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Higher Gross Margin for Under Armour Underpins the Bullish Outlook

Monday - 4/8/2013, 4:48pm  ET

Under Armour is a leading US-based retailer in the performance apparel market. The company's gross margin has decreased since 2010. During fiscal 2012, Under Armour operated on a gross margin of 47%, which is a slight decline from the previous year's. Surplus inventory that led to clearance sales and higher shipping cost predominantly drove the decline. However, going forward, I expect the gross margin to grow with a higher contribution from the direct to consumer business.

Direct to consumer business, which primarily comprises of the ecommerce channel, factory stores and specialty stores, operates on a higher margin. Furthermore, declining cotton prices will aid Under Armour in keeping material costs in check. Fabric costs 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 labor 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

Relative to the wholesale business, direct to consumer units operate on much higher margins. Under Armour is taking a serious initiative 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 specialty stores and ten factory house stores during 2013.

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

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 fiber producing areas in China.

However, since then the price of cotton has reduced significantly, and presently it costs 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, I don’t expect any sudden upside in cotton prices.

Competitive landscape

Under Armour primarily competes with Nike 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 of 44% and reported revenue 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 free cash flow to gross profit is expected at around 17.5% during 2013.

During the recently released Q3 fiscal 2013 results, Nike reported a 9% year-over-year growth in its top line and a marginal increase in its gross margin. In addition, revenue 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 revenue 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 revenue 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 labor cost. During 2012, it outsourced manufacturing to several suppliers based in Asia and South America. The labor 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.

An Increase in the price of oil 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 a 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 margin 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 increase margins.

According to the valuation provided by Trefis, Under Armour's gross margin should exceed 50% in the long run.

This article was originally published as Higher Gross Margin for Under Armour Underpins the Bullish Outlookon Fool.com

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