Apparel retailer Under Armour (NYSE:UA), is positioned as a leader in the performance apparel market. Its apparel gross margin increased from 46.3% in 2009 to 48.3% in 2010, driven by growth in direct-to-consumer sales coupled with lower sales markdowns and returns. However, the figure declined to 47.5% (estimated) in 2011, on account of higher cotton prices. In 2012, it again decreased to 47% (estimated) due to sales of excess inventory at factory stores at lower prices as well as rise in freight costs due to supply chain challenges.
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Going forward, we expect Under Armour’s apparel gross margin to rise and cross 50% in the coming years. The rising higher margin contribution of direct-to-consumer sales to Under Armour’s total revenues is expected to favorably impact its gross margin. In addition, the improvement in cotton prices will further support its gross margin. We believe Under Armour can leverage its brand strength and innovative product portfolio to raise its product prices in the future, which could lead to an increase in its profitability.
However, certain factors such as increase in labor wages and oil prices could lead to a significant increase in input costs. If Under Armour is not able to pass on these rising costs to customers, its gross margin may contract in the future.
Factors That Could Lead To An Improvement In Gross Margin
Increasing Contribution of Direct-to-Consumer Sales In Total Revenues
Direct-to-consumer sales (which include sales though factory stores, specialty stores and e-commerce channel) have higher gross margins as compared to wholesale sales. Under Armour is focusing on growing its direct-to-consumer business, and it opened 21 factory stores in the U.S. in 2012. It plans to open 10 factory house stores and up to two specialty stores in 2013. 
Under Armour’s direct-to-consumer net revenues grew by 34% in 2012, and accounted for 29% of the total net revenues as compared to 21% in 2010. We expect the rising proportion of direct-to-consumer sales in Under Armour’s total revenues to positively impact its gross margin.
Improvement In Cotton Prices
Cotton is one of the key raw materials used in the manufacturing of apparel products. Cotton prices peaked at around $2.30 per pound in March 2011, on account of drought in major cotton producing areas of China coupled with export restrictions in India and flood conditions in Pakistan. Since then, cotton prices have declined and they were recorded at around $0.80-0.90 per pound in March 2013.
We expect the upside in cotton prices to be limited in the near term, owing to high global inventories and lower consumption of cotton, and this factor is expected to bode favorably for Under Armour’s input costs. 
Under Armour Has The Capacity To Raise Prices To Offset Increasing Input Costs
With its HeatGear, ColdGear and AllSeasonGear product lines, Under Armour is positioned as the market leader in the performance apparel market and it commands a superior brand image in the market. We think that Under Armour can leverage its brand recognition and innovative product portfolio to raise prices and offset any moderate increase in input costs.
Factors That Could Lead To A Decrease In Gross Margin
Increasing Labor Costs
Under Armour outsources its manufacturing operations to factories located across the world. In 2012, its products were produced by 27 manufacturers located across 14 countries. Asia accounted for the largest proportion of products manufactured with 53% share followed by Central and South America (19%), Middle East (18%) and Mexico (8%).
Rising labor costs in Asia, particularly in China, could lead to higher input costs for Under Armour. Labor costs have been increasing at double-digit rates in China over the past few years.  Any increase in input costs that Under Armour is not able to offset with price increases will affect its gross margin negatively.
Increase In Oil Prices
Fabrics used in Under Amour’s products are manufactured using various raw materials including petroleum-based products. Hence, Under Armour’s product costs could be influenced by the long term pricing trends of oil. Inbound and outbound freight costs which are included in Under Armour’s costs of goods sold, are also affected by oil prices. Significant rise in oil prices could hurt Under Armour’s gross margins, as the company may not be able to pass on these incremental costs to consumers completely.
Rising Competition In The Performance Apparel Market
While Under Armour is positioned as the market leader in the performance apparel market, the competition is growing within this segment from bigger players such as Nike and Adidas. Increasing competition in the market could deter Under Armour from raising its prices aggressively in the future.
We have a near $50 price estimate, which is just ahead of the market price.Notes: