- There’s a divergence between Under Armour’s fundamentals and its stock price.
- Every growth story is bound to end or at least slow down at some point, and at that point the stock usually gets hammered.
- However, sentiment must not be underestimated as an $0.03 earnings beat can send the stock up 10%.
Crazy Stock Movement
Figure 1: UA’s crazy ride. Source: Yahoo Finance.
So what happened? Well, there wasn’t anything wrong with the company, revenue and earnings just kept growing. The company has doubled its revenue since 2013, it has also doubled its book value per share, but earnings haven’t doubled as they increased ‘only’ 20%.
What didn’t grow were the margins. Gross margin fell from 48.6% in 2013 to the current 46.4%, while operating margin fell from 11.4% to the current 8.7%. When a company is so focused on growth and expansion, it’s somehow logical that margins suffer a bit as market share is more important.
Figure 2: UA’s fundamentals have been growing with the exception of margins. Source: Morningstar.
The divergence between fundamental business growth and the stock price is where a great investing lesson can be derived. At the moment, we have improving fundamentals and a collapsing stock. In order to understand what really happened, it’s important to see what has been going on in the last 5 years.
Everything was going exceptionally well for UA until 2015. Revenues were growing at around 30% per year, and people were talking about how UA was a threat to Nike (NYSE: NKE). A Business Insider headline gives us an excellent example of the extremely positive sentiment toward UA up to that time.
Figure 3: UA was expected to become the new NKE. Source: Business Insider.
With revenue growing at 24% in 2012, 27% in 2013, 32% in 2014, and 28% in 2015, it’s easy to get caught up into the euphoria that UA would continue to grow at the same rate and become the new Nike. However, reality shows up sooner or later.
It’s much easier to grow revenue from $1.8 billion to $2.3 billion, as UA did from 2012 to 2013, than it is to grow it from the current $4.8 billion to $6.2 billion which would represent a 30% growth rate. As revenue growth started to slow down, the euphoric sentiment waned and the stock tumbled. Revenue growth is at 6.7% for Q1 2017 which is still great, but it’s far from previous levels.
How big the euphoria was surrounding UA is also signaled by the fact that investors were willing to pay 80 times UA’s earnings while NKE was trading at 30 times earnings.
Lessons To Carry Forward
The main lesson to take from the UA story is related to risk and return. Buying a company at 90 times earnings that is growing 30% per year is extremely risky because such a company has to grow for 7 years at that rate to justify the price paid. To illustrate this, I’ve made a little table that shows the growth necessary to justify an initial P/E ratio of 90 with the assumption that a normal long term P/E ratio for a company is 15 once it reaches maturity.
Figure 4: it takes 7 years at 30% growth to justify an investment at a P/E ratio of 90. Source: Author’s calculation.
Only extremely small companies can grow at 30% for more than 7 years. As soon as a company gets to the $1 billion threshold, 30% growth rates become extremely difficult to sustain because the competition will certainly want a piece of the potential growing market. Just look at how many car companies have added electric vehicles to their production lines since Tesla (NASDAQ: TSLA) started getting some traction in sales.
Figure 5: Tesla’s competition. Source: Forbes.
As competition intensifies, the growth rates enjoyed by a small company inevitably contract which leads to a normal valuation of the company. A curious fact is that Apple (NASDAQ: AAPL) was fairly priced consistently in the last 10 years despite the amazing growth it achieved.
Figure 6: AAPL’s P/E ratio hasn’t reach euphoric levels in the last 10 years. Source: Morningstar.
I like to use UA as an example because it has gone through a full stock market cycle. From a small apparel company, it became this cool company that was supposed to change the world of apparel by threatening Nike and was trading at crazy valuations. As the company became bigger, revenue growth slowed and the stock price fell more than 60%.
Recent earnings have been good with revenue growing 6.7% in Q1 2017, and the stock jumped 10% on Thursday. However, it’s still far from what had been expected from UA just a few years ago.
We’ll see how UA will fare in the future, but when looking at companies with extreme P/E ratios, be sure to plot growth rates into the future and see how long the company needs to grow in order to justify its current price if given a fair P/E ratio of 15 somewhere in the future. Such an exercise would have saved lots of people in the past by saving them tons of money and nerves. Don’t forget to add the possible influence of competition to a growth story, or the possibility of recession.