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Under Armour (NYSE:UA) has been one of the fastest growing retailers in the marketplace. Following the recent earnings announcement, revenue has again grown at +20% for the twelfth consecutive quarter. This impressive feat appears to be on track for repeat performance through the remaining quarters of 2013. Wall Street is well aware of the Under Armour growth story and shares currently trade at very lofty price multiples. Given the company's recently updated outlook for 2013, we have a better understanding of how management is forecasting the remaining three quarters.

Throughout this article I will highlight the current valuation of Under Armour's shares, model out estimates for the 2013 and 2014 income statement, and focus in on the gross margin problem which could spook investors into liquidating shares.

UA Chart

UA data by YCharts

Current Valuation

As the price chart above depicts, shares of UA had a rough start to the year hovering in the high $40 range and struggling to break above the $50 price level. This was a brief enough pullback in the stock to allow investors who were sitting on the sidelines to begin building a position. In the days leading up to the company's earnings release shares were bid up and price multiples ran up to their highest levels once again. As you can see in the two charts below, both the quarterly trailing twelve month price-to-sales (3.12x) and the trailing twelve month price-to-earnings (49x) are slightly below the historic highs.

(click to enlarge)(click to enlarge)

Source: Under Armour SEC Filings

Comparing the price-to-earnings ratio to Under Armour's competitors gives us an idea of how the stock trades versus peers. Nike (NYSE:NKE), although at a very different stage of corporate growth from Under Armour, is the best fit competitor. Shares of Nike trade at just under 24x TTM earnings. Similar competitors such as Columbia Sportswear (NASDAQ:COLM) and VF Corporation (NYSE:VFC), which owns the NorthFace Brand in addition to multiple other labels, trade at roughly 20x and 18x earnings, respectively. Although these companies may not capture the same consumer that Under Armour is striving for, they provide a good proxy for athletic retail competition. Another comparison would be the rapidly growing LuluLemon Althletica (NASDAQ:LULU). Shares trade at 40x TTM earnings and offer similar volatility to that of UA.

NKE PE Ratio TTM Chart

NKE PE Ratio TTM data by YCharts

My Thoughts on the Future

Management provided further clarity on the current year during the recent earnings call. The sentiment was quite optimistic and guidance was increased from levels given a few months prior. Below are some relevant points which management cited and I factor into my estimates:

  • Management raised its full year revenue of $2.21-$2.23 billion, representing 21-22% growth year over year. This is up from the prior estimate of $2.2-$2.21 billion; my estimate is slightly higher than management's new guidance
  • "We expect modest gross margin expansion from 2012", I estimate 8 basis points of gross margin improvement, from 47.92% to 48%
  • Management anticipates marketing expenses to remain flat as a percentage of revenues from 2012
  • Management anticipates modest operating margin expansion year over year, I estimate 25 basis points of operating margin improvement from 11.37% to 11.62%
  • Management anticipates operating income of $256-$258 million (up from $255-$257 million), my estimate lies at the midpoint of this range
  • An effective tax rate of 39% - 39.5%, I use 39.5% in my model
  • Diluted share count of 108-109 million, I use 109 million in my model

Please note that the estimates below are not guaranteeing any of the results will be met. These estimates are strictly based upon management's guidance, the company's SEC filings, press releases, and historical data.

2013

2014

Full Year Estimate

CS

YOY Growth

Full Year Estimate

CS

YOY Growth

Revenue

2,215,000,000

100.00%

20.71%

2,624,775,000

100.00%

18.50%

Cost of Revenue

1,151,800,000

52.00%

20.53%

1,362,258,225

51.90%

18.27%

Gross Profit

1,063,200,000

48.00%

20.91%

1,262,516,775

48.10%

18.75%

Selling, General and Admin Exp

806,000,000

36.39%

20.19%

952,793,325

36.30%

18.21%

Operating Income

257,200,000

11.61%

23.24%

309,723,450

11.80%

20.42%

Interest Expense

2,800,000

0.13%

45.98%

2,000,000

0.08%

28.5%

Other Income

1,000,000

0.05%

1469%

1,000,000

0.04%

0.00%

Pretax Income

255,400,000

11.53%

25.54%

308,723,450

11.76%

20.88%

Provision for income taxes

100,883,000

4.55%

35.12%

121,945,763

4.65%

20.88%

Net Income

154,517,000

6.98%

19.99%

186,777,687

7.12%

20.88%

Basic Shares Outstanding

107,000,000

109,000,000

Basic EPS

1.44

1.71

Diluted Shares Outstanding

109,000,000

110,000,000

Diluted EPS

1.42

1.70

Source: Under Armour SEC Filings, Under Armour Management Guidance, and my estimates based upon historical data and future expectations. Estimates given above are no guarantee of future results, please evaluate the company in greater detail before making investment decisions.

Gross Margin Concern

A common concern among analysts following this stock has been the rapid rate of revenue growth which has not been matched by inventory purchases. This brings up a number of questions; a few relevant ones investors should be asking are:

  • Is management worried about revenue slowing and therefore not stocking inventory?
  • Are suppliers not able to produce products fast enough or the quality standards Under Armour demands?
  • Is management trying to boost cash flow from operations and free cash flow?
  • What impact will this have on future gross margins?

While the first three questions are all legitimate concerns, I would focus on the last one regarding gross margins. Under Armour uses the FIFO method of accounting (first in first out). In a period of rising inventory costs, such as the period we are currently in, this will give the company the appearance of higher gross margins. However, when it comes time to purchase goods at current price levels, the company has two choices to make. First is to pass costs along to consumers. This is typically not a popular option, especially considering the disappointment from investors if this 20%+ growth spree comes to an abrupt end. The second and more likely option is to absorb the costs internally, thus resulting in a higher cost of goods sold and lower gross margins.

In the table below you can see that during 2011 quarter over quarter inventory growth was well above quarter over quarter revenue growth, a good sign for a company growing so rapidly (note that quarter over quarter is referring to the same quarter a year prior, not the previous quarter). Then, beginning in the second quarter of 2012, we began to see a trend developing of slower and even negative inventory growth. In the chart below the table, you see the same data plotted as a line graph. When the purple line (inventory growth rate) crosses over the red line (revenue growth rate) we begin to ask the questions above.

$ in ,000's

2011 Q1

Q2

Q3

Q4

2012 Q1

Q2

Q3

Q4

2013 Q1

Revenue

$312,699

$291,336

$465,523

$403,126

$384,389

$369,473

$575,196

$505,863

$471,608

QoQ Revenue Growth Rate

36.31%

42.26%

41.68%

33.86%

22.93%

26.82%

23.56%

25.49%

22.69%

Inventory

$248,614

$311,066

$318,888

$324,409

$324,354

$380,895

$312,158

$319,286

$323,509

QoQ Inventory Growth Rate

68.14%

73.63%

62.56%

50.64%

30.46%

22.45%

-2.11%

-1.58%

-0.26%

Source: Under Armour SEC Filings

(click to enlarge)

Source: Under Armour SEC Filings

Management has told investors to expect very robust inventory growth over revenue during the third and fourth quarter of this year. In my opinion this may be a very risky strategy by making major purchases all at once rather than spacing them out over time. Given the company's past history of inventory issues and getting products delivered on time (without incurring additional air freight costs), I would caution investors to watch this matter closely. If you work through the income statement above and slightly alter the "cost of revenue", dramatic changes will be made to bottom line numbers.

Conclusion

While I am a fan of the Under Armour brand and believe in the growth potential of this company, current valuations coupled with an uncertain back half of the year suggest patience is the best course of action. I would need to see either a pullback in share price or a major catalyst to change my rationale. While catalysts could come from various sources (further international expansion, greater acceptance of new shoes, or unanticipated new product launches, to name a few), given the high level of risk at current valuations, taking a position in the stock today while being hopeful of something materializing appears somewhat irrational.

Consider your investment goals and objectives before initiating a position in Under Armour and please remember that the value of investments in equity securities, like UA, will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Since I attempt to tailor my estimates above conservatively, any upside surprises would be beneficial, however, my investment position remains cautious.

Note: All data reported and graphed is pulled directly from Under Armour's SEC Filings, Press Releases and Investor Presentations.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Caution On Under Armour As Gross Margin Concern Grows