adidas: Slower Growth Does Not Kill Equity Appreciation

About: adidas AG ADR (ADDYY), ADDDF
by: Detroit Bear

adidas reduced its revenue growth guidance to 8-9% from 10%.

The company also increased its operating margin and EPS growth forecasts.

Stagnant sales in Europe are obscuring a business that is performing well otherwise.

Shares look slightly undervalued.

Shares of adidas (OTCQX:ADDDF) (OTCQX:ADDYY) are down about 15% off of their 52-week high as the company had to cut its organic sales growth guidance to +8-9% from its previous 10% forecast. Although much of the issue stems from weakness in Western Europe, I have some concerns about Yeezy product availability in the US that could weigh on the long-term health of that business. In terms of North American footwear, adidas has cooled off slightly, but I believe the brand is still performing well. A strong Q4 should provide additional margin expansion, which caused management to increase its EPS guidance for the full year. Shares look somewhat attractive at current levels, though adidas’ top competitor, Nike (NKE), is improving its performance. Let’s take a look at adidas’ recent performance, and why the company has upside from its current share price.

Q3 – A Slow Europe Clouds Broad-Based Strength

adidas posted solid Q3 results overall, with currency-neutral revenue up 8% y/y. Revenue was up just 3% y/y in reported Euro terms to 5.9 billion EUR as the company dealt with high inflation in South America as well as a Euro that weakened against the dollar.

On a geographic basis, two segments in particular stood out – North America and the Asia-Pacific. North America sales jumped 16.5% on a currency neutral basis to roughly 1.3 billion EUR. Impressively, the long-stagnant Reebok brand grew in the high single digits in the US during the quarter, and the core adidas brand was up a whopping 18% y/y in total North America. adidas benefited from greater availability of Yeezy products, as well as continued availability of Boost products. Initially, adidas had attempted more of a scarcity model, but I think the company has transitioned to wider availability, which continues to drive sales forward. The company also had a few strong products like the Falcon and Yung 1 that resonated with consumers. Foot Locker (FL) did not call out adidas' strength in Q3, and I think the brand could be slightly slowing. Nevertheless, growth remains strong.

China is another bright spot, as Greater China revenue was up 26% y/y, bringing Asia-Pacific revenue up 15% y/y to 1.9 billion EUR. Asia-Pacific is now easily adidas’ largest segment, and I believe the company has done a great job leveraging the Yeezy platform globally. As popular as the brand is in the US, it appears to be equally as popular in China. Although management expects a slowdown in Q4, China appears to be set to grow and deliver a margin above expectations.

At this point of the cycle, the true problem child is Europe, where currency neutral revenue declined 1.3% y/y to 1.6 billion EUR. Not only is adidas still comping against the strength of the Superstar and the Stan Smith, but the company also was not able to push the envelope on price point to the extent they originally predicted. Management noted that they have not nailed pricing in Western Europe recently, and I expect that we could see a change in pricing strategy going forward. Nevertheless, management added that Western Europe had 350 basis points of margin expansion. Net-net, adidas will have to strike a balance to maximize profitability, but I am hopeful the company figures out pricing in the near term.

Profitability Materially Improving

Although sales growth of 8-9% for FY18 will trail the original 10% forecast, the company is more than compensating with margin expansion. Gross margin jumped 140 basis points y/y to 51.8% of sales as the company rode the tailwind of Yeezy product as well as strong pricing across most geographies. With the strong growth in gross margin, adidas was able to invest in demand generation, increasing marketing spending by 40 basis points y/y to 12.2% of sales, and increasing operating overhead to improve fulfillment capabilities. This in turn helps support the e-commerce business, which was up over 70% y/y in Q3.

Overall, operating margin grew 130 basis points y/y to 15.3% of sales, well above Nike’s 13.4%, although Nike admittedly is almost twice as large from a sales perspective, and thus has a materially lower (44.2% in Q1 FY19) gross margin profile. Additionally, on a full-year perspective, adidas is guiding to an operating margin of 10.8% versus Nike’s 12.2% in FY18. adidas should be able to leverage marketing expenses and overhead a bit more in FY19 if growth remains strong, but it could be challenging to maintain the 50%+ gross margin while maintaining high single digits organic growth.

Still, profitability for the year will be around 100 basis points higher than in FY17, and if the company is able to bring this to ~11% in FY19, we will see another year of solid EPS expansion. adidas guided to a 15-19% increase in EPS ex-buybacks, and I believe we could see another year of low double-digit EPS expansion in FY19. Current guidance implies an FY18 multiple of 24x, and shares are trading at roughly 21x my estimate of FY19 EPS.

Shares look slightly undervalued

Currency can be a bit tricky, but when I model adidas in constant currency, I get to a fair value range of $240-260 based on slight operating margin expansion, a flat share count, and continued high single digits growth in FY19 that slows to mid-single digits thereafter. I like the company’s innovation cycle, as well as the ability for the company to quickly blowout inventory of products that are not moving (the NMD, Deerupt, and Prosphere come to mind).

The big risk for adidas at this point is competition. Nike is focused and smaller brands are gaining notoriety globally, with the likes of Vans (VFC) and Champion surging. Nevertheless, adidas remains the second most dominant player in the athletic apparel and footwear business, and I believe management’s growth strategy over the past few years has been solid. If the company is able to improve operating margins to the same level as Nike, then shares could prove to be more valuable than the high end of my fair value range.

Disclosure: I am/we are long FL.

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.