Higher Gross Margins for Under Armour Underpins the Bullish Outlook

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Under Armour (NYSE: UA) is a leading US based retailer in the performance apparel market. The gross margins for the company have decreased since 2010. During fiscal 2012, Under Armour operated on a gross margin of 47%, which is a slight decline from previous years. Surplus inventory that led to clearance sales and higher shipping cost predominantly underpins the decline in gross margins. However, going forward, I expect the gross margins to grow with higher contributions from direct to consumer business.

Direct to consumer business, which primarily comprises of the ecommerce channel, factory stores and speciality stores operates on a higher margin. Furthermore, declining cotton prices will aid Under Armour in keeping the material cost in check. Fabric cost from the eastern countries such as India and China have been dropping lately due to cheaper substitutes offered by suppliers based in Bangladesh and Srilanka.

Threats such as increasing labour cost and oil prices can impact its profitability, thus, it is highly essential for Under Armour to strategically forward the rising cost on to its consumers in order to maintain higher margins.

Increasing Contribution from High Margin Divisions

Direct to consumer business includes factory stores, ecommerce channel and speciality stores. Relative to the wholesale business, these business units operate on much higher margins. Under Armour is taking a serious initiatives to bolster the direct to consumer business. During 2012, the retailer opened twenty one new factory stores; in addition, it plans to launch two new speciality stores and ten factory house stores during 2013.

During the fiscal 2012, the revenues through the direct to consumer segment grew by 34%, and contributed approximately 29% to the overall revenues. In comparison the direct to consumer business only accounted for 21% during 2010, hence, the increasing proportion from direct to consumer business will enable Under Armour to consistently maintain high gross margins.

Declining Fabric Cost

Cotton is the most commonly used fabric in apparel manufacturing. During 2011, Cotton prices were soaring high at around $2.30/pound. This was predominantly due to export restrictions in India coupled with drought type conditions in cotton fibre producing areas in China.

However, since then Cotton prices have reduced significantly, and presently it costs at around $0.80/pound. Any upside in the Cotton price is primarily related to environmental issues such as droughts or floods. Unless, we witness such severe conditions in Cotton producing countries such as India or China, I don’t expect any sudden upside in Cotton prices.

Ability to Raise Prices to Offset any increase in Operating Cost

Under Armour is the market leader in performance apparel and possesses a supreme brand image. I believe it has the capacity to leverage its brand recognition and dynamic product mix to increase sale prices in order to make up for any minor growth in the operating cost.

Competitive Landscape

Under Armour primarily competes with Nike (NYSE: NKE) and Adidas (NASDAQOTH: ADDYY) in the performance apparel market. Nike is one of the largest sports footwear retailers. By the end of 2012, its footwear market share stood at 18.6%, which underpins Nike’s dominance.

Nike operates on a gross margin of44% and reported revenues of $25 billion during fiscal 2012. It has a market cap of $42.7 billion and the current stock price trades at around 97% of its 52-week high. According to the valuation offered by Trefis, the F-C-F to gross profit is expected at around 17.5% during 2013.

During the recently released Q3 fiscal 2013 results, Nike reported a 9%Year-on-Year growth in its top line and a marginal increase in its gross margin, in addition, revenues from the emerging markets also grew by 8%.

Similarly, Under Armour also competes with Adidas. The German group owns brands such Reebock and Rockport. Other than sportswear, the company also offers bags, shirts, watches and eyewear. During fiscal 2012, the company reported net revenues of €14.88 billion and an operating income of €1.18 billion.

The company presently operates on a gross margin of 47%. It generates the highest percentage of its revenues through footwear sales at $6.9 billion; this is followed by apparel at $6.2 billion.

Merchandise sold under Adidas generates the maximum revenue for the company, followed by Reebock and Taylor Made- Adidas Golf.

Threats

Going forward, Under Armour may experience pressure on its operating margin due to rising labour cost. During 2012, it out sourced manufacturing to several suppliers based in Asia and South America. The labour cost in China has been consistently rising during the past few years, and going forward, this might lead to a dip in gross margin if sale prices remain constant.

Increase in the oil prices has a direct impact on freight charges. This is usually included in cost of goods sold; hence, a sudden rise in oil prices will have a negative bearing on gross margins. Such drastic rise in costs is extremely hard to pass on to consumers without augmenting the product.

Therefore, it is essential for Under Armour to have a preventive strategy in order negate such threats.

Why a Bullish View?

The gross margins for the company declined during 2011 predominantly due to a higher material cost and clearance sales. However, based on my estimate, increased contribution from direct to consumer segment and declining cotton prices will enable it to maintain high margins.

 It should be noted, direct to consumer business that comprises of ecommerce channel, factory stores and speciality stores operate on relatively higher margins.

According to the valuation provided by Trefis, gross margins of Under Armour should exceed 50% in the longer run. Hence, I believe this stock will give robust pay-outs in the future.


Ashit Gulati has no position in any stocks mentioned. The Motley Fool recommends 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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