Stay away from Under Armour, Buy Nike Instead
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Although the Olympics have ended, sports are still going hot. Baseball is in session and there's NFL to be excited about. The point is this: Sports are a pastime in the US and abroad - they are here to stay. While many investors view large retailers as the most stable stocks, they should also look to firms like Nike (NYSE: NKE) for defense. Nike may be at a premium to the current market, but it still has greater reward than risk. Under Armour (NYSE: UA), on the other hand, is not "undervalued" - it is "overvalued". Below, I review the fundamentals of both firms.
Nike trades at a respective 20.6x and 16.6x past and forward earnings - high multiples against peers and historical levels. The PEG ratio stands at 2, which means that future growth has been more than fairly factored into the stock price.
Indeed, analysts forecast 10.3% annual EPS growth over the next five years, which translates to a future stock value of nearly $100 by 2016 at a 15x multiple. Discounting backwards by 10% yields a present value of $60 far below the current market assessment.
But here's the thing: Nike is unlikely to depreciate. It has a beta of 0.86, which means that it is 14% less volatile than the broader market. The target price on the stock is currently $105.87, and analysts lean towards a "buy" over a "hold." All in all, Nike is an unsuspecting defensive play. It is targeting the high-growth sports market and is able to succeed in what it does through low-cost manufacturing. In my view, it is the Wal-Mart of sports manufacturing. However, while it is the leader in low-cost sourcing, it charges fairly high prices, which reflect a premium brand. As the economy picks up and real incomes rise, Nike will benefit from a corresponding rise in consumer expenditures.
Over the past five years (a period that included and arguably still includes the challenging global recession), Nike grew earnings by 10.1% annually. With only 20 bps more expected for the next five years (presumably during a full recovery), the bar has been simply set far too low. This will enable the stock to outperform by convincing investors that the multiples are not too high and that the fundamentals are still strong.
Compared to Nike, Under Armour is significantly undervalued. Many individuals view the company as the next "Nike," and, indeed, growth has been strong over the past five years, with annual earnings gains of 18.6%. However, analysts are now forecasting 24.6% annual EPS over the next five years, and this has simply set the bar too high. As it stands, Under Armour is 57% more volatile than the broader market with no dividend yield, so the risk from a multiples contraction is significant.
There is, after all, plenty of room for the multiples to contract. They currently stand at a respective 62.5x and 38.1x past and forward earnings. While the company has positive liquidity with little long-term debt and a current ratio of 3.09, the PEG ratio still stands at 2.54 - indicating that future growth has been more than factored into the stock price. If you project 18.6% annual earnings growth over the next five years and employ a generous exit multiple of 25x, UA would be worth $64.26 by 2016. Discount backwards by 11%, since that is highly risky, and the present value of the business should be around $38 - around two-thirds of the current valuation.
And in terms of free cash flow, trends haven't even been that good. FCF for the TTM ending 2Q12 was -$1 million versus -$66 million in 2Q11 but $76 million in 2Q10 and $69 million in 2Q09. The stock has nevertheless soared by more than 60% YTD. Sales growth has fueled this phenomenal outperformance, but I do not believe investors can necessarily count on superior top-line momentum when the economy is in full swing. Plenty of firms will be fully recovering then and trumping Under Armour's performance, thereby taking away the one thing that Under Armour has to justify its pricey valuation. It is interesting that the PE multiple has risen even more than earnings, which suggests all of the exuberance surrounding the stock is exaggerated. Profitability is still mediocre with margins below peer averages and this will become particularly concerning when the brand matures and the top-line correspondingly slows. Accordingly, I recommend holding out from buying until stronger upside opportunities emerge.
TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Under Armour. Motley Fool newsletter services recommend 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.If you have questions about this post or the Fool’s blog network, click here for information.