Under Armour (UA): A Peek at 2037
Overview
Under Armour (UA) was founded in 1995 by Kevin Plank, then special teams captain of the football team from University of Maryland. Frustrated by the increase in weight traditional cotton T-shirts incur after heavy sweating, Plank set out to develop T-shirts using better materials. After a year of fabric and product testing, he settled on a compressed synthetic shirt that can be worn beneath an athlete’s uniform. The product provides a snug fit, while wicking sweat away from the body and remaining light.
Fast forward 20+ years later, UA has seen its product offering expanded to a wide variety of apparel, footwear, accessories and so on for both men and women. UA also now sells its products globally. In 2016, UA’s revenue has reached more than $4.8 billion, becoming the third biggest sports brand in the world after growing revenue 38% p.a. since 2002. They have also started cracking the lifestyle sportswear market in 2016 by introducing a new product line called UAS.
Despite, the diversification of product lines since its inception, it’s important to remember UA is still a performance wear company. All its products are designed to have an aspect of “performance”, including the new UAS line.
Business Description, Quality and Moat
It’s probably most helpful to understand UA in the context of its two biggest competitors.
Both Nike and Adidas started out as sports footwear companies. As of 2016, both of them still generate the majority of their revenue from footwear, 53% for Adidas and 65% for Nike.
And as brands with longer histories, both Nike and Adidas are more established internationally, generating more than 50% of their revenue outside of their home markets, i.e. Western Europe for Adidas and North America for Nike.
On the other hand, UA is much less reliant on footwear while much more reliant on its home market. With its roots in performance apparel, apparel still represented 67% of revenue for UA in 2016, with footwear at just 21%. UA’s reliance on its home market is more extreme. North America accounted for 83% of their revenue in 2016.
Despite the above two major differences, UA has displayed a remarkably similar financial profile when compared to either Nike and Adidas. First of all, all three of them have stable gross margins in the mid to high 40%. In fact, UA’s gross margin has been higher and more stable since 2002.
Stats for Gross Margin since 2002:
|
Company |
Average |
Median |
S.D. |
Coefficient of Variance |
|
Under Armour |
48% |
48.2% |
1.6% |
0.033 |
|
Nike |
44.1% |
44.5% |
1.9% |
0.042 |
|
Adidas |
47.1% |
47.7% |
1.7% |
0.036 |
A similar picture can be found for EBIT. This time, UA’s performance has only trailed Nike.
Stats for EBIT since 2002:
|
Company |
Average |
Median |
S.D. |
Coefficient of Variance |
|
Under Armour |
10.8% |
10.8% |
1.7% |
0.160 |
|
Nike |
13% |
13.1% |
0.9% |
0.070 |
|
Adidas |
8% |
7.8% |
1.4% |
0.177 |
The major reasons why these three companies can have high and stable gross margins are: 1) They are in the business of selling a brand, 2) they engage in the marketing and distributing of sportswear products but not in the manufacturing side of the business, 3) they have a diversified enough manufacturer base to benefit from scale production but not too reliant on any single one of them, 4) they also have a diversified enough retailer base to sell products to and 5) top brands do not compete on price.
Even though UA is only a fourth the size of Adidas and one sixth the size of Nike, and has been much smaller before, the above figures clearly suggests UA has already been big enough to achieve similar economics as found in the top 2 players even before its public listing.
While new entrants growing to be significant players are hardly unprecedented in the sportswear industry, it’s still relatively straightforward to point at what the likely sources of moat are. As companies that sell a brand and functionality of their products, two keys to their business are marketing and product innovation, both of which have imbedded scale advantages.
On the marketing side, sponsorship and endorsing top athletes are most important to expand and defend mind share. The size of sponsorship for top athletes or sports leagues is clearly a barrier. For instance, LeBron James’ lifetime extension deal with Nike is rumored to be worth $1 billion dollars. Another NBA superstar, James Harden signed a 13-year deal with Adidas for $200 million in 2015. Even sponsorship for college in the US has become exorbitant, with UA signing UCLA for a 15-year, $280 million deal last year. Smaller or upstart companies usually had to offer equity stakes to lure in athletes, like UA did when they signed Tom Brady in 2010.
To attract top athletes, not only do you have to offer big dollars, it’s also easier if you already have a visible brand. Endorsement deals that have worked out the best are all true partnerships. Brands are looking for top athletes to legitimize their performance products. On the other hand, athletes are also more likely to prefer the top brands who can reinforce their image within the sports through resources only the top brands command.
Product innovation is similar. While Adidas spent less than 1% of revenue on R&D in 2016, in absolute terms that was a meaningful amount of more than 160 million euros. Puma spent a not insignificant 94 million euro on R&D in 2016, yet that’s already 2.6% of its revenue. (Puma’s EBIT margin in 2016 was only 3.5%)
There are also emotional aspects to sports, further ingraining end consumers’ affinity to the brands they prefer or have grown up wearing. All in all, if you keep having a good roster of endorsers, alongside frequent product innovation, the durability of your brand will likely endure.
Historically, the total asset turnover for UA ranged from 1.5x to 1.7x, while using moderate debt of below 40% of equity. All this results in decent ROEs of around 16% for UA. With bigger scale, Nike’s ROE is closer to 20%. Combining decent return on capital with stability of profitability makes Under Armour, and its two biggest competitors, above average businesses.
Growth, Valuation and a Peek at 2037
After increasing revenue by more than 20% for 26 quarters in a row, UA saw its quarterly revenue growth fall below 20% earlier this year. This caused the stock to fall 25% on the day of the earnings announcement. Their sales have recently been affected by bankruptcies of their main distributor, Sports Authority in the US. Coupled with earlier growth warnings in 2016, UA’s stock price has fallen close to 50% in the past year. Despite the current challenges faced by UA, management is still currently guiding for growth of more than 10% in 2017.
UA now trades at around 50x P/E, an optically high valuation. (Nike’s P/E is 22x and Adidas at 31x) However, looking at the more appropriate metric of Enterprise Value/Sales, which reduces the reliance on the more dynamic variable in net income, you see a different picture. UA’s EV/S is currently at 1.84, Nike at 2.48 and Adidas at 1.74.
Even though Nike has had a higher net income margin historically than UA, given UA having a bigger underpenetrated market, such as the international market, it’s difficult to justify Nike should trade at a much higher EV/S multiple than UA, especially if you argue UA is already excessively priced.
The current valuation of UA does not make it a clear value investment. Yet, if UA can keep growing double digits in the next decade or more, this could still make it a decent investment. The key for an investment in UA now is thus its growth prospect.
Below I put UA’s current valuation against the context of potential returns over the next 20 years using 2 sets of assumptions. I am using 20 years because Kevin Plank, the CEO is now 44 years old. He controls UA through his Class B shares. Assuming he will focus on growing the company and retire by the age of 65, there is a 20-year runway ahead.
I have doubts about UA ever reaching parity with Nike. This is due to my lack of confidence in UA’s footwear and athleisure business. I don’t believe those two product lines will be failures per se. Nevertheless, I don’t have full confidence they will reach the level of popularity of Nike, especially footwear.
In case 1, all of UA’s footwear business is neglected. We look just at the apparel business. Here I make an aggressive assumption of its apparel business reaching parity with Nike in terms of market share over the next 20 years. That is UA would have increased its apparel market share by 2.78x by 2037.
Over the next 20 years, it’s very difficult to imagine the sports apparel industry will grow below world GDP growth. In fact, my honest guess will be the industry growing faster than world GDP. Let’s assume the overall sports apparel market will grow 5% p.a. worldwide. Adding UA’s market share gain, that would lead us to an expected 10% growth for UA’s apparel business over the next 20 years. UA’s apparel sales in 2016 was $3.23 billion. Growing 10% for 20 years will get them to $21.7 billion of sales by 2037, a figure below Nike’s current sales.
What should a more mature UA be trading at by then? Given their respective current EV/S, it’s not aggressive to assume UA should have an EV/S of 1.6x in a mature stage. This suggests UA would attain an enterprise value of $34.7 billion by 2037.
Under the above assumptions, the expected capital gain will be 7% p.a. But because we are only expecting a 10% annual growth in sales, UA will not have to retain all its earnings. Paying excess earnings out could result in another 1% of annualized return, giving us a total return of around 8% for holding UA for the next 20 years. At current valuations, the market as whole is not likely to provide this high a return.
And if I have been way too pessimistic about UA’s footwear business, that could only add to the upside of the whole investment case.
For case 2, let’s take a more comfortable assumption of UA’s apparel business reaching 50% of Nike’s market share by 2037. This then only adds 1.6% of annual growth on top of the global industry growth, i.e. 6.6% annual growth for UA’s apparel, reaching $11.6 billion by 2037. But here we should include footwear and others back to the UA’s business to be realistic. To achieve the same $21.7 billion in sales by 2037, businesses other than apparel will have to grow by 9.7% a year. Depending on how sizable businesses other than apparel and footwear you think can become, footwear may need to reach $6.4 billion (if it just grows by 9.7% annually) to $9.5 billion (if the other businesses do not grow at all) by 2037. Anyhow, even at $9.5 billion, UA’s footwear business will only be 50% of Nike’s current size of $19.87 billion. If Nike grows its footwear business by just 5% a year for the next 20 years, UA will still be less than 15% of the then Nike’s expected size in footwear.
Moreover, this second set of assumptions only needs UA to grow overall revenue by 7.8% annually for 20 years.
Misjudgment
One potential misjudgment is whether Kevin Plank will know enough to return capital to shareholders if his company really can only grow closer to 10% than 20% growing forward. For the past 20+ years, UA has always been on a high growth stage. The capital allocation decisions have all been steered toward reinvesting all earnings. However, even if Plank decides to hoard cash or invest in less productive usages, that only knocks off around 1 percentage point in our total return estimation.
Instead, the biggest potential misjudgment above is whether UA can really reach parity with Nike in global apparel market share or will it in any way grow close to 8% for another 20 years.
Here are a few more thoughts on UA’s growth potential:
The global trend toward more active lifestyle should be reasonably dependable over the next few decades. As people get wealthier, they are more likely to pay attention to their health. And the correlation between an active lifestyle and longevity is well understood by most. Hence my confidence that the global sportswear apparel industry can grow slightly above world GDP growth in the next couple of decades.
Moreover, the industry should continue to consolidate as it has been in the past. Another Focused Compounding member (Kevin Wilde) estimated that back in 1993, Adidas and Nike (alongside their eventually acquired sub-brands like Reebok and Converse) were around 15% of the global shoe and apparel markets (in terms of dollar, but not volume). As of 2013, their combined market share has increased to 35%. And throughout that 25-year period, Adidas and Nike grew 8% to 10% a year. Given the continued investments in sponsorship, advertising and R&D, it seems reasonable to expect the top brands, with UA joining the fold now, will control a bigger portion of the profit pool going forward.
One last point is the current trend for these top brands to expand their own stores and direct sales. Using Lululemon as a reference, we see that distributing products mainly through self-own stores and online could be a boost to net margin.
Conclusion
While UA is not a traditional value investment. Given the business quality and reasonable growth assumptions, buying its stock now may still get you market beating results if you buy and hold for 20 years.
But if you want a wider margin of safety, you should closely monitor the stock price. Let’s say the stock price drops another 20% or so, it may still trade at a seemingly high P/E of 40x. Yet, that would be a good entry point already, with an expected return closer to 9% to 10% over the next 20 years.