value and opportunity

Adidas, the iconic German sportswear company, seems to be a big topic for value investors these days. A couple of my readers mentioned Adidas in the comments and also Geoff Gannon thinks it is cheap at least compared to Nike and Under Armour.

Over the past decade or so, Adidas was a great performer, riding mostly on the “Emerging Markets consumer” megatrend. This year however the share price is down ~-37% at the time of writing,:

Nevertheless, the Stock is still not really cheap on an individual basis:

P/E 19
P/B 2,2
P/S 0,9
EV/EBITDA ~10
Dividend yield 2,6%

Since a couple of weeks, there are constant rumours that some activist hedge fund will sooner or later appear and press for changes how the company is run.

Maybe in order to make it harder for activists or other potential “predators”, Adidas just announced a 1,5 bn share buy back over 3 years. According to the Reuters article this seems to be a rather quick change of mind:

Chief Executive Herbert Hainer said in August that Adidas had no plans for a share buyback.

Adidas also just launched a 1 bn EUR bond issue, most likely to fund some of the share repurchases. The bond issue however doesn’t seem to have been a smashing success.

Why did the share price go down so much ?

They had to issue a couple of profit warnings in the last few months. According to Adidas, two reasons are to blame: The issues in Russia, a core market for Adidas and the problems with the Golf business (Taylormade).

With the football World cup in Brazil, everyone thought that Adidas will have a record year, but as of 6m 2014, Profit declined by ~.27%. Adidas is the German company with the largest share of Russian sales in the DAX 30 index with around 7,5% of total sales. Doing badly in a year with a football Worldcup is not a good omen for the eventless next year.

What I don’t like at Adidas:

When I look at an expensive company like Adidas, I always look out for things I don’t like. After reading the 2012 & 2013 annual report, here are my “don’t like” point:

– management targets do not include capital profitability
– growth in recent years mostly from retail business
– Sales decreased already in 2013, 2014 just extends the negative trend
– they blame FX for most of their problems but that is part of the normal risk of doing business in Emerging Markets
– Adidas is doing Ok, but both Reebock and Taylormade are shrinking
– as with EVS, 2014 should have been a fantastic year (Brazil, Socchi). 2015, without any big events will most likely be even worse
– US as a strategic growth market does not make that much sense to me
– comprehensive income is lacking net income by a wide margin
– reporting overall is not very good, lots of “Marketing stuff”, critical figures like profitability per region are missing

What I like

– clearly iconic brand with growth potential especially in EM
– relatively conservative balance sheet
– management salaries are relatively low compared to total profit

Let’s look at some issues in more detail:

Retail business

If you look at their historical numbers, a large part of the recent growth comes from their “retail segment”. They started opening own stores some years ago and have expanded them fast. In 2013, the traditional business which they call “whole sale” already shrunk and only retail had some growth. However retail is lower margin business (Operating margins ~20% against 30+%). They expanded their stores much more aggresively than Nike, especially in Emerging Markets.

Also, retail business in my opinion is riskier than their core business. If you are in retail, you are also in Real Estate. With the threat of the internet (Zalando, Amazon), they are walking on a thin line.

Interestingly, despite paying ~600-700 mn rents p.a. they are only disclosing 1,7 bn of operating lease liabilities. I am not sure what to make of this, it looks like they are only renting short-term which might be OK if EM continue to be weak.

Currency Management:

According to the CEO’s letter in the 2013 annual report, Adidas doesn’t hedge FX risk in Emerging Markets as it is “too expensive”. Well, that’s complete nonsense in my opinion. Of course it is expensive, but for an EM based retail business, not hedging FX is almost suicide. A retailer in Russia is short the USD vs. Rubles twice: First, all the merchandise will be imported from China on a Dollar basis. Secondly, most of the rental contracts will be in USD as well. Sales will be made however in Rubles, so if the Ruble declines against the Dollar, all the nice margins just disappear.

Instead of hedging, the report “currency neutral” sales growth etc. In my opinion this is definitely a weakness especially if you compare Adidas to their major rival Nike. If you look into the annual report of Nike, you can see on page 77 & 78 that they have a pretty sophisticated hedging program in place, which creates a lot less volatility in stated net income AND comprehensive income.

Comprehensive income

As this is often the case, the Comprehensive Income of Adidas is hidden deep within the annual report, in this case it is mentioned the first time on page 189. And, as it is not surprising, Comprehensive income is a lot lower than Net income as the table shows and also much more volatile compared to competitor Nike:

	Adidas			Nike
	EPS	CI	in %	EPS	CI	in%
30.12.2009	1,25	-0,4	-33,0%	1,99	1,81	90,8%
30.12.2010	2,71	4,4	161,9%	2,22	2,12	95,6%
30.12.2011	2,93	4,0	137,2%	2,48	2,48	99,7%
28.12.2012	2,52	1,5	60,9%	2,65	2,81	106,2%
30.12.2013	3,76	2,2	59,4%	3,02	2,83	93,6%
Total	13,17	11,8	89,3%	12,36	12,04	97,4%

Most analysts would ignore this, as they would call this a “non cash” accounting effect. But especially currency movements in the comprehensive income in my opinion have enormous predictive value. Although its true that the initial currency movement (i.e. the decline of the NAV of foreign subsidiaries) does not impact the cashflow, a permanently lower value of the foreign currency will clearly lower the future profits of the company, especially if they don’t hedge.

Ignoring this effect is like looking at your stock portfolio and ignoring the currency movements if you calculate performance. You can do this, but it does not reflect the underlying value.

Strategy & Capital allocation

Adidas’ strategy to focus on Emerging markets has paid of, despite set backs like currently in Russia. What I don’t understand why the want to target the US. In the US, they have no advantage against Nike, rather the opposite. Nike is much bigger in the Us and clearly has economies of scale against Adidas in advertising expenses.

In my opinion, this is mostly due to the fact, that return on capital is not part of the targets for Adidas management. They have target like sales growth, operating margins and some nonsense stuff like EUR amounts for investments, but no return on investment or return on invested capital targets. Nike, th main competitor, reports ROIC

This leads more often than not to chasing growth for growth sake and not creating value. In my opinion, Adidas clearly has a strategy & incentive issue here.

Brand & Moat

There are different opinions on this topic, but for me , a brand is not a moat. It is a competitive advantage, especially as we have seen in “new markets” like the EM, but on the other hand, brands can easily loose their power if they are not well managed. A sports brand like Adidas in my opinion is even more difficult than a “luxury brand”. Sports brands define themselves via sports stars. Signing sports stars or teams gets more and more expensive and when you are unlucky, your expensive star turns out to be a sex maniac or drug abuser and all the money is for nothing.

A real strong brand allows you to make above average margins and returns on capital, which somehow Adidas fails to deliver compared to some of its competitors.

Valuation

At a 2014 PE of 19, Adidas is clearly not in value territory, based on Comprehensive income, the stock looks even more expensive. In order to justify an investment, one would either need to assume EPS growth or multiple expansion. Yes, Nike trades at a lot higher multiple, but it is also a lot better company than Adidas with much better earnings quality. I also have doubts, that Adidas will increase stated EPS in 2015. Without a major sports event and with Russia still critical, they should rather be happy to maintain current profits.

The share repurchase will maybe add to EPS, but overall, for me Adidas is not a buy at the moment. If you are an event-driven investor wanting to bet on a short-term bump by someone like Icahn, Loeb etc. it could be interesting.

Summary:

Adidas is a company with an iconic brand, however stand-alone it is already quite expensive and the company has at best average management. Earnings quality in my opinion is clearly lower than for competitor Nike. Some activist investors might indeed shake up things a little bit and bump up the share price in the short-term, but the company is clearly facing a very difficult year in 2015. “Turning around” Adidas and bring them to Nike’s level in my opinion is not just spinning off Reebock and Taylermade, but a real change in startegy and incentives.

Adidas is clearly a bet on the Emerging Market consumer, which might work out over the long-term but is somehow maybe difficult in the short and mid-term. There are also cheaper stocks available if one wants to bet on an EM revival. On top of that, I am clearly no expert on branded sports good so for me, this would only a buy if it would look cheap from an absolute point of view, which it doesn’t.