Under Armour Stock Upgraded: What You Need to Know

By Rich Smith Markets Fool.com

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

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Wall Street got mad at Nike (NYSE: NKE) earlier this week, sending the stock down 7%despite a third-quarter report that showed the sneaker king beating analyst estimates by 28%. But there's good news in the athletic apparel world, too: Jefferies & Co. just upgraded shares of Nike rival Under Armour (NYSE: UAA) (NYSE: UA).

Here are three things you need to know about that upgrade.

Image source: Under Armour.

1. It all started two months ago...

...when Under Armour reported weaker-than-expected fourth-quarter results. Sales at the shoes and sportswear specialist rose a respectable 12% in Q4, but margins shrank and earnings per share sank 4%. Management also issued new guidance calling for continued 12%-ish sales growth in 2017, alongside continued gross margin shrinkage -- resulting in another big decline in operating profit.

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This, says Jefferies in a write-up on StreetInsider.com today, has attached "neg. sentiment" and a "compressed valuation" to Under Armour stock in the minds of investors. Indeed, the stock is now down 57% in 52 weeks -- but that could soon change.

2. Under Armour isn't out of the race yet

In Jefferies' view, poor Q4 results and conservative guidance for the coming year have formed a "bottom" under Under Armour stock, and the time to buy is now -- before Under Armour has a chance to exceed its own guidance.

At today's share price of $18 and change, Jefferies believes the stock is a buy -- and not just any buy. TheFly.com reports that Jefferies has put Under Armour on its "Franchise Picks List," the list of this banker's best bets.

Why?

Jefferies says that after surveying "2,000 consumers" it finds that weak earnings notwithstanding, Under Armour's brand appeal has strengthened over the past three years, while consumer demand for athletic apparel remains "robust." The analyst believes that investors are underestimating Under Armour's strength -- and that other analysts are as well. Dismissing consensus earnings estimates for next year (estimated at $0.51 per share, according to S&P Global Market Intelligence), Jefferies believes the stock could actually earn 13% more ($0.58 per share), and then keep on growing from there.

3. 40 x 40

In Jefferies' view, Under Armour's current stock price doesn't reflect the profits that the analyst expects it to earn. In support of which, the analyst shifts gears from real earnings to focus on earnings before interest, taxes, depreciation, and amortization (EBITDA). Jefferies posits EBITDA of $700 million by 2019. And, says Jefferies, if you value these hypothetical profits at 18 times EBITDA, Under Armour stock should be worth $12.6 billion, which "implies 40%+ upside."

Big as that sounds, Jefferies argues that its prediction is actually conservative because "a 18x mult" would actually be ">40% below [Under Armour's] 3-yr avg." (As you can see, Jefferies uses a lot of abbreviations when it gets excited about a stock.)

And yet, you can see why the analyst would be excited: 40 x 40 -- Jefferies is predicting 40% profits at a 40% discount to historical valuations, and potentially even greater profits if the stock gets revalued to what investors used to be willing to pay for it.

The most important thing: Being realistic

Are such high valuations realistic? I mean, Under Armour still basically sells shirts and shoes, right? It hasn't discovered the cure to cancer or something?

Maybe. Even after its steep decline in share price, Under Armour still sells for 14.6 times trailing EBITDA itself. Meanwhile, rival Nike stock sells for 17.2 times EBITDA. Crazy as it might seem, investors do sometimes seem willing to pay these kinds of prices for popular apparel stocks. But should you? And more importantly, should you pay these kinds of prices when they're predicated only on Under Armour's EBITDA, and not its actual net income?

Consider: Last year, Under Armour earned $0.58 per share. This year, that number is expected to decline to $0.42 per share, and most analysts don't expect to see earnings return to 2016 levels before 2019. Jefferies is predicting a resumption of $0.58 per share earnings a year earlier (in 2018). So depending on who's right, investors probably still have two to three years they'll have to wait before earnings at Under Armour even return to last year's levels -- much less resume growing.

Let's look even farther out. Most analysts agree Under Armour will only be earning about $0.95 per share four years hence -- which works out to 10% annualized earnings growthbetween 2016 through 2021. Yet, EBITDA valuations notwithstanding, Under Armour stock is already selling for 40 times trailing earnings (versus 25 times earnings for Nike, despite its more generous price-to-EBITDA valuation).

When you get right down to it, Jefferies' prediction of a 40% profit on Under Armour stock requires you to pay 40 times earnings today for a stock growing earnings at only 10% over the next five years. That seems a mite optimistic to me.

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Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Nike, Under Armour (A Shares), and Under Armour (C Shares). The Motley Fool has a disclosure policy.