Nike, Inc. - Employing a Conservative Option Strategy on Richly Valued Shares

Nike, Inc. (NKE) is a wonderful company. Shares, however, currently appear to be richly valued.

I wish to retain my shares in perpetuity, and therefore, am not prepared to sell my shares at a profit, crystalize my gains, and incur the related tax liability. I am, therefore, employing a conservative short-term out-of-the-money covered call option strategy to take advantage of NKE's lofty valuation.

This is a very conservative option strategy in which I merely wish to 'skim' additional income.

Summary

  • NKE is a very high quality company and great growth opportunities exists in fast-growing markets (eg. China) where more than 70% of NKE's growth over the next 4 - 5 years may be derived.
  • NKE is increasing innovation, direct-to-consumer sales, and speed which may improve margins.
  • Management has indicated membership growth in its digital channel is exceeding expectations.
  • NKE temporarily suspended share repurchase activity in March 2020 to maximize liquidity during the COVID-19 pandemic. Prior to this temporary suspension, a total of 45.2 million shares had been repurchased for approximately $4B resulting in ~$11B in remaining capacity under the 2018 share repurchase program.
  • I intend to hold my NKE shares for the very long-term and am not prepared to sell even though I view shares as being overvalued.
  • I am employing a conservative option strategy to skim additional income while NKE shares are richly valued.

Introduction

We have recently witnessed the use of aggressive option strategies and short-selling on companies of questionable value. This has led to some investors generating significant profits within a very short timeframe. While some investors have crystallized their profits I suspect a great number have held their position in these very weak companies and have watched their investment returns plummet in value.

I do not short sell and when I do employ the use of options, my trades are conservative. Yesterday, for example, I wrote covered calls against some of the Chevron Corporation (CVX) shares I hold in one of the 'Core' accounts within the FFJ Portfolio and in this article I explained my rationale for doing so.

In CVX we have what is arguably one of the best major integrated oil and gas companies in the world. It is, however, not insulated from the macro economic headwinds. Its results are weak and I expect these headwinds will persist for a few more months. I do not, therefore, envision a dramatic appreciation in CVX's share price over the next ~1.5 months.

Today I have written 5 Nike, Inc. (NKE) covered call contracts with a $155 strike price to expire March 19, 2021; the underlying shares are held in another account included within the 'Core' portion of the FFJ Portfolio.

NKE is a great company firing on all cylinders but I think its valuation has become stretched. An argument can certainly be made that if I think NKE is overvalued then perhaps selling the shares and repurchasing them if/when the share price drops would be a prudent idea. I initiated my position June 27, 2016 at an average cost of ~$52 so if I were to sell 500 shares at ~$138.30 I would be looking at a tax liability on a ~$44,500 capital gain. I am not willing to incur this tax liability and my plan is to hold my NKE shares in perpetuity.

Financial Results

NKE's most recently published earnings are for Q2 2021; these September 30, 2020 results were released December 18, 2020. Although I am dispensing with any commentary on these results, I did analyze FY2020 and YTD results for the purposes of deciding whether to place my option trade.

Credit Ratings

Moody's rates NKE's senior unsecured long-term debt A1 and S&P Global has assigned an AA- rating. Moody's rating is the top tier of the upper medium grade and S&P's rating is 1 notch higher at the lowest tier of the high grade. Both are solid investment grade ratings. As an equity shareholder who is assuming more risk than debt holders, I am comfortable with my degree of risk.

Dividend and Dividend Yield

While NKE does distribute a quarterly dividend (NKE's dividend history can be found here) my primary rationale for investing in the company is not for the dividend income. I expect the vast majority of my NKE investment returns over the long-term to come from capital appreciation.

Although NKE has yet to declare its next $0.275/share quarterly dividend I expect same to be declared within the next 2 weeks. This dividend will likely be payable at the beginning of April to shareholders of record in early March.

On the basis of a ~$138.30 share price, the dividend yield is ~0.8%. I hold shares in a non-registered account so I incur a 15% dividend withholding tax thus reducing my quarterly dividend to ~$0.23375 for a dividend yield of ~0.68%.

Valuation

Looking at YTD results, we see that NKE has generated $1.73 in YTD diluted EPS. Let's suppose the remainder of the current fiscal year is equally as strong as the first half and NKE generates full year diluted EPS of ~$3.50. Using the current ~$138.30 share price we get a forward PE of 39.5 based on diluted earnings. While there is no denying NKE is a wonderful company I think the current valuation is somewhat rich and in the upper 20s is where I would consider adding to my position.

Looking at FY adjusted diluted EPS guidance from 34 analysts I see a mean value of $3.02/share and a low/high range of $2.72 - $3.41. These values are even lower than the level I used above so the forward valuation on the basis of adjusted earnings is even higher than 39.5!

Option Trade

I am merely trying to skim additional income by employing this conservative out-of-the-money covered call option trade. I am not trying to 'hit a home run' which is why the $155 strike price is considerably greater than the current ~$138.30 share price.

I collected $0.98/share or $98/contract. Having written 5 contracts my total income is $490 less nominal commission. My breakeven point is, therefore, ~$155.98.

I note that the 52 week high is $147.95 and am reasonably confident NKE's share price will remain below the strike price between now and expiry. I could have certainly written option contracts with a lower strike price so as to generate additional income but with the extremely unhealthy investor behavior we have witnessed of late, I can not rule out that NKE's share price could jump dramatically over the next month and a half. I also note that NKE will likely be releasing Q3 2021 results right around the time my option contracts are set to expire. We could, therefore, see a surge in NKE's share price shortly before the results are released. I want a sufficient buffer so there is a very low probability of NKE's share price reaching my option strike price.

With the current share price well below the strike price, the option premium is 100% time value; there is no intrinsic value. As we approach the March 19th expiry date, this time value will begin to erode rapidly.

In the event NKE's share price approaches the $155 strike price I would likely close out my position and write new option contracts at a higher strike price further out on the calendar.

Final Thoughts

I am not a speculative investor, and therefore, would never consider assuming the degree of risk we have witnessed some investors take in recent days. The option strategy presented here and in my previous CVX article, is conservative. Returns similar to those which can be generated through the use of much more risky strategies, therefore, should not be expected.

I think NKE is currently richly valued but have no intention of selling my shares. I do, however, wish to generate income from my holdings over and above the quarterly dividend income. Given this and my low tolerance for risk I view this option strategy as one that can help me meet my objective.

I wish you much success on your journey to financial freedom.

Thanks for reading!

Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].

Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.

Disclosure: I am long NKE.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.