Under Armour: Value of the Vote (II)

I just wanted to note that WSJ’s “Heard on the Street”columnist Mariam Gottfried has picked up on this opportunity as well. Link.

She lists a new catalyst that I missed:

Struggling arb traders are likely avoiding this trade for now because it doesn’t have a payoff day, so it won’t help their returns this calendar year. But there is a good chance they will reconsider it starting next year.

Under Armour’s ticker change will take effect Dec. 7. Investors who bet on the Under Armour spread narrowing could be off to the races soon after.

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Under Armour: Value of the Vote

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Introduction

Under Armour (NYSE: UA), the Baltimore-based athletic apparel and footwear company, is well-known to most as the aggressive underdog in the industry dominated by the behemoths like Nike and Adidas. Dazzled by its growth, investors quickly took notice of its stunning growth and returns, and assigned it high earnings multiples (its trailing TTM P/E is a whopping 72x as of this writing).
At the helm of the company is Kevin Plank, the founder and CEO of the company. Currently owning approximately 66.5% of the voting power of all outstanding shares, Plank has majority control to guide UA to his vision.
March of this year, UA announced that it will issue a stock dividend, effectively a two-for-one stock split, except instead of two identical Class A shares, investors will get one Class C share for each Class A share they own. Class C shares don’t have the voting rights that Class A shares enjoy. The “change will [allow Plank] the flexibility of selling these non-voting shares of Under Armour over time while maintaining [its] founder-led approach.”
Shareholders didn’t seem too happy with the deal, evident in the large spread on the returns of the shares (shown in Figure 1). Note the heavy selling of both classes following the dividend.

Figure 1. 6-Month Returns on UA Class A vs. Class C Shares

chart
In this report, I argue that there is a long/short opportunity with these two shares. Specifically, that the spread between the two shares are excessively wide, and the spread should narrow over time. Furthermore, as voting power is essentially concentrated in Mr. Plank’s hands, the premium of a shareholder’s vote should not be as high as the market believes it should.

Breaking It Down

Under Armour has three classes of shares: Class A, B, and C. Below is a summary of the share structure :

  • Class A shares are publicly traded, and have one vote per share.
  • Class B shares are wholly owned by Plank and his Family entities, and have ten votes per share. Class B shares are also convertible to Class A shares, and once converted cannot be reissued. Class B shares are not publicly traded.
  • Class C shares are publicly traded, and have no voting rights.
  • All three shares have equal rights to dividends, liquidation proceeds, and considerations in special events

There are finer details surrounding this structure. Most importantly is that each Class C share gains one vote on the conversion of all Class B shares into Class A shares. And that event will most likely be triggered when Plank and his entities together own less than 15.0% of the total number of Class A and B shares outstanding, which immediately converts all Class B shares into Class A shares.

To sum up, once Plank and his entities’ collective interest in the company dips below 15.0%, all outstanding shares convert into Class A shares, regardless of their previous class.

As of June 30, 2016, Plank owns 15.9% of all Class A and B shares, and 65.3% of the combined voting power.

As of June 30, 2016 there were 183,388,910 shares of Class A Common Stock, 34,450,000 shares of Class B Convertible Common Stock, and 219,454,106 Class C Common Stock outstanding.

Value of a Vote

Given that Plank and his entities own a majority control of the company, is the public shareholder’s one vote per share valuable at all?

If not, Class A share should, for all intents and purposes, be equivalent to Class C shares. Given their price disparity, this implies Class A shares are overvalued and Class C shares are undervalued, relatively speaking.

If investors do find the one vote per share valuable, the question becomes “how valuable is it?” The authors of a Harvard Law School paper, The Market Value of Corporate Votes, estimate the market value of the right to vote using options to create a synthetic long position. Similarly to non-voting shares, synthetic positions have economic interest in the company but do not have voting rights. The authors find that the mean annualized value of a voting right to be 1.58% of the underlying stock price in the US.

Using a similar method, I derived the value of a synthetic stock using put and call options. Specifically, a synthetic long position in Under Armour’s class A shares can be created by going long a call option and short a put option at the same strike price, as well as a long position in a risk-free zero-coupon bond that expires with a value of the strike price at the expiry date of the options. This relationship is derived from the put-call parity formula, and can be summed up neatly with the equation below:

S=C-P+Ke^(-rT)

This relationship is modelled with European calls and puts, so for the American options I’m working with, the equation should really be:

S≥C-P+Ke^(-rT)

While this doesn’t provide exact pricing, it nevertheless establishes a minimum lower bound.

Using October 21st closing prices of November 16 call options, put options, and the underlying stock price, and assuming an annual risk-free rate of 0.66%, I get the following results:

Underlying stock price: $37.94

Strike price of $37.5:
C-P+Ke^(-rT)=$37.34

Strike price of $38.0:
C-P+Ke^(-rT)=$37.28

The difference in values come from using American options, as the option of early exercise has unequal effects on values with different strike prices, as well as the bid-ask spreads reflected by my broker. Nevertheless, it’s a good approximation of the value of a synthetic long position in UA.
These values are roughly in-line to the average value of 1.58% that the Harvard study found (1.58% and 1.74% for strike prices of $37.5 and $38.0, respectively). The options market evidently does not place too high a premium on a shareholder’s vote in Under Armour’s shares.

Mispricing

If a synthetic long position in Under Armour’s Class A shares is given only a modest discount for not having the privilege to vote, and Class C shares are similar to a synthetic long in sharing economic interest but lacking a right to vote, then the Class C share’s discount (or Class A share’s premium) is excessive and the spread should converge over time.

An argument for its significant lower price is could be due to downward pressure from Kevin Plank’s selling. On one hand, this makes sense – if there’s more sellers than buyers in the market, the price of the shares should go down.
On the other hand, this pricing disparity should not last for very long. Shrewd investors can find a bargain in Class C shares, buying an equal interest in the company for cheaper than Class A shares. The loss in voting power doesn’t matter too – Plank has majority control, and in the scenario that he relinquishes this control, Class C shares will be converted into Class A shares.

Recommendation

Given this price disparity, I recommend going short UA (Class A) and long UA.C (Class C), with an equal amount of shares on each side. I believe the spread between the two stocks will converge over time to a reasonable level. The uncertainty lies in the amount of time it will take for this spread to narrow.

Example.
T=0, UA: $37.88, UA.C: $33.00
Short 100 shares of UA, long 100 shares of UA.C
Spread: 14.8%
Net cost: cr. $488

T=1, UA: $40.00, UA.C: $39.20 (Scenario 1)
Exit short 100 shares of UA, exit long 100 shares of UA.C
Spread: 2.0%
Net cost: db. $80
Net return: 13.19%

T=1, UA: $35.00, UA.C: $33.95 (Scenario 2)
Exit short 100 shares of UA, exit long 100 shares of UA.C
Spread: 3.0%
Net cost: db. $105
Net return: 10.48%

Otherwise, an individual who wants to invest in Under Armour but finds the P/E multiple of Class A shares too expensive at a P/E of 72x might find the P/E multiple of Class C shares at 63x more reasonable (although given the aggressive scale UA is building, P/S multiples might be another way to judge relative pricing). Figure 2 demonstrates the relative cheapness of Class C shares compared to Nike’s shares.

figure-2

Catalysts

  • As Plank and his entities is only permitted to sell a limited amount of shares, the abated selling pressure should allow for the price disparity to slowly converge over time.
  • Plank is nearing the 15.0% threshold (currently 15.9%) that would convert all Class B shares into Class A shares. The conversion would be a significant catalyst in effectively converting Class C shares into Class A shares. This is unlikely to happen in the short-term, as Plank still has a sizable position in Class C shares.

Risks

  • Continued selling pressure by Plank and his entities may keep or widen the price disparity for an extended period (Plank currently owns approximately 15.4% of all outstanding Class C shares).
  • Conversion of all Class B shares may not happen on a timely basis.
    Because UA trades at high multiples, disappointing Wall Street’s expectations will serve to exacerbate selling pressure on both stocks, and hinder the price discovery process in the short-term.
  • Lack of a clear catalyst (e.g. repurchases) that would cause the spread to narrow.
  • Given the lack of a clear and timely catalyst, spreads could take a long time to narrow and significantly diminish time-weighted returns.

Foot Locker Investment Thesis

Click here for my Foot Locker Investment Thesis

Summary

Although the industry Foot Locker operates in is incredibly competitive, I believe the company is positioned strongly in a niche part of the industry that will continue to grow down the line. Other factors, such as excellent corporate governance structure and a history of meeting long-term objectives further add to my belief that Foot Locker is a competitive and attractive company.

Therefore, I believe Foot Locker is a strong buy with a price target of $96. I have no time horizon for this, but I believe the stock price will begin to trend upwards as the market begins to realize the high level of free cash flows and returns this company is able to generate. Further increase in dividend payouts or share repurchases will continue to support the price and help its convergence to intrinsic value.

Estimates of Value Low Base High
Bear case:  $   31.95  $   41.31  $   52.94
Base case:        87.22     105.79     133.55
Bull case:     110.47     135.96     167.96
Management’s guidance:        77.19        95.81     119.16

Herbalife – Starting From Zero

After the statement of the FTC was released on FTC v. Herbalife International of America, I wondered why the FTC agreed to a settlement at all. Their press statement asserted several findings on Herbalife (NYSE:HLF) that would logically draw one to conclude that it is indeed a pyramid scheme.

The SEC defines the classic “pyramid scheme” as participants attempting to make money solely by recruiting new participants into the program.

The hallmark of these schemes is the promise of sky-high returns in a short period of time for doing nothing other than handing over your money and getting others to do the same.” – SEC

According to Wall Street Journal and other news outlets, Herbalife will simply pay a fine of $200M and, in return, the company will not be classified as a pyramid scheme. However, when FTC Chairwoman Ramirez was asked if Herbalife was therefore freed from the pyramid scheme label, she replied: “I do not agree with that statement.” She later asserted that “they were not determined not to have been a pyramid scheme.”

On the surface, this settlement hints that Herbalife won. And that is exactly how Herbalife touted the ruling.

The FTC settlement is an acknowledgment that our business model is sound and underscores our confidence in our ability to move forward successfully, otherwise we would not have agreed to these terms.” – Michael O. Johnson, chairman and CEO of Herbalife.

However, a deeper dive into FTC documents and examination of government bureaucracy tells another story.

A good matador doesn’t go after a fresh bull. He sticks him, makes him bleed a little bit, and then goes for the kill.”

Former senior economist for the FTC, Peter Vander Nat, has asserted that the “process [in judging pyramid schemes] in which the prosecution takes so long that the deterrent effect is insufficient.” He alludes to another pyramid scheme, BurnLounge, that took the FTC seven years to shut down. As there is no established rule or precedent in judging these cases, the FTC is effectively starting from zero on every case.

It was this statement that tipped me into investigating the merits of the FTC injunction. My theory is that Herbalife aggressively negotiated away the label of “pyramid scheme,” and in exchange, conceded to the highest level of injunctive action imaginable. Certainly, Herbalife coordinated a massive PR campaign the day of the press statement.

Pic 1

Perhaps they even leaked false headlines to news outlets.

Pic2

Pic3

And of course, Dow Jones later corrected their statement (at Friday in the afternoon), when nobody was paying attention. As my colleague pointed out, nobody reads Dow Jones – not even Dow Jones.

“Buying a diet shake from a Herbalife distributor will now be harder than buying a gun.” – Matt Levine, Bloomberg View

In return for conceding the “pyramid scheme” label, the FTC is now given every authority to essentially break down Herbalife’s business in the US. In fact, the FTC statement affirms that Herbalife is, by definition, a pyramid scheme.

In fact, only a small minority of distributors have made anything near what the company promises, and they have done so mainly by recruiting a “downline” of distributors who buy the product at wholesale. Indeed, for years, Herbalife’s business model primarily compensated members for recruiting new distributors to purchase product, not for selling product at retail to users outside of the Herbalife network. As described in the complaint, this structure led many members to purchase an oversupply of product and rewarded only the tiny percentage of distributors with large downlines. As a result, according to the complaint, a large majority of distributors made little or no money and a substantial percentage lost money.”

Circling back to my theory that the FTC chose the path of least resistance, I reviewed the injunctive actions ordered by the FTC.

Here’s a summary of the FTC’s orders:

  • Limitations on Multi-Level Compensation
  • Collection of Retail Sales Information
  • Verification of Retail Sales and Preferred Customer Sales
  • Limitations on Thresholds, Targets, and Requirements
  • Required Training for Business Opportunity Partners
  • Prohibited Misrepresentations
  • Prohibition Against Material Omissions and Unsubstantiated Income Representations
  • Compliance Monitoring by Defendants
  • Independent Compliance Auditor
  • Customer Information

If you don’t want to pour through the specifics of the order, Matt Levine from Bloomberg succinctly summarizes the effects of this injunction: “Buying a diet shake from a Herbalife distributor will now be harder than buying a gun.” Moreover, restrictions are put on “Nutrition Clubs” such that it becomes more difficult than opening a McDonald’s. Under these constraints, it is almost impossible for any distributor to realize retail profit in a heavily competitive industry in which Herbalife sells at a significant premium.

The higher you are, the harder you’ll fall

All pyramid schemes, by the rules of simple mathematics, must come to an end. Such schemes are certain to fail because there is a limit to the number of new participants and the probability of success decreases for each new recruit. Once a top distributor leaves, the house of cards will surely collapse. It’s just a matter of time.

I’d like to conclude with an excerpt from a blog post on the FTC’s website:

“We’re glad to be returning $200 million to consumers. (Details about the refund program will be available soon.) But another key goal is to dismantle the alleged deception and unfairness built into how Herbalife does business. As the company rewrites its advertising claims and restructures its compensation system, we’ll be watching. The Auditor will be watching. And consumers should be watching, too.

My Short Thesis

HLF Summary PDF