adidas AG (OTCQX:ADDYY) (OTCQX:ADDDF) is an athletic and sports brand, producing and sell predominantly apparel, footwear and accessories worldwide.
adidas sells its products through approximately 2,200 own-retail stores, franchise stores, shop-in-shops, wholesale and its e-commerce channels.
adidas' stock has had a wild ten-years. The majority of it has been very positive, growing Y/Y. From its peak in late 2021 however, the stock has fallen over 50%. This is due in large part to changing macro-conditions and the Yeezy fallout.
With a bounce back from its 2016/2017 level, now feels like a good time to assess the attractiveness of adidas. In this analysis, we will consider the macroeconomic factors that have influenced the company so far, as well as providing out outlook for the next 12 months. Additionally, we will examine the planned transformations within the business and industry trends in the apparel sector. Finally, we will provide a thorough assessment of adidas' financial performance and arrive at a valuation based on its relative performance.
Economic conditions quickly reversed in 2022, with GDP growth beginning to slow. The US saw two successive quarters of negative growth in H1'22. The major contributing factor to this stems from a sustained increase in inflation, caused by an overheating economy, supply chain issues and rising energy prices. In order to bring inflation under control, central banks have increased interest rates to levels not seen since before the financial crisis. With heightened interest rates and inflation, consumers are struggling to meet their financial obligations, contributing to falling demand. Looking at retail sales, we see a several month stagnation followed by the first piece of evidence to suggest declining demand.
Going forward, we expect things to continue to weaken. Markets and the FED are in disagreement as to how much further rates will rise, but they do agree it will be in the region of 5%. With inflation in excess of 5%, we will likely see much of 2023 experiencing unsustainable inflation.
The current economic situation is a cause for concern for adidas. The brand's products, primarily athletic wear, fall under discretionary spending and with consumers facing financial difficulties, they may opt for cheaper alternatives or defer their spending altogether. For instance, a comparison between adidas and Reebok's prices shows a gap of approximately £15-£25 for similar clothing items. Consumers are usually willing to pay the differential but tightening finances can easily change this.
One key trend in the industry is the growing importance of sustainability. Consumers are becoming increasingly conscious of the environmental impact of the products they purchase and are seeking out products that are produced in an environmentally responsible manner. adidas has responded to this trend by implementing a number of sustainability initiatives, including using recycled materials in its products and reducing its carbon footprint.
One of the key initiatives that adidas has undertaken is the use of recycled materials in its products. The company has committed to using only recycled polyester in all of its products and packaging by 2024. This will help to reduce waste and lower the carbon footprint of its products.
Another important aspect of adidas' sustainability strategy is its efforts to improve labor practices throughout its supply chain. The company has established a comprehensive program to promote fair labor practices, including improving workers' rights, providing better working conditions, and promoting education and training programs for workers.
In addition, adidas is actively working to reduce its water usage and promote water stewardship. The company has set a goal of reducing its GHG emissions by 30% by 2030, and it is working with suppliers and partners to promote sustainable water use practices.
Goodonyou.eco evaluates companies' ESG efforts and provides a comparison between peers. They give adidas a "It's a start" rating, which is a 3 out of 5. They appreciate adidas' use of environmentally friendly materials but criticize the company for not ensuring fair wages for its workers. However, adidas has indicated that it will make adjustments to salaries in 2023 to address the impact of inflation, which could lead to a better ESG rating. adidas, Nike (NKE), and Puma (OTCPK:PUMSY) received the same rating, with Lululemon (LULU) being rated as "Not good enough" (2 out of 5). In a sector where ESG practices are relatively similar, adidas has an opportunity to differentiate itself. McKinsey research shows that consumers are aligning their spending with ESG-friendly products, with historic growth supporting this.
Many of the large retail brands have been execute a several year strategy to shift towards direct-to-consumer (DTC). The reason for this is that the brands can keep a greater share of margins and control pricing. This has been possible due to the decline of brick-and-mortar sales relative to e-commerce. The 3rd-party retailers are offering less-and-less to the brands as consumers are shopping online. A landmark example of this made the news as Nike announced it would reduce its allocation to Footlocker (FL) (our write up linked).
This has been great for adidas' margins, which have continually crept up in recent years. Assuming demand can be maintained long-term, which we see no reason to argue against, like-for-like sales will be more accretive.
This does not come without risks, however. With the DTC approach, the brands take the stock onto their balance sheet, as opposed to it being held by the retailers. This creates greater pressure to understand stock management and the risks that come with holding stock that takes time to shift. Unfortunately for adidas, we are now at a time like that. With slowing demand, inventory is beginning to build up. Retail Drive suggest these retailers are beginning to regret their decision, as these brands are holding a record level of inventory in the last few months.
In adidas' case, inventories have reached 28% of revenue, a record level compared to the 18% 10-year average. This means the risk of margin contraction is very high, as discounts will be required in order to shift stock. Management commentary suggests this is already occurring "adidas had reduced its full year guidance as a result ... higher clearance activity to reduce elevated inventory levels". Given that stock is still high, we could see this continue well into 2023. Management have forecast GPM to contract to 47%, which is 3.7% less than FY21. For a mature business, this is very poor.
Footwear and Apparel growth have been surprisingly erratic Q/Q, likely driven by lockdowns. Consumers quickly realised that working out at home was possible, and partnered with income support, it is unsurprising sales grew like crazy in Q3-20.
Over the whole period however, quarterly growth has been non-existent. With Yeezy footwear sales potentially falling off, it is difficult to not predict declining sales. Accessories have performed extremely well but are not a large enough component of total sales in order to move the needle.
Adidas has recorded impressive growth in its core mature markets of NA and EMEA, despite the impact from Russia, quarter-over-quarter. In addition, LatAm and Asia have performed exceptionally well. This level of growth for a mature business is remarkable. The growth can be attributed to several factors, such as the impact of sports events, including the 2022 World Cup, the return of tennis after the lockdown, and cricket tournaments, among others. The global reach of the World Cup, in particular, has likely fuelled a boost in sales during the run-up to the tournament.
Adidas sponsored the second-most jerseys at the tournament, including that of the eventual winner, Argentina. They are driving demand for activewear due to the interest in sport, but also for specific jerseys. With the World Cup being played in Q4, there is a good chance that Q4 results outperform, driving short term positive price action.
China is also a glaring issue. The issues in the country are not helping adidas in the slightest. We saw a zero-COVID policy up until recently, which meant lockdowns and depressed demand. Now we are seeing a wave of cases and naturally a reduction in athletic activities. It is difficult to see where the Chinese market will go from here, but prudence suggests a further year of declining sales is likely, although at a far lower rate. It is difficult to see what portion of the decline is attributable to a relative lack of competitiveness but if we look at Nike's decline in sales, it sat at 20%.
adidas has growth revenues at a CAGR of 4% across the last 10 years, driven in part by the partnership with Kanye in 2015, which revitalized a stagnating brand.
As previously mentioned, adidas has experienced an increase in margins as a higher proportion of sales are now made through direct-to-consumer channels, resulting in better margins. The company has successfully translated this improvement to its net income, with marginally less additional fixed costs.
S&A expenses have been noticeably increased disproportionately to revenue in recent years, indicating that adidas' marketing strategies are not producing the desired results. A portion of this is penetration into China and LatAm but the ratio suggests they are yet to yield the benefit of it. This has a direct effect on the company's Net Income, causing margins to drop to 2% in the fiscal year of 2020, which could repeat in the fiscal year of 2023.
From a balance sheet perspective, the company has seen a deterioration in its cash management. This is primarily driven by inventory management, as discussed previously, as well as delays in receiving payment. adidas' current ratio implies this will not cause a liquidity issue, but is further evidence that trading is getting tougher.
Debt wise, adidas is in a relatively healthy position. The large uptick in debt is attributable to a change in lease accounting standards. Our view is that a net debt / EBITDA ratio of sub 3x is healthy, which adidas is well within.
Adidas' approach to managing its capital is unusual. At times, the company has maintained dividends and repurchased shares when repaying debt, resulting in a net cash outflow. This strategy is acceptable only if the cash is surplus to requirements, but it raises concerns as it reduces the company's overall cash holdings to historically low levels.
adidas' performance relative to its peer group average is poor.
As a well-established business, one might expect greater consistency between companies, however, both adidas and Puma are noticeably lagging behind their peers. Although the discrepancy is less pronounced when considering the Free Cash Flow (FCF) metric, the situation remains disappointing. Poor stock management is a significant contributor to this; however, it fails to account for adidas's inability to surpass a 15% EBITDA margin over the past decade.
Furthermore, adidas' growth rate has been inferior to that of its peers for the past five years and is projected to continue in the future, exacerbating the issue.
adidas is trading at a discount to its peers, but above its historic average of 15x.
Our view is that the business is certainly in a worse position than it was prior to the cessation of the Yeezy deal, when they traded at 14.4x. The company has lost a chunk of profits and our view is that economic weakening will further lead to declining profits.
On a relative basis, our view is that the first 4 businesses listed above are superior on a trading basis, with Puma being comparable. In order to assess our relative fair value, we have applied a discount to these businesses to reflect the relative disadvantage in growth and profitability.
In comparison to its peers, our evaluation is that the first four companies listed have a stronger trading position, with Puma being similar. To determine a relative fair value, we have applied a reduction to these companies EBITDA multiple to account for the difference in growth and profitability. This would suggest a downside of 9%, similar to a reversion of adidas' historic valuation.
Analysts appear to have some concerns about the overall industry, as 5 out of the 8 companies have less than a 5% upside potential, according to analyst estimates. This raises the possibility that all current companies might be slightly overvalued. To counteract this, we have also performed a discounted cash flow analysis of adidas.
Our key assumptions are:
Based on our analysis, we have determined that there is limited potential for growth with an estimated upside of only 3%.
adidas has been impacted by the recent economic downturn, which has put pressure on consumer spending and created uncertainty in the market. Our view is that this will continue in 2023, resulting in flat growth. However, adidas has responded to these challenges by continuing to focus on direct-to-consumer sales, which has improved its margins. This may cause some short-term headaches with inventory management, but we are bullish on the long-term benefits of this strategy. Despite some ESG criticisms, adidas could differentiate itself in the industry by focusing on this area.
adidas' financials are uninspiring when compared to their peers, which when aligned with valuation, makes justifying this as an investment difficult.
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