Can Nike Keep Up With the Competition?

Nike (NKE) has long enjoyed a well-recognized brand name, quality products, cutting edge athletic technology, and a sound management team. Long time stockholders have been well rewarded over the past decade, having been the beneficiaries of increased stock buy backs, regular dividends, and most recently this spring, a two for one stock split.

Nike forges ahead each season by introducing hot new styles, and they always seem to have a product that is flying off shelves and causing traffic at the local sporting goods or shoe store. However, there are signs on the horizon that Nike may be losing a step on its competitors.

Nike has always ruled the athletic apparel business with new styles and affordable performance gear. With the introduction of dri-fit several years ago, they created the market for a type of specialty sweat resistant sportswear that enhanced performance. Not far on its heels was Under Armour (UA), who has since perfected the technology Nike first introduced, and is signing deals with collegiate and professional teams, left and right. However, as long as Nike is first to market with these new product introductions, it will continue to enjoy the prestige and profits associated with an industry leader.

Industry leadership has always been expected at the footwear business of Nike, the cornerstone of the company. However, in recent years, several specialty footwear companies are gaining momentum, and that should be of major concern to the Nike footwear business: Crocs, INC (CROX), and Heelys (HLYS). Both of these companies have created a new market, which in the past had been Nike’s game.

Crocs are a casual sandal made of plastic, and you have probably seen elementary age kids zip around the mall on their new Heely’s shoes. While still in their infancy, these two companies have already started to turn a generation of shoe purchasers away from the traditional athletic shoe, towards affordable sporty fashion statements, which is a market which Nike used to own.

Nike has several options as it tries to set its strategy in response this change in demographics and consumer preferences. Its first option would be to funnel the boatloads of cash it generates from years and years of frugal operations back into the business. In the past, Nike has used its cash flow from operations to fund stock buybacks and dividend payments (just under $1B in ‘06), as well as short term investments ($0.9M in ’06).

While investors cheer when cash is returned to them, one really has to wonder why Nike would tie up almost a billion dollars in cash for short term investment purposes. Wouldn’t this money be better suited on market research, new manufacturing facilities, or a new development lab? Perhaps this symptom of caution is a theme which will continue to play itself out on in the board rooms of Beaverton, until the footwear giant we know as Nike has lost its grip on the industry.

On the other hand, instead of treating that cash as an anchor on the company, Nike should take a big swing and acquire one of these specialty shoe companies. With the excellence in manufacturing and supply chain that Nike has learned, it could buy a company for both the breath of fresh air and talent, as well as leveraging its operational rigor to squeeze better profits from the new acquisition.

According to recent filings, Nike has over $2B in cash in the vault waiting to be used. After a quick comparison of other publicly traded apparel companies, there are multiple options for acquisitions that Nike could afford. The companies I looked at include K-Swiss (KSWS), Timberland (TBL), Skechers (SKX), Stride Rite (SRR) and Lacrosse (BOOT). The results of this analysis are in the table below:

The clear favorite here is K-Swiss. There are multiple synergies here that Nike could take advantage of, and this deal would make a lot of sense to both companies. A fellow West-Coast shoe company, K-Swiss is famous for its simple, yet recognizable, style of striped shoe. Sales have declined in the last year, as the main product line is not gaining the revenue traction in the U.S. market that management expected. International sales look quite robust, but this has not excited Wall Street. However, margins have continued to increase, which show a clear effort to deliver, despite the top line miss.

K-Swiss is funded without any debt, and is currently trading at only 14 times earnings, perhaps because of its conservative management, and use of capital. The recent concerns over the viability of a company based on a very limited product line have chipped off about 30% of the market capitalization (now just under $1B), and suddenly this company looks very very affordable for Nike. The beauty of this deal is that when Nike plugs K-Swiss into its existing distribution channels, Nike not only gets the benefit of a turnaround sales story at K-Swiss, but it also enjoys the profit margins which are currently almost double that of Nike’s. Cost savings and revenue expansions are a great formula for acquisitions.

There is no telling how long this deal will wait for Nike. With the amount of private equity in the markets these days, an operation like K-Swiss with healthy margins, a depressed stock price, and a pristine balance sheet shouldn’t have to wait very long to be gobbled up. The interesting thing will be to see if Nike will step up to the plate and open up the cash vault to make a deal, or be content to sit on it while the rest of the footwear and athletic apparel industry catches up to them.

Comments

[btrend:]

Not sure why you didn't look at Adidas as part of the competitive set....

2007 Jun 19 09:59 AM

[Brandon Smi...:]

btrend,

I left Adidas out of the comparison set for two reasons:

1. Since the Adidas / Reebok merger, the size of Adidas Group is clearly out of Nike's price range. The purpose of this study was to evaluate potential acquisition targets from Nike's perspective.
2. I focused on publicly listed companies on US exchanges. Because Adidas Group trades on the Frankfurt exchange and does not report in USD, I excluded it.

I hope this answers your question on the approach my analysis. Thanks.

B Smithson

2007 Jun 19 03:25 PM

[KoolAid:]

Why not consider an apparel company like Lululemon. The financials are available in their recent S-1, they look very strong and reflect good steady growth. More important, getting a stronger foothold in women's athletic apparel is something that Nike, Puma, and Adidas have all been struggling to accomplish over the years. Lululemon has built a strong following and brand in the fast growing yoga/casual athletic women's apparel sector. In my humble opinion, Lululemon would be much more attractive and strategically important than any of the companies included in your analysis. Nike should never let Lululemon hit the public market - they would be smart to preempt the public offering with a solid and fair offer.

2007 Jun 21 10:05 AM