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For P&G and Trex, the Outlooks Are Bright

Chris Hill, The Motley Fool

To succeed in the marketplace, the first thing you need is a good product. Or, better still, many good products. But that is far from all you need. Consider three well-known companies that reported quarterly earnings on Tuesday: Under Armour (NYSE: UA) (NYSE: UAA), Procter & Gamble (NYSE: PG), and Trex (NYSE: TREX). There's no denying that Under Armour's athletic apparel is high quality, but there's also no denying that its management hasn't been for awhile. P&G built a portfolio of classic brands, but then got caught with its pants in the laundry due to shifting consumer tastes and nimble new competitors. And as for Trex, well, the composite decking maker is so clearly the leader in its niche that you'd be hard-pressed to name another rival, but it's still not immune to supply chain woes, nor macroeconomic headwinds. However, two of those three are overcoming their challenges while one isn't.

In this MarketFoolery podcast, host Chris Hill and MFAM Funds CIO Bryan Hinmon dig into the underlying stories of these companies and their latest reports and offer some insights and takeaways for investors.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

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This video was recorded on July 30, 2019.

Chris Hill: It's Tuesday, July 30th. Welcome to MarketFoolery! I'm Chris Hill. Joining me in studio, first time in a long time, it's the chief investment officer of MFAM Funds, Mr. Bryan Hinmon. Thanks for being here!

Bryan Hinmon: Chris, it is great to see you!

Hill: It's great to see you! It was great to see you yesterday on the streets of Alexandria! You were out for a walk with our colleague Charly Travers and I spotted you. I was like, "Oh, wow!"

Hinmon: Your lasso is strong!

Hill: [laughs] Hinmon tried to hide from me, but I've seen him, and now I have to get him in the studio! I'm glad you're here because we've got earnings news in consumer products, in housing, or maybe housing-adjacent businesses. 

We've got to start with Under Armour. I think the good news for second quarter results for Under Armour were this: they lost less money than was expected. I think that's the good news. Everything else in Under Armour's second quarter looked pretty bad. Sales came in a bit low. Maybe worst of all, and with the stock down about 13% this morning, I'm assuming this is the big driver of the drop, is that they lower guidance for the rest of the fiscal year in North America. They previously said, "We think it's going to be basically flat in North America in 2019." Now they're like, "No, actually, it's going to be worse."

Hinmon: Yeah, the performance in North America has not been good. Sales were down about 3% in the quarter. This is the fourth straight quarter of declines in North America, which is their largest and most important reporting segment. It's actually worse than that because Under Armour changed how they did segment reporting a couple of quarters ago, so this is probably nine straight quarters, roughly. But it wasn't just North America. You saw international, which has been the only bright spot for them, in Q4 sales were up about 25%, 28% in Q1. That growth rate halved to about 12% in Q2. You don't have North America working, you don't have international working. Look at direct-to-consumer, which is their own stores, store count was up 15% but sales were only up mid-single-digits, which means that people aren't coming into the store, and comps were down. 

In Kevin Plank's opening remarks, he said something to the effect of, "As we're in the middle of year three of our strategic transformation," and I think that captures what's going on here. Investors are incredibly frustrated. And being in year three of a transformation highlights how much was broken, and how much needed to be fixed. And we're just not there yet.

Hill: I think this would be maybe not better received from investors, but maybe it would be a little bit more understandable if Under Armour didn't make good stuff. They appear in general to make quality merchandise. You can point to a couple of examples here or there. NBA star Steph Curry is an Under Armour representative, and he came out with a new basketball shoe a year or two ago that got made fun of, maybe sales haven't been that good, that sort of thing. There are those examples. But in general, Under Armour makes really good stuff. So, what is the problem here when you look at their business? I remember when Nike's most recent results came out, and Nike was starting to do better in North America than they had been. There had been a while there were Under Armour shareholders like me could take a little bit of solace from the fact that Nike was struggling in North America, too. Well, most recent quarter, Nike's starting to turn that around. I remember seeing that and thinking, "Now I know exactly what to look for in Under Armour's next report: are they going to present a similar improvement in North America?" And overwhelmingly, the answer is no.

Hinmon: Under Armour does make good stuff. And they've actually doubled down on being a performance-driven company rather than appealing to everyday wear, where Nike and Adidas have been taking share and performing really well. My team and I have been saying for the past couple of years, there are two really big problems at Under Armour. One is, Kevin Plank is hard to work with. There's been an incredible amount of executive turnover. The second thing is, his focus is entirely on building the brand and building really high-quality goods, and not focused enough on actually being an adult in how he runs the business. It's just not a smoothly running, professional organization. Those two things, if you look at this quarter, you actually see a little bit of silver lining here. A couple of years ago, they brought in a guy named Patrik Frisk from Aldo Shoes to be the COO. He just passed his two-year anniversary. So, tongue in cheek, I'm going to celebrate that he has survived two years working with Kevin Plank. The good news is, Kevin Plank is actually starting to listen to him. Under Frisk's tenure now, they've reduced the number of SKUs by 40%. They've reduced the types of materials they make product with by 70%. And they've cut vendors by 30%. This has really started to help simplify operations so that they're not doing too many things poorly. They can focus their efforts in a narrower range. 

The other thing that you see Frisk really pounding on is inventory. Under Armour had suffered for years from basically poorly managing its own inventory and flooding the market, which hurts the brand and causes them to have to cut prices, kill gross margins, and flood the market. In Q1, you saw inventory decline by 24%. In Q2, you saw it decline by 26%. We saw gross margins actually increase in Q2. They were able to get some of the inventory out of the channel without slashing prices. You are starting to see signs that Frisk is having a meaningful impact on how the organization is actually run.

Hill: When you look at the stock down 13% this morning, if you think this is going to continue with Frisk, do you buy shares here? Or are there still too many red flags? I bought shares at a much higher price, so I'll just say, for my own sake, I'm not looking to add to a stock that's already down for me.

Hinmon: I think you need to see a little bit more of the good stuff coming out of how they're operating the business. If we continue to see inventory tick down and gross margins tick up, I do believe that the brand's strength here remains. Eventually, we will see this go from a company that is guiding for 3% sales growth this year back to something that is more attractive, which will flow through the financial model and start to get people's attention again.

Hill: Procter & Gamble is closing out its fiscal year in style. Fourth quarter profits and revenue came in higher than expected. P&G has also raised guidance for fiscal year 2020. The stock is up. The stock over the past year is up more than 40%.

Hinmon: En fuego!

Hill: [laughs] That is not what we typically expect from consumer products giants like P&G.

Hinmon: Yeah, this quarter and year was all about broad strength. All categories and all regions were up. The organic sales growth in Q4 of 7% was the best organic sales growth since 2007. Really strong, good all-around performance by Procter & Gamble. This is another company, we were joking about the three-year transformation at Under Armour, this company is going through a similar thing. In 2016, 2017 announced huge restructurings. They had started to get disrupted from all sides by start-up brands, and decided that they needed to focus their efforts on doing less. They were going to back their chosen strong brands and strong categories. You're really starting to see now the power of when a company focuses its resources on key areas. You can actually have a really strong impact. Procter & Gamble, really a great quarter. That 7% growth was split in a healthy way between volume, price, and mix. Really firing on all cylinders.

Hill: It's funny because I think back to when we started doing this podcast in January of 2011, Procter & Gamble was a consumer products giant then, it is now, and yet the business when we started back then was pretty different. I think about the changes that P&G has undergone. What you just talked about, for the last three years, it started in smaller ways a couple of years prior to that. For all of its success and all of its size, there used to be a lot more products. There was a whole food division that they had that they decided, "We have to get out of this business." And as you said, they've really focused on what they do best, which is stuff in the home. Home care, cleaning products, home care products. 

I did want to ask you, though. You talk about how P&G is under siege from different upstarts. One part of their business that the upstarts appear to, maybe haven't won outright, but they appear to be winning in a pretty big way, is shaving. Did they write down all of Gillette to the tune of $8 billion? I thought I saw that this morning. 

Hinmon: No, I don't think that's right. Grooming was actually up 4% for them. They have definitely been under fire from these start-ups like Harry's and Dollar Shave Club and that sort of thing. They have responded in kind. You can now sign up for a Gillette subscription service. They certainly got caught a little flat footed with a failure to innovate. But you can copy a business model. And they have done that. What Procter & Gamble is incredible at is product development and knowing their customers. That has not changed. They have stopped that bleeding. And as you see, there's growth now back in grooming that has not been there for a while. They had relied too long on simply raising prices and adding another blade. They're back to a steadier cadence of innovation with much more reasonable pricing. That hurt them for a while. But we're on the other side of that now. And they are competing more effectively. It's funny, you mentioned their business has changed a lot. They have 60% fewer brands. They really narrowed their focus to be able to back winners and market smartly. You own this company for very simple reasons. It should be pretty stable. It's a blue chip cash cow. We saw cash performance really strong -- this was their fourth quarter, so I'll say this year. And, they guided for really strong cash flow performance next year. They've resumed growing their dividend. In 2017, they only raised their dividend 1%. Fiscal 2018, 3%. Fiscal 2019 was 4%. Things seem to be back in order at P&G. 

Hill: We've talked before about a company like Pepsi, when they are negotiating with grocery chains across the country, around the world, and they have not just all of these beverages, but they have all of the Frito-Lay products. They're operating from a position of strength in terms of where their placement is on the shelf. Think about Procter & Gamble. When they're going to negotiate with grocery stores, how much shelf space they are commanding, it's pretty incredible. 

One of the biggest gainers on the New York Stock Exchange today is Trex Company. Shares of Trex are up 16% after second quarter results. This is the outdoor deck company, essentially. You tell me because this is a company you follow a lot more closely than I do, what is driving the stock today? Was the second quarter that much better than anyone thought it was going to be? Are they raising guidance?

Hinmon: You've got a couple of things at play here. First of all, there's about 15% short interest in shares of Trex. Many investors are using Trex as a way to bet against the housing cycle, to bet against the health of the consumer and spending on home projects. As you mentioned, Trex is a composite decking company. It's basically, you choose to build a deck, your choices are wood or Trex. They have no meaningful competition. Trex came out, earlier this year, they had launched some new products and actually had some supply problems, and they couldn't get enough product to market. Sales growth looks pretty muted right now, only 2% or 3% in the quarter. But they guided for 25% growth in Q3 and alluded to getting back to more normal growth rates for them over the next couple of years, which is low teens. The outlook they see for demand for what is now a pretty robust portfolio on the high, medium, and low levels of composite decking, they think that they are going to be able to accelerate market share. Stealing market share from wood, that's essentially the thesis here -- the composite holds up better, over the lifetime of the deck it is cheaper, and it's easier to maintain. They have painted a rosy picture. I think the shorts got caught betting against this company specifically, and a turn in consumer spending on the home. They got caught, and that's why you're seeing the pop here.

Hill: Shares are up as, I mentioned. It's closing it on $80 a share. You look over the past year, it's been as high as $90, it's been as low as $50. The chart looks a little bit like a roller coaster. If someone is looking at Trex for the first time and thinking about, "This seems like a trend I can get behind, and I want a few shares for the next five, 10 years," is that the kind of volatility investors should expect? Or are the past 12 months something of an outlier?

Hinmon: I would expect it. This is, generally speaking, a high-budget purchase item of a one-off nature. There is no subscription element here that's going to smooth things out. 

Hill: It's not Procter & Gamble, they're not selling laundry detergent.

Hinmon: No. This is not a fast-moving consumer good whatsoever. You're spending thousands of dollars to repair a deck. I would expect this volatility. However, this is a good business. The company notches 45% incremental gross margins, has really healthy profit margins, is cash flow generative, generates way more cash than they need, great returns on capital. The thesis here makes it seem as though there is a long runway for growth. You've got wood capturing 80% of the share. Trex claims to have a better mousetrap with no real clear No. 2. This is a good business. What you're ultimately betting on is that market share gain, and you're betting on the remodel nesting HGTV movement to continue. That spending really seems robust, even if housing continues to slow down. You saw numbers in Sherwin-Williams a week or two ago, paint sales continue to rise. There's volume there, but there's a lot of pricing there, too. People want to spend on making their homes better. Trex is a very pure way to express that thesis.

Hill: Quick shout out to longtime listener and one of our Motley Fool members Robert Rosen, who is visiting today from Scottsdale, Arizona. Thanks for hanging out with us, Robert! And, he brought SanTan beer from Arizona.

Hinmon: Alright!

Hill: [laughs] Making several of our colleagues very happy.

Hinmon: This is what your podcast has come to, visitors bringing beer? I should come back more often!

Hill: People don't have to bring anything. We love when people come to visit. But if they're bringing stuff with them, it's always appreciated! You're here from our Colorado office. I've only been to Colorado a couple of times and I've enjoyed it immensely. When I've been there. Give me a tip, give our listeners a tip -- if they're going to Colorado, something to do, something to experience. 

Hinmon: Generally speaking, driving, be careful.

Hill: A cautionary tip?

Hinmon: Well, the scenery is so beautiful in Colorado, it's easy to get distracted. As you're driving through the mountains, you will inevitably find yourself being a looky-loo and taking in the beauty and not paying attention to the road. So, yes, a cautionary tale. But on the flip side, two hours driving in D.C., you might move 12 miles; two hours driving in Denver gets you to heaven. It's well worth the undertaking, you just have to be a little disciplined.

Hill: I experienced something similar this past weekend. I was down in Asheville, North Carolina. Same sort of thing. The mountains are gorgeous. The roads are windy. There were a couple of times when I was driving I was like, "OK, I need to stop looking at the gorgeous mountains of Asheville, North Carolina." Although, I will say, for anyone going to Asheville, we talked a little bit about this, Asheville is a really fun city. I would recommend a Mexican restaurant that I visited called Mountain Madre in Asheville. Had a fantastic meal there. And, just outside of Asheville, in the town of Black Mountain, the Blue Ridge Biscuit Company for one of those breakfasts that will basically set you up so you really don't need to eat the rest of the day.

Hinmon: [laughs] Since we're talking biscuits, I'll throw out another Colorado tip -- The Denver Biscuit Company is known for its biscuits and breakfast sandwiches. They have an outstanding biscuit cinnamon roll.

Hill: Oh, nice! I always think of you as a very healthy eater. I'm surprised that you would indulge in that.

Hinmon: Oh, 90% of the time I'm healthy. 

Hill: [laughs] That other 10%...

Hinmon: The other 10%, get away from my cinnamon roll!

Hill: Bryan Hinmon, thanks for being here!

Hinmon: My pleasure!

Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of MarketFoolery! The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening! We'll see you tomorrow!

Bryan Hinmon, CFA is an employee of Motley Fool Asset Management, a separate, sister company of The Motley Fool, LLC. The views of Bryan Hinmon and Motley Fool Asset Management are not the views of The Motley Fool, LLC and should not be taken as such. Bryan Hinmon has no position in any of the stocks mentioned. Chris Hill owns shares of Under Armour (A Shares) and Under Armour (C Shares). The Motley Fool owns shares of and recommends Nike, Trex, Under Armour (A Shares), and Under Armour (C Shares). The Motley Fool is short shares of Procter & Gamble. The Motley Fool recommends Sherwin-Williams. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com