Nike (NKE)

Founded as Blue Ribbon Sports in 1964, the company changed its name to Nike (NKE) in 1971 and is the largest sports footwear and apparel company in the world today.

The global business sells shoes, sports apparel, equipment, and accessories in nine major market segments: basketball, Air Jordan, football, men’s and women’s training, action sports, sportswear, and golf. Some of its key brands are Nike, Jordan, Hurley, and Converse.

Nike has three main reporting units: Footwear, Apparel, and Equipment. The Footwear segment is by far the largest source of sales, but apparel is the major growth driver.

• Footwear: 65% of revenue, growing at 2% in constant currency basis
• Apparel: 31% of revenue, growing at 7% in constant currency basis
• Equipment: 5% of revenue, growing at -4% in constant currency basis

The company also has a small global brands segment (less than 1% of revenue), which licenses its brands around the world.

Nike markets its products through numerous channels including wholesale sales to more than 30,000 retailers, online, and through its 1,142 company-owned stores (34% are located in the U.S.).

Geographically, Nike is highly diversified as well with sales in more than 190 countries:

• North America: 48% of revenue, growing at -4% in constant currency
• Europe, Middle East, Africa: 25% of revenue, growing at 9% in constant currency
• Greater China: 13% of revenue, growing at 15% in constant currency
• Asia, Latin America: 14% of revenue, growing at 8% in constant currency

While nearly half of sales come from North America, Nike has struggled in its home market in recent years. Fortunately, strong growth in overseas markets have lifted Nike’s overall revenue during this time.

Business Analysis

Despite operating in the fickle consumer discretionary sector, Nike has managed to drive consistent growth in both revenue and earnings over the years due to several enduring competitive advantages. One of the company’s core strengths is its brand power, which has been built up largely by Nike’s partnerships with globally known athletes and sports leagues.

For example, the company recently renewed a long-term agreement to be the sole apparel provider for the NFL. In addition, Nike has strong endorsement deals with both the Olympics and the World Cup, and its long-term relationship with Michael Jordan to license his name for its “Jordan” line of shoes has been one of the strongest growth drivers for the company.

In fact, Jordan sneakers accounted for 11% of company sales in fiscal 2017 and generated 21% revenue growth on a constant currency basis.

Nike spends about 10% of its revenue on advertising each year to maintain its strong brand edge, which amounted to $3.4 billion in fiscal 2017. These investments include the costs of endorsement contracts with athletes, brand events, and traditional television, digital, and print advertising.

While Nike’s advertising as a percentage of revenue is about in line with spending ratios at rivals like Adidas and Under Armour, the firm enjoys the industry’s largest marketing budget to protect its brand power since its revenue base is about 50% larger than its near two competitors’ sales combined.

That has helped the company’s average selling price to remain very strong. In fact, while the average selling price across the industry fell by 2% last year, Nike’s average apparel and footwear pricing increased 4% and 5%, respectively.

The second competitive advantage Nike has is its strong history of innovation. Over the last 25 years, the company has built the largest design patent portfolio in America. That includes new products like the newly released Air VaporMax shoe, which uses a lightweight foam that helped it quickly become the best selling $100+ shoe on the market. The company is planning on expanding this platform with VaporMax 2.0, VaporMax 97, and VaporMax utility products in the future.

Another example of innovation is the new Nike React technology, which uses new foam technology to create a lighter, softer, but springier shoe for better energy returns. React shoes set a company record for new product launches with initial supply selling out within hours.

Nike is investing heavily into technology to help drive more sales through its direct-to-consumer (DTC) channels as well. DTC is a combination of company-owned stores and online/mobile sales that has higher margins because it avoids the wholesale discounts that Nike has to offer its retail partners.

In fiscal 2017, Nike’s DTC sales rose 25% on a constant currency basis, making it the company’s fastest growing revenue stream. DTC account for approximately 30% of Nike’s revenue today and seems likely to continue rising at a double-digit annual pace going for the foreseeable future. Management projects digital commerce sale to grow from less than 15% of total sales this year to more than 30% over the next five years, driving over half of Nike’s incremental revenue growth during this time.

To continue growing the high-margin DTC business and remain relevant in an increasingly digital world, the company wants to create an even stronger consumer experience. As part of that effort, Nike has been investing in small bolt-on acquisitions.

For example, Nike bought Israeli software company Invertex in April 2018. Invertex makes software that lets consumers scan their bodies with their phones and thus personalize apparel while they shop online. Meanwhile, in March of 2018, Nike announced it was buying data analytics firm Zodiac to help improve its artificial intelligence-driven consumer personalization experience.

The company continues working on its Nike App, too. Specifically, by crunching data on past consumer purchases, Nike can help recommend new products for customers, locate them at the nearest store, and even allow customers to pay online and thus avoid the checkout line.

Nike is also working on a new “Flyknit” production process which generates 60% less waste per shoe. Flyknit is a material made up of strong yet lightweight strands of yarn that have been woven into a one-piece upper, securing an athlete’s foot to the shoe platform.

This highlights another competitive advantage possessed by Nike, which is maximizing efficiencies and economies of scale. For instance, the company has a very finely tuned global supply chain, allowing the company to source its inputs and manufacturing at the lowest prices.

In footwear, Nike holds the No. 1 market share position in all markets and all major categories. Nike’s footwear supply chain includes 127 factories in 15 countries with production most heavily focused in:

• Vietnam: 46%
• China: 27%
• Indonesia: 21%

The company’s apparel supply chain includes 363 factories in 37 countries with top production coming from:

• China: 26%
• Vietnam: 16%
• Thailand: 10%

Meanwhile, Nike is investing heavily into what it calls its “ManRev”, or manufacturing revolution. ManRev is a combination of increasing automation and 3D printing to help speed up the design and production process of its products. All while offering more personalized clothing and footwear that it can then sell at a more premium price.

Thanks to its substantial economies of scale, strong pricing power, and ongoing cost savings initiatives, Nike enjoys some of the industry’s best margins. The company’s operating margin sits near 13%, which is more than double the industry’s average.

Nike’s combination of industry-leading brand power, innovation, and constant improvements to its manufacturing and design processes has resulted in impressive top and bottom line growth over the past decade including:

• Annual revenue growth of 8%
• Annual EPS growth of 13%
• Gross margins up 0.7%
• Return On Invested Capital up from 21.9% to 34.7%

And thanks to the strong growth runway presented by international markets (55% of sales today and growing double-digits), its fast-growing high-margin DTC business, and long-term productivity initiatives to boost profitability, management believes Nike can continue that achieve similar results in the coming years.

Management Guidance through 2020

• High single-digit to low double-digit revenue growth
• Mid-teens earnings per share growth
• High-twenties to low-thirties percentage return on invested capital
• Free cash flow growing faster than net income

While Nike is the world’s largest footwear and athletic apparel brand, these ambitious growth targets are not necessarily unreasonable. For example, over 2 billion people in markets like China, India, and Latin America are expected to join the middle class by 2030. In North America, Nike’s primary consumer base is 50 million people.

If international population levels trend at the projected rate, Nike’s consumer base in China alone has potential to be more than 10 times larger than its reach in North American today. Simply put, the global footwear and sports apparel market is very large and should only continue to grow over the coming years.

Should management’s projections and execution prove successful, Nike has potential to continue generating solid double-digit dividend growth for shareholders. However, investors interested in Nike need to understand that the company faces certain risks that could make hitting those growth expectations rather challenging.

Key Risks

While Nike is an industry-leading business with several meaningful advantages, the company also faces numerous risks.

For one thing, as more of Nike’s business comes from overseas, the firm will become even more sensitive to currency exchange rates. When the U.S. dollar appreciates against local currencies, Nike’s reported sales and earnings growth decrease. This risk is unlikely to affect Nike’s long-term earnings power, but it can disrupt results any given quarter.

Another risk is commodity price fluctuations on key inputs such as natural and synthetic rubber, plastic compounds, foam cushioning materials, leather, nylon, polyester and canvas. Nike’s global supply chain gives it more sourcing flexibility than most rivals but rising commodity prices can pinch margins over the short term.

The industry Nike operates in can be cyclical as well. During the financial crisis, sales of sports and apparel fell 15%, for example. Nike also faces major competition from the likes of Adidas, ASICS, Li Ning, Lululemon Athletica (LULU), Puma, Under Armour, V.F. Corporation (VFC), and others.

Rising competition and digital disruption in the retail sector has recently hurt Nike’s North American sales, though management is confident that its home business will turn around in 2018. However, keep in mind that in North America many of Nike’s segments command market share near 50% or higher.

Even with its strong history of innovation and industry-leading marketing spending, Nike’s market share can only climb so high. With traditional North American retail markets largely stagnating, Nike could be forced to invest heavily into new products and marketing just to maintain its high market share position.

There’s always the risk of changing consumer tastes in this industry as well. About 60% of Nike’s sales come from performance-focused apparel and footwear. However, in recent years consumers have been gravitating more towards lifestyle and leisure apparel, meaning customers are less focused on improving athletic performance and more on comfort.

Should this trend continue or accelerate, it could pose a problem for Nike’s plans to offer more premium priced products, including through its DTC channels. And speaking of DTC, while much of management’s targeted investments in this area are focused on digital initiatives, the plan also includes opening more physical stores. More brick-and-mortar locations will increase Nike’s fixed costs and could make future margins more volatile during industry downturns.

Finally, it’s worth emphasizing that the company’s biggest growth engine remains emerging markets such as China. Should long-term middle class growth trends undershoot projections, Nike could remain more dependent on increasingly competitive developed markets, potentially jeopardizing its growth ambitions.

Nike’s market share in these regions is generally much lower compared to its position in the U.S. as well. Success is far from guaranteed, especially as consumers can remain loyal to the (likely cheaper) brands they currently purchase.

Closing Thoughts on Nike

Nike helped to pioneer the footwear and sports apparel industries and has demonstrated an impressive knack for continuously innovating its way to higher profits and dividends over the years. In fact, Nike has paid uninterrupted dividends for more than 25 years and increased its dividend every year since 2002.

The company enjoys a very strong competitive position thanks to its economies of scale, successful development of on-trend products, substantial marketing budget, and robust global distribution network. Thanks to the long growth runway provided by international markets and digital-focused expansion opportunities, Nike is potentially set for many more years of fast dividend growth.

While conservative investors are often best off avoiding fashion-related consumer stocks, Nike’s product portfolio, financial health, and durability are quite impressive. Overall, Nike appears to be a high quality business to consider for a long-term dividend growth portfolio.

To learn more about Nike’s dividend safety and growth profile, please click here.