In analyzing stock valuations, people often use the price-to-earnings ratio as a shortcut. The problem is, it is just that a shortcut. It is the stock price divided by the trailing 12 months' earnings per share. It is a simple measurement of past performance in a complex system that cannot be reduced to one number. P/E is a screening tool at best. It does not tell us enough about the most important factors of stock ownership: future earnings and cash flows.
Nike (NKE) has a P/E ratio of around 65, so investors are currently paying 65 times the last 12 months' earnings per share to buy the stock. If the last 12 months' earnings per share were to continue indefinitely, it would take 65 years to make your money back. So, initially, Nike looks extremely expensive. Thankfully, the appropriate price of a stock is based on a lot more than current EPS. Let's conduct a more detailed assessment of Nike's current earnings and project its future earnings to get a more accurate assessment of Nike's intrinsic value.
How Nike Makes Money
Nike is the leading athletic shoe brand in the world. It builds its products on the best research and development in the industry, wraps them in identity-driven designs, and attains endorsements from the world's top athletes to promote them. This business model has built a substantial moat and allowed the company to sustain superior growth over decades despite challenges in the economy, the industry, consumer behavior, and the company itself. Achieving market leadership has allowed it to become financially healthy and to shift its focus from profitability to sustainability.
Despite its maturity, Nike remains a growth-oriented company, and it is positioning itself to continue substantial revenue growth into the future. The company has the potential to automate much of its supply chain, allowing it to increase revenue from fast fashion and product customization and to reduce its labor and shipping costs, increasing its profit margins. Nike has the financial strength to invest capital toward future growth while continuing to improve sustainability and to increase its return of capital to shareholders every year.
Here are some visuals of how Nike's 2018 revenues break down, using figures from the 2018 Annual Report:
Nike's biggest sources of recent growth have been from the Greater China (+21% from 2017-2018) and Europe, Middle East & Africa (+16% from 2017-2018) segments. Apparel has grown +11% from 2017-2018. NIKE Direct sales grew by 15% and NIKE Basketball sales grew by 16%. The new NIKE Adapt shoes, which are now becoming more accessible to consumers, have the potential to be a game-changer for NIKE Basketball sales in North America.
The highlight of Nike's financial performance over the last 3 years is 2 consecutive years of 6% growth in sales. However, expenses have grown as well, and margins are tightening, but not at levels that would be concerning for a dominant market leader like Nike. The company's gross margin for fiscal 2018 was 44.8%, down from 46.2% in 2016, as cost of sales increased at 17.4% compared to a 12.4% increase in revenues. Nike attributes this to increases in "inventory costs, as well as warehousing costs (including the cost of warehouse labor), third-party royalties, foreign currency hedge gains and losses, and product design costs." Increases in selling and administrative expenses resulted in 1.3% decreases in EBIT and operating margin over the last 2 years.
The biggest impact on the bottom line in fiscal 2018 came from income tax expense. As I previously reported here on Seeking Alpha, Nike took advantage of the Tax Cuts and Jobs Act's opportunity to repatriate foreign cash, bringing back $1.9 billion in a one-time move that increased its fiscal 2018 effective tax rate to 55.3%. The $1,875 million repatriation expense created a one-time dip in net income that nearly cut Nike's EPS in half for 2018, but in the end, it will be a good thing. Due to U.S. tax reform and "variation in our mix of earnings geographically," CEO Mark Parker expects to continue having volatile tax rates over the next few years, but it estimates an effective rate in the mid-teens or slightly higher for fiscal 2019.
Nike's Financial Position
Nike is a model for financial health with a current ratio of 2.51 and a quick ratio of 1.45. While the company has a somewhat high total debt-to-equity ratio, it has very little long-term debt and more than enough current assets to cover both its short-term and long-term liabilities. The company's projected tax savings should allow it to reduce its long-term debt.
Nike's liabilities are 1.3 times equity, but its debt-to-assets ratio is only 0.56. GuruFocus calculates a trailing twelve month Z-score of 8.68, exceeding footwear competitors adidas's (OTCQX:ADDYY) and Puma's (OTCPK:PUMSY) respective scores of 5.47 and 5.84.
Nike has exceptionally healthy liquidity and solvency. It is not overly leveraged, nor is it slow growing. Most importantly, it is not dependent on debt to generate growth. With such an outstanding balance sheet, Nike has access to inexpensive credit that can provide extra capital when unique problems or opportunities arise.
Nike Revenue Forecasts
I typically like to apply an expectation of growth decay to financial forecasts. Seeking Alpha author Steven Chen, in his blog post on ROIC, turned me on to some excellent research on this concept available in Valuation: Measuring and Managing the Value of Companies by Koller and Wessels (2010). Based on this data, I prefer to assume growth rates will decay to their natural median around 5% with 4-8 years unless I see strong evidence otherwise. I have forecasted the next 5 years' revenues for each segment of the Nike Corporation based on industry outlook, regional economic forecasts, and the assumption of growth decay where appropriate.
The concept of growth decay is apparent in the world's largest economies at this time. We recently saw Apple (AAPL) reduce earnings guidance based on the expectation of slowing growth in China, where the IMF projects real GDP growth to slow from 6.6% to 5.6% from 2018 to 2023. The IMF also projects growth in advanced economies to fall from 2.4% to 1.5%. Global growth looks more stable with an expected reduction from 3.7% to 3.6%, thanks to rapid growth in India, Southeast Asia, and other emerging markets. I share their optimistic view on growth in India and Southeast Asia, due to a souring relationship between the U.S. and China, an interest among governments in the region to embrace capitalism and attract foreign companies, and a growing middle class of consumers among their citizens. The OECD released new numbers March 6th that are comparable to the IMF's, though slightly less optimistic, projecting global growth of 3.3%, down from their prior forecast of 3.5%.
Growth has been lackluster in North America for Nike and other consumer brands, but the company is targeting growth through direct sales, apparel, and women's shoes, which all provide tremendous growth potential in North American markets. Interestingly, the first two quarters of 2019 have shown strength in the Converse brand, which lacked in 2018. Here is a look at how those factors might work together to produce revenue growth for Nike:
Other Financial Performance Forecasts
Inflation and the Nike's sustainability campaign should result in a continued increase in fixed costs. The company's variable costs for 2018 were $0.69 per dollar. A recent 11.2% price increase in rubber, attributable to transportation issues in the fallout of the December tsunami in Indonesia, should increase variable costs for fiscal 2019. For these reasons, I am projecting a 4% increase in cost of sales each of the next 5 years, but revenue growth should be strong enough to allow for a slight increase in gross margins.
Nike's operating expenses average about 31.6%, and I anticipate that they will stay around these levels, as the company faces pressure to increase wages but can offset that with increases in productivity. Effective tax rates are expected to drop into the mid-teens and some increase from there over the next 5 years is safe to assume as the one-time repatriation benefit fades further into the past.
These potential increases in net income should enable the company to restore many asset and liability levels on the balance sheet to pre-2018 levels, to return cash to shareholders, and to increase retained earnings. Nike is about 3/4th of the way into a $12 billion share repurchase program that earnings growth should allow to continue. Earnings growth also enables Nike to continue increasing its dividend at similar rates as it has in recent years.
Using the above numbers and tools from Financial Reporting, Financial Statement Analysis, and Valuation by Wahlen, Baginski, and Bradshaw, I applied a weighted average cost of capital of 7.52% as a discount rate and came to a dividend-based valuation of $42.44 per share and free cash flow-based valuation of $42.59 per share.
If you would like a second opinion, GuruFocus offers an earnings power value of $30.88, projected FCF of $27.29, FCF-based DCF of $44.39, and earnings-based DCF of $18.23. Applying the 7.52% discount rate on Nick Kraakman's DCF calculator, which uses the average Wall Street analyst's 14.18% projected 5-year growth rate, we get a more generous $75.67. You can almost always count on those Wall Street analysts to be optimistic. They currently have an average price target of $87.48.
Most signs point to Nike being overvalued at the current share price, so the question is by how much. I have found the Kraakman calculator - combined with other valuation tools - to be very useful, and I worry that the GuruFocus numbers are more affected by 2018's one-time tax expense, so I am inclined to suggest that the actual intrinsic value is somewhere between $42 and $76, depending on how optimistic you feel about Nike's future earnings power.
A Point of Caution
The above forecasts are based on many assumptions and meant to be estimates to get an idea of what kind of growth we can expect in revenues, earnings, and dividends. Please do not take those numbers or the following numbers as specific expectations. Please also be aware of the many risks involved in investing in any stock and the risks directly associated with Nike, which you can read on pages 60-67 of the company's 2018 Annual Report.
I will leave you with some suggestions about how you might account for the possibility of a recession when considering Nike's value as an investment.
How Would a Recession Affect Nike?
There is a chance that an economic recession could slow growth in the U.S., China, or worldwide. The 2008 recession slowed Nike's growth considerably for a 2-year period. Revenue growth shrunk from 14.1% from fiscal years 2007 to 2008 to only 2.9% from 2008 to 2009. Revenues decreased by -0.8% from 2009 to 2010, then increased 9.7% from 2010 to 2011. Costs continued to increase, so net income decreased by 21.1% from 2008 to 2009, but it quickly recovered with 28.6% growth from 2009 to 2010.
Given how devastating the Great Recession was to many publicly-traded companies, these numbers are actually quite impressive. They indicate the low price elasticity that Nike's brand strength, technology, and partnerships offer. With Nike's continued innovation and its financial health, it is prepared to weather another severe recession, and that in itself may make it worth investing in at a bit of a premium. I personally am not comfortable with the current stock price, but Nike is at the top of the list of companies that I would choose to invest in if a major pullback in the stock market creates an opportunity.
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.