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Cracks in Under Armour

Marc Lichtenfeld

Under Armour's (UA Quote - Cramer on UA - Stock Picks) success is remarkable.

The upstart company, which started in a garage 10 years ago and reached $430 million in sales last year, has the potential to be the Apple of athletic wear.

Much like the way Steve Jobs' company endeared itself to techies as it took on giants such as IBM and, later, Microsoft, Under Armour has gained a reputation for quality, performance and trendiness among serious athletes and teens alike, as it competes for market share against sector leader Nike (NKE Quote - Cramer on NKE - Stock Picks).

The sky is the limit, and the market has afforded it a price-to-earnings ratio to match. At 46 times consensus 2007 earnings of 95 cents per share, the stock trades at nearly two times its projected growth rate of 24%. Strong growth deserves a premium, and Under Armour is expected to deliver strong growth.

But while the company's apparel and football cleats are selling well, its first missteps may soon be visible. The company's baseball cleats have received mixed reviews, and a new analysis from channel-check research house Farmhouse Equity Research indicates that the shoes may not get the traction that its other products enjoy. Its fishing apparel line does not look like it will emerge as a category leader. Additionally, buyers at sporting goods retailers are expressing enthusiasm for Nike's new moisture-wicking T-shirt.

Swing and a Miss

According to Newport, R.I.-based Farmhouse, buyers for sporting goods chains are reporting some resistance by their customers to the high price of the baseball cleats. Some reported that the average high school athlete can't afford the higher-end shoe, while cleats offered by Nike, a more established baseball brand, don't pose a price issue.

An anonymous buyer from a major national sporting goods retailer in Farmhouse's report said the store has received "a lot of negative feedback" about the shoe not fitting right. Clearly, not every buyer reported problems. But when a company is introducing a new product that will go head to head with a category killer like Nike, it can't afford to stumble out of the box if it wants to make it to first base with consumers.

The company may be in a tough spot with the product line if it doesn't compete well with Nike. Under Armour is considered a premium brand, so it can't lower its pricing by too much if it wants to maintain that image. Additionally, margins are likely to be lower than rival Nike's, because of the volume that each company produces. Therefore, Under Armour may not be in the position to lower prices unless it sacrifices significant margin.

The fishing apparel seems to hold even less attraction to its targeted audience. According to Farmhouse's research, many buyers reported that Columbia Sportswear (COLM Quote - Cramer on COLM - Stock Picks) remains the preferred brand. According to a buyer from one of the nation's largest sporting goods retailers, "Apparently, fishermen don't care for the style of the UA fishing shirts."

On the competitive front, Nike is not going to sit back and hand over market share to Under Armour. The footwear and apparel giant just introduced a cotton moisture-wicking T-shirt and expects to bring out several cold-weather apparel lines to go head to head with Under Armour's cold-weather gear. "National buyers are excited about Nike's competitive products and are making room for them," Farmhouse's Jim Sanderson says. Farmhouse does not do any investment banking. Sanderson does not have positions in Under Armour or Nike.

Under Armour did not return calls seeking comment.

Can't Hit Them All

Now before you Under Armour bulls start firing off angry emails, let me say that I am not predicting the downfall of the stock due to fishing shirts and baseball cleats. There were plenty of positive anecdotes from buyers in the report.

One buyer, who bought Under Armour lacrosse gear last spring, said "these were great for boys and men, and we had to go back and order more." Another said kids playing baseball and football "want to wear" Under Armour. "It's not a fad, it's good technical gear."

That being said, I do think it's important to call attention to issues when a stock may be priced as if the company will hit every pitch out of the park.

"Seven or eight months prior, anything with a UA label would sell through the door," notes Farmhouse's J.P. Mark, who also does not hold positions in Under Armour or Nike. "This is the first instance of buyers telling us there are problems."

Earlier in the month, Under Armour shares slid after the company warned that second-quarter earnings would be below expectations because of marketing expenses. The 9%, one-day selloff illustrates how quickly investors will dump a stock when expectations are high.

Shareholders of longtime highflier Whole Foods (WFMI Quote - Cramer on WFMI - Stock Picks) saw just what can happen when the growth story comes into question. Shares are off 14% since the grocery chain's disappointing earnings report.

High P/E growth stocks can be tremendous investment vehicles as long as the story is intact. But when doubts start to arise and ultimately problems appear, the stocks can get pounded like a Kei Igawa fastball.

So rather than considering this column headhunting, think of it as a little chin music, designed to back you off the plate and think about what's coming next.

"In a growth story, when you grow the top line with product extensions and then there is weakness in those products, that changes the story," says J.P. Mark. "Expectations are pretty lofty. At some point it's going to catch up to the stock."

I concur.