Since its inception 50 years ago, Nike (NYSE: NKE) built an empire out of shoes. Named after the Greek goddess of victory, the company has compounded its capital at or near 20% per year for decades. To no one’s surprise, he It turns out that making shoes for ~$25 and selling them for ~$100 is a great deal. However, NKE shares have been completely crushed in 2022, down over 40% as I write this. This is one of the biggest declines among large-cap stocks. There are a few possible reasons for this, but the reason that makes the most sense to me is that valuation got out of control in 2021. NKE now seems to be getting closer to fair value.
Nike releases its results after the bell on Thursday, September 29, giving a window not only into the company’s business, but also into the state of local economies in the United States, Europe and China.
How does Nike make money? A winning business model
Some companies keep their business mostly secret, but Nike is quite easy to analyze. Nike is widely studied by business school case studies. There is also a wealth of information available in the company’s 10-K report.
Nike shoes cost around $100, depending on the country. Of this amount, studies have shown that approximately $28.50 represents manufacturing and shipping costs. Nike then typically wholesales the shoes to retailers for around $50. That leaves about $21.50 in gross profit, most of which goes to personnel, marketing and administration costs.
Nike has historically made the vast majority of its money from wholesale to retailers. It’s not a bad deal, and it has the advantage of not having to deal with rent payments, employees, and inventory management. But the obvious downside is that you’re leaving a lot of money on the table. But with the unstoppable rise of e-commerce, Nike is increasingly selling directly to consumers and cutting out the middleman. This has been a key structural driver for earnings. Instead of earning around $20 gross profit per shoe, they can potentially earn 2-3 times as much. And of course, Nike not only sells shoes, but also sells sportswear and equipment, which often generates higher margins.
Nike is also a global company that makes more than 50% of its profits outside of the United States. And as the global economy grows slowly over time, the demand for footwear and apparel increases, creating another tailwind.
So why has Nike dropped 40%+ for 2022?
- Valuation – Whenever a stock with reasonably good underlying activity is crushed like Nike did, the valuation is the first place you should look. Nike has a PE of 21x to May 2024 earnings at current prices and earnings estimates. But at its peak last November, the company traded at more than 40 times its earnings estimate. Sure, earnings are now being revised down, but paying 40x for a large-cap company is a problem. In a common theme of many blue-chip growth stocks, Nike’s valuation has significantly outpaced its business over the past 10 years, and now it’s coming home.
Nike went from just under 20x earnings about 10 years ago to 25x, then 30x and finally about 40x last November. Of course, I’m smoothing out the trend note that 2018 came from the deferred tax burdens of the Trump admin’s tax bill, and 2020 came from early pandemic chaos. From now on, NKE is back in its historic range.
2. The US Dollar – Nike reports its earnings in dollars but sells a lot overseas. This means that a strong dollar will cause Nike’s reported earnings to decline. And if you’ve been paying attention lately, the dollar is skyrocketing. Forex is generally not worth worrying about when investing in individual stocks, but it’s a headwind.
3. Margins – The best thing about cutting out the middleman is that you can take all the profit for yourself. The worst thing about cutting out the middleman is that it means you’re stuck paying more employees, having the right inventory, and getting the right supply chain/logistics. Nike is not inflation-proof, and you can see from its 10-K that its EBIT margin has shrunk from 2021, in line with the rest of Corporate America. This is a question mark for the future and the company is going to have to up its game when it comes to supply chain and logistics.
4. Politics – Nike seems to have never seen a political issue that they don’t want to take sides on. Nike’s strong involvement in social and political issues is a liability for the company. Nike has long been a lightning rod for controversy, whether it’s sweatshop labor, Nike’s dealings with the Chinese government, Black Lives Matter and Colin Kaepernick, or Israel/Palestine.
Nike is a microcosm of the global economy
Consumer discretionary stocks like Nike are closely tied to the global economy. China is fighting for Nike as confined consumers aren’t really looking to buy new shoes. North America crushed it for Nike during COVID as demand remained strong and consumers opted to buy direct from the company rather than retailers. But how will this hold up with the slowing economy? Europe is another question mark now – how will the sharp increases in the cost of living and the war in Ukraine affect demand?
These are all macro issues that Nike’s earnings will provide insight into. However, in the long run, Nike’s business model is a winner. As annoying as constant controversy is, I’m not one to turn down money. Also up this week is Micron (MU), which will advise on semiconductor supply and demand. After the quarter ends this week, many of the first companies to report will be banks, with mega-cap tech companies reporting later in October. Each third quarter earnings report will place another piece of the puzzle for investors looking to understand what’s going on with consumers and the global economy. Of particular importance are the various consumer discretionary companies that have seen huge increases in earnings and valuation during COVID, and are now experiencing huge declines.
As for Nike, I think if you can get it below 20x fiscal 2024 revenue, it’s a good buy. That’s about $90 per share, assuming the company doesn’t seriously miss estimates. With the stock market plummeting, value is starting to come out of the woodwork in large-cap stocks, and NKE stock is a good example.