S&P Global Ratings reduced its debt ratings outlook to negative from stable due to the company’s recent operating performance deterioration and increased leverage.
S&P said Adidas AG’s third profit warning this year, stemming from continuing challenges in Greater China, expected deterioration of consumer demand in Western countries, and the announced termination of the profitable Yeezy collection’s distribution, will hurt its 2022 financial results and raise uncertainties around its 2023 operating performance.
The ratings agency said it expects a material deterioration of the S&P Global Ratings-adjusted EBITDA margin to about 9 percent in 2022 from 14.6 percent in 2021, leading to adjusted debt to EBITDA increasing close to 2x in 2022 and slightly reducing toward 1.5x by the end of 2023.
S&P affirmed its ‘A+’ long-term issuer credit rating on Adidas. Its negative outlook reflects S&P’s view of the significant pressure on Adidas’ operating performance in 2022 and uncertainties regarding the evolution of sales and profitability in 2023, as the group needs to execute its turnaround strategy in China, face the potential decline of consumer demand in Western countries on the back of high inflation and economic recession in some key markets, and manage the transition from the successful Yeezy collection that it recently terminated.
S&P said in its analysis, “We expect S&P Global Ratings-adjusted debt to EBITDA at Adidas will increase close to 2x in 2022 and will remain elevated at about 1.5x in 2023.
“Our ‘A+’ rating on Adidas is primarily supported by the group’s very low leverage, which has historically remained at or below 1.0x–with the exception of 2020 when adjusted debt to EBITDA increased to 1.2x amid pandemic-induced disruption. We believe that Adidas currently faces a combination of adverse conditions, which are weighing on its operating performance and ultimately pushing the leverage metric to a level not commensurate with an ‘A+/Stable’ rating.
“We expect a slower annual top-line growth of 4 percent-5 percent over 2022-2023 on average as Adidas tackles a combination of internal and external difficulties. These challenges include adverse conditions in China stemming from COVID-19 restrictions on the back of the ongoing zero-COVID policy, competitive pressures in China, inflationary pressures, and weaker economic growth in the U.S. and Europe, which will likely weigh on consumer spending in the fourth quarter of 2022 and in 2023. And, lastly, the recent announcement from Adidas that it will terminate its relationship with major design partner Kanye West, with whom it designed the profitable Yeezy collection.
“Adidas faces ongoing hurdles in the Chinese market, leading the group to revise its guidance for the third time this year. On October 20, 2022, Adidas reported its preliminary third-quarter 2022 results, posting €6.4 billion in sales in the quarter, an 11 percent growth compared with 2021 on a reported basis and 4 percent at constant currencies. At the same time, gross margin declined 100 basis points (bps) to 49.1 percent in the same period. In addition, for the third time this year, Adidas has revised downward its guidance on revenue growth to a mid-single-digit rate from mid- to high-single-digit rate in 2022 at constant currency. This revision came before the announcement that Adidas will terminate its partnership with Mr. West, which will trigger an additional reduction in sales for November and December 2022. The guidance revision primarily reflects ongoing traffic deterioration in Greater China because of COVID-19 restrictions and market share erosion in favor of local brands, which Adidas is tackling with a revised product offering and marketing strategy. The group would need to take back a material amount of inventory from their franchise partners, amounting to at least €400 million, to clean up the distribution channel and improve its product offering with high-priced products from 2023. This will support Adidas’ ambition to expand its presence in China, which at present remains limited to about 15 percent of total sales in first-half 2022, about 22 percent at the end of 2021. We regard China as one of the three key growth markets for Adidas and the sportswear market in general.
“Declining consumer demand and high inventory levels will increase promotions and discounts in the remainder of 2022. The global outlook for the sportswear market remains positive, supported by ongoing trends for casual clothing and higher sports participation. However, the deterioration of the macroeconomic context will likely reduce volume growth, primarily in the European market, which also faces strong inflationary pressures. According to Euromonitor, the sportswear market is expected to grow at a compound annual growth rate (CAGR) of 1 percent to 2 percent in Western European countries over 2023 to 2026. The sportswear industry faces high inventory levels, which the major players will manage through higher promotional activities toward the end of 2022. We expect this will hurt Adidas’ profitability in 2022; however, it should alleviate working capital pressures over the next few months. That said, we expect working capital will remain elevated this year, mainly because of the high inventories level and high lead times, which will cause a contraction of adjusted free operating cash flow (FOCF) to €200 million-€300 million in 2022 from €2.1 billion in 2021. We expect working capital should reverse in the first part of 2023 and normalize toward the end of the year, and we expect adjusted FOCF could approach €1.5 billion-€2 billion in 2023.
“Adidas’ decision to cut ties with Mr. West will have negative financial implications but has prevented reputational damage to the Adidas brand. Adidas has decided to end the production and distribution of Yeezy branded products after a detailed review of the partnership with Mr. West starting in early October after Mr. West made a series of anti-semitic comments. This is in line with similar actions taken by other industry players such as Gap and Balenciaga. The decision means that Adidas products developed with Mr. West will not be sold anymore. We estimate that the Yeezy collection, developed in collaboration with Mr. West, accounted for 5 percent to 10 percent of total sales, and its contribution to profitability was even more elevated. Given the seasonality of the Yeezy sales, skewed toward the fourth quarter because of the Christmas season, we calculated a €500 million to €600 million impact on sales in 2022, which is included in our current base case, while the net income impact is €250 million, as estimated by Adidas. We believe the Yeezy collection’s high profitability stems from its high price level, limited discount, low need for marketing investments, and a high proportion of sales within the direct-to-consumer channel. Adidas retains the design right on the Yeezy collection, which means it could relaunch these products under the Adidas brand in 2023. The brand’s strong credentials could allow the group to replace a material portion of the lost sales. However, we expect some of the sales will not be recovered before 2024, and we estimate that the profitability level will remain depressed in the short term, improving to about 10.5 percent-11.5 percent in 2023 from about 9 percent estimated in 2022. This is well below the 14.6 percent level achieved in 2021, and below the 10.7 percent achieved in 2020 despite COVID-19’s impact.
“Adidas’ change in leadership will provide more clarity on the group’s financial targets over the next three years. Adidas has announced a change of CEO from 2023. While the group’s “own the game” 2021 to 2025 strategic plan remains broadly unchanged, under the new leadership we would need clarity about the financial targets and confirmation of the strategy’s successful execution–primarily in terms of product innovation, marketing priorities, digital transformation, and new collaborations. The group keeps an overall cautious stance on capital allocation, which should enable it to reduce leverage toward 1.5x by 2023. Its net leverage target of 2x is unchanged.
“The negative outlook reflects our view of the significant pressure on Adidas’ operating performance in 2022 and uncertainties on the evolution of sales and profitability in 2023, as the company needs to execute its turnaround strategy in China, face the potential decline of consumer demand in Western markets amid high inflation and economic recession in some key markets, and manage the transition from the recently terminated Yeezy collection. While we expect that Adidas’ leverage could approach 1.5x in 2023 after the spike to 2.0x in 2022, we believe the group has no headroom under its leverage metrics to accommodate a deviation from our base case.”
Photo courtesy Adidas
