Built for the Long Run
The athletic-shoe company's short-term problems are creating a buying opportunity for long-term investors. How it's battling rising material costs and Wall Street's lowered expectations.
Hard-charging Nike has tripped over higher input and freight costs. The stock dropped more than 9% last month after the athletic-products giant reported disappointing third-quarter results. But Nike is a marathoner, not a sprinter, and it will get back on track over the next year.
The drop in the stock (ticker: NKE), from an all-time high of 92 to a recent 80, is giving investors the chance to snap up shares of the dominant player in the growing athletic sneaker and apparel markets for a still-reasonable 16 times estimated forward earnings. Nike's long-term goals, which include boosting revenue to $27 billion by the end of fiscal year 2015 from $19 billion now, remain realistic; the balance sheet, ironclad. The company's operations threw off close to $6 a share of free cash flow last year, providing a juicy cash-flow yield of 9%.
DESPITE THE NEAR-TERM HEADWINDS, the Beaverton, Ore., sneaker king's earnings per share are likely to grow by double digits this year, and demand for Nike's swoosh-emblazoned products remains hot across the globe, especially in emerging markets, including China. Concern over rising material costs have obscured the 9% third-quarter rise in orders for Nike products scheduled for delivery over the next five months, reflecting impressive top-line momentum. And that figure excludes the currency-exchange boost that a weaker dollar is providing.
A Nike Free women's running shoe, designed to simulate barefoot running.
Nike management acknowledges that higher bills for oil, cotton and labor could continue to put pressure on the company over the next year. But they expect to offset this by pushing through across-the-board price increases on sneakers and apparel in coming months. In the meantime, Nike is leveraging its supply chain and controlling costs to bolster its bottom line.
After slipping to 75 following the disappointing earnings report, Nike has recovered to 80, down 6% for the year. Bulls, like Marie Driscoll of Standard & Poor's, think that the stock could surpass its previous high over the next 12 to 18 months, if the price increases stick and consumer spending remains stable. "Nike is one of the better-situated companies to deal with cost pressures, given its strong brands, deep relationship with vendors, pricing power and economies of scale," comments Driscoll, who has a Buy rating on the stock.
Nike, co-founded in 1972 by Chairman Phil Knight, who retains a more than 25% stake, rode the blast-off popularity surge of basketball great Michael Jordan to sole dominance. But while the company's signature Air Jordans remain best sellers, Nike is much more than high-priced performance kicks. Footwear generates 62% of revenue, but apparel, which produces 31% of sales, is growing faster. U.S. apparel is up 18% this year. Equipment chips in 6% of sales. Nike also markets the brands like Cole Haan and Converse.
But while most of its businesses grew in the recent quarter -- overall sales were up 7% -- higher input costs held results below expectations and chased some investors to the exits.
On March 17, Nike said that its gross margin had fallen by 110 basis points -- 1.1 percentage points -- to 45.8% during the quarter, which ended on Feb. 28. Among other things, the footwear maker blamed higher freight costs, incurred, ironically, to satisfy strong demand for its products.
NIKE OFFICIALS DECLINED TO COMMENT for this article. But if they're sweating their ability to eventually beat rising costs, Chief Executive Mark Parker and other company executives didn't show it on their third-quarter conference call with analysts. "We're using our size and scale to leverage our supply chain and negotiate costs to help maintain profitability in challenging environments," Parker said.
Although Nike has already started pushing through selected price increases, in advance of the general increases on a broad array of products to be shipped in the second half of 2011, some critics knock the company for being slow to execute. The current round of new prices won't be reflected in profit-and-loss statements for three to nine months, say analysts. Still, the prices should stick because Nike's core customers are young, fashion-conscious and not easily dissuaded by having to pay a few bucks more for what they really like.
In addition, Nike is increasing production modestly, which, along with controlling costs, should help stabilize results. Analysts think that a gradual shift to apparel should also support margins. Some analysts look for Nike's overall gross margin to recover to 46.1% by fiscal 2013, which begins on June 1, 2012, from an estimated 45.7% this fiscal year. And Morningstar analyst Paul Swinand contends that operating margins eventually will grow to 14%, from 13% now, owing to increased product-development, supply-chain and distribution efficiencies and increased scale in emerging markets.
Driscoll expects Nike to post solid earnings growth this fiscal year, to $4.19 a share, from $3.86 last year. That will be driven in large part by an 8% uptick in revenue, to around $21 billion. The analyst sees higher international, direct-to-consumer and apparel businesses boosting the top line.
Improved pricing could help earnings jump to $4.86 a share next year, on $22 billion of sales.
The Bottom Line
After hitting a record 92 late last year, Nike is at 80.19. Bulls think that it could reach a new high over the next 18 months, if, as seemly likely, it can raise prices without hurting sales.
NIKE AND WALL STREET are also betting that the general sports-sneaker and apparel markets continue to expand amid the slowly recovering economy. Sneaker sales in the U.S., for example, climbed almost 8% last year, to $20 billion, according to Charlotte, N.C.-based marketing and research firm SportsOneSource. Nike has 35% of that market, well ahead of Skechers (SKX) at just 6%.
Improving industry sales and strong quarterly results helped Nike's stock recover after falling to 66 last summer, and some investors used Nike's third-quarter earnings miss -- its first quarterly shortfall since 2006 -- as a reason to take profits.
Goldman Sachs analyst Michelle Tan cut her rating on Nike to Neutral from Buy, following the earnings release. Tan noted that Nike's stock tends to lag behind the overall market when the company's annual gross profit growth falls below 10%, which the analyst expects to happen for the first half of the 2012 fiscal year.
Susquehanna analyst Christopher Svezia asserts that the stock could even fall to 70, or about 13% below the current level, if management misses on fourth-quarter results and gives a "weak" outlook, which is possible. "They're going into tough comparisons with significant production cost headwinds and [likely] higher SG&A [sales, general and administrative costs] with the start of the buildup to the 2012 Olympics," says Svezia, who has a Neutral rating on the stock. Nike will outfit several athletes at the Olympics, which will be held in London.
Some critics also sniff that Nike's price-to-earnings ratio, which exceeds analysts' long-term earnings growth expectations of 12% to 15% annually, is too lofty for a dented growth stock with near-term cost issues. But Nike's valuation is generally in line with the average for peers such as Under Armour (UA) and Deckers Outdoor (DECK). Bulls like S&P's Driscoll argue that Nike -- with its savvy management, excellent performance history and diverse portfolio of leading brands -- deserves a premium.
Nike is trying to ramp up its sales of high-margin apparel.
Furthermore, while smaller rivals such as Under Armour might be growing faster, Nike's propensity to return cash to shareholders make it a "safe" bet, says Driscoll, who sees the stock trading at 99 in 12 months, or 20 times her fiscal 2012 estimate.
Over the past three years, Nike has doubled its quarterly dividend, to 31 cents a share, and repurchased about $3.4 billion worth of its shares.
Nike also offers outsize exposure to emerging markets, in which its sales grew 19% in the third quarter. Sales in China, where Nike is the leading sports brand, rose more than 20%, to $554 million. The China total is expected to hit $2.3 billion by fiscal 2012, analysts estimate. But business in North America wasn't a slouch either, growing at a 9% clip in the quarter.
Nike might be winded, but the sneaker maker and its stock are built for the long run.
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