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Announcement on 08 October, 2024
Market Saturation Is Catching Up On Nike
- In Q1'24 Nike reported sales of $11.6B, down 10% from $12.9B YoY.
- Net income was also down 27.5% at 1.051B vs the $1.45B a year ago.
- Gross margin increased 1.2% to 45%. This means that operations are more efficient, but can also be read as Nike cheapening their product.
- Selling and administrative expenses decreased 2% to $4B primarily from lower wage expenses. However, marketing increased 15% to $1.2B driven by sports events advertising. This indicates that sales declined while spending more money on marketing.
- Nike changed their CEO on September 12th, and Mr. Eliot Hill will take over on October 14th. The company postponed their investor day.
- Nike retracted (p. 3, p. 14) the previous FY’25 guidance of a decline in mid single digits and now expects quarterly revenues to be down between 8% to 10%.
Declining sales, retracted guidance, change in management, and postponing key events are all negative catalysts for a stock, even more so when they happen all at once. However, this does not signal the magnitude of the problem as the company can be making good moves in order to prevent issues down the line.
In Q1, Nike returned approximately $1.8B to shareholders, including $558M in dividends and $1.2B in buybacks. Extrapolating to an annualized return, Nike will yield 5.8% returns at current price levels due to buybacks and dividends.
Nike’s cost of equity net of nominal growth is around 3.5% which means the company is well within its required return. However, should Nike consistently fail to deliver at least nominal bottom-line growth, its full cost of equity moves to 7.2% (or more), indicating that I believe the stock has a downside of 20% before reaching its required return.
Note: the cost of equity, or a stock’s required return can be delivered via cash (like dividends, buybacks), or the company can grow its bottom-line. This is why a mix of dividends plus growth is enough to satisfy a company’s required return. To get the 3.5% value, I took the 7.2% cost of equity found in Simply Wall St’s valuation stats, and subtracted a nominal growth rate of the economy as measured by the 10 year T-bond. My analysis works with a single-stage model as things get a bit more complicated with high-growth companies. Hence why I can combine the cash return with a nominal (driven by inflation) growth rate to see if a company is returning enough at its current price, and by extension if it’s fairly valued. The reason why I say that the cost of equity can increase if growth subsides, is that a decline can be a signal that there are more negative catalysts on the horizon, driving investors to increase their required return for the stock.
Brand Management Is A Key Factor In Nike’s Performance
Buying Nike footwear that is made in China, does not signal the same amount of quality differentiation it did 10 years ago when only a few competitors could produce footwear that was on par with Nike. Because of this, consumers will not be able to buy the same amount of status they could in the past and may look for alternatives for status signaling.
Nike is also engaging in social signaling marketing in order to give customers a new avenue of status. The shift from wealth signaling to morality signaling does bolster status for its core customers - However, it also alienates part of its customer base. People exhibit public preferences that may not transfer to their private lives, and can be a costly signal in mixed social circles, which encourages them to seek out more socially neutral signals. While I don’t typically focus on marketing assumptions, Nike’s core sales driver is marketing, hence why this factor is important in evaluating the company.
The downside of this approach is that once set, managing brand name associations may be difficult to change. Contrary to fashion trends, social trends may be more sticky to the identity of a brand, and may carry with them negative costs if the pendulum swings too far in the opposite direction. Investors may consider this to be a move that increases the risk of the stock, as social trends can shift in a completely unknown direction in 5 years, while the brand carries the burden of sticky past associations.
Ultimately, this strategy means that Nike may sacrifice market share in order to reinforce its pricing premium for core customers.
Valuation Implications
I expect that the current growth decline will be temporary and that Nike will revert back to slightly above nominal growth with a 4% CAGR. Because of this, I am lowering my 2028 revenue target from $69.2B to $62.6B and I expect the company to enter recovery after a slump in FY 2025.
I am maintaining my profit margin estimate of 11.5% resulting in a net income of $7.2B and I expect investors to keep reducing Nike’s valuation premium to 21x PE in accordance with long-term growth opportunities.
This results in a new 2028 forward value of $151B. Using a 7.2% discount, I get a present value around $75 per share.
When I first published this narrative, Nike was trading around a 30x PE, and has since started converging downwards. I believe that this is driven by a mix of economic headwinds, but as well as lack of growth opportunities that the company has little control over.
Nike is already a large company, holding some 50% of the footwear market share, and scaling these numbers becomes harder with time. Competitors keep solidifying their own market chunks and limit Nike’s expansion. I expect this trend to continue as innovation in footwear becomes confined to design patterns, and virtually every competitor can make footwear with equivalent quality as Nike. Going forward, the company will have to rely on brand power to fortify revenue as expansion opportunities dry up.
Key Takeaways
- While Direct-To-Consumer sales may improve Nike’s margins, it will make it harder for the company to retain their market share.
- The market is more accessible and Nike has to find ways to stay ahead of marketplaces, retailers, fast fashion brands, outlets, etc.
- Brand name and innovation may not be enough to justify a 30x PE premium.
- The office casualization trend is a viable growth vertical, but may not be as suitable for Nike, compared to casual footwear brands.
Catalysts
The Rise In Direct-To-Consumer Helps Competitors As Much As Nike
Nike’s Direct-To-Consumer (DTC) revenues grew 6% from $5.1B in Q1’23 to $5.4B Q1’24, and represented approximately 43% of total Nike brand revenues for Q1’24. Digital stores are the first step in the sales cycle as 90% of customers start their journey there. This may seem like a lot but it makes sense when you consider most purchase decisions usually begin with an internet search, which usually yields several online shopping listings for the item. Nike has posted a large DTC growth over the years with a 5-year CAGR of 12.6%.
Statista: Nike’s DTC annual revenue
This is important, as some analysts rightfully point out that digital sales growth increases profitability because Nike won’t have to maintain numerous physical stores and will control the advertising on their digital assets.
Conversely, Nike is not alone in exploiting the rise of DTC. Small business, outlets, retailers, and fast fashion chains have also been scaling up their direct to consumer supply chains. Marketplaces like Zalando and fast fashion brands like Inditex, H&M, now offer better access to their own and smaller brands. Nike has to move fast on DTC, but there is little it can do, as DTC is an easy growth avenue that will benefit competitors and keep fracturing market share as more businesses look to tap into the opportunity.
Ultimately, A more fractured market share could see Nike losing out to cheaper competitors as most decisions made in DTC purchases are based largely on price as consumers are forgoing the opportunity to ‘try before you buy’.
Product Innovation is Overstated in Footwear
Nike frequently points out innovation in their investor relations. However, I find it hard to imagine how this innovation can be protected against competitors that decide to make similar products.
Investing in footwear innovation may have limited growth potential, and may be more of a marketing move directed at investors. In my view, Nike’s biggest asset is its brand name, and any innovation produced will be adopted by competitors despite legal protections. Meaning, if investors are relying upon innovation to drive future revenue growth, I believe they will be disappointed.
Revenue and Margin Headwinds Will Be Short Term
Management expects (p. 12, 13) mid single digit revenue growth by the end of the year, and only a slight growth in Q2 revenues, in an effort to further manage working capital by employing more holiday inventory markdowns.
On the other hand, I’m expecting Nike to experience positive tailwinds such as a reversal of high input costs (albeit they’re still high - page 13), while freight costs have already normalized. This will mitigate the negative effects of an economic slowdown.
Overseas freight prices had been an issue for Nike in the past three years as most of their products are made in Asia and had to be transferred by container ships that were expensive for that period. Inventory increased in the post 2021 since Nike expected consumers to keep spending, and the market didn’t have a sense of how market tightening would unfold. This led to an inventory build-up and the company has been slowly reducing it ever since.
Statista: Global container freight rate index
Analysts expect revenues for Q2’24 around $13B. The quarterly forecast may suffer pressure because of seasonal discounts. Despite this, Nike seems to have stabilized costs and inventory enough so that these headwinds are relatively short-term.
The Highly Competitive Landscape Makes Nike’s Leadership Position Unstable
Nike has a number of high growing competitors that are gaining market share. Comparing peers by size, Adidas is Nike's biggest competitor, with annual revenue of over €22B, next is Puma with € 8.9B. Under Armour is a newer competitor known for its performance-oriented product, and has quickly grown to become one of the leading brands in sportswear.
SimplyWallSt: Nike’s Forward PE comparison to top peers
The combined revenue of all the mentioned peers is around $106B, with Nike holding some 50% of the market share:
- NKE $51.5B
- ADI €22.2 = $23.5B (owns Reebok)
- PUM €8.9 = $9.41B
- SKX $7.8B
- UA $5.9B
- DECK $3.7B
- ONON 1.6B CHF = $1.77B
- BIRK $1.5B
- LULU has likely less than $1.14B in footwear revenue. Coming from 13% of its $8.8B revenue, which is categorized as part of its “Other” segment, and is more of a limiting factor on Nike’s growth, rather than a direct competitor.
Lulu and Brickenstock have good performance and compete for the office casualization trend - characterized by the de-formalization of office wear and a move to a more casual office wardrobe inspired by the work from home trend which persists for some 13% to 28% of U.S. employees in 2023.
Being at the top of the hierarchy both on market share and margins, can be unstable, as companies have difficulty retaining a high level of market share in a highly competitive industry. Additionally, the high margins Nike earns implies it has a strong brand and is used by people as a way to signal status instead of having unique qualities.
There is nothing wrong with this approach, however I think that economic pressures will force consumers to switch from buying status items to items with better price to performance ratio. And if not that, I assume they’ll simply slow down their discretionary purchases, and not buy as many Nike shoes per year as they may have before in more favorable economic conditions.
Assumptions
- Business: Competition will keep fracturing the footwear market, as peers continue scaling their global supply chains, making it harder for Nike to keep their 50% market share based primarily on brand name. I estimate a revenue growth rate of 6.1%, resulting in $54.6B in the next 12 months, and $69.2B in 2028.
- Margins: I expect Nike to return to historical levels on its net profit margin and reach 11.5% by 2028.
- Buybacks: The company has authorized buybacks $1.13B for the first quarter of fiscal 2024 and a remaining $12.1B authorized in its buyback program. Nike has reduced its share count by an average of 1.4% in the last 2 years, and I expect this trend to continue. This will bring Nike’s outstanding share count from 1.52B to 1.42B in 2028.
- Forecast: With revenues of $69.2B and a net profit margin of 11.5%, I estimate that Nike makes $8B in net income in 5 years.
- Multiple: I estimate that Nike re-rates to a lower PE multiple of 21x by 2028, as the company matures and experiences a fracturing in market share.
Risks
- Equipment sales (p. 23): had the best performance and may turn into a high-growth vertical allowing the company to use its brand name and distribution channels to expand into new product markets.
- FX impact: Nike has some 58% of its revenue coming from outside the US. If the dollar strengthens against foreign currencies, Nike's products will become more expensive for consumers outside the US, leading to a decrease in demand. The risk here is that the FX impact could be significant enough to result in far less earnings than what my assumptions have detailed.
- Inflation: As consumers experience reduced purchasing power, they may stave off discretionary purchases and choose alternatives such as Sketchers or off-brand items.
- Reputational risk: Nike is relatively unscarred from recent polarization but could divide part of its customer base if it actively engages in controversial marketing.
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