Contents
Summary
- In early February 2019 I viewed NKE as expensive and wrote April 2019 $87.50 covered calls.
- NKE released strong Q3 results after the March 21st market close but results disappointed investors and its share price pulled back over 6.50% on March 22nd from the previous day’s ~$88 close.
- I view NKE as a solid long-term investment and intend to acquire additional NKE shares for the FFJ Portfolio but will patiently bide my time for a better valuation.
Introduction
On March 21, 2019, Nike, Inc. (NKE) reported financial results for Q3 2019 which ended February 28, 2019 following the market close. While NKE continues to be firing on all cylinders, Mr. Market has not reacted kindly to the reported results and NKE’s share price has taken a hit.
I hold several hundred NKE shares in the FFJ Portfolio and am of the opinion that NKE’s long-term growth prospects are extremely promising. Having said this, I was becoming increasingly concerned about NKE’s valuation which is the reason why I wrote short-term out-of-the-money covered calls in February 2018; I disclosed this trade in my February 4, 2019 article.
I have written recent articles in which I have disclosed my use of a conservative short-term out-of-the-money covered call option strategy when I think there is a strong probability a company’s valuation is stretched.
When I employ this strategy I am merely trying to skim additional income from my holdings. I certainly do not want to part ways with the underlying shares so I seek strike prices which provide me with what I think is a reasonable buffer.
In the case of NKE, shares were trading at ~$82 when I initiated my NKE option trade ($87.50 strike price with an April 18, 2019 expiry); I received a $1.35/share premium and following the March 22, 2019 plunge in NKE’s share price this option is valued at ~$0.40/share meaning I am currently ahead ~$0.95/share (I know this can very quickly change!).
On December 20, 2018, NKE had released Q2 results in which it had reported $1.19 EPS. I extrapolated earnings to estimate FY2019 earnings of $2.38 and added a buffer; I used projected diluted earnings of ~$2.50. I figured that if NKE’s share price was to rise to $87.50 and it did generate FY2019 earnings of $2.50 then NKE’s diluted PE would be ~35.
There is no disputing NKE is a great company but a diluted PE of ~35 is certainly a lofty level and is certainly much higher than valuation levels exhibited over the past 10 years.
So, what happened subsequent to me writing those covered calls?
Well, Mr. Market has certainly not been behaving rationally and, to quote New York Yankees Hall of Famer Yogi Berra, it has certainly looked like ‘déjà vu all over again’. Those of you who have been investing for some time can recall prior periods of irrational exuberance and can see some similarities with what we have recently witnessed.
Looking at the magnitude in which our investments have appreciated in recent months I am of the strong opinion that further growth in equity values is going to be far more subdued in the upcoming months; I wouldn’t be surprised to see a nice correction!
In my opinion, several major global economies face a number of major headwinds and investors should be prepared to get accustomed to looking at daily stock price changes which have a ‘minus’ sign a bit more frequently than the degree to which they have become accustomed.
If we look at NKE specifically, NKE’s share price rose above my $87.50 strike price to close at $88.01 on March 21, 2019! Following the release of Q3 2019 results after the market close on March 21st, however, and NKE is now trading at ~$82.19; this is very similar to when I initiated my covered calls.
NKE reported Q3 2019 diluted EPS of $1.87. Very simplistically, divide this by 3 and we get average quarterly earnings of ~$0.623.
As noted further in this article, US tax reform regulations have yet to be finalized so let’s be prudent in estimating FY2019 diluted EPS. Let’s say NKE has a fantastic Q4 and generates $0.68 EPS. This means NKE’s FY2019 diluted EPS would be ~$2.55. If we use the $87.50 strike price from my covered call and $2.55 we get a forward diluted PE of ~34.3. This level is still well above what I consider reasonable for NKE even though it is a great company!
With NKE trading at ~$82.19 and my optimistic FY2019 $2.55 diluted EPS estimate I still get a lofty forward diluted PE of ~32.23.
I certainly to do not profess to be able to accurately predict how a company’s stock price is going to perform in the short-term but I still stand by my February decision to initiate NKE short-term out-of-the-money covered calls.
Q3 2019 Results and Guidance
NKE’s Q3 2019 results can be found here and here.
NKE is certainly firing on all cylinders as borne out by senior management’s comments on the Q3 conference call.
Management’s outlook for constant currency Revenue growth and Gross Margin continues to improve; NKE is continually investing in the business so as to fuel strong sustainable growth.
On the Q3 conference call, management indicated it expects the FX headwind on reported revenue to lessen as it enters FY2020.
Q4 2019 Gross Margin is expected to increase 75 bps thus enabling NKE’s Gross Margin expansion to exceed its long-term financial model.
Despite strong sales growth at NKE’s higher margin NIKEDirect businesses, the business is expected to be negatively impacted in Q4 by higher input costs (cotton, chemicals, and labor), FX headwinds, and the shift of supply chain investments from Q3 into Q4.
US tax reform regulations, which have yet to be finalized, have increased the volatility in NKE’s tax rate; non-recurring items favorably impacted Q3 on a net basis.
NKE’s tax rate volatility is expected to continue until such time as these regulations have been finalized and management has indicated that, due to uncertain timing, not all of the potential non-recurring impacts have been factored into Q4 guidance.
While management is still in the early stages of its annual planning process, the preliminary outlook for FY2020 is high-single digit revenue growth as well as gross margin expansion and profitability in line with the long-term financial model communicated at the Investor Day in October 2017 and which I covered in this article.
Credit Ratings
There has been no change to NKE’s credit ratings subsequent to my previous NKE article. Moody’s still rates NKE as A1 and S&P Global still 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
In my September 26, 2018 NKE Stock Analysis article I indicated:
On September 25th, prior to the release of Q1 results, NKE closed at ~$84.80. On September 26th, NKE closed at ~$83.75. Using the current $2.66 consensus adjusted EPS from 35 brokers for FY2019, we arrive at a forward adjusted PE of ~31.5.
Projected adjusted earnings for FY2020 from 34 analysts is $3.14. Using the current ~$83.75 share price we get a forward adjusted PE of ~26.7. This level is closer to recent historical levels.
Consensus adjusted EPS from 34 analysts for FY2019 is now $2.58 and $3.08 for FY2020 from 35 analysts.
With NKE trading at ~$82.19 and FY2019 guidance of $2.58, the projected adjusted diluted PE is 31.86. The projected adjusted diluted PE using FY2020 estimates is ~26.69.
Dividend, Dividend Yield, Dividend Payout Ratio
NKE’s dividend history can be found here. On April 1, 2019, NKE will be distributing its 2nd $0.22 quarterly dividend.
Based on the current $82.19 stock price, NKE has a forward dividend yield of ~1.07% which is slightly higher than the 0.96% level at the time of my September 26, 2018 article.
I calculate NKE’s dividend payout ratio as ~34% which is the $0.88 annual dividend divided by my FY2019 diluted EPS projection of ~$2.55. I view this as a conservative ratio.
Option Strategy
Writing the same option I wrote back in February will net you very little premium so, if you think NKE’s share price will likely remain under pressure for another couple of months, let’s look at May 2019 contracts.
An $87.50 May 2019 NKE call would generate ~$1.07/share before fees while an $85 May 2019 call would generate ~$1.80/share before fees.
In my opinion, as an investor who wants to own NKE shares for the long-term, I would be reluctant to write an $85 call when NKE is trading at ~$82.19; the difference between those two values is just not enough of a buffer for me.
You could certainly go out further on the calendar but I hesitate to write options that go beyond 2 months.
If I did not already have covered calls outstanding I would not bother initiating a covered call trade.
Final Thoughts
At the end of the ‘Introduction’ segment of my September 26, 2018 NKE Stock Analysis article I indicated that ‘it is often advantageous to go against the crowd’. This is what I did when I wrote covered calls in February 2019.
The rise in NKE’s share price subsequent to me initiating that trade worked against me. Fortunately, investors came to the realization that NKE was trading at a lofty valuation and the share price has JUST pulled back.
I view NKE has a great company worthy of holding for the long-term. Despite today’s pullback, however, I still view its current share price as somewhat rich.
Using my $2.55 projected FY2019 diluted EPS and a 27 PE (still high but I don’t envision a PE in the low 20s unless the entire market collapses) I get a price of ~$69.
35 analysts project FY2020 adjusted diluted EPS of ~$3.08. If I use the same 27 PE I arrive at a stock price of ~$83.
This is certainly not an exact science but the mid-point of these two values is $76. I think NKE somewhere in the mid $70s would be a fair price to pay.
I recognize this may appear to be a low level relative to the $82.19 March 22, 2019 closing stock price but I am of the opinion that the broad market is ripe for a nice pullback. Given my outlook, I am cautiously optimistic that NKE in the mid $70s is not totally out of the realm of possibility and will patiently wait for this range to be reached before I acquire additional NKE shares.
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.
