To Own Nike Stock, an Investor Must Absolutely Trust the Industry

NKE stock - To Own Nike Stock, an Investor Must Absolutely Trust the Industry

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The stock market is supposed to be forward-looking. In the case of Nike (NYSE:NKE), it better be. NKE stock has gained more than 50% from October lows on the back of performance that truthfully hasn’t been that spectacular.

In fiscal 2018, ending April, constant-currency revenue grew just 4%. Gross margins fell 80 basis points, and selling, general and administrative (SG&A) expenses increased 9%. As a result, Nike’s operating profit for the year actually declined more than 6%. Results did improve at the end of the year, admittedly. Fourth-quarter results handily beat expectations. The third quarter looked solid as well, though I wrote at the time I wasn’t quite convinced.

Indeed, I’m still not — because the disappointing growth isn’t just limited to fiscal 2018. The company set a goal in 2015 to reach $50 billion in revenue by the end of fiscal 2020. It’s going to fall markedly short: Consensus suggests sales of barely $42 billion next year.

With NKE stock back to trading at a forward earnings-per-share multiple near 24x, clearly the market is pricing in an acceleration of growth. And while that’s certainly possible, it’s hardly guaranteed. For Nike to support even the current valuation, it’s going to have to do better — and get some help.

NKE Stock Rises and So Does the Industry

Certainly, Nike’s own results have driven some of its big post-October gains. Growth in North America has strengthened, after a disappointing first half raised serious questions about the health of that market — and of the Nike brand. Asia has rallied, with revenue in China growing 35% in Q4. Nike management promised that the second half of the fiscal year would be better. Those investors who believed management have been rewarded.

But there’s also been some strength in the footwear industry as a whole, suggesting that NKE stock has received some outside help. (To be sure, it’s also possible in some cases that Nike’s improvement has driven some of the gains elsewhere.) Under Armour (NYSE:UA)(NYSE:UAA) has gained a whopping 84% since Nov. 3. Foot Locker (NYSE:FL) is up about 70% from its lows around the same time. Smaller retailers like Shoe Carnival (NASDAQ:SCVL), which gets about 35% of its revenue from Nike, and DSW (NYSE:DSW) have rallied as well. Only Adidas (OTCMKTS:ADDYY) has been left out.

Admittedly, tax reform has helped, most notably for the retailers in the group. But clearly sentiment toward the industry as a whole, particularly in the U.S., has improved. Nike’s own results, in particular, suggest that the worries were a bit overblown. And that in part explains at least a portion of the big gains in NKE stock over the past few months.

Strength Must Continue

That said, at the current valuation, it’s reasonable to question whether the market has overshot in terms of both the industry and Nike itself. NKE stock is back toward trading at a 23x+ forward price-to-earnings multiple — similar to what it received when growth was much stronger.

Yet gross margins look like they don’t have a ton of room to move higher, with the strong dollar actually having a negative impact due to overseas manufacturing. What the company calls “brand creation” expense isn’t going to slow, given the intense competition both in the U.S. and in China. (The company will get a bit of a reprieve in Fiscal Year 2019 with no Olympics or World Cup.)

As for sales, Nike does have easy comparison in Q1 and Q2, particularly in North America. But the current valuation is starting to price in what Nike used to offer. Expectations suggest high single-digit revenue growth and margin expansion leading to a double-digit percentage rise in profits. That’s doable — but it requires a notable step up.

It also requires some help from the space as a whole. Competition is increasing in the mid-tier price range. Nike’s high-end shoes may become more of a luxury if and when the U.S. economy slows down. The “athleisure” trend is helping apparel sales — that category rose 1% in FY18, including 6% in Q4, against full-year declines in footwear and equipment. That, too, may turn.

Be Careful

Nike is a great American company, and admittedly the valuation isn’t ridiculous. There’s certainly a “wonderful company at a fair price” argument here.

But the optimism of late suggests that the company is heading toward a new phase of growth. That may be the case. Still, investors need to remember that increased growth will require better execution from Nike — and some outside help.

As of this writing, Vince Martin has no positions in any securities mentioned.

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