Profit margins could be at risk.
I should start by declaring that Nike is one of my favorite companies. I buy the sneakers, wear the clothes and appreciate the story.
When the coronavirus hit last year, Nike was one of the first stocks I reached for. I managed to pick up some shares at $67, an absolute bargain and one of my best buys of 2020.
But after a run of 150% in less than 18 months, it’s time to step back and re-evaluate the fundamentals.
Nike is such a quality stock because of its brand. For several decades Nike has had a brand that inspires and uplifts consumers. There are no shortage of competitors in this space but Nike continues to operate on a higher level to all of them. Adidas, Reebok, Puma, Under Armor. None have managed to capture the same space in a consumers’ mind as Nike.
You know you have a strong brand, when even vandals can’t get enough of your products. It seems that whenever there is a riot, looters head first to the Apple store and then to Nike, grabbing as many high-priced sneakers and t-shirts as they can carry.
To put a figure on it, Forbes magazine ranks Nike as the 13th strongest brand in the world with a brand value of $35 billion. That puts Nike one above AT&T and one below Intel. I would put Nike higher than that. I’d put it in the top 5, below Apple but above Facebook.
Could The Ride Be Over?
Despite my love for Nike stock, after a run of 150% in less than 18 months, it’s time to step back and look at the bigger picture. The stock, now valued at $250 billion, looks expensive on several fronts, and there are some key risks on the horizon. Here I will highlight three significant risks to be aware of.
1. The Chinese Boycott
Earlier this year a call went out on Chinese social media for consumers to stop favoring Western brands, including Nike. The boycott stems from the stance Western brands have taken against allegations of forced labor in Xinjiang, China.
Xinjiang is the largest region in China and is responsible for about a fifth of the world’s cotton. It therefore acts as a crucial cotton supplier to numerous global brands like Nike. Xinjian is also home to millions of Uighurs, a Muslim minority that has been the victim of persecution and human rights abuses perpetrated by the Chinese government. Many Western brands have said that they will not source products from the region while the allegations of forced labor exist.
However, Chinese consumers have not been happy with the stance taken by Western brands. They see the sanctions as an offense to the Chinese state and one-sided. As the BBC reported, there has been a huge backlash against Western brands. At one point, “I support Xingiang cotton” was the top trending topic on Weibo with more than 1.8 billion views.
As a result, Nike’s China sales grew only 9% in Q4 2020 on a currency-neutral basis. Meanwhile, Morningstar reports that Nike sales on China’s Tmall platform dropped 59% in April from a year prior. Chinese consumers have been searching more for domestic brands like Anta and Li Ning.
The Chinese boycott has shown itself to be a real threat to Nike’s China plans that could play out in two ways.
The boycott could keep bubbling to the surface and escalate to the point it causes long-term damage to Nike’s brand in China.
The boycott fizzles out over time and Chinese consumers go back to favoring the Nike brand over other rivals.
It’s not clear yet how this will play out. But it does represent a risk that needs to be factored in.
2. Secondhand Trend
Another issue Nike investors are overlooking is the transformative trend taking place in secondhand apparel. Very simply, there has been a dramatic shift in how younger generations view secondhand clothing. Young people see second hand clothing as better for the environment and cheaper as well.
In a world where billions of cheap garments are sent to landfill each year, younger generations are choosing to shop second hand and help save the planet. This has negative ramifications for retailers like Nike who produce millions of new clothes each year.
100 billion garments are made worldwide each year and 85% end up in landfill or being incinerated.
According to ThredUp, buying used clothing instead of new displaces 17.4 lbs. of CO2 emissions leading to an 82% reduction in carbon footprint. The secondhand market is projected to double over the next five years.
Furthermore, surveys indicate that more shoppers plan on shifting to secondhand clothing (as a spending category) than any other category. As the graphic below shows, 42% of consumers and 53% of millennials and Gen Z say they’ll spend more on secondhand in the next five years:
Although the trend towards secondhand clothing is in it’s infancy, it’s also a necessary movement that will only gather strength in the years ahead. Nike, and other retail brands, may be able to ride this trend in some respects. For example, by increasing the production of recycled clothing. However, the overall impact is likely to be pressure on sales and a tightening of profit margins.
3. Highly Priced
A key reason for Nike’s strong performance in 2020/21 was its decision to go direct to consumers and not rely on third party retailers. Direct to consumer sales increased 73% last quarter which also helped gross margins. As a result, earnings per share were up 123% on a year earlier and net income was up 126%.
This is all good news and shows that Nike is making the right moves with its online strategy. However, sales growth has also been influenced by the pandemic. Stimulus checks and lockdowns caused consumers to spend more time browsing Nike online. Furthermore, a broad market rally and explosion in speculative activity has pushed Nike stock to record highs.
Nike EV/EBITDA 31.6
This all fits together to paint a company that is trading at the high end of its valuation range.
The P/E, at 44.9, is 55% above the 5-year average of 29.
EV/EBITDA, at 31.6, is 24% times above the 5-year average of 25.4.
Price-to-sales, at 5.6, is 57% times above the 5-year average of 3.6.
Price-to-cashflow, at 54.4, is 65% above the 5-year average of 33.
Margins are also above their historical norms. EBITDA margin, at 17.9%, is 20% above the 5-year average. For a mature company like Nike, margins are more likely to revert to their historical mean than to stay elevated.
Back Of The Envelope Valuation
Nike has managed to increase EPS at rate of 23.78% annually over the last 10 years. That is a tremendous result which will be difficult to repeat.
If we assume that Nike can continue to grow EPS at roughly 20% a year the company will be earning roughly $22 a share by 2031. A 25 times multiple on that figure (closer to the historical average) would give us a share price of $551, a compounded annual return of 13.18%. On top of the 1% dividend, that’s not a bad result for investors but it’s not the best either.
Valuations look increasingly stretched when looking at Nike EV to EBITDA and revenue multiples. For example, EBITDA growth at Nike is only 12.26% over the last 10 years and revenue growth is only 8.44%.
If we assume Nike grows EBITDA 10% a year for the next 10 years then trades at a 25x multiple we get to an enterprise value of $516 billion in 2031. That would give an investor only a 7.45% annual return before the dividend.
Similarly, if we assume Nike grows revenues at 8% per year then trades at a 3.5 x multiple (closer to the historical average) the expected annual return drops to only 3%.
Alternate Valuation (Brand $40 billion)
We said earlier how powerful the Nike brand is so maybe it makes sense to incorporate the value of the brand into our calculations.
As you will recall, Forbes gave Nike a brand value of $35 billion and I said that I felt it was worth more. Let’s put an extra $40 billion of cash into the enterprise value of Nike and see what it does to our valuation.
An extra $40 billion means Nike can now be valued at $211 billion enterprise value or roughly $135 a share. Redoing our calculations gives us an expected annual return based on EBITDA growth of 9.3%.
Meanwhile, based on EPS growth of 20% annually we get an expected annual return of 15.10%. Both calculations are before dividends.
Return On Capital
A lot depends on Nike’s ability to convert revenue into bottom line earnings and, of course, the company has a tremendous history of being able to achieve it. Therefore, it’s unnecessary for Nike to grow revenues at an impressive rate to be able to provide strong investor returns.
A key component of Nike’s steady price growth comes from stock buybacks. Decreasing outstanding shares have been a staple for Nike investors and have fallen from 1.83 billion shares in 2011 to 1.57 billion in 2021. This reduction helps to increase shareholder equity and propel earnings per share.
The problem for investors is that the margin of safety at this juncture is very thin. Even with EPS growth of 20% per annum it’s unlikely the stock will achieve an annualized return in excess of 15%.
Final Thoughts - What’s Going On Here?
Nike is a quality company that is driven by one of the strongest brands in the world. I like the stock and the progress the company is making.
I believe the company will be thriving in 10 years time and still be a prominent and powerful force. As a result I will continue to hold my shares and look forward to checking in on future company updates.
However, I won’t be buying any more shares at these prices. There are risks on the horizon that investors are overlooking. With all valuation multiples above their long-term averages, the expected returns don’t look compelling enough. I would be a buyer on a significant pullback but right now, there are better opportunities elsewhere.
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Disclosure: I am/we are long NKE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This post expresses the opinions of the writer and is for information, entertainment purposes only. Joe Marwood is not a registered financial advisor or certified analyst and does not purport to tell or suggest which securities customers should buy or sell for themselves. The reader agrees to assume all risk resulting from the application of any of the information provided. We strive to provide accurate data and analysis, however, mistakes and errors do occur. Financial investing is risky and not for everyone. You should not bet more than you can afford to lose. Past performance is not indicative of future results.