Nike - Just Do It!
Since most investors are impatient with greedy aspirations, market inefficiencies are often found among businesses with predictably favorable long-term economics but soured short-run prospects. Let’s see how Nike fits into these two concepts.
We believe athleisure is in a secular uptrend. All species are wired to survive, and so, as a society, we value fitness as it leads to longevity. This basic need, combined with both population growth and the increasing discretionary time and income available as humanity gets wealthier, has caused a trend towards increased participation in sports and fitness, which in turn leads to a positive growth trend in the sale of athletic clothing and equipment. Nike dominates the space with leading market share in various categories such as sportswear ($7.5 billion in annual sales), running ($5.0 billion), basketball ($4.1 billion), and men’s and women’s training ($4.0 billion), selling products in footwear (65% of revenue), apparel (30%), and equipment (5%). Their sheer size provides them with bargaining power over retailers who depend upon volume and need Nike products to drive store traffic, entrenching them in global supply chains and further deepening their scale advantages. They are also diversified across several different geographies with over half of their revenues spread outside of North America.
Despite Nike’s massive size, they have been able to compound top line sales at an 8% per year clip over the past decade. We believe Nike has driven this growth through the aforementioned secular uptrend in athletic participation, international expansion, and pricing power as a result of Nike’s association with the best athletes and sports teams, and we believe these structural growth drivers are likely to remain in place for the foreseeable future.
Nike possesses a long runway for high growth in emerging markets. Nowhere is this bright future more apparent than in China, where they’re already the leader with nearly $3.8 billion in annual revenue (12% of revenues) growing at 27% excluding currency changes. Furthermore, the business they conduct in China has higher margins of 36% compared to the entire Nike brand average of 26%. Other emerging market exposure isn’t too shabby either, with another 12% of sales growing at 13% with margins already roughly the corporate average and likely improving. With a quarter of their revenue growing at high double digit rates and much of this revenue in higher margin businesses, their margins are likely to continue expanding, which would cause earnings to grow faster than sales.
We frequently discuss our desire to own businesses that participate in inflationary rather than deflationary categories such as selling computers and TVs. Often times, this is found among goods that convey social status, such as in our holding of luxury jewelry maker, Richemont, with their famed Cartier and Van Cleef & Arpels brands. As global wealth increases, discretionary income increases, allowing pricing power as consumers with insatiable appetites spend more dollars on luxury goods to try and prove they have the ability to command more resources than their neighbors. In many ways, Nike has become a luxury goods business (“Look at my brand new Jordan’s!”), as evidenced by Nike being listed among the most counterfeited brands in the world , right alongside other luxury goods makers. Even better, unlike Richemont and most other traditional luxury goods companies, Nike has a short-term repurchase cycle, allowing the company to have more of an “evergreen” cash flow component. One other interesting implication of the heavy counterfeiting of Nike products is the insight it gives into the true demand for the brand. One can only imagine how much business might increase if Nike management is able to address the counterfeiting issue. Hopefully, new innovative technologies like Flyknit, self-lacing shoes, or simply just having more personal customization will make counterfeiting more difficult.
This desire for personal customization also helps insulate Nike from the threat of Amazon. First off, Nike’s own online sales are growing quickly (up 51% over the past year) due to the desire to get hot, new, customizable products (which is surely a higher margin business by cutting out the middleman). This also means consumers are seeking out specific merchandise, distinguished from having product passively “pushed” onto them. And in the unlikely event that Nike did decide to offer customization through Amazon, they would likely control the negotiations in that relationship.
As is often the case with such dominant, high return on capital businesses, Nike generates excess cash flow in droves, creating a net cash position on the balance sheet and a consistent return of capital to shareholders in the form of dividends and share repurchases. And yet, at the current price, Nike trades for approximately 22x forward earnings.
If the business is so attractive, why has the stock price come under pressure and the valuation finally become reasonable, particularly relative to its growth prospects? Similar to our investment in Richemont, luxury goods are economically sensitive, and, with much of Nike’s anticipated growth coming from the Asia-Pacific region, Nike will clearly be impacted by the slowdown in China. Additionally, while we still believe athleisure is in a secular uptrend over the long-term, we recognize that activewear sales may be currently experiencing a boom and reaching temporary saturation. But we take heart that only 30% of Nike sales are in apparel, where there is more of a fashion element, and 65% in the more robust footwear category (as opposed to competitor Under Armour where the numbers are nearly reverse, with 71% apparel and 17% footwear).
This fashion element also poses a risk in an industry that faces intense competition with fickle, changing consumer preferences, where competitors such as Under Armour are growing quickly. Fortunately, though, when participating in fitness, people want to associate with high status individuals in that sport. By partnering with the best, Nike’s iconic brands have garnered worldwide recognition and the flagship Nike brand is considered the #1 most popular brand among millennials . We believe Nike can continue to get endorsements from the best because they have the most money to pay celebrity athletes. To put this in perspective, their marketing budget was 10% of sales and nearly $3.3 billion in the fiscal year ended May 31, 2016, larger than Adidas and Under Armour combined. Adidas spent about $2.6 billion or 13.5% of sales, and Under Armour spent $400 million, which was also about 10% of sales. However, in absolute terms, had Under Armour attempted to spend the same total budget as Nike, it would have sapped 80% of sales! True, Nike may miss signing someone like Steph Curry, but, despite this big miss, Nike still dominates the basketball category with 75% of online sales still going to Nike Air Jordan, 14% to Nike Kobe, 6% to Nike LeBron, and only 5% to Under Armour’s Curry.
We think it is irrational to acknowledge the attractiveness of an investment opportunity over the long term but refrain from buying because of short to medium term concerns. As we have outlined, we believe Nike is the juggernaut in a market poised to grow for decades to come in categories that convey social status, thus allowing pricing power over time. At the current price, we are happy to establish a position and would be even happier if it became cheaper so we could scoop up more.
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