Ensemble Capital Client Call Transcript: Nike Update
We recently hosted our quarterly client conference call. You can read a full transcript HERE.
Below is an excerpt from the call discussing our investment in Nike (NKE).
Excerpt (Arif Karim speaking):
Nike is a globally recognized brand for performance shoes and clothing with $34 billion in sales and 35% return on invested capital (ROIC).
This brand is built on the strength of its product innovation and performance, innovative marketing tactics, and global capabilities in manufacturing and distribution. All of these aspects of the company provide it with a moat that allows the company to charge premium prices, earn strong profits, and stay resilient in light of new and existing competitors and waves of fashion trends that have threatened it over time.
Its sales are 50% larger than its closest competitor Adidas and it is more than twice as profitable. The next few competitors, like Under Armor and Puma both at $5 billion, are markedly smaller in scale. When Nike was founded in 1964 by Phil Knight, Adidas was a much larger incumbent in the sneaker business and Nike was the scrappy startup. Knight was a passionate competitive runner and recruited others passionate about running or Nike’s business to build its early success, with a strategy that eventually centered around leading product innovation and more aggressive and creative marketing tactics than the incumbents’ as described in his memoir, Shoe Dog. In time, Nike opportunistically expanded to other sports like football, baseball and basketball.
Over the years Nike successfully built its moat as its brand came to represent innovation, performance, style, and, in the spirit of its namesake, winning. Winning meant partnering with winners, which became a hallmark of Nike’s marketing – signing endorsement deals with athletes who were stars or showed potential to become star performers. They used Nike’s products and their fans bought the shoes their heroes wore to feel connected with their favorite athletes and teams. As more people wore Nike’s shoes in and out of their workouts, fashion became an increasingly important part of the successful shoe formula, blending the utility of performance with fashion elements of everyday style.
As the success of the company grew, it was able to get more stores to carry its products, increasing distribution. Nike got its wholesale retail customers to even commit to advanced orders to secure the most popular styles for their shelves 6 months out. This gave Nike increasing visibility into demand but also created a symbiotic relationship between the company and its key retail partners in both driving and managing demand, which allowed Nike to better manage its supply chain and costs.
As its scale grew towards becoming the largest shoe company in the world, Nike was able to leverage its scale to control the relatively few shoe manufacturers in Asia. Making a shoe is a much more complicated process, with more specialized manufacturing, than making clothing, which is why there are generally fewer opportunities for competition in footwear by new companies. Innovative performance materials, efficiently scaling manufacturing techniques across thousands of SKUs (stock keeping units), comfort, fit, and durability are all key aspects in succeeding in the shoe business at scale. This makes companies with a greater emphasis on footwear, like Nike with 60% of sales from footwear, much more durable than competitors like Under Armor whose sales are much more skewed towards clothing, which is more easily penetrated by new players. You’d rather be the brand leader in athletic shoes while pulling in ancillary clothing sales than the reverse because your core is a much more competitively protected business.
In retail’s age of disruption, this is a key distinguishing characteristic under the constant threat of e-commerce’s behemoth, Amazon, with its crushing scale, speed, and resources, while on the other end are the plethora of smaller startups leveraging social media and fast turn retail techniques to disaggregate markets into smaller tailored niches they could better serve. Through this disruption, we believe the survivors will be those companies with strong emotionally charged brands that can connect with customers, with quick global product design, manufacturing, distribution, and marketing capabilities, efficient scale, and a resilient and adaptable organization.
All of these represent strong aspects of Nike’s moat that position it to continue doing well over the long term, from its world-renowned brand that connects with its customers across channels (via stores, web, mobile apps, and social media), the scale to invest in innovation in product, production, marketing, and distribution, and its ability to seek out and retain the top athlete endorsements in the world in a variety of increasingly global sports like basketball, soccer, running, and tennis.
As an example of the symbiotic cobranding appeal of Nike and its roster of athletes, its most successful partnership with Michael Jordan still drove $3 billion in revenue for Nike’s Air Jordan line in its last fiscal year (about 10% of total Nike brand sales) reportedly netting Michael Jordan royalty payments over $100 million in 2017 some 15 years after his third and final retirement from the NBA. Most of the NBA’s top stars are still signed up with Nike in large endorsement deals worth hundreds of millions with notable exceptions being Stephan Curry and James Harden. The scale needed to compete for these endorsement deals across global sports makes it increasingly difficult for new brands in retail to compete and increasingly irrational for the very top athletes to sign with brands that may not be able to endure over time.
While a brand like Amazon also has emotional ties with its customers, it is inherently based on higher level utilitarian, rational appeals. Amazon is great at executing in retail areas where selection, price, convenience, and reliability are paramount. Undifferentiated retailers just cannot compete. However, Amazon has not been able to develop brands that have ties to deeper, lower level emotions that are potentially more powerful such as team loyalty, hero-worshipping, self-confidence, and self-identity that a company like Nike appeals to. It is no easy feat to create a brand that does this effectively and the impact this has on its consumers is powerful because it’s hard to quantify or articulate that emotional boost, giving the company the upper hand in pricing negotiations in the consumer/company relationship at the purchase point moment of truth.
We got our opportunity to start buying the stock about a year ago as growth began showing signs of slowing from the double-digit range in the prior 5 years to more like the mid to high single-digit range that we foresaw over the next 5 years. The reset in market expectations in spite of continuing strong returns on capital caused the stock to fall from a high in the $60’s to a low of about $50 a share. Its valuation went from a 29x price to earnings ratio to 20x. Our research and valuation work suggested that in our normalized reasonable baseline scenario the stock was meaningfully undervalued given the durability of the brand franchise and returns on capital, as well as the global growth opportunity ahead in underpenetrated regions like China, Europe, and the emerging markets.
While the previous 5 years had seen strong growth from the more mature North American market with the trend towards causal/“athleisure” wear and the emergence of a stronger fashion and collectability trend among “sneakerheads”, 2016 and 2017 saw a plateauing of this trend and, in fact, a shift towards a different style of casual streetwear that corresponded with Adidas’ strategy of partnering with popular celebrities and its retro-styled sneakers. In addition, channel shift has been an ongoing theme over the past couple of years as brick and mortar stores have seen declines in foot traffic and ceded share to e-commerce players, disrupting traditional sales and ordering patterns. While this sort of shift is always a threat especially when the market leader like Nike accounts for half the market, we believe the shifts are a short-term dynamic which will stabilize.
The bigger growth opportunity going forward comes from the international markets, where Nike expects 75% of its future growth to come from and now accounts for about 60% of sales. In addition, this growth is likely to be more profitable over time as its direct to consumer business via its own stores, website, and app will account for a greater percentage of its total sales while creating a more direct relationship with the customer. What excites us is that Nike has oriented itself to take advantage of technological and cultural changes to improve its customer connection, brand experience, and retail position in contrast to most brands that are finding themselves in more defensive positions in adapting to these changes. Its recent shift to its “Triple Double” strategy – 2x Innovation, 2x Speed, and 2x direct customer connections – while reorganizing itself from an organization comprised of functional teams towards a more agile one centered around the 12 most important local influence markets it serves (12 major cities across 10 countries around the world), are examples of the company’s resiliency and adaptability.
The success of this positioning is already showing up in Nike’s latest quarterly results in which its digital sales grew 29%, total direct sales (about 30% of total sales) grew 15%, and international sales grew 14% driven by growth in China and Europe.
While the past couple of years have seen some challenges to Nike’s growth expectations, we believe that the next few years will see a return to healthy growth with improving profitability as a result of the changes management has made to its tactics built on the foundations of the company’s existing moat.
You can read the full transcript HERE.
Clients, employees, and/or principals of Ensemble Capital own shares of Nike (NKE).
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