As I’ve written elsewhere, I’m skeptical of the retail rally — and that goes double for the gains in Under Armour stock. At least some of the movers in retail like L Brands Inc (NYSE:LB) and American Eagle Outfitters (NYSE:AEO) are still cheap. Under Armour stock is not, trading at a whopping 71 times next year’s consensus earnings-per-share estimates. And, yet, investors are giving UAA stock another chance.
I think that’s a foolish move, as I wrote last month and as I’ve argued for most of the last year. But Under Armour does have a chance to drive a turnaround, and narrow net margins suggest it can grow into its valuation quickly if that turnaround transpires. The problem I see with Under Armour stock is that there’s basically one path to take.
And it’s a path that I don’t think is open.
All About Pricing
From here, Under Armour’s path to enough profitability to support even the current $15+ share price has to include a return to some level of pricing power. Under Armour already is making efforts to control costs. Selling, general and administrative (SG&A) expense was was flat in the third quarter. Product costs actually declined as a percentage of sales by 50 basis points, according to the company’s 10-Q.
There isn’t a lot of fat left to cut in terms of corporate expense. The continuing shift to direct-to-consumer selling should have a positive impact on margins, but, that aside, most other factors are outside Under Armour’s control. It can’t cut air freight rates or change the fact that overseas selling is less profitable.
Under Armour has to improve margins — again, the stock is trading at 71x next year’s EPS. Unless it plans on quadrupling revenue, margin expansion is necessary to get double or triple EPS — which is what’s required over time to move Under Armour stock higher.
The only way for operating margin to expand is through gross margin expansion. And, at this point, the only way for gross margin to expand is for pricing to hold. That seems like a big problem, for a number of reasons.
The Big Problem for Under Armour Stock
First, Under Armour obviously is in a tremendously competitive industry. It’s trying to compete with giant Nike Inc (NYSE:NKE) and a resurgent adidas AG (ADR) (OTCMKTS:ADDYY). And while a smaller, nimbler Under Armour was able to out-innovate those rivals earlier this decade, that no longer seems to be the case. Without that edge, Under Armour has to at least consider trying to compete on price — but that’s untenable from a margin standpoint.
The second problem is Under Armour’s new channels. It’s trying to push product through chains like Kohl’s Corporation (NYSE:KSS) and Dicks Sporting Goods Inc (NYSE:DKS). Those efforts don’t appear to be working: wholesale revenue declined 13% year-over-year in Q3. Meanwhile, even a cursory look at the Kohl’s and Dick’s websites shows an awful lot of Under Armour products on sale. So does Under Armour’s own home page, which at the moment advertises “1000s of items added to the UA Outlet.”
To be fair, Under Armour is trying to cut inventory as part of a recent restructuring effort. Still, there’s no evidence so far that Under Armour’s pricing problems are over — or anywhere close.
UAA Stock Still Has More Downside
Yet, Under Armour stock is pricing in some level of improvement in terms of both margins and revenue. Operating income this year is guided to $140-$150 million on nearly $5 billion in revenue, an operating margin of just 3%.
That figure needs to double, at least, simply to get Under Armour EPS above 50 cents and its multiple to a more reasonable 25-30. And I’m skeptical that even another 300 bps of margin expansion is on the way. Revenue growth is going to have to accelerate markedly to leverage SG&A, and Under Armour probably can’t cut too much in the way of cost. Gross margin, then, would have to return toward early-decade levels.
But this is a different company — in a different market. Essentially, investors still are betting that Under Armour can compete with the “big boys” Nike and Adidas. There’s an awful lot of evidence at this point to suggest that isn’t the case.
If those investors are right, maybe UAA stock can eke out some upside. But if they’re wrong — and I believe they are — Under Armour stock likely is headed for the single digits.
As of this writing, Vince Martin has no positions in any securities mentioned.