Stock Deep Dive Analysis - Nike (NKE) in Bear Market

Note from the author: The following is a 7-post series deep analysis of Nike that I completed in the past three weeks. Now I consolidate them into one post with some minor revisions. The writing made me think deeper about Nike's growth in the developing countries especially China. Here are some ideas:
- The huge population in China provides an immense market and NKE is far far from fully tapping it. If Nike moves A LOT more aggressively in this direction, is there a good chance that NKE surprises the investors with impressive numbers even we are deep in recession?
- Sure the layoff is everywhere, including China. But the question is to what an extent does this affect NKE's core customers in that market? They are more like the elite class in that society, the group that should be able to hold onto a job through the difficult times.
- Chinese people have a different spending style from the Americans. Normally they have more savings, little or no debt. The way the recession affects the spending style there must be different from here.
I need investigate further and will post to my blog. Here is the NKE Deep Dive.

Introduction

I am a big tennis fan and I watch a lot of tennis on TV, and as a result, I watch a lot of Roger Federer and Rafael Nadal. If you know even just a little bit about this sport, you know what I am talking about. These two guys battled each other in three of the last four grand slam champion games, and the only one that Nadal failed to reach the final, Federer was the eventual winner. Many people, more or less, have some impression of these unique two, might just from glimpses over the TV, handsome, energetic, elite, stylish, and .... swoosh-y. That famous logo seems to be blending into their images, and it is everywhere, head-bands, wrist-bands, shirts, shorts, shoes, and more importantly, almost every TV scene.

It is very impressive. Nike has been a hot stock since long time back. Now in a bear market, feels like a good time for a deep dive.

About Nike

This part is easy. Basically I copied and pasted from its 2008 10K.

'NIKE, Inc. was incorporated in 1968 under the laws of the state of Oregon'.

'Our principal business activity is the design, development and worldwide marketing of high quality footwear, apparel, equipment, and accessory products. NIKE is the largest seller of athletic footwear and athletic apparel in the world. We sell our products to retail accounts, through NIKE-owned retail including stores and internet sales, and through a mix of independent distributors and licensees, in over 180 countries around the
world. Virtually all of our products are manufactured by independent contractors. Virtually all footwear and apparel products are produced outside the United States, while equipment products are produced both in the United States and abroad.'

'NIKE’s athletic footwear products are designed primarily for specific athletic use, although a large percentage of the products are worn for casual or leisure purposes. We place considerable emphasis on high quality construction and innovation in products designed for men, women and children. Running, training, basketball, soccer, sport-inspired urban shoes, and children’s shoes are currently our top-selling footwear categories and we expect them to continue to lead in product sales in the near future. We also market shoes designed for aquatic activities, baseball, bicycling, cheerleading, football, golf, lacrosse, outdoor activities, skateboarding, tennis, volleyball, walking, wrestling, and other athletic and recreational uses.

We sell sports apparel and accessories covering most of the above categories, sports-inspired lifestyle apparel, as well as athletic bags and accessory items. NIKE apparel and accessories are designed to complement our athletic footwear products, feature the same trademarks and are sold through the same marketing and distribution channels. We often market footwear, apparel and accessories in “collections” of similar design or for specific purposes. We also market apparel with licensed college and professional team and league logos.

We sell a line of performance equipment under the NIKE brand name, including bags, socks, sport balls, eyewear, timepieces, electronic devices, bats, gloves, protective equipment, golf clubs, and other equipment designed for sports activities. We also have agreements for licensees to produce and sell NIKE brand swimwear, team sports apparel, training equipment, children’s clothing, electronic devices, eyewear, golf accessories, and belts. We also sell small amounts of various plastic products to other manufacturers through our wholly-owned subsidiary, NIKE IHM, Inc.

Our wholly-owned subsidiary, Cole Haan ("Cole Haan"), headquartered in Yarmouth, Maine, designs and distributes dress and casual footwear, apparel and accessories for men and women under the brand names Cole Haan® and Bragano®.

Our wholly-owned subsidiary, Converse Inc. ("Converse"), headquartered in North Andover,
Massachusetts, designs, distributes, and licenses athletic and casual footwear, apparel and accessories under the Converse®, Chuck Taylor®, All Star®, One Star®, John Varvatos®, and Jack Purcell® trademarks and footwear under the Hurley® trademark.

Our wholly-owned subsidiary, Hurley International LLC ("Hurley"), headquartered in Costa Mesa, California, designs and distributes a line of action sports apparel for surfing, skateboarding, and snowboarding, youth lifestyle apparel, and accessories under the Hurley® trademark.

On March 3, 2008, we acquired all of the capital stock of Umbro Ltd. ("Umbro"). Headquartered in Manchester, England. Umbro designs, distributes, and licenses athletic and casual footwear, apparel and equipment, primarily for the sport of soccer, under the Umbro trademarks.'

Economic Moat

Obviously NKE enjoys the economic moat - their products, although no much difference from its competitors in cost, are pricier, and have less discount, but they sell better.

Three pillars of NIKE's economic moat:

1) Innovation: this looks like the blood of NKE. Not much needs to be explained here, you get the idea by just looking at the awesome product line history, from the Bowerman's waffle sole about 30 years ago, to the famed "Air" cushioning system to the latest Nike+.

2) Fashion: For the past several years, the sportswear design started to display more and more fashion awareness. But you can perceive the clear differences between competing companies in how they adopt this fashion factor. Visit one Adidas store and one Nike store, you may easily come to the conclusion that Adidas is a more 'traditional' company than NKE. This goes beyond the variances in design ideas, more or less, it reflects the differences in the management philosophy. For me, I read it as Nike's superiority. For most people, sports and fashion share one fundamental aspect: to feel good about yourself. So moving around, breaking a sweat, feeling good inside and at the same time, dressing well to feel good outside, this caters to almost everybody's desire. Nike's capability to better blur the border between sportswear and fashion is a clear advantage here.

3) Branding: this is all about Nike's endorsement strategy. Check the line of stars behind it, Jordan, Tiger, Kobe, Mitchell Wie, and in my favorite sport: Federer, Nadal, Sharopova. First, if not the best in their sports, they are the top talented ones, and second, they are attractive, might be because of the look, or personality or temperament, or all above. Combining these two, you get the most influential athletes. There are controversies regarding Nike's endorsement cost, but for me, I like the overall strategy: pick the best few, yes they are very expensive, but every one counts; and second, these guys give Nike products the elite perception, which justifies its hefty price. Further, and more importantly, the relationship between NKE and these guys goes way more than that Nike pays them to wear clothes embroiled with the swoosh logo and show up in their commercials, actually they themselves become the work of Nike. The flying Jordan, the unyielding Tiger, the timeless classic Federer and the fighting Nadal, sure, they are born to have these characteristics, but can you deny the behind-the-scene Nike's marketing power? Their images are so deeply embedded with Nike's image, and from it, NKE obtains the unique power to define/lead the fashion/trend of its industry. This trend/fashion thing, as exposed to the feelings and sentiments of human being, may shift fast in unpredictable directions. Obviously the best players are not those only passively respond to it, but those anticipate it, influence and best, define/lead it. I don't see any other company enjoying such a position as Nike does in its industry.

Finally let's go a little further deeper to get a little abstract, what is the ultimate force that drives NKE to achieve this type of economic moat? My opinion, everything traces back to the company's culture or management philosophy. It's better that I stop here before this becomes an empty talk. So let me point out one last thing, NKE seems to have a superior culture or philosophy comparing to its competitors. What's more, NKE spent 30 years building a kingdom/system/team upon this philosophy, and this is the very thing guaranteeing that Nike's economic moat is almost insurmountable.

Crunching the numbers

Checked Nike's book for the past several years, nothing is alarming here.

1)Growth
In 2004, Nike generated revenue 12,253.1M and in 2008, 18,627M, the average growth rate is 11.7%; operating income in 2004 is 1,549.7M and in 2008, 2,433.7M, the average growth rate is 14.3%. So historically, a great great company. We will look at the future growth potential in one of the future posts.

2) Return on Asset (ROA)
I put together the numbers from Nike and two of its closest competitors, Under Armour and Adidas.

Company	2008	2007	2006	2005	2004	Average
Adidas (ADDYY)	6.60%	6.60%	6.84%	7.52%	7.30%	6.97%
Under Armour (UA)	10.89%	15.46%	15.81%	9.16%	12.91%	12.85%
NIKE (NKE)	16.28%	14.51%	14.92%	14.52%	12.95%	14.63%

Observation 1: The number for Nike is very healthy.
Observation 2: In Net Margin, Nike is better than Under Armour, although partially owing to lower tax rate. UA is better in Asset Turn Over. Actually I was surprised by the performance of UA.
Observation 3: Normally Adidas sells cheaper and has deeper discount, somewhat it seems they struggle to find the ingredients in the design that will make people (maybe only me) excited. Also since Adidas acquired Reebok, the latter gradually lost its characteristics, becoming dull and boring. Anyway, it is not perceived to be an excellently run company, and the number confirms it.

3) Return on Equity (ROE)

Company	2008	2007	2006	2005	2004	Average
Adidas (ADDYY)	21.06%	17.75%	17.53%	18.83%	18.83%	18.8%
Under Armour (UA)	16.12%	21.24%	21.35%	16.75%	67.47%	18.87%
NIKE (NKE)	23.78%	25.37%	22.41%	23.34%	23.24%	23.63%

Observation 1: Again very healthy numbers for Nike, a clear winner here.
Observation 2: The UA 2004 number is skewed by the unusually high debt level. Its average is based on the last four years.
Observation 3: Adidas posted similar numbers as the other two, but was boosted by much higher Financial Leverage (higher debt level).

4) Financial Health
As of 2009, Nike has a Current Ratio at 2.89, Quick Ratio at 1.44, Debt/Equity at 0.05, and around 1 billion cash in hand. Looks like a company well prepared to survive the recession.

(source: www.morningstar.com)

Evaluation and the Three Rules

For the past 10 year, Nike's P/E never dropped below 17, now at 11, price/sales, used to hover around 1.5, now at 1.1. So nothing to elaborate here, its evaluation is at historical low; pretty much it is the same situation for every company still alive today.

Now let's put it in the recession background.

My first article on the blog, click here if you'd like to read, talked about the three rules to screen stocks in today's market. Let's plug it in for the NKE case.

1) Big & Safe: As a company with 20 billion dollar revenue and 20 billion market cap, Nike is big. With almost 1 billion dollar free cash in hand and a current ratio around 3, it is pretty safe. Also NKE is the No. 1 in sportswear. If the entire industry has to go down, Nike may well be the last one.

2) International Revenue: see the table (all numbers in million except percentage).

Areas	2008	%	2007	%	2006	%
United States	6378.00	34%	6107.10	37%	5722.50	38%
Europe, Middle East and Africa	5620.40	30%	4723.30	29%	4326.60	29%
Asia Pacific	2881.70	15%	2283.40	14%	2053.80	14%
Americas	1154.10	6%	952.50	6%	904.90	6%
Other	2592.80	14%	2259.60	14%	1947.10	13%
Total	18627.00		16325.90		14954.90

As of may 2006, around 38% Nike's revenue is from the United States, and in 2008, the number dropped to 34%, and the quarter ended December 2008, 33%. Also you can see NKE is not tied to any single market/area on the globe. Sure we are having a worldwide recession, but it takes different forms in different countries. With the revenue as balanced as NKE, I can't expect any other company could better mitigate the impact.

3) Recover from depression: for me, NKE fits both types of companies I mentioned in the initial blog. I will cover the growth part later. What's more, I think the sportswear industry should be the one recovering earlier and faster from the recession. Nike is not a luxury brand, but their products are not cheap either. The recession forces people to scale back spending, reducing expenses in categories that are not everyday needs. Therefore, you see Walmart thrives but Macy's suffers. The government seems to be trying to put more money into the hands of the ordinary consumers to stimulate the entire economy - seems reasonable to assume people go get a pair of nice sneakers when finally there is some extra cash left in the pocket.

Growth
What is going to drive NKE's growth in the next 5-10 years? The answer is innovation and Asian countries. Let's dig a little deeper.

Innovation is particularly important for Nike in matured markets such as North America and Europe, where the product saturation already reached, price levels were set, brand image/perception was well established, and competition yet fierce, but won't take any new forms unless some of the players have significant missteps. In these markets, we have two levels of innovation. First, some technology progression and innovative marketing ideas seem to be a necessity to retain its current market position. The second level is beyond the first one, referring to the type of innovation that drives up revenue and market share, and we can call it growth innovation. The very last such innovation is Nike+, the marriage between Nike and Apple, which is one of the key drivers of its footwear growth in US region in the past few years. Technically, it is not something that you can count on 100% for sure, nobody could answer questions such as ‘when should we expect the next Nike+?’, further, also a legitimate question, ‘will there be such an innovation at all?’. So you can say nothing is guaranteed. However, given its history, I would like to believe NKE would come up with more growth innovations. And if such ideas do come up, I would also like to believe Nike, as its past illustrated, will execute them well and turn in good numbers on its book.

Compared to innovation, Asian countries are a much more concrete driving force of growth.

Modernization and westernization of the Asian countries created certain form of crave to American culture, and for reasons that we won't dig here, Nike became one of the symbols of American culture. I think partially this is the outcome of Nike's marketing efforts, but also I believe it is something Nike, as a pure business runner, didn't expect. Originating from this is its huge popularity. And Nike never stopped consolidating such popularity with successful marketing moves. In the discussion about the economic moat of NKE, I talked about Nike's branding. In its 10K, NKE stated its strategy as, 'to create long-term revenue growth by creating compelling consumer experiences by creating and delivering innovative, "must have" products; deep personal connections with our brands; and compelling retail presentation'. Nothing interpreted this better than Nike's success in these Asian countries, especially China and India - the fancy sportswear technologies, the fashion sense, the influence of those endorsed sports heroes made Nike not only a "must have" brand, but a "proud-to-have" brand. One more thing to add here, NKE actually put a higher price tag on its products in Asia, adding an extra luxury flavor, which matches perfect with its overall strategy, also results in higher margin.

The other side of the story, economic development in countries such as China and India created a bigger and bigger middle class group. Normally they are the younger generations, growing up in a relative open environment, having higher education, descent income, good sense of fashion and proper knowledge and awareness of health and exercise. Using China as the example, "The number of middle-class consumers on the mainland is expected to nearly triple to 100 million in 10 years from 2006" (source: http://www.chinadaily.com.cn/bizchina/2007-12/08/content_6307152.htm). They are the target consumer of NKE. In other words, NKE already has a huge consumer base and it is growing , and this will be the strongest driving force of Nike's future growth. (Several more words to revisit a previous topic, this explains why the international revenue is so critical for us to screen companies nowadays, especially considering China was hit not nearly as hard as the US by the financial crisis.)

One last contributor is from China. Chinese government is under great pressure from America and Europe to loose its currency policy. For Nike, since virtually all footwear and apparel products are produced outside the United States (a significant portion in China), the appreciation of Chinese currency value against American dollar may translate directly into surging numbers in revenue/profit on Nike's book.

Nike is well aware of the opportunities. One of the indicators, in Feb 2009, Nike broke ground on a distribution center in China, "a further demonstration of our (Nike's) long-term and unwavering commitment to China" (source: http://www.bizjournals.com/portland/stories/2009/02/16/daily28.html).

Risks

Thinking long term, I don't see any major risks with NIKE. Here are some comments on some common concerns.

1. Global Recession: there are two sides of the story. First, if the global recession continues long enough, it will eventually slow down the growth of NKE, or worse, wiping out the profits. Second, the bear market itself simply refuses to reward reasonable/high evaluations even NKE manages to turn in impressive numbers, on the other hand, it punishes harder if the company misses. Thus a good earning from NKE may not boost the price, while a bad one may drive it down big. The positive side, there is nothing specific or unique to NKE only, pretty much the same situation for every company.

2. Design Misstep: if you are familiar with apparel companies such as American Eagle (AEO), Abercrombie and Fitch (ANF), etc... you know the risks internal to this type of fashion player. From time to time, they will have some kind of design missteps, releasing products that deviate from the fashion trend of its targeted customer, thus excessive inventory, deeper discount, a poor quarter and lower stock price, then recalibrate and another round starts. This also applies to NKE. They may release products that the customer totally lack interest. The positive side, they are big, they never rely on one product line or one design concept for one quarter; their mixed product offerings should be able to mitigate the risks well. Further, bottom line, NKE is never a pure fashion player, it is a sportswear company. They can always use the sports stars' influence to offset a poor offering, or a mediocre design.

3. Inventory Pressure: A few days ago, Goldman gave cautious note on athletic apparel, footwear sector, citing the inventory may create near-term headwinds. Overall, it is a valid concern though NKE seems to have some edge over its competitors:
- If you haven't visited nikestore.com, check it once. I was surprised how well it was constructed. Actually more are more revenues are generated from its website, and more importantly, it provides an interface with the end consumers directly, this should give NKE some sort of 'prediction' power, second, they run a lot of secret codes, online coupons, displaying a very flexible pricing schema. Feels they can be very efficient in dealing with inventories.
- Nike runs a "futures" ordering program. From its 10K, "We make substantial use of our "futures" ordering program, which allows retailers to order five to six months in advance of delivery with the commitment that their orders will be delivered within a set time period at a fixed price. In fiscal year 2008, 86 percent of our U.S. wholesale footwear shipments (excluding Cole Haan, Converse, Exeter Brands Group, Hurley, NIKE Golf, Umbro, and NIKE Bauer Hockey) were made under the futures program, compared to 94 percent in fiscal 2007 and 90 percent in fiscal 2006." Five to six months should provide enough buffer time for inventory adjustment. This system sounds very helpful to offset the order volatility.

4. Strategy and Management philosophy: as discussed earlier, innovation, fashion, branding are the cornerstones of Nike's business model, and behind this model, I see the consistent strategy, culture and management philosophy. All these, sounds abstract, but are the ultimate force that drives NKE's success. I'd keep a close eyes on NIKE's management change. The serious deviation from existing strategy and philosophy might be the only thing that may hurt Nike big given the superiority and dominance it has been enjoying today.

Conclusion
Start accumulating shares. As of 2/28/2009, the close price is 41.53, it may go lower below 40, if so, buy more shares.