Adidas AG (ADDYY): Buy @ $115.00

March 12, 2017 Mariano R. Viola, PhD Consumer & E-commerce Analysis (917) 751-3733 [email protected] www.violaadvisory.com

Adidas AG (ADDYY): Buy @ $115.00 Buy Thesis: We maintain our Buy rating and raise our PT to $115 from $100. Management reported excellent results for FY2016 with 14% y/y Top-line growth and EPS growth of 53% y/y. Despite the difficult 4Q16 Holiday season, Adidas reported impressive growth in two of its three biggest markets: North America (up 30% y/y) and China (up 20% y/y). Sales Growth in Western Europe (up 7% y/y) is still impressive given that retail sales in the region was down for 3 consecutive quarters. We Believe Adidas’ Strategy of Accelerating Strategic Investments in North America comes at an Opportune Time when the Shift to Casual Lifestyle Favors its Core Strengths. We believe the current Lifestyle Trend could continue in 2017-18, giving Adidas plenty of runway for additional Market Share gains against Nike and Under Armour.

I.

Shift from Performance to Casual Lifestyle Plays to Adidas’ Strength

The NPD Group reported that the U.S. athletic footwear industry grew by 3% in 2016, generating $17.5B. Unit sales also grew by 3% and average selling price remained flat at $60.81. The industry grew in each of the first three quarters of 2016, slowing down slightly in 4Q16. Moreover, during the 4Q holiday season, slower traffic caused significant promotional activities earlier, deeper and broader than expected by the retail sector. Furthermore, the bankruptcies of The Sports Authority and Sport Chalet caused disruptions in the supply chain with the greatest impact occurring during 4Q16 when both retailers were shutting down. The NPD Group projects that the supply chain dislocation will likely continue through 1Q17, but after that the drag should be over and the trend should return to normal. FIGURE 1: U.S. Athletic Footwear Growth by Category 26%

11%

Classics

Casual Athlebc

2%

1%

Hiking

Running

All Cross Weather Training Boots -7% -11%

Walking Basketball

-14% -18%

Source: NPD Group Retail Tracking Service

In terms of category performance, the Classics category drove the industry, with sales increasing by 26% in 2016 (see Figure 1). NPD data shows the category growing sales by $1.7B over the past three years as trends shifted away from performance-driven categories to more retro styles. In its 4Q16 earnings call, Adidas indicated that for FY2016, its lifestyle category grew 45% y/y while performance category grew 13% y/y.

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03/12/17

Moreover, management also stated that the distinction between performance and lifestyle was somewhat artificial. While they believe that a small part of their lifestyle category was clearly fashion driven, led by retro silhouettes, they also categorize the sporting footwear and apparel as lifestyle, being used equally by the consumer as a performance product. NPD believes that the Classics category will remain the dominant fashion trend in the near-term, but success will not be easy as competition will intensify and brands must constantly update their styles. Moreover, to further distinguish themselves and stay ahead of the competition, brands should focus their innovation on the manufacturing side, emphasizing speed and sustainability, as this impact will be longlasting, regardless of where the fashion trends move the market.

II.

Adidas Footwear Drives Both Top-line and Margin Growth

We believe the shift in the sporting goods footwear trend from performance to fashion/lifestyle started to take hold in early 2015 when Adidas’ quarterly footwear sales first broke through the $2B level in 1Q15, reaching $2.1B. Prior to that, average quarterly sales in FY2014 were ~1.7B. Also, before the shift in consumer preference, Adidas’ product mix in FY2014 between footwear and apparel was roughly the same (see Figure 2). FIGURE 2: Footwear vs. Apparel Product Mix

43%

49%

46%

41%

2014

39%

2015 Apparel

In 2015, product mix began to shift with Footwear gaining 3 ppts and apparel losing 2 ppts. In 2016, the shift was even more pronounced with footwear driving ~53% of total sales while apparel declining to ~39% of the sales mix (see Figure 2). On a quarterly basis, growth in footwear sales continues to outpace apparel sales (see Figure 3 left). In 2015, footwear sales increased by an average 26% y/y while apparel sales grew by ~11% y/y. Sales of footwear cooled off slightly in 2016, averaging ~21.2% y/y while apparel sales fell even lower to 7.5% y/y.

53%

2016

Footwear

Source: Adidas AG

FIGURE 3: Footwear vs. Apparel Sales Growth (Y/Y %) (left) and GM Performance: Corporate vs. Adidas Brand (right) 49.4% 25% 23% 17%

21%

23%

47.2%

4Q15

47.4%

46.5%

46.5% 9%

1Q16

2Q16

Footwear Source: Adidas AG

48.8%

47.6%

12% 11%

48.8%

7% 3Q16 Apparel

45.6%

46.2%

3% 4Q15

4Q16

1Q16

2Q16 Corp.



3Q16 Adidas

4Q16



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Clearly, the consumer preference for classic retro sneakers which has benefited Adidas has not translated to sales growth in Adidas apparel. This could be due to 1 of 2 reasons: First, apparel design is clearly performance related. Adidas stated clearly at their 4Q16 call, that they are primarily a sporting goods company and not a fashion company. Second, as a matter of taste, consumers probably prefer Nike, Under Armour or even Lululemon athleisure apparel over Adidas. Gross margins from the Adidas brand (footwear and apparel) also contribute significantly to corporate gross margins. On a quarterly basis, Adidas gross margins make up ~95% of corporate gross margins, significantly outperforming Reebok and TaylorMade Golf brands (see Figure 3 right). Despite the heavy promotional retail environment in the U.S. during the 4Q16 holiday season, Adidas’ corporate gross margins grew sequentially from 47.6% in 3Q16 to 48.8% in 4Q16, an increase of 120 bps. This was mostly driven by the increase in the Adidas brand GMs from 45.6% in 3Q16 to 46.2% in 4Q16 (see Figure 3 right).

III.

Adidas Plans to Double Down in North America

During the 4Q16 earnings call, management announced plans to double down on investments in the U.S. particularly in the areas of personnel, infrastructure, marketing and point-of-sale. Management also singled out New York and Los Angeles as two cities that play an influential role in shaping trends, both nationally and globally, and also where it sold above-average volumes of sporting goods. Going forward, the goal is to double revenues in NYC and L.A. by 2020, compared to 2015. FIGURE 4: Sales Growth by Geography (Y/Y %) TABLE 1: Sales Growth by Geography (Y/Y %) 4Q15 1Q16 2Q16 3Q16 4Q16

35% 30%

W. Europe

33%

24%

26%

11%

7%

25%

N. America

22%

23%

23%

19%

30%

20%

China

28%

28%

21%

19%

20%

15%

Source: Adidas AG

10%



5% 0% 4Q15

1Q16

W.Europe Source: Adidas AG

2Q16

3Q16

N.America

4Q16 China

North America was the strongest performing region in 4Q16. After dropping slightly to 19% y/y growth in 3Q16, N.A. sales jumped to 30% y/y during 4Q16, far outpacing W. Europe which grew 7% y/y and China, where sales growth reached 20% y/y in 4Q16 (see Figure 4 and Table 1).



We believe the strength in N.A. took management by surprise. Management stated that it ran out of Boost footwear product as consumer demand for the popular running sneaker was far greater than the supply. While the technology in Boost footwear is performance-based, management did signal that it would integrate the performance technology found in Boost with the classic Originals retro sneakers to form a new product line called Nostalgia. This would integrate two distinct product categories, the sports performance line with the classic retro line, further blurring the difference between the two categories. Gross margins were stable among the three largest markets in 2016. China (16% of total sales) has the highest gross margins averaging ~58%, while gross margins for W. Europe (24% of sales) and N.A. (21% of sales) averaged ~44% and ~38% respectively for 2016 (see Figure 5). For its 2017 outlook, management guided gross margin to grow by about 0.5 percentage points to a level of ~49.1% up from ~48.6% in 2016.

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FIGURE 5: Gross Margin by Geography (%) 59%

57%

47%

46%

36%

4Q15

60%

57%

56%

44%

43%

44%

38%

39%

37%

37%

1Q16

2Q16

3Q16

4Q16

W.Europe

N.America

China

We believe the decision by Adidas management to accelerate growth plans in the U.S. market in the short term is a wake-up call to both Nike and Under Armour, whom we believe have lost share to Adidas at the last 4Q16 quarter. Clearly, the shift in the trend towards lifestyle has played to Adidas’ strength. However, shifts in consumer preference tend to occur swiftly and unexpectedly. Maybe this is the reason why management made the decision to quickly accelerate investment plans in North America. This may be the best and perhaps the only opportunity left to finally catch up to Nike in the U.S. after trying its best to do so over the last 10 years.

Source: Adidas AG





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03/12/17



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