On Holding Stock: Significant Challenges Ahead, Price Correction Likely

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Summary

We believe that On Holding AG (NYSE:ONON), despite its impressive growth and strong market presence in the athletic footwear and performance sportswear sector, is going to face significant challenges in maintaining its relatively high market valuation in the medium-term. With an EV/EBITDA (FY24) of 21.5x, the company is currently trading at a high premium to the average of its peers implying that the market expects On can achieve a high profitable top-line growth of >13% p.a. for the next 13 years. As a result, we believe ONON will face a similar destiny to other comparable consumer brands like Dr. Martens (OTCPK:DOCMF), Allbirds (BIRD) and Under Armour (UAA), which were all trading at high valuations at one point and eventually converged towards the industry average. We believe the market will realise that these long-term expectations are unattainable and reprice the shares. Central to our evaluation is our hypothesis that the performance of most entities tends to gravitate towards the industry average over time in terms of growth and ROIC and only few companies outperform the industry over a long period of time.

Overview Of On Holding

On Holding, also known as On Running, has established itself as a significant player in the athletic footwear and apparel market, appealing to a broad range of consumers from professional athletes to fashion enthusiasts.

Founded in 2010 in the Swiss Alps, the company has rapidly grown, both in terms of its product range and market presence and IPOed on the NYSE in September 2021 valuing the company at USD 7.3 billion. The brand is renowned for its unique honeycomb soles and a logo that resembles an old-fashioned light switch, distinguishing its products in the crowded Athleisure market.

On Holding’s financial performance has been impressive, with a reported revenue of over CHF 1.2 billion in 2022, marking a 68% increase year on year. Analysts are projecting revenue of CHF 1.79 billion for the current financial year 2023, in-line with the company’s guidance announced on November 14th, another strong increase of 47%. The brand’s appeal is based on its unique product design and the endorsement of high-profile athletes and celebrities, such as Roger Federer, Emily Ratajkowski, and Zendaya.

The question for us is, if the management team is capable to maintain the strong trajectory and deliver against the relatively high exceptions of the capital market implied in the current valuation.

Fundamentals

On Holding AG is presently trading at $29.95 per share, marking a 15% drop from its peak, yet it continues to command a substantial premium over its broader industry counterparts.

The company’s Enterprise Value to EBITDA ratio based on fiscal year 2024 consensus estimates stands at 21.5 times, significantly higher than the 8.9 times the median of its wider peer group. Similarly, On Holding’s Enterprise Value to Sales ratio is at 3.4 times, distinctly above the 1.3 times average of its peers. Notably, only Nike (NKE) with 21.1 times and Deckers Outdoor Corporation (DECK) with 18.2 times respectively, are trading at similar valuation levels.

In terms of profitability, On Holding’s reported EBITDA margin reached 11.6% in the fiscal year 2022 and is forecasted to rise to 16.9% by 2025, based on consensus estimates. In its Q3 report, the company itself reported an “adjusted EBITDA” margin of 15.2% in the first 9-month of FY 2023. The difference between these two margins are foreign exchange losses and share-based compensation adjustments, which amount to roughly 3.5%-points.

For perspective, Nike’s EBITDA margin is expected to hit 14.7%, and Deckers’ margin is anticipated to be around 20.4% in the same timeframe. Deckers, especially through its brand HOKA, seems to be following a similar path as On Holding, and is probably worth to look at as well.

Consensus analyst estimates indicate that On Holding’s revenue is projected to grow from CHF 1.23 billion in 2022 to CHF 2.976 billion by 2025. This represents a significant compound annual growth rate (‘CAGR’) of 35% over the next three years. In parallel, the reported EBITDA margin is expected to improve, rising from 11.6% in 2022 to an estimated 16.9% in 2025.

These forecasts are in line with the managements reiterated target in the last earnings call:

We continue to think long-term, and we expect these investments to have a positive effect on future sales and ultimately, on our ability to reach our long-term goals, doubling our net sales by 2026, while increasing our gross profit margin above 60% and our adjusted EBITDA margin to more than 18%.

As expected, the major focus of market participants are on top-line growth, gross and EBITDA margin as well as on working capital. While we believe the company will hit its targets to achieve high profitability in the short and medium term, we are in mostly concerned about the long-term growth and the working capital requirements. Regarding the latter, we observed that the inventory-to-revenue ratio increased from 19% in the fiscal year 2021 to 32% in 2022. In the first 9 months of FY2023, the company managed to improve working capital management slightly, however, based on our projections for fiscal year 2023 indicate that the company’s inventory levels remain elevated at around 30%. In contrast, Nike has maintained a consistent inventory relative to revenue at about 15% for the past decade. The same levels are also observed for Deckers with an average 15% in the last 5 years. We understand that On is still in a high growth phase compared to Nike, however, the high inventory levels should be monitored more closely and are significant risk, from our perspective.

In general, despite the management continuously bragging about great sell-through rates in all channels, so far we haven’t been able to find any actual numbers in any of the earnings announcement transcripts. However, our market research by talking to some stockists in the UK indicate that the On sales team is pushing stock into the existing wholesale channels aggressively and its partners are seeing a slight decline in the overall sell-out of the brand.

Another risk for On’s working capital lies in its increasing emphasis on apparel. While expanding into apparel might seem logical, given that consumers typically purchase more apparel than footwear, this shift poses significant risks, from our perspective. It requires substantial changes to On’s business model and risks diverting management’s focus from its core product: footwear.

The sports apparel market is fiercely competitive, arguably more so than footwear. For instance, Nike reported apparel revenues of USD 13,843 million, constituting 28% of its total revenue in the first nine months of FY2023. Nike lists around 7,200 apparel SKUs on its website and similar counts on major platforms like Zalando.com. In contrast, ONON currently offers only 99 apparel SKUs compared to its 71 footwear SKUs. This disparity highlights the considerable ground On must cover to become a significant player in apparel.

Historical precedents also suggest caution. Brands like Under Armour and Allbirds have attempted similar expansions, from apparel to footwear and vice versa, with limited success. This brings to mind the adage, “A cobbler should stick to his last,” underscoring the risks of straying from one’s core expertise.

Again, while expanding into apparel seems to be a logical step for On, especially given its growth ambitions and the need to deliver against the high capital market expectations, it’s fraught with significant challenges. As a consumer, one might question whether the success and appeal of On’s footwear, particularly its unique honeycomb sole, will translate into a willingness of consumers to also purchase its performance apparel. This expansion, though not impossible, is laden with potential pitfalls that On must navigate carefully.

Looking At Potential Headwinds Of Top-Line Performance

A detailed examination of direct-to-consumer (D2C) traffic, using Similarweb (SMWB), reveals that On has encountered some challenges in the past four months, especially when compared to its peers. In November 2023, On’s overall traffic was 9.3 million, a decline of 5.8% from the previous month. In contrast, most of its main competitors, except Asics, experienced an increase in site traffic, with gains of up to 10.8% (see table below).

Brand Site	Traffic Change (Aug-Nov 2023)	Raw Traffic Numbers (Nov 2023)
On-running.com	-5.6%	9.3 million
Hoka.com	2.4%	8.0 million
Nike.com	5.7%	159.4 million
Asics.com	-6.7%	13.0 million
Newbalance.com	10.8%	11.8 million

Click to enlarge

When comparing the top 15 countries that represent 90% of On’s desktop and mobile traffic over the last three months with its main competitors, we observe a decline in most of these countries for On. While August to October are typically slower months for retail sales, with a significant portion of sales occurring in November and December, a concerning trend for On is its loss of momentum in the crucial U.S. market. The table below indicates that all competitors have seen an increase in traffic in recent months in the US, while On’s traffic declined by 4%.

Furthermore, despite On’s management consistently positioning the company as a performance-led brand, our assessment presents a different perspective. An evaluation of authoritative running shoe review platforms, such as runnersworld.com, reveals a notable absence of On’s products in key rankings. For instance, a recent roundup of the “Best Running shoes in 2023” of Runner’s World did not feature any of On’s products. This omission is significant and contrasts with the management’s emphasis on performance. It suggests that On’s market perception may skew more towards being a lifestyle brand rather than a purely performance-focused one, which would make it a lot more difficult for the brand to retain its position in the long-term, from our perspective.

Analysis Of Implied Expectations Of On Holding

The main focus of our analysis is to delve into the long-term expectations that are currently factored into the current share price. For this, our methodology involves a straightforward yet sound analysis of a company’s implied market expectations. We employ a three-stage Discounted Cash Flow (‘DCF’) model for this purpose.

The model begins with an examination of the company’s past three years’ financial performance to establish a foundational basis for further analysis. This includes key financial metrics like Revenue, EBITDA, EBIT, capex, working capital and operating invested capital, with ROIC being calculated using the most recent company data.

The next stage incorporates 2-3 years of consensus broker estimates, focusing on key financial indicators. We rely on this approach as we consider brokers to possess the most accurate short-term projections for the company.

The final stage involves a 10-year forecasting period, maintaining consistency in major drivers such as margins and capital expenditures relative to revenue, and concluding with the terminal value calculated using the value driver formula (Terminal Value = NOPAT x (1-G/RONIC)/(WACC-g).

The Weighted Average Cost of Capital (‘WACC’), is derived using the Capital Asset Pricing Model (‘CAPM’), and cross-checked with the company’s own data. For the terminal value, we assume a long-term growth rate of 3% and apply a realistic discount on the Return on New Invested Capital (‘RONIC’) based on the calculated ROIC for the detailed 13-year analysis period.

Based on the methodology described above, our model suggests that to justify its current valuation, ON Holding needs to achieve an annual top-line growth of 14.1% until 2035 (2022-2035), resulting in total revenue of CHF 10.2 billion by 2035, an 8.3x top-line increase from its FY22 revenue.

To put this in perspective. ON Holding’s implied revenue in 2035 means that the company reaches 1/2 of today’s size of Adidas’s (OTCQX:ADDYY), 1/5 of Nike’s and almost 2x Under Armour.

We present these findings not as a definitive outcome but as a scenario based on our model’s assumptions, which includes a constant EBITDA margin of 16.5%, a marginal corporate tax rate of 19%, Capex at 3.5% of revenue, and working capital at 30% of revenue gradually lowering it to 20% until 2035. Our terminal value assumptions include a 3% long-term growth and a RONIC of 12%, with a WACC of 8.2%. Based on our assumptions, the ROIC of On in the explicit 10 year forecasting period grows to 39% until 2035. As described above, we believe that the long-term ROIC of most companies will eventually converge towards to cost of capital, however, in On’s case we assume a premium and use a RONIC of 12% in the terminal value. This means we assume the company is able to deliver an economic spread of 3.8%-points in perpetuity. Perpetuity is a long time!

While achieving short-term and maybe even long-term targets don’t appear totally unachievable, especially considering ON’s strong performance in recent years, there remains a significant risk that the company could follow the trajectory of other market newcomers that initially garnered substantial interest but later started to slowly fade. Examples include other consumer brands like Dr. Martens, Allbirds, and Under Armor, all of which once traded at EV/EBITDA multiples well over 20 times but have since declined to less than 10 times. All of these brands were compared to industry giants like Nike to justify their elevated valuation levels back in the days. However, it’s crucial to acknowledge that Nike’s estimated investment of USD 25 billion in branding and marketing over the past decade alone, hence it has significantly bolstered its global brand value and is one of the most valuable brands globally.

The Story Of Dr Martens

In our analysis of Dr. Martens’ market valuation, we’ve drawn parallels to On Holding, particularly given its similarly steep initial valuation. We acknowledge that Dr. Martens is serving a different customer and its TAM might be a lot smaller than the athletic footwear and performance sportswear industry. Anyhow, let’s have a look at the company’s implied expectations when it was still trading at levels similar to On Holding today. Dr. Martens, the renowned British boot brand, made a striking entry into the stock market in January 2021, valued at £3.7 billion. The IPO’s remarkable success, with shares starting at 370p each, was a result of intense investor interest, leading to an eightfold oversubscription. The company, primarily owned by private equity firm Permira, saw significant financial gains, with Permira’s share totalling around £970 million.

Looking at the market valuation in 2021, Dr. Martens traded at an EV/EBITDA multiple of 20-27x, but this has since adjusted to 5.9x, reflecting a significant decline over two years. Our analysis, using 2021 data, aimed to understand the capital market’s expectations at that time.

The company’s Return on Invested Capital (‘ROIC’) ranged from 22% to 35% during 2020-2022, with an EBITDA margin of 24-26%. As of June 2021, the Enterprise Value stood at GBP 5.4bn, with EBITDA projected between GBP 210-220m.

Using the same model as we did for On, assuming a relatively high steady EBITDA margin of 26.8% over a decade (2023-2032), indicated market expectations of an annual growth rate of 15.2%, coincidently very similar to what ON’s implied expectations are.

The decline in Dr. Martens’ share price can be attributed to operational challenges and some less-than-optimal management decisions. However, such risks are inherent in any long-term business strategy, where not all decisions yield high growth.

Comparatively, On Holding may have a more advantageous positioning than Dr. Martens, focusing on a larger Total Addressable Market (‘TAM’) in athletic footwear and performance sportswear. Yet, this sector’s intense competition, dominated by leading global brands, raises questions about On’s ability to meet high expectations in the medium to long term, and whether its valuation will rather align with industry averages relatively soon.

Trade-Off Analysis ON Holding

Our analysis also includes a trade-off table showing the impact of different growth rates and EBITDA margins from 2026-2035 on the company’s share price. The graph shows the potential down and upside of the current share price of USD 29.95.

Exploring The Upside Risks In On Holding’s Bearish Outlook

In presenting a comprehensive analysis of On Holding, it is vital to consider not only the factors that support our bearish stance but also the potential risks associated with this viewpoint. These risks, if realized, could lead to outcomes different from our current projections. The following section outlines key counterarguments and scenarios that, if materialized, could positively influence On Holding’s market performance and valuation, challenging our cautious outlook.

• Market Perception and Brand Positioning: Despite current market trends, On may successfully reinforce its positioning as a genuine performance brand. This shift, if aligned with consumer expectations and market demand, could enhance its competitive edge alongside established brands like Asics and Nike.
• Innovation and Market Response: On’s commitment to innovation and its ability to respond swiftly to market trends could lead to better-than-anticipated performance. If their products resonate well with both the performance-oriented and lifestyle segments, this could bolster their market standing.
• Efficient Capital and Operational Management: Effective management of capital and operational efficiencies, particularly in supply chain and inventory management, could yield higher profitability than currently projected in our analysis.
• Expanding Consumer Base: On Holding’s potential to tap into emerging markets or new consumer segments, coupled with a strong emphasis on performance attributes, might lead to a wider and more loyal customer base.
• Economic and Competitive Dynamics: The company’s adaptability to economic changes and its strategic moves in the highly competitive athletic footwear and sportswear market might outperform current expectations.

Conclusion

This analysis hopefully presents a different perspective on On Holding’s current valuation and its projected growth path. By examining the company’s historical data, consensus estimates, and long-term financial forecasts, we offer a perspective on what On’s management needs to achieve in the coming years. This analysis should serve as a tool for investors and market observers to form their interpretations and understand the potential trajectory of On Holding in the highly competitive consumer sector.