EUR 850.00 For Business Accounts Only

Morningstar | Adidas Posts Strong International Growth and Margin Expansion; Shares Overvalued

Narrow-moat Adidas delivered another strong quarter, with second-quarter sales growing 10% on a currency-neutral basis and operating income improving 120 basis points to 11.3% of sales. However, management maintained its previous fiscal 2018 guidance of 10% sales growth (versus our forecast of 7.6%) and operating margin between 10.3% and 10.5% (we forecast 10.4%). While we do not intend to materially alter our fair value estimate of EUR 152, which is based on our long-term forecast for 7.5% average sales growth and 10.3% average operating margins over the next five years, we may evaluate our near-term assumptions due to Adidas’ recent successes. We believe shares continue to trade at a premium to our valuation, and investors should wait for a larger margin of safety.

Overall, the key story for Adidas in the quarter was strong growth in North America (up 16%) and China (up 19%) and continued improvement on the gross margin line to 52.3% (up 220 basis points) contrasting with our expectations of 10%, 15%, and 50.7%, respectively. These results were driven primarily by pricing, which management qualitatively referenced, and channel mix, which can be seen through the continued reduction in store base and 26% growth in e-commerce sales. While these results have been impressive, we continue to believe that Adidas benefits from the athleisure fashion trend, and consistently adapting to changing fashion preferences will likely be tricky, which is represented in our lower long-term sales forecast of 7.6%. Additionally, while the 2018 World Cup took place over the quarter, management downplayed the impact due to Adidas’ more diversified category mix since the last tournament in 2014. We are skeptical of this claim and expect sales growth to be tepid next year as sports fans stocked up on merchandise for the 2018 event.

We are encouraged by the firm’s increased investment into its brand intangible assets, the key source of our narrow moat rating. In the quarter, advertising spending increased 14% (now at 13.5% of sales), which we contend will further improve visibility and awareness as the firm continues to expand into international markets. Additionally, we believe the continued product innovation pipeline that Adidas develops fuels the brand assets, seen with UltraBoost growing 50% (now close to EUR 1 billion in sales) and in the new iterations 4D and Parley products that launched this year. Finally, we maintain that the strength of the brand is seen in the improved gross margin of late and inventory levels decreasing (down 2%) in relation to sales growth (up 10%).