PMMAF - Puma: Continue To Stay Neutral Until 2H23

2023-05-19 11:44:41 ET

Summary

• Despite slower US growth, Puma's 1Q23 results showed positive momentum, with gains in key verticals and regions outside the US, indicating potential for growth.
• Puma's performance in China in 1Q23 was strong; however, more information is needed to assess growth targets and margin assumptions in China.
• My recommendation is to continue staying neutral until at least 1H23 is over so that we have more data and comments from management to assess 2H23 guidance.

Overview

My decision to avoid investing in Puma (PMMAF) turned out to be the right decision as the stock continued to fade downwards. I think the trigger for the recent 10% correction is due to the earnings, which showed that Puma continues to face slower US growth and that FY23 performance is going to be further pushed into the latter half of 2H23 - which means there are now more risk of Puma missing FY23 expectations. Apart from these, I actually thought that the 1Q23 results were not so bad, especially with the upcoming recovery of China and expected improvements in margin. As such, my assessment is that investors are stepping over to the side lines for this stock until they see a probable catalyst or more datapoint that suggest FY23 consensus figures can be met. Overall, I reiterate my hold rating for Puma for the time being.

Thoughts on 1Q

Casting aside the weak US and poor commentary, objectively, 1Q23 results were not so bad. According to management, Puma managed to gain shares across key verticals like football, running and basketball. In particular, the focus on signing up new brand ambassadors in a bid to extend reach has been quite fruitful, which has found its most successful manifestation in the 15% share reached in football. Furthermore, aside from the US, other regions did not demonstrate any deceleration in growth. As such, I believe if Puma can turn the US around, the market will start to attach more value to the other regions (which I think is heavily discounted today because Puma's largest market is down significantly). Finally, I note that the spike in operating expenses growth is not like-for-like as it grew from an exceptionally low base last year due to covid. The growth should normalize eventually, as such it is nothing alarming.

China

In 1Q23, China region experienced a year-on-year increase of 9.8%, primarily driven by a pick-up in traffic which seems to be counterintuitive given the weakness of mid-income consumers in China. What this tell me is the Puma has found the right strategy or sweet spot of the market to pound their fists against. The performance is relatively strong as well when we compare to Pou Sheng, Puma sportswear peer in China, who reported a year growth of 7% in 1Q23. Puma's recent developments in China present both challenges and opportunities for the brand. One notable development is the signing of Cheng Xiao as a brand ambassador, marking the first recruitment of a national Key Opinion Leader KOL in two years. I expect this to have a strong impact on growth when combined with the resumption of sporting events, especially as Western brands are gaining traction with local consumers. However, this strategy is not without concerns. My worry is if Puma will suffer the same fate as adidas (ADDYY) when it did a celebrity collaboration last year. Looking at the long-term prospects in China, the significance of the market has changed since 2019. In 2022, Greater China accounted for only 6% of Puma's total top line compared to 14% in 2019, and the EBIT margin deteriorated to 4% in 2022 from 33% in 2019. There are 2 conflicting views here:

1. Bull case: Historical performance suggests that Puma has sufficient room today to grow aggressively to previous levels. If done successfully, will be a meaningful contributor to earnings
2. Bear case: Puma has totally mismanaged its China business exposure since 2019, and there are no guarantees that things can be salvaged. Management could be pouring capital into a negative return venture.

As of what we know in 1Q23, I am inclined to go with the bull case given what they have done and their growth so far. However, I don't think it is right to commit fully into the bull case as the merits from the bear case is factual. I would advise investors to wait for more information to gain confidence in whether Puma can hit its growth targets and margin assumptions for China.

Outlook

Just by looking at the headline results, 1Q23 demonstrated very positive momentum in terms of revenue, with Own Sales Growth [OSG] up by 14% y/y. The stock would have reacted very positively on this news, however, the accompanied comments that came along overshadowed this positive news. Management guided OSG to slow down to low-single-digit to mid-single-digit % in 2Q/3Q23 and growth will only rebound to double-digit growth in 4Q23. A large part of why 2Q and 3Q is going to be slow is because the sell-in for the second and third quarters has already been completed, and retailers have been ordering less due to the normalization of supply chain constraints. Before I get into my expectations and why the weak 2/3Q and strong 4Q guide is not welcome by the market, it is worth noting that North America experienced a significant decline in OSG, down by -18.6% y/y in 1Q, mainly due to lower sell-in to the wholesale channel, particularly off-price. However, DTC channel sell-out showed growth at a mid-teens percentage rate. Puma is actively reducing exposure to the off-price channel in the United States to elevate the brand, and as a result, management expects North America to continue to be a drag on the topline. Now, the reason why the market hates such comments, I believe, is because it makes it so hard for investors to underwrite the FY23 consensus figures today. If 2Q and 3Q falls much worse than expected, then the burden on 4Q would be extremely high, which would very likely cause consensus to revise their estimates downwards, triggering a revision in price targets, driving negative sentiment. As such, the safe approach is to just avoid investing today and wait for 2Q commentaries about 3Q before investing.

In the first quarter of 2023, GM was down by 70bps, mainly driven by sourcing and freight cost inflation, while FX and promotional activities were a drag too. However, Puma managed to raise prices to offset some of these headwinds. Looking ahead, management expects gross margin to expand stemming from several tailwinds in 2H23. Mainly, the current freight contract is expected to end in June, and negotiations indicate that freight rates will approach pre-shipping crisis levels. Additionally, with the CEO suggesting that China is likely to contribute disproportionately to the company's high-single-digit growth target for FY23, the regional and channel mix should continue to be a positive factor. Lastly, reducing exposure to the lower-margin off-price channel, especially in the United States, is expected to contribute to improved GM. The same logic applies here, in that it is easier to ascertain the progress of all these after 2Q when management has more visibility into 3Q and possibly 4Q.

Conclusion

My decision to avoid investing in PMMAF has been validated as the stock continues to decline. While 1Q23 results showed positive momentum, with gains in key verticals and regions outside the US, I believe investors are adopting a cautious approach and waiting for catalysts or more data to regain confidence. I maintain a hold rating for Puma as uncertainty remains. China's performance in 1Q23 was strong, driven by increased traffic and effective strategies, but concerns exist regarding Puma's China business since 2019. It is advisable to wait for more information to assess Puma's growth targets and margin assumptions in China. Gross margin improvement is anticipated in 2H23 due to various factors, including the end of current freight contracts and a favorable regional and channel mix. However, it is prudent to wait for more visibility in 2Q before making investment decisions.

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