Under Armour: Great Business, But Still A Challenging Valuation

| About: Under Armour, (UAA)
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Under Armour has demonstrated an exceptional business and investment history.

The growth story is expected to continue with the company.

However, for the long-term owner, the current valuation could indicate that investment performance is apt to materially trail business performance.

In September 2015 I highlighted the idea that Under Armour (NYSE:UA) had a great goal - increasing revenue to $7.5 billion by 2018 - but the valuation was still a drag. From 2006 to 2014 Under Armour's net profits went from under $40 million to over $200 million - representing exceedingly impressive overall growth. During this time the share count increased a bit, thus earnings per share increased by a bit less, but this still represents outstanding growth.

Under Armour hasn't yet had a problem with growth - the business is doing quite well. And to be sure, the company is still expected to march along quite quickly (albeit perhaps not as quickly as it had). The general concern comes about when you look at the share price.

Both the company's profits and share price had increased by over 400% in the 2006 to 2014 period. Generally this isn't a worry - a share price tracking business performance. The issue comes about when growth starts to slow and the earnings multiple is already elevated.

By September of 2015 shares had reached a price of $104 or so, indicating a trailing earnings multiple of over 100. Since that time the share price declined to the mid-$60s before increasing to the $85 range as I write this today.

Now normally when you see a 20% lower share price in the matter of four months this is something to get excited about. With Under Armour it seems that the valuation could still be a challenge for the long-term owner. That is, the likelihood of investors capturing the long-term business performance appears to be subdued.

I'll provide a couple of examples to demonstrate what I mean. In the previous example I illustrated this case using two examples: Under Armour growing at 20% for the next decade or Under Armour growing at roughly 14% for the next two decades. Just to give you some reference, the second scenario implies that Under Armour becomes the next Nike (NYSE:NKE) size-wise in a quicker timeframe.

I think those are reasonably fair "base case" or even ambitious assumptions. From 2006 through 2014 the company grew profits by about 23% annually. As you get larger it becomes more difficult to grow. So assuming another decade of 20% growth would be a solid achievement.

Last year the company reported full year diluted earnings-per-share of $1.05. If this number were to grow by 20% for the next 10 years this would indicate a future earnings per share number of about $6.50. Incidentally, based on a share price around $85, this equates to a forward earnings multiple of about 13, in a decade. You don't often hear about decade-long forward multiples, but in this case it can be relevant. If Under Armour were to grow by 20% annually and trade at a 13 multiple in 10 years time, investors would be looking at a 0% return for the decade (presuming no dividend payments).

Of course if the company were still growing that fast there is certainly a reasonable case to be made for a much higher valuation multiple. Here's a look at the potential annualized gain based on varying future earnings multiples:

As described, even if the company grew by 20% annually for the next decade a mid-teens multiple would result in very little wealth creation. Once you start to move past this, say to 20 to 30 times earnings, you would be looking at mid-single digit returns. And if you suspect that shares can trade over 35 times earnings in the future then the return proposition starts to look more interesting.

Although with this view I think it's important to remain prudent. For one this is based on 20% annualized growth. If the company instead grew by "just" 12% or something the expected returns begin to decline materially. For most companies that would be exceptional growth. For a company trading at 80 times earnings you could have a bit of an issue if the lofty growth anticipation does not formulate.

You don't have to look far to find exceptional growth stories trading at much lower valuations. Apple (NASDAQ:AAPL) is a recent demonstration of the types of multiples that can be applied if you begin to see slowing growth. After growing very fast for years, slower growth is a possibility. Things can happen quickly. I'm not suggesting this will be the case with Under Armour, but I think it's prudent to think about a wide range of future possibilities. Solely relying on a 20% growth assumption and a 40 earnings multiple leaves little room for error.

The second scenario that I would like to highlight is if Under Armour becomes the next Nike. It took Nike about 50 years to reach $3.2 billion in profits. Under Armour recently celebrated its 20th year. Perchance Under Armour can reach the $3.2 billion in earnings mark a decade sooner. This would require an EPS number of about $15 (based on the current share count) in 20 years, equating to an average compound growth rate of about 14% per annum.

Here's what an investor's return might look like if Under Armour is generating $15 in per share profits two decades later:

Once again this can be instructive. Speaking of Nike the company is still expected to grow by a double-digit rate, yet the earnings multiple is under 30 times anticipated profits. In looking at the very long term I think it's somewhat difficult to make a case that Under Armour will provide substantially better results.

Using the examples above, in order to see double-digit gains over the next 10 years for Under Armour, you need a 20%-plus growth rate coupled with 35+ earnings multiple. In order to see double-digit annual returns over the next 20 years, you need a 14%-plus growth rate with a 40+ earnings multiple. Both of these scenarios could come to fruition, but neither are exactly cautious assumptions to make.

Ben Graham had this quote: "obvious prospects for physical growth in a business do not translate to obvious profits for investors." Right now, I think that idea applies to Under Armour quite well.

The business has demonstrated exceptional performance and to be sure it is expected to continue to do so. If you owned the whole thing at a fair price you'd be over the moon with how the business is doing. Yet there's this other part, the valuation, which tends to equal things out. In the case of Under Armour there's a very real possibility that you wake up in 10 or 20 years to a substantially lower valuation. As such, today's investor is apt to miss out on a bit (or possibly a lot) of the exceptional business performance that is expected to come along.

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

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.