With Shares Up 60% in the Past Year, Have You Been Overlooking Adidas?

Since 2015, Adidas (ADDYY -0.65%) stock has taken off, gaining almost 200% in value, while its major competitors like Nike (NKE 0.64%) and Under Armour (UA -0.38%) (UAA -0.44%) failed to keep pace. But even then, the German sportswear company doesn't seem to garner nearly as much attention as its competitors, especially in the North American market.

In this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Fool.com contributor Asit Sharma dive into what investors should know about Adidas and its fast-growing business. Find out why the company has enjoyed so much success in the last few years, what their growth plans are looking forward, and how American investors can buy into the German-based company.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen, and it's Tuesday, May 2nd. It feels good to be back in the studio after a brief hiatus. I hope everyone enjoyed the change of pace last week with Sarah in the host chair. If you actually missed that episode, you can go to podcasts.fool.com or your favorite podcast app to hear her discuss the "death of retail" with Dan Kline. But this week, I want to talk about a corner of the consumer and retail world that actually continues to enjoy strong growth with the help of some pretty favorable trends in consumer preferences, lifestyle, and more. Joining me today via Skype is Motley Fool senior contributor, Asit Sharma. Hey, Asit, great to have you with us!

Asit Sharma: Great to be back, Vince!

Shen: As a reminder to all the Fools listening, or if you missed Gaby's Financials show yesterday, we have a puzzle theme for this week, so make sure you tune in until the end of this episode to get today's clue and learn more about the contest. For our main topic of discussion, we will be fielding a question from The Motley Fool Podcasts group on Facebook. Johnny posted wanting to know more about Adidas and why it has seen incredible gains recently, far outperforming its major industry rivals, Nike and Under Armour. In fact, since the beginning of 2015, the stock has rocketed upwards, gaining nearly 200%, while Nike was up 20% over the same period, and Under Armour struggled with a 40% decline.

Asit, Adidas has been around for 70 years, it's the No. 2 sports brands worldwide, with revenue in 2016 coming in at over 19 billion euros, but it really doesn't get as much love as it probably deserves in the U.S. for consumers and investors, too. The first thing that comes to mind in this space is obviously the dominant, homegrown industry leader, Nike, then you have Under Armour as a scrappy upstart. But, as you research the company, did your due diligence for Adidas, what was your first impression?

Sharma: My first impression on Adidas is that it's a much-loved brand, as you implied, in other parts of the world. The U.S. is a football, basketball, baseball culture, and we're just turning into a soccer culture. But among sports like soccer and tennis, sports which aren't as traditional here but have been, in the last few decades, increasing, Adidas has more traction among consumers. It's a sort of this continent versus that continent dynamic. Nike is extremely strong in North America. That's a market that Adidas wants to break into, and vice versa. My first impression is, there's two-fifths of the world for which Adidas is the Nike in terms of brand dominance. I would say we have a bias here in North America for the wonderful explosive growth that Nike has enjoyed, so it's a top-of-mind brand for us. We'll get to this a little bit later in the conversation, but Adidas is trying to change that.

Shen: Yeah, absolutely. I think, though, while this, as we mentioned, part of the consumer and retail sector, in terms of sports apparel overall, has shown growth even in a space that has overall seen its challenges in terms of changes to the demand for brick and mortar stores, changes to digital operations, more e-commerce. Sports apparel is doing well, the space is doing well. Adidas in North America, I think a big part of why the company has seen such incredible gains in its shares has been the success that it's seen the past couple years in North America under a new overall strategy that they've dubbed "Creating the New" under new leadership with Mark King. Could you tell us a little bit about the results the company has seen recently, some of the progress they've made that has allowed them to really outperform Nike, and who was previously the growth leader in the space, Under Armour?

Sharma: Sure. Adidas, or, I should say, for this part of the segment, Adidas -- my wife is from India, and she tells me that in many parts of the world, that's how it's pronounced. I know, Vince, sometimes we talk about brands, is it "Nike" or "Nikey"? For this part of the segment, Adidas. One of the tremendous things that the company has implemented is an agile methodology of creating products and getting them to market, and then trying to follow through on those sales. You hear this word -- "agile" -- espoused by many companies. Everyone wants to be lean and versatile and aggressive and fast. But Adidas is one of these companies that has actually implemented this in a number of ways. They have a type of brand positioning, it's actually their strategy, it's based on four components: speed, cities, open source, and culture. Let's talk about the first of these. Speed really means what you think it might, in some ways. It means making products very quickly, getting them into channels quickly as well. But for Adidas, it also means, when we put a product on the shelf, we want to have enough inventory so that there's some left over. Traditionally, the model in footwear is that if you sell out, that's awesome. But Adidas says, "No, we get as much product as we can as fast as we can. Let's have some left over. Let's actually have inventory left in the channel, because what that shows us is that we haven't left money on the table." If you sell out, there's a span of time until you replenish that inventory where you've lost sales.

So, speed means, actually, something a little different here. It means flushing those channels with enough product so once they create that demand, I come and buy the shoe, right after me they have another pair waiting for Vince. I really like this part of what the company is doing. I want to point out that this is has resulted in a faster growth rate for Adidas versus Nike. Nike has averaged, for the past year or couple years, 6% annual revenue growth rate. Adidas is approaching 14%. When you think about a company that is $15 billion in trailing 12-month sales, that's a hard feat to pull off. One of the things -- again, I like this, speed.

And briefly, we'll talk about one more aspect of the strategy. This is cities. If you had to reinvent yourself as a sports and leisurewear company, there's so many ways you could go about it. Your first impulse might be to go to smaller metropolitan areas and gain exposure there, spend money on marketing, your supply chain, and try to get traction in smaller cities. That's very logical. Adidas did something extremely novel. They isolated six cities around the world. Those cities are London, Paris, New York, L.A., Shanghai, and Tokyo. They came up with the idea that, "Here, we want to be as aggressive as we can, because these six cities set the trends for the rest of the world. If we're selling at a high throughput in these cities, the taste will drift down." So, sort of trickle-down branding, we can coin a phrase today. And that's been effective for them. Their sales have really shot up in these cities, and it's giving them brand awareness in smaller markets which look to places like L.A. and Tokyo for their style cues.

Shen: Yeah. I think it's really important, and we'll get to the other two, which are open source and culture, but with speed and cities, it's really interesting with speed that one positive development that has come through that in terms of making sure that there's enough product in the channels, and not leaving money on the table, is the idea that, there's a very delicate balance there in having these more accurate demand forecasts. And that improves their profitability as well, meaning their products sell through, hopefully, at full price, and they resort to less promotions and discounts. Overall, that's going to flow down to their bottom line.

And the cities thing is really interesting because those six locations, setting the trend for the rest of the world, as you described, makes sense to me. They are really putting their money where their mouth is in those regions, in terms of, these flagship stores are opening, with one going up in New York very recently, they get exclusive collections, they get more innovative retail experiences focused in these cities. So, the marketing and the investments are really showing in these regions. I think they're also tied to the next thing, which is open source. At its core, it's using partnerships and sponsorships and different endorsements to further the reach in popularity of the brand. Have you seen, for example, Asit, a pair of Yeezys being worn on the streets when you're walking around at all?

Sharma: I have, but only briefly, because I wanted the pair so badly the dude started running away so I couldn't look at them anymore. But this is the type of thing that Adidas has become very good at. Instead of innovating from the inside out and pushing their ideas out and trying to market those ideas, they have really embraced a culture of design that's open source. So, what they mean by that is, as you might guess, they mean crowdsourcing ideas, they invite design engineers in house to come and pull up a chair in their offices and collaborate. They're very in touch with the consumers, as is Nike, we should say, they collaborate a lot with consumers on design ideas. But, the mentality is that, actually, there is no defined trend that you can see in the sportswear market, it's constantly evolving.

Today, with social media, ideas spread, consumers have as much power to create something as these big corporations do. And those that are realizing this and taking advantage, I think, have the potential to be quite successful. The example that I was looking at is a collaboration with Parley, which is an organization that's trying to save the oceans. Adidas has launched a shoe that's entirely made from ocean pollution, that's the plastic that's swimming in the oceans in these great gyres that you read about. Their phrase for this is "from threat to thread." Very persuasive. You can buy this shoe. Again, it's an idea that they didn't come up with in a corporate tower, they collaborated with a very small, socially conscious company. But, their first forays into this late last year sold out very quickly. I think it's going on sale in a broader way here in the U.S. this month. This is a great example of taking this idea of open source and not just having something nice to say to consumers, but bringing those profits to the bottom line, tell shareholders, "It's not just good for our image, it's good for business."

Shen: The last point, the way they show this in some of their company presentations. You have open source, you have cities, and you have speed in a triangle, that's their focus. But underneath all of that, of course, is the culture for the company. Management has talked a lot about really focusing on the customer the past few years with this new strategy, making sure that they're focused also on the brand and making that as attractive and desirable to consumers as possible. On the culture side, on the management side, I think it's important in terms of recent changes and also some of the people who have been leading the success of these efforts, really important, in terms of the CEO Kasper Rørsted, he's only been in the role since late last year. He came into this position at a time where you obviously want to stay focused on your most successful initiatives, letting the momentum build after a really strong 2016. Big part of that success, as we've mentioned with that almost 30% growth in the U.S. market, which is the largest market worldwide for these sports brands. Rørsted has made it clear from the beginning that winning in the U.S. is one of his top priorities.

On that note, you have Mark King, who is president of Adidas North America. He's been heading up that business since June of 2014. He helped turn that region around from a shrinking business, down 7% to 8% when he got into it, and now they're delivering double-digit growth rates. I think the company recognized that it really needed to dedicate the resources and focus on this market if it wanted to compete, not allow the design team and the marketing team to be coming out of its headquarters in Germany, instead moving some of that into the U.S. With the additional marketing, the right athlete and celebrity partnerships, some of which we've talked about, blending that athletic performance and style, the idea of athletes wanting things to perform on the court or the field, and then also looking good off the court and off the field. Anything else to add on that culture-management side, Asit?

Sharma: To reiterate what you said, Rørsted on a recent conference call said, when I came on board, a CEO's decision point, "Do I change the strategy or do I keep the current strategy?" If the CEO determines that the strategy is working, why change it? And that's exactly what he did. And I think that was important, because they were in the midst of building momentum. I wanted to go back to something briefly that you mentioned, which is the strengths of the North American business. That's confluent with another trend that we're seeing at Adidas. Adidas has an overall gross margin very close to Nike, it hovers every quarter in the mid-40s, about 45% gross margin. Their digital business, though, is throwing off a 60% margin. So, it's a higher margin business, more profitable, and it's growing much more rapidly than the rest of the business. Last year, the digital sales grew at a rate of 60% roughly from the prior year. This is actually very prevalent in North America. We are increasingly a society that's buying online and hardly leaving the house, I should say. So, to circle back around, these two trends, focusing on North America and the digital strength that is easy to tap into here in North America, I think will be very strong for Adidas. Why they didn't do this years ago, I don't know, but some of our listeners who are a bit older will remember the V-8 commercial, where people used to have an epiphany and slam themselves on the forehead and say, "I could have had a V-8!" I think at some point, back at HQ in Germany, leadership realized, "We should have been pushing North America much harder long ago." But they're certainly gaining momentum now.

Shen: OK. Moving on, then, to some of the numbers, some of the financials and the valuation. We've touched on bits and pieces here and there with specific segments. What have you seen in terms of some of the revenue growth, in terms of their forecast, what their ambitions are, they had this plan, and I have a slide from one of their presentations to touch on as well. But, some of their profitability, what are you seeing there?

Sharma: Profitability still needs to be improved at Adidas. We've talked about the comparison to Nike in terms of gross margins. But when you take away the selling expenses, think about all the operating expenses, administrative and general, I think Adidas is maybe about 50% where it needs to be. The reason is, at the end of the day, Nike has an 11% to 12% net margin every quarter. Adidas hovers between 4% and 5%. They know they can do a much better job. And some of this is being manifested in their evolution. We talked about trying to make sure there's enough product to make demand. The flip side of that, which you briefly alluded to, Vince is, you take a risk, you might have too much inventory where the demand trails off, and that costs you money. Their supply chain is something they have admitted needs work. But also, just optimizing retail channels will be very helpful to Adidas. As we mentioned, these digital sales can lift the overall company margin, that will take some number of years. It's interesting, the company is projecting that it's going to keep growing, I think, maybe, net earnings by a 15% rate, and also revenue at a low double-digit rate, for the next three to four years. And that's impressive to me.

Shen: Yeah. I have here their original forecast in March 2014, when they were kicking off the "Creating the New" strategy. Their ambition for 2020 was sales growth in high single digits. At their recent investor day, they upped that to low double digits, as you mentioned, 10% to 12%. Net income growth, they were hoping around the 15% range, that's been boosted to 20% to 22%. Ultimately, what the means, by 2020 they're hoping to see net sales of 25 to 27 billion euros. On the e-commerce side, even, they were hoping to hit $2 billion in terms of the digital e-commerce business in 2020. Now they're targeting $4 billion, because they've seen so much progress there, and boosting their operating margin from current levels up to about 11% by 2020. That's a huge part of it. The CEO has mentioned, he described it during one of the presentations how in the past eight years, they've experienced so much growth, which is great, but they have failed to scale that, and now that's very much a renewed focus for them. In terms of where their revenue was coming from as well, just over half their business now is in footwear, about 53% of sales. That share of revenue has grown quite a bit in 2015 and 2016 with this recent success. Footwear put up 26% currency neutral growth in 2016, really outpacing its apparel and accessory segments. I think this is important in terms of the history of this company, starting out as a footwear company, it's been around for 70 years.

A really interesting part of the history is the idea that these two brothers, the Dassler brothers, who started Adidas ended up coming to a head and developing the sibling feud, and Adi Dassler, who started Adidas, his brother actually ended up founding Puma. Very influential family, in terms of this sports apparel and footwear world. In terms of that footwear, within the U.S., despite some of the strides that they've made, only at 7% market share, so, plenty of runaway for further growth.

How about the valuation? I mentioned earlier that the stock over the past two years or so has gone up about 200%. Do you think that after those kinds of gains, this is still something that investors can get in on and enjoy further growth? Or are they better off potentially looking at Nike, which is still the leader in this industry, or even Under Armour which, though it suffered recently, may be an attractive price point now? What do you think?

Sharma: Vince, a few episodes ago, you and I were talking about comparing similar companies in a single industry. I was touting my love of forward earnings as a good way to compare two companies. Adidas has become pricey, to be frank, since it's had these tremendous gains. Just looking this morning, January 2015 to date -- you talked about a 200% gain, but in the last 16 months, the stock has doubled, and that's pushed its forward P/E ratio, that is, it's P/E on an estimated basis for the next year, to 30x, versus Nike, which is 23x. It's also pushed its trailing 12 month price to free cash flow ratio. If you take the free cash flow the company generates and compare that to its price, it is priced 53x free cash flow to Nike's 32x. What does this mean, though?

If growth looks like it can plateau, then you have a reason to really be concerned when a No. 2 company outstrips a No. 1 company in the industry in valuation. But, if that No. 2 company can make a persuasive case that its arc of growth is still intact and actually accelerating, then the shareholder can have some tolerance for a higher valuation. I think, for the time being, that's what you're seeing if you pull up the stock chart and compare Nike to Adidas together, and look at that ascending curve that Adidas has created. Shareholders are willing to take some more risk because they understand that, unlike Nike, which is extremely solid, and growing at its own handsome clip, Adidas has potential to accelerate. So, while I do see some risk in the stock, I can understand why there might be some support over the next two to three years in this timeframe you mentioned, Vince, where they're going to optimize all this work they're doing. What's your opinion?

Shen: I think despite, you mentioned the price to forward earnings of 30x, definitely a premium to its competitors like Nike and the industry overall with the exception of Under Armour, for example. I think the key thing to remember here is what you mentioned in terms of where they stand, in terms of their profitability levels being about half of where Nike is due to its scale and leaner and more efficient operations. If management remains focused on that and they can maintain the momentum they've seen in terms of the top line, in terms of their brand awareness and this growth that they've seen, double digits across all of their different markets, in terms of Europe, North America, and China as well, and these other regions. And, also, being able to boost that and scale that, as management has mentioned they're so focused on. Then, really, you see a lot of potential there for how that valuation can be justified, and how it's a premium worth paying, because this is really a company that's firing on all cylinders right now, and should be stronger as we go forward.

On that note, for any listeners who have had their interest piqued with this discussion of Adidas, there are a few things in terms of the logistics of investing in the company that should be known. That's in terms of the fact that there are ADRs you can invest in, and where those ADRs trade. Wrapping up our discussion of this company, there are some things you should know about investing in a non-U.S. entity like Adidas. As a European company, Adidas trades on the Frankfurt Stock Exchange under the ticker ADS. For a lot of our Foolish listeners, if you want to invest in the company, you would be looking at its ADRs or its American depository receipts. Those are under the ticker ADDYY.

These receipts essentially have the advantage of trading on a U.S. exchange in U.S. dollars, and ADR really makes it easier for Americans to invest in foreign companies like this. Deutsche Bank actually sponsors the ADR program. What that means is it buys a bunch of Adidas shares off the Frankfurt Exchange and reissues them as these ADRs. In this case, there's a ratio. Two of these American depository receipts equal one ordinary share of Adidas stock. As a result, if you buy these ADRs, you can avoid some of the complications like exchange rates that you would otherwise encounter if you bought the foreign stock directly. A second point to keep in mind is, these ADRs trade over the counter in the U.S. Asit, can you give us a rundown of what listeners should know about these OTC exchanges?

Sharma: Absolutely. Over the counter, OTC, when you deal with ADRs, they have a few subspecialty markets to choose from, and Adidas trades on the OTCQX, which is the premiere market. That sounds very lofty. But what's really important to focus on is what sponsored level of ADR does Adidas trade at. There are three levels. Adidas trades as a sponsored level 1 ADR. What that means is they have a little bit of less onerous reporting requirements, and for those analysis mavens who are listening today -- I know we have a few -- you won't be able to pull a GAAP-style statement, a form 20-F, that you might be used to looking for when you buy ADRs and want to check up on them. Their financial statements will actually be issued under international financial reporting standards. They have a lot less compliance. For a company like Adidas, it's not because they want to stay under the radar screen or have something to hide. It's just more efficient and cheaper, in some ways, to be a level 1 ADR. Their sponsoring bank, of course, is Deutsche Bank. It should be extremely easy if you want to trade under that symbol, which Vince mentioned. You shouldn't have any problem. Now, what's the difference if you move to a level 2? If you move to a level 2 ADR, then you can trade on the New York Stock Exchange, or another American exchange. For Adidas, a global company, it's not that big of a concern. There's no need for them to build their brand -- they've been around for decades -- and get on an American exchange, they've been around for decades. So, level 1 ADR, we easily find the symbol, as Vince said, and happy trading, if you're interested.

Shen: Thank you, Asit. Wrapping up our episode, I wanted to get to the details of our puzzle and our contest. We love games here at Fool HQ. These different puzzles and challenges that we have are a really big part of how we team build, how we collaborate together at the company. We actually have a chief collaboration officer and puzzle master named Todd Etter. I've participated in several of these different challenges that he's created, they're really incredible, really fun. This week, we wanted share some of that experience with our listeners, and let them in on some of the fun in that we have here at Fool HQ.

Giving you all a taste of Todd's challenges, we asked him to put together a puzzle for you guys. Every day this week, each host is going to wrap up their show with a clue, and the answer to that clue is a company name. Monday through Friday, we'll be able to bring all these together into a final puzzle that will be revealed on the Friday Technology show with Dylan. So, if you want to solve the whole thing, you need to listen to every episode this week. What do you get for jumping through all of our clue hoops? The first 10 listeners to shoot us an email after Friday's show with the five company names and the answers to the puzzles, and the final one that Dylan shares on Friday, will get Fool swag. 

Today's consumer and retail clue is: If you add the letter T to the beginning of a two-word clothing company, you will get the name of a hypothetical clothing company that specializes in headwear wraps. What is the name of the original company?

Starting Friday, if you solve every clue, write in to [email protected] with the email subject line "Puzzle" and the answers. Wait until Friday when you have all of the clues and the answers to write in. Also, make sure to tell us your T-shirt size. If you're stumped and want the reveal, on May 12th, we'll post them to The Motley Fool Podcasts Facebook group and the Industry Focus Twitter account. To enter this contest, there's no purchase necessary, and the contest is open to all legal residents of the United States and Canada, excepting residents of the province of Quebec, over the age of 18. Employees, affiliates, and contractors and their families at The Motley Fool LLC or any of their affiliates are not eligible. Void where prohibited by law. For a complete list of contest rules, visit puzzle.fool.com. Asit, thanks again for a great discussion on Adidas, and for joining us today!

Sharma: Great fun. Thanks a lot, Vince!

Shen: This podcast is produced by Austin Morgan. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thank you for listening and Fool on!