adidas Stock: Execution Going Well But Valuation Has No Margin Of Safety (OTCMKTS:ADDYY)

Overview

My recommendation for adidas (OTCQX:ADDYY) is a hold rating as I remain cautious on ADDYY ability to execute its strategies and the ongoing growth in key markets. So far, execution has been fine as ADDYY shows robust top line sales growth and gross margin, and is actively reducing its large inventory size while capturing improving demand trends. Note that I previously rated hold rating for ADDYY as I await the new CEO to deliver.

Recent results & updates

ADDYY has posted robust Q2 results, marked by impressive top-line performance fuelled by strong underlying brand momentum. Notably, the strong Direct-To-Consumer [DTC] demand, with own store sales soaring by 21% YoY, excluding Yeezy and LFL sales. The recovery in the Chinese market has been consistent, as indicated by the sales numbers, showing significant double-digit YoY growth 16% YoY [currency neutral]. ADDYY’s effective control over operating expenses and remarkable profitability in Greater China [2Q23 operating margin at 22.6% compared to 2Q22’s 13.7%] have contributed to a robust gross margin of 48.5%. Additionally, there are promising signs of progress in inventory clearance, with units decreasing by 11% YoY. ADDYY continues to view 2023 as a transitional year dedicated to clearing inventories, with plans to further reduce existing Yeezy inventory.

In 2Q, the Chinese market exhibited impressive revenue growth. Sales in the Chinese market increased by 16% YoY in currency-neutral terms, showcasing strong double-digit growth in both wholesale and retail sectors. This performance marks a significant improvement compared to the 9% YoY decline observed in the first quarter of 2023, reaching 63% of pre-Covid levels. In the same quarter, the gross profit margin reached 54%, indicating a YoY increase of 2.6 percentage points, while the operating margin reached 22.6%, a substantial improvement from the 13.7% recorded in 2Q22. The region is currently grappling with the impact of excess inventory levels in the market. In response, ADDYY has implemented substantial measures to reduce its sell-in inventories, bringing them closer to a more typical level. This strategic shift involves placing a greater emphasis on replenishment, with the goal of enhancing flexibility and permanently reducing the need for reclamation and clearance processes.

Latin America remains at the forefront of growth, registering a remarkable 30% YoY sales surge in 2Q23, when measured in constant currency terms. Conversely, North America and Europe, the Middle East and Africa [EMEA] experienced declines of -16% and -1% year-over-year in constant currency sales, respectively. The decline was shaped by a deliberate approach of exercising cautious control over sell-in to curtail inventory levels.

Turning attention to product trends, the Samba product line has consistently expanded its presence on a monthly basis, and the true impact on ADDYY performance is just starting to become evident. Furthermore, ADDYY has observed a strong demand for the Campus line, with the core color variations of the Superstar line gaining exceptional popularity among fashion-conscious consumers. This success can, in part, be attributed to a “halo effect” stemming from the Terrace line. Footwear revenues in the quarter showed a 1% growth, driven by robust performance in categories such as football, basketball, tennis, and U.S. sports. In contrast, apparel sales experienced a 3% decline, primarily due to elevated inventory levels. Performance-oriented product categories demonstrated positive momentum, while sales in the lifestyle segment saw a decline.

Regarding the wholesale market, it remains subdued, and H2 order books are lagging behind YoY comparisons. This is primarily due to the substantial baseline set in the previous year when orders surged to high levels in response to low market inventory. It’s worth noting that U.S. retailers are particularly focused on making real-time adjustments to their inventory levels to adapt to the changing dynamics of the market.

Put together, with ADDYY’s robust sales growth and strong gross margin performance in 2Q, along with the encouraging trends in demand, a more robust recovery in China than initially anticipated, effective control over operating expenses, and efficient inventory management, I anticipate that these developments will drive sustained long-term revenue growth and an expansion in EBITDA margins for the company.

Valuation and risk

Using consensus figures which I believe depicts the bull case of ADDYY reaching historical EBITDA levels (~EUR3+ billion), ADDYY is valued EUR295 in FY24, representing an 89% increase back FY19 levels. If ADDYY can execute as expected, it deserves to continue trading at this high multiple as I expect the market to recognize the new CEO capabilities and ADDYY turnaround situation as a success. ADDYY is now trading at 18.5x forward EBITDA, which I see as the market already pricing in the turnaround as a success given it is trading at valuation similar to Nike and Lululemon. My take is that it is still early to tell whether the trend is sustainable. Any execution hiccups could cause multiple to revert back to a discount easily. Remember that ADDYY historical average is at 14x, so there is plenty of room for multiples to fall.

The potential for a new marketing strategy initiated by the new CEO to gain less traction is a concern. This could be due to either increased competition in the market or a lack of resonance with the new marketing materials, ultimately resulting in a limited boost to top-line momentum. Other risk include the possibility of a significant deterioration in U.S.-China relations, which may lead Chinese consumers to prefer domestic brands over international ones. There is also the risk of marketing missteps diminishing the brand’s appeal or external factors causing consumers to become less receptive to the brand. Furthermore, the rapidly changing landscape of consumer confidence and disposable income in the face of persistent inflation poses additional challenges.

Summary

I maintain a hold rating for ADDYY based on ongoing cautiousness regarding its execution strategies and market growth in key regions. While the company has demonstrated strong performance in Q2, including impressive DTC demand and a rebound in China, challenges persist in North America and EMEA. Promising product trends and inventory management bode well for long-term revenue growth and EBITDA margin expansion. However, ADDYY’s current valuation at 18.5x forward EBITDA appears to price in the successful turnaround, similar to peers like Nike and Lululemon, leaving little room for setbacks.

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