Will the Stock Behind "On" Running Shoes Be the Next Big IPO?

The market is hot for performance apparel, and On Holding (ONON -2.01%) is the newest public business looking to capitalize. In this episode of Industry Focus: Consumer Goods, join Motley Fool analysts Asit Sharma and Emily Flippen as they continue the footwear discussion in today's episode about On Performance running shoes. 

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This video was recorded on September 28, 2021.

Emily Flippen: Welcome to Industry Focus. Today is Tuesday, September 28th, and I'm your consumer goods host Emily Flippen. Today I'm joined by Motley Fool Senior Analyst Asit Sharma. We thought it would be fun to keep up our discussion on the shoe market after last week's episode over Allbirds, by discussing our recent IPO On Holdings. They're the maker of the On running performance shoes. Asit, thank you for joining as always.

Asit Sharma: Emily, thanks for having me and I hope to have my game on for the next 25 minutes or so.

Flippen: We're going to set the bar high for the number of punches we can make during today's episode.

Sharma: Rock on my friend.

Flippen: On, it's really interesting. It reminds me a lot of Allbirds. We'll get to how they are different. But I do think in a lot of ways I'll probably compare the two in the first way that it's similar to Allbirds. It's actually through its founding stories, it is another shoe company that was founded by a group of people that are really into shoes and they do have a focus mostly on performance and we'll get to that, but there's an echo element to this business as well.

Sharma: The thing that strikes me between the two companies is that it's something you pointed out in the notes actually, Emily, when we were preparing for this episode. On seems to have more of an entrepreneurial bent to it or more of a killer instinct to make money. Although it's got a foot, a shoe in the sustainability pond, I think that it is maybe more geared ultimately toward performance we talked about, financial performance here, not necessarily running performance, although the shoes have a very interesting technology that underlies them. We talked about the fact that Allbirds had both the B-certification and some other elements in the company that made them more friendly to shareholders values. That element is here, but not as strong in On Holdings.

Flippen: Yes, definitely. There was a business that was founded a while ago though back in 2010 in Switzerland of all places by Olivier Bernhard. I hope I'm pronouncing their name correctly. But Olivier and two friends, one was a six time Iron-Man champion, and a three-time World Champion. Also a professional athlete. He really wanted to give the world a better running shoe. In particular, he was going after this thing that he calls rift. I think a lot of runners will be familiar with it. It's a nice little bounce you get when you run. I have to say, I'm a little skeptical. I'm by no means a fervent runner. There are people at The Fool and across the world who run marathons, even half marathons. I'm not that person. I'm a casual runner at best. I've been wearing the same pair of running shoes since, quite literally, high school, I believe. They've come with me through everything and the idea of having a little bit of bounce underneath my foot actually doesn't sound better feeling to me. I always feel like I'm cheating myself, their running experience, but apparently for a lot of runners and Olivier being one of them, this is a really valuable aspect as part of their running regimens, and that technology is the idea that underpin the creation of On Running.

Sharma: That's really curious, Emily. I actually have the same feeling when I look at shoes. I don't want a to be so advanced that I feel like I'm cheating, but apparently for many serious runners, it's more about using the technology that is going to propel you, but also do less harm to your joints. I guess the way that you can visualize this is not too dissimilar from the way a good running form works because you're going to be leaning forward, landing hopefully closer to the balls of your feet, if I'm not mistaken. I've been a runner for a long time, but I know there are many different ways to look at proper running form. But that lean forward, land on the balls of your feet. Mimics that because the balls of your feet, of course, has cushioned and then bone underneath it so it has a land and then propel forward. You naturally have that land and propel forward motion when you run. I think personally that this mimics it a bit. Cushion landing and a firm take off, the shoe has basically rubber structure underneath it that collapses when you hit the ground and then helps push you forward. 

We talked with Allbirds about the fact that, as you mentioned, this was started by athletes who teamed up with an engineer. I want to make sure everyone heard that Emily gave the actual statistics for Olivier Bernhard. I said last time that the Allbirds founder almost made the national Australian soccer team and I was corrected on Twitter. One of our friends tweeted out that no, he actually made the team and he played in a few games. I'm glad you caught the facts here straight. 

Flippen: Well, let's hope I did it. Certainly it is impressive whenever you have a business that's founded by an athlete because you get some, I guess, buy in about the technology, the need for the creation of this business. I like having Bernhard, I guess, at the helm of the creation of On Running, because it says, "Hey, here's an athlete who had a problem, who wanted to solve that problem". It was very quickly after founding the business in 2010, that on running's prototypes started getting transactions. They were winning awards, and professional runners were getting interested in them. It didn't take very long for this idea to just really start getting exciting, especially in Europe. You might be in the U.S. thinking, I haven't heard about this, but this technology has been around for decades across Europe.

Sharma: They started, as you said, in 2010, they have, as you mentioned, a co-founding team. One of the co-founders, David Ullman, gives the history of how the company took off in Europe. When they went to trade shows and running events, they would wear t-shirts that said, "Don't ask me about the shoes". They would literally make people try on the shoes before they answered any questions. Which is the reverse in a sales situation you've got the shoe in front of you, you want people to ask your questions, so you can demonstrate the shoe, they made people put them on and then they talked about the shoes, which I thought was a really intuitive way to have people generate word of mouth after trying them on, wanting to buy them. This seems like a smart strategy. I also want to mention here they have two additional employees they brought early on in 2013, Mark Moore and Martin Hoffman. Both of these came from a food business called the Valora Group. Moore and Hoffman now are co-CEOs. Hoffman's also the CFO's. The co-founders in the prospectus talk about how they don't want to have a very hierarchical structure at the company. They have a team of equals that are running this and they appoint executives to be in charge of certain areas of the company that aren't attached to titles, but they're just strategic areas. They have a very team approach to managing the company. So far, so good as we'll talk about here in just a minute, their revenue has been very impressive today.

Flippen: I will say, historically speaking, having co-CEOs has been a challenging proposition for businesses. I can probably count on my hand just the number of businesses that have made co-CEO roles work. I think Atlassian stands out as one, but it's challenging, you talk about how great it is to have a flat team-based structure, but when push comes to shove, it's challenging to run a business that isn't hierarchical when there isn't a single decision maker, a single point of responsibility. I'm not saying that they're going to fall into that trap here, but I think it's something to watch out for. 

I will say, I love when you said they have to force people, put on the shoe before you ask questions about it, and I think this idea probably still persists today, because I'll tell you what, I went onto their website, I looked at some of these shoes fully thinking, maybe this is like Allbirds, maybe I'll replace that very old pair of running shoes. They are nearly double the price of Allbirds. I think they're right around the $200, $300 range for a pair of shoes. Certainly trying them on first might make someone more amiable to spend that amount of money on a pair of shoes.

Sharma: For sure. I have a little bit of experience on shoes. Never purchased them before, and I'll be honest, when our friend and colleague, Brian Feroldi suggested that we tack on this show since we had done Allbirds, the name flew over my head. But my three sons, who now, the last one, just started college last week, they were all cross country runners in high school, and I remember going to our local runner's shoes store looking at all these brands. If you are a runner, these shoes aren't necessarily expensive. They are, for serious runners, priced alongside shoes like Brooks, Hoka, Saucony, Asics, as well as more familiar brands that offer higher-end running shoes with their normal spectrum shoes like Nike and New Balance. If you are serious about the sport, the price range, for me, is $140 as an average price for a new Brook shoe, and also these shoes fall into that range. That's probably what you plan on spending. 

My memory is that that was a painful price tag to look out, with three young men who are spaced two apart, all on cross country teams. We often bought the last year's model of Brooks on sale and the high school had time with the shop, so there was an additional discount on top of that. But beyond seeing the on shoes and Hoka shoes, these shoes which are higher tech, we never really tried them on. Maybe if I became a more serious runner I would. I lean to what you're saying, Emily, because there's a bigger thing we need to extrapolate out of this. This is not a mass market shoe that on its brand power alone is going to become a Nike. It's going to remain a specialty shoe and the company's strategy is to stay up market, I think. They're opening retail stores, which we'll talk about in a bit. But this is not a shoe that you're going to buy just on a whim.

Flippen: It's a smart move, in my opinion, to stay up market because this also isn't a shoe that you're going to be purchasing very frequently. You'll have a lot of very serious runners who may have to replace their shoes once every year, two years. But this isn't something that somebody is repurchasing on a frequent basis. In fact, unlike Allbirds, On Holdings didn't report out what their repurchase rate was, what percentage of revenue comes from existing customers. What they did say is that 40% of their sales do come through their direct to consumer channels. That's good for their brands because even if it means that they aren't getting a majority of sales from existing customers, presumably they're doing a good job of converting new ones.

Sharma: Yes. This is an important part of their model to increase the direct channel because obviously it's higher margin. But also you're able to reach out to a customer once you get them in your database, you're working on that repurchase, so I do think that's a smart strategy as well. As for the other 60% that's wholesale, they've got partners in 50 countries across 8,100 stores. That sounds like a big number, but they've been very methodical since their founding in working with very small running shops and larger chains as well. They are selective about which stores their shoes fall into. Emily, you liked the fact that the store in New York City seems very experiential.

Flippen: It is. It's a flagship store. It's their first store in New York City. It's a destination, it's not intended to be really accretive in terms of sales, although I'm sure that's what they want, but it's a brand building store. One of the aspects of the store that I thought was cool is that they have what they call their magic wall. It's a digital wall in front of the streets of New York City that you can run in front of and it will analyze your running style and recommend a shoe type to you. These kinds of tech enabled aspects make the brand standout as one that I think people will be willing to pay more for, because of the technology and the research that's gotten behind it.

Sharma: I wonder if I visit that store and scan my running style, if it wouldn't stop and just tell me, "This isn't the store for your running style, so bad. There's a store down the street for middle aged men who maybe need loafers". Let's talk about this expansion. They started in Switzerland, as you mentioned, entered Germany in 2011, the U.S. and Japan in 2013, most recently China and Brazil in 2018. But Emily, that's not what really started to propel them over the last few years.

Flippen: I can't believe you are going to make me say this because I'm about to embarrass myself. The business really started to take off when Roger Federer.

Sharma: Federer.

Flippen: Federer. I'm just horrible at this.

Sharma: Emily I can't really do this, you're revealing something about yourself, which I never would have expected. But please proceed, Roger Federer. Yeah, oh my gosh.

Flippen: Yes.

Sharma: Federer.

Flippen: Roger Federer. Thank you, Asit. I really should have dug bigger that out before we came into the podcast. But I guess in the back of my mind, I was hoping you'd be the one to read this point. But he's a professional Swiss tennis player, apparently a world-renowned Swiss tennis player. He had to take a shining to the shoes. In 2019 he came onto the business and they actually worked with them to develop a Roger line of products that were specifically focused to reinvent the tennis shoe. I'd love again that we're having another professional athlete come onto the business talking about the technology, but more just the aspects that I think are maybe underrated in this business. We talk at this point about running, but this is really a shoe that can be customized to fit the needs of any type of athlete. Whether it's tennis, maybe eventually something like soccer, basketball, whatever it may be I think On Running has the internal research and development team to make that a reality as they did here with Roger.

Sharma: I think they absolutely do. I just want to point out that that's a tremendous brand endorsement. Because we moved to this shorter format for the podcast, Emily, you're off the hook. I'm not going to barrage for the next five minutes, that you don't know who Roger Federer is or how big a brand he is in the sports world and in the consumer world in general. Let's move on. We talked about them incorporating ESG factors into their shoe development, they've got a recyclable shoe. They estimate they've cut down on the environmental impact of shoe production by about 50% with this shoe. It's called the Cyclon, it's only available via a subscription model. Basically you use the shoe, you send it back, you get a new pair. I think that might be a blueprint for future higher-margin sales since we see everyone and his brother is moving to the subscription model in this world. I also briefly want to mention they do have a very high net promoter score like Allbirds. A net promoter score of 66, which is nearing world-class. They have advocates of their brand. Customers seem to be pretty satisfied in general.

Flippen: Even as we're taping here on Motley Fool Live, I see a comment coming in from somebody who says, oh, my daughter has a pair of these shoes and she loves them. Again, it goes back to the fact that people who purchase these shoes do tend to enjoy being brand endorsers as well. Personally, I don't know anybody who has them yet, granted again, I'm not deep into the running realm, but I'm getting sold on them throughout this research.

Sharma: Yes, we're taping live here on Motley Fool Live, Emily. For those of you who are going to listen to this later, just before the podcast started, I was mentioning that I was in Chicago last week and I saw tons of young people wearing these shoes. I was very surprised. I know there's a scientific phenomenon where you don't see something in nature and then you see it everyday afterwards. I've forgotten the name of the effect, but it's certainly happened to me.

Flippen: Certainly. Let's talk about the financial performance here because we've talked about the brand, but how does it translate into numbers? I will say it translated nicer than I think I expected it to in terms of financial performance. In fact, the total amount of revenue that this business is doing was pretty staggering to me. They have expected revenue around $700 million-ish this year. I'd say almost $1 billion in sales, which I think is pretty impressive again, for a relatively niche shoe business. But over the past six months, revenue has grown nearly 85%; a really interesting business.

Sharma: Yeah, they've got very healthy long-term growth rates. I think over the past couple of years they have compounded annual growth rate, let's say since 2018 is about 35%. Sales do look like they're tapering off a bit this year, but that's either maybe a COVID effect or it could have something to do with seasonality. Traditionally, they've had a stronger third and fourth-quarter every year. Last year, the company recorded 60% of total sales in its third and fourth quarters. Maybe there is just a little bit of normalization from both of those factors. If you've already purchased this recent IPO, you are going to want to monitor those third and fourth quarters. I like that they are expanding into Europe, Emily. 52% of their sales come from North America. 

The company has talked about in various interviews the importance of that North American market, that huge sneaker running shoe market. They've done very well here. They get about 41% of sales from Europe, only 6% in Asia, but they are expanding in Asia. They've got a few retail stores, they are going to add more. I think that's a wide open whitespace for them. I also want to point out in the financials that their balance sheet is pretty clean. Now, they report in Swiss francs. They raised about 555 million Swiss francs in their IPO. Let's call that 600 million greenbacks. That brings the company's working capital balance to about 750 million Swiss francs against only 150 million in long-term liabilities. Most of those are long-term lease obligations. They've got quite a stash there Emily, with which they can invest in inventory. They're going to be building out new headquarters both in Europe and Portland this year, and they are opening a Berlin office. They've got the retail expansion, but they've got plenty of dry powder now for all those objectives. Also that research and development aspect of the company which you mentioned earlier, which gives them possible expansion into their apparel and accessories lines, which right now makeup only about 5% of the business, but hold some promising optionality going forward.

Flippen: I do like that in-house research demo, it reminds me of businesses that grew up from that level, something like Lululemon where they had an idea and they ran with it. I wonder what On can do next. Again, I think there's probably some untold optionality with where the shoes could go. I do feel like we talked a lot about running here. That really is this business is bread and butter, but they do have other options. They have apparels, other types of shoes. Worth noting that I think management is thinking about that. That being said, there are obviously risks associated with this business. The one that just stood out to me like a sore thumb was simply the valuation that we're seeing right now. I know it's an old adage that great businesses never look cheap. Did I read this correctly a $24 billion business. I know I was impressed with their sales, but again, less than a billion dollars in sales, relatively low margin. I think this business, if it stays at $24 billion, would be trading at something like 1,700 price to earnings if they are able to achieve that 2% net income margin this year. It strikes me as expensive just to put it lightly.

Sharma: Yes. It's a paraphrase from the Lord of the Rings, we hate it precious. It doesn't matter now what you do when you come to market. If you've got very strong revenue growth, the market's going to assign you an insane multiple. They almost don't look at anything else. Here we have a manufacturer with a decent 52% gross margin, but that doesn't deserve this kind of price to sales multiple. Now, Roger Federer, being a big brand advocate, the fact that the company was just a running shoe company primarily, has been able to generate so much revenue. Maybe it is something that you can look forward to if you are a very long-term holder. But that's the business that I would put on the radar screen just for a market crash. If it looks like it got a steep haircut during a market correction, I would consider it then. This is almost setting up to fail, if the business that you're buying, the underlying business is not a Software-as-a-Service company. This multiple valuation on either the net income side or the revenue side works if you're selling software, it doesn't quite work as well if you're selling sneakers. I didn't like that about it. This is already, as you mentioned, a $24 billion market cap business, so not a lot of room here for error.

Flippen: That might become increasingly challenging as we think about the supply chain issues that have impacted so many businesses this year. Again, these are probably short-term problems. I think if you're a long-term fan of On Holdings, of their running shoe, if you're interested in owning shares for the long term, you can tune me out now because this will be very short-termist, but we have seen a lot of issues regarding supply chains as a result of the COVID lockdowns across Southeast Asia, especially in Vietnam. Since On Holdings doesn't manufacture internally, they're not in the United States manufacturing, they are outsourcing, that does mean that, hey, next quarter or next couple of quarters, we're probably going to see some issues. Maybe they won't be able to keep up with demand if their supply is limited, thanks to these protocols.

Sharma: That's a very keen observation. Sometimes supply chain problems aren't about not being able to deliver products, they're about not being able to capitalize on demand. This company has now roughly 100% of its footwear products sourced, manufactured in Vietnam. That's an advantage vis-a-vis having all of your manufacturing centered in China. But it creates a brand new risk in that everything is focused on this one small country. Honest, always maintained this outsourced distribution and manufacturing philosophy, which helps them with their net income and it provides a path to future profitability. But maybe in the future, management's, we'll see them branch out into a wider distribution and manufacturing footprint. It's a different story for their apparel and accessories. Those are a little more diversified in terms of manufacturing, but again, that's only 5% of the business for now. A little bit of a risk there. Emily, one last risk before we go, internal controls, I haven't heard you mention this risk before in any of the companies we've discussed.

Flippen: Yes, it's a completely new risk. It's going to sound really unfamiliar to everybody listening. I'm a broken record about it. At this point, there isn't a single business that I'm looking at that probably doesn't have some issues with internal controls. Which part of me hopes that at some point in the future this results in some type of meltdown that reminds everybody that these things are very important. But with the way the market is going right now, it's almost like I just have to take it at face value, which is good companies not quite prepared at the same level, they should be necessarily to be public companies and on-holdings alongside 90% of the companies that we talk about here on the consumer goods podcasts does have issues with internal controls, something to keep your eye out. If this is a deal breaker for you, you should know it upfront, if it's a yellow flag, be aware. There's a risk for material misstatements here. Although I will say I like the fact that this company is moving toward profitability in the last six months have been profitable. My hope is that they take some of this money. Maybe they don't necessarily put it all into research and development for new shoes, but they take some of it, and hire people with the appropriate accounting knowledge as necessary to be a public company. That's my hope, but it is a risk.

Sharma: I think they just capitalized as so many companies have, on a hot market for IPOs and new issues. It's a great piece of advice for management now, yet you came to market maybe a little bit, but let's fix some of these issues and invest where the growth will be strongest.

Flippen: Perhaps an unfair question to you as we finish up here. Between On Holdings and Allbirds, does one of these standout to you as a business that you are more interested in, in comparison to the other?

Sharma: It has to be On, because of their share scale. You know that's close to $0.5 million in revenue in just the last six months, plus that big brand endorsement from Roger Federer, which I will get you about offline. I think that this company has maybe an easier path to becoming a bigger brand. Especially if they pour some money into accessories and Lululemon eyes their offerings a little bit. It has to be that, but that's not to say I'm not interested in Allbirds, I like their story. I like the sustainability focus, and that's one to watch too, and is maybe a little more samely priced.

Flippen: Yeah, I definitely agree with your analysis there. The next time I'm in New York, you know I'm going out of my way to go run in front of that magic wall.

Sharma: Same here.

Flippen: Asit, thank you so much as always for joining.

Sharma: It was great fun, Emily, thanks so much.

Flippen: Listeners, that does it for this episode of Industry Focus. If you have any questions or just want to reach out to say "Hi," shoot us an email at [email protected] or tweet us at @MFIndustryFocus. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for his work behind the screen today. For Asit Sharma, I'm Emily Flippen. Thanks for listening and Fool on.