Under Armour Sits Poised to Surprise...to the Downside

UA is poised to surprise investors with a substantial decline in sales growth, resulting in a rapid sell-off as investors reevaluate high expectations for long-term growth rates. This change in investor sentiment will come as a result of three prevailing headwinds:

1. Increasing competition from Nike in apparel
a. UA has historically taken market share from Adidas, but now faces far tougher competition from Nike
b. Our research indicates that Nike is discounting products in an attempt to arrest Under Armour’s growth

2. Insufficient infrastructure to maintain rapid footwear growth
a. Footwear is the source of investors’ hopes for future growth, but market expectations are too high
b. Our research tells us that due to a lack of infrastructure (distributor relationships and running shoe sales channels) UA will struggle to gain market share at the pace investors demand

3. Too much, too fast
a. UA has been aggressively expanding into new categories such as soccer and basketball, as well as pursuing its online Connected Fitness platform
b. Our research indicates that it will take much longer than investors expect for these costly investments to result in material market share gains in such intensely competitive categories

Valuation
We modeled three scenarios for the income statement out to FY 2016. The independent variables in our base, bull, and bear case scenarios were revenue growth rates, gross margin, and operating margin. We looked at historical forward P/E ratios to find a relevant multiple to apply to the estimated FY 2016 EPS to arrive at an implied equity valuation. We then weighted our base case price target by 0.50 and the bull and bear cases each by 0.25 to arrive at a price target of approximately $62.

Projections Base Case Bear Case Bull Case Analyst Estimate
FY 2016 Sales Growth 22.1% 20.1% 22.7% 22.7%
FY 2016 Gross Margin 49.3% 49.1% 49.4% 49.5%
FY 2016 Operating Margin 10.6% 9.9% 11.0% 11.3%
Price Target $60.9 $49.8 $77.6 $85.7

Support for Investment Thesis
1. Increasing Competition
To better understand the athletic apparel landscape, we conducted numerous interviews with key industry players. We found that many were observing an unusual amount of discounting among Nike athletic compression products, which directly target many of Under Armour’s bestsellers. Significantly, all of the people we interviewed stated that Nike performed very well against Under Armour when products were at the same price point. We began to keep track of 22 Nike products across 8 categories at Under Armour’s largest customer, Dick’s Sporting Goods. We found that there was a clear trend towards more discounts, which led us to believe that Nike was cutting prices to target UA market share.

After establishing Nike’s strategy, we began to monitor online discount retailers for any evidence that UA was trying to unload surplus inventory caused by Nike discounting. Shortly afterwards, the online “flash sale” company Zulily hosted a large UA sale of over 1,200 products. Two weeks later, UA products began to show up both online and in-store at the discount retailer Nordstrom Rack. We also learned from an early retail partner of Under Armour’s that the women’s division is still struggling, and that products currently have far too many SKUs relative to sales numbers. We suspect that these are all signs of the increasing competition that UA is facing as it grows larger. In coming quarters, we expect this competition to materialize in the form of decreasing sales growth and loss in pricing power in apparel.

2. Insufficient Footwear Infrastructure
In the course of our interviews with major U.S. retailers regarding athletic apparel, we became interested in the footwear business as well. All of the retailers we interviewed agreed that UA does not yet have the infrastructure in place to maintain its current growth and ensure that its shoes get to the proper channels. Growth in footwear depends heavily on the sales force and marketing/promotional strategies, and this is something that takes much longer to build than the actual product itself. Investors are currently underestimating the time required to build out the footwear infrastructure to support the expected level of sales growth. We see this providing downside pressure to the stock price over the next few quarters as investors reevaluate the time horizon for Under Armour to significantly grow its market share in footwear.

3. Too Much, Too Fast
Amidst the inevitable slowdown in top-line growth as Under Armour matures as a company, management has aggressively pursued expansion into new categories such as Soccer, Golf, and Basketball. Investors expect these categories to drive future growth even as the core apparel division slows, but we suspect that the time frame expectation on these initiatives is far too optimistic. All industry professionals we interviewed confirmed that these were categories where success was measured on a 10+ year scale, and that it is unrealistic to expect any substantial amount of success in the short term.

Similar to the situation in sports apparel, we see a longer-term story for Under Armour’s Connected Fitness platform. Under Armour recently completed several costly acquisitions related to its pursuit of establishing the Connected Fitness online fitness community. Under Armour’s hope is to leverage its new community of 120 million active members, but this is a long-term goal that will not materialize for years to come. This $710 million venture contributed just $8 million in sales in Q1 2015 and operated at a loss of $15 million. All in all, we see these varied initiatives dragging on SG&A in the short term and taking far longer to pay off than investors currently anticipate.

Risks
There are two major risks to the investment thesis:

a. Accelerating international growth overshadows the increasing competition in the U.S.
b. UA could benefit from positive macro trends in the industry despite declining fundamentals

We have limited insight into the international markets, but we have learned in interviews that Under Armour is encountering difficulties breaking into soccer overseas. Soccer is typically what drives international growth for U.S. apparel manufacturers, and we see this as a positive sign that no significant headway will be made during the 6-month time horizon of our investment thesis. Similarly, we believe the risk is low that the sports apparel industry experiences a surge of unanticipated growth within the next six months.

Valuation
Under Armour’s 1-year forward valuation has recently and drastically diverged from projected growth rates. Departing from its historical correlation with revenue growth, Under Armour’s average forward P/E ratio has sharply increased from 34.3 in FY 2013 to 54.6 in YTD 2015. However, consensus growth estimates for FY 2015 and 2016 call for a decline from 2013 levels.

We believe the cause for such a divergence is that the buy-side expects far greater results than sell-side analysts are currently projecting. In contrast, our research leads us to believe that Under Armour’s sales growth, gross margin, and operating margin will disappoint both buy-side and sell-side analysts within the next two quarters.

Assumptions & Projections
Base Case
We see FY 2016 sales growth declining to 22.1% (consensus 22.7%) on the basis of a sharp decline in apparel growth and consistently slowing footwear growth. We expect a gross margin of 49.3% (consensus 49.5%) on lower pricing power as competition increases. We modeled operating margin at 10.6% (consensus 11.3%) as our "too much, too fast" thesis plays out and SG&A expenditures rise. We expect a modest reversion in the P/E multiple back to the 1-year average of 45.5. Applying this multiple to our EPS estimate of $1.34 (consensus $1.45), we derive an implied share price of $60.9.

Bear Case
We are projecting a substantial slowdown in FY 2016 sales to 20.1% (consensus 22.7%) as apparel growth experiences high pressure from competition and footwear struggles without the necessary infrastructure. We see gross margin of 49.1% (consensus 49.5%) on reduced pricing power. We project FY 2016 operating margin of 9.9% (consensus 11.3%) as SG&A costs rise amidst too many ongoing projects. We see investor sentiment retreating from record highs back to more historical averages, and have applied the 3-yr average P/E of 40.9 to our EPS estimate of $1.22 to arrive at an implied share price of $49.8.

Bull Case
We project FY 2016 sales growth of 22.7% in line with analyst estimates. We see a slight decline in the gross margin to 49.4% (consensus 49.5%) reflecting a mild slip in price points as a result of increasing competition. We project an operating margin of 11.0% (consensus 11.3%) due to rising but manageable SG&A. This leads to a projected EPS of $1.42 (consensus $1.45). We expect that this relatively mild underperformance will result in a marginal change in investor sentiment, and have selected the YTD average forward P/E of 54.6. This results in an implied share price of $77.6.

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