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Adidas AG: Is the Current Pullback a Buying Opportunity?

Adidas (ETR: ADS), Europe’s largest — and the world’s second largest — sportswear company is going through a rough time. Its share price is down 37% from its all-time high, which it hit in early January 2014.

Assuming the company reaches its latest profit outlook (€3.10 per share) in 2014, it would represent a price-to-earnings (P/E) ratio of 18.8, compared to 27 for Nike (ETR: NKE) and 88.2 for Under Armour (FRA: U9R), its major competitors.

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Combine this with a lot of positive publicity from a successful World Cup in Brazil — Adidas outfitted both World Champion German team and runner-up Argentina, and the company is expected to reach over two billion Euro in sales from football in 2014 — and the casual observer may reach the conclusion that today’s price represents a good buying opportunity.

Would they be right?

Adidas’ own original 2014 outlook showed stable, if moderate, growth. Based on the first half year’s results, this had to be significantly reduced (see table).

2013 actual

2014 outlook (March 2014)

Latest forecast

(31 July)

Sales

14.5bn

High single-digit growth

Mid-to-high single-digit growth

Gross Margin

49.3%

49.5% – 49.8%

48.5% – 49.0%

Operating Margin

8.7%

8.5% – 9.0%

6.5% – 7.0%

Net Income

€ 839mm

€ 830–930mm

€ 650mm

Earnings Per Share

€ 4.01

€ 3.97 – 4.45

€ 3.10

Source: 1H 2014 report; currency adjusted sales growth.

Investors were not amused, and the share price has dropped 17% since 31 July 2014. But why was there a profit warning?

The year 2014 year didn’t start well. In the first half of 2014 compared to first half of 2013:

  • Sales were down 2% at seven billion Euro (5% up on a currency neutral basis)
  • Gross margin was down one percentage point at 49.2%
  • Operating margin was down 2.2 percentage points at 7.5%
  • Earnings per share (EPS) was down 27% at  1.67 Euro

Growth problems
The sales development is especially worrying since both Nike and Under Armour showed strong growth in the comparable period (+13% and +31% currency-adjusted sales growth respectively).

This trend didn’t start this year. Full year 2013 sales growth was only 3% for Adidas, compared to 11% for Nike and 27% for Under Armour.

Also, while Adidas managed to show strong (currency-neutral) sales increase in emerging markets — albeit overall not better than Nike — Western Europe sales only increased by 6% (Nike +18%), and in North America sales dropped by 10% (Nike +11%). In Adidas’ strategic plan — the so-called “Route 2015” — North America was one of the top three “attack markets,” so the results from this continent were especially disappointing. It seems that while Nike is growing strongly in every region, Adidas is struggling in its core Western European and North American markets.

Gross margin was also down, driven by a combination of currency devaluation and hedging rates, higher input costs and lower margins in the struggling golf equipment business. Also, other operating expenses grew faster than sales, further deteriorating operating margin.

Steps forward
In order to address these negative developments, the company announced (among others) the following measures:

  • Restructuring of the struggling golf equipment business;
  • strong reduction of the opening of new stores in Russia/CIS due to increased risk in the region;
  • consolidation of the North American Adidas and Reebok units under a new president; and
  • bigger investment in advertising and marketing, including “the biggest marketing campaign ever.”

At the same time, the leadership team also sounded some positive notes, based on the growth in the emerging markets and on good second quarter momentum — partially credited to the World Cup — in the core markets.

My Foolish Assessment
I remain skeptical. Growing in the emerging markets is essential, but having a strong position in one’s core markets is equally important. Also, the World Cup only happens every four years, so any bump will probably be short-lived.

Even though I believe the industry as a whole has stable growth potential based on GDP growth in emerging markets and a shift towards fitness, Nike seems to be better poised to take advantage of this opportunity.

As Warren Buffett said, it’s better to invest in a great company at a good price than in a good company at a great price. Therefore, a 37% drop in itself — without proof of the health of the underlying business — doesn’t make Adidas shares attractive for me yet.

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Miklos Szekely does not own any of the stocks mentioned. The Motley Fool recommends Nike and Under Armour. The Motley Fool owns shares of Nike and Under Armour.

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