I’ve written a number of articles about Under Armour Inc. (UA, Financial) (UAA, Financial) over the past 12 to 18 months (here’s the main one). I don’t want to beat a dead horse, but I like to share my thoughts when I make changes in my portfolio. The reason I do so is because I like the feedback (and pushback) that I get from readers. As always, you should do your own research and come to your own conclusions.
With that, I would like to outline the rationale for trimming my stake in Under Armour.
Valuation
The first point is the most important one. Since the end of last year, Under Armour shares have had a good run. When the stock was at $12 per share, I was comfortable with the assumptions I needed to make to justify owning the stock in size. At those levels, I thought the risk-reward tradeoff was out of whack. But with the stock now north of $21 per share, I’m less comfortable saying that.
My read on the recent financial results is Under Armour still faces some notable short-term headwinds. The company’s direct to consumer and international businesses continue to grow at an impressive pace, but they are still relatively small. For now, trends in the North America wholesale business are still quite important for Under Armour. That’s a long way of saying my fair value estimate and my thoughts on the company have not meaningfully changed from where they were a few quarters ago.
What has changed over that period is the stock price. When Under Armour kept making new lows and reached a level around 10 times pretax normalized earnings, I thought it was time to buy. Now that the stock has risen pretty significantly, I think it makes sense to cut back a bit. Under Armour has become relatively less attractive as it has moved higher over the past six months.
Position sizing
This point ties into the first one. As I noted in my 2017 year-end portfolio review, I bought a fairly significantly amount of Under Armour near the end of last year. As I made clear at that time, and as is the case with every investment I make, I had absolutely no idea what the business or the stock would do over the short term. I certainly didn’t expect it to move significantly higher over the next six months (said differently, I got lucky).
At year-end, the Under Armour position accounted for a mid-single-digit percentage of my portfolio (and a much higher percentage of the equity bucket). With the stock moving higher in 2018 and without any selling along the way, I was left with a position that accounted for more than 10% of my portfolio. As a result, Under Armour recently passed names like 21st Century Fox (FOX, Financial) (FOXA, Financial), Comcast (CMCSA, Financial) and Microsoft (MSFT, Financial) to become my second-largest holding.
In recent weeks, I have found myself thinking about Under Armour’s stock price. My sense is that I’ve been thinking about it a bit too much. When I start focusing on short-term price movements, it is usually a sign that something needs to change. I think the reality is I am not comfortable with the position size north of 10%, particularly in light of what I said above about valuation.
Tax considerations
When I invested in Under Armour, I had enough cash on the sidelines to put the entire position in my individual retirement account. As a result, there are not any tax implications associated with selling a few shares. That’s an important consideration, particularly when you’re dealing with short-term capital gains. The tax tail shouldn’t wag the investing dog, but it would be just as foolish to go to the other extreme and completely disregard tax implications. If I had to send a portion of my gains to Uncle Sam, I’m not sure I would’ve made this decision. In this situation, holding the shares in my IRA allowed me to be more active than I would’ve been if the shares were held in a taxable account.
Conclusion
Under Armour’s market cap is roughly $9.4 billion. On expected 2018 revenues of roughly $5.1 billion and assuming normalized pretax margins of roughly 10%, the stock trades at about 18 times pretax earnings. If the long-term effective tax rate is near the fiscal 2018 number (mid-20s), the normalized price-earnings ratio is on the order of 25 times earnings. Based on reasonable growth expectations and a discount rate of roughly 10%, I’m getting to a comparable terminal multiple when I look out a few years.
Does that number (25 times) makes sense in light of the company’s long-term growth prospects? Maybe. But it’s also off of a normalized earnings per share estimate, which doesn’t hold as much weight in my mind as actual results (said differently, it is way too optimistic if Under Armour can’t deliver). I’m also thinking about this in relation to the Bill Nygren (Trades, Portfolio) quote I shared in a recent article:
“For almost all businesses, our crystal ball goes dark after seven years, so we assume all businesses trade at similar P/E’s after seven years. With an estimate of fair value seven years in the future, we can discount that back at an appropriate risk-adjusted discount rate to estimate today's value. Whether that results in a near infinite or a negative P/E on current earnings is not of concern to us.”
Even though I don't buy in entirely, I think there’s merit in that approach. It may lead to being a bit too conservative, particularly on businesses where outsized growth and / or above-average business quality seem highly likely beyond the forecast period, but it also keeps you honest (predicting what will happen beyond 2025 is not an easy thing to do).
For these reasons, I think it makes sense to pull back a bit on my Under Armour position.
Disclosure: Long UA, FOX, FOXA, CMCSA and MSFT.
