By Valuentum Analysts
Nike Inc. (NKE) is home to some of the biggest names in apparel and footwear. Its exposure to the sportswear trend, combined with its stellar digital operations and significant pricing power, underpins Nike’s bright growth prospects. Adjusted for Inventory breakdownNike has pushed for substantial increases in its dividend in recent years (including a considerable boost in November 2021). We expect Nike’s excellent dividend growth track record to continue in earnest going forward, aided by its rock-solid financial position.
Nike focuses its “Nike Brand” product offerings in the following categories: Running, Basketball, Football (soccer), Men’s Training, Women’s Training, Nike Sportswear (sports-inspired lifestyle products), Action Sports, Gold and the Jordan brand. The breadth and depth of its product portfolio has resulted in consistently strong results.
back in June 2017, Nike announced its “Consumer Direct Offense” initiative which aimed to aggressively increase its direct-to-consumer (“D2C”) sales through digital channels such as mobile apps and Nike-operated websites. In subsequent years, this program was a home run. Success on the D2C and digital front underpins Nike’s promising prospects for revenue growth and margin expansion over the long term.
Even in the face of major headwinds from the coronavirus (“COVID-19”) pandemic, Nike has delivered tremendous financial performance. Please note that the company’s fiscal year ends in May. In financial year 2021, Nike’s GAAP revenue increased 19% year-on-year to $44.5 billion, while its GAAP gross margin increased approximately 140 basis points to approximately 44.8%. The success of its D2C and digital operations has been key here, as Nike has been able to continue to meet strong demand for its offerings as many brick-and-mortar stores have temporarily closed, while using its pricing power to maintain and grow its margins. Its “NIKE Direct” sales increased 32% year-over-year in fiscal 2021, while its “NIKE Brand Digital” sales jumped 64%. Nike’s apparel, equipment and footwear offerings all saw strong sales growth in fiscal 2021.
Primarily due to the pandemic, Nike’s operating expenses fell year-over-year in fiscal 2021. Reduced operating expenses, revenue growth and expansion of the gross margin offset a higher corporate tax bill and allowed Nike to more than double both its GAAP operating profit and GAAP net income for fiscal 2021 on an annualized basis. Its GAAP operating margin increased by approximately 725 basis points in fiscal 2021 compared to fiscal 2020 levels, reaching approximately 15.6%.
This impressive performance translated into excellent cash flow performance. Nike generated $6.0 billion in free cash flow, defined as net operating cash flow less capital expenditures, in fiscal 2021. This is a sharp increase from $1.4 billion free cash flow that Nike generated last year. Additionally, Nike spent $1.6 billion to cover its total dividend obligations and an additional $0.6 billion to repurchase its common stock in fiscal 2021, activities fully covered by its cash flow. available cash.
Nike has been facing headwinds lately due to manufacturing and other supply chains obstacles in Southeast Asia. Its GAAP revenue grew only 1% year over year in the second quarter of fiscal 2022 (period ended November 30, 2021) although its GAAP gross margin still exploded by around 280 basis points during this period. Once again, the strength of its D2C and digital operations impressed. NIKE direct sales increased 9% year-over-year and NIKE-branded digital sales increased 12%. The company’s pricing power has allowed it to offset various inflationary headwinds and preserve its margins. Nike’s marketing spend has normalized in recent fiscal quarters, weighing negatively on its bottom line, although its GAAP net income still rose 7% year-over-year in the second fiscal quarter.
We appreciate that Nike ended the fiscal second quarter with net cash of $5.7 billion (including short-term investments and short-term debt). This financial strength has enabled Nike to announce it was sequentially increasing its quarterly dividend by 11% in November 2021. Going forward, we expect Nike to continue to steadily increase its dividend while repurchasing significant portions of its stock. During the first half of fiscal year 2022, Nike generated $3.5 billion in free cash flow and spent $0.9 billion to cover its total dividend obligations and an additional $1.7 billion to repurchase its common stock. Once again, both activities were fully covered by its free cash flow.
Economic profit analysis
The best measure of a company’s ability to create value for its shareholders is expressed by comparing its return on invested capital [‘ROIC’] with its weighted average cost of capital [‘WACC’]. The gap or difference between ROIC and WACC is called the economic profit gap of the firm.
From fiscal year 2018-2020, Nike’s return on invested capital (excluding goodwill) was 34.2%, higher than its cost of capital estimate of 8%. In our view, Nike is a tremendous driver of shareholder value. In the upcoming chart below, we show the likely trajectory of ROIC over the coming years based on the estimated volatility of the key drivers of the metric. The solid gray line reflects the most likely outcome, in our view, and represents the scenario that results in our estimate of fair value.
The upcoming chart below shows how we calculated Nike’s estimated WACC.
We believe Nike is worth $133 per share in our “base” case with a fair value range of $106 to $160 (the upper rung represents our “bullish” case scenario and the lower rung represents our “downside” case), derived through our rigorous discounted free cash flow analysis process. In short, we forecast Nike’s future free cash flow in perpetuity and discount that cash flow at the appropriate rate (its estimated WACC) and then factor in its balance sheet considerations. The near-term operating forecasts used in our corporate cash flow models, including revenue and earnings forecasts, do not differ materially from consensus estimates or management guidance.
Our valuation model reflects a compound annual growth rate of less than 10% over the next few years and an average projection of operating in the mid-teens. Beyond Year 5, we assume that Nike’s free cash flow will grow at an annual rate of 4.6% for the next 15 years and 3% in perpetuity. For Nike, we use a weighted average cost of capital of 8% to discount future free cash flow.
Our discounted cash flow process evaluates each business based on the present value of all future free cash flows. Although we estimate Nike’s fair value at approximately $133 per share, each company has a range of likely fair values created by the uncertainty of key valuation factors (such as future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn’t see much volatility in the markets, as stocks would trade precisely at their known fair values.
In the next chart below, we show this likely range of fair values for Nike. We think the company is attractive below $106 per share (the green line), but quite expensive above $160 per share (the red line). Prices that fall along the yellow line, which includes our estimate of fair value, represent a reasonable valuation for the business, in our view.
Nike is a stellar company. Its balance sheet is spotless, the company is a tremendous generator of free cash flow and shareholder value, and its pricing power continues to impress. We like how its D2C and digital operations are supporting both Nike’s sales and margin performance, and see room for further upside going forward. Shares of NKE are yielding a modest ~0.8% at the time of this writing, although we expect Nike’s dividend per share to grow at a healthy pace over the next few years.