Just Do What?

Nike is a monster. It is the largest athletic apparel and footwear manufacturer in the world.

It sports mouth-watering returns on invested capital (25-30%), and has been consistently growing revenues and EBIT in the 6-9%/year range for well over 10 years now.

It is a growing, profitable, wide-moat business with an iconic brand.

Its has sales of over $34B, net-income of $4.2B, which towers over Adidas ($20B sales) and Under Armour ($5.5B) sales. Footwear and apparel account for 65% and 30% of revenues, respectively; the remaining sliver comes from equipment sales.

International sales now account for over half of Nike’s sales (~55%). About 30% of its revenues are DTC (website and company owned stores). In the medium-term both these slices are likely to continue growing.

Unlike Under Armour, Nike is a shoe company gate-crashing into the apparel market. The total addressable apparel market is $135B, almost 2x that of footwear. The size of the market and the popularity of athleisure provides a tailwind, and a new market for Nike to grow into.

It has stellar management (interview with CEO), and high insider ownership.

Essentially it is a great business. Usually such businesses are not cheap.

However, a glance at its chart reveals that it currently sits close to its 2-year low.

Screenshot from 2017-10-08 16-49-46

Might this be a good time to ease into NKE? Before we look at valuation, it might be useful to understand what the bear case might be.

Amazon. Of course.

It is killing retailers (Footlocker etc.) which still account for a majority of Nike’s sales. It is also jumping into Amazon branded apparel.

While I respect Bezos too much to dismiss Amazon, I think the actual threat posed by Amazon to Nike is far weaker than perceived.

Nike is a powerful identity brand. Like Ferrari, Harvard University, and Rayban. Unlike Gillette, Tide, or Hanes underwear, whose brands were protected through the premise of lowering search costs. Amazon (or Dollar Shave Club or Kirkland) could kill such categories with their store branded products. And they probably will.

Perhaps a bigger threat is that the apparel industry is subject to fashion trends. Nike knows how to engineer performance shoes that are sought after. The transition to a casual fashion brand may be not be easy.

The game is different. Just because someone has a black belt in karate, doesn’t mean they will do well in the boxing ring.

Currently, the North American market environment is overly promotional. This will eat into margins. However, over a few years, one would expect this latest catfight for market-share to have play out, and settle. So while this does present short-term headwinds, perhaps we should be thankful to it for allowing us to buy a great company at a reasonable price.

Which finally brings us to valuation.

Graham’s formula for growth companies, suggests a fair P/E ratio of (8.5 + 2g). In NKE’s case growth is approximately 7% for quite a few years to come. So that would suggest a reasonable P/E of 22. For FY2018, EPS is expected to be around $2.40.

This would imply a fair value of 22*$2.40 = $53, which is close to today’s share price.

One could also use a terminal value formula to come up with an alternative fair P/E, and isolate the drivers of value.

P/E = Value/NOPAT(t+1) = (1 - growth/ROC)/(COC - ROC)

If we assume Nike is a truly great company capable of growing profitably for quite some time, we might assume growth = 7%, COC = 10%, and ROC = 25%. This yields a fair P/E of 24, which after subtracting the $2.50 debt/share brings us to a fair value of $55.

If we treat Nike like a solid (but not extraordinary) company, with growth ~ 4%, and ROC = 20%, we get estimates of value between $35-40.

Thus, despite the fall in stock price Nike is not really cheap. For $50-$55, we are, at best, buying a wonderful company for a fair price. It will probably turn out to be a fine investment. However, this is not a back-up-the-truck price, just yet.

In my opinion the $35 estimate provides a lower bound. It implies a P/E less than 15 for a company like Nike!

Given the liquidity of the stock and share price, NKE might be an ideal candidate for selling cash secured puts. I would like to try to build a sizeable long-term position in NKE, especially if I can reduce the cost basis to the lower of mid $40s.



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