3 Reasons to Remain Pessimistic About Adidas

Figures in this article reflect prices as of market close on 11/14/2014 unless otherwise specified.

Adidas (ETR:ADS) has had a rough 2014. Even though it could boast of outfitting both Germany and Argentina for the World Cup, it reported disappointing results for the first half year and issued a profit warning in August. Not surprisingly, its share price has taken a beating — at its lowest point in the year, it lost as much as 43% compared to its all time high reached in early January 2014.

After the quarterly earnings report at the beginning of November, the stock price has recovered some of its losses and is trading 19% higher than its 2014 low. Is this the start of a possible turnaround in the stock performance, or is the optimism misplaced? I still have my doubts. Here are my key reasons.

1. Sales in Western Europe and North America remain weak

One of my key worries is the fact that Adidas continues to lose ground to Nike (NYSE:NKE)(ETR:NKE) in the key Western Europe and North America markets, which add up to about half of global sales. The below table shows the year-over-year sales growth for the last three reported quarters:

Source: quarterly reports; currency-adjusted sales growth vs. prior year

The above periods are not fully overlapping because Nike’s quarter-end is one month before Adidas’, but the table still illustrates my major concern well. Adidas has consistently lagged behind its archrival in 2014 in both key markets, and this trend did not improve in the third quarter.

In Western Europe, Nike has consistently outperformed its European competitor, growing its sales by 21% compared to Adidas’ 7%. My prediction: If this trend continues in the coming quarter, Nike will become the number one sportswear company in Western Europe in 2014.

In North America, Adidas lost 7% sales compared to prior year. Even if we adjusted results to exclude the “Other Businesses” segment — the majority of which is the troubled golf business — quarterly growth rates would only be -13%, 5%, and 3% for the first, second, and third quarters respectively, and a 2% reduction for the nine months overall, which is significantly below Nike’s 11% growth.

To rub salt in the wound, by the end of the third quarter Under Armour (NYSE:UA)(STG:U9R) pushed Adidas back to third place in North America, increasing its 2014 sales by 20% to $1.2 billion compared to Adidas’ $1.1 billion.

2.  Gross margin and operating profit erosion continues

Below graph shows that — compared to prior year — Adidas had a significant drop in its gross margin percentage in each quarter. Moreover, this margin erosion has accelerated in the last quarter with a drop of 190 basis points.

Source: Quarterly reports

Also, operating profits — both in euros and as a percentage of sales — are below prior year levels for the third quarter in a row, and €230 million (or 20%) behind 2013 levels for the first nine months of the year.

According to the company, about €150 million of this profit drop is driven by unfavorable currency developments, mainly in the emerging markets. However, Nike is also exposed — albeit, based on the regional allocation of its global sales, only to a lesser extent — to similar currency developments, and Nike managed to increase both its gross margin percent and its operating profits in each of the last three quarters.

In addition, the troubles in both the golf equipment business and in the Russia/CIS region continue to add pressure to profits.

In the first nine months, sales at TaylorMade-adidas Golf dropped by 29% (on a currency-neutral basis) and operating profits are €150 million below 2013 levels. While focusing on inventory cleanup, shutting down a factory in Texas and reducing workforce in the golf segment by 15% will help improve profitability on the short run, an overall decline in the golf industry — driven by a drop in participation rates and disinterest among young people — will continue to be a strategic challenge, especially since the segment represented 9% of total sales in 2013.

Adidas has a traditionally strong business in Russia. However, partly due to the geopolitical tensions, consumer sentiment has been falling and the rubel has depreciated over the last few quarters. This — and related promotional efforts to clear inventory — had about €100 million negative profit impact in the first nine months. To counter this, Adidas is reducing its footprint in the country — closing stores and opening less new stores than planned — but short- and mid-term challenges will remain.

3.  The cash flow situation is worsening

As the below graph shows, Adidas has consistently generated less cash than in the previous year.

Source: Quarterly reports

My main concerns around cash flow are threefold:

•  It’s not clear whether the actions to reduce working capital are aggressive enough and fast enough. Receivables grew more in the third quarter than sales did — which affects cash flow negatively, as the company has to run after more cash — and inventory levels are still 5% above last year.
• Cash outflow from investing activities continues to be higher than in 2013. One could question whether the reduction in new store openings is cutting deep enough, or whether there could be further reduction in investments.
• Adidas recently announced a share buyback program of up to €1.5 billion. According to the company’s announcement, this is in addition to its dividend payments and is supposed to be financed predominantly from free cash flow. While buying back shares when the stock price is down can often be positive for shareholders, I prefer to see this with companies like Apple that have a large pile of cash available and/or are generating a healthy free cash flow. At this point neither is true of Adidas, and it’s unclear to me how the buyback will ultimately be financed.

My Foolish assessment

Adidas’ third-quarter results were not as bad as many analysts may have expected and the stock has rallied. However, I don’t believe this optimism is warranted. The company keeps losing ground in key markets to its main competitors, margins keep eroding, and the key issues of the golf segment and Russia will not go away quickly. In addition, its cash position is worsening and the share buyback initiative might not be as good for shareholders as some may believe. As a result, I do not believe that investing in Adidas is the right choice.