Description

Introduction

 

NIKE, Inc. currently trades at a 50% discount to its intrinsic value and at the cheapest level in well over a decade.  Much has been said and written about how cheap many large-cap stocks have gotten, but very little mention has been made of NIKE, which astounds me considering that NIKE now sells for 6.5x next year’s EBITDA and 11.7x next year’s earnings.    Over its history, NIKE has compounded its revenue and earnings per share growth at 10% and 20%, respectively.  Return on Invested Capital is consistently well over 20%, and going higher.  It is by leaps and bounds the market share leader in its category with the preeminent global brand that according to BusinessWeek is worth over ten billion dollars.  Finally, NIKE, whose shares trade at $77, has $6 per share in net cash, which is equal to roughly 8% of its market capitalization.  Each year NIKE generates more than $1bn of free cashflow which it uses to enrich shareholders through dividends, buybacks and balance sheet delivering. 

 

One investor who likes to find the proverbial “50 cent dollars” is Warren Buffett.  Indeed, the Oracle of Omaha began picking at NIKE’s share in the second quarter and has built a smallish 1% position.  Needless to say, this is the type of business that WEB salivates over.  With a leading 34% global market share of its industry and an established, capital-light, brand-heavy business model, it’s the type of company that should theoretically fetch a hefty Price-to-Earnings Ratio premium to the S&P 500. Instead, it is now trading, amazingly, at a discount to the S&P 500 Index’s next year’s Price-to-Earnings ratio of 15x.  This is an aberration.  I believe this discount will dissipate over the near term and that, eventually, NIKE will regain its historical 25% P/E premium to the S&P 500.  On that basis, I believe the fair value for NIKE’s stock is in the range of $120-$140 today and much higher as we look out two or three years into the future.

 

I believe this is a tremendous opportunity to buy a one-of-a-kind business at historically low multiples to earnings and cash flow.  Granted, with many consumer-oriented stocks now trading at or near 52-week lows, I acknowledge that equity prices in part reflect concerns about an impending economic slowdown and it may very well be the case that higher rates, the housing slowdown, gas prices, or a myriad of other factors will pinch consumers’ wallets which will in turn pressure NIKE’s short-term profitability.  Over a longer time horizon, however, NIKE is better positioned than ever to extend its track record of growth and profitability, and therein lies the opportunity today: to steal this business at less than 7x EBITDA when it should fairly trade at better than 10x EBITDA.  Moreover, there are so many financial levers here that could be employed to enhance shareholder value that it’s hard for me to envision NIKE staying at $77 for much longer.

 

Description

 

By far and away the best-known footwear and athletic apparel maker in the world, NIKE is solidly built on a long and rich history of product and brand development.  The NIKE swoosh has been cultivated into an immensely valuable global icon that is uniquely and decidedly non-replicable.  NIKE’s market share figures are impressive:  In footwear, it commends a 34% market share globally and slightly higher at 37% in the U.S.  NIKE’s main competitor is the newly-combined Adidas AG / Reebok, which is a distant second with 25% global share.  And while most people may think of NIKE has a shoe company, the fact is that NIKE has made significant inroads in the branded athletic apparel category.  NIKE today has grabbed an 8% global market share in apparel, and that business, which is 28% of consolidated sales, is growing as NIKE leverages its brand and distribution to gain share.  For better or worse, NIKE also has significant exposure to emerging market economies and to the tremendous long-term demographic opportunities that they present to premium-priced consumer products such as those offered by NIKE.  The expanding middle classes in the BRIC (Brazil, Russia, India and China) markets will continue to increase their purchasing power and with higher level of disposable incomes among the first things they buy with the newfound wealth – alongside Sony flat panel TVs, Dell computers and Coach handbags – will be NIKE Airs.  In fiscal 2006 (ended May 31, 2006), NIKE’s generated only modest sales in emerging economies with Americas Ex-U.S. sales amounting to approx. 6% of total sales and the Asia-Pacific region amounting to slightly less than 14%, but these markets are growing exceptionally fast, in line with the economic expansions enjoyed by emerging economies over the last several years.  NIKE’s brand awareness in BRIC and other emerging markets ensure that NIKE’s track record of consistent growth will continue well into the future.  At NIKE’s current valuation, the market is simply not giving the company any credit for its ability to leverage its brand to fuel consistent, long-term top line growth of 10% and EPS growth of 15-20% which NIKE will achieve through a combination of organic operating income growth and share buybacks.  The market is also ignoring NIKE’s pristine capitalization, its $6.00 in net cash per share and its highly-liquid, rock-solid balance sheet that not only gives it the flexibility it to pursue growth initiatives that build long-term shareholder value, but also means NIKE can buyback it own stock with tedious regularity (in June, NIKE’s board authorized a new $3bn share repurchase program). 

 

NIKE is an easy company to understand but it’s not as easy to truly appreciate the scope, scale and diversity of its various businesses.  While NIKE is widely viewed as an American company, the fact is that it generated about 56% of its NIKE brand revenue overseas in fiscal 2006.  Overall, international markets accounted for approximately 53% of NIKE’s consolidated revenues in 2006 and 57% of its pre-tax profit, before corporate overhead.  NIKE’s revenue split for the NIKE brand, by geography is as follows: U.S., 44%, Europe and Middle East, 33%, Asia-Pacific, 16% and Americas, 7%.  NIKE’s geographic diversity means several things, and they are all germane to my thesis.  First, since more than half of NIKE’s revenues come from outside of the U.S., concerns over a potential domestic economic slowdown posing a significant risk to NIKE are probably somewhat overplayed.  Second, NIKE’s exposure to non-dollar denominated economies, especially the Eurozone and China, plays nicely into the widely-held thesis (championed by the likes of Mr. Buffett and Jim Rogers, among others) that the value of the U.S. dollar is in a long-term secular decline.  In effect, owning NIKE allows one to participate in what essentially is a foreign company while enjoying the benefits of owning a U.S.-listed company with American management that adheres to U.S. GAAP, Sarbox and SEC regulations and is under the jurisdiction of the U.S. court system.  Third and finally, NIKE’s geographic footprint means it has at its disposal a number of distinct and uncorrelated levers with which to grow the business.  This third and final point is perhaps more important than the first two, because as we look out to the next decade it is NIKE’s emerging markets that will account for a growing percentage of revenue.  NIKE’s sales in the Americas region grew by 20%, excluding currency translation (30% including favorable currency translation), led by sales increases in Brazil, Argentina and Mexico.  It is not unreasonable to model in consistent 20%+ returns in this and similar emerging markets for the foreseeable future; I believe NIKE’s Americas business can top $2bn in sales by 2010 and reach $5-plus billion by 2016, at which point it will likely account for 20% or more of NIKE’s global sales, up from only 6% this year.  Similarly, China represents an untapped market that will someday be very big and important to NIKE.  The takeaway from these examples is that NIKE is well positioned to grow, on a consolidated basis, as various regional markets around the world expand while others cool.  With the exception of the U.S., NIKE isn’t dependent to any one market in particular; it can find high-quality growth by simply leveraging its brand and market presence globally, as opposed to chasing dilutive acquisitions in order enter markets. 

 

These characteristics of the business are central to my thesis that NIKE should commend a premium valuation, commensurate with its (a) attractive mid-teen percent growth prospects, (b) product and geographic diversification, (c) industry leading operating margins, (d) cash generation power and most importantly (e) its one-of-a-kind global brand identity.

 

 

Financials

 

NIKE has 259.4mm fully diluted shares outstanding.  Equity market capitalization is $19.9bn.  As of May 31, 2006 NIKE had $2.3bn in cash and investments and $709mm in debt.  NIKE’s employees are not unionized and therefore pension is a non-issue.  NIKE is an investment grade company with an A2/A+ ratings from Moody’s/S&P.  Enterprise value is $18.3bn. 

 

Fiscal 2006 was another good year for NIKE as revenues and EPS increased by 8.8% and 20%, respectively.  Few companies match NIKE in their ability to generate consistent growth over long periods of time.  Over the last fifteen years, NIKE has compounded sales at an annual growth rate (CAGR) of 11%, EBITDA at an annual growth rate of 10.6% and EPS at 12.4%.  NIKE has never relied on acquisitions as a growth strategy and has achieved the bulk of its growth organically.  A high-level financial summary is presented below.

 

			2002A	2003A	2004A	2005A	2006A
Revenue			$9,893	$10,697	$12,253	$13,740	$14,955
EBITDA			1,324	1,492	1,863	2,181	2,400
Free Cashflow *			815	751	1,026	1,274	1,336
EPS			$2.46	$2.77	$3.51	$4.48	$5.40
Free cashflow per share			$2.99	$2.81	$3.80	$4.71	$5.15
EBITDA margin			13.4%	13.9%	15.2%	15.9%	16.0%
Return on Invested Capital			15.0%	17.8%	21.8%	25.0%	26.7%
Return on Equity			18.2%	18.9%	21.6%	23.2%	23.3%
* Defined as cash flow from operations less capex.

 

Over the five years from 2002 to 2006, NIKE’s revenue and EBITDA compounded at an annual growth rate of 11% and 16%, respectively.  During this period, NIKE generated $5.2 billion of free cashflow, repurchased about 14mm shares, distributed nearly $1bn in dividends to shareholders and paid down $670mm of debt. 

 

It is instrumental to note NIKE’s high quality of earnings: FCF per share is greater than EPS in all but one year, reflecting in part conservative accounting (i.e., no shenanigans like incredulous booking of revenue or channel stuffing) and in part depreciation expense that exceeds annual capital expenditure requirements.  NIKE has also been able to improve its EBITDA margins, Return on Invested Capital and Return on Equity with each successive year.  In its fiscal 2006, NIKE generated a higher return on its invested capital than the venerable Coca-Cola Co., which has long been the gold standard for generating outsized returns on capital and is a perennial Buffett favorite.

 

Over this same five-year period, NIKE almost doubled its sales in Asia-Pacific and more than doubled its non-NIKE sales, partially through the acquisition of Converse but also through internal growth.  A five year summary of sales by region is presented below:

 

Sales by Region								'02 - '06
			2002	2003	2004	2005	2006	CAGR
United States			$4,670	$4,637	$4,782	$5,129	$5,723	5.2%
Europe, Middle East, Africa			2,697	3,222	3,828	4,282	4,327	12.5%
Asia-Pacific			1,135	1,341	1,611	1,897	2,054	16.0%
Americas			568	509	605	696	905	12.3%
Other Brands			824	988	1,428	1,736	1,947	24.0%
Total			9,893	10,697	12,253	13,740	14,955	10.9%
Americas + Asia-Pacific % of total			18.8%	19.1%	20.5%	21.6%	22.7%

 

 

Each one of NIKE’s geographic regions is highly profitable, but emerging markets such as Asia-Pacific and Americas enjoy slightly lower EBITDA margins than NIKE’s larger and more established markets.  EBITDA margins in the Americas and Asia-Pacific regions were 19.8% and 21.5%, respectively, as much as 300 bps lower than the 23% margins in the U.S. and Europe.  As NIKE grows its business in the Americas and Asia-Pacific (in particularly in China and India), the opportunity to improve margins through scope and scale is immense.  We expect operating margins in emerging markets to ultimately catch up to the U.S. and Europe, which portends a significant opportunity for sustained earnings momentum.  EBITDA by region is presented below:

 

			2006	2006	2006
			Revenue	EBITDA	Margin
United States			5,722.5	1,313.3	22.9%
Europe, Middle East, Africa			4,326.6	1,007.6	23.3%
Asia-Pacific			2,053.8	440.9	21.5%
Americas			904.9	179.0	19.8%
Other Brands			1,947.1	232.5	11.9%
Corporate and other			0.0	(773.2)	-5.2%
Total			14,954.9	2,400.1	16.0%

 

 

Product Lines

 

NIKE- branded footwear accounted for approx. 53% of the company’s consolidated sales in 2006.  Branded apparel and equipment together accounted for 34% of sales, while the company’s other brands, which include Cole Haan and Converse, contributed the remaining 13% of sales.  Footwear is obviously NIKE’s mainstay business and arguably its most mature product line given NIKE’s penetration of that market.  Footwear sales, however, continue to be robust and increased 11% in 2005 and 9% in 2006.  Over the last two years, NIKE has grown its footwear sales by $1.4 billion, from $6.5bn to just south of $8bn.  In the fourth quarter of 2006 footwear sales increased 10% year over year, and management indicated that they continue to take share from competitors.  Looking ahead, NIKE continues to sign high-profile athletes across all sports; and while competitors are catching up, NIKE is still the leader in R&D and product innovation.  China is also a major growth lever in footwear and this was evidenced in 4Q 2006 when NIKE reported a 50% increase in revenue there.  The 2008 Olympics in Beijing will likely build excitement and further open up that market to NIKE over the next two years.  Branded apparel is another interesting and important revenue opportunity.  NIKE holds only an 8% share of this $48 billion market, and over the next decade should be able to leverage its brand in apparel and grow its share of the market to the range of 25% to 35%, similar to its market share in footwear.  The apparel business topped $4bn for the first time in fiscal 2006, and finished the year with a very strong fourth quarter particularly in the U.S. market where sales increased 18% year over year.  Apparel likely will be a major growth engine for NIKE given its relatively small share of this large market. 

 

Financial Outlook and Projections

 

Management’s publicly stated goals are to deliver high single digit revenue growth and mid-teens EPS growth.  I think NIKE can achieve sustained top line growth of close to 10%, driven in the near-term by the strength of the U.S. market and the recoveries underway in Western Europe, but increasingly by Asia-Pacific and the Americas markets in the outer years of the model.  In fiscal 2006 ending May 31, 2006, NIKE generated adjusted Earnings Per Share of $5.40 (excluding a $52mm charge relating to an arbitration ruling against its Converse brand), and we think next year the company should be able to do $6.04 in EPS before taking into account share repurchase activity, which will have a significantly accretive effect.  The street consensus for 2007 EPS is $5.61 according to I/B/E/S, which we think is too low.  With a new $3bn share repurchase program authorized by the board, we think NIKE management will look to use repurchase activity as an important lever for EPS growth.  In particular, NIKE will be an aggressive buyer of its own shares if the stock price continues to stagnate. Share buybacks have the power to increase our 2007 modeled EPS from $6.04 to $6.18, assuming NIKE uses its free cash flow after dividends to buy back shares. 

 

The primary thesis underlying our modeling assumptions is that NIKE will continue to achieve outsized top line growth by focusing on its core products while cultivating its presence in faster-growing markets.  EBITDA should increase slightly faster than revenue thanks to economies of scale in emerging markets that will lead to expansion of operating margins. Share buyback activity will also be an important driver of earnings growth and we think that over the next three years NIKE will have the capacity to buyback close to 20% of its shares outstanding simply by using future free cash flow.  The modeled projections do not make the assumption that NIKE uses its significant balance sheet cash ($1.6bn as of May 31), although any use of that cash toward share repurchase is an option that could unlock value and we will discuss that shortly.  Our estimate of 2008 EPS is $7.18, reflecting an 8% revenue growth but no margin expansion:

 

		Fiscal years ending May 31,
		2006A	2007E	2008E	2009E	2010E
Revenue		14,955	16,397	17,764	19,442	21,310
% Growth		8.8%	9.6%	8.3%	9.4%	9.6%
EBITDA		2,400	2,617	2,838	3,114	3,424
% EBITDA margin		16.0%	16.0%	16.0%	16.0%	16.1%
EPS		$5.40	$6.18	$7.18	$8.52	$10.21
% Growth		20.5%	14.4%	16.3%	18.6%	19.8%
Free Cash Flow		$1,336	$1,554	$1,692	$1,865	$2,061
Shares Outstanding		259.4	243.6	227.4	210.7	193.3

 

 

Valuation

 

In the past ten years, NIKE traded at an average Price-to-Earnings multiple of 21x and an average TEV-to-EBITDA multiple of 11.3x.  Currently NIKE’s valuation is 7x next year’s EBITDA (which will fall to 6.5x by the end of this fiscal year as NIKE shrinks its enterprise value by repurchasing shares or further delivering, or a combination of the two).  To put things in perspective, NIKE’s enterprise value at the end of its 2004 fiscal year (May 2004) was $400mm higher than its current enterprise value, while EPS that year was $3.51, or less than half of my forecast for 2008E EPS.  What we’ve experienced over the last couple of years is NIKE’s valuation falling whilst its earnings power has come close to doubling. 

 

If NIKE shares stay at their current price of $76.77, NIKE will be trading at 6.5x EBITDA and 11.7x earnings by May 2007 and at 5.6x EBITA and 10x earnings by May 2008.  NIKE shares are cheap on a trailing basis as well, trading at 7.6x and 13.6x last year’s EBITDA and EPS, respectively.  Price-to-Earnings excluding cash is calculated by deducting NIKE’s $6 of net cash from its stock price and excluding from earnings the interest income generated from the cash.  

 

			Fiscal years ending May 31,
			2004A	2005A	2006A	2007E	2008E
Year-end stock price			$71.15	$82.43	$76.77	$76.77	$76.77
FD Shares Outs.			269.7	270.3	259.4	243.6	227.4
Year-end Market capitalizaiton			19,189	22,281	19,935	18,721	17,476
Year-end TEV			18,795	21,219	18,341	17,127	15,883
TEV / Revenue			1.53x	1.54x	1.23x	1.04x	0.89x
TEV / EBITDA			10.1x	9.7x	7.6x	6.5x	5.6x
Price / Earnings			20.3x	18.4x	14.2x	12.4x	10.7x
Price / Earnings excluding cash			20.2x	18.0x	13.6x	11.7x	10.0x

 

At these multiples, NIKE is being valued like a company with no growth prospects.  A multiple of 11.7x earnings may be appropriate for companies in cyclical or commodity-based industries or those with capital-intensive businesses, but not for NIKE.  The market’s valuation of NIKE implies just 3% earnings growth over the next five years based on a discounted cash flow model.  This is completely out of synch with the near certainty that NIKE will continue to compound revenue and earnings at double digit growth rates.

 

Fair Value

 

Fair value today is $120-$140 per share on a present value basis, which is based on several valuation data points.  One data point is NIKE’s historical multiples.  NIKE’s ten-year average P/E of 21x applied to next year’s earnings results in a $130 stock price.  Similarly, applying NIKE’s ten-year average multiple to EBITDA of 11.3x yields a share price of $120.  While this is a useful exercise, I concede that it’s problematic given that companies change and businesses mature and yesteryear’s multiples reflect yesteryear’s environment.  In NIKE’s case, however, the company’s growth prospects remain strong so I see no reason for the multiple deflation.

 

Another data point is Adidas AG’s acquisition of Reebok International, Ltd. in August 2005, which was consummated at approximately 11x EBITDA and 17x earnings.  On that basis, NIKE should be worth about $105 - $117 per share. 

 

The new Adidas (ADS GR) is NIKE’s closest comparable.  Its shares trade at 15.3x next year’s earnings, which when applied to NIKE yields a $95 stock price.  Given NIKE’s better balance sheet and size, I think a premium to Adidas is warranted.  A 10% premium to Adidas’s multiple implies a $104 stock price.  In addition, Adidas is a highly-levered company that burdened with integrating Reebok while NIKE could theoretically use its $2.3 in cash to increase EPS through a tender offer or recapitalization, but more about that shortly.

 

For valuation purposes, other comparable footwear and apparel companies include Puma AG, Skechers USA and Timberland:

 

			2006E P/E
Puma AG			15.0x
Skechers USA			16.1x
Timberland			14.4x
Deckers Outdoor			15.8x
Average			15.3x

 

At the average multiple of 15.3x, NIKE would trade at $95.  However, this comparable universe excludes younger faster growing companies like Under Armour and Crocs, which trade at 44.5x and 28.6x projected earnings, respectively.  I wouldn’t make the silly argument that NIKE deserves a hyper-growth multiple, but I would remind you that NIKE is levered to the same markets and products as UARM and CROX and warrants a multiple that reflects that. 

 

Another perspective to this multiples-based valuation is to look at NIKE as a global branded consumer product company and not just as a footwear manufacturer with a second-rate brand (like Timberland) or a reliance on one product (like Deckers Outdoor’s Uggs).   Instead, NIKE should be compared against similar “Global Brands”: Coca-Cola, Pepsi, Disney, Anheuser Busch, Procter & Gamble and Colgate.  These companies trade at 19.1x next year’s earnings because they are able to leverage their brand equity to provide shareholders with consistent growth, have high returns on capital, and generate tons of free cash flow.  NIKE has all of these characteristics.  At 19x earnings, NIKE’s implied fair value is $117 per share. 

 

Thus far, the discussion has ignored the possibilities created by NIKE’s large cash position.  However, the fact is that NIKE is significantly under-levered and can do many things to bolster shareholder value through a recapitalization or even a going-private transaction. These two are discussed below.

 

The Recap

 

NIKE can undertake a Dutch tender offer to buy back as much as a full one-third of its shares outstanding.  Doing so would mean borrowing about $4.5bn (about 2x EBITDA)  and using the $2.3bn in cash it already to buy back approximately 85mm of its shares, assuming the tender can be carried out at $80 per share.  This creates significant EPS accretion, increasing next year’s projected EPS from $6.18 to $7.46 (this assumes 8% cost of debt).  Applying a fair multiple on this pro forma “Recapitalized EPS” yields a fair value range of $111 - $156:

 

 

The Management Buyout

 

Since Phil Knight already owns approximately 29% of the company and through his ownership of Class A shares effectively controls the Board of Directors, he could choose to take the company private if the price got low enough.  Such a scenario, while hypothetical, is undeniably doable and would be lucrative to both Knight and the private equity firm he chooses as his partner.  I believe Knight could affect a going-private transaction by buying the shares he doesn’t already own at a 25% premium to the current price, or $96 per share.  Knight would roll over his own equity and buyout shops would provide the remaining $4bn of equity necessary to finance the deal.  The rest of the deal would be funded with cash on hand and about $12bn of bank debt and bonds (leverage would be about 4x EBITDA).   Such a deal would give Mr. Knight 64% ownership of the new equity in NIKE, and generate returns for the private equity investors in the range of 20-25%, depending on various assumptions (such as exit in five years, etc.).  This particular scenario, however far-fetched, underscores my thesis that there are many potential value catalysts in this situation.

 

Conclusion

 

NIKE today is undervalued by almost any measure.  Mr. Market, as Benjamin Graham would probably say, is simply mispricing this one.  NIKE is a large-cap company that merits, at the very least, a multiple on par with the general market.  At the very best, NIKE deserves a significant premium to the market, one which appropriately reflects its long-term growth prospects and its top-percentile returns on capital.  Moreover, NIKE is an under-leveraged company, affording it the optionality to enhance shareholder value whenever it chooses through share buyback programs, a Dutch tender and recapitalization, a going-private transaction or a special dividend.  NIKE could also continue to increase its regular dividend; shares today yield 1.6% and with the payout ratio a mere 23%, the company could increase this dividend by a factor of four.

 

My fair value range is $120 - $140, based on the preceding discussions on comparable multiples, ability-to-pay in an LBO or going private transaction, and discounted cash flow models.  The downside is limited and with some $3bn allocated to share repurchase, I firmly believe NIKE will not let its share price linger for much longer.

 

Catalysts

 

• Valuation - multiple expansion
• Dutch tender and/or leveraged recapitalization
• Going-private transaction
• Increase in regular dividend or a one-time special dividend
• Sustained revenue and earnings growth and cash flow generation will alleviate concerns and reignite investor interest

 

 

Catalyst

* Valuation - multiple expansion
* Dutch tender and/or leveraged recapitalization
* Going-private transaction
* Increase in regular dividend or a one-time special dividend
* Sustained revenue and earnings growth and cash flow generation will alleviate concerns and reignite investor interest