Threats to Under Armour’s Business Worrisome

Under Armour’s (UA) success over the past ten years has been impressive, yet serious threats to the company’s growth should concern investors. Investors are strongly discounting the fierce competition in the sports apparel industry that has the potential to seriously hinder the continued success of Under Armour. Since the company’s founding in 1996 by Kevin Plank, a former University of Maryland football player, the company’s sweat-wicking performance apparel has propelled Under Armour to the top of the industry.

As the first company to develop this widely popular and innovative product, it has allowed Under Armour to gain a strong following of satisfied and dedicated customers. Thus far, the company has remained dedicated to producing high-quality products that are focused on performance. For the past few years as the economy was expanding, this business model remained successful; however, as consumer confidence has plummeted, and as aggregate discretionary income has drastically depreciated, this model will be tested. 

Dependency on Innovation

Under Armour’s success thus far has been dependent on the company’s ability to innovate new products and they have relied upon the success of their current product. As the product has become more successful, they have caught the attention of the major competitors like Nike (NKE) and Adidas (ADDDY.PK).

However, Under Armour has no patents on its technology to prevent these competitors from reproducing similar products. Nike has done just this and has launched a line of sweat-wicking products, called Dri-Fit, that use the exact same technology Kevin Plank developed over ten years ago. 

The marketing strategy of Under Armour should also face intense scrutiny, as the companies offers an extremely wide-range of products, yet only focuses on their football apparel for male athletes. Their product offerings target a very large market and have the ability to appeal to a much larger target market. Under Armour produces products for a wide range of products - everything from hunting to volleyball – yet these products are widely undiscovered. 

On the other hand, the ability of the company to create quality products that draw the athletes’ attention remains strong. The company has diversified its product line with their entrance into the footwear segment two years ago. Similar to how the company moved quickly into the sports apparel industry, Under Armour quickly gained market share, and currently has an estimated 20% share of the football cleats market. After their success with baseball cleats, the company has since released baseball and softball cleats, and is currently developing sneakers and training shoes. These products have the potential to extremely successful, but they also face an immensely entrenched competition. 

Financial Stability

The competition has a much larger cash flow and short term assets to be used for capital expenditures and other investing activity. To put the size of Under Armour and its largest competition, Nike, in perspective, we can compare their cash flow statements (click to enlarge image):

Nike is able to fund over 10 times the amount of capital expenditures per quarter as Under Armour is able to. Nike’s net cash flow is negative from the company’s stock buyback program along their large negative cash flows from investing activities. However, both companies are well capitalized with sufficient short term assets to meet current liabilities; Nike has an acid-test ratio of 1.75, while Under Armour has a ratio of 1.52. Moreover, the debt-to-equity ratio of Nike is 0.082, compared to Under Armour’s 0.117. Also, Under Armour still is not producing a positive free cash flow, which should be worrisome to investors; in the second quarter of 2008 Under Armour reported a free cash flow of -$42.2 million. 

With the current condition of credit markets, and the possibility of further instability, Under Armour may have trouble financing further research and development. I see no reason for the company to reduce their capital expenditures, but it is unlikely that the company will be able to continue to grow year-over-year capital expenditures by over 125% as seen in 2007. If capital expenditures continue to sharply grow, the company could quickly move away from its well capitalized position in the market. 

Valuation

The serious risks to Under Armour’s business model are heavily discounted by the market and are reflected in the stock’s high valuation. Under Armour is trading at a twelve-month trailing P/E ratio of 27.5, and the forward P/E based on the estimated earnings for fiscal-year 2009 is 19.5. The stock is also trading at 3.7 times book value and 4.5 times tangible book value. Furthermore, the price divided by the net current asset value per share (NCAVPS) is 5.9. 

The company is expected to have strong growth over the next 5 years, and these expectations are currently priced into the stock as shown by these high valuation metrics. During a time where the aggregate market is receiving a large discount, Under Armour’s relative valuation is elevated; the relative P/E ratio of Under Armour versus the S&P 500 is 1.3.

The growth prospects of Under Armour remain strong as the opportunities available to the relatively small company are nearly endless; however, serious risks to Under Armour’s business threaten these growth prospects, and investors should remain cautious at these high valuations. 

Disclosure: none

Comments

[John316:]

If you believe the growth projections, how does a peg of 1.05 reflect a stock that is over valued? Cleats and cross trainers are growing...credibility and following is growing...foorwear line is growing...hedge fund selling is slowing....I think you got this one wrong and as growth materializes and inventories are managed well the market will reward UA with a peg closer to 1.5 than 1.05....

2008 Nov 11 08:59 AM

[Digdug:]

I have to go with Andrew on this one. I think you have nailed the financials, but you are evading the trend and "causal" data.

According to the trade pubs, UA is gearing up to launch a series of 6 performance running shoes. The set-up and R&D associated with such an entry are profound, but given the apparent success of the XT launch this past May, and the fact that the Athletic Specialty channel has now bought into the running launch in a big way (Jan. 2009), I think they will "blow it up" with Q2 & Q3 earnings.

The final piece is that UA is the only company that has cracked the desire code like Nike. Having spent 20 years on athletic storefronts, I have watched kids beg, borrow, and steal to get the gear they want, and not the '91 - '93 recession, nor the dip in '01 - '02 impaired that. Other companies may have a tough go, but I see Nike and UA weathering this storm.

P.S. I put my money where my mouth is and recently picked up 200 shares of UA.

2008 Nov 11 09:17 AM

[Fam62c:]

Times are tough for any consumer discretionary item there's no doubt about that but UA has one very good thing going for it: It's brand name. I see people wearing their stuff all over the place and it's not always athletic looking people if you know what I mean. Consumers can be fickle and brands go in and out of style but I think that UA has done a great job in creating a very well known, visible brand in a very short time. Brand names mean everything in retail because they give you market share and pricing power. The athletic apparel space isn't as crowded as some less specialized retail areas and UA has a good foothold. I looked at this stock a couple of years ago and passed because of the sky-high valuation but I'm buying a little at a time now and hoping that in a severe recession the price will really drop so I can get some more.

I have to believe that brand value will make UA a winner in a strong economy and they are still a relatively small company so they have good growth potential. I also think there's a chance that somebody, like a private equity firm, could make a run at UA when and if the economy starts to improve and the post-recession M&A frenzy starts.

2008 Nov 13 10:35 AM