Nike stock valuation stutters (NYSE:NKE)

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It feels like yesterday that shares of Nike Inc. (NKE) were the dog of Wall Street. Shares couldn’t climb out of the low $50s after some weak quarters caused the market to judge the apparel titan had lost its mojo. Due to Nike’s fundamental strengths, I enjoyed the stock as a great long-term investment when shares were around $52 per share. Fast forward to today and after a run up to $70, investors are back to singing Nike’s praises. We consult with Nike to determine what investors should do now.

source: Nike Inc.

Origins of a decline

After peaking at over $67 per share in late 2015, Nike’s stock price has eroded to just over $50 per share. To understand why, we have to recognize Nike’s reputation as a growth stock. By 2015, Nike had grown revenue at a five-year CAGR of nearly 10%. Earnings also increased by almost 14% CAGR during this period. The market had pushed the stock to an earnings multiple of 33X when the stock was near its peak, despite the stock’s median multiple over the past decade of 22X.

When a stock is listed at such high valuations, the market practically expects “perfection” in the performance of the company. If anything comes below that, there is plenty of room for the stock to fall. This is indeed what happened, and it’s a valuable lesson that valuation matters – no matter the title. With the future of traditional retail being disrupted by e-commerce players forcing investors to rethink the industry, industry headwinds along with slowing revenue growth have hit Nike hard. Shares slid lower, bottoming just below $50 per share. The stock hovered in the mid-$50s until late 2017, when Nike’s strategic shift in its go-to-market approach began to pay off.

Nike’s triple double turnaround

Source: Kick

As the retail sector continues to face increasing pressure from online competitors, Nike has taken an aggressive approach that has proven effective. He launched his “Consumer Direct Offense” which targeted key markets that will drive 80% of Nike’s growth through 2020 (management says). These cities include New York, London, Tokyo, Berlin, Paris, Los Angeles, Mexico City, etc.

Nike’s triple-double approach increases consumer product choices, reduces the time it takes to bring products to market, and diversifies into the digital market to reach consumers directly through online and smartphone apps. The strategy was announced in June 2017 and the results have been noticeable.

GraphicNKE revenue data (annual) by Y-Charts

After bottoming out last summer, revenue growth began to pick up again in fiscal 2018. Nike spent much of 2018 building momentum and ended the year with a solid fourth quarter which saw revenues increase by 9% (excluding currencies) Year after year.

Source: Nike Inc.

The company’s presence in China is growing rapidly with full-year sales growth of 18%. This is huge for Nike, as China’s population of 1.4 billion still represents a market that offers room for growth and has a growing middle class.

GraphicNKE Gross Profit Margin Data (Quarterly) by YCharts

Margins also rebounded for Nike as the company’s profitability benefited from its new direct-to-consumer approach. With both revenue growth and margins returning to form, investors are once again excited about the stock.

Evaluation

With this excitement, it looks like we’ve come full circle since the summer of 2015. Shares have surged above $60, recently hitting $81 per share.

GraphicNKE data by YCharts

Analysts expect Nike to earn around $2.65 per share in fiscal 2019. Based on the current share price, we’re looking at a multiple of 30 times earnings. Although the stock price is higher due to Nike’s continued strong earnings growth, the valuation has once again reached 30 times earnings or more. Not as incendiary as when the 33X earnings multiple in 2015 represented a 45% premium to the decade norm, today’s multiple still points to a considerable 36% gap.

If we look at the FCF yield, we get a similar conclusion. Free cash flow yield is great because it helps indicate how much free cash flow we are getting for our investment. If we are able to capture a high rate of FCF per dollar invested, our likely return on investment will be favorable as cash flow fuels everything in a business, from dividends to growth initiatives. We want to maximize our cash flow as investors.

GraphicNKE Data on Free Cash Flow Yield (TTM) by YCharts

If we look at the current yield, we can see that it has trended lower as the stock price has appreciated. When investors bought stocks at a low in the yield of the FCF, stocks continued to rise in the months that followed. Either Nike must continue to grow its FCF (while stocks remain stagnant) or the stock price must fall. The drastic profit premium is a reflection of this. Even though we have accepted a slight premium for the stock (say 24X to the decade median of 22X), we are still looking for an entry point of $63.60 per share.

Wrap

It looks like Nike, from an investment perspective, has come full circle. The summer of 2015 taught us what can happen when we subscribe to ratings that reflect perfection. Companies rarely uphold such high standards indefinitely. When faced with a setback, companies with inflated valuations will see a rapid compression of the P/E occur.

Nike – although not as high an earnings multiple as a few years ago, has returned to a very rich valuation. Investors who already have a position should keep their shares. Nike is a quality slot machine that deserves a reserved place in any long-term portfolio. Those looking to swap the name or add shares should exercise caution. A soft quarter or broad market reversal can see stocks repeat what we saw after the last time optimism around Nike was so high.

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