In Part I (link), I looked at Nike's (NYSE:NKE) business prospects, geographical operations, and financial position. Continuing on, I'll look at some of Nike's competitors to see how Nike measures up and do a DCF to get a ballpark estimate on share value.
Unless it is mandatory to own a stock in a certain sector, I'm not a strong advocate of comparable valuations because they assume that the sector itself is fairly valued. It could be the case that an individual stock is undervalued on a relative basis, but that doesn't necessarily mean much if the sector itself is overvalued.
That being said, a comparable analysis is still useful to get a baseline on some performance metrics. The following table contains some performance and price measurements for several of Nike's largest competitors.
Under Armour is a comparatively smaller company and is still in the midst of its growth phase, allowing them to handily outperform everyone on growth metrics. Under Armour is expected to continue to exhibit strong growth as it further establishes itself as a major player in the industry. Li Ning had strong results prior to 2012 when things went off the rails. Their sales dropped by 25% and they realized substantial operating losses resulting from AR and Inventory write-offs.
Nike's revenue growth over the period is slightly below the industry average (note that Nike's revenue growth is biased downwards slightly as years prior to 2011 include revenue from Cole Haan and Umbro, while the following years do not), however through a combination of share repurchases and operational efficiency, EPS has grown at a more impressive rate of 15.4%. Adidas, Puma and Li Ning grew their revenues but experienced falling profits nevertheless.
Nike's strong profitability becomes more apparent looking at ROE over the period. Nike has averaged the highest and most consistent returns. Of note, both VF Corp and Under Armour have been steadily improving their ROE. During the financial crisis, Nike's ROE of 18% was still quite strong, indicating Nike's ability to generate strong and resilient returns.
Gross margins are the major area in which Nike can improve. Although currently an area of weakness, the fact that all of their major competitors have higher gross margins suggests that it should be possible for Nike to achieve similar margins operating in the same industry.
Controlling labour, raw material and warehousing costs, and managing wholesale prices will be important, as will expansion of DTC operations. Efforts could be hindered by what management described as a "significant" shift towards a lower margin product mix in FY 2013. Assuming this develops into a continued trend, Nike may be able to offset the effects through continued product innovation and emphasis on the premium segment of the market, where they have greater pricing power.
There is a noteworthy disparity between Nike's weak Gross Margin and strong EBIT Margin. It indicates that Nike's has been very effective at creating operating leverage, which their major competitors (with the exception of VF Corp) have not been able to achieve. This is a big positive as restructuring operations to reduce SGA is both time consuming and expensive. It suggests that Nike is well-managed and can generate strong sales per dollar of overhead, advertising & endorsement expense. Overall, Nike has been one of the strongest performers in its industry group; however it currently trades at an inflated multiple of more than 25x both normalized and TTM earnings, and seems overvalued on that basis.
Direct-to-Consumer (DTC) & Lululemon:
Nike's direct-to-consumer segment offers the potential to grow Gross Margins. DTC consists of in-line stores, factory outlet stores, and online activities. Nike is in the process of expanding their operations in these areas. DTC has the advantage of offering higher Gross Margin and more direct control over retail experience & presentation. The disadvantage is that physical stores require heavier upfront investment (leasehold improvements, equipment, and working capital/inventory), higher SGA (staffing and overhead) and is more difficult to exit.
On the other hand, Online requires less investment while also still offering higher margins. Up until recently, Nike's online activities have primarily been focused on creating a digital experience and consumer relationships rather than driving sales. Management believes there is the potential to leverage these already-established relationships into sales as they begin to invest more heavily in online sales.
Lululemon (LULU) provides an interesting point of comparison. Rather than selling to wholesalers, they operate as a vertical retailer, selling their products exclusively in their own retail stores and via their website; in other words, the same as Nike's DTC business. The following table compares Gross Margins, EBIT Margins and ROE of Nike, Lululemon and the Industry Average.
Lululemon is a model for the financial success of a vertically integrated retailer. Their gross margins are much higher than both Nike's and the industry average (since retailers, wholesalers, and distributors do not take a piece of the pie). Their products also fall into the premium category, commanding high ASPs. High gross margins also flow into EBIT margins. Even factoring out the effect of strong gross margins, LULU's EBIT Margin is still around 180 basis points higher than Nike's. Their strong business model has also resulted in a very high ROE. Nike likely won't achieve these margins as a large portion of their business will remain wholesale; however, it demonstrates the potential value of expanding DTC and Nike's interest in doing so.
The discounted free cash flow model was built based on the following assumptions:
I. Revenue has grown at a CAGR of 7.9% over the last 8 years. This was considered the baseline trend.
II. Chinese revenue was assumed to decline by 10% over the next 2 years as the restructuring process continues, subtracting 50 basis points from total revenue. After this time, if China returns to its prior trend, this will add about 150 basis points to growth.
III. Western Europe revenue has been flat since the GFC, mainly due to the persistent sovereign debt crisis in the region. Nevertheless, WE still represents the second-largest geographical segment after the US. If NKE can return WE a modest growth of ~5% per year as the situation improves, this will add 80 basis points to total revenue. Improving conditions in the larger Western European countries could also help boost economic activity in Central & Eastern Europe.
IV. US revenue growth has been well above trend the last couple years, at 16-18%, versus an average growth of 10% for the region. US revenue was assumed to gradually revert towards trend over the next several years, ultimately subtracting 200 basis points from revenue growth.
V. Emerging Market revenue has had the strongest growth over the past few years, however it slowed slightly in 2013. With the World Cup in 2014 and a related major product release hinted at by Charlie Denson during the most recent earnings call, EM has the potential to rebound towards its trend, which would add around 90 basis points to revenue.
VI. Japan revenue was assumed to remain flat.
VII. Hurley, Converse and Nike Golf (in total, representing 10% of revenue) were assumed to continue to grow at their historical trend.
2) Gross Margin: Over the forecast period, gross margin will expand from 43.6% in 2013 to the industry average of 46.8% by 2020. During the previous 7 years, NKE has been able to achieve margins in this vicinity on two occasions, so it is within the realm of possibility. The gross margin expansion will be driven by:
I. NKE plans to continue to expand its Direct-to-Consumer segment (in-line stores, factory stores, and e-commerce), which have the benefit of offering higher gross margins (at the cost of higher SGA and CapEx requirements). E-commerce in particular has been underutilized by NKE and offers a robust opportunity for gross margin expansion.
II. Products incorporating Flyknit have higher ASPs and are comparatively cheaper to produce (requiring less labour and material). As Flyknit is scaled to and applied to other product lines, gross margins will expand.
III. As problems in China are resolved and supply chain management improves, fewer discounts on close-out inventory will be required, boosting gross margin.
IV. Continued labour inflation in countries where NKE products are manufactured will act as an offset, limiting gross margin improvement.
V. Gross margins have been under pressure in recent years due to weakening EM currencies (relative to the USD). If this trend persists, margins will continue to be suppressed. However, a reversal would have the opposite effect. This represents a wild card for NKE and so it was not accounted for in the model.
I. Demand Creation Expense was expected to remain relatively constant, with a slight increase over the next couple years to support new product releases hinted at by management, as well as spending associated with the 2014 World Cup and the 2016 summer Olympics.
II. Operating Overhead Expense was expected to grow as a proportion of revenue due to the expansion of NKE's DTC segment and the related labour, rent and depreciation costs.
4) Income Tax Expense. NKE's effective income tax rate has averaged roughly 25% since 2008. This rate was assumed to persist until 2019, when a tax holiday on foreign earnings expires. Historically this tax holiday has resulted in a 3-4% reduction in effective taxes.
5) CapEx was expected to be comparatively greater in the near future as DTC operations are expanded (owned stores, lease-hold improvements, equipment, etc.) and as Flyknit is scaled and other new products are developed. Depreciation rises accordingly in later periods. Additionally, half of the recent $1 billion debt issuance was assumed to have been spent on CapEx over the next 3 years.
6) Debt Repayment is based on the maturity schedule for existing long-term debt.
7) Interest Payments are based on new debt issued in FY 2013 since net interest on existing obligations has historically netted out to an average of around 0.
8) Working Capital Investment is based on historical working capital requirements, but rise over the forecast period due to expansion of DTC operations which need to be supported with greater WC.
9) Required Return of 9.72% was determined using CAPM, with 10 years of weekly price data for NKE relative to the NYSE producing an adjusted beta of 0.90.
10) Growth Rate of 3.80% was determined using Nike's rate of reinvestment in the terminal year of the forecast and ROIC. It is in-line with long-term nominal economic growth and therefore seems reasonable.
Using these inputs, the DCF model shows a value per share of 54.84, indicating that Nike is currently overvalued by around 25-30%. A rich valuation significantly increases investment risk. This overvaluation is exacerbated by Nike's recent addition to the Dow Jones (necessitating buying for index funds and boosting the share price further).
Nike operates in an attractive industry, characterized by low buyer and supplier bargaining power, oligopolistic competition, and moderately high barriers to entry. Nike sells to a diverse number of retailers and wholesalers and is not overly reliant on any single one. Additionally, through intense marketing efforts, Nike has created a strong brand image and a demand-pull structure where retailers are compelled by consumer demand to carry Nike products. Manufacturing is done by a large number of independent contractors and again Nike is not overly reliant on a single one. Furthermore, a Nike contract represents substantial volume for a manufacturing contractor, meaning that Nike has a high degree of control over them. Competition is centered around a few well-known, entrenched companies who have strong brands and financial capability. Companies compete on product differentiation and brand affinity rather than on price. Oligopolistic industries are capable of supporting long-term above-average profitability. Barriers to new entrants include the extensive distribution network, economies of scale, and the brand power of incumbent firms.
Nike's EPS has grown faster than revenue due to a combination of operating efficiencies and share repurchases. Revenue growth has been slightly below the industry average over the past 5 years, however neither revenue nor earnings took a big hit during the GFC and both recovered within one year, demonstrating the resiliency of Nike's business. Nike is continuing to return value to shareholders via share repurchases, and with a low payout ratio and high dividend coverage, there is the potential for a rising dividend stream down the line.
Nike has outperformed their industry group with a consistently high ROE and by effectively managing expenses to generate a high EBIT Margin. They lag their competition in terms of Gross Margin, which is an area Nike is attempting to improve upon. Expansion plans for Flyknit and DTC operations will both help improve Gross Margin. Flyknit-based products have higher ASPs and lower labour and material costs. Based on a comparison with Lululemon (a company whose operations closely resemble Nike's DTC), DTC has the potential to offer higher margins and profitability (as measured by ROE).
Nike's recent debt issuance (despite their very strong cash position), taken in conjunction with comments made by management seems to suggest that Nike will be increasing their investment in product innovation and/or DTC, both of which will help to drive growth and operating results for Nike.
North America, China, and Emerging Markets (particularly Brazil, Argentina, Mexico and South Korea) have been the strongest drivers of revenue growth and earnings in recent years. With 41% of revenue coming from North America, Nike will need to maintain growth and margins in this region in particular. Nike is also contending with some inventory and brand management issues in China which slowed sales in 2013. These problems will take time to resolve, but Nike appears to be making headway. Additionally, improving economic conditions in Europe, along with the World Cup in 2014 could provide a tailwind to Western Europe, which was previously a larger component of Nike's revenue, but has stagnated as a result of the sovereign debt crisis in the region.
Financial risk is very low. Nike has a strong liquidity position (high current and quick ratios), and a low overall proportion of debt. Cash flows and earnings are more than sufficient to cover debt payments. Nike has very strong financial flexibility to fund investment in product innovation and DTC.
On the other hand, valuation risk is high. Nike trades at 27x normalized earnings, and a DCF with what I think are reasonable assumptions, produced a value of 54.84 per share. Although Nike is a well-managed company with strong earnings, cash flows and operating results, it would be prudent to wait for a better entry point.