the way for another promising company.

Under Armour is currently among the 5 companies with the lowest market capitalization in the S&P 500 index, which further strengthens our thesis.

Can a company of Under Armour’s brand image be really kicked out from the index?

The short answer is, YES! Empirical evidence suggests that a company of any scale and size can be deleted from the index for not meeting a set of requirements as seen necessary by the indexing committee. Below are 5 classic examples of companies that received the red notice from the index as their business operations deteriorated.

  • Sears Holdings
  • Lehman Brothers
  • Dell Computer
  • Avon Products
  • Radio Shack

The list goes on. According to data from Refinitiv, a staggering number of 1,800 companies have represented the S&P 500 index at one time or another.

Investors should likely remember how General Electric (GE) was removed from the Dow Jones Industrial Average in 2018. This was a company that was part of the Dow for more than a century, but the committee had to make this bold decision considering the deteriorating financial position of the company. General Electric was replaced by Walgreens Boots Alliance (WBA).

David Blitzer, chairman of the index committee at S. & P. Dow Jones Indices, had this to say about the decision to drop General Electric.

The low price of G.E. shares means the company has a weight in the index of less than one-half of one percentage point. Walgreens Boots Alliance’s share price is higher, and it will contribute more meaningfully to the index.

John Coffee, director of the Center on Corporate Governance at Columbia Law School, had this to say about the removal of GE, which serves as a warning sign for Under Armour investors.

As economies change, some companies become old. You no longer want the buggy whip factory in the S&P 500 and GE is now seen as a declining conglomerate. So it goes and you want to bring in the new people like the Amazons of this world, and that’s been going along at a gradual pace.

Macy’s was dropped from the S&P 500 index on April 6 as well, and Under Armour could become the next retailer to be deleted from the index.

Under Armour’s journey has been a struggle in recent years, and revenue has been flat since 2016 despite the favorable macro-economic conditions. Now that the going will be tough for all retailers in the next 12 to 24 months, Under Armour will come under immense pressure to remain solvent and relevant.

The life beyond the S&P 500 index will be difficult for Under Armour

What happens to the stock of a company that is removed from the S&P 500 index is a question many investors would want an answer to. Empirical evidence indicates that the share price of a company generally improves in the years after it is included in the index for the first time, whereas companies that are removed from the index DO NOT necessarily underperform the index.

A study conducted by The Journal of Finance to determine the impact on the share price resulting from the additions and deletions from the S&P 500 index concluded the below.

There is a permanent increase in the price of added firms but no permanent decline for deleted firms. These results are at odds with extant explanations of the effects of index changes that imply asymmetric price response to additions and deletions. A possible explanation for asymmetric price effects arises from the changes in investor awareness. Results from our empirical tests support the thesis that changes in investor awareness contribute to the asymmetric price effects of S&P 500 index additions and deletions. Copyright 2004 by The American Finance Association.

When a company is removed from a major index such as the S&P 500, investors generally look down on the shares of such companies paving the way for anomalies between the economic reality of a company and its market value. As this study found out, this could be one of the reasons behind this phenomenon.

In any case, Beat Billions believes Under Armour’s struggles would be far from over even when business activities return to normalcy. The meager prospects for revenue and earnings growth give no reason for us to take a long position even though shares have fallen off a cliff this year.

Takeaway

Beat Billions is dedicated to uncovering untold truths about small-cap stocks and our mission is to help investors make better decisions by presenting them with a complete picture of listed companies.

In our search for an attractive investment in the retail sector, we figured out Under Armour stock might come under massive selling pressure if the oversight committee at S&P decides to remove the company from the S&P 500 index. Historically, such decisions have led to drastic declines in the share price within a few months from the announcement. This uncertainty is ONE of the reasons we have decided to steer clear from Under Armour for now.

Our investment thesis for the company is primarily based on its inability to improve its financial performance, and we believe what it couldn’t do in the last 5 years won’t happen in the next 5 years.

We plan to revisit Under Armour in the next quarter to see whether there is any improvement in its profitability profile. Stay tuned!

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