S&P Global Ratings followed Moody’s in downgrading the debt ratings of Adidas due to the company’s downward revision of guidance largely tied to the end of its partnership with Kanye West.
S&P lowered its long- and short-term issuer credit ratings on Adidas to ‘A-/A-2’ from ‘A+/A-1’.
The outlook remains negative, reflecting the limited visibility on the group’s strategic initiatives to mitigate the negative impact due to the termination of the Yeezy business, regain market shares in China, and manage the excess inventories, which could hinder its ability to reduce its leverage to the 2.0x-2.5x range by 2025.
Moody’s reduced its debt ratings for similar reasons on February 17.
S&P said in its analysis, “Higher-than-anticipated inventory levels at end-2022 will translate into negative free operating cash flow (FOCF) and a material increase in leverage to close to 3x in 2022. Based on Adidas’ preliminary unaudited 2022 financial results, reported revenue increased 6 percent to €22.5 billion, up 1 percent excluding favorable foreign exchange (FX) effects. The reported operating margin declined materially to 3.0 percent from 9.4 percent in 2021, although this was broadly in line with our expectations. We calculate the revenue for fourth-quarter 2022 was broadly flat year-on-year and volumes were largely negative (down 10 percent-15 percent according to our estimates) primarily affected by slowing demand in major Western markets, the termination of the Yeezy partnership (announced in October 2022), and business disruptions in the Chinese market due to stringent social restrictions (which were recently lifted). This resulted in higher-than-expected inventory levels the company would need to manage through promotional activities in 2023. We estimate FOCF turned negative in 2022, in the €1.0 billion-€ 1.2 billion range before principal lease payments mainly driven by working capital requirements. Therefore, we expect S&P Global Ratings-adjusted debt to EBITDA to approach 3x in 2022 compared with our previous expectation of 2x. This represents a significant deviation of our base-case scenario and a material increase compared with the group’s track record of an S&P Global Ratings-adjusted leverage ratio consistently below 1.5x.
“We expect S&P Global Ratings-adjusted debt to EBITDA to exceed 2.0x over 2022-2025 as the group faces several business challenges. This represents a material change from our previous base-case scenario, leading us to revise the company’s financial risk profile assessment and lower the ratings. The previous ‘A+’ rating was primarily based on a track record of very low leverage, well below 1.5x in recent years. We believe the group has the potential to reduce leverage toward 2x, in line with its financial policy target of maximum net leverage at or below 2x. However, this will require time; under our base-case scenario, we anticipate the company will approach this level by year-end 2025. This is because of a mix of business and industry-specific challenges the group is facing, including an excess of inventory at the end of 2022 on sluggish consumer demand in Europe and North America and delays in the delivery time; declining market share in China, in favor of local brands; and business and financial implications from terminating the Yeezy partnership (including deciding how to manage related inventory), which would need to be replaced with new products to prove Adidas’ ability to innovate and establish new partnerships.
“Ending the Yeezy partnership with Mr. West will have a stronger-than-expected hit on the group’s operating performance in 2023. On Feb. 9, Adidas communicated that terminating the partnership will lower 2023 sales by €1.2 billion and operating profit by €500 million compared with 2022. The company now expects for 2023 the top line will decline 7 percent-9 percent on an organic basis, with reported underlying operating profit at break-even. This estimate is materially worse than our previous base-case scenario. Based on our previous conversations with management, we expected Adidas could have rebranded a portion of the collection thanks to the legal protection of the design rights, which the group owns. However, the company’s latest guidance factor in the scenario of not selling any existing Yeezy stock. We understand the company continues to review options for using the Yeezy inventory, and we expect a decision in the next few months. According to the group, should Adidas decide not to repurpose any Yeezy products, this would result in a write-off (noncash) of about €500 million, affecting group EBITDA. This strategy will have the benefit of cleaning the distribution channel and supporting Adidas’ launch of new collections. However, given how profitable the Yeezy partnership has become over the past seven years, it will take time for the company to restore its revenues and EBITDA base close to 2019 levels.
“Under our base-case scenario, we estimate S&P Global Ratings-adjusted debt to EBITDA will peak at 4x-5x in 2023, then decline to the 2.0x-2.5x range over the next couple of years. Our forecasts are based on expected annual revenue for 2023 in the €20.5 billion-€21.0 billion range (a decline of 7 percent-9 percent year-on-year) and EBITDA margin of 6.0 percent-6.5 percent in 2023 from 9 percent in 2022 primarily because of higher promotional activities, the Yeezy partnership termination, and one-off costs of €200 million announced by the company as part of Adidas’ strategic review. Our base-case scenario does not consider the potential write-off of inventory related to Yeezy because the company is still considering alternative options on how to manage the stock. Looking at our sensitivity analysis, should the inventory write-off occur and Adidas’ worst-case scenario materialize (with an overall expected operating loss close to €700 million in 2023, in line with the company’s guidance), S&P Global Ratings-adjusted EBITDA margin would likely fall close to 2 percent-2.5 percent (negatively affected by the write-off) with a subsequent further significant spike in S&P Global Ratings-adjusted debt to EBITDA. We believe in the next few months we will have better visibility on the group’s key strategic initiatives, enabling us to monitor the progress on their execution and the group’s ability to reduce its leverage in the 2.0x-2.5x range over 2024-2025, which is the requirement for the ‘A-‘ rating.
“Adidas’ financial policy has not changed. The company remains committed to its financial policy of a net leverage target at 2.0x or below. For this reason, we revised downward total shareholder remuneration, with no further share buyback to be considered over 2023-2025. Dividend policy is unchanged, at 30 percent-50 percent of the previous year’s net income, so we expect a material reduction in dividends following an expected contraction in the group’s net income. If we exclude 2023 (assumed to be an exceptional year) from our calculations, we expect S&P Global Ratings-adjusted debt to EBITDA to decrease to the low end of the 2x-3x range over 2024-2025 on average, approaching 2.0x by end-2025. In addition, from 2023, the company will focus on annual FOCF and thanks to better-working capital control and careful capital spending, we expect FOCF to improve to €1.0 billion-€1.2 billion per year (before principal payments on leases) and adjusted FOCF to debt in the upper end of the 15 percent-25 percent range.
“The negative outlook reflects the volatility around our base-case forecast and the limited visibility on the strategic initiatives the group will implement to mitigate the impact of the terminated Yeezy partnership, regain market shares in China, and manage the excess of inventory from lower consumer demand in Western countries. This means operating performance could remain under pressure for a prolonged period, hindering Adidas’ capacity to generate annual FOCF of at least €1 billion per year and achieve S&P Global Ratings-adjusted debt to EBITDA in the 2.0x-2.5x range over 2024-2025.”
