One example of a recent short position is Under Armour, Inc (NYSE: UA). Under Armour has persistently ranked near the bottom of our universe over the last few quarters. Let’s take a closer look at the factors we analyzed and the red flags they raised.
Revenue: Score - F. A continued increase in accounts receivables calls into question the quality of reported revenue. In the most recent quarter, the company posted four consecutive year-over-year increases in receivables on its balance sheet. This increases the risk that revenue recognition may have been accelerated.
Cash Flow: Score - F. Poor trends in working capital such as receivables and a significant inventory build up have deteriorated the sustainability of the company’s cash flow. While earnings are often the focus of investors, earnings cannot be spent. Cash flow is kind. Under Armour’s cash flow quality has suffered for numerous quarters due to these poor working capital trends.
Earnings Quality: Score - F. As the result of inventory buildup in prior quarters, sustainable profit margins were overstated. Recent margin pressure from inventory liquidations has led to earnings shortfalls.
Expectations: Score - D. Under Armour has been a key growth stock holding in many portfolios. The red flags in its financial statements such as unsustainable profit margins have largely been ignored. Expectations and estimates did not come down fast enough and the stock price faltered.
Valuation: Score - F. Since Under Armour has been a widely-loved growth stock for many years, shares traded at a premium valuation. This dramatically increased the downside risks as earnings quality deteriorated in recent quarters.
Shareholder Yield: Score - F. While share count has not been reduced to boost bottom line results, the company also does not pay a dividend on its common stock. The deterioration in the quality of cash flows raises risks for future shareholder yield.
Subsequent to the short position in the index, shares of UA suffered a dramatic fall. In the most recent quarter, the company missed both revenue and earnings expectations with EPS coming in at $0.23, $0.10 short of expectations. Furthermore, the company reduced 2017 guidance and announced the departure of its Chief Financial Officer.
Under Armour is one example of how poor working capital trends and earnings quality, high expectations and a stretched valuation can lead to significant downside if those lofty expectations are not met.
Holding short positions in such stocks can benefit a portfolio’s performance regardless of overall stock market direction.