Follow Federer to Uniqlo

It was the summer of 2019 when I first began to brace myself for the end. Most of England was celebrating a remarkable cricket world cup victory. I was mourning the loss of two Championship points, Roger Federer’s last at Wimbledon.

It’s not the first time I remember exactly where I was when the greatest sportsman of all time exited the world’s greatest sporting spectacle (neither claim is up for discussion in my book). Every pre-semi final defeat since 2011 (the year I had recently finished my A-Level exams and was attempting to follow the score of Federer vs Jo Wilfred Tsonga on BBC Sport while on a shopping trip in Bicester Village) is a painful memory.

And I’ll remember where I am when Federer leaves the game forever in London at this weekend’s Laver Cup tournament. Not at the O2, where resale tickets for the Friday night session are being sold for over £1,500 each. The Laver Cup has always been an expensive tournament, but now that Federer has used it as the location for his final bow, ticket prices have become astronomical. Such is the power of a sporting hero.

Sporting apparel companies know this power which is why they have long been willing to pay up to associate themselves with the biggest stars. Perhaps it is giving Federer a little too much credit to suggest he had a hand in the 145% share price rise at Uniqlo’s parent company, Fast Retailing Co since 2018 when he joined the brand. Nike - the affiliation he broke when he joined Uniqlo - has underperformed the market in that time with a share price rise of 86%.

So as the old guard makes way for a new generation at the top of tennis, sporting apparel’s old guard is also on shaky ground. Nike’s long time rival Adidas has endured a miserable five years with its share price down 30%. Under Armour has fared even worse, down 43% in the same time. Meanwhile a host of smaller brands have started to tiptoe into the market by way of Instagram, Crossfit, and wealthy, healthy Gen Z consumers.

The sports apparel industry was valued at $180bn in 2021 and is expected to reach $250bn by 2026. Online sales are driving that growth, with compound annual revenue growth forecast at 12.4% in the period. In theory, there should be plenty of room for companies big and small, old and young to capture a slice of that growth. But supply side constraints have hampered progress in 2022 and with the odds of recession creeping higher, fears are mounting that demand may stutter. Discretionary items like branded running t-shirts tend to be the first to be axed when times get tough.

Let’s take a look at the financial fortitude of the big three.

Nike

There is no denying Nike’s quality. Set aside the Covid-afflicted 2020 financial year and the company’s return on capital employed (ROCE) has held firm above 20% since 2015. Even with the Covid-blip ROCE has averaged 25% in the last five years.

The company has historically been adept at converting profits into cash. Pre-Covid, the operating cash conversion rate rarely dipped below 100%, although since the pandemic it has averaged 82%. Operating margins have recovered back to 14% in the year to May 2022 and revenues and profits are strong with forecasts for continued growth.

But all is not well. Nike’s inventory levels are higher than they have been in recent years and this has affected efficiency and cash conversion. Free cash flow dropped in the 2022 financial year and is expected to fall again. The outlook for growth also looks rather optimistic, especially in Asia and the US - Nike’s big growth market and main revenue generator, respectively. First quarter financial results are due next week and given the gloomy economic outlook, we don’t expect much positivity from management.

Adidas

When Adidas committed to improving the carbon footprint of its products, many people took notice. The company set a target of 100% recycled trainers in its collection by 2030. And although the pandemic derailed the revenue trajectory, the effects were only short-lived. Consumers have flocked to buy Adidas’ green apparel. Revenues have risen at a compound annual rate of 3% since 2016 and are forecast to keep climbing in the current financial year and beyond.

But margins and profits are another story. At the operating level, Adidas margins never held up quite as well as Nike’s and have now fallen from 9.6% in 2017 to 7.2% in the last twelve months. In 2022, net profits are forecast at €1.3bn, from €2.1bn the previous year. That poor performance has had a knock-on effect on all the fundamentals that used to make Adidas such a high quality operator - cash conversion rate and ROCE have fallen dramatically since the pandemic.

In August last year Adidas finally cleared its hands of Reebok - the struggling brand which it had held for sale for the best part of two years. The company eventually sold Reebok for €2.1bn - €1.3bn less than what it paid for it.

Fast Retailing

While Nike has battled to keep reporting positive numbers and Adidas has endured a dramatic demise, Uniqlo’s owner Fast Retailing has gone from strength to strength. In July the Japanese company reported record quarterly profits (up 37% year on year) and raised its full year forecasts as a result. For Uniqlo, the US and Europe are the two big growth markets, where growing brand identity has helped lift revenues massively in recent years.

Importantly, the company’s margins are heading in the right direction. Operating margins have risen from 9.5% in 2017 to 11.7% in 2021 and to 13.3% in the last twelve months. Net profits are forecast to rise to Y250bn in 2022, from Y170bn last year.

But Uniqlo is facing the same headwinds as its Western peers. Economic frailty in its domestic market has hurt performance before and it is unlikely the recent run of excellent growth can continue if consumer spending begins to drop. With a price to earnings ratio approaching 40 times (which has contributed to the company’s value rank of 8), Fast Retailing could be at risk of a sharp correction if it fails to continue on its strong trajectory. Picking the right time to buy into highly priced shares is not easy.

Is the time right to buy?

The share price performance of Nike and Adidas in recent months presents a tempting entry point for those who have a long-held belief in the quality of these companies. When a share falls so hard and (in Nike’s case) indiscriminately, the temptation can be to bundle in. But it is worth approaching this decision with some caution.

When it comes to Adidas, I fear that quality is waning with the share price. Management has made a series of poor decisions - the bungled sale of the Reebok brand, a fierce investment in expensive new methods of producing clothes and shoes and a strange attempt to enter the world of virtual fashion via the blockchain (a business venture which completely obliterates its green credentials). These mis-steps have cost the shareholders dearly already and I am not convinced the ship will be righted any time soon. A PEG ratio of 1.3 times looks tempting, but when good value comes at a time of falling fundamentals, we could be looking at a value trap.

By contrast, Nike’s share price stumble seems more related to external, economic fears than anything going fundamentally wrong at the company. But still a price to earnings ratio of 25 times looks a little rich for a company which could be facing a downturn in demand in the very near future. I don’t think the worst has yet come for Nike and it might be worth waiting for more bad news before adding this company to a portfolio.

By contrast, Fast Retailing is benefiting from strong momentum which is absent among most of its peers (not just in sports retailing but most of the consumer-facing sectors). But with a price to earnings ratio of 38 times, this is an expensive stock. Perhaps a bit too pricey considering the economic outlook - and the fact that Uniqlo’s key brand ambassador retires from tennis tonight.