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Adidas and On Holdings. How do currencies impact the business model of two very different European sportswear companies? And is it possible to thrive in the context of a strong currency? Welcome to CurrencyCast! My name is Agustin Mackinlay, I’m the Senior Financial Writer at Kantox and your host. In this episode, we discuss the foreign exchange-related challenges and opportunities of a well-established player and its smaller and younger competitor.
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Now, let's start with Adidas. We know that the company outsources 100% of its production to what is called manufacturing partners that are located mostly in Vietnam, in Indonesia, in China, and to some extent in Turkey. Why does the company do that? Well, it's a way to reduce what is called operational leverage, namely the proportion of fixed costs to total costs. In 2023,
00;01;02;25 - 00;01;30;26
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and with the expectation that it would go on in 2024, Adidas discussed with investors unfavourable currency developments. What are these unfavourable currency developments? Well, they occur both on the contracting side and on the revenue side. On the contracting side because, although those manufacturing partners are located in Vietnam, in Indonesia and in China, they are paid in US dollars.
00;01;30;27 - 00;02;01;26
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And that means that there is a large exposure for Adidas to the US dollar. They is also announced a billion euro revenue shortfall, presumably on account of the weak Japanese yen and South Korean won against the euro in recent months. So there you have it. There are unfavourable developments for Adidas expected to continue well into this year, both on the contracting side and on the revenue side.
00;02;02;01 - 00;02;36;08
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And they are the result of what Adidas itself called its multi-currency cash flows. Adidas applies a centralised approach to foreign exchange risk management. It does so to remove costs, to reduce risks, to avoid siloed currency management. And perhaps above all, to maximise exposure netting. But what does a centralised approach to foreign exchange risk management mean? I think there are two defining features.
00;02;36;12 - 00;03;05;11
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Number one, Headquarters sets FX policy for the entire group. And number two, the Headquarters is the only one responsible for the execution of external FX trades with banks. Now, granted, there is room for some flexibility, and we know that this is the case at Adidas. Let me give you an example. Subsidiary A might find that Headquarters is the best bank in the world.
00;03;05;14 - 00;03;47;19
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Why? Because with the help of FX automation, Headquarters could grant liquidity to subsidiary A on a 24/7 basis. Granted, it would include perhaps a markup based on the tenor, on the the timing, on the currency pair, and on the size of the transaction. But still, it would be a great advantage. Now, say that subsidiary A tells Headquarters that in a special case for example the euro to the Brazilian real exchange rate it could achieve better terms on its own compared to Headquarters.
00;03;47;21 - 00;04;19;29
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And in that case there is room for flexibility. And we know that this is the case at Adidas. Adidas recently announced a €100 million shortfall on account of the dramatic fall in the Argentinian peso. While that announcement was made, rival firm Puma also admitted that its quarterly performance had been devastated by the collapse in the Argentinian peso.
00;04;20;01 - 00;05;05;06
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Now, this is a special situation. There are no hedging instruments of any sort for this particular currency. Yet there is a lesson here for currency managers. Time and again, currency managers tell us that they neglect minor currencies on purpose. Because manual execution would be too time-consuming and to resource-intensive a process. And that's where currency management automation comes to the rescue. Because it provides a way to manage all your currency exposure, be that in major currencies or in minor currencies.
00;05;05;09 - 00;05;35;11
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Founded in 2010 by three Swiss entrepreneurs and backed by tennis superstar Roger Federer, On Holdings is emerging as a major player in a market dominated by brands such as Adidas, Nike, Puma, New Balance, Asics and others. It has recently reached the 2 billion Swiss franc mark in net sales over the last 12 months, and it has 60% gross margins.
00;05;35;13 - 00;06;05;25
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Some analysts think that gross margins could go a lot higher, thanks to recent innovations. So let's dig a little bit deeper and see what role, if any, the currencies play in that amazing story. Look at this shoe, it retails at about €175. When you hold an Adidas or Nike shoe, one of the first things you notice is that it says manufactured in Vietnam or in China.
00;06;05;28 - 00;06;35;08
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But look at this On holdings. So what you notice is a tiny Swiss flag and the inscription Swiss engineering. And it does have an impact. Let me explain. First, there is the cushioning technology, which makes these shoes a pleasure to wear. And this might have implications in financial terms. Because if you are inclined to use them all the time, as I am personally, well, you would buy them
00;06;35;11 - 00;06;59;24
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whether the economy does well or whether the economy is in recession. And that lowers the better in your cost of capital calculations. But there is an even more powerful technology developed by On Holdings. It's called Light Spray™, it allows or it will allow at some point the manufacturing to take place in a matter of minutes,
00;06;59;26 - 00;07;34;17
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right at the retail store. The company tells us that with that technology, the number of elements used, of materials used goes down from 37 to 7. 37 in traditional shoe-making, 7 materials with the Light Spray™ technology. It would have a lower carbon footprint. And crucially, there's a timing issue when a well, what it takes months for Adidas or Nike to arrive at a prototype.
00;07;34;19 - 00;08;07;04
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This could be achieved in a matter of minutes with Light Spray™ technology. But there is an even more important point from the financial perspective, and it has to do with the inventory-to-sales ratio. When you are in manufacturing and you produce real goods, you know that you need inventory if you want to sell the product. But that creates the risk of unwanted inventory. And it has to be marked down with potential impact in terms of cash flow generation.
00;08;07;06 - 00;08;33;15
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Note that this is a problem for Adidas, but it would be less of a problem if the use of Light Spray™ technology allows for manufacturing to take place right at the store in a matter of minutes. So, taking down the inventory-to-sales ratio is a sign of a strong financial performance.
00;08;33;17 - 00;09;05;04
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All of this is fine, but what about currencies? On Holdings says very little about currencies. The treasury teams take a constant currency basis to assess the performance of net sales. It also makes a mention to the recent strength of the Swiss franc, which is interesting considering the fact that production currently takes place mostly in Vietnam. So here's my hypothesis: On Holdings has a low sensitivity to FX.
00;09;05;07 - 00;09;42;15
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At Kantox, we developed the concept of FX sensitivity. We say that a business is sensitive to currencies or to FX if it has low profit margins and a high proportion of FX in his business. Bit on the cost side, or on the revenue side. Now, On Holdings has currently 60% of total gross margins and, according to some analysts, if the use of Light Spray™ technology is more widespread, those margins could go a lot higher.
00;09;42;17 - 00;10;14;06
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So here's the point, On Holdings is way less sensitive to FX than Adidas. When discussing the strong Swiss franc in terms of corporate performance, what usually comes to mind is not a pretty picture. In a recent episode of CurrencyCast, we discussed the case of Swiss watchmaker Swatch, which, according to Bloomberg, suffered in 2023 a 550 million Swiss franc revenue shortfall on account of the strong Swiss franc.
00;10;14;08 - 00;10;43;17
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And then there's the matter of the deep forward discount of many currencies against the Swiss franc. If you're going to sell Brazilian reals forward or Mexican peso forward against the Swiss franc, you need to face a deep forward discount. In other words, a high cost of hedging. Now, here's the paradox about On Holdings. It's actually able to take advantage of the strong Swiss franc.
00;10;43;20 - 00;11;13;09
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Now, the Swiss franc is arguably the strongest currency in the world. It's not just a cyclical phenomenon. For example, the Argentinian peso is currently pretty strong, but it's not obviously a structurally strong currency like the Swiss franc. And that is due to the universal confidence in the performance of contracts. Thanks to things like judicial independence and the independent central bank, a little bit like the Singapore dollar.
00;11;13;12 - 00;11;36;24
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And what happens when you have a structurally strong currency like the Swiss franc? Well, the good news is that the cost of capital will be low, interest rates will be low. Now, currently at about 1.25% in Swiss franc. Now, let's go back to the inventory-to-sales ratio. We know that this is a major problem for Adidas and to some extent for Nike as well.
00;11;36;27 - 00;12;16;14
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And consider the fact that interest rates are pretty high in dollars and in euros, especially compared to Swiss franc interest rates. That's how On Holdings takes advantage of the low cost of capital. It allows the company to invest in groundbreaking technology. Now, at some point there will be the need, surely, for more active currency management. So for example, the company could announce or implement a layered hedging program for its exposure on the cost side to, perhaps, directly the Vietnamese dong.
00;12;16;16 - 00;12;44;20
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We know that there are discounts already in terms of pricing. This is a competitive market and a Layered Hedging Program would allow the company to keep prices steady for as long as possible. Also, there could be the need for centralising FX Management, so allowing the company to maximise exposure netting.
00;12;44;22 - 00;13;15;04
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The purpose of this podcast is not to compare Adidas and On Holdings. The two are not really comparable companies. Why? Because they find themselves at a different phase of their own corporate lifecycle, to take the terminology of Professor Damodaran. While Adidas finds itself in the mature growth phase of its corporate lifecycle, quite obviously On Holdings is at the young growth phase of its own corporate lifecycle.
00;13;15;07 - 00;13;43;11
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Now that has implications in terms of the finance team because different parameters will be taken into account when making investment decisions, financing decisions and dividend decisions. Rather, we want to illustrate two things. Number one, that it is possible to thrive in the context of a strong currency, provided that management and especially the finance team is able to take advantage of the corresponding low cost of capital.
00;13;43;14 - 00;14;12;18
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And number two, there are lessons in terms of corporate storytelling. We know, for example, that Adidas has a brand narrative around each of its products. That's a good thing to do as corporate storytelling is emerging as a major issue in modern management. Let me give you an example. At Kantox, we have developed many stories based on real situations around what we call the benefits of embracing currencies.
00;14;12;21 - 00;14;47;10
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So, for example, instead of paying its manufacturing partners in US dollars, Adidas could use directly the yuan, the Chinese yuan, the Vietnamese dong and the Indonesian rupiah, with the help of automated solutions as both parties would gain. The manufacturing suppliers would not need to manage the corresponding FX risk and Adidas would see a boost in terms of its profit margins because FX mark ups would instantly vanish.
00;14;47;13 - 00;15;04;15
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So what makes a good corporate storytelling? It’s not about stories that are thread based, that have a beginning, a middle and an end. Rather, it's about opportunity based, open ended narrative that have no end in sight.
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