Description

ON Holding AG. (ONON)

Ticker: ONON

Price: $19.13

Market Cap: $6.1B

Price Target: $11.00

Overview

On Holding AG became public in the Fall of 2021, part of a class of COVID IPOs, where high topline growth rates commanded expensive multiples. Since then, the macro environment has shifted, the company’s topline trends have slowed materially, and the brand looks like it is over-distributed and fully penetrated in the wholesale channel. We believe the culmination of these impacts will create a tough outlook for the company in 2023 and thus see the risk reward as negative in the near- to medium-term.

Description

On Holding AG is a Swiss-based retailer and wholesaler that designs and sells shoes (94% of sales), apparel (5%) and accessories (~1%) that are designed primarily for athletic use, although a significant number of products are also used in an athleisure capacity. Last year, the company did about CHF725mm in revenue with 57% of it coming from North America, 36% from Europe, 6% from Asia Pacific and the remaining 2% from the rest of the world. ONON sells its products through wholesale and its DTC channel, although wholesale represents the majority. 

Business

On Holding AG broke onto the scene with its Cloud Technology running shoes over 10 years ago. Its shoes have a differentiated design and silhouette relative to others on the market. As of FY21, 94% of revenue came from Footwear, 5% from Apparel and the remaining ~1% from Accessories. The company has a global presence but is primarily in North America and Europe, making the company’s financial results more concentrated. North America makes up 57% of total revenue while Europe accounts for 36%. The remaining ~8% comes from Asia Pacific and the rest of the world. ONON employs an omnichannel strategy in which it sells to other retailers (department stores, running stores, etc.) and through its DTC channel where it sells products online and in brick & mortar locations.

ONON first started selling its shoes in Switzerland in 2010, but then slowly started to expand outwards into neighboring countries like Germany in 2011. It eventually moved into the US and Japan in 2013, China and Brazil in 2018, and then to the 60+ countries they operate in today.

As of FY21, the Global Apparel and Footwear category was $1.7T, including $364B from the Sports Apparel and footwear categories. The Global Apparel and Footwear category is expected to grow +5.4% on a 5yr CAGR basis, with the Sports Apparel and Footwear category projected to grow slightly faster at 7.1% on a 5yr CAGR basis. While the broad category is expected to grow modestly, we believe that ONON’s topline will grow but decelerate materially.

When comparing ONON to its closest competitors, the company has an inferior financial profile. Although its revenue growth in the last twelve months is more than double that of LULU, it is largely due to the law of big numbers. Meaning, since ONON is a newer company and has a lower base, it is able to grow at a more rapid pace. Its gross margin is lower than that of LULU and the company is likely to only become profitable this year.

ONON’s near- to medium-term future looks pressured as the demand environment will likely remain soft in 2023 as consumers feel the impact of higher rates and elevated inflation levels. Lastly, as the company continues to innovate in the footwear and apparel space, it could become associated with fashion trends, which would negatively impact the company’s sales if they were to “go out of style”.

Investment Thesis

Despite the volatile macro and retail environment over the last two years, ONON’s topline growth far exceeded that of its peers. In 2021, ONON sales grew ~171% vs 2019, far greater than its competitors (DECK +26%, LULU +34%, and NKE +14%). Like many other retailers in the first half of 2023, ONON will be lapping tough comps. While other companies’ underperformance may be tied solely to the softening macroeconomic picture, we believe that ONON’s will be due to a combination of the weakening macro picture and company-specific problems. Thus, we see downside in excess of 30%.

The past two years have produced an extremely unpredictable macroeconomic picture and this year will be no different. Regardless of one’s macroeconomic view, it is evident via Bank of America Credit card data, that spending levels have slowed significantly since earlier in the year. In May, total card spending, according to Bank of America, was +6% YoY, compared to +1.7% YoY in November. Furthermore, as the macro conditions continue, if not worsen, we believe that spending will continue to decelerate this year.

On Holding AG is also having problems with both sales channels, which is not surprising given the current environment. When asked about wholesale expansion, management noted that it would take 3-5 years to push into DKS or FL, which implies that the wholesale channel is fully penetrated

ONON had its IPO in September 2021, when a hot IPO market awarded rich multiples to companies that had little to no earnings but high growth profiles. Since then, the environment has drastically changed – GDP growth and consumer spending has slowed, and more importantly, the US 10yr increased significantly to 3.77% from 1.62% compared to the September 2021 average of 1.39%. In its roadshow, the company laid out aspirations to grow their topline to CHF4-5B, which would equate to a 20-25% CAGR over the next several years – a similar growth pattern to LULU in its earlier years. As a result of the market environment and the company’s growth profile, it came to the market with a ~30x EV/EBITDA multiple, which was a 3-4 turn premium to both NKE and LULU at the time. The stock’s multiple exponentially increased to 130x EV/EBITDA multiple several weeks later. For a frame of reference, ONON still trades at 23x EBITDA, two turns above NKE and six turns above LULU.

Since 2018, ONON has grown net sales at +68% CAGR. One problem with this growth is that public data is only available for the pandemic years, a time when the retail industry was extremely volatile. Another problem is that shoes represent about 94% of the revenue base, mainly coming from one SKU. Despite making several comments about investing behind and growing the apparel business, it has not materially grown or gained share within the overall business. As of FY21, apparel sales were CHF36mm or only 5% of total sales. On the most recent earnings call, management noted that the apparel category grew below internal expectations but reiterated their commitment to grow the business. Their commitment to investing in this segment of the business is worrisome since the business unit is seeing below-expectations growth. Moreover, their shoes have become extremely popular and have become over-distributed, which has driven sales in recent quarters. As a result of the recent growth, people are extrapolating these sales trends and making that the run-rate, which seems unsustainable, especially in a macroeconomic environment like this.

Given the current environment, it is not surprising to see that ONON is seeing softening sales trends in both channels. In 3Q22, both wholesale and DTC saw decelerating growth QoQ despite somewhat easier comps. Recently, there have been third party channel checks that have called out the apparel and shoes finding their way into the off-price channel, which is never a good sign for a brand.

By looking at credit card data, it is apparent that the DTC trends are slowing. The graph below shows ONON’s YoY DTC sales for 2022. Credit card data for 4Q22 is projecting ONON sales +75%, a material step down from its 100%+ growth in Q2. Despite the high growth rate in absolute terms, we believe this still poses a risk as investors are mainly focused on the topline growth rate.

At this point in the company’s public history, investors care more about the topline trends than they do about the margins. Investors believe this is the next Lululemon. However, its different product mix, reliance on one SKU, and the propensity to become associated with fashion all pose significant risk. In our opinion, ONON and LULU are not as similar as one may think. We believe that the company will enter a period of negative earnings revisions as DTC and wholesale channel growth has slowed over the past several quarters and is entering a period of extreme volatility in the retail industry.

Valuation

Over the last several months, ONON’s valuation has contracted, partially due to the broader market sell-off and partially due to the fundamentals of the stock. It is currently trading at 26.3x FY24 EBITDA, about four turns below its IPO valuation, but significantly below its peak multiple in November 2021. Using P/E, the stock is currently trading at 43.2x FY24 earnings. We value the company using an equal-weight combination of P/E and EV/EBITDA.  We use an EV/EBITDA multiple of 19.0x and P/E multiple of 40.0x to get a price target of $11, about 43% downside from current levels. While, at this point in its journey, we do believe that ONON should trade at a slight premium to both NKE and LULU due to its higher growth profile, but not as large as its current one. The stock is now up modestly from when it reported earnings in the middle of November. We believe there is further downside in the near- to medium-term as slowing growth will impede on the company’s financial algorithm.

Catalyst

Catalysts

·         SKX, FL, or department stores mentioning weak footwear sell through

·         Negative commentary regarding retail sales at ICR conference (early January)

Risks

·         Positive commentary regarding retail sales at ICR conference (early January)

·         Pre-announcements regarding strong footwear sales trends