Adidas Stock Is Currently The Best Pick In Its Sector

  • The New captain of Team-Adidas could prove to be a golden substitution.
  • Adidas is struggling with margins and the new CEO is the right person to change that.
  • Overall growth is not an issue though it should come from core sports brands as well, not only from casual wear.
  • Adidas stock doesn’t come cheap but is attractive compared to its peers.

Finally, Team-Adidas gets a new captain. After more than 15 years, Herbert Hainer will step down as Adidas (OTC:ADDYY) CEO in October this year. Kasper Rorsted, currently serving as CEO of Henkel, will be the new front runner at the HQ in Herzogenaurach. Make no mistake: CEO Hainer delivered much sought-after growth for the brand with the three stripes. The problem is that Adidas lacks profitability and needs margin improvement, and Rorsted may be just the right person to do that.

Investors in athletic apparel can’t complain about the performance during the recent years. But Adidas-shareholders could use a boost, as the graph below shows. Whereas its main competitors  like Nike (NYSE:NKE) saw their stocks either triple or in the case of Under Armour (NYSE:UA) almost quintupled during the last five years, Adidas stock added ‘only’ 60%.

ADDYY stock chart

Source: Adidas Stock Price Data by amigobulls.com

A key reason for the underperformance of Adidas stock is the poor operating margins compared to its peers. Where Nike shows a healthy 14% operating margin, Adidas stays well behind with a mere 6% margin. The German apparel maker struggles to grow more efficiently. During the previous earnings call, Adidas noted that gross margins are expected to drop a full percent and sales & marketing costs will increase by 20 bps (as % of sales).

That’s something new CEO Rorsted may well seek to turn around. His image at Henkel indicates that he’s the right man for this task. There’s a lot to be gained in the field of overhead costs. The new CEO is expected to look closely at central costs and could close a number of foreign locations and subsidiaries. Rorsted may also want to improve cash flows by shortening the cash conversion cycle.

Nevertheless, he might be unable to reduce sales costs. This type of costs depends a lot on endorsements of athletes and teams, which are pricey but also very rewarding if they provide a sales boost on the back of the popularity of sports stars. Analysts expect sponsoring costs to increase by $150 million in 2016, or 0.8% of total revenues. There's a clear trend in the industry towards individual endorsements. Adidas contract with football (soccer) teams Manchester United (NYSE:MANU), Juventus Turin and Bayern München causes significant costs, as the chart below shows.

Adidas - endorsements

At bottom line, cost improvement and higher sales should result in at least 15% EPS growth during the next year. This is roughly in the same area as main competitor Nike, but Under Armour shows much stronger growth figures (see graph below). Nevertheless, UA’s EPS growth could be hampered in case the brand becomes more aggressive in its endorsements of athletes.

Adidas Nike Under Armour - EPS growth

At the top line, there’s not much reason for concern. During the past 18 months, organic growth reached 10%+ and for the next years, growth could be well in the 8%-area. Nevertheless, Adidas depends a lot on the trend of athleisure, which could harm Adidas as a real sports brand. Looking at the sales breakdown, casualwear divisions Originals and NEO are outpacing the rest. The issue with too much focus on lifestyle is that it may weaken the sports brand Adidas and innovation in core sports categories. Furthermore, lifestyle products are much more exposed to changing consumer preferences. So investors will take a close look at brand category growth.

The next earnings release is scheduled for March 3 (Q4-2015 and full year results). Next to the above mentioned points, investors are interested in the management strategy for the TaylorMade Adidas Golf division. This division is currently struggling and a big announcement is expected. Another closely watched item is the volume response on price hikes in struggling ‘emerging’ regions Russia and Latin America. This could be a dark horse during the earnings announcement.

The question is what to do with Adidas stock in the meantime and long term. From a valuation perspective, based on 2016 EPS of EUR 4.00 (Thomson Reuters consensus), shares are trading at a price/earnings-ratio of 23.9. That seems quite lofty, compared to earnings growth of approximately 15%. That means a PEG (P/E compared to growth) of 1.6. (Remember: classic theory teaches below 1 as undervalued, above 1 is expensive.)

However, this is cheaper than its direct peers Nike and Under Armour. Nike is trading at a 2016 P/E of 28.8 and a PEG of nearly 2. Under Armour, obviously trading at a premium due to its stellar growth rates, quotes a P/E of 64.9 and PEG of 2.7. The chart below shows that currently investors pay a significant premium for future growth of Under Armour, maybe a little too much. The discount for Adidas compared to Nike could be too large and would speak for a position in the German sports brand.

Adidas Nike Under Armour Price earnings

Concluding, shareholders’ enthusiasm on the announcement of a change at the top is justified. The coming CEO Rorsted, with a good cost cutting image, is just what Adidas needs due to its current struggle in margin improvement. Investors should closely monitor growth in the core sports brands and not only in Originals and Neo. Furthermore, the company needs to make a decision regarding the future of TMaG. Although the sector doesn’t come cheap, Adidas is the preferred name for investors. A market neutral position could be a long position in Adidas stock and short in Nike/Under Armour.

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  • I do not hold any positions in the stocks mentioned in this post and don't intend to initiate a position in the next 72 hours
  • I am not an investment advisor, and my opinion should not be treated as investment advice.
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  • I do not have any business relationship with the companies mentioned in this post.
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