Tuesday, December 24, 2013

Nike - Solid Company, Promising Future; but is its stock burnt out?

Nike - Solid Company, Promising Future; but is its stock burnt out?

Written: Monday December 23/24, 2013

As an Oregon native, my preference for athletic apparel lies predominantly with Nike. I love the company, it's story, its LOCATION etc.. But I must admit that those are all hometown biases. Moving away from that bias, this post examines the public companies fiscal Q2, as per its recent earnings release and its subsequent impact on its stock. I am indeed bullish on Nike's future outlook, but I do have my reservations that I will attempt to outline. I will also share my potential trade strategy.

 Summary of Results

The company posted total revenues of $6.4B (up 8% year-over-year) with earnings of $0.59 / share, beating Wall Street consensus estimates by a penny. Converse revenues grew 11% accounting for $360M of Nike's total revenue. Gross Margin increased to 43.9%, aided in part by higher selling prices, along with improved direct-to-consumer (DTC) performance which enjoyed a 20% increase in comparable store sales. Free cash flow (FCF) for this quarter, $492M, was considerably down from this time last years FCF number of $983M. In response to an analyst question towards the end of the earnings call, the company spoke about certain emerging market FX headwinds affecting the top-line, while other investment expenses applying upward pressure on selling, general and administrative expenses (up 14% y-o-y at $2.1B). My take is that these factors along with an increase in demand creation expenses ($691M) stemming from upcoming events - The World Cup, Olympics, product launches etc. - applied downward pressure on the company's FCF. Total futures orders, which can be a telling sign for a given company's outlook, were up 13% y-o-y, on a currency neutral basis. The company is also in the midst of an $8B share repurchase program, purchasing an additional 5.5 million shares this past quarter for around $4.2M. Lastly, inventories for the company were up 11% y-o-y.

 International Footprint

Internationally, Nike had mixed performance; with certain areas enjoying increased success and others still needing improvement. Western Europe saw currency neutral revenue and futures orders growth of 15% and 23%, respectively. CEO, Mark Parker explained that the company underwent a strategy reset in this region, adding a centralized organizational structure to help: manage relationships, enhance regional consumer focus with relevant product innovations, develop deeper brand connections and create a greater retail experience. As per the mentioned revenue and futures orders measures for this region, the shift in strategy appears to be working.

Another coveted region the company seems to be paying great attention to is China, where Nike only saw modest improvements in currency neutral revenue and futures orders growth. Revenue in this region grew only 5% with futures orders barely growing at 1%. Although a strategy reset has been initiated in China as well, it clearly has not yet had the same affect as it did in Europe. The company is looking to segment and differentiate points of distribution in China, which will potentially create a more focused consumer experience. Moreover, Nike believes their merchandise strategy needs to be much better in the region as well, and they are looking to work with their whole share partners to create a "seamless operating platform."

While China is yet to reach the improvement Western Europe has realized from the company's strategy reset, performance in Emerging Markets (EM) for Nike has had multiple stories. EM currency neutral futures orders came in far higher than the greater China region at 15%, however their currency neutral revenue, grew y-o-y at a frail rate of 3%. Although revenue growth in EM was fairly weak, the company is still very confident about their future performance in various emerging markets as much of the weakness was attributable to logistical complications in Mexico. The company explained that they had endured a rocky transition from their prior Mexican logistics partner to a new third party partner in the region. Shipments from their regional distribution centers to whole sale partners were delayed which caused inventories to build up in these distribution centers, creating a shortage a of Nike product in the Mexican markets. The company emphasized it was working with their new partners to ensure fluid logistical coordination in the region, and although they expect to ship at demand by the end of next quarter, it will take a few more quarters to fully straighten things out.

Future Progress and Innovation 

The company plans to continue innovating and launching impressive products, as it has been known to do for many years. Mark Parker cites new innovations such as color dry and its new fly knit technology among many others. Color dry is an impressive dyeing process, allowing the company to replace water with recyclable carbon dioxide in its color dye process, and provide more consistent and brighter fabric colors. The fly knit technology is a material the company has began to use across many different athletic shoes, most recently in the newly designed Kobe 9 masterpiece, worn by NBA all star Kobe Bryant. To my understanding, the material serves as the only material on the upper of a given shoe, in contrast to the majority of shoes, made by any company, which incorporate multiple pieces. In addition Parker has praised new technology used in newly released World Cup Soccer Jerseys for the French and Brazilian national teams. In the earnings call he stated:

"Each kit integrates technical performance innovation with team-specific design elements. The kits feature Dri-Fit Technology, engineered mesh and laser- cut ventilation for better cooling, and our lightest NIKE Pro baselayer ever. In fact, the uniforms are 16% lighter than our 2012 Euro Champ uniforms. And they are made of recycled polyester, using the equivalent of 18 recycled water bottles in every kit."

In addition to apparel product innovation, Nike has expressed its intent to continue investing and developing its digital ecosystem. This includes the development of digital products and services such as the Nike Fuel Band as well as the further expansion of its e-commerce business, which grew 33% y-o-y.  Parker however, is convinced that this business still has significant room to grow, as it is currently less than 15% the size of Nike's DTC business in terms of revenue growth. 

Conclusion; Company and Stock Outlook

Overall, I think Nike reported another reliable quarter. The company showed growth in all major businesses and has continued to reach out to the consumer in the most effective way for them. DTC sales can be difficult for some retail business to sustain due to added fixed costs, however Nike has enjoyed wonderful success in their direct-to-consumer stores. As this quarter is traditionally the busiest for Nike's basketball category, the company's brands, NIKE and Jordan, sustained significant growth and robust sales performance. Increased connections with the worlds greatest athletes has kept the company's basketball products the most innovative and consumer attractive in the world. This strategy has also helped Nike grow or gain market share in other sport categories as well. Lastly, continued innovation and investment in its digital platform offers great potential for the company. 
 In addition, the company has recognized its shortcomings and appears diligent in their efforts to improve any struggling parts of their business, as is evident in their strategy resets and realistic projections for better logistical performance in EM. From a financial standpoint, the company remains extremely stable; continuing to create shareholder value through its overall growing business, along with its dividend increases and its current $8B share repurchase program, executed by its strong executive and management team. 

I think Nike will continue to lead the athletic apparel and footwear industry, yet that notion seems to be priced into the stock as it trades at a price-to-earnings multiple premium, relative to the market. My reservations for the stock lie predominantly with its valuation. The S&P 500 currently has a PE ratio of around 18, while Nike currently trades at a PE multiple of roughly 26; significantly higher than not only the market but the industry average as well which has a PE multiple of 23.3. The other metric that stands out to me is its Price/Cash flow (P/FCF) ratio, currently at 22.8 for the company. The S&P has a P/FCF multiple of 10.0 while the industry average is 10.3. Although Nike appears to be a bit over valued as per these metrics, I'm still bullish on the stock as I think we need to take a look at these metrics relative to other comparable companies and brands and not the entire industry. Industry averages can contain any type of niche athletic apparel company, yet Nike should only be compared with other diversified giants such as an Adidas or rising competitors such as an Under Armour. Nike's PE multiple relative to these companies is actually low, with Adidas trading at a 36.4 PE multiple and Under Armour at 62.1. 

As described earlier in this post, the headwinds that brought FCF down were related to demand creation expenses revolving around future events and other investments. It was not as if the business had worrying struggles that ate into its FCF, and so I am not too concerned with its P/FCF multiple considering over a 5 year average this multiple is usually around 20. I also think it is worth noting that the company has a brand and consumer loyalty that almost any company would be envious of. I personally know people, who ARE NOT from Oregon, that literally will sport no athletic apparel unless it has the famed swoosh on it. Take a walk through the campus as well, and you will notice a corporate culture and atmosphere that is surreal on some fronts. These traits are near impossible to instill for some businesses, so maybe; just maybe, a premium valuation on the stock is indeed warranted. 

A variety of large mutual funds and institutions also own the stock, which in my opinion, protects it from unhealthy volatility as these funds are not typically looking to trade in and out of the name on a frequent basis, that is, barring any unforeseen events that would warrant a sell off. The recent earnings release disappointed some, however if this were a name in reasonable trouble, we would have seen the stock tumble far more than the 1.5 - 2% we saw it decline. We must also consider that the stock is up near 52% on the year and so expectations tend to get a bit overstretched for companies that have significantly outperformed their counterparts. Below is a list of the top 5 mutual funds and institutions that own the stock:

Mutual Fund Ownership -
% Total Shares Held
% Total Assets
Vanguard Total Stock Mkt Idx

Institutional Ownership –
% Total Shares Held
% Total Assets
Vanguard Group, Inc.
State Street Corp
Fidelity Management and Research Company
Capital Research Global Investors
BlackRock Fund Advisors
* Above data provided by Morningstar

Trading the Name

This last part of the post will focus on my potential trading strategy for the stock. Below is a useful chart to visualize some of my rational.

The chart above is a 6-month daily chart. The white lines I have drawn in are support levels I believe are critical to the performance of the stock. As of now the stock has held that $76 area bouncing to $77.66 by the close today. I partially think some of they hyped product releases such as the Kobe 9 Masterpiece shoe or events such as the Winter Olympics are already priced into the stock, however as they surface I think we can still see an uptick in the stock. Further, I think this is a name that investors want to own over the long haul and thus, I don’t think it will see a significant drop. For now I’m looking for the $76 level to hold for at least the end of this week before I would be interested in owing the stock outright. That being said, I would much rather own the stock around the $70 range, my next support level. That would entail a 10% drop however, which I don’t expect anytime in the near future, so my ideal spot to begin nibbling would be between $72-$76. I'd also like too see the MACD convergence line cross above the signal line which could indicate a shift in momentum. This is shown on the lower portion of the above chart.

As FCF for the quarter was down considerably from last year, I think the company will be able to work out its logistical issues in EM and decrease spending for demand creation over the next 12 months. This should help bring FCF at least back to even with its 2012 Q2 number of $983M, potentially providing a nice cushion under the stock. 

I believe a sideways pattern for this stock would actually be healthy for now, but I would not want to miss out on gains if investors begin buying this dip following earnings. I trade mostly options and so I am more inclined to use derivatives to take a position in or around the name. I am considering a February 75/80 long call spread. Buying the 75’s for about $4 and selling the 80’s for $1.32, giving me a net debit of $2.68 in my account. I think the stock definitely has potential to break above $80 here soon, but I feel safer buying an in the money call, and foregoing some profit if it hikes above $80. I also feel safer selling the higher call against the purchase of the lower as I can limit my loss to a predetermined value.

Thanks for reading, and HAPPY HOLIDAYS!

*Disclosure: I currently hold no position via the options market or outright ownership in NKE. I may or may not enter into a position in the near future.

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