I have been examining other apparel companies in recent articles when I decided to take a closer look at Nike (NKE). At first glance, the shares may seem wildly overvalued. However, there is a very compelling story unfolding at the company. I wanted to see if this was fully reflected in the stock price or if there is an investment opportunity here.
Looking at short-term results, Nike had a decent fiscal Q1 2021 (ended August 2020). Over-all revenues were flat compared to the same time last year at $10.6 billion. From the looks of it, the Nike benefited from a surge of “post-lockdown” sales as revenues were dramatically improved from Q4 2020 (which was down 38%). Many analysts were speculating that sales spike could be partially attributed to people spending their stimulus checks on sneakers like Nike. With the vast majority of entertainment outlets closed, other discretionary goods companies received some of that windfall from spending. The US government is currently discussing the next round of stimulus. If another direct to consumer cash transfusion happens that may benefit Nike as other options for discretionary spending like travel, restaurants, movies live entertainment, etc. remain closed. This simply means even in a situation like this ongoing coronavirus pandemic there is still a demand for the company’s products.
Consumers have more money in their pockets thanks to government stimulus checks — and apparently many are using it at malls and online to buy new sneakers, which is good news for Foot Locker. Sales were so strong because of “pent-up demand and the effect of fiscal stimulus,” Foot Locker chairman and CEO Richard Johnson said
Nike’s revenues come mainly from two channels, wholesale sales and direct to consumer sales. Nike’s direct sales were $3.7 billion for the quarter up 13% compared to the same time last year. While close to all of Nike’s stores were open during the Q1 2021, Digital sales continued to perform exceptionally well with an 83% increase compared to the same time last year. Nike has been a pioneer when it comes to digital transformation and managing customer relationships.
Our results this quarter continue to demonstrate NIKE’s full competitive advantage, as we strengthen our position in the midst of disruption,” said John Donahoe, President and CEO, NIKE, Inc. “In this dynamic environment, no one can match our pace of launching innovative product and our Brand’s deep connection to consumers. These strengths, coupled with our digital acceleration, are unlocking NIKE’s long-term market potential
NIKE is recovering faster based on accelerating brand momentum and digital growth, as well as our relentless focus on normalizing marketplace supply and demand,” said Matt Friend, Executive Vice President and Chief Financial Officer, NIKE, Inc. “We continue to drive investment in capabilities that will fuel our consumer-led digital transformation, catalyzing long-term growth and profitability for NIKE
Nike has performed well during the coronavirus crisis yet many are calling the stock over-valued. There is some aspect of truth to it as in 2020 (ended June 2020) full-year revenues fell by 2% and EPS shrank by 36%. At 2020 EPS of $1.6 the company has a P/E ratio of 81x. Even using EPS results from 2019 of $2.49 we arrive at a high valuation of 52x. These are valuations usually reserved for high growth tech stocks. Nike after –all is a pretty mature business and has been growing revenue at an average CAGR of 3.7% annually.
Nike is a fantastic business with EBIT margins higher than its immediate peers. The company has a strong economic moat due to the strength of its brand and marketing prowess. However, at annual sales averaging $36 billion and a recognizable global presence, I believe much of the future EPS growth won’t come from top-line sales growth. Rather I believe that the shift to digital has the potential to boost Nike’s future earnings.
Historically close to 65-70% of Nike’s sales are sold through the wholesale channels. In the US the biggest partnership the company has is with Foot Locker (FL) which I have written about here. The two companies almost have a symbiotic relationship as they work together to sell Nike’s footwear. If Nike is able to achieve full digital transformation and “remove the middle man” its margins would improve dramatically. Nike will no longer have to give discounts and absorb the profit margins of wholesalers like Foot Locker if it is able to sell directly to consumers.
Author calculations using data from Seeking Alpha
Estimating the value of digital transformation
Unfortunately for us Nike does not breakdown its operating profit from the whole wholesale and direct to customer segments. We do know a few key pieces of information 1) Nike’s total EBIT margin of 12% based on a 5-year average, 2) the revenue split between wholesale and direct channels (70-30 split), and 3) Foot Locker’s EBIT margin of 10.7% based on a 5-year average. We can assume the EBIT margin for direct to consumer sales is equivalent to Nike’s average EBIT margin plus Foot Lockers average EBIT margin. While I admit this estimate is a rough calculation, with regard to sanity check it is close to Lululemon’s (LULU) EBIT margin. Lululemon sells its apparel directly to customers making me confident in the assumption we have. For the wholesale margin, we can use the excel solver function to estimate this value using the given data points. I ended up with a direct to customer EBIT margin of 22.7% and a wholesale EBIT margin of 7.4%.
For my valuation estimate, I am using 2019 revenue which I believe better reflects the business at a steady state. For Interest and tax expense I simply used the 5-year average. I assumed in the future state that Nike would have 75% of its business as direct to customer and 25% of its business from wholesale. Running the calculations gave me an EPS of $4.00. Comparing this EPS against the current stock price of $129.70 we get a P/E ratio of 32x. Not terribly expensive but not cheap either. Note though that this model makes the assumption using 2019 sales. When this pandemic is over, Nike’s sales could increase even more due to trends or shaking out of competition. At this level though given the amount of execution risk involved with a digital transformation, I believe that Nike is fairly valued.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Caveat emptor! (Buyer beware.) Please do your own proper due diligence on any stock directly or indirectly mentioned in this article. You probably should seek advice from a broker or financial adviser before making any investment decisions. I don’t know you or your specific circumstances, therefore, your tolerance and suitability to take risk may differ. This article should be considered general information, and not relied on as a formal investment recommendation.