By Greg Ruel, Senior Research Associate
In September, two share repurchases were announced that GMI Ratings found too large to ignore. One was at CVS Caremark Corporation (CVS), where the board approved a $6 billion share buyback on September 19. On the same day, Nike Inc. (NKE) announced a board-approved buyback of $8 billion. At CVS, however, the buyback comes as shares are trending upward - trading at over $48 and only pennies off their 52-week high. At Nike, the repurchase announcement comes as the stock is trending down, exposing the company to the risk that shares will be purchased at prices that will soon be lower.
While management considers the buyback a "prudent use" of excess cash, it is very likely that the situation with Nike's falling profits could get worse before it gets better. In a recent KeyMetrics series piece, we summarized how companies will use buybacks to artificially inflate EPS, as well as increase executive pay. There is certainly reason for suspicion for this effect here.
In Nike's first quarter results, the company announced EPS that was down 10 percent. As far as executive pay, half of the cash element of the long-term plan is based on diluted earnings per share. There is also the $20 million in restricted stock the board granted to CEO Mark Parker in May as part of a $35 million total summary compensation package. The stock will vest in five years and likely benefit from the buybacks.
Motivation for the buyback could also stem from management feeling that the stock is trading below what it perceives as intrinsic value. However, we're less optimistic about this particular buyback and have initiated a watch that could see Nike's ESG Rating of "C" downgraded further.
Shares at Nike climbed in the spring following the announcement of mid-teens growth for 2012. However, its stock is currently down nearly 20 percent off 52-week highs, resulting largely from a steep decline in international orders in the first quarter, especially from China, as well as an increase in operational costs. For example, selling and administrative expenses for the first quarter rose 16 percent to $2.2 billion and operating overhead expenses grew 12 percent to $1.3 billion. The buyback is expected to start following the company's fiscal second quarter 2013.
Nike's internationally recognized brand has also been hit hard by the global slowdown. Net income decreased by 12 percent in the first quarter as operating overhead expenses increased by the same percentage. Nike blamed the compression in margins on rising input costs.
The company also explained that the additional overhead expenses were "due to additional investments made in the wholesale business to support growth initiatives and higher Direct to Consumer costs from the addition of new stores over the last year." Gross margin also declined by 80 basis points, with the company attributing its EPS decline to "lower gross margin, higher SG&A and an increase in the tax rate." In fact, gross margin has declined for five straight quarters.
It's the international orders that have been most concerning. Especially in China, where Nike says gross margin was negatively impacted by "the conversion of the China market to direct distribution for Converse." Also, while future orders - those scheduled for delivery from September 2012 through January 2013 - were strong in North America, they fell by 6 percent in China.
Last fiscal year, China accounted for more than 10 percent of Nike's sales, with Canaccord Genuity Analyst Camilo Lyon estimating that the country represents 30 percent of the company's operating profit, yet is falling victim to "macro pressures and a highly promotional competitive landscape". Ms. Lyon added that orders from China "were worse than anyone expected."
The sporting-goods company also has an excess of inventory that increased by 10 percent in the first quarter. Mr. Parker has been discounting merchandise in China from 25 percent to 30 percent to clear out slow-selling inventory impeding the demand for new products. However, it is unclear how much demand there is for Nike's high-priced merchandise amidst a slowing economy. Take for instance Nike's new shoe, the Lebron X. "The LeBron X will be launched in the fall at a suggested retail price of $180," Nike spokesman Brian Strong said. The highest-end version of the shoe looks to be priced at $270.
Nike allegedly went into damage control mode as initial reports in the Wall Street Journal had the price estimate for the sneaker as high as $315, which would have made the Lebron James shoes the most expensive sneaker ever produced by Nike. While this type of shoe might appeal to a few sneaker enthusiasts, it seems to be ill-timed during an economic downturn and makes the company appear out of touch.
Some even found the shoe itself to be insensitive, charging that these sneakers are targeted at kids and teenagers who likely cannot afford them. "It's the consumer's choice after all, but it's insensitive to market a $300 shoe to kids and teenagers as people are going back to school and struggling to buy school supplies," he said, noting that he was wearing a pair of Nike Free sneakers on Tuesday. "This is not food, this is not rent, it's a single pair of sneakers." This ongoing controversy leads us to question not only the decision making of management, but also that of the board charged with overseeing these decisions.
Chairman, former CEO, and Nike founder Philip H. Knight has the ability to elect three-quarters of the board by virtue of 75 percent ownership of Class A shares. But with nearly 70 percent of shares held by institutional investors, the board he elects does adequately represent these interests. One director in particular, Phyllis Wise, would likely not be on the board if it were left up to anyone but Mr. Knight.
On her most recent election to the board, Dr. Wise received 41.06 percent of votes withheld against her re-election. She has virtually no experience pertaining to Nike's core business, serving as Executive Vice President and Provost of the University of Washington, where she is also professor of physiology and biophysics, biology, and obstetrics and gynecology.
In 2011, Dr. Wise was the only director to fail attendance standards, "due to scheduling conflicts with certain Board of Regents meetings of the University of Washington". She currently serves on two of Nike's five committees and earned $237,889 in director compensation at Nike for fiscal 2012.
As stated earlier, Mr. Parker received $35 million in total summary compensation for the 2012 compensation year, an increase of 220 percent over the prior year. The increase is primarily the result of the $20 million in time-vesting stock he was awarded "in recognition of his leadership and his critical role in driving the company's growth strategy in future years". The award helped catapult Mr. Parker's 2012 fiscal year compensation to nearly eight times the median of other named executive officers. However, the stock award isn't all that surprising if you look at who helms Nike's compensation committee.
Apple CEO Tim Cook also moonlights as Nike director, chair of its compensation committee and member of the nominating committee. He earned $245,285 as a director of Nike for fiscal 2012. Mr. Cook received almost $378 million in total summary compensation from Apple, $376 million of which was a stock award structured similarly to Mr. Parker's. Mr. Cook's stock award cliff vests in two tranches, after five and ten years, compared to Mr. Parker's award, which will cliff vest in five years. The similarities bear notice. Other Nike compensation committee members include an executive from General Electric, the chairman, president, and CEO of Eli Lilly, and a retired CEO from TV One, LLC.
Additional questions exist on board and management oversight. For instance, three of the CEO's siblings work at Nike. Also, board member of more than 20 years, John Thompson Jr., is father to the head coach at Georgetown University, whom the company paid $258,000 in endorsements and consulting services last year.
Nike's share repurchase comes at critical time for the company. Inventories are up, along with overhead and the price of its sneakers - all at a time of worldwide economic concern and a decline in orders from key international markets. While the repurchase may inflate EPS over the short term, the company will require more than substantial name recognition to weather a tough economic environment that could see consumers retrenching and seeking less expensive alternatives.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.