All In On adidas (OTCMKTS:ADDDF)

Demand for running shoes has seen an upward trend since the last few years due to increasing popularity of outdoor activities, according to Transparency Market Research.

That’s been good news for adidas (OTCQX:ADDYY), which is now the second most valuable apparel brand in the world, according to Kantar. Athleisure brands in general have been on the up, including Nike (NKE), Lululemon (LULU) and Puma (OTCPK:PMMAF).

The German group sells a range of shoes, clothing, and sports equipment in over 2,100 adidas-owned stores, 15,000 franchises, and around 150,000 wholesale offerings worldwide. There is also an online channel that in the last few years has been growing rapidly. adidas has also diversified geographically. The Americas and Europe represent just over half of total sales together, and Asia-Pacific now makes up one-third of sales.

Buy The Dip

adidas’ stock price has dropped about 35% this year, thanks to soaring inflation and lockdowns in China, which have put pressure on the consumer discretionary sector. Investors have differentiated athleisure brands though, and adidas has fallen behind its larger rival Nike in 2022, which has a market-leading 25% of the fitness-and-fashion footwear category. Second place adidas has 15% market share. Normally, this size difference is reflected by only a small valuation gap between the two groups. This year, that valuation gap has widened quite a bit, with Nike shares currently trading at 24x forward earnings, while adidas is only on a forward price to earnings PE multiple of about 16, which is a seven-year low for adidas.

I think this valuation difference is out of balance since as adidas has a leading brand and a wide global footprint and has been growing its annual earnings faster than Nike for much of the last decade. adidas is valued even below its smaller rival Puma, which is on forward PE ratio of 22x, despite making only having a third adidas’ sales level.

Nike and adidas, as the two largest names in the sportswear market, have a lot in common. They charge premium prices and have massive budgets. In fact, only Nike and adidas have the financial muscle and worldwide appeal to dominate advertising and sponsorship. Smaller rivals like Under Armour (UAA) and Puma just don’t have the star power to sign deals with the best athletes and sports teams. adidas’ sponsorships for big teams and big stars accounted for about 50% of its €2.5 billion in total marketing spend in 2021.

All Weather?

This spend, which is intangible, helps adidas for all economic environments. Strong brand power really helps, historically, in retaining both customers and pricing power, relative to competitors, in a downturn. The brand defends pricing power. adidas’ pricing power is evident in its 10-year average gross margin of 50%. This is even higher than Nike’s. It’s also thanks to its higher mix of higher margin clothing and sports equipment sales. adidas, in my opinion, is one of the best global non-defensive stagflation investments.

adidas can increase gross margin a few percentage points from an estimated 52% in 2022, thanks to its ‘Own the Game’ strategy. This is an increased focus on Direct-To-Consumer sales, which adidas began in 2021. Around 60% of adidas’ revenues come via multi-brand retailers, and getting away from this allows adidas to capture the entire profit from a pair of trainers.

adidas is looking to make Direct-To-Consumer make up more than half of sales by 2025, and it plans to double its ecommerce sales to €9 billion in this timeframe too. This push has already started, with growth in North America increasing to over 20% in Q1 of 2022. adidas’ ecommerce focus is on the right track also, with sales nearly doubling over the past three years to almost €4 billion in 2021.

adidas’ Q1 2022 results can be found here.

Risks

Steep materials inflation being passed on to consumers might reduce demand, all else being equal, but as mentioned, I think the adidas brand mitigates this. A poor performance from adidas sponsored teams and players in this year’s soccer World Cup might see soccer spend move to Nike or Puma – but this is a short-term issue.

Asia Hiccups

One of the reasons the adidas stock price has fallen is because it has become more reliant on China. The lockdowns in China have been impacting sales, as revenues fell 16% in Asia-Pacific during Q1 of this year. The lockdowns have also prevented the expected growth from Chinese markets to disappear. China has been the fastest-growing athleisure market in the world, so this has been a big blow.

However, adidas management expects to offset China’s slowdown with “strong double-digit” growth across the rest of the business, which makes up 80% of its sales. Q1 constant currency sales growth of 12.8% and 9.1% in North America and Europe, Middle East and Africa regions, respectively, points to good performance in core markets. Chinese growth has been postponed only – there is nothing fundamentally wrong with adidas in China – so this sets up a nice period of future growth down the line.

Shareholder Returns

Another reason to be bullish on adidas’ is its improving position on shareholder returns. Last year, adidas took a big bath on Reebok, which it sold for €2.1 billion to Authentic Brands Group when it paid €3.1 billion for it in 2006. Management is being more cautious on spending now, and the Reebok sale enabled adidas to pay down €600 million of debt in 2021. The group has doubled its dividend payout since 2015 with incremental increases, and it has a 2.4% dividend yield now. I expect that adidas will pay about €3.7 billion in dividends over the next five years, from the €12.5 billion it should generate free cash flow over that period, and management has committed to stock repurchases, which I estimate would account for another €7 billion in shareholder returns.

Summary

China is a near-term concern, but this issue is priced in already. As investors, we need to look forward. The growing athleisure market trend seems unlikely to reverse, and adidas has a leading position and strong brand. Its healthy cash generation and new focus on shareholder returns means good upside potential.