Three months ago, I wrote about Under Armour (NYSE:UA) and issued a SELL opinion on the stock with a target price range of $36- $46 per share ($18 - $23 post-split). I said that the target would likely have been achieved by the end of January 2017. At that time, the price was about $72.15 per share ($36.07 post-split), so the expected return was approximately 36%- 51% back then. You can read the full report here.
However, as it happens with the market, I was wrong about the timing. As you can see in Diagram 1, on January 27, the stock increased dramatically by more than ~22.5% after the annual results had been published. Later on, the stock tested the $36 level again and then continued the rally up to ~$47 per share, where it stands now.
Source: Yahoo Finance
People, who followed my initial advice, have lost about 16% so far on the short position in the stock or a lot less, if they bought put options, as I had recommended. I feel sorry about that. I have also lost some money on this trade because I believed the market would be more rational about the stock. Fortunately, when the stock was at around $100 per share, I bought some puts, so I am break-even now.
Well, it is time to analyze what has happened in the meantime. I have not lost the belief that the company is an excellent business. Nevertheless, I do think that the current market price of its stock is too high for its business. In addition, the market is irrational at times.
The Recent Trends
During the last four months, a few events took place that should be closely paid attention to:
- Just before the annual results came out, some analysts downgraded Under Armour's stock. Piper Jaffray reduced its valuation target from $88 to $66 per share ($44 to $33 after split). Deutsche Bank downgraded the stock to $95 from $110 (to $47.5 from $55 after split). Morgan Stanley took a huge chunk of the stock's valuation away, cutting the target price from $103 to $62 per share ($51.5 to $32 post-split).
- On the 27th of January, UA announced its Q4 and annual results for 2015. The Q4 EPS was 4%+ higher than what analysts had expected (the consensus was right about the figure of $0.46 per share or $0.23 post-split), while the Q4 apparel and footwear revenues showed a large increase to $865M and $167M, respectively (a growth of 22% and 95%, respectively).
- As a result, Q4 revenue was $50M higher than what had been expected by the analysts, and the total annual growth in the top line was in excess of 28.5%, almost reaching the $4B level. Nevertheless, the annual net income only increased 12% indicating problems with the gross profit margin (it declined from 49% of revenues in 2014 to 48.1% in 2015), the EBIT margin (11.9% in 2014 vs. 10.5% in 2015) and thus, the net profit margin (6.7% in 2014 and 5.9% in 2015).
- As I said before, the market became irrational about the optimistic Q4 and annual growth results without considering the decline in the margins. The stock hit an $84 level, rising from $67 per share.
- Under Armour has made a 2-for-1 split after the issuance of C-class shares.
According to the above information, I do not see any excessively positive events that can explain the rich valuation of the company. Nevertheless, the company has been showing explosive revenue growth in the past several years, so I cannot state that UA is a dog, either. However, the diminishing margins are a red flag for the future problems.
Now let us proceed to the renewed version of the company's valuation. I have updated the DCF, zero-growth and comparative analyses.
The Company's Valuation
You will be very surprised to learn that my model's forecasts have been matched almost perfectly by the company's results published in the end of January (see Diagram 2). I was correct about the size of the revenue and its growth, the cost of revenue and the gross profit margin. I did not expect operating expenses to decline as much as they did in absolute terms. However, I was absolutely correct in my estimates of earnings before taxes, the effective tax rate and thus, the size of the net income (the net profit margin and the diluted EPS, as well).
Another great issue pertains to working capital management. As you can see from Diagram 3, I expected the cash conversion cycle to be at around 135 days. However, the days of receivables increased, the days of inventory on hand increased, while the days of payables have substantially decreased. As a result, the actual cash conversion cycle was 26 days higher than the number I had expected. Other things being equal, it is yet another "alarm clock" that investors should recognize, if they do not want to find themselves in the Skechers' (NYSE:SKX) investors' shoes.
(Source: author's calculations)
My old model
The actual FY2015 results:
(Source: data - Morningstar.com, infographics by author)
As a result, I decided to keep the Base scenario the same and even make it somewhat more conservative in some instances (e.g. the management of the new working capital).
My new DCF model is presented in Diagram 4. In Diagram 5, you can see how different metrics of Under Armour are expected to change during this period. You can see my new assumptions in the "Assumptions" tab of my Excel file. The cost of equity is nearly the same as was in my previous model (around 6.65%).
My revised model shows that, after subtracting the market value of debt, minority interest, and adding back cash and investments with the discounted operating working capital balance, the market value of equity is around $9.4B in the Base scenario. Consequently, the fair value per share is around $21.41.
Comparing to my previous report, the new price is even 6% higher than the previous one. Nevertheless, it is still 51%+ higher than the current market price of the stock.
My new model:
My old model:
Source: data - Morningstar.com, DCF model by author
Note: In the new version of my model I also estimated the discounted operating working capital amount, as an addition. Setting the discounted OWC to 0 in the new model makes the fair price per share $16.10 - much less than before.
The Zero-growth analysis has been described in one of my articles before. You can read more about it here.
According to this analysis, the current stock price still shows no margin of safety. The valuation gives a fair market value of equity of $5.16B, which translates into a fair price of $11.67 per share. This price level is 75% lower than the current level. However, if we used only net income in the numerator, the result will be a share price of $8.14. It is~83% lower than the current price level. Depreciation & Amortization benefits mean a lot here, but on average the fair value is 77% lower than the current market value of the company's equity. Hence, the odds of successful by buying the stock now and holding on to it in the long run are rather slim, as this analysis suggests.
My comparative analysis is based on three key ratios: P/E, P/S and P/BV (see Diagram 6). All ratios still show that the stock is overvalued by 60%+. Even the PEG ratio, which, according to Yahoo Finance, is 1.53, is much higher than the normal level of 1.0x, even with such tremendous growth results.
The current EV/EBITDA multiple is at a 39.41x (in the previous analysis, the number stood at 35.74x), which is 3.5x higher than the industry's average of 10.84x (according to Damodaran). Hence, the comparative analysis implies the stock is substantially overvalued.
(Source: data - Morningstar.com, infographics by author)
Under Armour's annual results have met all my expectations. Moreover, in some cases (especially in the working capital management's effectiveness), I was too bullish. Hence, I do not see any catalysts, except the smaller cost of equity, which would alter my initial valuation of the company.
I set a SELL opinion on this stock and calculated a fair price range of $19.43-$23.70 per share. This price range can be translated into a 49%-58% opportunity for short-position takers. However, I would not recommend shorting the actual stock - use put options instead. For example, the July 15, 2016, puts with a strike of $40 cost only $0.65 apiece (according to Yahoo Finance).
"This is one of the central points of Graham's book. All investors labor under a cruel irony: We invest in the present, but we invest for the future. And, unfortunately, the future is almost entirely uncertain. Inflation and interest rates are undependable; economic recessions come and go at random; geopolitical upheavals like war, commodity shortages, and terrorism arrive without warning; and the fate of individual companies and their industries often turns out to be the opposite of what most investors expect.
Therefore, investing on the basis of projection is a fool's errand; even the forecasts of the so-called experts are less reliable than the flip of a coin. For most people, investing on the basis of protection-from overpaying for a stock and from overconfidence in the quality of their own judgment-is the best solution."
Benjamin Graham - The Intelligent Investor
Disclosure: I am/we are short UA.
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.