Nike an Example of Graham's 'Goodwill Giant'

Ben Graham has become associated with a tangible book style of stock picking, where the investor looks to physical assets, particularly cash, for value and margin of security. While he was fascinated by the market inefficiencies that made it possible at times to buy real companies for less than net cash, he also was also aware of the merits of what he called “goodwill giants.”

From “The Intelligent Investor,” here is a brief discussion:

...here we found – contrary to our investment philosophy – that companies that combined major size with a large good-will component in their market price did very well as a whole in the 2 1/2-year holding period. (By “goodwill component” we mean the part of the price that exceeds the book value.) Our list of “good-will giants” was made up of 30 issues, each of which has a good-will component of of over a billion dollars...the group...acquitted itself best among the 20-odd lists studied.

As used in this passage, by goodwill he did not mean the accounting residue that accumulates from serial acquisitions, all too often lingering until a downturn in the fortunes of the business results in large write-downs. What he was looking at was something else that is not on the balance sheet, the intangible strength that lets Coca-Cola (KO) profit hugely from carbonated water loaded with high fructose corn syrup. Or that makes Procter & Gamble's (PG) soaps an endless source of profit. It's a powerful combination of brand strength and well-earned consumer trust, the accumulated benefit of years of successful marketing and product development.

Warren Buffett was trained by Graham and has developed his own principles. His picks frequently reflect a preference for goodwill giants, such as KO and PG which are fixtures of his portfolio. Also owned by Buffett is Nike (NKE) famous for athletic footwear. The company has a history of making fine profits from selling sneakers, endorsed by an endless series of high profile athletes. I have been long Nike since August this year, when I added it to my portfolio while restructuring to more conservative type stocks. The position has performed beyond my expectations, and now I am beginning to suspect that Nike too is a goodwill giant.

Five Metrics – based on Wednesday's closing price of 63.64

Metric	Multiple	Industry multiple
Price/Sales	1.7	1.7
Price/Earnings (TTM)	21.2	26.5
Price/Cash Flow	15.1	18.3
Dividend Yield (%)	1.6	1.3
Price/Book	3.5	3.2

Valuation – my methods include a consideration of 5 year average EPS, typically consisting of 4 years history and one year of projections. My current estimate is 3.27. While I am usually looking to pay less than 15X on this metric, I have noticed that some of the best quality companies trade around an average of 20 X, with the high around 30 and the low seldom going to less than 15. In the case of Nike, the stock never went below a multiple of 17 on 5 year average EPS from 2004 to 2008. Of course, during the March meltdown it briefly reached a multiple of under 12, but is now trading around 64. It is back up in the area of 20 X on my preferred metric.

Growth stalled due to the economic downturn and financial meltdown, and I estimate going forward they can grow at 7%, supporting a price in the 65 area. However, if growth were to get back to the 9% level the company achieved in the past, a price around 75 would be in order.

Strategy – from the 10-K:

Our goal is to deliver value to our shareholders by building a profitable global portfolio of branded footwear, apparel, equipment and accessories businesses. Our strategy is to achieve long-term revenue growth by creating innovative, “must have” products; building deep personal consumer connections with our brands; and delivering compelling retail presentation and experiences.

...Since the adoption of this long-term strategy in 2001, on an annual compounded basis, NIKE, Inc.’s revenues and earnings per share have grown 9% and 14%, respectively.

R&D – again from the 10-K:

We believe our research and development efforts are a key factor in our past and future success. Technical innovation in the design of footwear, apparel, and athletic equipment receive continued emphasis as NIKE strives to produce products that help to reduce injury, enhance athletic performance and maximize comfort.

In addition to NIKE’s own staff of specialists in the areas of biomechanics, chemistry, exercise physiology, engineering, industrial design and related fields, we also utilize research committees and advisory boards made up of athletes, coaches, trainers, equipment managers, orthopedists, podiatrists and other experts who consult with us and review designs, materials and concepts for product improvement. Employee athletes, athletes engaged under sports marketing contracts and other athletes wear-test and evaluate products during the design and development process

Endorsements – the company has many well-known athletes and teams under contract. Their endorsement contractual obligations are 711 million for 2010 and extend out well into the future, totaling over 4 billion. These amounts are not reflected on the balance sheet. Based on past performance, the sums expended for these purposes have been well spent.

The amounts involved are large and the investor needs to develop an opinion as to how effective these contractual future expenditures will be in promoting revenue growth.

Entrepreneurial Accounting Analysis – In situations where the investor suspects that R&D or advertising may be creating value, it may be helpful to consider some of these expenses as investments, in effect looking at them as going to the balance sheet. The thinking would be, if R&D and/or advertising/endorsements are contributing to future sales then they should be capitalized and amortized over the periods where the resulting revenue is realized. This is not according to GAAP but can be useful in developing an appreciation of how and why a company makes money.

Demand creation expense, consisting of advertising and promotions and including endorsement contracts, came to 12.26% of revenues in fiscal 2009.

This is what Graham was seeing in the results for “goodwill giants.” Of course the invisible asset can be tarnished, witness Coca Cola's difficulties with the revised formula and return to “Classic Coke.” But if properly nurtured, the out-performance and competitive advantage can last a very long time.

Dividend and Share Repurchase – Nike pays a dividend of .25 quarterly, currently yielding 1.55%, and has a 5 billion share repurchase plan in place. Share counts have decreased in recent years, and dividends have been increased from time to time. Average repurchase price based on the 2009 10-K was 54.87 per share, well under the current price. Long term debt is trivial. The largest constituent of shareholder's equity is retained earnings.

Investment implications – Nike is a good long-term holding for conservative, dividend growth type investors. Possibly it is a good will giant, along the lines suggested by Ben Graham.

Disclosure - net long NKE and PG, no position in KO

Comments

[nomorehomes]

It appears he fails to mention NKE's competition which is unheralded today compared to the past.

Adidas, Puma, Peak Sports, Under Armor and Asics.

They are gaining like never before as people try to differentiate themselves and/or choose more appealing or more comfortable apparrel and shoes. I mean really. Who runs in Nikes when they can run in Asics? That is just one example. Under Armor has better space at Dick's and Sports Authority. Nike may have a few more puffs in it but at 20 times earnings I wouldn't be in a rush to buy NKE or with this market $100 sneakers for my kids.

2009 Nov 20 08:25 AM

[slam stocks]

I own lots of NKE @ $50 and have been well rewarded for my efforts. The above numbers are exactly the reason for purchasing this company. Valuations are not that superior to the industry and in some cases lower. A good buy from a premium industry leader and long-term winner. I also compare their clothing to trendy/fad wears like LULU, ARO, GAP, APO, COH, RL etc. and they also hold their own. Yes, clothes and shoes are pricey, but to own a timeless brand name at a reasonable price, I'd stay with this company then any other clothing or luxury goods mfg.

2009 Nov 20 10:03 AM