What do you get when you combine a stock with an expensive valuation , potential inventory problems, and a fickle consumer? One word: Trouble. Unfortunately this is exactly the situation facing investors in Under Armour (NYSE:UA). The stock has been a terrific investment over the last year in particular, with shares up nearly 70%. However, it's possible investors have become complacent. Unfortunately, growth stocks and complacency are a dangerous combination.
Masking a potential problem?
In Under Armour's recent quarter, it seemed like the company was beginning to overcome one of its biggest criticisms. Every retailer has to balance the need to build inventory to meet future demand, with the drag that too much inventory can cause.
Under Armour has been growing quickly and as the company tested different designs, excess inventory was a natural result. Several years ago, Under Armour carried more inventory than it could sell in a quarter. In the last several quarters, Under Armour reduced its inventory to roughly 80% of current quarter sales. In fact, in the current quarter, the company's inventory to sales dropped to less than 69%.
By comparison, Under Armour's competition such as Nike (NYSE:NKE) and Lululemon Athletica (NASDAQ:LULU) carried inventory to current quarter sales of 58% and 54%, respectively. However, Under Armour's last quarter sales were significantly higher than the prior three. The first reason investors should worry is, under more normalized sales the company's inventory levels would be more elevated than they currently appear.
In the prior three quarters, sales were less than $500 million. Based on Under Armour's current inventory levels, a normal quarter would represent a near 100% of inventory to sales. By comparison, competitors Nike and Lululemon had relatively normal sales quarters. If Under Armour can't get its inventory under control, the company may need to mark down the excess, which would hurt future earnings.
Great potential also holds major risks
One of the things that makes Under Armour a compelling growth story is the company's reliance on apparel sales. Whereas Nike gets the majority of its sales from footwear, Under Armour and Lululemon get the majority of their sales from apparel. The second reason investors should worry is, as Lululemon found out last year, a quality-control issue can damage a company's reputation and potential sales.
Lululemon had to recall yoga pants that were deemed too sheer for customers. Since the company's reputation is that of a premium brand, a product with quality issues was a major blow to Lululemon. Prior to this quality issue, most analysts were expecting Lululemon to grow earnings per share by more than 27%. Due in part to this issue, Lululemon's sales suffered, and now analysts are expecting EPS growth of just less than 22%.
Though Under Armour hasn't reported an issue similar to Lululemon's yoga pants issue, this risk is significant. With more than 75% of Under Armour's revenue tied to apparel, any issue with Under Armour's quality control would be a significant blow to the company.
These numbers can't be ignored
The third reason investors should worry about Under Armour's stock is the value of the shares doesn't leave much room for error. With a trailing P/E ratio of nearly 60 compared to the current P/E of the S&P 500 sitting at about 17, the stock trades for a significant premium to the overall market.
Though Under Armour has been a phenomenal growth story, investors are expecting very fast growth to continue well into the future. While it's not hard to argue that Under Armour deserves a higher multiple than the average S&P 500 stock, it's difficult to believe the company is more than 250% more valuable. With this type of P/E ratio hanging around the company's neck, any slowdown in earnings or revenue growth would likely cause the stock to sink like a stone.
While Nike trades for a similar PEG ratio of more than 2, Lululemon's PEG ratio is down to slightly more than 1.1. The difference between Nike and Under Armour is, Nike is a well-established brand that pays a dividend and is a consistent performer.
While Under Armour is a great growth story, this growth may be slowing. For one, Under Armour's gross margin over the last five years has averaged 51%, whereas the company's margin today sits at slightly more than 48%. In addition, in the last five years Under Armour has grown EPS by nearly 29% per year. In the next five years, analysts expect earnings growth of about 22%.
With a high level of apparel sales and the risk associated with this business, Under Armour can't afford any missteps. Given that the company carries relatively more inventory than its peers, investors should watch this trend carefully.
Even if Under Armour keeps inventory and quality control in check, the stock is less attractive than in the last few years. The company's gross margin and EPS growth are below their five-year averages, though the company's P/E ratio is near a five- year high.
Given these risks, investors need to tread carefully and make sure they don't expect too much.
Chad Henage has no position in any stocks mentioned. The Motley Fool recommends Lululemon Athletica, Nike, and Under Armour. The Motley Fool owns shares of Nike and Under Armour. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.