Can Under Armour Protect Its House?

| About: Under Armour, (UAA)

Since shares of Under Armour, Inc. (NYSE:UA) bottomed on August 19, the stock is up 55.1% versus the S&P 500 performance of 10.8%. Closing Friday at $81.86, and trading at 34.9x 2012 estimates and 27.7x 2013 estimates, it is clear that the investing community is pricing in significant growth into UA's future. The optimism, in buying through the August lows, was validated on the back of the company raising the 2011 outlook nominally in the October 25, 2011 earnings release, highlighting what will be (assuming numbers are hit) a very strong year for UA on the growth side (42%-44% operating income growth year-over-year). UA has been a great stock in 2011, up a shade under 50.0%. But headed into 2012, it is time to short UA, with the stock reasonably valued based upon balanced expectations at $50.00 per share.

The reasons to short UA are:

  • Inventory is not turning over quickly. The LTM Inventory Turnover Ratio of 4.3x, as compared to 4.9x at year-end 2010 and 5.8x at year-end 2009 highlights that the company is not selling stuff quickly enough. The 4.3x is similar to what the ratio looked like in 2007 and 2008, when the economy begun to plunge into recession, and net income fell year over year (falling from $52.6 mm for the full-year 2007 to $38.2 mm for the full-year 2008). Without being too draconian, the inventory turnover problem could be a sign of falling margins (to clear it out) and potentially, less growth in 2012 (which would be an issue considering the growth being priced into the current multiple). As a comparison, peers Nike, Inc. (NYSE:NKE) and Lululemon Athletica Inc. (NASDAQ:LULU) have ratios of over 8.0x and 10.0x, respectively.
  • The lack of inventory turnover has been tough on the company's cash flow situation. Over the past three quarters, UA has generated negative FCF of $57.8 mm (3Q), $17.2 mm (2Q) and $96.3 mm (1Q). For a growth company that is not in a particularly capital intensive business (they don't build plants, drill for oil or build buildings), negative FCF is not encouraging (as the FCF yield as an investment metric is not supportive of a high valuation).
  • What is in the SG&A? Assuming that margins hold generally constant for the year-end 2011, UA will have gross margin of in the 47.5%-50.0% context, and an operating margin of around 10.0%. SG&A is a huge expense for this company, and I am not sure what is in there. Compare UA to NKE. SG&A is 11.0%-13.0% of NKE's revenue, versus 35.0%-40.0% for UA (and around 30.0% for LULU, if you want a smaller peer). Consistent with the inventory turnover situation, it would appear at first glance that SG&A is not particularly well contained either. What I am getting at: this company does not appear to be managed particularly well from a cost perspective, which is troublesome for a stock trading at 34.9x next year's estimates.
  • The growth embedded into the estimates, and thus, the valuation, is totally arbitrary, as the track record of growth is not clean (look at the consistent net income from a LULU over the past several years with consistent growth, whereas UA has had fits and starts). UA did not grow through the 2008 cycle. While the company has done well in 2011, the market is ahead of itself on valuation.

I am not going to call out the consensus and will use the $124.4 mm of net income as the baseline for valuation (I can't, as my numbers are as arbitrary as the sell-side analysts). Assigning a multiple of 20x 2012 is appropriate (arriving at a PEG of 0.75), to reflect the upside growth potential associated with the UA brand (which does really exist, as the market is big and their share is small so there is room to growl, especially considering the focus on only the US and any expansion globally will be accretive), balanced against execution risk, operations management and some looming financial concerns. Under that scenario, the stock is worth a few bucks under $50.00 per share.

The risk here is obviously inventory conversion in the 4Q and a strong 2012 outlook (although at 34.9x, the market appears to be pricing in a strong 2012 outlook). Another way to express a bearish view with significantly less risk (or other melt-up scenarios around stocks in general) could be a bear call spread, using July 2012 options (sell the $82.50 calls, buy the $95.00 calls, which allows for a $4.40 pick up as of the close on 12/1). Regardless, I see UA having a tough time protecting their house next year.

Disclosure: I am long NKE.

Additional disclosure: I may initiate a short position in UA over the next 72 hours.