On Monday, the SEC announced settled charges against Under Armour, Inc., a manufacturer of sports apparel, for misleading investors by failing to disclose material information about its “revenue management practices.” According to the Order, Under Armour had established a reputation for consistent revenue growth that exceeded analysts’ consensus estimates. But when internal forecasts began to indicate that it would miss those estimates, the company sought to close the gap by accelerating—“pulling forward”—existing orders that had been scheduled by customers for future quarters. Although this practice continued for six quarters, the SEC charged, the company failed to disclose this pull-forward practice as a driver of its revenue growth nor did it disclose the “known uncertainty” that this practice created with regard to revenues in future quarters. It’s worth noting that the SEC’s charges related solely to disclosure failures; the Order expressly indicated that the SEC did “not make any findings that revenue from these sales was not recorded in accordance with [GAAP].” Under Armour agreed to pay $9 million to settle the action.
According to the Order, for 26 consecutive quarters, Under Armour had reported year-over-year revenue growth in excess of 20%. But the chances of maintaining that record started to look dicey in mid-2015, when the company determined that, as a result of warmer weather and other factors, revenue growth would not be as strong as anticipated. Beginning in the third quarter of 2015, the company’s internal revenue projections did not meet analysts’ estimates, and management sought to close the gap by identifying “existing orders that customers had requested be shipped in the next quarter that could instead be shipped in the current quarter.” From the third quarter of 2015 through the fourth quarter of 2016, the company’s internal projections showed that it would continue to miss analysts’ revenue estimates, leading the company to pull forward an aggregate of approximately $408 million in orders to help it meet those estimates. The amounts pulled forward began with $45 million in Q3 of 2015 and ended with $172 million in Q4 of 2016, as each quarter drew from sales scheduled for the next quarter. As one executive explained in an email, “Let’s see how of [sic] this goes and if we can get enough pull-forwards or extra business to close the Q1 gap. The issue is that we pulled forward a lot in Q4 and there is not as much room in Q2 but we will see.” In the absence of these pulled-forward sales, the company would not only have missed analysts’ revenue estimates for those quarters, but would also have failed to continue its historic year-over-year revenue growth rate of 20% in some quarters.
Although at one point, the revenues pulled forward accounted for as much as 13% of total quarterly revenue, the SEC alleged, nevertheless, the company did not disclose its reliance on pulled-forward revenue. Instead, the company continued to highlight “its streak of quarters with 20%-plus revenue growth,” attributing the revenue growth “primarily to innovative new product offerings, ‘a growing interest in performance products and the strength of the Under Armour brand in the marketplace,’ and increased sales in footwear and apparel,” or “‘growth in men’s training, women’s training, golf and team sports,’ ‘strong growth in running and basketball,’ ‘growing interest in performance products and the strength of the Under Armour brand in the marketplace,’ and increased sales in footwear and apparel,” and so on.
To persuade customers to comply with its requests, the company periodically used sales incentives, such as extended payment terms and discounts. An example cited in the Order highlights the problem: “in September 2016, Under Armour requested additional pull forwards from a key customer, after already having asked to move more than $30 million in sales from the fourth quarter of 2016 to the third quarter of 2016. The customer responded by saying: ‘We just brought a bunch of your goods in early to help out your quarter. . . Now you want more. . . More..More..more..30% [price discount] please.’ Under Armour ultimately agreed to a 25% price discount and an extra 30 days to pay to secure an additional $6.7 million of pull forwards.”
By the fourth quarter of 2016, it became clear that, even with $172 million of revenues pulled forward that quarter, the company would not be able to meet analysts’ revenue estimates for the quarter or its own annual guidance. At an executive meeting in December 2016, one “senior executive stated that the company had ‘been living in this bubble for a while,’ that pulling forward revenue in each quarter was not healthy, and that the company was ‘not going to compromise 2017 . . . we’re not going to take from next year.’” Following internal discussions, the company decided to forego pulling forward more revenue (beyond the $172 million) for the quarter, even though that meant that the company would announce year-over-year revenue growth for Q4 of only 12%, which was not only below analysts’ estimates but also broke its long streak of reporting year-over-year revenue growth of over 20%. The announcement did not disclose anything about the revenue that was pulled forward, but rather emphasized that the company’s “growth story” was still “intact” and that its brand was “truly stronger than it’s ever been.” On the day of the announcement, the company’s stock price dropped by approximately 23%.
According to the Order, the company’s “reliance on pull forwards to meet financial targets was compromising the company’s future revenue and revenue growth rate. When Under Armour convinced customers to accept shipment of product earlier than forecasted, Under Armour could record the sale as occurring in the earlier quarter but, all things being equal, would lose that particular sale in the later quarter when it had been originally scheduled.” That is, the sale was made and recorded under GAAP in the earlier quarter, but the effect was to create often increasing revenue “deficits” in the subsequent quarter: “Under Armour had to replace the sales it had previously taken from 2016 through additional customer demand and new products, but also demonstrate the same percentage revenue growth when compared to the 2015 revenue totals (which in turn had been enhanced with pull forwards). In internal emails, Under Armour acknowledged this ‘double impact on the growth rate’ resulting from pull forwards because they ‘take the base up’ in the earlier year and down in the later year.”
The Order concluded that the company “knew or should have known that its use of pull forwards concealed its failure to meet analysts’ revenue estimates,” was reasonably likely to have a “material negative impact on future revenue,” and that its reported results “were not indicative of its future financial results.” By failing to disclose the use of pull forwards—which senior management “implicitly admitted” was unsustainable, as well as “bad,” “unnatural” and “unhealthy”— the company materially misled investors, the SEC charged. According to the Order, the company’s use of pull forwards created a known material uncertainty about future revenues, which was not disclosed. In addition, the company’s “failure to attribute growth in revenue to the use of pull forwards did not provide investors with material information about its revenue necessary for an understanding of its results of operations.”
The SEC found that the company (which had sold securities to employees under employee plans during the period) had violated the antifraud provisions of Section 17(a)(2) and (3) of the Securities Act, which prohibit misleading statements in connection with offers and sales of securities. In addition, the SEC found violations of Section 13(a) of the Exchange Act and related Rules 13a-1, 13a-11, and 13a-13, which require reporting companies to file with the SEC complete and accurate annual, current and quarterly reports, as well as Rule 12b-20, which prohibits materially misleading omissions in filed statements or reports. In particular, the SEC found that the company’s failure to disclose the use of pull forwards and the resulting uncertainty regarding future revenues violated Item 303 of Reg S-K (MD&A), which requires reporting in Form 10-K of “any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations,” as well as “any other significant components of revenues or expenses that, in the registrant’s judgment, should be described in order to understand the registrant’s results of operations.” Instruction 3 requires that the “discussion and analysis shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.” Item 303(b) includes similar requirements regarding material uncertainties in Form 10-Q.