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Stock Strategist

We Think Under Armour Is Overvalued

This sportswear maker is a high performer, but its shares are breaking a sweat.

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This year's NCAA men's basketball tournament "March Madness" was once again filled with buzzer-beating shots, overtime thrillers and numerous upsets. However, we contend that competition off the court has been just as intense.  Nike (NKE) has held the number-one seed year after year, and we recognize the strides  Under Armour (UA)--the underdog--has made in performance athletic apparel. However, given that its lofty shares are trading at nearly two times our fair value estimate, we believe investors are overestimating the firm's underlying fundamentals.

While its new cotton offering looks like a Blue Chip prospect, it still lacks big-game experience. Based on our initial channel checks, we believe that Under Armour is looking to rack up the score with its new cotton products, and we contend that its expanded lineup of cotton products could also boost the firm's position within the women's sports apparel segment. Although we believe the company has plenty of orders from chains such as  Dick's Sporting Goods (DKS) and privately-held The Sports Authority, differentiation is a challenge. We believe that consumers may not understand the benefits of the new cotton shirt (priced at $25), especially when it sits next to a $19 polyester shirt, and is surrounded by $25, $30, and $50 compression/fitted shirts.

Could Cotton-Picking Lead to Cannibalization?
Like a blue chip prospect, there's potential here, and we view the launch of cotton products as an intriguing test of brand equity. We estimate that these offerings only account for--at most--2%-3% of Under Armour's sales at major sporting goods retailers this year, based on price points and on-hand units. From our perspective, however, it's likely that these new offerings could cannibalize sales of the firm's higher-margin offerings, which is far from ideal. For example, we believe another of Under Armour's innovative products, shirts made from recycled plastic, is poised for success. However, it's still fighting for shelf space, and may be crowding out a very good line of technical running products.

What do Muggsy Bogues (5'3"), Earl Boykins (5'5"), Nate Robinson (5'9"), and Under Armour have in common? They each needed to overcome huge obstacles in order to succeed on the biggest stage. The basketball players listed above each offset their (relatively) diminutive stature by becoming great passers, ball-stealers, and the fastest players on the court rather than dominant shot-blockers. Under Armour is no different. The company has performed well in its core performance athletic apparel business, as its technologies, designs, and marketing strategies have--so far--been able to differentiate the brand from its far larger and more powerful competitors. However, we're concerned that the company's seemingly unending desire to grow could eventually come at the expense of profits. We would prefer that the firm take the time to fully develop, test and properly launch new products that play to its already strong consumer following, rather than push too hard for growth in too many directions, and risking the possible dilution of its brand equity.

Is Pricing Power Weakness a Crack in the Armour?
Small but noticeable price promotions, and the presence of some markdowns at full-price stores also makes us raise an eyebrow. In addition to the threat to the long-term brand image (consumers know that Under Armour never "goes on sale"), we believe these pricing actions affirm our concerns that inventories have been growing faster than sales for the past two quarters. Again, this is not a disaster per se, but in our opinion one of the strengths of the Under Armour Outlet retail business was that a fair amount of it was full price, and the web business was often a channel for products that consumers couldn't find at retail. We understand that as the company continues to increase its breadth and scale, promotions and markdowns are inevitable. Still, we feel the shift toward more frequent markdowns on its own website is not well-timed, given the growth in its average inventory numbers. As such, we're less convinced that the company will drive its operating margins meaningfully higher over the next five years.

Success in the basketball shoe segment is not the "Diaper Dandy" that the investment community made it out to be. Initial reactions to the Under Armour basketball shoe had been positive. However, consistent with our own thinking, Nike has been nearly impossible to unseat. We believe that Under Armour's basketball shoes are slowly making their way to the back of the few stores that actually carry them, as Nike has approached the category with a full-court press defense and "run-and-gun" style offense--marquee basketball shoe launches and key allocations at prime shopping outlets during fourth quarter of 2010. We don't expect that this intensity will abate in 2011, which could all but obscure consumers' view of Under Armour's court-friendly footwear.

Under Armour is far from the slam dunk that its stock price would suggest. Virginia Commonwealth University (VCU), a member of the Colonial Athletic Association conference, has been to the NCAA tournament nine times since 1980 and has delivered a respectable 5-9 record in tournament games. In its most recent tournament run, the team fell just short and lost to Butler in the Final Four.

Much like its basketball counterpart, Under Armour has built a solid foundation over the years, and appears to be peaking at the right time. Shares have more than doubled since last summer, driven by momentum in its core apparel assortment, and building optimism for the firm's expansion into new footwear categories and new products, such as cotton.

Under Armour remains a top player in the performance athletic apparel category it helped to revolutionize, with sales increasing fourfold over the last five years. However, the category's attractive growth prospects and strong profit margins have not gone unnoticed, and Under Armour is no longer an underdog. The larger industry participants have been studying game film and have developed similar performance apparel offerings to counter the moves of their smaller adversary.

Highlight Reel: It's Tough to Remain a Perpetual All-Star
Under Armour has no moat. It does not have anything structural or defendable as a competitive advantage that would ensure that it makes above-average returns on capital over the long run. The company has tremendous brand equity and, over the few years that its shares have been publicly traded, returns on capital have been high. We caution investors that consumer companies that have highly desirable products or fashions often make great returns on capital over the short term, but sustaining those outsized returns over the long term is substantially more difficult. While Under Armour's brand and marketing do serve to protect it from competition and allow it to charge a premium for certain apparel products, it remains to be seen if those advantages in compression performance apparel can be translated into higher returns in other sporting goods categories. As an example, we cite the difficulties the company has encountered trying to get its broader range of athletic footwear products right, both in terms of margins, and in terms of making the elusive connection between matching product attributes, and consumer appeal.

Paul Swinand does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.