By The Valuentum Team
Under Armour's Investment Considerations
• Under Armour (NYSE:UA) makes branded performance apparel, footwear and accessories for men, women and youth. The brand's moisture-wicking fabrications are engineered in many designs and styles for wear in nearly every climate. CEO Kevin Plank is one of the great entrepreneurial success stories in modern America.
• The company's brand mission has been a hit: 'to make all athletes better through passion design and the relentless pursuit of innovation.' Its vision is 'to empower athletes everywhere.' Net revenue and operating income performance has been fantastic since the firm went public.
• Under Armour recognizes the significant importance of finding the right athletes to help propel the brand. Nike and Jordan, for example, have set the standard across the industry. Under Armour is investing aggressively in the Curry One basketball shoe after star Stephen Curry. This could be a huge needle mover for the company.
• The resilience of Under Armour has never been more apparent. The company was blamed for the poor speedskating performance of the US team at the Sochi Olympics, but it will continue to design the suits for the team going forward. Management handled the pressure with poise.
• We like Under Armour's business model and growth potential a lot. But investors have to be reasonable. Shares are trading at extremely high earnings multiples. The firm has to execute flawlessly to grow into that valuation.
Economic Profit Analysis
From our point of view, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Under Armour's 3-year historical return on invested capital (without goodwill) is 34.7%, which is above the estimate of its cost of capital of 10.7%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Under Armour's free cash flow margin has averaged about 4% during the past 3 years. As such, we think the firm's cash flow generation is MEDIUM across our coverage universe.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company.
At Under Armour, cash flow from operations increased about 10% from levels registered two years ago, while capital expenditures expanded about 177% over the same time period.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
Our discounted cash flow model indicates that Under Armour's shares are worth between $42-$70 each. Shares are currently trading at ~$81, well above the upper bound of our fair value range. This indicates that we feel there is significantly more downside risk than upside potential associated with shares at this time.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $56 per share represents a price-to-earnings (P/E) ratio of about 59.1 times last year's earnings and an implied EV/EBITDA multiple of about 28.1 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 21.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 27.9%. Our model reflects a 5-year projected average operating margin of 12%, which is above Under Armour's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 10% for the next 15 years and 3% in perpetuity. For Under Armour, we use a 10.7% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $56 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
In the graph above, we show this probable range of fair values for Under Armour. We think the firm is attractive below $42 per share (the green line), but quite expensive above $70 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Under Armour's fair value at this point in time to be about $56 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Under Armour's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $76 per share in Year 3 represents our existing fair value per share of $56 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Wrapping Things Up
Under Armour has been a tremendous growth story since it went public. The firm's mission and vision have been a hit. It may have hit a home run with the exploding star Stephen Curry promoting its basketball shoes, but only time will tell how long and bright that star shines. We're fans of the company's business model and growth potential, but investors must keep valuation in mind when considering the firm. Shares are trading at extremely high earnings multiples, and the company will have to execute without misstep for some time to grow into that valuation.
All things considered, we are not fond of Under Armour as an investment idea at this time. In fact, the firm registers a 1 on the Valuentum Buying Index, the lowest possible rating. We're staying away.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
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.