One Number That Shows Under Armour Has Room to Improve

By Markets Fool.com

"There is nothing sexier in finance than evaluating the cash conversion cycle."

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-- Nobody

The cash conversion cycle of a company is not a topic that will get most people out of bed early in the morning. However, it is a very powerful metric to measure company performance.

The cash conversion cycle, or CCC, measures the number of days cash is tied up in working capital (inventory, accounts payable and accounts receivable). The faster a company can sell its inventory and collect from customers, the faster that company can utilize cash for other purposes, including reinvestment in its own business.

The formula to calculate CCC is:

CCC = Days Inventory Outstanding + Days Receivables Outstanding Days Payable Outstanding

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More detail about the CCC can be found here, but below is a quick primer on each component.

1. Days inventory outstanding (DIO):the number of days inventory sits on the shelves. The lower this number is, the better.

2. Days receivables outstanding (DRO):the number of days it takes to collect on sales. For companies that sell perishable goods, DRO will generally be lower.However, a wholesaler may extend credit to a customer, in which case the wholesaler will have a receivable that will extend out multiple days, weeks, or even months. As with DIO, the lower the DRO, the better.

3. Days payables outstanding (DPO):the number of days the company takes to pay its own bills. A higher DPO means the company is able to hold on to its cash longer. However, a rising DPO can also be an indication of financial trouble. A bit more digging will be necessary if you see this number get out of line.

The cash conversion cycle is not very useful metric in analyzing a company in isolation. However, when comparing a company's trend over time and against its peers, the metric can be very telling.

For example, let's take a look at how Under Armour has fared at turning athletic wear into cash.

The trend
Here is Under Armour's cash conversion cycle over the past 5 years.

Data Source: UA 10k filings.

As of the end of 2014, Under Armour took a net 102 days from the moment a product was manufactured and included in inventory to when it was able to sell, collect, and pay for that product. There are two observations of note when looking at Under Armour's five-year trend.

First, there is an obvious uptick in the CCC in 2011. When digging further into the reason for the increase, it can be seen that from 2010 to 2011, there is a six-day increase in the Days Inventory Outstanding and 8-day decrease in the length of time Under Armour took to pay its vendors.

2010

2011

2012

2013

2014

DIO

124

130

123

120

117

DSO

31

29

31

30

29

DPO

52

44

47

47

44

CCC

103

114

107

103

102

Data source: UA 10k filings.

An increase in DIO is an indicator that inventory has become stale. This is a bad sign for retailers as it usually means aggressive discounting may be needed to sell excess inventory. This looks to be the case with Under Armour as gross margins decreased 150 basis points from 2010 to 2011.

DPO is a little more difficult to dissect. With troubled retailers, a falling DPO is often an indication that vendors are fearful about getting paid and instill stricter payment terms. Since Under Armour is not struggling, it may have negotiated new terms with its vendors or just increased the amount of business with vendors that require faster payment. This isn't necessarily a bad sign, especially if Under Armour is able to receive a discount for paying early.

The second observation is that despite the inventory hiccup in 2011, Under Armour appears to have addressed the issue. Both DIO and CCC have recovered nicely and improved every year since 2011.

The competition
I like to compare Under Armour with three companies Nike , Adidas , and Lululemon Athletica .

Nike and Adidas more or less sell the same type of products to the same demographic sports apparel and footwear to men, women, and youth (basically everyone but Droids). Lululemon's market is a bit more focused on women and yoga gear but it is in a similar stage in its growth cycle as Under Armour. Below is a detailed view of all four companies' cash conversion cycle as of each company's latest annual filing.

DIO

DRO

DPO

CCC

Under Armour

117

29

44

102

Nike

91

41

45

87

Adidas

124

47

83

88

Lululemon

82

3

5

80

Data source: Company filings.

What sticks out immediately is that Under Armour is converting inventory to cash at a much slower rate than its competition. Nike and Adidas have a CCC 15 days lower than Under Armour while Lululemon is 22 days lower. Lululemon is almost not a fair comparison as most of their sales are direct to consumer through its retail and online channels. The other three companies have a diversified mix of selling its products through wholesale and direct to consumer channels.

So why is it important to minimize the cash conversion cycle?

For starters, lowering the cycle means the company will be run more efficiently, which means it has to borrow less money to fund its operations. But more specifically, lowering DIO is where retailers can make the largest impact to company performance.

More efficient inventory management leads to higher gross margins, profitability, and cash flow. Better inventory management also means the company has an understanding of the products customers want and can get it to them quickly. In turn, discounting is avoided. Under Armour's struggles in this category are apparent as former CFO Brad Dickerson made the following comments regarding 4th quarter inventory and gross margins:

...we are now planning higher excess footwear liquidation sales as part of our normal inventory management process, which will negatively impact gross margins in the fourth quarter.

Despite the hiccup, the importance of efficient inventory management is not lost on Under Armour management. During Investor Day, management stressed improvements in business operations. Actions taken to improve business performance includes implementation of a SAP enterprise resource planning solution. Chief Information Officer Paul Fipps stated:

...from this initiative we expect to see revenue growth, inventory optimization, service level improvements, and effective margin management.

If successful in improving its cash conversion cycle, Under Armour will reap tangible benefits in its business. The company expects to reach about $4 billion in annual revenue in 2015, which translates to just under $11 million in sales per day.Using these numbers as a rough proxy, by improving its CCC by 15 days, Under Armour could have roughly an extra $160 million in cash to work with. This would come in handy, especially considering that Under Armour accessed $200 million from its revolving credit line for working capital needs.

Over the past few years, Under Armour has done a good job of improving its ability to churn out cash. However, there is still room for improvement. Going forward,business moves that result in a tighter cash conversion cycle could prove accretive to Under Armour shareholders, and that's something worth getting out of bed early for.

The article One Number That Shows Under Armour Has Room to Improve originally appeared on Fool.com.

Palbir Nijjar owns shares of Nike. The Motley Fool owns shares of and recommends Lululemon Athletica, Nike, and Under Armour. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.