Monday, July 28, 2008

Nike Equity Analysis

Portfolio Suitability: In the last three years, Nike’s correlation to consumer discretionary sector is at 0.01. In simple terms, for the last three years, Nike’s stock doesn’t have any relation to the movement of consumer discretionary sector. So, even though Nike is considered to be a consumer discretionary stock, its stock isn’t behaving in line with the sector. The reason for this anomaly could lie in the fact that most consumer discretionary stocks are heavily dependent on US for their revenues while Nike isn’t. Infact, Nike’s three year correlation to the consumer staple sector is at 0.91 and at 0.89 to the utilities sector. This reinforces the theory that Nike will not be severely affected by a further slide in the US economy.

Sector Performance: Nike belongs to the consumer discretionary sector, a sector which we have been underweight since we started seeing some signs of an economic downturn in the US in June (2007) when an inverted yield curve puzzled everyone. An inverted yield curve is almost always a leading indicator of an economic slowdown since forward yields are low in one of the two circumstances; either the GDP growth is expected to decline or inflation is expected to decrease. However, with central banks worldwide having trouble keeping inflation at bay, the possibility of decline in GDP growth was more realistic. A decline in GDP wouldn’t bode well for the consumer discretionary sector and so we have been underweight on that sector for quite some time now. In the first half of 2008, we have seen a slowdown in GDP growth coupled with high inflation. However, the yield curve is now upward sloping and so GDP growth is expected to pick-up sometime next year (2009). This begs the question if it is a good time to get back into the consumer discretionary sector while it is still reeling from an effect of a downturn and selling at a discount; XLY - Consumer Discretionary SPDR - is selling close to its five year lows in the mid 20s. The yield curve is just one indicator of GDP growth and so I looked at performance of XLY during the last economic recession; I used the last recession as a point of comparison since the macroeconomic conditions would be the closest, if not the same, for companies operating in the last 10 years. As we can see in the first chart, XLY underperformed S&P only for one year – 2000 - during the last recession. We want to check the performance of XLY in the last one year; the next chart compares XLY’s performance with S&P in the last one year and it has underperformed the S&P by about 10 percentage points. However, given the current credit market turmoil, I was still a little wary of this sector. Focusing on companies with extensive international exposure would mitigate the risk of a prolonged downturn in the US markets and Nike tops that list, moreover, Nike is underpriced which makes for a good value investment.
Nike’s Stock Performance: NKE’s stock closely followed XLY during the first recession of this decade and underperformed the S&P for about one year in 2000-2001. In the last one year, Nike has outperformed the S&P by about 15 percentage points while XLY has underperformed the S&P by 10 percentage points. Clearly, Nike is not following declines of the consumer discretionary sector in this downturn and that could be because of its extensive international exposure. In 1999-2000, Nike’s revenues from US were at 52% while 34% of Nike’s TTM revenues are from US. The recent slide in Nike’s price is attributed to flat orders from US for the rest of 2008 and so a slowdown in the US is already priced in the stock. The market ignored Nike’s excellent performance in the international segment. Nike’s revenues are well diversified and a slowdown in any one region of the world is less likely to have a significant impact on Nike’s overall performance.
Growth Catalysts: In the short term, revenue growth from Olympics will continue to provide support to the stock price. Nike is sponsoring 22 of China’s 28 Olympic teams. Moreover, Nike is expanding its distribution in China to 500 cities in the next three years from the current 300 cities. Basketball is the most popular sport in China and Nike is well established in that segment worldwide and has extensive experience in US basketball segment. Soccer is one of the most popular games in Nike’s growth regions – EMEA, Asia Pacific and Americas. Nike was historically a second rung player in the soccer segment but is now pursuing it aggressively; Nike bought Umbro in 2007 to strengthen its position in the soccer segment. Nike’s soccer teams did extremely well in the 2008 European Championships with five of the eight quarter finalists sponsored by Nike. Nike’s focus on Soccer will also boost sales in emerging markets such as Brazil and Russia.
Industry Analysis: The athletic footwear industry is in consolidation mode and Nike’s two top rivals, Adidas and Reebok merged in 2006. The global sports footwear market is almost an oligopoly between Nike and Adidas-Reebok. Oligopolistic competition could be good or bad for the participants based on whether the participants engage in a price war. Oligopolistic competition between Intel and AMD proved to be destructive for the industry due to a price war while the same between Pepsi and Coke without the price war is beneficial to both companies. Fortunately, Nike and Adidas-Reebok have avoided getting into a price war. This may also be due to the fact that consumers of Nike-Adidas sports gear are relatively inelastic to price since that expenditure forms a small part of their total expenditure. The demand curve in such a market is kinked and so is inelastic to price decreases; firms don’t gain a substantial number of customers by reducing prices. In such cases, firms utilize non-price competition in order to accrue higher revenue and market share. By definition, participants in an Oligopolistic market have significant economies of scale advantage and present strong entry barriers. Nike has distribution deals with large retailers which guarantees shelf space; it also has a size advantage when negotiating sourcing and sponsorship contracts.
Valuation: Our valuation model yields a price of $68/share while its current price is $57.24; undervalued by 19%. The valuation model uses a short term CAPM cost of equity of 8% and a long term CAPM cost of equity of 9%. Net profit margin is constant at 10% since Nike has an excellent track record of improving profitability and its TTM net profit margin is at 10.11%.

A scenario analysis of the above valuation model shows that its current stock price of $57.24 reflects a lower net profit margin of 8.5% or a slower short term revenue growth of 6.5%. The probability of an 8.5% net profit margin or a 6.5% revenue growth is extremely low and hence its current price has sufficient built-in margin of safety.
Nike maintains a lower effective tax bracket (24.7% for the last quarter) since it doesn’t repatriate earnings from international operations and instead uses it to grow in those regions. We view this arrangement to be very beneficial since Nike’s stock value is extremely sensitive to net profit margins; a one percentage point change in net profit margin is equivalent to $6/share while each percentage point in revenue growth is equivalent to $3/share in Nike’s intrinsic value. In the last five years, Nike has traded in the range of 14x to 25x earnings and at an estimated EPS of $3.95 for FY 2009, Nike’s stock should trade in the range of $55 to $98. Nike will also have support on the downside from a $2.2 billion share buyback approved for the next two years; in Fiscal 2008 (May 2007 to 2008), Nike spent $817 million on buybacks. Nike is relatively inexpensive at a PEG of 1.1 and has doubled its dividend in the last two years. Moreover, insiders haven’t sold a single share in the last one year below $57.08 with majority of the sell trades above $66 levels. Given the current uncertain market conditions, Nike is a perfect defensive (beta at 0.85), underpriced stock and has significant upside potential once the markets get out of the bear territory. Overall, it’s a consumer discretionary stock with the downside risk of a consumer staple and upside potential of a consumer discretionary stock.

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