Description

Summary

Nike is a well followed company but the last write up on VIC was almost seven years ago, so I thought it might be worth writing about it after the recent sell-off. Amongst large caps, I believe Nike is a high quality and well-managed company that is worth a place in a long-term oriented portfolio, especially for those that need to invest in large-caps, in this environment where most high quality companies are selling at such steep valuations.

Bear in mind this is not a write-up about which brand will outperform over the next quarter or two. I am writing this from the perspective of a business owner who is willing to hold on for five plus years. I think the odds are in your favor over this time frame. Nike seems to be another case of an investment in which investors place too much emphasis on near term missteps and competitors’ temporary strength and under-weigh all the great things Nike had done in the past, their long-term competitive advantage and the possible good things that might happen (perhaps not the next few quarters but most likely in the longer term) based on their historical track record. 

Business

From their 10k: NIKE designs, develops, markets and sells athletic footwear, apparel, equipment, accessories and services worldwide. The critical point in the sentence above is that NIKE doesn’t actually make any of their own products, because from a strategic logic perspective, manufacturing is the most commoditized part of the value chain and it brings no benefit from doing it themselves. For shoes, third party contract manufacturers in Vietnam, Indonesia, China (50%, 27% and 18% respectively in FY2024 ending May 31 2024) make them. For apparel, factories in Vietnam, China and Cambodia (28%, 16% and 15% respectively) make them. Hence from a supply chain perspective, China is not as high of a risk as it used to be. 

Nike is currently the largest seller of athletic footwear (shoes are 2/3 of overall sales) and apparel in the world. Globally, Nike sell in 190+ countries through NIKE Direct Operations (ie., Nike owned retail stores, direct digital channels) and wholesale accounts (independent distributors, licensees and sales representatives). Nike has >1000 stores it operates (1/3 in US, 2/3 outside US) and ~6000 franchisee stores (mostly in Greater China). Some key metrics below.

A few high-level stats for Nike from FY2024 (ending May 31st 2024): $51.4M revenue (of which $2B is Converse and the rest Nike and Jordan) vs $51.2B in FY2023. Direct was 44% of revenue. Gross margin 44.6%, EBIT margin ~12%. Company reported TTM return on invested capital of 34.9% (more on this below). Sidenote: isn’t it nice when the company you’re looking at is already *actually* profitable and you can analyze it without using some kind of “Adjusted” numbers to make them *appear* profitable.

Again, I take this from the MD&A section of the 10k because it’s critical: Our goal is to deliver value to our shareholders by building a profitable global portfolio of branded footwear, apparel, equipment and accessories businesses. Our strategy is to achieve sustainable profitable long-term revenue growth by creating innovative, "must-have" products, building deep personal consumer connections with our brands and delivering compelling consumer experiences through digital platforms and at retail.

I think they said it better than any paraphrase I could have done and they have shown over the years they do stick to this formula to deliver the shareholder returns. Just look at the numbers below and I think it’s evident the company have delivered. Obviously, past performance is no indication that the business will continue to do so well, but it’s still better to understand the history than not. Who could have predicted selling something so commoditized can be so profitable for so long? Things never go up on a straight line and to the right (like on sell-side reports) but over the past 19 years, top line grew on average 7% each year while net income grew 10% on average. Op margin has been surprising consistent, averaging around 13% during the 20 years (so no “operating leverage” improvement that you see in most models �). It’s also interesting to see that between FY2005 and FY2024, revenue 3.7x, net income 4.7x, EPS went up 6.7x! because share count today is 70% of what it was when the period began. Isn’t it interesting if you can have a consistently good business that produces increasingly more cash, you really don’t need to do magical things for real earnings power per share to go up. 

Lots of Competition and Some Competitive Advantage

Lots of competition..

There is no doubt Nike sells very simple products. There might be some “tech” that goes into some shoes, apparel or equipment but the basics don’t change very much and I argue whatever “tech” that goes into these running shoe soles aren’t that hard to be taken apart and copied by competitors. Trends also come and go. Hoka and “On” seem cool today but more likely than not, the next trend comes along and they are soon forgotten. If we have better memories, we remember the And1s, Reeboks and even Under Armours that “nearly” took over the world. But they are all quite insignificant today, without scale and with Nike the clear leader.

On Nike’s 10k, it lists the following as competitors: adidas, Anta, ASICS, Deckers, Li Ning, lululemon athletica, New Balance, On, Puma, Under Armour and V.F. Corporation. You can think of many more: reebok, Lacoste, Brooks, Hoka, Fila, Onitsuka tiger, Wilson, Yonex, Sketchers, even Uniqlo (Federer wore a bit of Uniqlo towards the end).. the list doesn’t end. 

Nike’s gross margins (45%) is actually lower than Puma (47%), Adidas (51%) and Under Armour (48%). Lululemon and On have gross margins approaching 60%, because they have higher price points on average. So at the COGS level, it’s likely that all these brands use overlapping set of contract manufacturers and scale actually don’t bring much benefits. Even though Nike is 2x Adidas’ size, they are clearly not squeezing or choosing not to squeeze their contract manufacturers a bit more.

So what is Nike’s edge vs competition

Even though Nike’s revenue base in FY2024 of $51B is 3.7x that of FY2005, its op margin really hasn’t improved that much. While in absolute dollar terms, its EBIT dollar increase would be the envy of 90% of companies out there, op margin today actually is lower than what it was almost 20 years ago. Most analysts would have you imagine that as revenue base increases, there’s some kind of magical “operating leverage” that happens in *every business* and that things would be great. This is clearly not the case for Nike. Why is this so? Obviously, when the business gets bigger there inherently come layers and layers of bureaucracy and fat. But I think this is not it. My argument is the cost of doing business in this industry just keeps going up and only by spending an increasing portion of revenue on paying the very best athletes, doing fancy ads, the sales and marketing, the research, and the SG&A can Nike maintain its “differentiation” vs competitors.

Digression into market share

Obviously, it is not easy to delineate between sports and non-sports shoe/apparel these days with the uptick in athleisure trend and most people wearing sportswear for non-sports purposes and traditionally non-sports focused brands threading into sports categories. However, Nike holds ~18% of global sportswear share, about 2x that of Adidas, according to EuroMonitor. In North America, Nike has 18% share vs Adidas 5% and Lululemon 4.5% in 2023. In Europe, Nike has 18% vs 12% for Adidas. In China, Nike has 23% market share in 2023 vs local brands of Anta and Li Ning which both have 20% and 10% respectively.

Entrenched brand that gets more entrenched..

Precisely because there is little, if any difference, between the products, much about the business is about who can spend the most to create the best brand image for its products. Nike breaks down its SG&A into what they call demand creation expense and operating overhead. In FY2024, Nike spent $4.3B on “demand creation expense”, which consists of advertising and promotion costs, including costs of endorsement contracts, complimentary product, television, digital and print advertising and media costs, brand events and retail brand presentation. This is ~8.3% of revenue. 15 years ago, they were spending $2.4B (12% of revenue). I say this is the real useful stuff that maintains the edge, the money that pays LeBron James, Caitlin Clark, Christiano Ronaldo and back in the day Federer and Nadal, and to have their logos on team USA/Germany/China jerseys, plus the fancy ads we see on tv, etc. 

Nike is a good business today precisely because it actually is playing in the most competitive of industries. Contrary to popular beliefs, there is little, if any, loyalty in the Nike brand, or the Adidas brand or even Lululemon or On or Hoka for that matter. Brands will come, and brands will go. You can argue the only thing that’s saving Nike is the $4B+ they spend to appear alongside the best athletes, the best sports teams, to make the most fancy ads and being able to raise the game and keep paying the best athletes more because of their scale. In fact, they should spend even more on this demand creation expense (and cut management fat to fund it) to make these endorsement deals even more unaffordable for the Adidas, Pumas and Under Armours of the world.

Borrowing Nick Sleep’s “scale economies shared”, I call Nike’s business model scale economies shared, not with customers but with the athletes. Obviously, because they are at a 2x scale vs any of their competitors, they can afford to pay the most (if they want to) and make it unaffordable for all the other players vying for the same athletes, teams and leagues. Who else can afford lifetime deals with Christiano Ronaldo, Lebron James, Kevin Durant while at the same time pay to be the uniform provider of NFL, NBA and MLB? Nike spent $1B (8 year deal) to replace Adidas (who was paying $400m over 11 years) beginning 2017/18 season. And they replaced Reebok in the NFL, paying a lot more for sure.

Another amazing stat: three quarters of NBA players wear either Nike/Jordan and 50% players in 2022 FIFA world cup wore Nike. And this https://www.wsj.com/sports/basketball/caitlin-clark-nike-deal-415ee8ec

And sometimes they don’t even have to pay top dollar to get best because of their history with the best. Remember, the next generation of the very best grew up watching and idolizing the last generation of greats and what do the last generation wear? A lot of Nikes! And sometimes it influences athletes’ decisions. This article (https://www.esquire.com/sports/a43580533/jeff-benedict-lebron-james-book-excerpt/ ) talks about Lebron James picking Nike ($90M) over Reebok ($115M). I mean he probably figured he’ll make much more over the long run with Nike but it also shows sometimes Nike doesn’t have to pay the most and still win. 

Excerpt from the article: A week later, Nike sent a private jet to bring LeBron, Gloria, and Maverick to Beaverton, Oregon. Nike’s corporate headquarters lacked the glamour of an oceanside mansion. But for LeBron, being on the Nike campus was like entering a fantasyland. There were buildings that featured larger-than- life images of the immortals—Michael Jordan, Tiger Woods, Bo Jackson. LeBron entered the Mia Hamm building and walked down a long hall- way lined on both sides with glass cases containing Air Jordans and other iconic sneakers worn by NBA stars. At the end of the hall was one empty case that was illuminated by a light, making it easy for LeBron to envision his shoes in the hallowed passageway.

Basically, as long as Nike doesn’t f-up too much with their brand, they will most likely sign the highest percentage of the each generation’s best athletes because either they can pay the most and keep upping the ante (scale economies shared with athletes) or because these young athletes grew up idolizing the greats who wore Nike. What we have to remember is this pool of the best that matters never gets bigger. There are always only the same number of top 10 tennis players, top 10 soccer players, top 15-20 nba/nfl players that really move the needle. But the cost to get this select set just goes up each year as these athletes’ influence goes up (with live tv, social media clips, etc., they really do reach the entire world) and the interest/willingness for fans to spend on these athletes goes up. 

On the other hand, the smaller brands can only afford a handful of the best athletes. Under Armour basketball has Curry and who? (https://underthelaces.com/posts/under-armour-curry-12-team-usa-colorways-paris-2024-release-info-details-images-01j5c98f6akg) Side note: Joel Embiid signed with Skechers (there you go again, in theory any brand can challenge Nike, in reality, they can almost never have the wallet size to match Nike’s). 

Nike spent $12B (24% of rev!) of that FY24 $16.6B SG&A on operating overhead, which they say consists primarily of wage and benefit-related expenses, research and development costs, bad debt expense as well as other administrative expenses such as rent, depreciation and amortization, professional services, certain technology investments, meetings and travel. Much of it might be of real use (say fancy stores to reinforce the brand image, the Running app you get for free, etc.) but much I believe is corporate speak for a lot of fat that can be cut to spend even more on the next LeBron or to increase earnings.

Yes, in the short term, some trends or technology might have an edge. Like every brand is now crazy finding the “best” foam for their running shoes to cater to current consumer taste. I’m not a runner, so I can’t tell, but I’m sure it matters a ton for those who run 26 miles regularly. https://www.wsj.com/business/running-shoe-cushion-foam-technology-comfort-1db65b04 

Say even if this “tech” matters (a lot), and now Nike is falling behind, remember these guys have $12B in SG&A, is it really that hard for them to put whatever million they need to hire a few scientists and take apart a Hoka to replicate the same? Of course not! Even today, Nike spends just 1% of revenue on R&D and that’s already $500M (say you assume these “scientists & designers” cost $300k per person all in, that’s more than 1500 people running around working on how to make athletes jump a bit higher or run a bit faster �. And they don’t have enough brain cells to replicate a Hoka?) #2 Adidas today spends EUR151m on R&D. The argument here is Nike really can afford a few missteps (missing consumer taste, tech) and still catch up.

And then it comes back to who can put out the best ads, sponsor the best runners and pay to go to running clubs. 

https://www.wsj.com/business/nike-running-sneakers-competition-1d735fc8

In summary, Nike should be able to consistently get the very best athletes and retain consumers’ imagination that their shoes are “better”. Yes, once in awhile, some brand can go viral on Tiktok, but these are very feeble right? Some brands might get lucky getting the next Federer early on. But it’s okay right? The higher Nike can raise the cost of sponsoring the best players and the best teams (there will always only be 10-15 NBA players that matter, 5-10 tennis players that matter, etc.) the longer they can maintain this edge and put out the best marketing campaigns. The more we all see Nike everywhere, the longer Nike is ingrained in our brain, the more stable their edge in branding becomes and the more they can survive missteps like forgetting how to make the next “high tech” shoes. Btw, if you tuned into the Olympics, you still see tons of Nike, some Adidas and almost no On, no Hoka – that’s more reinforcement. They recently signed a 100m euro deal the German national soccer team (and Adidas is obviously German).

https://www.wsj.com/business/retail/nike-and-adidas-dont-want-to-share-the-olympic-podium-e4f48e9b 

Best distribution (maybe)

Obviously, they have some edge in distribution too. Perhaps the wholesalers like Footlocker, Dicks can never afford to drop Nike but I’d argue direct to consumer has blunted Nike’s edge here. Most brands can sell online DTC at pretty low cost these days. And there’s Amazon, Zappos, Tmall (Alibaba) etc. Whether being on Amazon is a good strategy or not, that’s for another day, but it’s an option that was not available to any newcomer in the past. And it’s also an option today to go viral on TikTok/Instagram and sell DTC. Retail partner shelf space still matters (more on it below) but perhaps less today. 

Recent Problems

2024Q4 wasn’t great. Revenue was down 2%, NIKE Direct down 7%, NIKE stores down 2%, and NIKE Digital was down 10%. Wholesale grew 8%. North America down 1%, EMEA up 1% and China up 7% (which is a big disappointment because it included contribution from an earlier Tmall shopping “holiday” – think equivalent of Amazon Prime day). They guided FY25 revenue to be down mid-single digits with the first half down high single digits and obviously stock sank like a rock. Next quarter topline will be down 10%.

They guided SG&A for the year to be up with more “demand creation” expense “to ignite brand momentum and maximize reach and impact” which is probably a good thing for the long term and much better than them pulling back to make good short term earnings. 

There were two problems that are most talked about. The first issue being shifting sales from retail partners to DTC where they had better margins, perhaps too aggressively. They actually dropped one third of sales partners and sold less to Foot Locker, Macy’s, etc. Bad move! I say really stupid (despite distribution being less of an edge today than in the past, it still matters a lot right!). CEO’s excuse was they had supply chain issues and hence was forgoing lower priced shoes and these retail partners sell these lower priced shoes. I just think it’s a bad mistake and a bad excuse. When you pull back, you are letting your competitors capture more of Foot Locker’s shelf space, you are letting your customers try your competitors’ shoes, and when they try, they might just buy their shoes right? You’re giving your edge away. Of course you want to hog as much shelf space as you can so your customer can never try the new brands. Yes, new brands can still sell online (lower odds buying a new brand without trying) or opening their stores (high upfront costs). Thank god they are reversing this. Management simply overestimated their brand power. It really shows how fickle consumers are and there is little brand loyalty here. All those ad dollars matter, all those endorsement deals to make your shoes seem “better” than they are matter, and as much shelf space as you can hog matters.

Good article here: https://www.wsj.com/business/retail/nike-reverse-innovation-stalls-rivals-gain-c3ed8e63?mod=article_inline

The 2nd issue that has been talked about is Nike falling behind the likes of On Running and HOKA in terms of innovation. Apparently, instead of figuring out what runners want, Nike started betting on NFTs for god sake. Perhaps Covid really made these guys think we will all be running in the virtual space and they have to start monetizing the Swoosh there. All I can say is luckily they are running a business that can afford a few really stupid decisions and still make $6B EBIT in the past few years. A sign of bad management (bad)? But also a sign of a good business that even an idiot running for a bit and it’s still okay (good)? I think one part is consumers willing and wanting to try new brands and to wear something different (to feel different) and another part is Nike inviting competition with these dumb moves. If it’s more the former, it would be a bigger issue and I’m not denying at some point, we don’t want to be all wearing the Swooshes. It gets boring after awhile. This is the biggest risk long term. We are all okay drinking the same coke or buying the same Geico car insurance, but to make it be clear, we don’t want to be all wearing the same Nikes and Jordans. So there’s a risk of saturation, which begs the next big question, can they grow again?

https://www.wsj.com/articles/nike-buys-into-nfts-eyeing-real-money-from-virtual-sneakers-11639926005?mod=article_inline

If you watch many of those who wear “On” on New York City streets, many of them do not actually look like someone who can run a few hundred meters without panting. I think the bigger worry here is many who wear Nike do it more for fun, to look good, to associate with the best athletes, and if consumers start wearing “On” or any other brand to look cool, and Nike loses its edge, it’ll be terrible (very bad indeed). Again, the “tech” is besides the point. It’s back to making consumers feel good. Nike has to make consumers feel cool again and again and again. It is a real risk that Nike becomes not cool to wear. But on the balance, with the amount they can spend on ads/endorsements and making cool looking shoes, I think they are still the best horse to bet out there (over the long term).

Can they grow again?

I am going to pull a number out of thin air and assume sportwear market should grow a bit faster than global GDP – say 5% (some strategy consultants think it’s more like 7% - but it doesn’t matter – just need to be roughly right here) - as the rest of the world get richer, they should spend more on sports and sportswear like the Western world. When you are pulling weeds to grow rice, you don’t spend time hitting a yellow ball across the net. When folks get richer, they have more time, and they just run for fun (instead of for their lives) and become more willing to splurge a bit on fancy shoes/apparel to feel better about themselves. Anyways, 5% out of thin air. Let’s not forget, there are millions of Indonesians or Latin Americans who are still dying to get their first pair of genuine Jordans or Christiano Ronaldo cleats when they can afford. Even if the Chinese consumers slow down (a lot), there is some natural hedge in the business, because athletic brands actually “travel” pretty well (those Buffett fans would have remembered him saying See’s Candies just don’t travel well outside the West Coast – Nikes and Jordans fortunately do). 

If the above market share data from Euromonitor is right, Nike has an 18% market share globally. And let’s just assume they can hold on to this share by doing all the above and not mess up too much, it is not too crazy to think they can grow around 6% top line for the 5-6 years after the 5% decline this coming fiscal year to maintain share, given their scale advantage. And if they can just maintain share, by definition, their shoes should not be saturated (yet, hopefully). Of course this growth won’t be even, real life is never even growth. 

Capital Allocation track record and Valuation 

With the growth rates above, revenue should hit ~$65B during FY2030 and let’s also assume they can do 12.5% in *real* profit margin. They did 12.9% during those peakish years of FY2021 and FY2022, so 12.5% in 5-6 years don’t seem outrageous. That’ll be $8.2B in net income in FY2030. 

If you look at the chart above, these guys are consistent share buyers and share count today is ~70% what it was 20 years ago. So you can almost bank on them reducing share count if things don’t suddenly go hell (and they can’t). They currently have a four-year, $18B buyback program announced in June 2022 and they have done $9.1B as of May 31, 2024. And they generated ~$6.5B FCF last year and has $11.5B of cash against $12B debt on the books. So you can bank on them buying back 2.5-3% of shares (2.5% buyback costs ~$3B at current share prices ($83) + $2.2B in dividends). If share price goes up, they can’t buy back as much, that’ll be okay too because the stock went up! With that cash on balance sheet, ability to generate at least $4-5B FCF, and that history of consistent buyback, this is not all that hard to do. 

Share count would drop from 1.5B today to 1.3B by FY2030. That means an EPS of $6.20-$6.30 for FY2030, and assuming a forward 20x PE (which is not outrageous I say), shares should be worth ~$125, meaning a 50% return in 5 years. Not great, but not too bad for a business that is definitely better than the average business in the S&P, especially in this environment when all the good large caps are not cheap. For the long-term holder, you in fact want the stock to go down a lot the next few quarters, given their ability to buyback aggressively and the long term advantage of the business (borrowing Buffett’s words again). And you get a 1.5-2% dividend while you wait. My advice is don’t buy if that’s too little upside (and too much risk) for your liking and just wait and perhaps it will would become more attractive (this was a ~$70 stock just a few weeks ago).

Another thing that is useful is when management calculates and posts their ROIC numbers, whether they truly care or not, it keeps their perspective for shareholders in tact. Nike has one on their 10k, which I take it as a good sign. For the long term holder, I’ve found that companies that care about ROIC tend to do less bad than those who don’t (how could it be otherwise). 

Something else to point out. Historically, other than buybacks, these guys do the occasional M&A. They bought Converse for $305M in 2003 when it was doing $205M in 2002 sales. Today Converse does $2.1B and $500M operating profit. If you assume a 20x EBIT multiple on Converse, that’s worth $10B today – that’s 30 bagger in 21 years – on top of all the cash the brand has generated – not too bad actually. They also had Cole Haan (bought for $95M and sold for $570M after 24 years). They divested Hurley in 2019 – didn’t disclose how much they lost or made. But I think net-net, they do a more than decent job with M&A.

In summary, I think this is another case of market overweighing the near-term concerns (fleeting fierce competition, bad management moves, consumer slowdown) and underweighing the company’s long term competitive strengths (scale economies in endorsement deals, advertising). If you read through those sellside reports, you’ll see “no catalysts” near term, no attractive product launches near term, or too much competition and “long term profitability” unclear – since when do they care about the long term. 

Ideally, a cheaper valuation would make the thesis more attractive but I thought the risk reward is decent enough for someone with a longer time horizon (at least 5 years) and who craves good sleep over fast rewards. This is not for those guessing which shoe brand will be hotter over the next two quarters. Finally, as a bonus, read Shoe Dog by Phil Knight. It probably won’t make you an entrepreneur or know more about shoes, but it is just a blast of a read. In fact he didn’t talk much about shoes.. which I guess is the point of this write-up. The shoes don’t really matter, it’s the ads, the athletic spirit and the halo effect from the athletes. 

Risks

CEO might do more silly things that weaken the brand and distribution edge but hopefully Phil Knight still has enough influence to stop him

China seems weak and could get weaker and China actually is a higher EBIT margin business than other regions (FY24 China EBIT % was 30.6% vs North America of 27%, in FY19 China was 38.3% vs NA of 24.7% - franchised stores = higher margins in China). Yes, China is slowing but the bet here is the Nike/Jordan brand travels so well, hopefully other regions can make up for it. Also, while the average Chinese still loves American goods, government pushing nationalistic sentiment and local brands won’t help either. I’ve worn some Chinese brands and it all feels the same. But even the Chinese still adores Kobe and LeBron after all these years – and they won’t have their own version of Kobe or LeBron anytime soon and many will still buy Nike in 5 years.

Western world consumers trying new brands and realizing shoes are mostly the same. That would be bad. That means having LeBron + Alcaraz wearing the shoes mattering less, that means the thesis is wrong.

Catalyst

- Sales growth turning positive and they show better earnings power than expected

- More buyback driving EPS growth (more “investors” will care about real EPS growth when market conditions get scarier)

- 2026 World Cup and 2028 Olympics both happening in the US and that’s Nike’s hometown – you would think that’ll be good for topline but who can wait so long

Bonus: Caitlyn Clark!