Lululemon Has Tanked, Is Under Armour Next?

Lululemon Athletica (LULU 1.95%) shareholders endured a torrid 2013 with multiple price plunges as well as very worrying manufacturing and supply chain issues. The latest development, when its management issued a weak fourth-quarter forecast and lowered the full-year guidance, provided the final straw. The stock plunged a massive 17% in the space of just a week.

The stock's market correction was probably long overdue, since Lululemon traded at enormous valuations in both 2012 and much of 2013. That brings us to the big question: will Under Armour (UA 2.26%) follow in Lululemon's footsteps, since both are viewed as growth stocks in the sports apparel industry? Although Lululemon traded at a considerably higher valuation than peers Nike (NKE 0.97%) and Columbia Sportswear (COLM 0.26%), Under Armour has been trading at even higher valuations for the last twelve months which truly reflect the heightened expectations of growth for the company.

The outlook for Under Armour is not so rosy
With that kind of valuation, there are genuine reasons to be concerned about a market correction for Under Armour, just like what happened with Lulu. After the massive drop, Lululemon's stock now has a forward P/E ratio that is comparable to Nike's.

Worryingly for Under Armour several analysts, including Trefis, predict that Nike will continue growing its global market share through 2020 and this will quite likely come at the expense of its competitors. Nike's global market share in the sports apparel market grew steadily from 3.7% in 2007 to 4.9% in 2012. The company's market share is predicted to continue growing at a steady pace in the coming years to hit 6.5% in 2019, reflecting the growing global popularity and increasing acceptance of the brand even though it has been in the market for half a century now.

Under Armour still plays second fiddle to Nike in the U.S. market with a 14.7% share of the market compared to Nike's 27% share. Its sneakers simply can't touch Nike's with a paltry 2.25% market share which compares to Nike's industry-leading 44.7% share (60% when you include the Jordan and Converse brands).

The high valuation of Under Armour results from the company's past stellar performance in terms of sales growth. Its 38.7% compound annual growth rate, or CAGR, between 2010 and 2012 is only second to Lululemon's 38.7%.

The table below shows how Under Armour, Lululemon and Nike are expected to grow their top and bottom lines in 2014.

Although Under Armour is undoubtedly the leader in regard to these data points, Lululemon is not far behind. Yet Lululemon's forward P/E ratio of 30 is just half of Under Armour's ratio of 60. That could spell trouble for Under Armour's share price.

Columbia Sportswear's stock is trading at 52-week highs, yet its valuation remains quite decent. Columbia is a family run company, headed by the iconic octogenarian CEO Gert Boyle of 'One Tough Mother' ads fame. The company has been growing admirably and it recently hiked its dividend by 14%. The stock now yields 1.5%. Despite being smaller than its peers (market cap $2.46 billion), the sportswear maker has a huge global presence with brands such as Mountain Hardwear, Outdry, Columbia, Sorel, and Montrail available in 100 countries around the world.

That said, Under Armour will be hard pressed to maintain that kind of growth in the coming years to justify its lofty valuation. Here are a few reasons why:

1. Intellectual Property Rights
   Under Armour's products are popular for the specialty fabrics used in their manufacture. These are mostly technically advanced products developed by third parties. The fabrics are sourced from suppliers that are pre-approved by Under Armour. Under Armour does not own any process or fabric patents for its products. The patents are mostly held by its suppliers, and Under Armour's products will be open to competition from comparable products after they go off-patent. Nike already produces many products using the novel technologies that Under Armour uses such as DRI-FIT. Larger competitors such as Nike or Adidas can leverage their economies of scale to make products comparable to those of Under Armour at cheaper prices.

In its defense, in the last two years Under Armour has been moving quickly to build a patent portfolio of its own. The company has already applied for several patents on unique designs and products and plans to continue doing so.

1. Cotton prices
   Cotton is the main raw material used in Under Armour's products. The company's profit margin hinges strongly on international cotton prices. Cotton farming is highly labor-intensive. The spiraling cost of labor has made the venture less profitable in recent years. As a result, farmers have been steadily turning away from cotton toward other more-profitable crops, which has led to cotton prices shooting up a hefty 55% in the last year.  This could result in declining profit margins for companies such as Under Armour that rely heavily on cotton.

1. Competition
   Under Armour is a company that mainly concentrates on selling to niche customers. The growth potential of its specialty niche market is limited, and the company will have to resort to serving the wider market in a bid to continue growing. Therein the trouble lies. With large competitors such as Nike and Adidas, Under Armour will be in a precarious position. Unless the company can differentiate its products so the market sees them as significantly better than those of its rivals, Under Armour is likely to find its growth tapering off to a level similar to those of its larger competitors.

Foolish Bottom Line
Although Under Armour recently got a huge endorsement after Notre Dame ditched Adidas in favor of the company, the lofty valuation of the shares is a major point of concern. Lululemon shares were flying high until the company suddenly hit a wall after it announced that its growth was going to slow down going forward. Maybe it would be wise to wait for a 10%-15% pullback in Under Armour shares before establishing a position in the stock.