Some Reasons to Short Nike

In this article, let's take a look at NIKE, Inc. (NKE, Financial), the giant in the sport business, and see if this is an appealing investment opportunity or not.

Nike is the strongest player in the industry, and we all know this top position is not easy to maintain because the industry has evolved steadily over the past four or five decades. Moreover, the competition is high with few barriers to entry, which means that well-known brands or new competitors could grow quickly helped by innovation. In such scenario, the only way is to reach differentiation to justify higher prices. Among the reasons for this admirable position, three of them are: size, brand image and competitive advantages. I believe the company will maintain its leadership because it plans to continue making efforts to innovate with focus on marketing campaigns as well as distribution strategies. For example, the improved version of Nike Flyknit Free, situated Nike in a higher level. All the above are drivers for long-term growth of the company. Furthermore, in this industry there is something that is true: higher innovation means higher prices. The company also plans to lower costs through supply chain and reaching efficiencies could have greater impact in margins. Also, propaganda strategy with top athletes generates consumer confidence and long-term credibility to the brand.

Deserves special mention the global soccer market, where Nike has been gaining market share at a good pace. Despite the recent scandals in FIFA, no one doubt about the growth of the sport worldwide.

Other growth driver is international expansion. Although, North America continues to be the principal market, some regions seem attractive too. When looking at geographic reach, the six areas are: North America (47% of FY 14 revenues),Western Europe (19%), Emerging Markets (15%), Greater China (10%), Central and Eastern Europe (6%) and Japan (3%). In my opinion, the opportunities for growth are strongest in China and emerging markets, because middle-class income is growing and thus also consumption.

Revenues, margins and earnings

Total revenue for the third quarter of fiscal 2015 was $7,460 million, an increase of 7% compared to $6,972 million in the comparable period in fiscal 2014. Along with this, earnings per share significantly increased by 18.7% in the third quarter compared to the same quarter a year ago showing strength in various categories and markets. The net income increased by 16.0% in the same comparison, to $791 million from $682 million.

The firm had one of the highest operating margins the sub-industry (higher than 85% of the companies in the global footwear and accessories industry), reaching 14.03% as of February 2015. Moreover, the net margin is at 10.6% at the end of that month an also outperform the sub-industry median. But in terms of ratio analysis, what matters most is the evolution, and both ratios are somewhat volatile.

In the next table, we can appreciate Nike's earnings estimates, which are used as a benchmark to measure a firm's performance relative to how experts expected it would do.A good candidate for a long position might be a company with five years of solid earnings growth and strong earnings growth estimates for the coming years. I actually think at least two years. Further, earnings surprise is important because it can move a company’s stock price.

Source: Yahoo Finance

Although positive surprises continue, as you can appreciate, they start to be less in the last two quarters. But it is very important to remain positive.

Growth of $10,000

Nike has the best price performance among peers in a one year period and over a period of five years, it is only surpassed by Lululemon Athletica Inc. (LULU, Financial). An investor, who invested $10,000 five years ago in Nike, would triplicate its performance today, to $30,791, which represents a 25.2% compound annual growth rate (CAGR). In my opinion, this is a good CAGR, as well as the ones achieved for revenue, EBIT and earnings from continuing operations which were 7.7%, 8.4% and 12.6%, respectively.

Return on equity

I always like to see one of the most important financial ratios applying to stockholders, the best measure of performance for a firm's management: the return on equity. The ratio has increased from the same quarter one year prior and this is a clear sign of strength within the company. Some of its major competitors include Lululemon, Gap (GPS, Financial), and Adidas (OTCQX: ADDYY). Let´s compare the current ratio with the peer group in the next table:

Nike has a good ratio of 27.2% higher than the one registered by Lululemon. We think that a ROE greater than 30% is quite enough to provide dividends to owners and have enough funds for future growth of the company. For investors looking for a higher ROE, Gap could be the option with an impressive ratio. It is very important to understand this metric before investing and it is important to look at the trend in ROE over time.

Relative valuation

From a valuation standpoint, trading at a 42.6 P/E, which stands at a premium compared to the industry mean, indicates that other companies operating in the same sub-industry are less richly valued. The following table compares the current valuations:

While Gap trades for almost 13 times trailing earnings and Adidas trades at a P/E of 29.9, Nike trades at a higher valuation, at a 30.9 P/E. Gap looks the most attractively valued looking back the trailing ratio. Considering the relative valuation, at the current price level I think Nike is relatively expensive compared to its peers and the industry median of 21.2.

Nike stock price has been moving in a trading range of $74.40-$106.85 in the 52-week range. The stock is currently trading at the top of this range. In my opinion, this does not create a good opportunity to start an investment in Nike stock.

Top hedge funds holdings

I always like to see which hedge funds have long positions in the stock. Paul Ruddock and Steve Heinz´s Lansdowne Partners held 8.77 million shares at the end of the first quarter. The value of the stake amounted to $880.0 million. In that period, the stock gained 4.35% and perhaps this is the reason why the hedge fund has decreased the stake by 6%. The second-largest shareholder is Stephen Mandel´s Lone Pine Capital, with 5.67 million shares, valued at $569.7 million, held as of the end of the first quarter of 2015.

Final comment

Nike is the world's largest seller of athletic footwear and apparel, but there are some reasons that make me suspect that now it is not the right moment to initiate a position in the stock.

Although the company experienced stronger-than-expected results for the first nine months of fiscal year 2015, with a weaker-than-expected revenue growth in North America and Europe, we view the shares as not attractively valued at recent levels.

The company focuses on R&D while making efforts to innovate design and approving large marketing budget to maintain brand positioning. Despite Nike´s global brand positioning initiatives, there are some risks such as response to new demand or the unfavorable foreign currency fluctuations to be aware of.

According to the P/E ratio, the stock is relatively overvalued and subject to a potential sell recommendation. Because the stock market is forward looking, stock prices are established based on the expectations that investors have for the future earnings power of the firm. A proxy for the market’s expectations is analysts’ consensus earnings estimates which we see are positive but declining.

Its stock price performance growth over the past year was the highest between peers. Although the consensus 12-month price target is $109.31, a 3.1% expected increase from current prices, the actual price level is indicating a relative overvaluation.

In my opinion I would not recommend investors to consider adding Nike for their portfolios. Billionaire’s hedge fund managers Steven Cohen (Trades, Portfolio) and Joel Greenblatt (Trades, Portfolio) have reduced strongly their position in the first quarter of 2015 by 91% and 81%, respectively.

Disclosure: Omar Venerio holds no position in any stocks mentioned

• Steven Cohen Undervalued Stocks
• Steven Cohen Top Growth Companies
• Steven Cohen High Yield stocks, and
• Stocks that Steven Cohen keeps buying
• Joel Greenblatt Undervalued Stocks
• Joel Greenblatt Top Growth Companies
• Joel Greenblatt High Yield stocks, and
• Stocks that Joel Greenblatt keeps buying