2023-07-13 15:57:22 ET
Summary
- Swiss footwear and apparel company On Holding AG has seen impressive growth in its revenues due to high consumer demand, but I believe the stock is overvalued.
- On Holding's financials show strong growth levels, with revenues growing significantly and profitability achieved in 2022. However, the company's ability to achieve high margins is yet to be proven.
- Despite the company's strong performance, I maintain a sell-rating on the stock, as I believe that the company's valuation doesn't give a margin of safety for investors.
On Holding AG has had an impressive run with its revenues, as consumer demand for the company’s shoes and other apparel has been magnificent. At $31.43 per share, though, I believe the stock’s valuation has been way too stretched, as the speedrun needs to last for a long while for the investment to have a decent return. This is why I hold a sell-rating on the stock.
The Company
On Holding is a footwear and apparel company based in Switzerland. The company’s area of competency is its shoes, which have garnered a large audience in the runners’ community. On Holding sells lightweight shoes through its brand, On. The shoes are heavily marketed as lightweight, as their shoes are most branded with the word ‘cloud’:
www.on-running.com
Beyond the Cloud 5’s, On’s lines include Cloudgo, Cloudrock, Cloudswift, Cloudtrax, Cloudrunner, Cloudwander, etc – the trend is clear. The company’s shoes are on the more expensive side, as their prices range from $129.99 to $329.99.
The company’s heavy focus on footwear shows in their financial statements, as in Q1 footwear revenue represented around 95% of the company:
On Running's Sales (On Holding Q1 Press Release)
The company’s line of products is highly regarded, as in the company’s annual report of 2022 the company states that the company has imitators on page 28:
“Competitors have and will likely continue to attempt to imitate our premium products and technology and divert sales.
As our business has expanded, our competitors have imitated, and will likely continue to imitate, our premium product designs and branding, which could harm our business, results of operations, financial condition and the price of our Class A ordinary shares”
This could be seen as a positive and a negative – the company’s offering is very competent as competition for similar products is rising. It could be a risk for investors too, though, as competitors could start taking market share from On Running, forcing them to cut gross margins or to keep a lower growth in the company’s revenues.
Financials
On Holding has been able to maintain insane growth levels for years, as their shoes have been in high demand – the company’s revenues have grown at an impress ive CAGR of 66 percent fr om 2019 to 2022. For 2023, the company guided a revenue of at least 1740 million Swiss franc, a growth of 42 percent from the previous year.
Looking down the income statement, On Holding has been able to turn its revenues into profitable territory from 2022; currently, the company’s EBIT margin stands at 8.8 percent. Furthermore, On has ambitions of EBITDA-margins in the high teens, as told in the company’s Q1 Earnings Call . As On’s depreciation and amortization are at around three percent of the company’s revenue, this would correspond to around a 15 percent EBIT margin that the company’s trying to achieve. This is in line with analysts’ forecasts, as they forecast these margins to reach 15 percent in 2027.
I don’t take the company’s profitability ambitions as granted. Although they could well achieve the said goal, rising competition is in my opinion likely to eat away from excessively high margins. A 15 percent operating margin would imply higher margins, than a company like Nike has achieved in its last ten years on average:
Nike's Operating Margins (Tikr)
Nike’s average operating margin for FY2014 to FY2023 is 11.7% - and we’re talking about a market leader in terms of shoe branding, as well as a massive scale of $51 billion in sales.
Although On has achieved profitability, the company’s ROIC doesn’t impress me. According to Tikr the company’s trailing return on its capital stands at 10.5%, a decent figure but not one where growth creates immense value for shareholders. Demonstrating this ROIC is On’s required capital expenditures – for 2022 the company had capex of around 60 million Swiss franc, scaling with the company’s revenues. Also, the company has needed to tie up a large amount of working capital to maintain growth, which I’m assuming to continue as long as the company grows:
Seeking Alpha
On Holding has a healthy balance sheet, as the company doesn’t hold any interest-bearing debt and its cash position stands at 361 million Swiss franc, with an additional 35 million in short-term investments. As the company is still young and rapidly growing, with turbulent and most often negative cash flows, I believe their equity financing strategy is justified, although in the future the company could leverage debt to achieve cheaper financing, as its cash flows stabilize.
Valuation
The company is currently valu ed at a trailing P/E of 105 . A lso, the fact that On’s cash flows have been negative doesn’t help the case. The company needs a long road of rapid earnings growth for the valuation to look modest in the medium-term.
I constructed a Discounted cash flow model of the company to visualize the stock’s price better. In the DCF model, I use bullish estimates to demonstrate the stock market’s expectations of the company – for 2023, I’m expecting revenues of 1833m CHF, five percent above the company’s guidance. From that point, the inputted values expect rapid growth for many following years, as revenues in the model reach 5675 million CHF in 2027 – a 36% CAGR from 2022.
On the margin side, my inputs are that On Holding reaches near the 15 percent range as its revenues grow and economies of scale realize themselves. As I’ve stated before, I don’t believe the company is likely to achieve these margins, but they demonstrate the markets’ expectations well. Converting accounting earnings into free cash flow is another important step in determining On’s intrinsic value. The company has invested a lot of capital to grow and will probably continue to do so for a while. The prior combined with On Holding’s growing working capital needs, I believe the company will only begin producing free cash flow slowly, with an only slightly positive free cash flow in the current year. With these expectations, my estimated value for the stock is the following:
DCF Model of On Holding (Author's Calculation)
The DCF model gives a value estimate of $22 – a downside of over 31 percent from the stock’s current trading price.
The used cost of capital of 12.16% comes from a Capital asset pricing model that I constructed:
CAPM of On Holding (Author's Calculation)
The company doesn’t have debt, so given cost of debt figures are estimates – a 15% debt to equity is a possible future scenario. On the cost of equity side, I used the Swiss National Bank’s guided interest rate of 1.75%. As the equity risk premium, as I’m used to, I have Professor Aswath Damodaran’s estimate of Switzerland’s ERP. The company has a high beta of 1.95 with Tikr’s calculations – On Holding’s performance is highly correlated with the larger economy’s performance, as this is one of the largest betas I’ve seen. Finally, I believe the stock deserves a small liquidity premium of 0.25%, as the stock is quite liquid.
How I’d Turn Bullish
For me to turn bullish, the company’s stock needs to come down from its current levels. A good base case for such a level is my DCF model’s fair value of $22.1. Before that, I think the stock’s expected rate of return is too low compared to its risks.
Another way for me to turn my rating would be an even more impressive growth run than I’ve anticipated in my DCF model. This seems unlikely, though, as the estimated figures are on the high side. The company has historically proven very high rates of growth, though, and they are profitable. The management could further prove even more impressive figures, at which point I could turn bullish even with current stock price levels.
Closing Remarks
On’s products are marketed as Swiss-made, but unfortunately, they do not tell the time. I believe the company’s long-term margin ambitions have a downward pressure, which the company’s valuation doesn’t support at current levels. As often is though, quality companies come with a price premium – a price that I wouldn’t personally pay.
For further details see:
On Holding Needs A Perfect Run To Satisfy Investors