Under Armour Is Undervalued

While these expansive plans have driven Under Armour to build out its infrastructure, crimping near-term operating income potential, we think these investments should further support its brand intangible asset and ensure that the company remains a valued partner for retailers. Further, we think that its efforts to expand its sales base, particularly internationally, should solidify the pricing power inherent in the brand, the primary factor behind our narrow economic moat rating, as Under Armour increases brand awareness and garners a larger share of its addressable market over time. Additionally, the company should reach a more scalable sales base over the next few years, enabling margin expansion, which could have implications for an improving cost position long term.

Despite investments to support its strong brand, Under Armour has fallen victim to tepid consumer demand for athletic apparel recently, particularly as consumers have shown a penchant for fashion-athletic apparel at the expense of performance (not dissimilar from past trends). As such, we view Under Armour’s efforts to expand its direct-to-consumer reach as a prudent means to bolster its brand equity, by affording it more control of the consumer experience, and better match consumer preferences and demands. Additionally, we think the launch of its Connected Fitness app, which tracks user data, could offer further insights into consumer trends, enabling Under Armour to better tailor merchandise to local preferences, further stabilizing its brand and pricing power.

Respected Brand Digs Moat We've assigned Under Armour a narrow economic moat rating for its brand intangible asset. The primary factor behind our rating is the company's well-respected brand, with a reputation for performance and innovation, which has resulted in pricing power. Over the coming years, we expect the company to expand its products across multiple categories, geographies, and demographics and to garner a larger market share of performance apparel and gear by expanding its addressable markets.

Respect for the brand is driven by unique products and technology stemming from investments in innovation and consumer connectivity. Examples include the company’s Connected Fitness app, which has 200 million registered users, and merchandise like its Connected shoe, which continue to attract new customers and warrant premium prices. Helping market such items are many high-profile athletes via endorsements, as well as sponsorships with collegiate and professional teams, which we think heighten the visibility of such products. Given continued investments to bring superior performance products to market, we think consumers will continue to pay premium prices for Under Armour’s fare, supporting its intangible assets as a moat source.

Our narrow moat rating assumes retailers continue to support the brand as an alternative to Nike and Adidas, the number-one and -two players in the space. The Under Armour brand has shown its ability to drive traffic for retailers, which enables dedicated floor space with a shop-in-shop offering. We view this brand presentation as reinforcing the company’s intangible asset moat source, with the strength evident in its returns on invested capital, which have averaged 17% annually over the past five years, outpacing our 9% cost of capital estimate. We expect Under Armour to return toward 10% over the next few years and generate excess returns for shareholders.

With this said, we think the company falls short of having a wide moat because it operates with less scale and faces intense competitive pressures, tempering our confidence that Under Armour will be able to generate excess returns on invested capital for the next 20 years.

Moat Trend Has Stabilized While we previously thought Under Armour's competitive position as strengthening, given its rapidly expanding brand equity (as evidenced by its growth from just $500 million in annual sales a decade ago to roughly $5 billion today), we now believe those positive effects have been delivered and the company's moat trend has stabilized. We still believe Under Armour's investments in its brand, including expansion globally and across categories, should ensure it will continue to win with both consumers and retailers, preventing market share degradation, and will maintain its pricing power. The company has successfully positioned itself to compete on the larger stage, as evidenced by its 10- to 15-year contracts with Major League Baseball, higher-profile athletes, and collegiate teams, which are reserved for only the largest performance gear manufacturers. While the company has pushed into lower-tier retailers like Kohl's (which could raise questions about the brand's perception and premium pricing power), we believe share gains despite steep competition with wide-moat Nike and narrow-moat Adidas speak to its brand strength. Additionally, we continue to see long-term opportunity for Under Armour to expand its brand, especially within footwear (only $1 billion in sales versus wide-moat Nike's $21 billion last year), women's ($1 billion in sales, which could reach $3 billion over our 10-year forecast period), and international. The company had just $1.1 billion in international markets (22% of sales) at the end of fiscal 2017 but is working to close the gap on Nike's $17 billion in international sales as Under Armour is growing over 50% a year in this segment. We expect a 20%-plus compound annual growth rate over our 10-year forecast, toward 40% of sales.

Our stable trend rating assumes that the company’s direct-to-consumer initiatives (34% of sales as of fiscal 2017 but growing at a 20% CAGR over the next five years), including its website as well as owned physical stores like its flagship 5th Avenue store opening in 2019, continue to bolster its brand intangible asset. We believe the DTC channel raises the experience, service levels, and price points and should reduce the dependence on the wholesale channel (61% of sales). This is rather important as cyclical issues have plagued the North American wholesale market, including liquidations due to retailer closings and a fashion shift into athleisure wear that has dragged on Under Armour’s performance/sport wear recently. However, with tighter product lead times in the DTC channel, merchandise supply and demand can improve, which should stabilize the brand through future fashion cycles.

Supporting the company’s established brand equity are innovative devices and products like its Connected Fitness app (over 200 million members across four downloadable apps), which we see having the potential to enhance Under Armour’s moat as a result of not-yet-realized network effects. As more and more customers use the device, data and workouts are shared and also stored by Under Armour. This increases user engagement and becomes increasingly more valuable to all parties, the users as well as the company. With these insights, Under Armour becomes closer to the customer, which gives it the ability to tailor merchandise to specific geographies and demographics, something we think works to support its brand and pricing power.

Should the company’s margins continue to be constrained relative to competitors, outside the cyclical industry pressures felt by all, we would consider a negative moat trend rating as this would suggest brand intangible assets are weakening. We expect returns on invested capital to expand from their trough of 5% in 2017 toward 14% over the next five years (still lower than its previous five-year peak of 20%), which we attribute to margin expansion and sales resuming to their historical trajectory rather than an improving competitive position.

Athleisure a Threat The main risk associated with Under Armour beyond macroeconomic factors, more specifically consumer spending, is the shift toward lifestyle/athleisure in regions with declining interest in competition and the value-added performance merchandise that Under Armour predominantly sells (roughly 95% of its business). Additionally, rivals Nike and Adidas continue to fight for market share and expand in segments like footwear, sportswear, and women's, where fashion wins are driving outsize gains presently. But we think results based on fashion (as opposed to performance) could be subject to volatility down the road, as a failure to predict or react to prevailing consumer trends could constrain results.

To help with supply and demand of inventory, customer personalization preferences, and a faster go-to-market strategy, the company is investing in its direct-to-consumer channel, which includes its own retail stores and e-commerce site (34% of sales now, but we forecast more than 50% of sales by 2021). While we view these efforts as a prudent means to offset languishing growth in brick-and-mortar retail, the DTC channel poses execution risk as well as requiring greater investmens (fixed costs of equipment, inventory, IT, and operating leases, among others), increasing the cyclicality and operating leverage as well as the risk that such investments could dilute returns in the longer term should volume decline. Also, investments made internationally, across product segments, and into Connected Fitness may pressure margins if sales do not reach a level to effectively scale.