When markets are going up, investors are only concerned with capital appreciation. When markets are sluggish or headed lower, the theory is capital preservation. As a writer, I look for both long and short opportunities in the market. Since I do write a fair amount about the consumer goods sector, I like to analyze different names over time.
Today, my focus is on Under Armour (UA), the athletic apparel maker. After analyzing the company, especially when compared to some other names in the space, I have come to the conclusion that the stock is a bit overvalued at these levels, and may even be a short opportunity. Here's why.
A few weeks ago, the company reported its fiscal first quarter results. Overall, the company had revenues of more than $384 million, up 23% year over year, and that beat estimates by about $4 million. Earnings per share rose from $0.23 to $0.28, beating by four cents. The company announced it expects 2012 revenues of $1.78 to $1.80 billion. Currently, analysts are expecting $1.82 billion. The revenue guidance was a slight uptick, as they had previously forecasted to the low end of a 20% to 25% range. They are now expecting 21% to 22%, but still, that is below current estimates.
On the face of it, the quarter appeared good. However, there were some red flags. The company's cost of goods sold for Q1 rose nearly 24.8% from the prior year period, which was faster than the 22.93% rise in revenues. That caused gross margins to decline from 46.39% to 45.58%. That was the second straight year of Q1 gross margin declines, from 46.92% in 2010. Selling and general expenses were only up 21.7%, but it wasn't enough to offset the decline from gross margins. Operating margins declined from 6.76% to 6.35%, quite a bit of a decline. The company did see a decline in their effective tax rate, which helped to offset some other expenses. However, net profit margins still declined year over year, from 3.88% to 3.81%. All three primary margins declined, which is not a good sign.
Another red flag was the statement that the company only saw marketing expenses of 11.5% of net revenues, compared to 13.3% of net revenues in the prior year period. Why is that negative? Well, the company said that they decided to shift some marketing expenses to subsequent quarters. So they reduced marketing expenses in Q1, still saw all three margins decline year over year, and will have more marketing expenses in future quarters. That doesn't sound good.
When it comes to margins, it does help to look at some other names. I'll focus on Nike (NKE) and Lululemon (LULU) for comparisons. While they aren't 100% true competitors, they do compete in some respects. Here are the trailing twelve month margins for all three.
Under Armour has higher gross margins than Nike, but still ends up with lower operating and profit margins. They have just too many selling and general costs, which were just under 40% of net revenues in Q1. While Lululemon has gross and net profit margins about 12% higher than Under Armour, the net profit margins for LULU are nearly three times that of Under Armour. Again, they are slightly different business, but Under Armour is a very low margin business. Any slowdown in revenues or small uptick in costs, like those marketing costs coming down the road, could have a huge impact on profit margins.
We should also look at future growth potential. The following table shows revenue and earnings growth based on current analyst estimates for this fiscal year and next. Under Armour uses a calendar year, so these numbers are for 2012 and 2013. Nike's current fiscal year ends this May, and Lululemon's current fiscal year ends in January 2013. The fiscal years are slightly off when compared to Nike, but the real comparison is with Lululemon. I've also included the price to earnings multiple for each, based on this and next year's currently expected earnings per share.
|Current Year Revenue||23.40%||15.70%||34.80%|
|Next Year Revenue||20.90%||9.70%||24.00%|
|Current Year EPS||28.11%||12.30%||29.37%|
|Next Year EPS||27.00%||17.44%||27.61%|
|Current Year P/E||40.01||21.96||45.12|
|Next Year P/E||31.50||18.70||35.36|
This is part of the reason why I feel Under Armour is overvalued. When Under Armour is compared to Nike, it costs you nearly twice as much on this year's numbers, and the revenue growth isn't twice as much. Nike also pays a dividend. The real comparison comes against Lululemon. Under Armour is projected for a bit less growth, although Lululemon does trade for a slight premium. However, if you remember the margin table from above, I think Lululemon deserves a bit more of a premium.
Thus, I would say that Under Armour is fairly valued at a current year P/E of about 35 to 37, which is an approximate range of $83 to $88. With shares currently around $95, I think the price is a little high. I wouldn't be a buyer here. The average analyst price target is $100 currently, so even the analysts don't see much upside. Also, the number of "Buy" ratings on the name has dropped from 10 to 8 over the past month, with "Hold" ratings increasing from 14 to 18.
Another thing that concerns me a little is their balance sheet. Now, remember, Under Armour's business is a bit seasonal, and they generate a large portion of revenues in the second half of the year. They sell a ton of cold gear for the winter, and we did have a very mild winter. Look at the impact that had on Deckers Outdoor (DECK). Deckers had very sluggish sales and a high amount of inventory, which has forced them to put some items on the clearance rack, negatively affecting margins.
What would happen if we get too hot of a summer this year? Yes, Under Armour has a bit of "cool gear" aimed at summer sports, but there comes a point when guys will just go shirtless. Remember, this is a discretionary item to begin with, and with an economy that isn't in the greatest shape, this is an item that a family could sacrifice if money is tight.
Under Armour's inventory grew 30% over the prior year period. That might seem like a lot, but it actually was the lowest year over year increase in six quarters. However, revenues only rose 22.9%. In fact, over the last seven quarters, Under Armour's inventory has shown a larger year over year increase than the revenue increase. Over the last two years, revenues are up almost 68%, but inventory levels are up more than 119%. Obviously, you can't sell what you don't have, but do they possibly have too much inventory?
The amount of inventory, as a percentage of current assets on the balance sheet, is 46.73%. That is up from 44.55% in the prior year period. Under Armour noted in their 10-Q filing that cotton prices were up a bit and that the company expects them to remain elevated. That might be part of the increased inventory balance, but that will transfer to cost of goods sold on the income statement, which could pressure gross margins.
Overall, their balance sheet is fairly healthy. At the end of Q1, the company's current ratio was 3.8. That is good, although Lululemon's was closer to 4.0. Under Armour had a debt ratio (liabilities to assets) of about 26.75%, while Lululemon's was a little over 18%. Also, Under Armour's current ratio was at its lowest Q1 ending point since 2009, and their debt ratio was at its highest point since then. The debt ratio increased 267 basis points from last year's Q1 end. It is not troubling at the moment, but if it continue to rise, there may be an issue. The company took out a loan to acquire a new headquarters, which has increased interest expenses.
Overall, Under Armour's stock is a bit expensive at these levels. The Q1 numbers had a few red flags, including decreases in all three margin categories. Cotton prices are expected to remain high, pressuring gross margins, and Under Armour has told us marketing costs will be higher in the next few quarters. Inventory levels are a little elevated. Their balance sheet is in good shape, but has weakened, and isn't as strong as that of Lululemon. Lululemon also boasts higher margins and is growing a bit faster, which means Lululemon deserves to trade at a bit of a premium. The premium isn't tremendous currently, and I tend to think that Under Armour is more overvalued now than Lululemon is undervalued.
I feel that Under Armour is worth about $85 now, not the $95 it currently fetches. I'm not pitching a total short like I was with Deckers (from $90 to $50), but I think there is some room to the downside for Under Armour. If shares get closer to $100, it becomes even more of a short candidate.