2023-09-27 15:48:40 ET
Summary
- On Holding AG continues to gain market share in the performance footwear category with its advanced running shoes.
- The company has a significant opportunity to increase its brand awareness globally.
- The recent share price weakness presents a buying opportunity for investors interested in a high-quality company.
Investment Thesis
On Holding AG ( ONON ) is a relatively young company that is making huge strides in the performance footwear category. It continues to take market share with its technically advanced running shoes and has a huge opportunity if it can continue increasing its brand awareness globally.
Because On's earnings are still on a lower base, the strong forecast growth and potential return on capital make the current forward P/E multiple of 51x look reasonably attractive when valued on a longer-term discounted cash flow model. The recent weakness in share price post the Q2 2023 financial result is offering investors an opportunity to buy this high quality company at an even better price than recent months.
In this article, I will discuss my thoughts on the share price weakness in light of the Q2 2023 result, and present a view as to whether or not this is warranted.
Q2 2023 Result Commentary
I discussed in my last article covering On that understanding expectations is key to understanding if On (or any company) is likely to outperform or not. This is demonstrated in by the On stock price reaction after its Q2 '23 result : second quarter sales increased 52% and adjusted EBITDA doubled compared to the year before, but the share price fell 14.0% on the day. The following table summarizes the result compared to the prior quarter (1Q23) and the prior corresponding period (2Q22).
In million CHF | 2Q23 | 1Q23 | q/q % | 2Q22 | y/y % |
Revenue | 444.3 | 420.3 | +5.7% | 291.7 | 52.3% |
Gross margin (%) | 59.5 | 58.3 | |||
Operating income | 39.4 | 42.3 | -6.9% | 26.3 | +49.8% |
Operating margin (%) | 8.9 | 10.1 | -11.9% | 9.0 | -1.1% |
Net income | 3.3 | 44.4 | -92.6% | 49.1 | -93.3% |
Net margin | 0.7 | 10.6 | 16.8 | ||
EPS (CHF) | 0.01 | 0.14 | 0.15 |
The notable item from the table above is the movement in net income and EPS. On the surface, this looks like a dreadful result. However, this sharp fall in profits was a result of a huge movement in foreign exchange, which negatively impacted the result due to the strength of the Swiss Franc against the U.S. dollar. The foreign exchange result is presented as its own line below operating income on the income statement, which enables analysts to clearly account for it in their numbers.
Excluding the foreign exchange result, net profit and net margin would have been CHF 31.8m and 7.2%, respectively. This implies a q/q decline of 11.2% from 1Q23 and 88% growth y/y from 2Q23 when the foreign exchange line is stripped out. This isn't a perfect exercise, but does paint a much clearer picture.
More important are the comparisons to expectations. I'll use FactSet estimates and will compare both the result and the updated guide to compare what the analyst community was expecting and what impact this had on expectations.
In million CHF | 2Q23 actual | 2Q23 consensus | beat/miss |
Revenue | 444.3 | 416.4 | +6.7% |
Gross Margin | 264.5 | 243.2 | +8.8% |
Operating Margin | 39.4 | 43.8 | -10.4% |
Net Income | 3.3 | 31.5 | -89.5% |
Operating Cash flow | 3.3 | 187.8 | n/m |
Things look really good at the top line, but the foreign exchange movement, primarily, resulted in a big miss where it counts.
However, what really dented the share price was the change in future expectations, since (my belief is that) stocks are valued on the value of expected future cash flows discounted back to a present value. The following table shows the FactSet consensus estimates for key reporting lines for the next 3 years before and after the result. This gives an insight into how the result changed the expectations of the analyst community.
CHF, m | 2023 | 2024 | 2025 | |||
Before | After | Before | After | Before | After | |
Revenue | 1,779.6 | 1,782.7 | 2,355.9 | 2,347.0 | 3,070.0 | 3,053.7 |
EBIT | 201.1 | 205.2 | 284.1 | 279.9 | 377.2 | 378.9 |
Net income | 155.6 | 132.1 | 203.7 | 199.5 | 271.7 | 273.4 |
Free cash flow | 145.6 | 73.6 | 135.7 | 161.2 | 195.5 | 160.0 |
It is evident that expectations across the board fell for 2023 numbers but did not show a large move in the later years, with the exception of free cash flow, which is notoriously difficult to forecast as it is.
This analysis suggests that the aggressive share price decline post result was largely a result of the lower expectations for the 2023 fiscal year because expectations for 2024 and later years were little changed.
This is seen in the following chart, which shows the dramatic stock price fall in August after the results were released. Note that the FY1 P/E (based on forecast 2023 earnings) remains about the same, while the FY2 P/E (based on forecast 2024 earnings) falls noticeably from about 43x to 37x. This tells us that the stock price fall was commensurate with the decline in forecasted 2023 earnings, but since the earnings for 2024 remained about the same, the 2-year forward P/E fell.
What does this mean for investors?
It means that the long game is still very much intact. Growth expectations have been tempered a bit, but let's not forget that the company actually upgraded their 2023 fiscal year revenue guidance ever so slightly (from CHF 1.74m to CHF 1.76m), driven by "encouraging feedback from wholesale partners and a strong start to Q3," while maintaining gross and EBITDA margin expectations. The sales guidance takes into account CHF 20m of forex headwind and the margin guidance provides for upside if the Swiss franc remains strong against the dollar.
But all this is short term thinking. Over time, currency exchange rates tend to , (but don't always) mean revert. Given that foreign exchange rates are very difficult to forecast with any accuracy, including assumptions in long term forecasts is just as likely to introduce errors, so I take that view that there is little point in making them.
Valuation
In my valuation, I model a 24% 10 year revenue CAGR, which, after some net margin improvement to 12% results in a 36% net income CAGR off a small base. I temper my middle-term revenue expectations a little from my last shared valuation, just to make a little more conservative.
WACC remains at 9.0%, which may seem low, but is driven by a bottom up beta of 0.94 that takes the median beta (1.3) and debt/equity (76%) of a large peer set, and re-levers the unlevered peer set beta for ONON's debt/equity ratio, which is far lower than the industry median, implying lower financial leverage. Using ONON's regression beta (which is higher at 2.05, per FactSet) would be meaningless, given its short time as a listed company and the volatile market it has found itself in.
The above assumptions produced an estimated fair value of $37.80 per share, which is a 35% premium to the current share price, which is around $28.00.
Risks
The risks since my last article have not changed, but are worth repeating. Firstly, On is early in its lifecycle and is challenging entrenched competitors that have large balance sheets and larger marketing budgets. There is a lot of competition in the premium shoe industry, all you need to do is walk into a quality running shoe store to see a wall covered in high priced quality footwear. Focusing on one company only (such as On) is likely to result in tunnel vision, but believing that On's shoes are the only high performance shoe on the market would be worse than naive. Nike Vaporfly, Saucony Endorphin Speed, Asics Gel Kayano, Hoka One One Bondi are four competing high performance, maximalist running shoes off the top of my head, and are all around a similar price point. To invest in On Holding you need to believe that On can stand out from these and others and, as a part of a cohort of upstarts, take market share from the incumbent behemoths Nike, Adidas, and Asics.
The other more immediate risk pertains to macroeconomic conditions. On is a premium product and arguably a discretionary product. While I could put forward a strong argument that those with incomes that allow for the regular purchase of premium-priced performance shoes and those buying performance running shoes are the type of runner who will replace shoes after 300 to 500 miles (thus encouraging regular repeat purchasing) and therefore might be less susceptible to macro conditions such as moving interest rates, I could just as easily put forward the case of how easy it would be for the next footwear purchase to be a lower priced model of Adidas or Nike shoes instead of a pair of premium On Cloudmonsters. So far, the premium athletic wear companies have weathered the consumer sentiment storm without injury, but the story has yet to be fully written.
On to hold its first Investor Day
On announced they will hold their first investor day on October 4. Since they have not held one before, what this will entail remains a mystery. While I am only speculating, I could see On using this opportunity to reveal progress they are making in improving shoe design, improving sustainability, geographic roll out, or new product lines. The latter two particularly would be most likely to get investors excited as these are likely to be core drivers of growth over the coming years. As a new shareholder in the company, I am looking forward to hearing from management beyond the regular reporting conference calls.
Conclusion
The negative factors to an investment in On Holding AG stock all pertain to the short term. Shares have fallen 16% since I recommended ONON as a buy in July and nothing about the outlook has changed. On Holding has a long runway in front of it from the lethal combination of geographic expansion and increasing market share. The valuation looks expensive on a pure short term P/E basis, but this ignores that fact that the company is investing for growth and is early in its lifecycle, meaning earnings are on a low base. This makes forecasts look aggressive, but not unachievable. The recent pull back in ONON stock is giving investors another great opportunity to buy.
For further details see:
On Holding: Price Weakness Presenting Great Long-Term Opportunity