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Footwear marathon, an analysis of operations and returns

The global footwear market is expected to reach US$ 350 billion in revenues by 2020. Presently, the market size is pegged and estimated at US$ 260 billion, with c. 35% or approx. US$ 92 billion of the market share, attributed to Athletic Footwear (A.F). The remaining 65% of the market share is claimed by Non-Athletic Footwear (N.A.F). However, the athletic footwear industry is expected to grow at an average annual rate of 5.6%. The industry will benefit from; a boom in the global fitness industry, that is likely to see lower cyclical sales and a more sustained and stabilised demand pattern since athletic shoes are increasingly becoming a necessity.

Whereas both athletic (A.F) and non-athletic (N.A.F) often have a large number of overlapping customers, the performance of both these sub-sectors is hinged on their ability to reduce manufacturing cost and improve revenues. Further, raw material and other direct production expenses (including labour) make up c. 70% to 80% of N.A.F manufacturers cost, their operating expenses can be controlled by opting for more efficient sourcing and production alternatives. On the other hand, A.F manufacturers utilise a more specialised array or raw materials which are primarily derived from petroleum. The operating profit in this segment is open to fluctuations due to petroleum price movements, which are partially exposed to volatilities in prices. In addition, these specialised raw materials are sourced from a select few suppliers which make it harder to identify alternate suppliers in the short term.

The cost structure of these two sub-sectors requires a special mention as there are certain differences that tend to have a major impact on the profit margins. Firstly, the gross profit margin for A.F is 46% as compared with c. 26% for N.A.F. Secondly, A.F players have a higher EBITDA margin of c. 14.2% as compared with 12% of N.A.F. Considering that all the four companies analysed are market leaders internationally and that their distribution costs are as efficiently low as possible under current circumstances, the primary driver for the difference in margins is labour and raw material costs. Moreover, A.F manufacturers tend to command a higher premium pricing (as compared to the respective production costs). This is a result of high unit sales prices attributed to a dearth of competition in the A.F sector, which is basically dominated by a few large players. The rising levels of disposable income and decreasing costs of production (arising out of economies of scale) form an entry barrier of sorts for new entrants in A.F segment. A major C.O.G.S driver, the raw material is c. 30% of revenue for A.F players like Nike and Under Armour. On the other hand, the raw material for N.A.F is between 38%-40% of operating revenue (this does not necessarily mean cost is high, it could be that per unit sales prices realized is lower). This difference in margins can be attributed either to a better bargaining power enjoyed by A.F manufacturers among suppliers or to the pricing pressures to which N.A.F’s are exposed to. Both these point towards the N.A.F’s inability to charge a higher premium.

Note: On average, a mid to high-end non-athletic shoe is more expensive to produce as compared to an athletic shoe; the type of leather used and the skill/craftsmanship required in manufacturing non-athletic footwear is often a major factor that directly impacts N.A.F costs. Furthermore, the average A.F is sold by Nike and Under Armour at 1.86x and 1.94x of production costs respectively, however, the average N.A.F by players like Steve Madden are sold at c 2.74x of production costs.

In addition, other operating expenses are also a point of focus as A.F manufacturers tend to have a much higher budget allocation for marketing and sales, most of which are athlete or sports association; on an Avg. 2.62x that of N.A.F manufacturers. These costs are pivotal in establishing a brand in the industry since the sector is dominated by limited players (Oligopoly). The R&D expenses are another cost that is generally higher for A.F manufacturers. In the case of Under Armour, this was c. 23% of the revenue and Nike did not disclose its R&D expenses, the same can be pegged between the mid-high range; alternatively, N.A.F had an average R&D cost of 3-5%. While A.F firms have a strong gross margin, the operating profit margin is substantially low due to the various demand creation activities were undertaken and the increase in other costs like manpower and other overheads. These costs generally remained steady as a percentage of the revenue, c. 30% for Nike and c. 37% for Under Armour. These costs were reflective of the above-mentioned expansion that the A.F market was experiencing.

Footwear manufacturers such as Nike and Steve Madden generally display a relatively lower level of operating leverage. The Degree of Operating Leverage (DOL) measures the percentage change in operating income as compared to a percentage change in operating revenue. A higher DOL volatility reflects a higher level of fixed costs and lower variable costs. As per the analysis, the DOL for N.A.F was more volatile as compared with that of A.F. In the case of Steve Madden, the DOL volatility was a result of higher recurring costs, partly due to an 11 p.p increase in warehousing costs driven by a 13 p.p increase in revenue. The company also has a strong captive retail network (apart from its third-party distributors) and is further subject to incremental costs from new store openings. This along with falling organic sales contributed to fixed overheads resulting in leveraged operations. In the case of N.A.F, the costs recurring need to be further reduced to stabilise the DOL, typical of a mature industry. In contrast, A.F currently displays a far less volatile DOL, this is however due to the current growth spurt experienced by the A.F market. The A.F players must substantially reduce recurring operating costs whenever the segment market matures.

The A.F firms have displayed a higher level of revenue contribution from the e-commerce as per the revenue growth recorded for all three firms in the above table. This transition could help A.F firms to further reduce their operating lease expenses, which in turn, would help improve EBITDA margins and stabilise the degree of operating leverage.

However, the non-athletic footwear market is at a mature stage with operating costs stagnant, the athletic footwear market is experiencing a surge in activity driven by a high demand for its products. The A.F segment is expected to streamline their operations to efficiently capture the returns stemming from low production costs and thus, improve their returns. A combination of higher fixed assets and relatively lower net profit margins for A.F firms, provide for a higher equity multiplier as compared with N.A.F manufacturers*. This seems to be the primary ROE driver (in terms of velocity) as the other two drivers of ROE (asset turnover and equity multiplier) appear to exhibit numbers that are more generic to the overall footwear manufacturing sector. ROIC for Steve Madden is higher as compared with all the other players, this is driven by a lower invested capital (fixed assets + non-cash working capital) as is the case for Stella International. The net operating margin seems to be aligned to the size of the operations.

*Note: Under Armour’s ROIC and ROE fell in 2016 as a result of a mix of increased advertising activity, higher freight costs and currency translations. 

 

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