ADDDF - adidas AG: Unscheduled 'Kitchen Sinking' Update

Summary

• New CEO Bjorn Gulden kicks off his tenure with a major reset of adidas' FY23 guidance.
• While the size of the writedowns at Yeezy and the 'strategic review' allocation indicate conservatism, the new CEO's turnaround plans could still entail more P&L disappointments ahead.
• Pending visibility into the mid-term strategy, the prudent move is to remain on the sidelines, in my view.

With new CEO Bjorn Gulden getting on board this year, the base case expectation was for a 'kitchen sinking' quarter in Q4/FY22 for Germany-based sportswear and sports equipment producer adidas AG ( ADDYY ). The extent of the FY23 guidance weakness (disclosed in a surprise trading update last week), though, was a negative surprise.

Embedded within the guide were several one-off expenses, including a ~EUR200m 'strategic review' allocation, as well as major Yeezy-related writedowns. All in all, this was the third profit warning in the last four months, highlighting the fading adidas brand momentum and validating concerns over how long and costly a turnaround process might be. While the China reopening will help, the stock's >50% rally from November lows (post-CEO announcement) means expectations aren't low. Plus, the valuation isn't cheap - even if we were to underwrite an FY24 normalization (consensus sees an optimistic return to 6% operating margins by then), adidas still trades at >20x fwd P/E at these levels. Pending better visibility into the new CEO's mid-term plans, where more 'kitchen sinking' elements could be announced, I would hold off on buying into the turnaround story just yet.

New CEO Kicks Off the 'Kitchen Sinking' Exercise

Expectations were already low heading into Q4 earnings – not only does adidas have to contend with a challenging macro/consumer environment, but also the loss of Yeezy and a lack of innovation in the product pipeline to compensate. The latter necessitates more investment in rebuilding brand momentum, which the company will need to balance with ongoing digital platform expansion efforts amid heightened competitive intensity in key regions like China. Plus, new CEO Bjorn Gulden has just taken over in January, and new management tends to kick things off with a major expectation reset ('kitchen sinking'); hence, a low FY23 guide was on the cards ahead of the scheduled March earnings report. Yet, adidas' unscheduled trading update still disappointed – to recap, management guided to a high-single-digit % FX-neutral revenue decline and operating break-even (on an underlying basis). For context, even the heavily COVID-impacted FY20 saw adidas come out with a low-single-digit % EBIT margin.

The release didn't offer as much color as I would have liked, but the crux of the problem seems to be the Yeezy inventory situation. Somewhat conservatively, the company has assumed no contribution from repurposing Yeezy products for FY23, driving a EUR1.2bn and EUR500m headwind at the revenue and EBIT levels, respectively (vs. a EUR250m net income impact for FY22). Also worth noting is the inclusion of an incremental EUR200m allocation for 'one-off costs' related to an upcoming strategic review which, combined with the Yeezy writedown, will contribute EUR700m of EBIT loss for the year. While there is an argument for conservatism here, the lack of detail in the release makes it challenging to reconcile the FY22-FY23 EBIT bridge. For now, I would expect the disclosure of more 'kitchen sinking' drivers, such as additional non-Yeezy inventory writedowns, as well as restructuring-related investments, at the upcoming earnings result next month.

Recreating the Puma Playbook Comes at a Price

On a more positive note, Bjorn Gulden, the new CEO of adidas, started earlier than expected on 1 January 2023 (recall Puma (PMMAF) only announced his departure in November), negating concerns of potential non-compete hurdles. Given his extensive sporting goods experience (including at adidas as the Senior Vice President of Apparel and Accessories) and track record of brand building at Puma, I agree with the market's optimistic assessment of his candidacy. Not unlike Puma back in 2018, adidas has suffered years of underperformance due to a lack of product innovation, worsened by industry-wide challenges due to macro and COVID-driven headwinds. This has culminated in a slew of profit warnings in FY22, with the latest reset in FY23 marking the first one under Gulden's tenure. Still, the hope is that he can replicate the strategic playbook and execution which reignited Puma, though the increased scale and complexity of adidas' issues mean a turnaround effort will be even more challenging this time around.

That said, it remains early days, and Gulden is likely still in the midst of a thorough review of all business units to assess areas of improvement ahead of a full strategy announcement (likely at this year's capital markets day event). Using his tenure at Puma as a guide, expect a multi-year effort focused on market share gains through demand creation (i.e., building 'brand heat') and product innovations at the expense of near-term margins. As indicated by the latest trading update, Yeezy is the first on the chopping block, with its inventory set to be sold through to mitigate reputational risk. Elsewhere, it will be worth monitoring incremental changes to the existing product and marketing pipeline – depending on the extent of the overhaul (note it can take up to two to three years to create new ranges and get them to market), consensus' margin expectations could still be vulnerable to more resets.

Unscheduled 'Kitchen Sinking' Update

New CEO Bjorn Gulden's tenure kicked off with a surprisingly large guide down for FY23 - even relative to already lowered consensus estimates following three consecutive profit warnings in almost as many months. As expected, adidas has opted to book several one-off costs, including massive writedowns related to Yeezy. Not all of the 'kitchen sinking' has been disclosed, though, and all eyes will be on the details of the FY22-FY23 EBITDA bridge at the upcoming Q4 earnings call next month.

More broadly, the extent of the latest P&L disappointment highlights the likelihood that a smooth adidas turnaround isn't a given, nor that the new CEO's successful Puma playbook will be easily replicated here. Reversing the declining brand momentum will be the core mission, though the key question for investors will be how long and how expensive the process will be. Consensus estimates call for a ~6% operating margin in FY24 (vs. ~3% in FY22), so expectations aren't low any longer. And with the stock already up significantly to ~39x FY22 P/E (and ~21x 'normalized' FY24 P/E), I would exercise caution pending visibility into the mid-term plan.

For further details see: