UPDATE: SECRET PM: ADIDAS
Interesting note from Exane today. Looking at Adidas from a deep value perspective and re pushing their recent M&A note. Net net the company now looks vunerable to corporate activists. Worst case is disposal of brands and best case a full bid for the company.
POST NUMBERS
Thursday • 06 November 2014 • 10:59
There isn’t much we can conclude following these numbers. The jury is still out! Management are continuing with their strategy – as we described in the note – of growing the business through the opening of “own retail” stores. This is certainly driving good growth (especially in EM where there is less established sports retailers). For example, emerging Europe +20% and Latin America +22%. That is spectacular. The “problem” with the strategy is that is comes with a big upfront investment. Operating costs increased 3% in Euros – which implies big local currency cost increases – as new stores are opened. Overall for the quarter sales grew 6% but operating profits fell 12%! Some of that change is explained by one-off advertising spend around the FIFA world cup, but nonetheless, the evidence is clear that sales growth comes at a cost. And that is why the share price has cratered: investors are sceptical that these store opening costs will ever go away. Store investment may be forever required in order to drive sales and thus margins may be forever constrained to 7-8% versus their target of 11%.
There is nothing in this quarters results to make investors less sceptical of the strategy. The only incremental positive is that sales into the US market were less bad, down 1% for the quarter compared to down 7% year to date.
As discussed in the note, “growth risks” in Russia have pushed the management into slowing the store base expansion. Over the course of the next few quarters we will see if this shows up in the P&L as slowing cost growth. If management can demonstrate that sales stay firm even when store investment is reduced then investors may start to believe that the strategy can get the business to 11% operating margins.
Bottom line is these results don’t show that sales growth can be maintained without big store investment – so today is probably not the day to chase the stock. However, stepping back, it remains a compelling investment since the current value of EUR 12.5bn clearly doesn’t reflect the earnings potential if they can deliver 11% operating margins.
GUILTY UNTIL PROVEN INNOCENT?
Wednesday • 22 October 2014 • 10:59
Adidas is a business with a huge margin expansion opportunity, and, a plan to realise that opportunity. Management made the targets public in 2010 as part of the “Route 2015” strategic business plan.
The plan aims to increase sales by 50% from 2010 levels, to EUR 17bn by 2015. The plan targets an operating margin of 11%, up from 7.5% in 2010. An 11% operating margin on EUR 17bn of sales translates into net profit, after a 30% tax charge, of around EUR 1.3bn.
Since the plan was initiated adidas’s strategy seemed to be working, albeit slowly. Own-retail store openings produced impressive growth and new revenue scale led to modest cost leverage allowing operating margins to rise from 7.5% in 2010 to 8% in 2012 and 8.7% in 2013. Improving profitability, together with falling interest payments, saw net income grow from about EUR 560mln in 2010 to about EUR 850mln in 2013. adidas’s market cap marched higher in unison, from EUR 9.5bn in 2010 to EUR 19bn in 2013, valuing the company at a PE ratio of 15x its “Route 2015” targeted net income of around EUR 1.3bn.
Fast forward ten months and the market cap of adidas is EUR 11.8bn – a PE ratio of 9x the ”Route 2015” targeted net income. Having gradually reappraised the business from 2010 through to 2013 the stock market has quickly turned 180 degrees, questioning the attainability of the “Route 2015” plan and the sustainability of the strategy to execute the plan.
For an investor today the set up is enticing. If the plan’s targets can be reached and net income of EUR 1.3bn achieved, a market cap of EUR 20bn is likely, 70% higher than today. So, is EUR 17bn of sales and an operating margin of 11% reasonable, and, is the strategy employed the right one to achieve those targets?
The fact that rival, Nike, reported operating margins in excess of 11%, averaging 13%, for more than a decade serves as evidence that adidas’s margin targets are not unreasonable. The revenue target of EUR 17bn requires compound growth of 7% from 2010, something adidas has struggled to deliver in recent years. Currency-neutral growth in 2013 was 3% and 5% so far in 2014. Big currency devaluations in major markets, like Russia and Brazil, has seen revenue plateau since 2012. 10% currency-neutral growth in Q2 this year shows the EUR 17bn revenue target is achievable, but, perhaps only in 2016 or 2017.
If the target of EUR 17bn of sales and EUR 1.3bn of profit is doable the investment prospect is obviously excellent. All we are left to assess is whether the strategy employed by management will get adidas to those targets.
To understand adidas’s strategy today you have go back to the pre-2006 adidas. From 2000 through to 2005 adidas was a predominantly wholesale business (most of the product it sold was sold to retailers). It had a big presence in Europe, a weak position in the US, and large market shares several emerging countries. The “problem” for adidas was that Europe showed little growth – sales in 2005 were less than in 2003. Moreover, its emerging market presence was too small to help. Latin America, for example, was less than 4% of total sales. Nike, on the other hand, enjoyed a strong US position, which helped it to grow sales by 15% in 2004 compared to a 6% sales decline reported by adidas.
Pre-2006 Nike was outgrowing adidas thanks to its dominant US position. Growth and size is important for branded goods companies because large costs like advertising are “fixed”. A 30 second advertisement at the US Superbowl costs they same for Nike and adidas, so having more revenue to spread over those costs helps. In 2004 Nike had close to double the revenue of adidas yet spent only 40% more on marketing. This revenue scale advantage for Nike was a key factor behind the difference in the firms’ profitability: Nike reported operating margins of 12.7%, adidas 9.3%.
With a subscale US business what did the management of adidas do? They bought Reebok, making adidas/Reebok a business with EUR 10bn of sales in 2006, not far off Nike’s EUR 11.5bn. The theory behind the move was correct but in practice the Reebok brand was suffering from underinvestment: marketing spend at Reebok, for example, was about 10% of sales compared to 14% at adidas. adidas bought Reebok to increase US scale and insodoing improve cost efficiency. They didn’t have the desire (or the vision) to increase investment in the Reebok brand, which would have meant higher costs. Instead the management continued to underinvest. Sales suffered. Rather than increasing cost efficiency Reebok’s weak sales led to cost de-leverage. Reebok reported an operating loss in 2008 ultimately forcing a strategy rethink.
During 2010 adidas launched a new strategy called “Route 2015”. The new plan called for increased investment, but targeted behind adidas’s strengths, emerging markets for example, instead of trying to play catch-up in weak areas. Specifically, adidas sought to bolster its “brand experience” by investing in own-retail stores, in particular, in the emerging markets where it held high market shares.
From 2009 until 2013 adidas opened a net 500 own-retail stores, taking their total store count from 2,200 to over 2,700. In comparison Nike opened only 200 stores. Own-retail store led growth proved very effective in emerging countries with less established sports retailers: adidas grew by 23% and 27% in China during 2011 and 2012 compared to Nike at 18% and 23%, similarly in Eastern Europe and Russia adidas grew by 15% and 22% compared to Nike at 4% and 15%.
The strategy of own-retail store led sales growth was evidently working to grow revenue. Unlike in the pre-2006 period adidas equalled or bettered Nike’s growth. Moreover, with a retail focus adidas was in control of its growth trajectory, sidestepping the wholesale channel’s inventory glut that Nike experienced in China. On margins, however, the results were mixed. Revenue scale did lead to cost leverage across rents and marketing, but, new store openings led to fast rising employee costs. Total employees exceeded 50k in 2013 up from 34k in 2009. So, while growth was good margin expansion was slow: operating margins rose from 7.5% in 2010 to 8% in 2012 and 8.7% in 2013. Investors were left wondering: when new store growth slows will margins rise, as seen at Home Depot for example, or will store investment be forever necessary to maintain sales momentum leaving margins capped, as seen at Burberry?
2014 started with investors believing revenue growth would outpace cost growth going forward. Currency-neutral growth during the year was good: own-retail sales increased 22%. But, much the same as 2013, a big devaluation of the Russian Rouble all but eliminated this sales growth as reported in Euros. In Latin America, for example, 25% currency-neutral growth translated into just 4% growth in Euros. This persistent currency headwind was enough to tip the balance on cost leverage. At mid-year 2014 adidas operating profit margins were back to where they were in 2010, at 7.5%! The stock market was not forgiving, wiping 60% off its value. Investors turned 180 degrees, deciding that store investment would be an unavoidable cost of growth meaning adidas’s margins would be capped in the 7-9% range.
Such a vicious reappraisal of the business in just ten months appears rash. There isn’t enough evidence yet to say conclusively whether adidas strategy to achieve its “Route 2015” goals is doomed to capped margins. Thus for an investor today the set up is enticing.
In response to growth risks in Russia management are “significantly” scaling back new store investment. If margins respond positively to reduced new store investment then the poor margin performance in 2014 may be put down to “growing pains,” and the potential for EUR 1.3bn in profit and a market cap of EUR 20bn, will be back on the table.
If the strategy is wrong, you paying a fair EUR 11.8bn, a PE ratio of 15x, for a business with EUR 15bn of revenue generating EUR 700-800mln of profit, with opportunities available today to realise value either through disposing adjacent businesses (TaylorMade, Rockport, maybe even Reebok) or using the balance sheet to return cash to shareholders. Already in October a EUR 1.5bn buyback was announced, good for returning 13% of the current market cap, and, buying interest in Reebok was announced.
adidas delivering EUR 1.3bn of profit is not an unreasonable target. And, with a market cap of EUR 11.8bn investors buying today can do very well irrespective of whether the current strategy employed to achieve that target is the right or the wrong one.