Under Armour, Inc. (NYSE:UA) the Baltimore-based designer and marketer of sportswear and casual apparel made a gap up opening on July 24, 2014 by 8% to open at $65.51 in response to the Company's strong performance during the quarter.
The stock had been on the downtrend losing 25% from March 2014 to May 2014 on concerns of its declining volumes and profitability. Even a 2:1 stock split in April 2014 failed to revive investor sentiment, but now the positive results posted in Q2, 2014 appear to have renewed interest in the stock.
Nonetheless, based on performance over the last few days, the stock seems to be dropping down to more reasonable pricing levels, as the impact of Q2 earnings surprise begins to die.
This is why Under Armour rallied to create a gap up
The net revenue increased 34% to $420 million led by the international division and the footwear segment, each of which posted net revenue growth of 34% and 80% respectively. The company also expanded its product lines into golf, outdoor, running and women's studio segments.
The footwear segment saw the release of pinnacle football cleats, which showed higher sales during the second quarter.
Generally, investors welcomed the news of impressive revenue and operating income growth rate and responded by buying the stock. The expansion of the product offerings was also a positive move by the company as it seeks to augment its existing revenue streams.
Furthermore, Under Armour had experienced extended periods of decline between March and May, as fears over sustainable revenues and pressure on profits spread across investors. However, the improvement reported in top line in Q2 results erased a significant chunk of these concerns thereby creating a positive atmosphere for the stock.
This is why Under Armour could drop further to fill the gap
Under Armour wowed investors with its impressive Q2 performance in revenue and operating profit. However, earnings failed to hinge higher while margins declined.
The net profit remained flat at $17.5 million while the operating margin as well as the net profit margin declined to 5.7% and 2.9% from 7.1% and 3.9% respectively in 2013 which is a worrying trend.
This shows how much the massive increase in revenues influenced results in other performance measures. With margins declining, the company could have easily posted a decline in both operating profits and earnings, had revenues not soared so much.
Though cash balance increased to $300 million, the Company still posted a deficit in operating cash flows. Therefore, the additional $100 million debt played a huge role in boosting the company's cash flows, despite spending $30 million in capex during the quarter.
The company's working capital department is not doing any favors to cash flows either as the level of inventories increased massively compared to receivables for the six months ended June 2014. Inventories increased by close to $200M from six months ended Dec 2013, as compared to just $60M added on receivables.
On the other hand, accounts payables increased by 100% to $334M from $165M posted for six months ended Dec 2013. Now, this shows that operating cash flows will be under more pressure in the coming quarters unless the company enhances efficiency in its working capital operations.
Under Armor boosts guidance, but can it deliver on bottom line?
The company made an upward revision of its FY14 guidance on the back of growth in Q2 2014. The expected net revenue is now estimated at about $2.98 billion to $3 billion representing a 28%-29% growth over 2013. Nonetheless, the prospect for growth in profit margin remains a grey area as the tax rate is already slated to increase to 40% from ~38% last year.
The company is also facing competition from giant sports apparel players like Nike (NYSE:NKE) and Adidas (OTCQX:ADDYY). The Company's new ad campaign targeting female athletic wear has cost around $15 million. The women's wear segment is expected to contribute about 30% of revenues in the future.
This campaign is also likely to contribute a great deal of lowering operating margins. The opening of new stores in Brazil, Panama will add to the depreciation cost bringing down the operating margin further.
While the revenue outlook has been improving, the declining margins are still a major concern to investors. The stock is already trading at very high valuation multiples when compared to rivals Nike and Adidas.
Under Armour is currently trading at a P/E of 83x its trailing twelve months EPS of $0.77. This compares to Nike's 26x on $2.93 trailing 12-month EPS and Adidas' 17.65x on $2.20 EPS.
Now, considering that the company's earnings are under pressure from declining margins, Under Armour's valuation multiple could edge higher soon if the price fails to fall. This would make the stock look even more expensive when compared to peers, thereby increasing the possibility of a pullback.
Currently, the stock has already declined marginally following its recent rally. However, it still appears much overpriced compared to the industry average of 20x in P/E.
Under Armour closed on Wednesday, August 6 at about $68 per share, which coincidentally happens to be the consensus price target from leading analysts. This means that at current pricing, the stock's upside potential seems to be squeezing.
The company's current campaign will play a huge role in increasing revenue. However, as spending and tax liability soar, then profitability growth is likely to remain muted.
This is likely to affect investor sentiment and help lower the current valuation metric. For instance, Thomson Reuters' consensus forward P/E estimate for Under Armour has been lowered to 70x.
Therefore, it seems that the gap up opening which the stock made recently could be filled soon. For instance, based on Thomson Reuters' forward P/E of 70x and the consensus EPS of $0.94 for year 2014, Under Armour stock should be trading at about $65.80 per share. This further indicates that at $68, Under Armour could still fall further.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.