Under Armour margins make sense

September 06, 2006|By Jay Hancock | Jay Hancock,Sun Columnist

Under Armour CEO Kevin Plank is scheduled to profile his company this afternoon at the Goldman Sachs retailing conference in New York, and the assembled investors will probably harp about profit margins.

Margins - sales minus costs expressed as a percentage of sales - are the obsession of Under Armour analysts and seemingly the Achilles heel in Under Armour's armor. After one margin measure slipped 2 percentage points in the second-quarter report, the Baltimore company's stock went from $40 to $33 in two weeks.

But investors should get over the fixation.

If Under Armour is to succeed long-term, it must invest in the brand's mystique and expand into products far beyond moisture-wicking "compression" garments. The only way to do that is to develop new lines, such as the football cleats introduced this year. Which sometimes hurts profits temporarily. "We're effectively paying our dues," Plank said on the phone yesterday. "I think the lights are beginning to come on, [but] I wouldn't say a broad share of the market has understood why we got into the cleat business."

I'm not saying Under Armour's margin deterioration is a good thing. Obviously, if continued it would suggest deeper problems than mere growing pains. But the fluctuations so far result not from mistakes but from investment in Under Armour's future, and that future looks pretty bright.

Over and over, analysts on Under Armour's second-quarter conference call asked about gross margins, which are sales minus manufacturing expenses and other direct costs of goods.

What made them slip? Should second-quarter margins be compared with those of the first quarter of 2006 or the second-quarter of 2005? What are margins for the international business? And so on.

In fact, the entire decline in second-quarter margin can be explained by Under Armour's launch of football cleats for the fall season. Cleats are inherently less profitable than sports garments, and nearly a fifth of the company's second-quarter business was cleats. So gross margin fell from 50 percent for the same period last year to about 48 percent.

The cleat debut was even more successful than anticipated. Under Armour took 22 percent of the football-shoe business, according to Plank, and the company's total profit for the second quarter rose by a third compared with the second quarter a year earlier.

Wall Street, however, acted as though it was a disaster. Valuation models used by New York analysts project profits for years to come, which is why even small changes in margin cause huge swings in the present value of the stock.

But the step into cleats isn't about puffing up profits for a few quarters. It's a logical, well-executed move toward eventually making Under Armour a billion-dollar, multiproduct company.

For Under Armour, cleats aren't about the income statement that analysts focus on. They're about the balance sheet and strengthening the value of Under Armour's most important asset: its brand.

I have written skeptically about Under Armour's challenges, its stock price and its margins.

But the company has done everything perfectly. Its TV ads are miniature works of art. Its marketing campaign is up there with Geico's among the best. Along with Nike, Under Armour is responsible for most of the recent menswear sales increases at Dick's Sporting Goods, Dick's executives said a couple of weeks ago.

Cleats may not fetch 50 percent gross margins. But as crucial gridiron hardware they furnish the "authenticity" that Plank seeks for Under Armour in the same way that expedition backpacks sell North Face raincoats. Under Armour's new cleat deal with the NFL just made them a heck of a lot more authentic.

Paradoxically, selling low-margin cleats is helping turn Under Armour into a cult brand with the potential to command higher margins down the road, as the mystique factor boosts demand.

Even after last month's decline, Under Armour stock is still very expensive in relation to profits. Now Plank has to expand the company into the stock. I don't know if he can, but I know he has a much better chance if he pursues an intelligent brand-extension strategy than if he sticks to a core product and broods over margins.

Under Armour will have to succeed on margin and volume. At 48 percent, its gross margin for the most recent quarter was better than the 44 percent at Nike, a company it aspires to imitate. But Under Armour sold only $80 million worth of merchandise. Nike sold $4 billion worth. Do the math.

jay.hancock@baltsun.com

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