Under Armour: Plenty To Like In Earnings

| About: Under Armour, (UA)

Summary

Under Armour's reputation for innovation has created a strong revenue growth and profitability.

The company's stock declined after Q2 earnings, in spite of a solid result.

Under Armour represents a high-risk, high return proposition to investors and is one with which I'm happy to go along for the ride.

Under Armour (NYSE:UA) reported fairly strong growth in its latest Q2 earnings report. Revenue increased by over 20% again for the 25th consecutive quarter. In fact, the company clocked in with revenue that grew 28% year-on-year. In this current environment of tepid growth that's on display by many large companies, this represents something of a breath of fresh air.

Key highlights of the quarter were that apparel, Under Armour's largest segment with $600M in revenues, grew by 19% year-on-year. Footwear, which brought in $240M in revenues, grew 58% year-on-year.

Nevertheless, in spite of such rapid top line growth, it appears clear that investors weren't impressed with the results. The shares of UA were being marked down close to 8% after earnings were reported.

The biggest reason for this aggressive markdown appears to be the missed expectations around profitability for the quarter. Under Armour reported a small operating profit of $6M. On first blush, such a small operating profit on over $1B of revenue seems to suggest a business that has little focus on operational efficiency and profitability.

Under Armour was blighted by the liquidation of the Sports Authority in the last quarter's results, which resulted in $23M impairment for the business. However, that alone doesn't explain or justify the poor level of profitability. The high level of sales and marketing expense is really the prime culprit, given healthy gross margins of 48%.

I think what's missed from that discussion is the fact that Under Armour still remains a rather niche brand with limited brand recognition. The business is focused on trying to achieve a much bigger piece of a rapidly growing market. Under Armour's strategy of entering the market with a reputation for premium performance has given it a unique niche in the fitness and apparel market amongst fitness-oriented consumers.

Nonetheless, the business's ~$4B in sales pales in comparison to Nike's (NYSE:NKE) $30B in revenues, a reflection of Nike's longevity and broad-based appeal. However, this emphasis on performance apparel has helped Under Armour generate significant endorsement from an emerging crop of athletes.

In order to grow brand awareness, Under Armour has to continue with marketing investments. In my view, this is money well spent at this phase of Under Armour's growth as customer acquisition will lead to a sustained revenue stream of clothing, footwear and accessory sales that will pay back many times over.

This is particularly so if Under Armour is successful at migrating customers to digital platforms. That return on investment will be magnified through the provision of targeted analytics and personalized apparel recommendations that will create a virtuous cycle of product purchase, analytics and feedback and product upsell.

All of a sudden, the high levels of marketing spend to acquire customers will generate meaningful return on investment. What was also significant in Under Armour's earnings announcement was the discussion of the partnership with Kohl's (NYSE:KSS).

Such partnerships will meaningfully expand UA's distribution strategy and take the brand from one that is more popular with fitness-oriented consumers to a more mainstream brand. Such moves will play a meaningful part in the company's next phase of growth.

In my view, Under Armour's strategy is playing out exactly as it should be. High growth in a smaller niche market of high-performance consumer athletes is being steadily expanded to a more mainstream market to build brand presence and brand awareness. This is being coupled with a connected technology platform which will enhance customer targeting, upsell and personalize recommendations.

When you overlay the likely explosion in fitness-related activities that will happen in emerging markets like China, as consumer's disposable income increases and consumers start to engage in leisure and fitness activities, that makes Under Armour all the more attractive.

The biggest point of pause with the Under Armour story in my view is valuation. Current valuation metrics likely suggest that this is a business that's overpriced.

I do believe, however, that this is a company that can likely quadruple revenue and significantly improve its earnings profile over the next decade. This should make it a stock that has multi bagger growth potential.

Make no mistake though, there remains significant risk in the Under Armour story. As the business expands from a targeted niche with a willingness to pay for performance, to discount retailers such as Kohl's, there is a risk of brand dilution and margin compression as channel discounts are given and the sales mix alters. However, other growth brands have successfully navigated this challenge and there is no reason to think that Under Armour won't be able to do so.

The connected platform story really has significant potential. Providing users with analytics on their performance, getting insights on their goals, and providing them apparel and footwear that best meets these goals is a marketer's dream. However, doing all this in a way that doesn't alienate the user with spam provides significant execution challenges. Over the medium term, these connected technology platforms should significantly decrease Under Armour's sales and marketing cost as well as drive incremental revenue if the company is successful at leveraging this channel.

Under Armour isn't a stock for the faint of heart. Those that have the conviction to stick along for the ride will be well rewarded in the long term, I believe. There are relatively few businesses that I see in the market that have the risk-return profile of this business.

At this stage, I am happy to remain along for the ride and will continue to hold Under Armour in my Project $1M Portfolio. I will look to selectively add at price points in the low to mid $30s.

Disclosure: I am/we are long UA, NKE.

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.