Nike's Revision: Revenue Missed On My Expectations But Margins Are Good

| About: Nike Inc. (NKE)

Summary

Since my last report the Nike’s stock price has fallen by ~12%. People who followed my recommendations nine months ago have earned around 11.2% so far.

During the last eleven months, Nike has not shown good revenue growth results. The $50B figure by 2020 is in question now.

However, the margins are in line with my forecasts or even better. The net profit is only $26M lower than what I expected.

Hence, I do not think that Nike’s fair value has significantly changed during this period. I issue a HOLD recommendation in accordance with my DCF and comparative analyses.

On October 30, 2016, I published an article that outlined the main reasons why I considered Nike Inc. (NYSE:NKE) as a good stock to sell. Since then, the stock has declined in value by more than 12% (see Diagram 1). However, Nike paid some dividends during this period, so the total profitability has been around 11.2% for the period. The stock dividends are not considered because their mechanism works the following way: "make a split + sell these stock to current investors". The buybacks' effect has been reflected in the stock price, too. You can read the article here.

I am going to revise my opinion in light of the latest news and financial results.

Diagram 1.

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( Source: Yahoo Finance)

Latest developments

1. Nike has signed a life-time contract with Lebron James, a famous basketball player. According to different analyst estimates, the contract cost Nike $1B and is expected to bring more than $1T in sales. However, I do not believe these figures as the expected revenue depends not only on the sports brand but also on the quality of products, purchasing power of customers, rivalry, and economic conditions.

2. Nike reports good results in revenue and margins, but misses on inventory and EPS. Inventory and accounts receivable levels are painful topics for Nike, and I will discuss them later.

3. Nike has nullified the contract with a boxing star Manny Pacquiao after his homophobic remarks. In my opinion, that was a good decision because LGBT members and their supporters contribute significantly to Nike's current and future revenues.

4. Dave Dombrow, a senior VP of design, left Under Armour (NYSE:UA) for Nike.

5. The FQ3 and FQ4 results were the same as FQ2: revenue and margins are good, but FQ3 inventory is 8% higher and FY2016 is 12% higher on the YoY basis. The fact that Nike missed on revenue led to a stock price decline. In my last article, I said that Nike would experience problems with sales.

In light of this information, I made three conclusions:

1. Nike's revenue is lower than expected

2. Nike's inventory is increasing

3. Margins have improved.

I am going to discuss the FY2016 results, comparing them to my expectations. As you can see from Diagram 2, Nike missed on my expectations of revenue. However, I was correct on the gross profit margin figures and too bearish on EBIT and EBITDA margins. Moreover, my net profit and diluted EPS estimates were in line with the forecast: I expected net profit and diluted EPS to be $26M and $0.01 higher, respectively.

Diagram 2.

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(Sources: calculations by author, Nike's 10-K)

I see two points of concern that still make me feel uncomfortable about Nike, even not taking into account the short-term revenue misses:

1. The company spends a lot of cash on buybacks and dividends. As you can see from Diagram 3, FY2016 cash burns were more than 111% of FCFF: spent on stock repurchases and on dividends (35%). In total, Nike spent more than 146% of its free cash flow on these activities. With the significant cash burns, I do not understand how the company is going to beat Under Armour.

Diagram 3.

(Source: calculations by author)

2. The working capital efficiency has not improved since FY 2013 (see Diagrams 4 and 5). The most concerning metric is days of inventory on hand. This ratio has been increasing since FY2013 making an enormous impact on the cash conversion cycle (see Diagram 5). The only reason why cash conversion cycle has not rocketed is that the days sales outstanding have been declining year-over-year.

Diagram 4.

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(Source: calculations by author)

Diagram 5.

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(Source: calculations by author)

I have revised my DCF model with the following changes:

+ Revenue growth - lowered

+ Gross profit margin - stable

+ EBIT as % of gross profit - improved

+ EBT as % of EBIT - lowered

+ Tax rate - lowered

+ Terminal EV/EBITDA - lowered.

DCF Analysis

My DCF model is presented in Diagram 6. In Diagram 7, you can see how different metrics of the company are expected to change during this period. I have made and revised several assumptions, which can be seen in the "Assumptions" tab of my Excel file.

My model shows that, after subtracting the market value of debt, minority interest, adding back cash and investments, the market value of equity is around $101B in the Base scenario. Consequently, the stock's fair value is around $57.86 per share. It is a little higher than the current market price ($57.6 per share) and a little lower than my previous estimate ($58.4, adjusted for the split).

Diagram 6.

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(Source: data - Morningstar.com, DCF model by author)

Diagram 7.

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(Source: data - Morningstar.com, model by author)

Sensitivity Analysis

The sensitivity analysis is presented in Diagram 8. According to the Base scenario and the assumptions for the EV/EBITDA multiple and WACC, the price range is estimated to be between $52.81 - $63.74 per share. This price range translates into a (-8%)-11% downside opportunity.

Diagram 8.

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(Source: data - Morningstar.com, model by author)

Comparative Analysis

My comparative analysis is based on three key ratios: P/E, P/S, and P/BV (see Diagram 9). All ratios show a downside potential, even the industry's top 25%. Hence, investors should be careful about going long with this stock and better hedge their position with put options (consider selling calls against the stock to finance the puts).

Diagram 9.

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(Source: data - Morningstar.com, infographics by author)

Opinion

Nike Inc. missed my revenue expectations and did not deliver on the bottom line numbers . Hence, I think that Nike's fair value has not significantly changed during this period. I recommend investors to HOLD this stock and set a target price range at the level of $52.81 - $63.74 per share.

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.