Description

CERTAIN STATEMENTS CONTAINED HEREIN REFLECT THE OPINION OF THE AUTHOR AS OF THE DATE WRITTEN. NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT. YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. Please see additional Important Disclaimers at the end of this analysis.

Investment Pitch: Adidas is one of the few large-cap, high-quality, globally recognized brand businesses (founded in 1949) I’m aware of in which the Covid-19 pandemic has structurally improved its long-term profitability and growth, but has a stock price (in local currency) as of 5/7/21 that is approximately 3% below where it ended 2019. Compare that to Nike whose stock price is up about 36% from that same point. I believe an investment in Adidas can deliver a mid-teens IRR over the next 5-10 years. Given U.S. capital gains taxes are likely only going up over time, there are tax advantages to investing in long-term compounders, which I believe Adidas is one.

The Covid-19 pandemic has improved the structural profitability of Adidas’ business due to: 1) The acceleration in its business mix toward the much higher margin direct-to-consumer (DTC) channel; and 2) The greater free time people have working increasingly from home has resulted in people playing more sports such as tennis, golf, running and general fitness training. In a post pandemic world where corporate offices are fully open, many employees will likely utilize a hybrid model where they come into the office 2-3x per week instead of the historical every day routine. Less time spent commuting means more free time. This has translated into a more active lifestyle behavior, which I believe will continue on post pandemic. This bodes well for Adidas as well as other sports/active apparel companies such as Nike and Lululemon. 

Even though Adidas does not sponsor the same level of depth as Nike when it comes to superstar athletes, it still has a number of big names behind each major sports category…

Soccer: Lionel Messi, James Rodriguez, Gareth Bale, Mesut Ozil

Basketball: James Harden, Damian Lillard, Donovan Mitchell

Football: Patrick Mahomes, Aaron Rodgers, Travis Kelce, Alvin Kamara, JuJu Smith-Schuster

Tennis (a trio of next gen stars/top 10 players): Dominic Thiem, Alexander Zverev, Stefanos Tsitsipas

Golf (a trio of next gen stars/top 10 players): Jon Rahm, Xander Schauffele, Collin Morikawa

Additionally, Adidas has built successful partnerships with the likes of Kanye West’s Yeezy, Beyonce’s Ivy Park and Pharrell William’s namesake brand.

Adidas has consistently traded at a valuation discount to Nike over the decade prior to the Covid-19 pandemic.[1] From 2010-2019, Adidas traded at a 12% discount to Nike on a forward P/E basis and now stands at a similar discount.[2] The key question is whether or not a discount is justified and if so, to what degree. Looking at the decade prior to 2020, Adidas grew its revenue at a 8.6% CAGR compared to Nike’s 7.4%. Adidas’ operating margin in 2019 was 11.3% (13.6% EBITDA margin) compared to Nike’s FY2019 operating margin of 12.2% (14.0% EBITDA margin). And if you back out the much lower margin Reebok business (which Adidas plans to sell in 2021), the operating margin of the core Adidas business was more in-line with Nike’s despite Nike having approximately 50% higher revenue in 2019.[3]  

Looking at geographic mix can help one understand why Adidas has underperformed Nike so much over the past 16 months (since the end of 2019). Looking at their respective businesses, based on 2019, unsurprisingly Adidas has a higher European mix (36.5% v. 25.1%) whereas Nike has a higher North America mix (40.7% v. 22.5%). Asia Pac/LatAm mix for Adidas is 41.0% compared to Nike at 34.3%. It is widely known that Europe’s economy has fared much worse than North America and is still very much in the doldrums due to the Covid-19 case rates and relative lack of vaccine distribution. However, if we look at how fast the U.S. has rebounded over the past few months as vaccines have been increasingly administered to the U.S. population, it is reasonable to believe Europe should follow the same path over the coming year. Regardless, Adidas’ exposure to Europe relative to Nike’s is only 11.4% more—in my opinion, not enough to justify the big delta in stock price performance since the end of 2019.

Even though Adidas’ management is acutely focused on growing the business in the right manner by focusing on the DTC channel and its core brands as well as investing the necessary resources behind them, its margin targets over the coming years appear to be very conservative. Adidas’ 2019 core (ex-Reebok) operating margin was approximately 12% on €22 billion in revenue. Meanwhile management has a 2025 operating margin target of 12%-14% on approximately €30 billion in revenue. Management expects DTC to make up about half or €15 billion of the business of which €8-9 billion is e-commerce. 

Adidas’ DTC business should have approximately twice the margin of its traditional high-single digit margin wholesale business. Lululemon’s business, which is entirely DTC, had a 22.3% operating margin on nearly $4 billion in revenue in 2019. Meanwhile Foot Locker had a 8.9% operating margin (11.1% EBITDA margin) in 2019 on $8 billion in revenue—and it’s margin like this that Adidas would be capturing by selling more of its product DTC. Therefore, it seems reasonable if Adidas is able to achieve a 50% DTC mix on €30 billion in 2025 revenue, its normalized operating margin should be in the mid-teens.

More importantly are: 1) Its higher margin DTC business mix should continue to increase and I believe could easily be 60%+ by the end of the decade. 2) The flywheel effect of a higher operating margin on a growing revenue base would allow it to reinvest more into its brand/endorsements/DTC platforms such that it could continue to grow unit volumes above global population growth and average unit retail (AUR) pricing at least in-line with inflation for many years to come.

Valuation/Expected Return: Using a 15% operating margin on €30 billion in 2025E revenue, a 28% tax rate and a 23x P/E multiple (NKE’s average P/E from 2010-2019) coupled with approximately €10 billion of capital returned (including the Reebok sale) to shareholders through dividends and share repurchases, I think there is ~55% upside (or a mid-teens IRR) over the next few years. Thereafter I think one can continue to earn low-to mid-teens returns based on continued high single digit revenue growth, steady operating margin expansion from a growing DTC mix and continued capital returned to shareholders through dividends and share repurchases.

Risks: Brand deterioration; poor execution by management; European economy continues to struggle.

Important Disclaimers

The provision of this report does not constitute (and should not be construed as) a recommendation, financial promotion, investment advice, encouragement or solicitation to buy, sell, or hold the security of the subject issuer (the “Security”), or any other securities, discussed herein. This report is for informational purposes only. All of the information contained herein is based on publicly available information with respect to the security and the author’s analysis of such information. Past performance is no guarantee, nor is it indicative, of future results.

Certain statements reflect the opinions of the author as of the date written, may be forward-looking and/or based on current expectations, projections, and/or information currently available. The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term. The views are those of the author acting in his individual capacity and not as a representative of the firm.  The author’s opinions on this Security may change at any time in the future and the author will not, and disclaims any obligation to, update this report to reflect any change in opinion. The author further disclaims any obligation to respond to any comments or questions posted regarding the Security discussed herin.

NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT.  YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. AN INVESTMENT IN THE SECURITY DOES NOT GUARANTEE A POSITIVE RETURN AS STOCKS ARE SUBJECT TO MARKET RISKS, INCLUDING THE POTENTIAL LOSS OF PRINCIPAL.

The author or his or her respective employer or employer’s clients, affiliates, officers, managers and directors, may or may not hold positions in the Security noted in this article. These parties may trade at any time, without notification to this community, and will not disclose this information to this community. The author and his employer disclaims any liability for investment losses that you may incur under any circumstances.

The author does not hold a position with the issuer of the Security such as employment, directorship, or consultancy.

[1,2,3] Source for all Adidas, Nike, Lululemon and Foot Locker data and statistics: Company financials, Capital IQ

Catalyst

Vaccine dissemination across Europe improves over the coming year, which allows the European economy to improve; continual growth in higher margin DTC business mix.