Adidas’ fourth-quarter sales and earnings came in slightly below expectations even when backing out charges and write-downs related to fraud in its Reebok India unit, but we are encouraged by the company’s ability to hold gross margins in a tough macro and rising input cost environment. The company now sees operating margins approaching 9% in 2013 and beyond, and its mid-single-digit growth forecast sounds conservative. However, 2012 included a number of tailwinds such as the European soccer championships and the London Olympics, making it a tough basis for comparison.
Coming off such a strong year, shares are now above our EUR 58 fair value estimate, though this will move up slightly as we incorporate management’s outlook and the time value of money. The increase in operating margin assumptions will be offset by a sizable increase in capital spending, from EUR 434 million to EUR 500 million-550 million. We believe the branding from the Olympics (where adidas was the title sponsor) and the hard work on sourcing (an area where we previously believed Nike to have an advantage) both point to solid competitive advantages that would be difficult for other sporting goods companies to copy (excluding Nike), thus supporting our narrow economic moat rating.
Finally, although we’ve been at times critical of Reebok’s emphasis on fad and fashion and lack of brand direction, the current drag on sales from Reebok is partly due to the exiting of the NFL license, and we believe repositioning the name as a fitness and training brand is finally a solid plan, in which the pro sports licenses Reebok previously held did not fit.
Although sales in the seasonally weak fourth quarter were up only 1% (currency neutral), we highlight the importance of technology and branding as two key drivers of competitive advantages in sporting goods. Although adidas has long lagged Nike in basketball, it has been able to expand in basketball at a time when Nike is charging hard in the category, mainly due to its “crazy light” shoe, which even die-hard Nike sneaker aficionados admit is a serious contender.
In addition, although we view some of management’s enthusiasm with a dose of skepticism, the new foam technology introduced for running shoes may not change the sport of running, but it may reinforce the brand image of technological leadership, similar to adidas on the soccer field, Nike in basketball, or Under Armour in apparel. Looking to other growth drivers, while the wholesale division contracted 4% in the fourth quarter, the retail and other divisions continued to grow, other being driven by technology advances in golf, again showing double-digit gains in a stagnant category. And although we’ve expressed some skepticism of retail door growth in the past, particularly in China and Eastern Europe, control of the brand distribution and leasing key locations may be more important than in mature markets such as North America and Europe.
Although our return on capital model does account for retail lease payments and we are aware of the still-mounting real estate risks in China, we note that lease agreements in China appear to be offering tenants more contingent rent (likely reflecting the increasing supply side of the real estate equation), which thus shifts some of the risk to the landlord. Finally, we are encouraged by the plans for Reebok, which has had ups and downs, dating to before it was acquired by adidas. Our view that the brand has introduced too much fashion, or followed a trend too far (such as toning), can perhaps be reversed if the long-run plan to stick to the brand position of fitness and training can be adhered to.
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