UPDATE: THE SECRET PM

ADIDAS

An Adidas investment is built on the prospect for margin expansion. Despite similar gross profit margins to Nike, adidas has reported operating margins averaging 7.5% over the past 5 years versus Nike’s 13%. This shows up in their relative valuations: 1x EV/sales for adidas compared to 3.5x for Nike. Sure, Nike has some enduring scale advantages when it comes to media and endorsement spending, but that still leaves adidas with the potential to get operating margins to 10%.

Adidas has struggled to get its margin expansion back on track in 2015 (Operating margins increased from 7.2% in 2011 to 8.7% in 2013. In 2014 margins took a step back, to 6.6%). Where the business has sustained sales momentum margins have expanded. Key markets like China, for example, had currency neutral sales growth of 21% in Q1 and 19% in Q2, pushing margins in that market up 90bps year on year to 36.5%. Similarly in Western Europe sales were up 12% in H1, pushing margins up 280bps to 22%. In both markets adidas’ margins beat Nike.

Masking this improving operating leverage is a further step down in Russia: sales fell 3% in Q1 and 14% in Q2. And a continued collapse in the US golf business: sales down 9% in Q1 and 26% in Q2.

By Q2 costs and inventories in Russia were right-sized (adidas closed 67 stores) helping the business back to 15% margins. This should have been enough to get the group’s margins up 60bps to 7%. But instead heavy discounting at the US golf business cost adidas roughly Eur 40mln in operating losses. With the golf business loss making, and perhaps in decline, any efforts by management to sell or restructure the business will boost group margins – they have hired an investment bank.

Looking just at the core business, management is committed to investing heavily in marketing behind its brands: marketing spend increased 16% at adidas and 34% at Reebok in H1. This means the core business, currently operating at about 7% margins, will likely see only very gradual margin expansion if EM economic growth is slow and US markets remain very competitive. The margin expansion outlook is further clouded by higher US Dollar sourcing costs and weaker EM selling currencies, Brazil and Russia in particular.

So we are left with a business with maybe 300bps of margin potential but in a slower growth environment where management (probably rightly) are going to spend a lot to defend their positions in EM and try to grow the US business. In a low growth environment this is just a cost of winning business? Until the growth outlook becomes clearer and marketing investments can be leveraged investors are likely stuck with a 7-8% margin business. In which case the stock looks fairly valued.

 

HEINEKEN

An investment in Heineken is built on the “embedded” margin expansion within the business. Heineken’s markets with the most potential for growth in beer consumption: Africa and Asia, both enjoy oligopolistic positions with margins far higher than the group’s average (26% margins in Africa compare to 11% margins in Europe). As Heineken’s growth market mature the group’s margins will gradually expand. SAB Miller went through a similar transition from 2005 to 2011 thanks to its investments in Colombia and Peru. SAB’s operating margins increased from 15% to 25% and its valuation rose in tandem, from 3x EV/sales to 6x. Heineken today is valued at 2.5x EV/sales.

During 2015 this trend has been in play. Group volumes increased 1%, driven by 3% growth in Africa and 6% growth in Asia. So despite an increase in marketing spending group margins expanded 20bps. Management targets 40bps annual margin expansion.

 

HSBC

An investment in HSBC is built on the prospects for profit growth from deploying the balance sheet cash at higher interest rates and cutting costs in subscale markets.

So far in 2015 HSBC has continued to execute on its plan: winding down capital deployment in the US (US assets fell $35bn) and redeploying capital into advantaged positions in Asia (Asian assets increased bn $39nm). Costs are being addressed by selling the subscale Brazilian business. The Latin American business, for example, made only about $220mln of pre-tax profit last year (less than 2% of the group total) yet it employs 16% of the group’s personnel.

Valued at 10x current profits (excluding Bank of Communications) HSBC is being given no credit for its prospects for profit growth.

 

COACH

An investment in Coach is based on the insight that the handbag business, thanks to the presence of high-end luxury players charging very high prices, enjoys “structurally” high gross margins (roughly 70% versus 40% for apparel). Thus even though Coach is willingly losing about $1bn in US sales as it “resets” its American business by closing 70 stores and stopping most promotions, it will nonetheless be able to hold its operating margins in the high teens.

During the fiscal year 2015 ending in August, for example, Coach saw US sales fall by $600mln (down 20%) as it closed 74 stores and dramatically reduced promotions yet it still reported operating margins of 18.9% thanks to the dependable 70% gross margins the handbag industry enjoys. That’s good for over $500mln in profit.

Retail “turnarounds” often don’t turnaround because falling revenues leave little or no profit for the management to use to reinvest in the brand. As Coach numbers demonstrate the handbag business is different. Despite $1mln in lost US sales Coach has not cut investment, instead marketing investment has increased by 60%.

For Coach to be a great investment it needs to get its US business growing, so far in 2015 it is showing it has the resources and willingness to invest to do this.

 

IMI

IMI is a business with great engineered products have has been hamstrung in the past by commoditised divisions and underinvestment. This has limited the company’s growth. The new CEO, Mark Selway, plans to do for IMI what he did for Weir. Already Mark has made an important investment with the acquisition of Bopp & Reuther.

So far in 2015 the business, like its peers, has faced a tough economic environment as falling commodity prices cause reduced capital goods investment. Away from the difficult business cycle the company is making progress improving its operations. For example, they say: “To date 290,000 SKUs have been eliminated from the division’s 450,000 European product portfolio. A new product introduction process has been developed and a new Divisional Quality System has been piloted. In addition a new ‘out of the box’ JD Edwards ERP system is now in the final stages of configuration.”

The big opportunity for IMI will come for deploying capital into growing the business. GBP 500mln in free cash over the next 5 years together with GBP 500mln of borrowing should allow Mark to grow the business to GBP 2.2bn in revenue, good for GBP 250mln in profits.

Today the business is valued at GBP 2.8bn, evidently aware of the painful business cycle but ignoring the capital deployment opportunity.