Under Dog

Over the past three years, Under Armour’s (UA) market cap has fallen by nearly 80%. Just over the past year, shares have lost 2/3 of their market value.

The most recent quarterly (Q3 2017) earnings report was brutal. Everything that matters was revised downwards. A series of external pressures (North American weakness, price war etc.), and internally inflicted wounds (ERP integration mismanagement etc.) have conspired to make 2017 a year UA would like to forget.

This is what happens when a growth story goes wrong. The sentiment against the company is overwhelmingly negative. The short ratio is around 10-12%, and the days to cover based on normal volumes is now about 15.

Is UA broken for good? Or are its troubles temporary? Will the company plough through this bad patch, and return to “normal”? Is the rational behavior at this time, to fold and cut our losses, or to hold our noses and double down?

Back Story

Previously, I thought UA was worth somewhere in the high teens. That was earlier this year, when the stock was trading near $20.

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Since I was learning a new put-writing option strategy, I thought UA – with its high volatility – might be a good candidate to experiment with. I began writing $20 strike puts in Feb 2017, and kept rolling them until August. After Q2 results, the stock dropped to the $15-16 range, and I got assigned my first set (400) of UA shares.

At that time, I revalued UA, and thought the long-term thesis remained mostly intact, and began writing more puts. This time at $16.50 strike. I kept doing this, until Q3 earnings were declared on 10/31. The stock subsequently dropped further, and now hovers between $10-11. The puts are deep in the money, and will likely get assigned when they expire on 11/24/2017 (500 more shares).

All said and done, I now have 900 shares at an average price of $15.50 (~$14k). My total maximum target allocation for UA is $25k (for a 5% position), which means I could more than double my ownership at current prices.

Valuation

After I factor in the disastrous Q3, and modest improvements over the next three years, followed by a return to industry averages by year 10, I get a DCF value of $15-16.I think this is a conservative estimate.

At current prices of $10-$11, the stock may be undervalued by nearly a third.

UA

Any improvement beyond the currently depressed valuations, any unexpected return to 10-20% growth rates in the near/medium term, and resulting multiple expansion could easily double the target price.

Five years from now, we might look back at this period as a good buying opportunity.

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Comparison of Apparel Companies

Earlier this year, I looked at a bunch of apparel companies. Sometime during my research, I compiled the following table to take a cross-sectional view of the space.

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NKE at $90B+ market cap is the big kahuna. It has stable growth of nearly 8%, high ROIC. Not surprisingly, it commands a premium price.

Adidas is also quite large. It seems to be getting its act together. Historically ADDYY has been a laggard in terms of ROIC, margins, and growth.

LULU and UA had spectacular growth spurts that seem to be slowing. LULU has delicious margins, and ROIC, but view from the wind-shield is not as rosy as that in the rear-view mirror. Unlike LULU, UA’s margins and ROIC have been okay, but not great. LULU is more expensive than UA.

VFC is a mature, boring, slowing, and solidly profitable company. Operationally, HBI seems the lousiest of the lot. However, it uses leverage and tax shields to play in the big leagues.

Note that good companies (growth, margins, ROIC) are more expensive than so-so companies. This is the free market at work.

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.