Nike: Just Don’t Do It!

Nike (NKE) is the world’s largest athletic apparel and footwear maker, and they reported fiscal fourth quarter results after Wednesday’s close.  The company earned $521.9 million or $1.06 per share, which was a penny better than analysts’ expected and 53% improved from last year.  Overall revenue grew 7.7% to $5.08 billion, while strong this was a disappointment as Wall Street called for 9.1% growth.  As expected, growth was strongest in emerging markets and those sales surged by 47% over a year ago.  Emerging markets now account for 11% of sales, but Nike has stated that they want to increase that percentage to 40%.  China, an increasingly important market for Nike, sales rose by 12% and orders grew by 19%.  Japan was the weakest region with sales falling 8% and orders falling even worse.  Overall, future orders also looked strong, as the company sees $8.8 billion to be delivered between June and November a 10% gain on a constant currency basis.  Part of the optimistic sales outlook is because of the world-wide popularity of World Cup Soccer, which benefits the company once every four years.  Soccer related sales were up 40% in the quarter thanks to World Cup excitement and marketing.

The market had high expectations for this quarter, and the stock fell as much as 4% as of early afternoon trading on Thursday.  On balance the quarter was a respectable one, although some detractors point to easy comparisons to the quarter a year ago that saw a number of one-time and restructuring costs.  Far more important than that to us was the company’s outlook on increasing costs going forward. Nike management had effectively cut costs, maintained strict inventory controls, and raised profit margins over the last year, but external impacts appear to be working against those efforts.  As of these results, gross margin had expanded to 47.4% from 43.4% a year ago.  However, as CFO Don Blair said on the conference call, “Currency changes and input cost inflation will put significant pressure on our reported top and bottom line results for fiscal 2011.”  The recently announced increased flexibility of the Chinese yuan will likely have an adverse effect on Nike as it will likely raise input costs and labor costs.

Further headwinds can be found in Europe, weakness in the Euro may lower comparable sales in that region and almost certainly after those sales are translated back into relatively stronger dollars.  This trend that had already shown up significantly in the last quarter’s report.  Orders in Europe fell 2%, but taking away currency impacts sales would have actually risen 11% in Western Europe and 3% in the rest of the region.

At Ockham, we recently downgraded Nike to Overvalued because the stock had appreciated outside of the price level we would expect given current fundamentals.  For example, coming into this week the company was trading for 1.92x price-to-sales per share, which is relatively high compared to the market’s historically normal price-to-sales range for NKE of 1.17x to 1.75x.  Furthermore, price-to-cash earnings of 19.4 is on the high end of their historically normal range of 13.5x to 20.3x.  When we look at the market’s historical valuation of Nike using current fundamentals, we believe a price range of $59 to $70 would be a reasonable expectation.  Of course, the stock (which closed at $74.94 when we issued our current rating) has fallen back into that range now following the results.

Given our valuation outlook and the company’s own view of the likelihood of rising costs, we would suggest value investors look elsewhere for buying opportunities.  We do not deny that Nike has an enviable market position in both developed economies and emerging markets, and over the long term the yuan’s appreciation will have an overall positive effect on Nike by empowering consumers within China.  However, at this point, we see better opportunities elsewhere unless Nike falls back into the high $50’s or even low $60’s.

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

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