Why the Recent Under Armour Downgrade Misses the Mark

Image source: Under Armour.

Shares of Under Armour (UAA -0.80%) (UA -0.68%) have dipped more than 5% since an Argus analyst downgraded the stock on Aug. 31, citing how expensive continued expansion will be and saying that the stock is overpriced. Here is why that downgrade misses the mark and has created a buying opportunity. 

The bear vs. the bull on Under Armour

The analyst starts by listing what will help drive Under Armour sales -- the opportunity for growth internationally (which currently makes up just 15% of Under Armour sales), rising footwear sales, and diversification into more department and specialty stores. Then he goes on to question continued earnings growth. 

We think that further expansion will require substantial business investment, which will add debt and interest expense and weigh on earnings growth.

Under Armour is making a lot of big bets. Over the last few years, it has spent more than $700 million acquiring fitness apps, as well as opening a new Austin, Texas, headquarters for its Connected Fitness division with increased staff and other investments. This has all been in an effort to build its digital platform that now has more than 170 million users. Then in June, the company unveiled its "Lighthouse" manufacturing center, which uses 3D printers and other technology to overhaul modern manufacturing, with the goal of promoting local production. 

Part of Under Armour's Lighthouse manufacturing facility. Image source: Under Armour

Under Armour's debt has grown over the last two years as a result of those investments to now over $1 billion as of the most recent quarter, but its debt levels are still very much in control. Under Armour's debt-to-equity ratio, which measures the percentage of growth fueled by debt vs. by equity (1 would be equal parts of each) is still just 0.57. While 0.3-0.4 is considered optimal from a risk perspective by many analysts, 0.57 is certainly not unreasonable. Another common measure is current ratio, which calculates current assets by current liabilities to assure assets can cover liabilities in the short term. Under Armour's current ratio is at 2.6, which is in the range of 1.5-3.0 generally considered as healthy. Compare that to Nike's current ratio at 2.8.  

As for interest expense weighing heavily on earnings, Under Armour's profit margin has declined in recent years, but only about 1% from 6.3% as of early 2015 to the current 5.2%. That decline is a small price to pay for the aggressive investments Under Armour is making, and there is room for that to decrease slightly more without too much worry because of the rate of sales growth. 

The analyst goes onto discuss the company's high price-earnings multiple:

Under Armour trades at a high current-year P/E, well above the average for apparel companies in our coverage group, and we see little room for further improvement.

The analyst is exactly right with the first part. Under Armour stock is very expensive by P/E at over 100 times Q2 earnings, compared with just 27 times for Nike and 20 times for the industry. However, there is still plenty of room for improvement through higher earnings. Under Armour is priced at less than 50 times next year's earnings estimates, and it gets better the further out you look, thanks to the company's rapid growth prospects. 

Under Armour announced an aggressive plan to reach $7.5 billion in sales by 2018. Even at the newly lowered 5.2% profit margin, that would be $393 million in net income, or 68% above 2015 earnings. That puts today's price at just 19 times those forecast 2018 earnings. This is still a long way out and plenty could go wrong between now and then, but with the investments above and the continued success of Under Armour's sales growth -- more than 20% year over year for each of the last 26 quarters -- so far the plan looks on track.  

This could be a buying opportunity

What separates the bear and the bull case on Under Armour is the investing time horizon. Under Armour's earnings are pressured by the expenses that the company is plowing into growth and innovation, and the stock is certainly expensive based on its price to earnings. If you are thinking about buying Under Armour for a quick sale, don't. 

However, if you believe that the company can continue to make great products and make good on its plans to innovate in every category, grow worldwide, change the manufacturing industry, and more, then bet on Under Armour for long-term growth instead.