Is Under Armour Under-Valued?

Under Armour (UA and UAA, depending on share class) is a well-known apparel, footwear, and accessories company which operates primarily in the athletics and sports industry. They also have a strong digital arm under the “Connected Fitness” banner, whose goals sometimes sound a little too futuristic. It is led by its passionate founder, Kevin Plank (who recently got into trouble due to his remarks on Trump). He seems driven to succeed, and has plenty of skin in the game. You should look up his videos on YouTube; he is a passionate leader, and owns most of the voting shares. If you do not trust him, then you should get out of UA.

I decided to look at UA somewhat accidentally. A friend mentioned that the stock had fallen more than 50% from its high over the past year, and might be worth a look. Normally, I don’t care for such high-flyers. However, I am a committed user of myFitnessPal, which UA bought for nearly half a billion dollars, not that long ago. These two data points piqued my interest. I figured I might as well learn a little bit about the company.

History

From the get go, it is abundantly clear that UA is a growth story. Revenues grew 10x from $430M in 2006 to $4.83B in 2016. The 3, 5, and 10 year revenue CAGR are nearly 25%. The operating margin has hovered between 10-14%. Operating income has grown at a brisk 20% clip. Last year was disappointing: revenue grew only 22%, while EBIT margins dropped below 10% for the first time. Return on tangible equity is still in the high teens; it generally oscillates between 15-20%.

Such spectacular growth, however, doesn’t come free. Indeed, UA has spent more on CapEx and acquisitions over the last ten years than its operating earnings. Thus, cumulative FCF has been negative. This hasn’t satisfied UA’s appetite for growth. Since operating cash flow cannot fuel it, UA has had to resort to debt. LT Debt has ballooned from $50M in 2013 to ~$800M in 2016 (2x TTM EBIT of $420M). The debt to capital ratio is about 1/3; not alarming, but the rapidity with which it has risen is something to keep an eye on. Debt should help UA lower its tax rate, which has been unusually high in the past (30-45%). On the flip side, interest payments will consume significant future cash flow.

2017 and 2018 are expected to be years of more sowing and investing into the business. This will probably be good in the long term, but near term cash flows will be affected. Its competition is Nike and a reinvigorated Adidas, which are both strong competitors, and will ruthlessly use any weakness to seize market share. For comparison, Nike and Adidas had TTM revenues (operating income) of $32.4B ($4.5B), and $18.77B ($1.1B), respectively, compared to UA’s $4.83B ($0.42B).

Valuation

Damodaran in his “Little Book” on valuation, used UA as a case study, when it was a much younger company. It is interesting to see how UA has been able to grow revenues relentlessly since then. Somehow, it has managed to stay young for nearly a decade.

In any case, I took Damodaran model as a basis, and made a few changes to reflect the present. For 2017, I assumed management’s guidance ($5.4B revenues, and $320M EBIT corresponding to a low 6% EBIT margin) for 2017, and then increased revenue growth to 16% in year 3, and wound it down to 3% in year 10. I assumed that EBIT margins would rise steadily from 6% in 2017 to industry average of 11% by year 10. I used a tax rate of 33% and a sales/capital ratio of 1.95 to calculate reinvestment, and FCFF.

For the cost of capital, I assumed a beta of 1.8 in 2017, decreasing to 1.1 in year 10 reflecting a more mature company. Assuming a stable debt/equity ratio, I got a steadily decreasing cost of capital (from over 9% to 6.5%).

For growth companies like UA, most of the value is embedded in the terminal value. This is simply the nature of the beast. When such a company is growing rapidly, it reinvests most of its cash flow into the business, resulting in very little “free cash” for owners. Amazon is an example of a company that has mastered this playbook. Only in the terminal regime, when the company has matured, and cannot grow revenues as fast, does reinvestment drop, and “free cash flow” to owners begin to gush. The risk, as always, is malinvestment; spending on assets that don’t result in future cash flow.

Anyway, I use the same assumptions that Damodaran used for terminal value: stable ROC of 9% (reflecting the value of the brand), growth rate of 2.25%. These yield a value of $8.286B for the firm. Subtracting net debt, and dividing by the full diluted share count, I get an approximate value of $17.30 for UA. Currently, the class C shares trade for a tad under $20, suggesting that UA is trading approximately at fair value.

It is useful to understand how much of the value comes from future growth. Analysts project EPS to be $0.70 in 2017 and $0.80 in 2018. Thus, the forward PE ratio is still quite high at nearly 30. UA’s return on capital (mid teens) exceeds it cost of capital (>9% currently) – thus growth increases value. The bull case for UA says that this profitable growth will cut down the PE ratio to more reasonable levels.

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