Yeezy Just Jumped Over Jumpman

| About: adidas AG (ADDYY)

Summary

Adidas recently signed Kanye West, and he's creating tremendous buzz around the brand.

I think we'll see some convergence between the Nike's and Adidas's valuations as North American performance improves for the latter.

In a tough market, I think long Adidas/short Nike is an interesting pair trade.

For the first time since the days of Tracy McGrady's signature sneaker, Adidas (OTCQX:ADDYY) seems to have stolen the thunder from Nike (NYSE:NKE) and its signature Jordan line. In my view, it's due almost entirely to one man: Kanye West. While this change could be short-lived, trends indicate that now may be the beginning of the end of Nike's unquestioned dominance in the US athletic apparel space. As such, I suspect the valuations of Adidas and Nike to converge over the next 6 months.

Kanye's move to Adidas is just starting to yield results

When Kanye West left Nike for Adidas, the general reaction was a question of why he left Nike rather than excitement over his Adidas line. Some speculated that the success of Kanye West's Nike collaborations where equally dependent upon the brand cache of Nike as the popularity of Kanye West. However, Kanye's position as the biggest star in music and influencer in fashion was clearly underrated.

Kanye's Yeezy Season 1 clothing line has sold exceptionally well in limited distribution at places like Barney's New York and independent boutiques. More importantly, his Yeezy Boost shoes have sold out immediately and garnered prices 3-5x the retail MSRP on eBay (NASDAQ:EBAY) and other secondary marketplaces. In fact, tastemakers are so infatuated with Kanye that even his wearing of any Adidas shoe will almost insure a sellout and healthy resale market. Adidas is applying Nike's long-time strategy of limiting distribution to drive exclusivity and brand excitement, and I believe it is working exceptionally well.

Meanwhile, though still selling exceptionally well, Jordan Brand's newer reissues like the Jordan VIII Aqua, the Jordan V, and the Jordan II have sat on shelves-with the exception being Jordan's collaboration with popular Chicago designer Don C. As I've noted previously in my Finish Line (NASDAQ:FINL) analysis, Nike has moved from limiting Jordan Brand issues to increasing retail distribution while also lifting the price tag. Though this is ultimately leading to better sales results for Nike and its retail partners, I think the change of direction has created an opening for exclusivity that Adidas is greatly capitalizing upon.

With its smaller size, the ability to take share from Nike in the tastemaker market could lead to a much better growth rate overall for Adidas. Once the brand starts converting tastemakers, I think we will see a spillover effect into other areas like basketball and apparel. And, because of Nike's unfettered dominance over the past decade, I'm not sure the company is fully equipped to fight back.

Overall, the combination of Kanye and saturation of Jordan products could lead to outsized market growth for Adidas.

Movement towards running fashion will hurt Nike

On the other end of the convergence, I think Nike will experience some pain as basketball continues to fall out of favor. Former top sellers like the LeBron and Kevin Durant lines are now sitting on shelves collecting dust, and basketball product in general has fallen mostly out of favor in fashion circles. Under Armour (NYSE:UA) is the lone company performing well in the premium basketball market.

Retro running, driven by Kanye and a general focus on more minimal silhouettes and earth tones, is not an area of weakness for Nike. Nike has a catalog of great Air Max styles and other strong products. But price points for retro running are much lower than signature basketball, and I think a shift away from basketball will almost certainly lead to a decline in sales growth.

Sales growth delta and margin expansion will drive rerating

Company

Fwd PE

Operating Margin

NTM Rev Growth

Nike

26

14%

4%

Adidas

20

7%

9%

Under Armour

59

10%

26%

Click to enlarge

Sources: DB, Company filings.

Ultimately, valuations in the athletic apparel space seem to be driven largely by revenue growth and operational success. Adidas currently sits below both Under Armour and Nike from an operating margin perspective, but robust sales growth should help Adidas grow its operating margin closer to 9-10%, particularly as the company will have many of its fixed costs in Euros while receiving a great deal of its revenue growth in US dollars.

Investors looking to get market neutral exposure to the US athletic apparel makers may consider a long Adidas/short Nike strategy. However, I caution that my view is highly US-centric. My view of performance in the EU and China does not materially differ from consensus in the same fashion. Further, I think it is much easier to simply purchase shares of Foot Locker (NYSE:FL) or Finish Line-who will benefit no matter which company performs better.

Disclosure: I am/we are long FINL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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