Yesterday, shares of Under Armour (UA) fell 6.2% after Morgan Stanley analyst Jay Sole noted that Under Armour is reducing the sale price of its women’s footwear and is still expected to lose market share over the course of 2016. This is noteworthy because Under Armour is expected to reduce its women’s footwear pricing by 20% (compared to the industry average of 4%) and still lose market share over the course of 2016. Although the specific metrics have been first articulated by Mr. Sole, the understanding of this general trend has taken the stock from a high of $105.90 in 2015 to $69.96 at the close of yesterday’s trading.
This 30% decline in the price of Under Armour stock, even while earnings continue to grow, illustrate the power of “expectations” in setting the price of stock. It is such a powerful force that Professor Jeremy Siegel’s book “Stocks for the Long Run” challenged the conventional wisdom that “stocks do poorly when interest rates rise / do well when interest rates decline” by providing data to suggest a more accurate understanding would be “stocks do poorly when interest rates rise greater than expected / do well when interest rates decline greater than expected.” This type of logic was on display when Warren Buffett wrote a 1982 article for Fortune Magazine in which he argued that the best stock selections are those in which his forecasts were significantly more favorable than what the analyst community was predicting.
Since hitting the scene in 1996, Under Armour has been an excellent growth company. Its costs have been significantly higher than Nike, and that is why Under Armour only has operating margins in the 13% to 15% range which is lower than I expected for a company that sells in the semi-premium clothing market. But what it currently lacks in cost efficiencies it makes up for in the size of the frontier it is conquering. Because Under Armour is such a niche player in the industry, gaining a few points of market share has been enough to propel growth. Under Armour sold $281 million worth of merchandise in 2005, and sold $3.8 billion worth of merchandise at the end of 2015. Profits have also grown from $20 million to $240 million over the same time frame.
The challenge of investing is that recognizing a great growth stock is not enough of an insight to make a fortune. You also have to get the stock price’s “zone of reasonableness” correct and act upon it. Between 2009 and 2014, Under Armour delivered 56% annual returns and turned a $1 into $11.76 in just five years. But over this time, profits at Under Armour only grew from $0.23 to $0.95. The business only grew 313%, but shareholders earned returns of 1076%. Under Armour doesn’t pay a dividend; those profits came from an inflating P/E ratio as Under Armour closed the 2014 calendar year trading at 77x earnings. If you held Under Armour stock from 2009 to 2014, the business performance itself only justified about one third of your overall returns. The rest of it came from investors bidding up what they were willing to pay for each dollar of profits.
While the business growth aspect of returns are not a zero-sum game, the effects of a P/E valuation shift are. Essentially, because the 2009-2014 investors achieved far superior gains than they deserved, the future shareholders will earn less than the growth of the business would suggest because the valuation still has much compression left to do before it reaches its long-term equilibrium.
The reason why Under Armour stock has fallen from $105 to under $70 in less than a year is not because the company’s earnings fell off a cliff, but rather, because the rate of expected growth cooled off a little bit. After years of 30% annual growth, earnings of $0.95 only grew to $1.08 in the past twelve months. It is weird using the word “only” in this context. That is 13.68% annual earnings growth. In most circumstances, that is fantastic. If you owned a fairly valued asset that grew at that rate for a long time, your family would be very well off. But Under Armour found itself in one of the few circumstances in which 13.68% growth is not enough: a super-high P/E ratio that demanded years and years of seemingly perpetual 20%+ annual growth.
The $105 stock price, compared to $1.08 in earnings, suggested a valuation of 97x earnings for a stock then valued at $23 billion. This sounds like a dotcom era reference of insanity. People with that value investing instinct embedded in their bones might now be wondering: So is Under Armour a good deal now that it is trading at $70 per share? Well, Under Armour is expected to generate $1.35 in profits over the course of 2016. The current price suggests a forward P/E valuation of 51x earnings. While not as bad as last year, this is still close to a dotcom era reference of insanity. And, compared to current earnings of $1.08, the P/E ratio of the stock is still 64.
I am open to the argument that companies with extraordinary growth characteristics may merit a little bit of readjust upwards for defining your comfort zone. My hard-line for a company like Under Armour would be 30x forward earnings, or $40.50 per share. That kind of valuation recognizes that fast growth can burn off some excess valuation quickly while also recognizing that price is the anchor against which all future returns are determined.
The reason why I would not yet consider Under Armour an adequate candidate for purchase is because even a “good case” scenario leaves me unsatisfied. Let’s assume, for the sake of argument, that Under Armour delivers 20% annual growth for the next five years, performing in the top quintile of analyst expectations. That would give you $1.32 in 2016 earnings, $1.61 in 2017 earnings, $1.96 in 2018 earnings, $2.39 in 2019 earnings, and $2.91 in 2020 earnings.
At that point, you will have to figure out: What will be the fair value P/E ratio for the stock at that point? 20x earnings? 25x earnings? 30x earnings? Those assumptions would suggest a fair value somewhere between $58.20 and $87.30. Think of it like this: If you use optimistic assumptions, and calculate 20% annual earnings growth and a closing valuation of 30x earnings, you will still only generate 4.75% annual returns from now until 2020. To make good money five years from now, you will need growth well above 20% and/or a P/E ratio well above 30. Who wants to go through life relying on assumptions like that?
The issue is that the stock is still trading at 64x earnings even after the recent haircut of over 30%. That’s tolerable for a company that is in the infancy stage of its business growth– but that is not okay for a company like Under Armour that is already selling $3.8 billion in annual merchandise.
A close study of what has been happening to Under Armour stock teaches us some good lessons: (1) A substantial price decline such as 30% does not mean much if it only signals the stock is shifting from super wild overvaluation to wild overvaluation; (2) stocks with super high P/E ratios can experience high, justified price declines even while still delivering double-digit earnings growth if the pre-existing expectations called for higher growth, and (3) severe valuation shifts in a stock mean that if some investors earn much higher returns than the business performance itself would justify, the next crop of investors will be paying off the valuation debt with lower future returns than the business growth would suggest.