A Chink In Under Armour's Armor

| About: Under Armour, (UA)

As the athletes parade into the Olympic Stadium in East London to begin the 2012 Summer Olympics, investors will be hard pressed to see Under Armour, UA or any other brand sold by Under Armour, Inc. (NYSE:UA). The fast growing performance apparel and footwear producer is sitting out the Summer Olympics in favor of preparing for future world soccer events next year. The company recently landed an endorsement by the English soccer club Tottenham Hotspur and the boys make great models for Under Armour's selection of seasonal of athletic clothing.

Certainly that makes it timely to look at UA shares, but whether it is a buy or a short is not so certain.

Fast Growth, Strong Balance Sheet

CEO and founder Kevin Plank has delivered impressive growth, more than doubling revenue since 2007. What is more, the momentum has been building. Sales grew 38.4% in 2011 to reach $1.4 billion. This compares to 24.2% growth in 2010 and 18.1% growth in 2009. Alright the exceptionally warm weather in the 2011-2012 winter probably led to a slowdown in the early part of the year. Year-over-year growth in the first half of 2012 was a slower rate of 24.8%. Nonetheless, Under Armour reports continued strong sell-through to its network of worldwide distributors.

My favorite measure of business health - conversion of sales to cash - is not so impressive. Under Armour converted only $15.2 million of its 2011 sales to cash. However, the company has been investing heavily in inventory for new product lines. That usually bodes well for future top-line growth and cash flows.

Besides, Under Armour's balance sheet is strong enough to support a bit of risk taking by management. The last time Under Armour reported balances at the end of June 2012, the company had $142.9 million in the bank and just $73.9 million in debt. That means the debt-to-equity ratio was a meek 0.11 compared to the apparel industry that on averages runs as much as 0.42 debt-to-equity.

Much of that growth and balance sheet strength has been delivered by a unique line of apparel marketed for three seasons (cold, warm and all-season) and with three fit types (compression or tight-fit, athletic or close-fit and loose or relaxed-fit). Under Armour clothing is distinguished by its moisture-wicking fabrications that keep skin dry and at optimum temperature. The fabric selection was notable for a 100% synthetic composition. Under Armour even campaigned against cotton fabric.

That is until last year when Under Armour introduced under the brand name CHARGED COTTON in the first quarter 2011. Clothing in this line is made with natural cotton but Under Armour has applied some highly protected "textile know-how" that allows the fabric to perform like Under Armour's other synthetic products. They dry faster and wick away moisture from the body. The CHARGED COTTON fleece products have a unique, water-resistant finish.

Chink in Under Armour's Armor

As impressed as I am with Under Armour's move to cotton and the resulting boost to the top-line, it also leaves the company's profit line a bit more vulnerable to raw materials prices - specifically cotton - that may move with greater volatility than synthetic textiles. The precise portion of the product line that is now made from cotton is not disclosed, but the CHARGED COTTON line is expanding and sales are rising.

Last year cotton prices spiked to record levels but have since pulled back. The problem is those prices might not hold. To begin with planting intentions by U.S. cotton farmers were down 7% for the year 2012. Plantings are one thing, but harvesting is the key element. After a year of record drought conditions in the Southwest where most of the U.S. cotton crop is grown, there is great concern for the U.S. cotton crop. Crop yields are expected to be significantly lower than usual and abandonment rates are estimated to be near 35% compared to the average 20%. According to the National Council of Cotton Producers, the cotton crop in the rest of world is also expected to decline by 5% in 2012, with most of the reductions in China (-8%) and India (-5%). Depending upon China's willingness to continue dipping into its cotton reserves, overall supplies of cotton could decline and that could lead to higher prices.

There's the rub…

Thus just as Under Armour has adopted cotton, the company may be facing some new pressure on margins. Where profits go, often so go stock prices.

Yet in announcing second quarter 2012 results, management raised guidance for both sales and earnings in the rest of the year. Athletic shoe lines and new products aimed at women athletes as well as expansion of the CHARGED COTTON line are expect to drive sales in coming seasons.

So the question is which factor presents the stronger valuation driver: higher sales on fresh products or margin pressure from new exposure to volatile commodity prices.

A hint was provided by investor reaction to the second quarter 2012 earnings announcement and increased earnings guidance. UA shares set a new high on the news and at least one analyst upgraded the rating. There is nothing like a strong fan base to boost a stock even when the future holds potential for tough going.

However, this pushed the trailing price earnings multiple to 55.5 and the forward multiple to 35.0 times the consensus estimate of $1.18 per share for 2012. Analysts have projected growth near 22% over the next five years, suggesting those multiples are more than generous. So even if you conclude that cotton prices are of no significance in the greater scheme of things for Under Armour, the price stock has got to give pause to bull-case investors.

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.