Under Armour's Overvalued
Our view of the brand is only getting more positive, but market expectations outstrip ours.
We recently upgraded Under Armour's (UA) Economic Moat Rating to narrow from none. This indicates our increasing confidence in the company's brand intangible asset and coincides with improvement in several areas where we had previously seen challenges, notably footwear, women's, and international. Gross margins had fallen with the increase in growth, from 49.9% in 2010 to 47.9% in 2012, but have now ticked up to 48.7% in 2013 and are expected to reach 49.0% in 2014. In addition, women's, footwear, and international are now contributing strongly to growth, while new product platforms such as cotton and footwear are growing year over year. We now believe these should continue to build for a number of years while new technology platforms are added.
Additionally, the length of some of Under Armour's new sponsorship deals and the consistency of its returns over the past 15 years suggest that it would be difficult for a competitor to unseat its brand position or imitate its advantages in the marketplace. We believe consumers will continue to pay a premium for the Under Armour label, and retailers will continue to support the brand for the traffic and margins it generates and as an alternative to larger competitors Nike (NKE) and adidas (ADS).
Although our view of the brand has always been positive and is now even stronger, we still believe the market is pricing in overly aggressive valuation assumptions. Our fair value estimate of $65 implies a forward price/earnings ratio of 35 times 2014 earnings per share, yet the market price of shares is now more than 58 times the mean estimate for 2014 earnings. We assume operating income will grow more than 20% for 10 years and excess economic returns will persist for five years or more beyond our explicit forecast period.
Looking at what it would take to justify Under Armour's current market price, our discounted cash flow analysis suggests that the company's top line would need to grow 25% on average for five years and 20% on average for 10 years, with minimal volatility and cyclicality. Total revenue would need to exceed $3.2 billion in 2014 and grow to more than $15 billion in 2023, compared with our base-case estimate of $2.9 billion in 2014 to $10.5 billion in 2023. Operating margins would need to average nearly 14% annually for 10 years and reach nearly 16% by the end of our 10-year forecast period, compared with 2013's 11.4%. On an absolute dollar basis, operating profit would go from $265 million in 2013 to $2.4 billion in 2023, implying nearly 27% five-year average annual growth and 23% 10-year average annual growth. By comparison, Nike's operating margins have only once exceeded 14%, although its gross margin high-water marks are 45%-46%, lower than Under Armour's, but with a higher dependence on footwear sales.
Continuous Improvement Has Put Brand on a Better Track
As a leading innovator of performance apparel, footwear, and accessories, Under Armour is establishing itself as a global athletic brand, in our opinion. Consumers have shown great affinity for the label across multiple product categories, and retailers have been more than happy to give Under Armour shelf space, reducing their dependence on Nike. The firm's entry into additional categories, such as footwear, has exhibited strong but uneven growth, but continuous improvement, along with above-expectations gains in the core domestic apparel business, has put the brand on a better track.
Under Armour's key growth strategies are to increase footwear, drive direct-to-consumer growth from owned stores and Internet sales, and accelerate international expansion. The company recognizes footwear is a big part of the athletic business and it will continue to develop capabilities there, but it also intends to continue expanding its core apparel business. Increasing average price and margin in apparel and from direct sales has a strong influence on returns. We believe many of Under Armour's national collegiate and international soccer sponsorships are an integral part of being able to eventually compete with Nike and adidas to offer both apparel and footwear to young athletes and fans. In apparel, Under Armour has made great strides in its women's business by becoming more focused on fit, silhouette, and workout occasion, and we think further women's growth will come. In youth, the firm continues to dominate and is still gaining floor space in new and existing channels. In its core men's business, innovation in core categories such as ColdGear Infrared or treated cotton have driven increases at retail partners' stores, while penetration of new sports and categories such as outdoor have driven distribution growth. International expansion remains more of a challenge but also a bigger long-run opportunity, as recently only 6% of revenue was from outside North America. We believe the soccer team deals, door growth planned for Asia and Europe, and recent launches of soccer cleats and new ColdGear products should start generating momentum.
Moat Builds on Reputation for Performance and Innovation
As Under Armour continues to build its brand equity in North America and internationally, it possesses a brand intangible asset with a reputation for performance and innovation that would be hard to undo by smaller competitors. With the ongoing brand popularity, we believe consumers will continue to pay a premium for the Under Armour label, and retailers will continue to support the brand for the traffic and margins it generates and as an alternative to larger competitors Nike and adidas.
Recent and ongoing sponsorship deals, including a number of new high-profile collegiate partners and an increasing number of international teams, give us high confidence the brand will be sought after for at least the next 5-10 years, driving returns on capital higher from the midteens to the mid-20s over the next decade. The firm has also picked its spots with individual athletes, preferring to bet on younger stars such as Cam Newton in football and Derrick Williams in basketball and Olympic athletes such as Michael Phelps and Lindsey Vonn. On the product side, the company continues to innovate, and our upgrade to narrow moat assumes existing technologies and platforms such as Storm fleece and Spine footwear as well as new innovations across multiple categories will continue to command premium prices. Although Nike remains dominant in certain categories such as basketball and running, Under Armour's popularity among high school team sports athletes continues to strengthen, in our view, which has fostered longer-term brand loyalty (and has been at the root of recent collegiate sponsorship deals). Nike's rivalry with adidas has perhaps led to some opportunities as smaller European sporting goods labels are forced to focus on fewer international soccer teams, leaving the door open to this American innovator. The Under Armour brand has also been successful extending to areas where Nike has failed in the past, such as the outdoor segment.
High Returns Can Be Difficult to Sustain
We assign Under Armour a high uncertainty rating. The firm depends on consumer demand for a specific range of athletic products driven by its brand equity. Although Under Armour's performance products enjoy strong brand reputation and awareness, consumer companies with highly desirable products that make great returns on capital in the short term find it much harder to sustain such returns over the long term. Under Armour remains a top player in athletic performance apparel, but the category's attractive growth prospects and strong profit margins have not gone unnoticed, increasing the risk of new performance apparel offerings from nascent brands or heightened competition from larger rivals such as Nike and adidas.
New product launches could have a dilutive impact on merchandise margins. Footwear, for example, generates lower margins than Under Armour's core strength, performance apparel. Increased product development, marketing, and international expansion also entail risks and costs that may be unforeseen. This could weigh down operating margins over the short run. However, we believe these investments, if made carefully, will better enable Under Armour to grow over the long haul.
An increase in distribution intensity also carries certain risks. Large chains such as Dick's are still expanding their Under Armour business, but at a declining rate, while other chains such as the Sports Authority are losing share, in our view. Growth in the footwear specialists and in outdoor channels appears well managed and with differentiated products at present, but could pose risks if demand softens. Further, we think that while the direct-to-consumer business appears to have good returns, it carries higher risks and requires ongoing investment in stores, websites, marketing, and customer service.
Paul Swinand does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.