Nike Is A Cash Machine: So Why Is The Stock Down 40% YTD? (NYSE:NKE)

Large NIKE store at night with many people's silhouette

Robert Way

Since its founding 50 years ago, Nike (NYSE:NKE) has built an empire out of shoes. Named after the Greek goddess of victory, the company has compounded capital at or near 20% annually for decades. To no one’s surprise, it turns out that making shoes for ~$25 and selling them for ~$100 is a great business. However, NKE’s stock has been absolutely crushed in 2022, down over 40% as of my writing this. This is one of the bigger drops among large-cap stocks. There are a few possible reasons for this, but the reason that makes the most sense to me is that the valuation got out of hand in 2021. NKE now appears to be approaching fair value.

Nike reports earnings after the bell on Thursday, September 29th, giving a window into not only the company’s business, but how the local economies are doing in the US, Europe, and China.

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Data by YCharts

How Does Nike Make Money? A Winning Business Model

Some companies keep their business mostly secret, but Nike is pretty easy to analyze. Nike is heavily studied by business school case studies. There’s also a wealth of information available in the company’s 10-K report.

Nike shoes retail for about $100, depending on the country. Of this, studies have shown that about $28.50 dollars of this is manufacturing and shipping costs. Nike then generally wholesales the shoes to retailers for about $50. That leaves about $21.50 in gross profit, most of which goes to payroll, marketing, and administrative costs.

Nike historically made the vast majority of its money from wholesaling to retailers. This is not a bad business, and it has the advantage of not having to deal with paying rent, employees, and inventory management. But the obvious downside is that you leave a lot of money on the table. But with the unstoppable rise of e-commerce, Nike is increasingly selling direct to consumers and cutting out the middleman. This has been a key structural tailwind for earnings. Instead of making 20 bucks or so in gross profit per shoe, they can potentially make 2-3x as much. And of course, Nike doesn’t just sell shoes but also sells apparel and sports equipment, which often carry higher margins.

Nike is a global business as well-making more than 50% of its profit from outside the US. And as the global economy slowly grows over time, demand increases for shoes and apparel, providing another tailwind.

How Does Nike Make Money?

Nike Sales Breakdown (Nike 10-K Report)

So, Why is Nike Down 40%+ For 2022?

  1. Valuation- Anytime a stock with a reasonably good business underlying it gets crushed as Nike has, the valuation is the first place you should look. Nike has a PE of 21x against May 2024 earnings at current prices and earnings estimates. But at its peak last November, the company traded for over 40x earnings estimates. Of course, earnings are now being revised down, but paying nearly 40x for any large-cap company is asking for trouble. In a theme common to many blue-chip growth stocks, Nike’s valuation far outran its business over the past 10 years, and now that’s coming home to roost.

Nike PE ratio history

Nike PE Ratio Over Time (Macrotrends)

Nike went from trading a bit under 20x earnings about 10 years ago to 25x, then to 30x, and finally to about 40x last November. Of course, I’m smoothing the trend-note that 2018 was from deferred tax charges from the Trump admin’s tax bill, and 2020 was from the early pandemic chaos. Now NKE is back in its historical range.

2. The US dollar- Nike reports earnings in dollars but sells heavily abroad. This means that a strong dollar will cause Nike’s reported earnings to drop. And if you’ve been paying attention lately, the dollar is soaring. Forex generally isn’t worth worrying about when you invest in individual stocks, but this is a stiff headwind.

3. Margins- The best thing about cutting out the middleman is that you get to take all of the profit for yourself. The worst thing about cutting out the middleman is that it means you’re on the hook for paying more employees, having the right inventory, and getting the supply chain/logistics right. Nike is not immune to inflation, and you can see from its 10-K that its EBIT margin decreased compared with 2021, in line with the rest of Corporate America. This is a question mark going forward and the company is going to need to up its game on supply chain and logistics.

4. Politics- Nike seems like they’ve never seen a political issue they’re not willing to take sides on. Nike’s heavy involvement with social issues and politics is a liability for the company. Nike has long been a lightning rod for controversy- whether it’s around sweatshop labor, Nike’s relations with the Chinese government, Black Lives Matter & Colin Kaepernick, or Israel/Palestine.

Nike Is A Microcosm of The Global Economy

Consumer discretionary stocks like Nike are tightly tied to the global economy. China is struggling for Nike, as locked-down consumers aren’t really looking to buy new shoes. North America crushed it for Nike during COVID, as demand stayed strong, and consumers opted to buy directly from the company rather than from retailers. But how will this hold up with the economy softening? Europe is another question mark now- how will brutal increases in the cost of living and the war in Ukraine affect demand?

These are all macro questions that Nike earnings will give a bit of insight into. However, in the long run, though, Nike’s business model is a winner. As annoying as the constant controversy is, I’m not one to turn down money. Also up this week is Micron (MU), which will give its take on the supply and demand for semiconductors. After the quarter ends this week, many of the early companies reporting will be banks, with the mega-cap tech companies reporting later in October. Each Q3 earnings report will place another puzzle piece for investors looking to figure out what’s going on with consumers and the global economy. Of particular importance are various consumer discretionary companies that saw huge rises in earnings and valuation during COVID, and that are now seeing huge declines.

As for Nike, I think if you can get it below 20x FY 2024 earnings, it’s a good buy. That’s around $90 per share, assuming the company doesn’t severely miss estimates. With the stock market in free fall, value is starting to come out of the woodwork in large-cap stocks, and NKE stock is a good example.

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