ONON - On Holding On The Run: Mini Deep Dive For On Running

2023-12-27 17:03:17 ET

Summary

• Increasingly more people are wearing On Running shoes today, marking the brand's shift from elite running circles to widespread consumer adoption.
• On Holding AG is taking market share from larger footwear companies like Nike, Adidas, Under Armour, etc., and I expect this trend to last for at least another few years.
• Strong revenue growth, expanding margins, increasing profitability, and global brand makes On Running one of the best consumer stocks going into 2024.
• Strategic foray into apparel has the potential to accelerate growth.

I started to notice more and more people at my gym and around Boston wearing On Holding AG ( ONON) sneakers at the beginning of 2022. Sneakers that only hard-core runners wore were now all over the place, including people of all ages.

I bought my first pair of On sneakers sometime in the Spring of 2022; now I have nine pairs, with my Cloudmonster's being my favorite sneaker in my collection (~80 pairs). FWIW, those are NoBull sneakers below my On and Hoka sneakers above them — these are two other brands I’m quite fond of, but right now On takes first place in my book.

I wasn’t paying much attention to ONON (the stock) until late 2022, after the stock had already dropped 70% from the post-IPO highs and the valuation was starting to make more sense.

In late February 2023, I finally started a position in ONON, after doing a deep dive on the company, covering everything from the company's background to looking at the overall opportunity and accessing a competitive advantage over big guys like Nike ( NKE ) and direct competitors like Hoka ( DECK ).

This worked out pretty well for me, because when the company reported 2022 Q4 earnings in March of 2023, they crushed it, and the stock gapped up 20%. However, that was only the start because, over the next few months, the stock rallied more than 70% from where it was trading going into that Q4 earnings report.

I had a full position in ONON going into their Q2 earnings report on August 15, but the markets weren’t acting well, so I decided to trim my position. Despite strong Q2 results and raising full-year guidance, the stock did not hold up and dropped ~15% over the next couple of days. I ended up selling my entire position in August to protect my gains.

ONON continued to drift lower before bottoming out in the $23 range in October, which was a 36% correction from the August highs. That’s when I jumped back into the stock because I felt it was being unfairly punished. Investors were becoming overly concerned about a possible recession in 2024, and ONON was getting too cheap, given the strong fundamentals and potential upside over the next few years.

Even though ONON has been a bumpy ride the past ~6 months, nothing has really changed fundamentally: On Holding remains one of the fastest growth companies in the consumer sector, far outpacing all of its competitors, including Nike, with 30-40%+ growth expected for 2024 after 50-60% growth in 2023.

Despite ONON seeing a significant deceleration in Europe (where the company is a more mature brand), they are still growing in their other two key markets – the United States and Asia. I honestly believe that brands like On and Hoka will continue to grow ~25% for the next five years while legacy brands like Nike struggle to grow mid-single digits. Analysts are looking for Nike to grow only by ~6% for the next five years.

Some people would call me a sneakerhead, although I don’t consider myself a collector and don’t care about sneaker conventions. Perhaps my love for my On sneakers is making me a little biased, but I believe many other consumers feel the same way, which is why 40-50% of the sneakers in my gym are now On or Hoka.

I believe On Holding is setting up for a strong 2024 unless we run into a really bad global recession, in which case most consumer brands will suffer, including ONON. Right now, most economists and strategists are looking for a soft/no landing, which should bode well for ONON and might mean that current 2024 estimates are too low.

Investment Thesis

My investment thesis for On Running starts with the overall market opportunity and the company's impressive growth rates for both revenues and earnings. The global activewear market (includes footwear, apparel, and wearables) is a massive $300+ billion market; set to grow to over $450 billion by the end of this decade. This growth is supported by secular tailwinds of health and wellness, as well as fashion trends, specifically a shift to sportswear fashion.

Despite the fierce competition, On Running is gradually gaining market share from established brands like Nike, Under Armour ( UA ), and Adidas ( OTCQX:ADDYY ) while the size of the total market continues to grow. ONON expects to generate more than $2 billion of revenue in 2023, while Nike will do more than $50 billion. We all know that Nike is still the King of athletic footwear and athletic apparel, but companies like On Running, Hoka, Lululemon, Vuori, Gymshark, Ola, and dozens more are coming for the King.

To be honest, I’m not sure how much longer Nike can fend off these new brands, which might force them into doing some M&A deals since organic growth is now single-digits, and with Nike stock still trading at 30x NTM earnings, I’m not sure how investors can justify that P/E multiple unless Nike finds a way to accelerate growth and/or expand margins. During Nike’s latest earnings call , they revealed a $2 billion cost-cutting plan, which tells you they are clearly worried about growth and margins.

I believe ONON has created a distinctive position in the premium footwear market with innovative product designs combined with increasing consumer preferences for specialized, high-quality athletic footwear. ONON is going after the higher-end of the market, which includes consumers who are used to paying over $100 for the best footwear.

Regarding apparel – it is the third point in my investment thesis (after the market size/growth and ONON’s fundamentals). While the footwear category is by far the most popular among existing customers and currently generates the majority of On's net sales (>95%), the apparel category is twice as large as footwear and presents a tremendous growth opportunity over the next decade. ONON’s expanding product portfolio is pivotal for sustaining growth in the 25-30% range, not to mention apparel might be a bigger driver of brand visibility than footwear, which is basically the Lululemon (LULU) playbook and why their yoga pants became such a phenomenon and helped turn them into a $65 billion company.

There are no guarantees that ONON will be as successful in apparel as they are in shoes. Despite seeing solid growth in apparel sales (40.9% in the first nine months of 2023 compared to the same period last year), as a percentage of total revenue, apparel sales declined from 4.2% in 2022 to 3.7% so far this year — partly because footwear is simply growing faster. ONON is building the foundation for future success in this category by investing in internal capabilities, product assortment, and customer experience for apparel. This category should become a meaningful part of ONON's business over time. In the recent Investor Day, management outlined its plans to grow its apparel penetration to >10% over the coming years from 4% in 2022.

Americas and Asia-Pacific markets are driving growth right now for ONON — both regions are increasing their share of total sales from the European market, perhaps due to the recession in that region as a result of the Russia-Ukraine war.

ONON’s popularity in the Americas and Asia-Pacific markets is snowballing because they’re expanding their presence in these regions both online and physically. Direct-to-consumer (( DTC )) represents 36.4% of sales, while wholesale represents 65.4%; I suspect we see these numbers closer to 50/50 in just a few years. Based on the number of online ads I see, it’s pretty clear where ONON is spending its sales & marketing budget. Not only does DTC offer higher margins, but it creates better engagement and allows ONON to know who their customer is so they can continue to drip on them with new products, sales, etc. — better than-expected growth in DTC would be a very bullish sign for me.

I also expect ONON to continue strengthening their position/brand with a larger retail presence that will drive brand awareness and apparel penetration — this includes their own standalone ONON stores as well as expanding with their largest wholesale partners like JD, Foot Locker, and DICK'S. These retail partners will be important for apparel growth in addition to footwear.

As a shareholder of ONON, I’d definitely be a little disappointed if they got acquired unless it was a sizeable premium (at least 40% above the current price). In late November, I did a deep dive on Rover () after starting a position, and less than two weeks later, they got acquired for a ~30% premium, which was nice (for my portfolio returns) but also a little disappointing because I thought that stock could double over the next 18 months. Not many people realize that Hoka is owned by Deckers, who bought them ~9 years ago for just $1.1 million, and now Hoka is probably worth $8-9 billion. Outside of Nike, Adidas, and Lululemon, I’m not sure which footwear/apparel company would be big enough to swallow ONON in an acquisition, so it’s definitely unlikely that it happens; I’d put the probability below 10%.

ONON’s market share of athletic footwear and apparel is less than 1% (~$2 billion / ~$300 billion), which means lots of growth potential going forward. I’m excited to see what ONON looks like in five years — my investment model down below will show you where I think they can be.

Latest Quarter

On Running reported its latest quarter (Q3 2023) on November 14, beating both EPS (EPS of $0.25 beats by $0.08) and revenue (revenue of $540.81 million beats by $33.02 million) expectations. The company's revenue increased 47% YoY, or 58% on a constant currency basis.

Management continued to improve its outlook, raising guidance from CHF 1.76 billion to CHF 1.79 billion ($2.07 billion), which implies a full-year growth rate of over 46%. With the holiday season coming in Q4, I expect the company will deliver yet another revenue surprise. Last year, ONON exceeded analysts' expectations by 34%, beating consensus by over $100 million.

Some notable highlights for me from these earnings are DTC growth outpacing wholesale growth (55% vs. 43%), strong product innovation pipeline (including successful launches of new models like Cloudeclipse and Cloudtilt), continued global expansion (especially in China, where the company is already present in 18 cities and 47 stores including 4 to open by the end of 2023), and healthy financials.

The latter is what interests me the most. First, the company achieved a gross profit margin of 59.9% this quarter, the highest in almost two years. Margin expansion, even a slight one, is always a positive sign and something I particularly like to see. Next, the company recorded significant positive cash flow, which grew to almost CHF 100 million in the first nine months of 2023 from negative nearly CHF 200 million in the same period last year. This year will be the first year in the company's history with positive free cash flow, which should accelerate in the following years. Last but not least, ONON has an exceptionally strong balance sheet, which gets better and better from quarter to quarter. As of September 2023, the company had CHF 432 million in cash and cash equivalents, up 16.4% from CHF 371 million at the end of 2022, and no debt.

Something to consider: first – although adjusted EBITDA reached a record high of CHF 81.3 million, the adjusted EBITDA margin slightly decreased to 16.9% from 17.2% in the same period last year. Second – higher marketing expenses, specifically for brand awareness campaigns, will have an impact on the overall profitability in the short term. I am not overly concerned about either of these two right now, as the company sees no cancellations and a strong mix in the order book going into 2024, including robust pre-orders for apparel and new product silhouettes like Cloudtilt?.

During Investor Day, management announced plans to double its net sales in the next three years and increase profitability to 18%+ adjusted EBITDA while laying the foundation for the most premium, global sportswear brand.

Valuation

Right now, ONON’s valuation looks very compelling, especially if you compare it to Nike, Deckers, and Lululemon — these are all fantastic companies, but I believe ONON has the most upside over the next few years because they’ll have the best growth rates and they currently have the lowest PEG ratio of these four companies.

ONON has a current enterprise value of $8.6 billion, and they’re expected to generate $432 million of EBITDA in CY2024, which means the stock is currently trading at 19.9x 2024 EV/EBITDA, with ~38% EBITDA growth expected in 2024.

NKE has a current enterprise value of $166.7 billion, and they’re expected to generate $7.7 billion of EBITDA in CY2024, which means the stock is currently trading at 21.6x 2024 EV/EBITDA, with ~8% EBITDA growth expected in CY2024.

DECK has a current enterprise value of $17.3 billion, and they’re expected to generate $896 million of EBITDA in CY2024, which means the stock is currently trading at 19.3x 2024 EV/EBITDA, with ~9% EBITDA growth expected in CY2024.

LULU has a current enterprise value of $64.4 billion, and they’re expected to generate $2.9 billion of EBITDA in CY2024, which means the stock is currently trading at 22.2x 2024 EV/EBITDA, with ~14% EBITDA growth expected in CY2024.

Now, if we look at the forward estimates for ONON and plug them into my investment model, using some reasonable P/E multiples, adding back the cash and accounting for 0.2% annual dilution through stock-based compensation, or SBC… I believe there could be a 121% upside over the next three years, which is a ~30% CAGR, higher than what I believe you’ll get from NKE, DECK, or LULU over the next three years.

I have high confidence that ONON will achieve these revenue growth estimates (or do even better), so the bigger wild card will be margins. NKE, DECK, and LULU are all more mature companies with better net income margins ranging from 10% to 16% — I think ONON could be at the higher end of this range in 5-6 years, but only if they’re able to maintain/expand their current gross margins (~59%) as they grow their apparel business and their footwear portfolio.

Just like DECK bought Hoka for $1.1 million and grew them into a $8-9 billion brand, I wonder if there’s some tiny, emerging footwear brand that ONON might be able to buy to accelerate their push into new categories… similar to Crocs ( CROX ) buying HeyDude a couple years ago.

Conclusion

I remain bullish on On Holding AG because I believe in the brand, the growth story, and the current valuation.

Currently, my ONON position is approximately ~3% ( my current investment portfolio is available here ), and I added to it when it pulled back on the bad earnings report from NKE. If you look at my valuation comparisons, it’s pretty clear which of these two companies is more compelling on a forward EV/EBITDA multiple basis. I’m actually thinking about doing a pair trade on these two, which would be “long ONON and short NKE” going into 2024.

Even though my investment model shows a 121% upside over the next three years, my revenue estimates may be too low, as well as margin estimates and/or P/E multiple, in which case ONON could have more than a 121% upside over the next three years. This is especially true if you’re like me and trade around core positions, which essentially means trimming/selling after big rallies and then adding/buying after big pullbacks.

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