2023-07-06 03:24:39 ET
Summary
- On Holding has a high-quality, technically advanced product that has big potential to take market share from incumbents.
- It is early days in the business lifecycle so the revenue and earnings base is small, giving potential for an extended period of high growth.
- Despite an optically high P/E, growth and ROIC potential suggest the company is undervalued.
Investment Thesis
On Holding ( ONON ) provides investors willing to take a higher amount of risk an opportunity to buy a company in the very early stages of its company lifecycle at what could prove to be a very reasonable valuation. On Holding is a high growth company, having grown revenues at 58%, 70%, and 69% in the last 3 fiscal years, and 78% in the first quarter of 2023. On has just turned profitable, and it is expected to grow these profits as a higher rate than revenues over time. With the growth that has already been experienced, the future expected growth, and with profits still on a low base, the valuation is quite reasonable.
The Bull Case
There are several reasons that make an investment in On Holding compelling:
- Despite being the newcomer, On's Cloudfoam technology appears by all accounts to be industry leading. Their products have received very positive reviews across the board and are becoming increasingly popular with runners.
- On's brand awareness is low, so efforts to increase brand awareness coupled with product education are likely to have a material positive impact on sales. Sales growth may continue to be explosive, as the company is still on a small base compared to juggernauts Nike ( NKE ) and Adidas ( OTCQX:ADDYY ).
- Athlete sponsorships are in the early stages but are bearing fruit already. Iga ?wi?tek, the current women's tennis world number 1, recently signed a sponsorship deal and won the Stuttgart Open in On gear. In addition, the recent winner of the Boston Marathon, Hellen Obiri, did so wearing On shoes. Nike has shown how powerful brand sponsorships can be, but the difference is Nike now uses sponsorships to maintain market share, while branding activities can really move the dial for On, given their early success to date.
- On has already upgraded 2023 guidance and continues to believe their current forecasts are conservative. Given the guidance growth is still far below what previous periods have achieved, we could see more upgrades through the year. Seeking Alpha Consensus is already forecasting higher than guidance revenue growth.
- New product lines such as activewear, accessories, and other sports shoes (such as tennis) will expand the sales opportunity, allowing for more sales growth. Tennis could be the next big mover, with a product developed with Roger Federer (and named after him), specifically designed for high performance tennis.
- Operating Leverage is already apparent in the business and is expected to continue. This is a stated objective of management as an avenue to grow the profits of the business. This highlights management's focus on costs and demonstrates a mentality that is anything but growth at all costs.
- The valuation is quite undemanding, if On's growth continues at a high rate. See Valuation section for more detail.
The Roger Pro (On Running website)
Understanding the Expectations
The only way to outperform is to bet that the expectations embedded within a stock price are wrong to the downside. Assuming a stable P/E, a share price grows either via increasing earnings and/or increased expectations of future earnings. Earnings expectations are what businesses are valued on, which come from company guidance and/or analyst expectations. If you believe either management or consensus are undercooking what the company could do in the future, this is an excellent opportunity for earnings upgrades.
We could be seeing this exact scenario playing out with On Holding. Current revenue expectations are for 3 year compound annual growth of 37% and 67% for net income. This would be an excellent outcome for any company, but I think On can do more given the low base of, especially, net income.
On has already produced revenue growth of 78% in 1Q23 and net income tripled to CHF 44 million. I am not saying that On will do this every quarter because the company is cycling a weak comp in 1Q22, but the current revenue forecasts of 42% (guidance) and 50% (consensus), may prove to be too low if the current momentum is anything to go by.
On Earnings Forecasts
Over the next 10 years, off a base of 2022's CHF 1.2 billion revenue and CHF 112 million EBIT, I think a 10 year CAGR of 27% and 33% respectively is well within the realms of possibility.
This revenue forecast assumes that there will be industry growth over time and that On will aggressively take market share from incumbents in the active footwear sector. Statista forecast the footwear industry will grow by 4.15% to 2028. If we (simplistically) extend this to 2032, our forecast period, based on the reported sales for the top 7 athletic footwear companies (including NKE, ADDYY, PMMAF, SKX, DECK, VFC, ASCCF, and UA), total industry sales would increase from $119 billion to $178 billion from the last 12 months revenues to 2032. At On's forecast growth rate of 27% in the same period, this would imply revenue would grow to CHF 13.7 billion (or approximately US$15 billion).
This would imply approximately 8% market share compared to their current estimated 1.1% market share based on the same cohort. This doesn't sound ridiculous when put in these terms and would put On approximately in line with the market share of Puma, Sketchers, and VFC today.
Global footwear and apparel estimated market share (Company Reports, FactSet)
(Note that I haven't stripped out footwear from company results, as most produce apparel as well, as will On. I don't think this harms the analysis).
Risks to the thesis
Since my thesis is based on the company producing results that are ahead of current company expectations, if this does not occur, the investment thesis falls over. This could be due to any number of reasons including their well-funded and strong-branded competitors releasing shoes of equal performance that hinders On's growth in the key premium performance category.
The other immediate risk is macro in nature. It is no secret that interest rates have been rising globally, which has been impacting the sales of many retailers in recent months. Those at the premium end do not seem to have been affected, On included, but I'll also call out Lululemon ( LULU ), whose sales have also remained robust.
Consumer confidence has been improving, but is still at levels not seen since the GFC, as per the Michigan Consumer Sentiment Index . That said, from the onset of covid-19 the index has been falling, and with the exception of the initial covid shock in the 1H20, global footwear sales have continued to increase. The savings buffer created by government stimulus has kept discretionary spending high but as the economy heads towards a possible recession, On's sales, as a premium-priced product, could be hit.
Footwear and apparel sales continue to rise (Company reports, Bloomberg)
Valuation
As is my preference for high growth companies, I value On using a 10 year discounted cash flow model to allow a time for the company to move past the high growth stage and enter into steady growth. This comes with the caveat that the future is unknowable, but if we understand the inputs, we can understand the output (the valuation).
I have modeled for 27% revenue CAGR and 34% operating income CAGR to 2032 which is assuming faster growth than consensus is forecasting. This flows through to an assumption that free cash flow to the firm (FCFF) increases from a loss in 2022 to CHF 1,350 million in 2032 (CAGR is not meaningful).
ONON DCF model (Author analysis based on FactSet data)
I've used a 9% WACC (4% risk free rate, 0.95% bottom up levered beta, 5.3% ERP) and a 2.5% terminal growth rate.
This gives On a valuation of $40.74, a 23% premium to the current share price of about $33.
Incredibly, my valuation implies a fair value forward P/E of 71.5x, above the current P/E of 55x. It is tempting to look at On's forward P/E of 55x and say this company is expensive. But to do so undermines the growth potential of the business and the ability it should have to reinvest profits at high rates of return for many years. Return on invested capital is currently low, as On has only just hit profitability, but my model forecasts ROIC to reach 30% before the decade is out.
This increase in ROIC will be driven by sales growth and operating leverage, as costs will not need to rise as quickly as revenue is forecast to. On Management has stated they are targeting 15% Adjusted EBITDA margins in 2023 and with further cost controls this could settle between 17.5% and 18% in future years. The slight decline seen in the above chart is a result of growth slowing on an increasing equity base due to high levels of retained earnings. If the company can begin to pay out a dividend or buy back shares towards the end of the forecast period without impacting its ability to reinvest in the business, it is likely that elevated ROIC levels can be maintained.
Even if you wanted to very simplistically look at On Holding on a PEG basis, consensus is forecasting EPS to almost double in 2032, which gives ON a forward PEG of 0.59, well below what is generally considered attractive.
My big caveat here is that these are admittedly some pretty aggressive forecasts, but in my opinion not unreasonable. If you believe the forecasts are possible, then On is a buy. If not, avoid, it's as simple as that.
While most 10 year forecasts (for any company by any analyst) will be wrong, it demonstrates what is possible under a certain set of circumstances using current known information. More importantly, while not precise, I think the growth forecasts will be directionally correct and the current expectations will prove to be too conservative.
Conclusion
That previous paragraph above is what this investment thesis boils down to for me. On is extremely early in its life and there is a huge runway ahead of it if it can get its product and branding right. The early signs are that they will. Increased market awareness will increase sales, and operating leverage over their fixed costs will do the rest.
This is not a short-term trading idea, this is a long-term opportunity to buy a high growth company that has an opportunity to compound its earnings at high rates of return for many years to come.
For further details see:
On Holding: A Potential Long-Term Compounder