Description

Founded in 1964 as Blue Ribbon Sports by University of Oregon track athlete Phil Knight and his coach Bill Bowerman the company at first operated as a distributor for Japanese shoe maker Onitsuka Tiger.  In the early 1970s Blue Ribbon Shoes renamed itself Nike and launched its own line of footwear bearing the now ubiquitous ‘swoosh’ design which Phil Knight commented on at the time “I don’t love it but it will grow on me.” 

By 1980 Nike had attained nearly 50% of the U.S. athletic footwear market and went public in 1983.  Since then, apart from a brief period in the late 1980s when Reebok overtook it, Nike has been the leading global sports brand.

Our timing for looking at Nike was fortuitous given that its stock price had declined by nearly a quarter from an all-time high of US$67 at the end of 2015 to around US$51 today.  Of course, there are reasons why the market has repriced the stock, which are discussed later, however we believe it has provided an attractive opportunity to purchase part ownership of a company which should remain the clear leader in an industry which still has decades of growth ahead of it.

Why do we like Nike?

1.    Brand and scale in marketing

Nike is the leading global sports brand, a position obtained through four decades of clever marketing and endorsement of leading sports teams and stars.  This has created a loyalty among its customers.  One retailer we spoke to estimated that c.50% of Nike customers would only ever consider Nike when purchasing athletic footwear. 

In a self-reinforcing cycle, Nike’s scale enables it to continually reinforce this brand.  Nike’s marketing budget of US$3Bn represents 10% of revenue.  Adidas must spend 14% of revenue on marketing to compete and Under Armour with total revenues of US$4.7Bn is having to issue stock to entice sports stars to sign for them, a situation we believe long-term is unsustainable.

The power of its brand means Nike is one of a select group of companies that are able to continually raise prices above inflation without any impact on demand.  Though as a caveat we do not view Nike as one of the truly great brands such as Snickers, Colgate and Tabasco given that it is still exposed to the vagaries of fashion.  It cannot rest on its laurels and must continuously work to stay at the forefront of the fashion curve.  We have incorporated this fact into the quality scoring we have assigned to the company in our portfolio model.

2.    Unparalleled global distribution

The company has an unrivalled global distribution platform. Three quarters of the company’s sales are generated through 20,000 3^rd party retailers with 110,000 stores.  Nike’s position of strength in the value chain enables it to dictate to these 3^rd party retailers what product is stocked and how it is priced and presented.  In many cases these 3^rd party stores are exclusive to Nike.  The company also has a higher-margin, faster-growing ‘Direct to Consumer’ retail channel which includes its bricks and mortar Nike stores (of which it has over a thousand globally) and a fast-growing e-commerce platform.  The company’s ‘factory’ outlet stores are an important asset which gives it a retail channel through which it can dispose of excess or out of season inventory without diluting the brand.  In many cases retailers are forbidden from discounting stock and are required to return it to Nike which then sells it through its factory store network.

3.    Capital light business model

Nike operates a capital light business model.  Nike designs, develops and markets its products but outsources the low margin commoditised production of shoes and apparel to 3^rd party contract manufacturers predominantly based in Asia.  This capital light business model enables Nike to earn >50% on incremental capital invested.  

4.    Long runway for growth

Given that Nike is trading at a price to earnings multiple of 23x we had to get comfortable we could conservatively model future growth for the company.  There are several underlying drivers of growth:

Decades long trend towards sports/athleticwear footwear and apparel

Although ‘Athleisure’ is considered a recent fashion phenomenon people have in fact been trending towards sport/athletic inspired clothing for over a century.  Ironically the tailcoat, which is now considered the most formal of wear, was originally worn as a horse-riding sports coat.  We believe this trend still has room to go, especially given the ever-increasing focus and interest in exercise and healthy lifestyles.  There have been short periods in the past where this trend has gone into reverse, for example in the U.S. from 1994 to 1998 when hiking boots and casual leather shoes came into fashion.  However, the longer-term trend of sports shoes taking market share was ultimately robust enough to reverse this shorter-term fashion change.

Current underrepresentation by female customers

There is significant room for sports brands to increase the share of revenue generated from female customers.  The major sports brands only generate 15% to 25% of their revenue from female customers.   If the sports/athletic segment of the market was to converge with the rest of the clothing industry over time, then this percentage would rise to 65%.

Emerging Markets

Emerging Markets currently contribute 30% to Nike’s revenues.  We spent a lot of time analysing data on per capita consumption of shoes vs. per capita GDP and income.  When analysing the data, clear correlations can be seen between the wealth of the consumer and the number of shoes they purchase.  For example, per capita consumption of shoes tends to double as GDP per capita increases to over US$10,000, it then nearly doubles again as GDP per capita crosses the US$30,000 threshold. 

Furthermore, in emerging markets sports shoes on average account for 10% or less of the total footwear market whereas this figure is closer to 30% in the U.S. and U.K.  As consumers become wealthier in emerging markets they also increasingly switch from local to leading global brands as can be seen by the market share losses China’s domestic sports brands such as Li Ning have suffered over the past decade. 

We also spent time doing qualitative ‘on the ground’ work including a trip to Nike’s China HQ in Shanghai and stores visits there.  The popularity of western sports brands, predominantly Nike and Adidas, can clearly be seen when walking the streets.  Even at 9pm on a Friday night Nike’s flagship store in Shanghai was bustling with activity.

Product innovation driving increases in average selling prices

Nike has a surprisingly large portfolio of patents covering design and manufacturing processes.  These innovations enable Nike to charge higher average prices for new product releases.  As an example, Nike’s patented ‘Flyknit’ production process, which uses automated fabric weaving technology, allows for almost limitless pixilation.  The Air Jordan XX9 shoe features 25 million colour pixels allowing colour and shading previously unachievable.  Nike is able to charge a +20% price premium for these shoes generating a 60% gross margin versus its average of 40%. 

By modelling conservative scenarios for the combined effect of these various levers of growth we believe that it is highly feasible that Nike can double its revenue to over US$60Bn by 2030 and continue to grow it at low single digits from there onwards.  If Nike can do this while earning high returns on incremental capital invested, then the company looks to be trading at a significant discount to its intrinsic value.  This discount to intrinsic value should provide a margin of safety against the following bear cases, which we largely refute, that have been weighing on the share price:

1.       Threat from competitors Under Armour and Adidas

One of the main fears the investor community has towards Nike is the rapid growth of Under Armour and the resurgence of Adidas.

Founded in 1996, Under Armour initially found success with its ‘compression’ shirts worn by American Football players.  The company has gone on to sell a complete range of sports clothing and footwear competing head on with Nike.  An area of particular concern for investors is Under Armour’s success in the ‘signature’ basketball shoe segment of the market.  Under Armour’s success in this market has been built on the back of its endorsement of NBA star Stephen Curry.  In this segment of the market Nike has had to reduce prices on its competing signature LeBron and Kevin Durant shoes from US$200 to US$175 and US$180 to US$150 respectively.

We believe the market may be over estimating the threat to Nike.  The signature basketball product category accounts for less than 5% of Nike’s overall revenue.  In the North American basketball shoe market Nike still has over 90% market share.  Although Nike has had to lower prices in this category its most recent earnings results showed that Nike overall is still able to increase prices of its products on average.  Something the industry as a whole seems to be successful in doing:

“I don’t think it is fair to say that there is any significant drop in price.  Nike is a little under pressure in the basketball market because of Under Armour’s Stephen Curry success. For Puma a US$110/120 running shoe is now US$130 – it’s not the same shoe but we are not reducing prices for comparable products.” - Puma, Director of Strategy

In retrospect Nike made a mistake in not signing Stephen Curry.  The laws of probability will inevitably mean that Nike will occasionally make the same ‘mistake’ again.  However, the laws of probability also mean that in most cases Nike will beat its competition to signing up star athletes given the financial firepower its scale gives it.  For example, in basketball Nike endorses nearly three out of every four NBA players.

We have also heard from retailers that the Under Armour brand may be losing some of its shine:

“Under Armour is struggling in Europe especially at the higher end.  Customers associate it with retailers like Sports Direct.  They have a good story to sell in that they are the underdog and have some great endorsements with up and coming stars such as Stephen Curry and Jordan Spieth.  However they haven’t got their distribution right.  Also, their designs especially in shoes are poor, they just don’t make good looking shoes.  Sales of Under Armour in our stores is virtually nothing, we are considering dropping the brand.” – Sports store owner

Over the last couple of years the Adidas brand has had a resurgence with its success in the fashion orientated segment of the market.  This has been driven by endorsements of non-sports personalities such as Kayne West and the return to fashion of some of its classic brands such as the Stan Smith tennis shoes.  We believe it is instructive though to look at the long-term market share trends in the industry.  Over the past couple of decades the relative market share of Nike and Adidas has been remarkably stable with Nike on average being 1.9x larger than Adidas in terms of revenue with only small variations over time around this mean.

2.       Rising cost of endorsements

Industry sell side analysts have raised concerns over the impact the increasing cost of endorsement contracts will have on margins.  However, we think that this will if anything help to widen the moat Nike achieves through its scale.  As mentioned previously Under Armour is having to issue stock to entice athletes to sign for them, a situation we do not think is sustainable long-term.  We also analysed the economics of some of Nike’s largest endorsement contracts and were pleasantly surprised.  For example, we assumed Nike’s recent £900m 15 year sponsorship deal with Chelsea F.C. would be a considerable marketing expenses.  However after running the numbers we believe that this deal is at least break-even or even a profit stream for Nike.  This shows the power of Nike’s distribution, which enables it to generate free global marketing for its own brand!

3.       Rising manufacturing labour costs

Labour costs at Nike’s contract manufacturing partners have risen at double digits per annum over the last decade.  To date Nike has been able to negate the impact of these increases in labour costs (which make up c.25% of Nike’s cost of goods sold) on its gross margin through productivity improvements of 7-8% per p.a. and annual price increases of mid-single digits. 

The industry is now entering a period of seismic change that should further help Nike overcome rising input costs while at the same time widening its moat.  The shoe and apparel industries have been some of the last to automate. The vast majority of work is still done by hand with less than 5% done by machines.  However, this is likely to change with the introduction of new machinery and production processes.  As one example Nike’s Flyknit weaving technology can save c.30% of labour costs by replacing the traditional cut and sewing process for the upper part of the shoe.  These new manufacturing methods also reduce the amount of waste material as they are ‘additive’ processes rather than ‘subtractive’.  In other words, rather than starting with whole cloth and cutting down the materials to those that are required for the product, new additive methods start from zero and build materials into the product.  Nike currently spends over US$1Bn on material that does not end up in finished products.

Typically, we avoid investing in companies that operate in industries undergoing periods of significant change because of the uncertainty it brings.  However, we believe from Nike’s perspective the manufacturing revolution will be almost entirely beneficial. This is because it owns the IP to much of this technology.  Furthermore, its strength in the value chain means that it is its manufacturing partners who are having to make the capital investment in the required equipment rather than Nike. 

If automation of production more than offsets increasing labour costs, then Nike’s margins could expand significantly as the strength of Nike’s brand should enable it to retain this margin for itself rather than pass it on through to the customers.  However, this is something we are not assuming in our modelling though it could provide considerable upside.

Having spent several weeks analysing Nike’s competitive advantages and reaching a conclusion that it is priced at a sufficient discount to its true value we decided it was time to ‘Just Do It’ and add Nike to our fund.

Catalyst

Bear cases against the company not playing out.