Nike (NYSE:NKE) is a familiar name to many of us. Its ubiquitous tick logo and to be found almost everywhere you look if you care to take the time to notice them. It is a brand of apparel which has really sunk its teeth into our culture.
Of course, Nike is more than just its eponymous brand. Nike also includes the Converse, Hurley and Jordan brands. Me and my family certainly have a number of Nike and Converse items around the house which are used (and replaced) very frequently indeed.
After recently selling certain brands including Umbro they have become more focused on these remaining brands. Although maybe, as a result, less diversified across brands these brands appear to offer enough diversification in themselves.
Take a look at Nike's sales by geography, for instance:
Certainly, North America is its biggest market. But with a generous and growing segment outside North America it is becoming increasingly diversified with itself plugged nicely into long-term growth regions. Nike's remaining labels clearly carry great brand power across the globe.
Nike also is heavily tilted towards footwear as its major segment (especially when you include Converse in that segment):
But all of this looks good as it is the footwear and Converse segments which are leading the way for growth at the business:
Indeed, the two shrinking segments are also the two smallest. Clearly, therefore, Nike is a business securely growing in the right places. All great news for an investor.
So let's take a fuller look at the business beneath these brands.
Why The FCF 5?
I use these free cash flow tests to begin my analysis of potential investments.* Recently I reviewed fellow apparel peer, V. F. Corp (NYSE:VFC).
Using them provides a detailed (although far from exhaustive) breakdown of the financial health of the company. Its solvency. Its efficiency. Its value.
Cash is king, and these tests look to set the ability of the business to produce free cash flow against its debt, dividends and more besides. I use these as a screen to find businesses for a more wide-ranging analysis later that steps beyond the cash flow statement.
So how does Nike do against these tests? Let's take a look.
1: Positive Free Cash Flow
My first test is simple. I look for a company which has managed to produce positive FCF over the last five years. Here, Nike does very well indeed:
Not only has it managed to produce positive FCF throughout the last five years but its FCF has also grown at a CAGR (compound annual growth rate) of nearly 22%. That is hugely impressive.
Nike has therefore got off to a magnificent start with a comfortable PASS.
2: CROIC: Cash return on invested capital
Next up is the CROIC. What this tells us is how efficient the company is in producing FCF from its invested capital (in other words, its equity and debt).
What I look for is a figure above 10%. In other words, I want to see the company consistently produce $0.10 in cash for every $1 of capital invested in the business.
So how does Nike do here? Very well indeed. Over the last five years it has averaged a CROIC of 17.6%. But this gets better. When we look at the results for each individual year we see an even more impressive picture:
Nike has not seen its CROIC fall below 10% at any point over the last five years. What is more, it has been expanding its CROIC significantly over this period. Whereas in 2011 it was producing an already impressive $0.13 for every $1 of capital, by last year it was producing nearly $0.27.
How much more it can expand this CROIC is unclear. But I suspect there is still more room in this regard. Nonetheless, even if it was to fall back to its 5 year average around the 17% mark it would be a very attractively efficient cash-generating business.
Another PASS here for Nike.
3: EV/FCF Valuation
This is a very basic test.^ Here all I want to see is that the business is not obviously overvalued according to its FCF generation. In order to ascertain this, I use the enterprise value to FCF metric instead of the more familiar PE ratio.
All I ask for here is that the EV/FCF is below 22. It does not start well for Nike. At present it is sitting at an EV/FCF value of 24.29.
However, I also like to include the future projected FCF in this test. I work out my predicted FCF by taking the revenue predictions for the next two years and multiplying it by the average FCF/Revenue ratio taken from the two figures:
- The FCF/Revenue average over the last five years; and
- The FCF/Revenue ratio in the last FY.
Now, for Nike these figures would read:
- 8.29%, and
This leaves us with an average 10.32%. Using this figure we would have estimated FCF like this:
Now, personally I think the FCF/Sales ratio in the future will be closer to last year's figure (12.15%) than the five-year average (8.29%) and I would therefore expect to see FCF grow again on the back of what analysts expect will be another sales revenue growth couple of years:
Nonetheless, we will take these conservative FCF estimates in my current calculations. Doing so produces EV/FCF figures like this:
Averaging these figures we would come out with an EV/FCF value of 25.25. This is obviously above my target of 22. Indeed, even if we assume Nike repeated its FCF/Sales conversion ratio of 12.15% it would still average over 22 (just).
As such, Nike has to receive a FAIL here.
4: FCF to Debt
Next we turn to debt. Debt has indirectly featured in most of the above metrics. But focusing down on it individually is also important.
Nike is, in fact, very lightly leveraged. Looking at its debt to equity ratio, despite growth in recent years it is still extremely low:
Indeed, it is so lightly leveraged that it makes V. F. Corp's 25% debt to equity ratio look quite heavy (which, of course, it is not).
However, for me the most important point is how well covered this debt is by FCF. What I look for is for the entirety of the company's debt load to be covered at least 25% by FCF. What this would mean is, in theory, the company could repay the entirety of its debt in four years just by using FCF.
Needless to say, with such impressive FCF figures and low debt, Nike does very well here:
Indeed, at FY2015 time, Nike's FCF covered it entire debt by nearly 300%. In other words, it could repay its entire debt using its FCF in about 4 months. Very impressive indeed.
Of course, that means that Nike easily PASSES this test.
So how does Nike do on the dividend front? Here I look for a pretty straightforward set of targets:
- A FCF yield (the yield if the entirety of a company's FCF was paid as a dividend) above 3.5%;
- A current FCF dividend payout ratio below 75%.
Nike does pretty well in this regard again:
With a FCF yield over 4% it certainly beats my 3.5% target. Similarly, with a payout ratio of only 22% it is easily below by 75% target.
That being said, its FCF yield is not that impressive. V. F. Corp managed a FCF yield of 5.7% whilst also having an equally modest payout ratio and more generous current dividend yield.
Nonetheless, we cannot deny that Nike has again PASSED this test.
FCF Fair Value
So now we have to turn to the fair value part. Is Nike, as it is currently priced, an attractively valued company? Here we again turn to a FCF metric with our old friend EV/FCF making a return. First, I work out what the average EV/FCF for Nike has been over the last five years:
Using these historic EV/FCF values we get an average of 29.74.
I then use this figure to multiply the average FCF per share derived by using that of the FCF per share in the last financial year and those predicted over the next two years (as ascertained above).
Doing so, suggests that Nike has a FCF fair value of $62.50. With Nike currently trading around the $60 mark that would suggest that it is trading a little below fair value which, I think, is a pretty fair assessment.
Nike has done pretty well in these tests. It passed four out of five tests with only the absolute EV/FCF valuation falling short. However, as the FCF fair value calculation suggests that it is still trading below fair value (even with my conservative FCF estimates) I would argue that it is hard to argue that Nike is not an attractive buy today.
The Nike brand was recently (and very deservedly) judged to be the 18th most valuable brand in the world by Forbes. With revenue set to continue to grow at about 8% per year going forward, it is hard to challenge anyone with a bullish sentiment for the company going forward. Its value seems set to continue to grow.
It is an efficient, healthy and growing business with impressive cash generation capabilities backed by a modestly-sized but robustly performing brand portfolio.
Would I buy Nike over V. F. Corp today? I am not really sure. In reality, I'd be happy to add both today with them still producing consistent and impressive growth and adding massive amounts of shareholder value to boot.
Whatever, the futures for both businesses and their shareholders look very good indeed.
* In this article, I use free cash flow as calculated by subtracting capital expenditure from operating cash flow.
^ I am thinking of retiring the absolute EV/FCF valuation test in future. Instead, I will likely make the EV/FCF fair value test at the end part of the main testing series.
Unless otherwise stated, all graphs and tables and the calculations contained within them were created by the author. Creative Commons image reproduced from Flickr user sneakerphotography.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.