Under Armour (UA) has been one of the best performing stocks in our small cap fund in recent years. The stock rebounded strongly after a pullback earlier this year and is up 33% this year. Last year the stock was up 80%. The company has little debt and a solid balance sheet. It is still led by its charismatic 42-year-old founder Kevin Plank, a former college football player who began the company selling shirts out of his car in the late 1990’s. UA has pretty much everything you look for in a stock except one big thing: the valuation. The stock is trading at a whopping 76 times trailing earnings and 64 times 2014 earnings. So is it finally time to sell this high-flying momentum stock?
(Source: Telemet Orion)
Admittedly, I have little bit of an attachment to Under Armour. I first became a fan when I played football in high school. The old cotton t-shirts we would wear under our shoulder pads would bunch up and get soaked with sweat, making them uncomfortably heavy. Then Under Armour appeared with their close-fitting, sweat-wicking shirts that kept you dry and made you feel fast and light. Unlike older synthetic materials, Under Armour felt soft on the skin. Pretty soon everyone was wearing them. I only wish I had been savvy enough to buy the stock when it first went public the year after I graduated from high school in 2005. Since then the stock is up more than 10-fold.
The Growth Story
Now more than ten years later, Under Armour has gone from a niche apparel company to a major sports brand. They have the endorsement of Patriots quarterback Tom Brady and recently announced largest-ever college sponsorship deal with my own alma mater Notre Dame. In the recent Masters golf championship Under Armour-sponsored golfer Jordan Spieth came in second place, giving massive publicity to the company’s fast-growing golf apparel business.
The Under Armour brand is seen as being newer and more innovative and appeals to a younger audience than more established competitors like Nike (NKE) and Adidas (ADDYY). Athletic gear is increasingly incorporating technology and Under Armour is well positioned to take advantage of this theme. Under Armour has always prided itself on innovation. The company has a secretive lab in its headquarters where it tests new high-tech ideas. Last year the company acquired MapMyFitness a self-tracking and social networking app company with 20 million registered users. This allows UA to compete with Nike+ in the growing wearable/self-tracking technology space.
Under Armour’s growth strategy is fairly straightforward: continue to expand its sleek and innovative products into new sports and new markets, taking market share from the bigger players. When we first bought the stock, the company, which was known for its sweat-wicking t-shirts, faced a lot of skepticism that it could expand successfully into the crowded athletic footwear market. Last quarter, however, footwear revenue grew 41% to $114 million and made up about 13% of the company’s total revenue. CEO Plank says the company is just getting started in footwear and aims to eventually become a top three footwear company.
(Source: Under Armour website)
The popular new Speedform Apollo running shoe (above) has helped establish the company as a credible, high-quality shoe company. The growth of footwear has shown that Under Armour can move quickly and effectively into new markets. Glenn Silbert, vice president of global product, said at an analyst meeting, “We are on a mission to be the head-to-toe brand in baseball, softball, soccer, football … basically any participation sport that Under Armour can make a difference.” Aside from the traditional U.S. sports where Under Armour already has a presence, there are still lots of untapped areas like outdoor gear and outerwear where the company could expand.
Where Under Armour lags its bigger competitors is in international markets, which made up only 6% of revenue in 2013. The brand is only beginning to break into soccer and is conspicuously absent from the World Cup. Traditionally UA has been known primarily for American sports such as football and lacrosse. So how can UA grow into foreign markets where most people have still never heard of it? The company seems to be trying to follow in the footsteps of Nike which transformed itself from an American running shoe company into a global sports brand through partnerships with prominent players and top teams in Europe and across the world. More than 60% of Nike’s revenue now comes from abroad. Currently Under Armour’s visibility abroad is limited, but growing. The company sponsors Tottenham Hotspur in the English Premier League which is the 19th most popular soccer team. UA also sponsors soccer teams in Chile and Mexico and the Welsh national rugby team. Still, only two of the 800 or so World Cup players in this year’s tournament are wearing Under Armour cleats.
Though much of Under Armour’s domestic sales come through large chain stores like Dicks Sporting Goods and Hibbett Sports, in international markets the company is going mostly straight to consumers through its own “brand house” stores and websites. In China Under Armour opened 13 stores earlier this year and plans to add as many 50 by the end of the year. Stores in China are not as natural a fit as in U.S. though. CEO Plank said at an investor conference that the company’s Chinese stories are as much devoted to educating consumers about sports as selling products right now. At the Shanghai store opened in October visitors can watch a series of video “vignettes” where Michael Phelps demonstrates “the will of an athlete.” Stores opened in Mexico and Brazil earlier this year and will ramp up to the 2016 Summer Olympics in Rio. Plank says he aims to increase international sales to 12% of revenue by 2016. Every dollar of international growth, however, will require significantly more investment than U.S. growth since the company needs lots of expensive sponsorships and advertising to get their brand more visibility abroad. Because of this investment Under Armour is still losing money in its international operations. Nike’s expansion abroad too, was not always smooth as the company learned the hard way that American advertising does not always translate into foreign languages and cultures.
(Source: Under Armour website)
Its last quarter of earnings confirmed that UA’s growth story is continuing to play out very nicely, but the stock reaction also indicted that the market’s valuation of the company seems to be getting overheated. Under Armour has beaten earnings expectations almost every single quarter since 2009, though the market’s response has not always been positive. In the last reported quarter, the first quarter of 2014, which was reported on April 24, EPS came in at 6 cents compared to an average estimate of 4 cents. Revenue was up 36%, also handily beating the estimate. Apparel revenue grew 33% and footwear 41%, while total net income was up 73%. Gross margin increased by 100 basis points. The company announced guidance for revenue growth of 24-25% for the year and operating income growth of 25-26%. Both numbers were higher than previously expected. And still the stock fell 10%, an indication of the extremely high expectations the market now has for the stock.
(Source: Zacks Research Service)
Now that I’ve discussed the growth strategy and the recent results, I want to get back to the big question: valuation. Is Under Armour’s P/E of 75 times earnings justified? Nike (NKE) with impressive numbers albeit more normal growth levels, trades at a mere 26 times trailing earnings, while Adidas (ADDYY) trades at an even more modest 22.6 times. Surely, given the discussion above, Under Armour’s growth will continue to top that of its big competitors for several years as the brand breaks into new sports and new markets. But how long can it keep up this kind of growth? In order to get a better handle on whether the company is really overvalued I did a quick Discounted Cash Flow valuation to see what sort of assumptions you have to make to arrive at share price around $60 where UA has recently been trading.
I assumed a revenue growth rate of 27%, which is roughly the rate that analysts are expecting for 2015, to continue for the next ten years. This is a fairly aggressive assumption. Growth then levels out to 6.5% in perpetuity after ten years. I also used optimistic assumptions for cash flow from operations, smoothing out last year’s drop in cash flow. This model assumes that Under Armour will grow from last year’s $2.3 billion of revenue or 1.6% of the $140 billion athletic apparel market to $21.7 billion or 10% of the market in ten years. Nike for comparison has revenue of about $28 billion or about 12% of the overall apparel market now.
So the market is predicting that though Under Armour is still a largely domestic brand, it will maintain its current high growth rate for a decade and grow to be nearly as dominant as Nike is now in the global market in ten years. According to this scenario, UA is roughly fairly valued right now. So is there any upside? One scenario could be what some observers have argued, that the global athletic apparel market will grow significantly faster than the 4% I assume above. If this more optimistic growth of 8-9% happens than you can argue that after its ten years of rapid growth, in its mature stage UA will still level out to a growth rate closer the 8-9% rather than the 6.5% I assume, bringing its intrinsic value considerably higher than $60. This is not inconceivable because Nike, even in its mature stage, has this kind of growth.
But there is also plenty that could go wrong. If Under Armour’s international expansion stalls or if its brand falls out of fashion due to over-exposure in the U.S. or even if it faces a significant downturn in consumer spending as it did in 2009, the stock would pull back sharply. Looking back at Nike’s (NKE) growth in the 1990’s, the company also had explosive revenue growth, though it was not consistent. Though the company grew enormously, in 1994, 1999 and 2010 revenue declined. One bad year like that for Under Armour would hit the stock price hard. Nike, for example, reached a peak around $18 per share in February of 1997 and did not reach that point again until near the end of 2004 before it resumed its upward path. The market rose 40% over this period.
For another angle on the valuation we can look at comparable companies. In the retail/consumer discretionary area it’s hard to find anything closely comparable to UA. Companies like Lululemon (LULU) and Deckers (DECK), which I use in the table below, experienced Under Armour-like growth for a while but then pulled back to more reasonable levels. Even Michael Kors (KORS) which has been on a torrid run with growth close to UA’s, is valued at a multiple well under half that of UA. None of these companies are perfect comparisons for UA but still, as the table below shows, UA is trading at well over two times the average P/E, P/B, P/S and EV/EBITDA of these other retailers. The PEG ratio, moreover, is about 3 for trailing and 2.5 for forward earnings. Generally anything higher than 1.5 is expensive and 2 is very expensive.
Under Armour is a great company with huge potential, but a worryingly expensive valuation. After a lot of research, I have decided to sell half of our fund’s position in the stock to lock in some of the large gain we have now while also continuing to have exposure to the stock as it expands into international markets.