Contents
Summary
- NKE reported Q3 results March 22, 2018 which were better than expected when the one-time ~$2B impact from the Tax Cuts and Job Act is excluded.
- Despite the tax hit, NKE has indicated the TCJ is slightly favorable in terms of its normalized steady state effective tax rate and because it will provide NKE with more efficient access to capital.
- NKE is aggressively introducing new products which are resonating with consumers.
- Technological advancements are expected to significantly improve the consumer experience, to drive down labor costs, and to shorten the manufacturing to consumer cycle.
- While NKE is a great company with huge growth potential, it is somewhat expensive at $64.63, and therefore, I will not be adding to my position. If NKE were to retrace to $58 or less, I would consider adding to my position.
Introduction
On April 2, 2017 I wrote my initial Nike (NYSE: NKE) analysis and followed up that review with another post on November 20, 2017.
Now that NKE has released its Q3 2018 earnings on March 20, 2018 and its stock price has ticked up in an otherwise mostly down market, I thought I would quickly revisit NKE.
When I first wrote about NKE, it was trading at $55.73. The second time I wrote about NKE, shares were trading hands at $59.19. As at the close of business on March 23rd, NKE was at $64.63 representing a ~16% increase from my initial article on April 2, 2017.
The purpose of this article is to determine whether adding additional NKE shares at current levels is the best use of funds currently available for deployment.
Business Overview
In my November 20, 2017 post I indicated that at NKE’s Investor Day in October 2017 management had discussed the significant potential it saw in its international markets.
Shortly thereafter, NKE launched SNKRS apps in China in December 2017; in the first month there was over 2 million downloads.
On the Nike+ front, NKE is scaling its Nike+ membership which is still in the early stages. Strong consumer response was evidenced in Q3 with new members rising more than 50% versus the same period last year. There are also plans to launch it in all 12 of NKE’s key cities within FY2019. These cities (New York, London, Shanghai, Beijing, Los Angeles, Tokyo, Paris, Berlin, Mexico City, Barcelona, Seoul, and Milan) are expected to represent over 80% of NKE’s projected growth through 2020.
At the Investor Day presentation NKE laid out how its 2x direct initiative is delivering a vision for a more differentiated marketplace which will connect the NKE brand in deeper ways with consumers. This is being led with NKE’s digital business which was up 18% on a currency neutral basis in Q3.
The Consumer Direct Offence and triple double strategy discussed in my November 20th post has enabled NKE to secure early wins through new NKE consumer experiences and has differentiated retail across direct and partner channels.
Growth at NKE has historically commenced with innovation and great product. In Q3, NKE intensified the pace and scale at which it is bringing new and unexpected products to consumers. Examples of this include the Air Vapormax in which NKE delivers lightweight comfort with a distinct style; it quickly became the number one performance shoe above the $100 price point. NKE is currently scaling that platform into millions of pairs of shoes and will be introducing new designs like the Vapormax 2.0, the Vapormax 97, and the Vapormax Utility.
Another new product is Nike React. Initially the product was offered exclusively to Nike+ members and it sold out within hours. When NKE broadened the launch, it sold several weeks’ supply in just four days.
In addition, NKE introduced the Airmax 270 and the Air Vapormax. NKE now expects to grow the Nike Air business by several billion dollars over the next few years.
As NKE finalizes its investment plans for FY2019 it is prioritizing accelerated investment in the areas of the business that will fuel Nike's Consumer Direct Offense and drive long-term growth. At the top of the list is digital which ranges from new Nike+ membership experiences to new capabilities including data and analytics to NKE’s core enterprise resource planning platform.
An example of the extent to which NKE is using technology to enhance the customer experience can be found in its new NIKEiD Direct Studio. Through this technology, consumers are presented with an all-white version of a sneaker which can be designed in the NIKEiD Direct workspace. The shoe is then connected to the NIKEiD configurator. As soon as color and material selections are made, they are projected onto the shoe for a clear, immediate representation of the final product. This allows consumers to immediately experience their personalized design. Once the consumer approves the look of their personalized design, the design is sent to at a NIKEiD factory.
As far as technological enhancements on the manufacturing front, shoes require a lot of labor to produce. NKE has already been investing in advanced manufacturing with the goal of creating an entire shoe without human interaction.
Impact of the Tax Cuts and Jobs Act (TCJ) on NKE
In Q3, NKE reported a ~$2B income tax provisional charge. This was primarily related to the transition tax on its accumulated foreign earnings and the remeasurement of deferred tax assets and liabilities. These onetime charges include some non-cash impact with any cash impact to be paid over several years.
As a result of this charge, Q3 diluted EPS was ($0.57) since the TCJ resulted in a one-time $1.25 negative impact on EPS.
While the effective tax rate for Q4 is expected to be 10% - 12%, NKE’s tax rate may be volatile as it expects to continue receiving more specific legislative and regulatory guidance as to the application of the TCJ.
The impact of TCJ, however, is slightly favorable to NKE in terms of its normalized steady state effective tax rate. NKE has also indicated TCJ will provide it with more efficient access to capital.
Q3 2018 Results and Forecast
On March 22, 2018, NKE released its Q3 2018 results. Additional information can be found here.
NKE delivered strong and sustainable growth across all of its international markets. It exceeded the revenue and gross margin expectations set in the previous quarter. This was fueled by an unprecedented flow of new products and innovation platforms that will scale over time.
In the March 22nd analyst call, management highlighted Greater China where positive macro trends are accelerating from consumer spending to sport participation; in Q3 NKE’s Greater China business grew ~24%. It now sees an opportunity to expand its full digital portfolio starting with key cities such as Shanghai and Beijing.
The North American market, however, has certainly been a challenge for NKE as it has struggled with declining revenue in recent quarters (refer page 3 of 5 in each of the most recent quarterly reports - Q1 2018, Q2 2018, and Q3 2018). On the conference call, management indicated that in an effort to solve its problem in North America it has deliberately tightened distribution, made improvements to the Nike/Michael Jordan brand, accelerated innovation, and has sharpened its digital marketing. With these changes, NKE is confident Q3 marks a significant turn in North America and a reversal of the negative trend is expected in Q4.
NKE remains confident it can deliver on the growth and profitability expectations that were previously communicated for FY2018 (excluding the one-time impact of the TCJ).
NKE expects Q4 reported revenue to grow in the high single digit range. This growth reflects continued strength in its international geographies and reversal of the negative trend in North America.
Q4 gross margin is expected to be roughly flat or slightly up versus the prior year.
Management is of the opinion that foreign exchange headwinds are largely behind NKE. It now expects the impact of foreign exchange on earnings before interest and taxes (EBIT) net of hedging to be roughly neutral in Q4 and there should begin to be a shift to a slight tailwind in FY2019. Nike North America revenue is now projected to be roughly flat relative to Q4 2017 and there should be a return to growth in the first half of FY2019.
FY2019 planning has not yet been finalized but NKE currently expects FY2019 reported revenue growth in the mid to high single-digit range.
Potential Tariff Impact on NKE
Here is an interesting article on why Trump’s America-first trade policy makes little sense.
As far as the threat of a potential trade war, NKE manufactures the vast majority of its sneakers overseas so every dollar it has to spend on tariffs to bring those goods back to the U.S. is likely to cut into profits or to cause prices to rise. NKE, however, has had to deal with high tariffs for years and might be able to handle any new tariffs. Tariffs are already high for footwear, ranging from 5% - 40% depending on the materials used with ~20% being the typical tariff level for athletic shoes.
If tariffs on Chinese goods are imposed, I imagine NKE would move production to other low-cost countries. It would not move production to the US given that high wages might still make domestic production more expensive, even if new tariffs are added.
Furthermore, NKE is somewhat insulated from Trump’s threat to impose tariffs in that over the past several years it has reduced its exposure to China. Much of what used to be manufactured in China has been transferred to other countries. In fact, 40% of NKE’s sneakers are manufactured in Vietnam.
Looking at Nike’s Manufacturing Map, I see that NKE has operations in 42 countries, 554 factories, and a workforce in excess of 1 million people. Of this, 131 factories are in China (23% of all factories) and it has a workforce of ~163.5 thousand (~16% of the global workforce). By comparison, NKE currently has 8% of its factories in the US (44 for apparel and 1 for footwear) but these factories employ a total of less than 1% of NKE’s global workforce.
Credit Ratings
Moody’s rates NKE as A1 and S&P Global rates it AA-. Moody’s rating is the top tier of the upper medium grade. S&P’s rating is the lower tier of the high grade.
These ratings are acceptable from my perspective and I have no reason to believe my current NKE investment is at undue risk.
Valuation
When I wrote my November 20, 2017 post, the mean projected adjusted EPS from 36 brokers was $2.32. This translated into a ~25.5 PE based on the $59.19 stock price as at the close of business on November 17, 2017. This was relatively consistent with recent historical levels.
Now the current mean consensus EPS estimate from 37 brokers for FY2018 is $2.35. Using the March 23, 2018 $64.63 closing stock price we get a forward adjusted PE of ~27.5; I view this as somewhat elevated and will seek other investments that are more reasonably valued.
NKE’s dividend history can be found here. NKE has not yet updated its site to reflect the $0.20/share dividend on the outstanding Class A and Class B Common Stock which will be payable on April 2nd to shareholders of record at the close of business on March 5th; this represents the 2nd payment at this level.
Based on the March 23rd $64.63 closing stock price, NKE has a forward dividend yield of ~1.23%.
NOTE: Canadian readers interested in acquiring US listed shares in non-registered accounts or Tax Free Savings Accounts (TFSA) should be aware of the 15% withholding tax on dividends from US listed companies. In my case, NKE’s dividend yield is ~1% when the withholding tax is factored into the equation as my shares are held in a non-registered account.
NKE’s dividend payout ratio is distorted because it reported a diluted net loss of $0.57/share. This loss is attributed to the significantly higher income tax expense from the enactment of the TCJ which resulted in one-time provisional charges that reduced diluted EPS by $1.25.
Typically, NKE keeps its dividend payout ratio under 30% of diluted EPS. I am comfortable with this dividend payout ratio level.
NKE’s stock split history can be found here.
In Q3, NKE repurchased 14.6 million shares for ~$0.962B. This repurchase was part of the 4 year $12B share repurchase program approved by NKE’s Board in November 2015.
As of February 28, 2018, a total of 126.4 million shares had been repurchased under this program for approximately $7.2B.
Management has recently indicated that as a result of the TCJ, it should have more efficient access to capital which should enable it to complete its existing four year $12B share repurchase program within FY2019; this is roughly 1 year earlier than originally planned.
Final Thoughts
As far as the threat of tariffs being imposed, I strongly suspect NKE will be able to adapt as tariffs is not new to its business.
In my opinion, the recent announcement regarding tariffs which has rattled North American equity markets will likely continue to put pressure on the stock price of many other companies.
I strongly suspect Trump will not make it beyond one term as President. If I am correct, I think any incoming President may repeal whatever tariffs are imposed during the Trump administration. This would likely have a positive impact on many companies whose stock price will have suffered in a higher tariff environment. I am, therefore, paying close attention to the stock price of companies of interest to me to see to what extent their stock price will retrace.
IF, however, NKE’s stock price were to retrace to $58 or less, I would very likely acquire additional shares. At this level NKE would be trading at a more reasonable ~24.7 forward adjusted PE level. This is a reasonable valuation for a company with NKE’s growth potential.
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: Long 506 NKE shares in the FFJ Portfolio.
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.
