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An Update on Under Armour

- By The Science of Hitting

Under Armour (UA)(UAA) recently reported results for the fourth quarter of fiscal 2018. For the quarter, revenues increased 2% to $1.4 billion (up 3% in constant currencies). Revenues were up 4% for the year to $5.2 billion. Growth was roughly split between Wholesale and Direct-to-Consumer, with DTC accounting for 41% of the business in Q4 (for the year, DTC accounted for 35% of UA's revenues). North America struggled as expected, with revenues contracting 6% year-over-year (well below the high-single digit growth that Nike (NKE) has reported in North America in recent quarters). This was offset by strong International growth (+28% in constant currencies), led by strength in EMEA and Asia Pacific. As a result of this discrepancy, International continues to represent a larger piece of Under Armour's business, accounting for 30% of revenues in the fourth quarter.


While revenue growth in 2018 was lackluster relative to the company's peers and its own historic performance, the headline numbers do not tell the whole story. Put simply, Under Armour has made adjustments over the past two years to try and put the business in a healthier place. As CEO Kevin Plank noted at the 2018 Investor Day event, "as we expanded our distribution, we learned we could have been better with differentiation among our basic core products... our segmentation strategy needed to be sharper". The company has been addressing those missteps - and we're seeing progress. For example, inventories declined 12% year-over-year in the fourth quarter. In addition, gross margins increased by 160 basis points in the quarter, reflecting advantageous channel and region mix, product cost improvements and lower promotional activities (for the year, promotional activity in North America declined by about one-third). As COO Patrik Frisk noted on the call, an improved inventory position and SKU reduction is important for the business looking forward:


"As we continue into 2019, we believe that our assortments, product flow and cleaner inventory positions will create greater opportunities for clear differentiation and therefore improved segmentation amongst our retail partners ... For North America that means we are at a point of stabilization. Inventory is cleaner and tighter to demand. Our pricing and promotional activities are normalized at lower levels than just two years ago, and our product segmentation strategy continues to get sharper."



The company is also doing a better job controlling operating expenses, with selling, general and administrative expense declining 1% in the quarter (for the year, SG&A expenses increased 4%). While the company appears to be heading in the right direction, the income statement still shows that there's a lot of work to be done. Under Armour generated $180 million in operating income in 2018, good for 3.5% operating margins. For context, the company consistently generated margins of 10 - 12% over the decade through 2015 - at a time when revenues were much lower than they are today (revenues in 2018 were roughly 5x higher than they were in 2010). It's worth noting that management has called for EBIT margins to climb back towards 10% over the next five years.

For the year, Under Armour earned 27 cents per share. With the stock currently trading around $20 per share, Mr. Market is clearly assuming there's room for improvement in the years ahead.

Looking ahead to 2019, management expects another year of low-to-mid single digit revenue growth, with continued outperformance by the International business. Margins are expected to expand as well, reflecting continued channel and region mix benefits and outsized growth in DTC.

But even with revenue growth and some margin expansion, we will probably only see EPS climb to 30 to 35 cents. Even if you assume margins return to their historic level, you're talking about $550 million to $600 million in operating income. After accounting for interest expense and taxes, that leaves $430 million in net income - or less than $1 per share of normalized earnings power.

Looking out further, management recently guided to a roughly 40% earnings per share CAGR over the next five years. Starting from 2018, that gets you to $1.30 to $1.40 per share in 2023. Relative to the current stock price, that's a multiple of roughly 15x on 2023 earnings. Again, that seems to be asking a lot. To own the stock you must assume that management will be able to execute (it's worth noting that Under Armour missed the 2013 Investor Day targets by a wide margin, so it wouldn't surprise me if they approached the exercise with an extra dose of conservatism this time around).

Conclusion

When I discussed Under Armour in my 2017 Year-End Portfolio Review, here's what I said:


"I have no idea what will happen in the short-term for Under Armour (the business or the stock price). It could be a year or two before it gets back on track. There is no question some of the current issues are self-inflicted wounds. These company-specific issues have been exacerbated by industry headwinds in North America. While the financial results have been ugly as of late (and may continue to disappoint in the near future), I think these issues are temporary. By my math, I bought most of my Under Armour shares for somewhere around 10x normalized pretax earnings (it is worth noting they will benefit from lower corporate tax rates). I think the risk-reward looks pretty good, assuming you have a long-term perspective."



Since then, it's fair to say that some of the clouds have cleared. The industry as whole is in a better place (Nike's results speak to that) and UA has laid the groundwork to potentially return to its former glory. But as always in investing, the question is what that means relative to the current valuation. And on that front, I think the risk-reward is much less attractive today than it was a year ago.

Just to be clear, I still have no idea what will happen in the short term for Under Armour (that goes for the stock and the business). It seems that momentum is on their side and maybe that translates to optimism from Mr. Market (and a higher stock price in the short term). But that's not the game I'm playing. I care about one thing - the stock price relative to my estimate of intrinsic value. And to be honest, I have a tough time arguing UA is undervalued at $20 per share. For that reason, there's a good chance I'll sell the remainder of my UA position if the stock price keeps climbing.

Disclosure: Long Under Armour.

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This article first appeared on GuruFocus.