Adidas Is Still Kicking It

North America has also provided a growth opportunity over the past few years as Adidas has focused on aggressive marketing to tout its differentiated products and has partnered with athletes and social influencers to increase awareness. Products have resonated with consumers, with a push to launches focused on lifestyle wear as opposed to the active wear focus at Nike and

Looking forward, profitability will be affected by cyclicality in fashion cycles, which tend to falter every five to seven years, making the achievement of consistent performance tricky. However, we think the company's strong association with the expansive global soccer market should continue to aid its brand equity, providing stability to its revenue and profit stream, offsetting any fashion volatility. Additionally, overall profitability has risen with Adidas' divestitures of underperforming brands TaylorMade and CCM (6% of sales), which should reduce complexities and narrow the company's focus--both supporting brand equity over time.

We assign Adidas a narrow economic moat due to its strong brand, as evidenced by its position as the second-largest player in the global athletic footwear, apparel, and equipment market. Adidas has earned the ability to price products at a premium after developing seven decades of brand loyalty, which is particularly impressive given the fleeting nature of brands in the consumer space. We view this as support for our thesis that Adidas has an intangible asset moat, further shown in its ability to outearn its cost of capital (with previous five-year average returns on invested capital including goodwill of 11% versus our 9% cost of capital) and our expectations that it can continue to do so, with ROICs averaging 17% over the next five years.

Its dominant position in Europe and an expanding presence in North America and select emerging markets (across demographics and product categories) are enabled by a long history of product innovation with close coordination among its research and development teams, social media impressions, and top athletes. These verticals allow Adidas to differentiate itself, and innovative tactics (like producing shoes from ocean plastics) help market the brand beyond just athletic performance into the lifestyle category, raising visibility by reaching a wider consumer base. Our narrow moat is supported by the consumer's willingness to pay premium prices for these products, which have delivered gross margins averaging 49% over the last five years (rising to 51% over the next five years). We expect this pricing power to endure, given Adidas' history of product innovation and its extensive spending to support its brand--almost $2 billion on endorsements and $187 million in research and development in 2017, combining for over 10% of sales.

Although Adidas can rationally spend at levels reserved for the largest companies, we think it falls short of a cost advantage, with its previous five-year operating margins averaging around 8%, lower than Nike's 14%. We attribute this to Adidas' global market segmentation, which limits its concentration in markets--negatively affecting its economies of scale and the company's negotiating leverage with vendors (we note that Nike derives 45% of its sales from North America, roughly equal to Adidas' revenue contribution from Western Europe and North America combined). We would require increased brand relevance, price leadership, and/or scale advantages before awarding Adidas a wide-moat rating.

We still think Adidas, as the second-largest global sporting goods manufacturer, is well positioned to expand its global market share over the next decade, evident by our 10-year average 6% top-line growth estimate. With a strong and growing Chinese middle class, we see China leading the charge with almost 10% average growth over our forecast period, followed by North America at 6%, both bolstered by the firm’s expanding position in soccer. We also believe the company should post above-average results in fiscal 2018 (with sales growth of nearly 8%), supported by the World Cup in Russia. Despite strong sales, our valuation is held back by gross margins, which we believe will be constrained to around 50% on average due to moderating fashion cycle benefits. We believe the company can maintain gross margins above its historical five-year average of 49%, however, largely due to its growth in direct-to-consumer, including its retail owned stores and online channel (e-commerce specifically expected to reach EUR 4 billion by 2020 from EUR 2 billion today), which typically carries higher gross margins. We see moderate leverage to fixed costs, due to a higher sales base, with SG&A averaging 41.3%, driving our operating margins to average around 10%.