Nike (NKE): A Quality Dividend Growth Stock Down Over 20%

Since its founding in sleepy Beaverton, Oregon, in 1964, Nike (NKE) has grown into the world’s most dominant sports apparel supplier, and 18th most valuable brand in the world.

 

Along the way they have made countless long-term dividend investors very rich. In fact, from 2006 through 2015, Nike has returned 20.9% per year (including dividends) compared to the S&P 500’s 7.4% annual return.

 

However, over the past year, concerns over slowing sales, increasing competition from the likes of Adidas (ADDDF) and Under Armour (UA), and falling margins have sent shares nose diving over 20%.

 

Learn if the king of sports apparel could be unseated from its throne and if this recent sell off makes now a reasonable time to buy what could prove to be one of the best blue chip dividend growth stocks of the next decade.

 

Business Description

Nike designs, develops, markets, and sells footwear, sports apparel, equipment, and accessories around the world 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.

 

It has four main reporting units: Footwear, Apparel, Equipment, and the Global Brands division. However, as you can see, Footwear, and Apparel are by far the largest, fastest growing, and most important divisions.

 

Division	Fiscal Q1 Revenue	% of Revenue	YoY Change	YoY Constant Currency
Footwear	$5.472 billion	64.7%	7%	10%
Apparel	$2.549 billion	30.1%	9%	12%
Equipment	$423 million	5.0%	4%	6%
Global Brands	$15 million	0.2%	-42%	-30%
Total	$8.459 billion	100%	8%	10%

Source: Nike Earnings Release

 

By geography, approximately 47% of Nike’s sales are within the U.S. Around two thirds over Nike’s total revenue is generated by North America and China. The business is very global.

 

Business Analysis

Barring times of extreme global economic weakness Nike has been able to generally put up annual high-single to low-double digit sales growth, even more impressive EPS growth, and steadily rising returns on investor capital.

 

Since 2005, Nike’s revenue has more than doubled and EPS has more than tripled.

 

These are all signs of the company’s strong innovation brand equity, which gives Nike good pricing power and a strong moat. Speaking of innovation, over the past 25 years, Nike has built the third largest design patent portfolio in the country.

 

Once the company invents a product, it can scale it across sport categories and geographies. As the world’s largest footwear and athletic apparel brand, Nike also enjoys economies of scale in its production processes.

 

The final result of these strengths can be seen in Nike’s industry leading margins and very impressive return on capital.

 

Company	Operating Margin	Net Margin	Free Cash Flow Margin	Return On Equity	Return On Invested Capital
Nike	13.1%	11.6%	6.8%	30.6%	27.0%
Industry Average	11.6%	8.9%	NA	23.6%	NA

Source: Morningstar, Simply Safe Dividends

 

Of course, with the global economic slowdown recent sales growth hasn’t been nearly so good, and a recent increase in inventory, and the commensurate markdowns needed to clear them, has pressured margins somewhat.

 

However, that hardly seems to justify the market’s overreaction over the past year. That’s because of several key positive factors that Wall Street is currently overlooking.

 

First, keep in mind that Nike’s brand strength remains as robust as ever, thanks to it having honed athlete endorsements down to a science, as seen with the decade’s long premium pricing power of the Air Jordan brand.

 

Second, international growth, especially in developing markets, gives the company a very long growth runway. For example, in the last quarter constant currency sales growth in China, Japan, and Emerging Markets came in at 21%, 18%, and 11%, respectively. That’s especially true given that the global sports apparel and footwear industry is estimated to be over $270 billion in size, meaning that Nike’s overall market share is less than 15%.

 

Third, some of the increase in inventory is due to Nike executing extremely well in its direct-to-consumer, or DTC efforts, especially with sales through Nike.com. For example, DTC and NIKE.com sales in the fiscal Q1 were up 22% and 49%, respectively; far higher than retail sales in any of its international markets. Nike’s e-commerce business is a little over $1 billion and is expected to grow to $7 billion by the end of fiscal year 2020.

 

Finally, while Nike may not seem like a tech company, it’s in fact adopting the latest in manufacturing technology in order to boost sales, earnings, and margins. For example, online sales allow customers to customize shoes, which sell at premiums compared to what is available in stores.

 

In addition, management is currently investing heavily in what it calls “ManRev,” or manufacturing revolution, which is expected to further boost the company’s core strengths.

 

CEO Mark Parker, who started out as a shoe designer, has been with the company for 30 years, and has been in the top job since 2006, points out that through the benefits of further production automation, and 3D printing, the company can reduce waste in product manufacturing, increase how quickly new products can hit the market, and offer customers even more customization.

 

In other words, via investing in state of the art manufacturing processes, the company can cut costs, maintain or win market share, and boost margins. In fact, Morningstar analyst R.J Hottovy thinks that Nike can boost its gross margins by as much as 310 basis points, or 3.1%, to 49% by 2020 using such techniques.

 

To put that in perspective, the last year’s margin decline that caused the stock to collapse by nearly a quarter was just 30 basis points. Which means that the market’s reaction to a successful implementation of even better economies of scale, and superior manufacturing methods should be much greater, resulting in potentially amazing capital gains.

 

Key Risks

There are several important risks to consider when evaluating Nike.

 

First and most obvious is the growing competition from upstarts such as Under Armour (UA) and Lululemon Athletica (LULU). That’s both due to strong execution on the part of these rivals, as well as the growing importance of sports apparel, which is more prone to fickle changes in fashion tastes.

 

A recent Bloomberg article noted that Nike generates more annual sales than Adidas, Lululemon, Under Armour, and Foot Locker combined, underscoring the increased challenge Nike has to defend its market share and generate healthy growth figures compared to its smaller rivals.

 

The article goes on to discuss that Nike might be having a harder time pushing through price increases on its shoes like it has been able to do in the past. This is due to more competition but also consumers “switching out of their running and basketball sneakers in favor of more casual styles, such as the Stan Smith and Old Skool lines of Adidas and Vans, respectively.”

 

The chart below shows the growth rate of Nike’s futures orders, which retailers place in advance of delivery. Futures orders are a decent indicator of future demand. Nike’s growth rate has slowed considerably in North America (green line) and China (blue line).

 

 

We can’t forget that sports apparel is a cyclical industry as well, as seen by the -15% sales growth decline during the great recession. Slowing growth around the world, but especially in China, could hurt sales and make management’s goal of achieving $50 billion in revenue by 2020 (nearly 60% growth compared to 2015 sales of $30.6 billion) a tougher target to hit.

 

Nike’s large international presence also means that the company’s reported sales, earnings, and free cash flow can be hurt when the U.S. dollar strengthens (Nike converts local currencies into dollars for reporting purposes). While this risk doesn’t impair Nike’s long-term earnings power, it can still weigh on the stock over shorter time periods.

 

Thus far the stronger US dollar is costing the company 2%, or 20% of its reported growth, although the effect varies from region to region. For example, in strong currency regions such as Europe, the negative currency effect eats up 30% of reported growth. But in emerging markets it can be as much as 120%, which is what happened in the most recent quarter when emerging market sales rose 11% but ended up -2% thanks to the strong dollar.

 

Dividend Safety Analysis: Nike

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.

 

Nike has a Dividend Safety Score of 99, indicating that it is among the safest dividends of any stock in the market today. Nike’s strong safety rating begins with its healthy payout ratios.

 

First, Nike’s free cash flow (FCF) payout ratio over the last 12 months is a moderate 50%, meaning that FCF could theoretically get cut in half and the current payout would still be safe. And keep in mind that such a FCF collapse would take dire economic conditions indeed.

 

The company’s FCF payout ratio has yet to rise above 50% in the past decade, even during the worst economic catastrophe since the Great Recession.

 

 

Speaking of the Great Recession, Nike’s business powered through. Sales dipped just 1% in fiscal year 2010, and Nike’s stock outperformed the S&P 500 by 19% in 2008. Resilient businesses often have safer dividends as well.

 

 

Nike has consistently generated great free cash flow as well. Free cash flow is the money Nike has left after reinvesting back into its business and is the sign of a healthy business. It also allows for sustainable dividend payments.

 

 

The other key protective factor is the company’s strong balance sheet. As you can see, though the sports apparel industry isn’t a highly capital intensive one, Nike nonetheless has a very low level of debt.

 

In fact, the company has a net cash (cash + cash equivalents – total debt) position of more than $2.5 billion and is generating annual free cash flows of over $2 billion a year. Nike also maintains an AA- credit rating with S&P.

 

Simply put, Nike is a blue chip with a fortress balance sheet that can withstand pretty much any economic calamity barring an outright apocalypse.

 

 

Overall, Nike’s dividend is about as safe as they come. The company’s healthy payout ratio, durable business model, excellent free cash flow generation, and pristine balance sheet position it well to continue making dividend payments for many years to come.

 

Dividend Growth Analysis

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Nike’s Dividend Growth Score is 93, indicating that investors can likely expect many more years of strong payout growth. The company’s strong dividend growth prospects are driven by its healthy payout ratios, excellent balance sheet, and solid earnings growth potential.

 

Nike has paid uninterrupted dividends for more than 25 years and increased its dividend every year since 2002. The company is a Dividend Achiever, having raised its payout for at least 10 straight years.

 

As seen below, Nike’s dividend growth has been exceptional and consistent. The company’s dividend grew 15.4% per year over the last 20 years and by 15.6% per year over the last three years. Nike last raised its dividend in late 2015 by 14.3%.

 

 

Looking ahead, Nike has potential to continue rewarding shareholders with 10%+ annual dividend increases thanks to strong earnings growth and flexibility with its healthy payout ratio and balance sheet.

 

Valuation

Even despite its 24% share price collapse over the last year, Nike’s stock still trades at a forward P/E ratio of 21.3 and offers a small dividend yield of 1.3%, which is about in line with the stock’s five-year average yield.

 

Nike doesn’t look like a bargain today, but high quality dividend growth stocks rarely do. If the company can deliver double-digit earnings growth over the next decade, which would be in line with the company’s historical results and hopes for the future, shares of Nike would likely deliver annual total returns of at least 10%.

 

Alternatively, if smaller companies and evolving consumer preferences begin making future growth more difficult to come by for Nike (which is largely why the stock has declined over the last year, in my view), future earnings growth could disappoint. In this scenario, Nike’s P/E ratio would likely slip below 20 and result in more of a mid-single digit annual return profile for long-term investors.

 

Conclusion

Nike has proven itself to be one of the best long-term wealth builders in the US stock market, a true dividend growth blue chip. With seemingly plenty of growth runway still ahead of it, a strong brand, and a solid plan from management to further boost sales, margins, and the dividend in the coming years, Nike looks like an interesting candidate for long-term dividend growth investors to consider.

 

Nike’s keys to success will be continued innovation and marketing investments to hold its profitable market share as demand for athletic apparel and footwear rises around the world. I have a hard time pulling the trigger on consumer stocks, especially those related to fashion because trends can be so unpredictable, but Nike’s investment case for our Top 20 Dividend Stocks portfolio is beginning to look more compelling.