Company Valuation

Corporate Finance- Final Case Section N3: Group F

IMBA Nov 2012 Vivek Jha

Jason Habel

Ushinor Dey

Jann Ewerhart

Hilda Henriquez

Takanori Murakami

Haydar Olkan Erkan

July 2013

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TABLE OF CONTENTS

INTRODUCTION ........................................................................................................................................................ 2

KEY ASSUMPTIONS ................................................................................................................................................. 2

CAPITAL STRUCTURE ............................................................................................................................................ 4

DIVIDEND POLICY.................................................................................................................................................... 6

FIRM VALUATION .................................................................................................................................................... 7

CONCLUSION ............................................................................................................................................................ 10

DISCLAIMER ............................................................................................................................................................. 12

APPENDIX.................................................................................................................................................................. 13

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INTRODUCTION

Established in post-war Germany in 1949 (in its current form) by Adolf Dassler, the adidas Group has been synonymous with sports and sportswear for the last 60 years. The company has been part of many significant sporting moments, including but not restricted to the 1954 and 1974 German victories in the football World Cup, the recently in news Boston and Vancouver Marathons, and all World Cup and Euro Cup footballs since 1970.

The phenomenal growth of the company has been primarily off the back of clever sponsorships of key athletes and teams, and also through the design of innovative new technologies. For example, adidas was the first footwear brand to develop football boots with removable studs in the 1954 World Cup, and more recently in 2005, the design of the first shoe with an in-built microprocessor that can adjust itself as per the runner’s needs. Alongside this, their revenues have been growing roughly at 11% year-on-year with the latest financial reports of 2012 showing Revenues of €14.9 billion and Net Income of €526 million.

Adidas Group counts amongst its brands the flagship “adidas marque”, “adidas Originals” and “TaylorMade-Adidas” (golf range), amongst many others. In 2005, adidas acquired Reebok for $3.8 billion, thus bringing it closer to its largest rival Nike in terms of Sales, and making it the number two athletic shoemaker in the world. Apart from Nike, other competitors for adidas include Puma, Deckers, Crocs and Callaway Golf (competing with adidas’ golf range – TaylorMade).

The operating environment of adidas is the sportswear and fashion industry, which has seen outstanding growth since the economic recession. Worth less than $200 billion in 2008, it is projected to grow to $300 billion in 2017. This growth provides tremendous opportunities for sportswear firms, both large and small, to expand and establish their business in this arena. Most of the growth in this segment is provided for by the United States, Brazil, China and Russia, who together account for 60% of the total growth. However, challenges for the industry still remain in the form of market saturation in developing countries and the subdued economic environment.1

In the following report, we analyse the corporate structure of adidas AG, and look at the firm’s Capital Structure, Dividend Policy and the Firm Valuation. We use our analysis to determine the stock value of the firm and we compare that to the actual price at which the stock is trading.

KEY ASSUMPTIONS

Sales Growth

Our future sales growth rests on three pillars: historical data (trends), analyst estimations and adidas’ own expectations. Historical Data - Analysing the last 10 years of sales data paves the way to estimate the future based on the trend. The steady sales growth only shows two anomalies: one in 2006 and one in 2009. The first, a peak of sales of 50%, was due to the Reebok acquisition in 2006 and the World Cup in Germany. Before the acquisition, the company was growing steadily between 2.5% to 3.5%. The 2009 anomaly has its roots in the effect of the global financial crisis, yet surprisingly sales only decreased by a mere 3%. After the last anomaly the company growth has been a staggering 11% year on year. Events such as the Football and Cricket World Cups, the Euro Cup, etc. do affect the Adidas sales but the equal distribution in terms of the timing of the events mute the effect.

1 Euromonitor International - http://go.euromonitor.com/ApparelWebinar2013_RegistrationPage.html

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Analyst Estimations – Estimations here vary widely. According to Deutsche Bank’s reports, the company has strengthened its infrastructure and retail capabilities hence the future sales growth of company will remain steady (11%). However, given that the core sales growth stems from Russia, Latin America and China, currency risk is the main threat to growth, projected to decrease to 4.7% for the next 5 years. On the other hand, Bloomberg predicts an average growth of 4% and Reuters calls for a 7% range. Adidas’ Expectations – Being optimistic about the world GDP growth and its positive influence on their business, as well as the overall expansion of the global sporting goods industry, yet a slightly negative currency translation to the top line, adidas’ prediction is a mid-single-digit rate in 2013. Drawing upon these three sources of input we decided to opt for a flat pro forma sales growth of 11%, which corresponds to the average growth rate over the last few years. While this estimate is higher than the analyst or Adidas estimations, we are confident that the continuing recovery in the world economy will yield comfortable room to grow; especially from the Emerging Markets that Adidas already operates in and will possibly expand to further.

Terminal Growth Rate

In order to calculate the Terminal Value of adidas at the end of our projections, we determine the expected nominal potential GDP growth rate of all the markets that adidas operates in. We do this by taking the following steps:

1. We take the six major regions listed in the adidas Financial Highlights, and work out what proportion of total current sales are contributed by each region.

2. We find out the constituting countries of each region, and calculate the potential nominal GDP growth rate of each country as per the below formula: Nominal Potential GDP Growth = Labour Productivity Growth + Labour Force Growth + Inflation

3. We calculate the relative size of the GDP of each country in proportion to the total GDP of the region, and use this to calculate how much of the regional growth will be contributed to by each country.

4. By summing up each country’s contribution, we get an aggregate weighted average nominal potential GDP growth rate for the region.

5. Next, we multiply the regional growth rates thus obtained to the proportional contribution of the region to adidas’ growth. For example, Latin America contributes 10% of all adidas’ sale, and the region is projected to grow at 6.29%. Thus, we can calculate the Latin American contribution to adidas’ growth as 0.63%.

6. Finally, we add up each region’s contribution in order to arrive at the final growth rate for adidas AG.

The number we derived as per the above process was 4.2716%. The detailed calculations done to arrive at this number can be seen in Exhibits 1 & 2.

Change in Net Fixed Assets (Depreciation & CAPEX)

An important part of the FCF calculations circulate around depreciation and CAPEX. We define , where we assume no assets are being disposed of. Over the last 10 years we can easily see that it grew steadily and strongly correlated to sales (5.5-8% as can be seen in Exhibit 3). This correlation encourages us to apply the same for our pro forma calculations. A growth in NFA from one year to another implies CAPEX outstripping depreciation, and vice versa. (Exhibit 5 shows the calculation of for the FCF estimations).

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Working Capital Requirements

Due to a lack of correlation to sales, we excluded cash from our working capital calculations. Other Assets and Other Liabilities also haven’t been taken into consideration in the WC calculation for the same reason. Hence we computed from . (Exhibit 5 shows the calculations of for the FCF estimation).

Number of Shareholders

We assume that Adidas will not issue any new equity and keep its outstanding common shares at 209.22m for the forecasted period.

CAPITAL STRUCTURE

Current Capital Structure

The capital structure is derived by looking at the market value of debt in comparison to the market value of equity. In the case of Adidas, the total interest bearing debt, which is not part of the working capital, is set at a book value of €1.487bn. Amongst the debt held, two bonds are publically traded (499m @ €103.80 and 449m @ €125.52), which thus translates into an overall market value of debt of €1.620bn (or D=10.32% of total value). The market value of equity is a function of . With 209.2m shares and a share price of €67.33 at the end of 2012, the market value comes to €14.085bn (or E=89.68% of total value). The firm value comes to €15.706bn.

Applying this, the WACC given the current capital structure is:

[( )

] [

]=[( ) ] [ ]

Composed of, The Risk Free Rate – Despite its international operations, adidas is a Germany based company and is listed in the DAX index (representing the German stock market). Two arguments speak for the selection of the 30-Year Bund rate (2.383% 31Dec12) as the risk free component in our calculations. First, being a very sizable German company that is of importance for the local economy but also a local “champion”, government aid by Germany if needed is likely and thus leaves the Bund rate as reference. Second, the funding that Adidas has drawn upon to date has been drawn locally. The Market Premium – In line with the risk free rate conversation, the comparison of Adidas is against the DAX. Exhibit 6 shows the yearly returns from 1994-2012 of the DAX, the 30-Year Bund, and the difference between the two. The resulting average spread of 5.24% constitutes the market premium to investors for the extra risk of choosing equity investments over bonds. The Equity Beta – The equity beta was derived through the regression of monthly Adidas

share prices and DAX values, from the last three years. Using these values and the correlation formula

( )

( ) ( ), the equity Beta,

given the current capital structure, is 0.67x.

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The Cost of Debt – The book value of interest bearing debt for 2012 came to €1.487bn, whereas the interest expense amounted to €97m. The corresponding average interest rate stands at 6.52%. The Cost of Equity – The cost of equity is calculated via the CAPM (

). Since Adidas is a large Cap stock, we do not need to undertake a liquidity or small firm size adjustment. The Tax Rate – The effective tax rate for 2012 is 38%, as per the income statement of adidas.

Optimal Capital Structure

Is adidas using its optimal capital structure at this point in time? In order to answer this question, a look at varying D/E levels and the corresponding WACC and enterprise value levels is required. Whichever capital structure allows minimizing the WACC and thus, maximising enterprise value can be deemed optimal. Exhibit 7 visualises the simulation results. By keeping the EBIT constant and defining the terminal growth rate (see above section), the D/V level is set as variable. The numbers show that the WACC is minimized and enterprise value is maximised with a 10% debt component. This shows that the “current capital structure = optimal capital structure”. Interestingly, this is higher than the debt level of its industry peers. While Puma’s current D/V level is 1.7% (with no long term debt), Nike operates at 7.89% D/V level. Looking at the simulation, it is apparent that as the debt percentage increases, the interest coverage ratio goes down. This is due to the increasing interest expenses in comparison to the steady EBIT. The lower the ratio drops, the more worried an investor will get. The debt investor will require a higher premium to offset the higher default risk he is taking. The debt rating serves as a proxy here to assess the size of the default premium. Exhibit 7 shows the historical premiums over the risk free rate associated with the respective rating (e.g. AAA = Rf + 0.2%). The bankruptcy cost is another element to consider, as it is not fully considered in the default premium, given it is firm specific. Derived by looking at the historical volatility in EBIT versus interest payments of a firm, and thus the likelihood to cover those payments, can be coupled with the bankruptcy cost (estimated at 20% of firm value) to quantify what premium would be required. In the case of adidas we simplified our workings by only including the default premium. The equity investor, on the other hand, will also demand a higher premium given that common equity holders get paid last (after bonds and preferred shares). The increase is reflected in the growing cost of equity. The current level of 10% debt creates a high level of financial flexibility for adidas. Thus, should adidas need to spontaneously resort to additional leverage, in order to finance a positive NPV project or respond to external factors, they are well positioned to do so. Last but not least, the effective tax rate decreases from a 30% Debt/Value ratio onwards since the interest payments outstrip EBIT. This results in a lower tax shield advantage and thus makes debt less attractive.

Applying this, the WACC given the optimal capital structure is:

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DIVIDEND POLICY

The past history indicates a growing dividend per share. As per the Annual report, the target dividend payout ratio of adidas is 40%. Dividend per share increased from 0.25 (Dec’ 03) to 1.35 (Dec’ 12) as shown in Exhibit 8. Based on the above data and adidas AG’s own estimates for 2013 and 2014, the growth rate in Dividend Per Share (DPS) is estimated as 25% based on an average of the last 3 years. Using the estimated growth rate in DPS, the calculation for FCFE and Dividend payment is calculated in Table 1.

Table 1: FCFE Calculation (shares & EUR million)

It can be seen that with the estimated growth rate of 25% in Dividend Per Share, adidas will have sufficient cash flows to pay the dividends. However a larger portion of that amount comes from the debt issued, which increased the firm’s leverage. The estimated payout ratio is also higher than the current target payout ratio of 20-40% (Table 2).

Table 2: Payout Ratio (EUR million)

Looking at the sensitivity analysis on the growth rate in Dividend Per Share (Exhibit 9), to maintain the payout ratio, the optimal growth in Dividend per share is determined as 5%. Hence there is a need for adidas to slow down its dividend payment. However if the firm decides to slow down the growth in Dividends Per Share, it could face some challenges as detailed below.

Sticky Dividends - adidas has continuously raised its dividends year on year since 2001. The shareholders of adidas have enjoyed a steady stream of dividend flows. While dividends are known to be “sticky”, the successive raises have most likely also become “sticky”. Adidas’ financial leverage is only 10%, which means, it has the capacity to pay higher dividends should it require. Nonetheless, it can’t continue to raise dividends indefinitely.

Clientele Effect - Shareholders expect a steady income source with adequate growth in income. In the event of a slow/no growth, investors might simply sell and move on to other companies that promise higher returns. Thus, adidas would favour continually increasing

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dividends. Floatation Cost – Whenever adidas proceeds to get funding, whether equity or debt, it will be

confronted with the cost it takes to float (mainly the cut of the financial institution take out).

Incurring any extra cost is unfavourable. In line with the pecking order theory that dictates

internal financing is preferred over debt financing, which in turn, trumps equity financing,

Table 1 illustrates that dividend financing is only possible through the debt increases (hence no

internal financing). Thus, adidas will face the flotation costs attached.

Transaction Costs – A decrease in the dividend payment would result in investors looking to

sell adidas stock. Whenever a buy/sell operation occurs, the investor needs to pay a transaction

cost (the broker’s spread). From adidas management’ perspective, who have the shareholder’s

“well being” as top priority, transactions costs are to be avoided. This translates into not

changing the course of dividends or the associated growth of them.

Agency Cost - Shareholders will expect management to run the company in order to increase shareholder value, and as such, decrease the costs of available incentives like stock options, performance bonuses, etc. and instead pass the benefit on to shareholders. Adidas would need to consider the above expectations of shareholders while balancing dividend payouts with the funding requirements in the future.

Asymmetry of Information – It is a fact that managers know more about the company than investors. Any deviation in the dividend payment trend will therefore send signals to the market. adidas dividends have been steadily increasing, hence a halt or reduction will send a negative signal to investors who are left believing that the company does not have positive future prospects. Share prices tend to fall as a consequence. In turn, a higher than expected increase will send a strong positive signal and a share price increase is an observed phenomenon. Dividend Yield - On Dec 2012 the dividend per share was 1.35 and the share price was 67.33. This leads to a dividend yield of 2.01%. This means that out of the 5.89% return on equity, dividends accounted for a 34% share. As such investors still draw the majority of their returns from stock appreciation. This alleviates yet doesn’t resolve the associated problems of a potential dividend cut.

FIRM VALUATION

To estimate the value of Adidas we looked at three different frameworks: 1.) The Discounted Cash Flow Method 2.) The Dividend Discount Model and 3.) Comparables.

Discounted Cash Flow Method

The first step was to calculate the pro forma for adidas from 2013 to 2017. The most important underlying driver was the growth rate, which was set at the historic level of 11% (reasons stated under key assumptions). The remainder of the forecasted inputs was derived as a historical percentage of sales. The exceptions were Shareholder’s Equity, which was a function of previous equity and new retained earnings (net income less dividends), as well as long-term debt, which served as the plug. Exhibits 3a/b & 4 show the full pro forma (Balance sheet & income statement). By taking ( ) , we arrived at the FCF for years 2013-2017. In 2017 the horizon value was computed and added to the 2017

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FCF. Once discounted by the WACC, the enterprise value of €26.386bn was derived. Taking out the end 2012 market value of debt, as well as adding back non-operating cash, we get the equity value: €26.893bn or €128.54 per share (209.22 million shares outstanding). Exhibit 11 shows the full overview of how these figures were derived. Time Horizon – adidas has a long-standing history and has been around since 1949. We no longer consider it to be in its growth stage and rather assume it to be in a stage of maturity. This means that free cash flows are considered to be stable, which allows us to limit the forecast period to five years. Beyond that time period, we apply the horizon value method. Horizon value – We identified several different ways to estimate the horizon value:

Liquidation / Scrap value Book Value P/E multiple Perpetuity Growing Perpetuity

First and foremost, adidas is a going concern, which eliminates the liquidation / scrap value method. Second, we assume Adidas FCFs are bound to grow at the potential weighted growth rate of the countries it operates in, in the long term. Hence our choice fell on the growing perpetuity model. It is important to note that 96% of the discounted FCFs are generated by the horizon value, which emphasises the need to run a sensitivity analysis regarding the terminal growth rate we estimated. Sensitivity Analysis – An important consideration is that our calculations for adidas are only as good as the assumptions we make. While we believe adidas can grow in line with the economic potential of the markets it operates in, it is worthwhile to stress test its perpetual growth assumption of 4.27%. In addition, exogenous variables may result in cost of debt or equity changes, or adidas may be forced to change its capital structure. The factors will affect the WACC and should also be stress tested. Table 3 depicts the associated sensitivity analysis and the resulting market value of equity that would be the outcome.

Table 3: Equity Value Sensitivity Analysis

Dividend Discount Model (DDM)

The DDM is based on the notion that shareholders receive a steadily growing dividend, forever. The corresponding present value of this growing perpetuity should then yield the current intrinsic price of the stock. In other words, all future cash flows to investors (all dividends) discounted to the present at the cost of equity, should reflect what the stock is worth to the investor. In the case of adidas that would be €152.67 per share; resulting in an equity value of € 31.941bn.

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Next Dividend D1 1.62 (Dec 31, 2013) Growth rate (g) 4.27% Return on Equity (r) 5.89% Price/share = €152.67 No of outstanding shares = 209.22 million Equity value = €31.941bn

Comparables Method

Based on industry data collected, the following can be considered as comparable firms:

Table 4: Comparable Firm Snapshot

However, adidas can’t be compared directly to its competitors, as its size and scale are very different from the two (Exhibit 10). We can see that the firm lies somewhat midway between the two most identical competitors. Hence, we shall be using the average of the multiples for the valuation using ratios. For the purpose of valuation, the following ratios can be used:

Price/ Earning Price/ Sales Enterprise Value/ EBIT Enterprise Value/ EBITDA Enterprise Value/ Sales

However, in our opinion, Price/Sales is inconsistent since the numerator (price) relates to the share price or equity component whereas the denominator (sales) relates to the both equity and debt component. Hence we shall discard this ratio. For the rest, as discussed earlier, we shall use the average of the data from the competitors. The average of the multiples are given in the Table 5.

Table 5: Multiple Averages

Table 6 shows our valuation for Adidas using the above averages.

Ratios Nike Puma Average

Price / Earnings (x) 22.87 47.94 35.41

Enterprise Value / EBIT (x) 14.92 11.93 13.42

Enterprise Value / EBITDA (x) 13.23 9.73 11.48

Enterprise Value / Sales (x) 1.91 0.97 1.44

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Table 6: Adidas Valuation from Multiples

Our best guess for Equity value = €16.047bn (Averaged)

CONCLUSION

Based on our weighted valuation we believe the stock of adidas has an intrinsic value of per share, as of 31.12.2012. The actual stock market closing price of adidas on the same day was per share. (Deviations in the underlying assumptions and calculations drive the difference) We deployed three models to determine the enterprise value of adidas. Table 7 gives the overview of the individual results, as well as the weighted valuation.

Table 7: Overview of Valuation Methods

DFCF – We give our discounted cash flow a 60% weight. First, the model underlies a more through process in deriving enterprise value, largely due to the array of assumptions that are taken along the way. Since all assumptions were crafted ourselves, based on the data and approaches we used, we feel comfortable with the results. Second, the DFCF is firm specific to adidas in our case. Third, we control several variables, which gives us more flexibility (and hopefully accuracy) in the scope of the calculations. What prevented us from solely relying on the DCFC was that we wanted to buffer and neutralize against an “own assumption bias”, especially in light of deviating data regarding public sales growth estimates. DDM – We gave the Dividend Discount Model a sole 10% slice. We feel that the model assumes too much simplicity and has too much dependence on too few variables. While the horizon growth rate (g) is the main driver in the equation, it is also the hardest to predict. In addition, adidas’ dividend yield is not the main driver of return to equity holders and despite the steady dividend growth in the last few years; it could easily adjust the number going forward. That would change the outcome of the dividend growth model as it assumes steady growth.

Ratios

Ratio

used

Enterprise

value for

Adidas Debt Equity Value

Price / Earnings (x) 35.41 18623.94

Enterprise Value / EBIT (x) 13.42 13344.02 1220.00 12124.02

Enterprise Value / EBITDA (x) 11.48 14446.22 1220.00 13226.22

Enterprise Value / Sales (x) 1.44 21434.05 1220.00 20214.05

Average 16047.06

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COMPS – We opted for a 30% allocation. Main argument against this approach is the fact that other companies are simply different from us, even if in the same industry. Another supporting justification for the low weight is the fact that comparable valuations lose ‘value’ if the industry is over/undervalued. Yet we decided to include the average of the comps in order to reduce our “own assumption bias”, as stated under the DFCF, which is only as good as the assumptions that underlie it. Finally, there are a few additional points to take into consideration. A fourth way to value a company could have been to look at recent transactions, possibly of similar companies in the same industry that took place. Yet for adidas we could find no useful information on this front. Furthermore, it is important to separate between valuing a company for a minority and a controlling stake. In the case of the latter we would most likely have to pay a premium over the quoted share price to entice current shareholders to hand over their stake. In our case we are valuing adidas from a minority stake view. Likewise, had adidas not already been publically traded (lack of marketability) we would have had to apply roughly a 25% discount to the enterprise value we calculated. Last but not least, adidas is a multinational company so that an even more stringent approach would have been to split the individual geographical regions into silos. Each individual silo might then have its own WACC, corporate structure and future growth assumptions. Once each silo has an enterprise value attached, a simple or weighted sum would give us, a possibly more refined, overall adidas AG enterprise value. This approach however is a lot more complex and is beyond the scope of the mission set out in this report.

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DISCLAIMER The content of this report has been prepared by Group F, N3 of IMBA Nov 2012. The report is based on the publically available data, data from FactSet, Bloomberg, Yahoo Finance and Website of Adidas-AG. The group has made certain assumptions as part of the valuation and made their best effort to validate them to the extent possible. As a consequence. The findings of this report many not align fully with the publically available results (intrinsic share price). The report is prepared for academic purpose only and not to be used as a basis for any investment related decisions. The contents of this report should not be published by anyone without the prior consent of Group F, N3 of IMBA Nov 2012.

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APPENDIX

Exhibit 1 – Calculation of Terminal Value Growth Rate

Exhibit 2 – Regional Breakdown of Terminal Value Growth Rate Calculations

WESTERN EUROPE

EMERGING EUROPEAN MARKETS

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NORTH AMERICA

GREATER CHINA (China, Taiwan, Hong Kong, Macau)

* We don’t have data for Productivity Growth for China and no data in the World Bank database for Taiwan. We use actual growth rates where possible and ignore Taiwan for its comparatively small size relative to China.

OTHER ASIAN MARKETS

* Data not available for Productivity Growth. We project past actual growth rates.

LATIN AMERICA

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Exhibit 3a – Pro Forma Balance Sheet (Assets)

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Exhibit 3b – Pro Forma Balance Sheet (Liabilities & Shareholder’s Equity)

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Exhibit 4 – Pro Forma Income Statement

Exhibit 5 – Calculation of and for the FCF Estimations

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Exhibit 6 – Adidas Equity Beta Calculation

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Exhibit 7 – Minimum WACC Calculation

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Exhibit 8 – Dividend per Share Increase

Financial year FY '10 FY '11 FY '12 FY '13E FY '14E

Dividend

Growth rate 25% 35% 20% 25% 22%

Exhibit 9 – Dividend Growth Rate Sensitivity Analysis

Exhibit 10 – Adidas vs. its Comparable Competitors

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Exhibit 11 – FCF Calculations & Intrinsic Share Price Determination