Monday, July 8, 2013

The Pressure is Bulding on Nike

Nike (NYSE: NKE) is one of those companies whose results will interest the whole of the retail industry as well as its own shareholders.  And given its recent results there are many things to consider. It’s a story of strong execution in North America and with footwear in particular. However, its European markets remain weak and China is displaying the kind of softness that others are seeing.

In summary, Nike's prospects are reliant upon continued success within its North American operations and the belief that it will turn around its performance in China. If either of these things fail then the stock's evaluation will start to look a little stretched. The stock may have some good near-term upside drivers, but I think it also has downside risk and this article will explain why.

Nike triumphs in North America

In order to illustrate the importance of the performance of its North American operations I’ve broken out its quarterly earnings before interest and taxes (EBIT) below.

Indeed over the course of this graph, its North American segment has increased its contribution to overall segmental EBIT from 44.3% to 48.6%. Meanwhile China (traditionally its highest margin market) has disappointed and the only other regions to be at a high watermark are emerging markets and the CEE.

Moreover in terms of categories, footwear contributes two thirds of its North American revenues and the growth outside North America is largely coming from footwear.

Clearly the strong performance over the last years is thanks to North America and footwear globally. Part of this is – no doubt- due to the success of sponsorship deals with established stars in sports like basketball and running. Another favorable aspect is the trend towards casual footwear.

The last point is an industry trend that shouldn’t be underestimated. For example a company like V.F. Corp (NYSE: VFC) has some strong outdoor activity brands such as The North Face, Vans and Timberland. All three of these brands contain a strong superficial appeal to consumers but, not necessarily from those that do actually undertake mountaineering, hiking or skate boarding! People will buy the products just to be associated with these sports (and the lifestyle) even if they don't do them so -almost bizarrely- marketing efforts must focus on promoting these activities.

Growth opportunities

Aside from ongoing execution in North America, there are three main near-term growth opportunities.

Firstly, not only is Nike getting its marketing right but its multi-channel efforts are bearing fruit too. Direct to consumer (DtC) sales in North America increased 20% to $2.5 billion for the year while e-commerce sales up were up 30%. Again this sort of growth is in line with industry trends. For example, V.F. Corp is also investing in its DtC facilities in order to increase its share of revenues from 21% in 2012 to 23% in 2013. Overall Nike’s DtC revenues grew 24% (at constant currency) and now make up nearly 19% of total revenues. In a sluggish global economy I would expect more emphasis to be placed on this secular trend.

The second near-term catalyst will come from next year’s soccer World Cup in Brazil. Soccer gear only makes up 9.2% of total revenues but it is a strong category in emerging markets (which grew 19% last year) and a World Cup in Brazil (Nike sponsors the Brazilian team) will obviously have added allure. Nike should be able to generate revenue growth in strategically important markets.

The third catalyst could be a pick-up in performance in China. As ever investors will consider whether this is a macro or company-specific issue. On the macro side, even though Nike said that conditions hadn’t changed over the last quarter I note that V.F.Corp and others have been performing relatively weaker in China. Elsewhere there are signs that China is experiencing less rapid growth in its business sector then many may have hoped. Is this feeding through into the consumer?  On the company specific side, Nike has been undertaking concerted efforts to increase sales efficiency in China for a few quarters now.

The company is taking a long-term view over China, but for the very near term it expects Chinese revenues in the first half of its 2014 to be lower than last year and its future orders are flat on last year too. Any weakening in the Chinese economy will hurt Nike as the country currently provides nearly 22% of segment EBIT.

Where next for Nike?

Nike’s future orders indicate growth of 12% for North America and emerging markets, respectively, while Western Europe and China future growth is at 0%.This pretty much defines where the near-term growth will come from.

Analysts have low teens earnings growth penciled in for the next two years. I would argue that the stock is close to 'fair value'  as it is currently generating 4.7% of its enterprise value in free cash flow.This suggests that the best its stock price can do is to return its earnings growth over the next few years. There is nothing wrong with this because low teens stock returns are fine for most people. On the other hand these earnings prospects will rely on the issues discussed above. An increasing reliance on North America and footwear could place pressure on its performance whereas a stock like V.F. Corp has a wider and more diverse range of brands.

By way of comparison V.F. Corp registered mid-single digit declines with Timberland in Europe (its strongest market) but was able to offset this by generating an incredible 30% increase in Vans sales in the region. Moreover it increased its global DtC revenues for The North Face and Vans by 25% and 20% respectively. Clearly the company has more opportunity to shift emphasis onto brands/geographies that are working and it also trades on an evaluation discount to Nike. V.F.Corp trades on 18x this years earnings while Nike trades at nearly 21 times earnings to next May.

In addition from a historical perspective Nike isn’t particularly cheap.

NKE Price to Earnings Less Cash TTM data by YCharts

In conclusion, the stock isn’t really a value prospect but more of a growth at reasonable price proposition. Ultimately an investment decision will be based on how you view its ongoing growth prospects. So with a degree of uncertainty over China at the moment I think cautious investors would do well to wait for confirmation of better conditions there before buying in here. Its evaluation leaves little room for error.

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