The share price of Nike (NKE) has risen significantly by 26.0% since it touched the 52-week low at $43.89 in June 2012. At $55.30, the stock appears to be trading at a stretched valuation relative to the company's fundamentals. I am currently holding a small short position in the stock as I expect a notable pullback ahead. My bearish view is backed by the following 4 reasons:
1. Nike shares are pricey on a relative basis (see chart below). Consensus estimates on average predict the company's revenue, EBITDA, and EPS to grow at 2-year CAGRs of 6.4%, 13.1%, and 19.1%, respectively. Those figures are considerably below the averages of 13.8%, 17.6%, and 19.5%, respectively, for Nike's primary industry peers. Similarly, Nike's long-term EPS growth rate is forecasted to be 11.4%, markedly below the average estimate of 15.4% for the comparables. On the profit side, however, Nike demonstrates a better performance as most of its margin and capital return metrics are above par. The firm also carries a relatively low debt load as reflected by its below-average leverage ratios. In terms of liquidity, Nike's free cash flow margin is fairly in line with the group, but both its current and quick ratios are below par, reflecting a mediocre balance sheet condition.
To summarize, although Nike's above-average profitability performance would likely be supportive to the stock valuation, given the company's notably weaker growth potential, I believe the stock's fair value should trade at a modest discount relative to the peer-average level. Nevertheless, the current valuation at 11.7x forward EBITDA (next 12 months) is in line with the peer average. Despite the fact that Nike's forward P/E multiple of 19.1x is 11.1% below the group average, after accounting for the company's long-term earnings growth potential, the stock's PEG is at a 23.4% premium above par, suggesting an overvaluation on a relative basis (see chart above).
2. Moreover, Nike's forward P/E multiple has recently recovered from its 6-month trough (see chart below). The recent valuation recovery appears to be driven by small increases on the company's consensus revenue, EBITDA, and EPS estimates for fiscal 2013 and fiscal 2014 (see chart below). However, given the small magnitude of the growth revisions and the fact that analysts' average long-term EPS estimate has been reduced from 12.6% to 11.4% over the past 6 months, I believe the trading multiple expansion is somewhat exaggerated (see chart below).
3. With a further look-back, Nike's trailing P/E multiple is approaching its 3-year high (see chart below). This appears to be a stretched valuation level provided that:
1) Nike's capital return performance has experienced almost no improvement over the period (see chart below);
2) The firm's various profitability and free cash flow margins have slightly compressed (see chart below);
3) The company's key efficiency measure, average inventory outstanding days, has increased notably over the 3-year period, indicating a deteriorating trend for operation efficiency (see chart below).
4. According to Thomson One, analysts' average 1-year price target is only at $55.87 despite the fact that there are still 10 buy ratings out of 22 in total. In a research note dated February 11, 2013, Corinna Freedman elaborated on her negative near-term view which I tend to agree on (sourced from Thomson One, Equity Research):
"We're cautious for 2H13 EPS due to tough comparisons and backend-weighted gross margin expectations. Near-term, we believe that tough comparisons this spring and summer could hold back results relative to consensus estimates. The athletic segment comps against last year's very strong footwear cycle driven by simultaneous shifts in color and silhouette, which we believe may have inspired an unusually strong year in running shoe purchases."
Bottom line, Nike's current valuation is fragile as the shares are priced for perfection. Given that the overall US equity market is near the record high and the company's stock has experienced a significant run-up, investors should consider pocketing the profits or even taking a small short position as a near-term trading strategy.
Disclosure: I am short NKE.