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Investing, Stocks  | January 28, 2019

While it has been suspected since May, Nike (NKE) has finally inked a deal with MLB to be the official uniform and apparel provider for Major League Baseball. When this deal picks up, Nike will have rights to provide apparel for the three largest sports leagues in North America. With rival Under Armour (UAA) (NYSE:UA) struggling financially (company backed out of MLB deal for financial reasons), and adidas (OTCQX:ADDYY) supplying only the NHL (the smallest of NA's four major sports leagues by revenue), Nike's perch on top of the sports apparel world is more prominent than ever. Nike has the deep pockets to support these long-term contracts, further strengthening the bull case for Nike as a long-term wealth generator.

While it has been speculated since Under Armour dropped the MLB deal in May, it became official on Friday when a 10-year deal was announced between Nike and the MLB. The deal will begin with the 2020 season. Under Armour originally secured a deal with the MLB in 2016, its first major league apparel contract. However, the company had to back out of the deal before ever getting started due to financial reasons. Under Armour's deal was supposed to begin with the 2020 season. Fanatics, Inc. has retained retail licensing/distribution rights as part of the original deal.

Source: howmuch

The deal gives Nike apparel rights for the three largest sports leagues in North America (NFL, MLB, and NBA). As of now, Nike's contracts run as follows:

  • MLB through 2030
  • NFL through 2028
  • NBA through 2025

Given Nike's $3.4 billion cash hoard and ability to generate more than $4.7 billion in annual free cash flow, Nike is obviously financially positioned to support and maintain these commitments. These contracts give Nike dominant market exposure for years to come. This further reinforces our long-term bullishness on Nike that is already built upon a foundation of Nike's strengths.

Return To Growth

Nike had been facing declining revenue growth from 2015 through the summer of 2017. Nike innovated and implemented new tactics built on bringing products to market faster, and aggressively expanding its digital presence. These tactics were aimed at boosting a direct-to-consumer retail experience.

The strategy has been working wonders for sales, as Nike's quarterly revenue growth has accelerated back to high single digits since the summer of 2017. With the continued rollout of this strategy combined with Nike's continued expansion in China and women's apparel, we expect revenue growth to maintain a 5% rate.

Strong Fundamentals

This type of revenue growth goes a long way for Nike because the company is effective at generating cash. The company turns almost $0.11 of every sales dollar into free cash flow. The resources that the business does generate are efficiently deployed by management. Looking at the cash rate of return on invested capital, Nike realizes a 34.7% rate of return. Looking backwards, this rate of return is consistently above 16% which is already a strong rate. For reference, we typically look for a rate in the low-teens or higher as a benchmark.

How much has top line growth and high efficiency boosted cash flow for Nike? In 2009, Nike generated $1.2 billion in free cash flow. Over the trailing 12-month period, Nike has generated $5.8 billion in free cash flow. Having this much cash is crucial when you consider the massive advertising expenses and endorsement deals that Nike routinely spends on. These strong cash streams have made it possible to navigate these expenditures without crippling the balance sheet.

Nike only carries a net debt position of about $460 million thanks to a $3.4 billion cash balance. Its leverage ratio of 0.7X EBITDA is well below the 2.5X threshold that we use as a "warning sign" that a company is over-leveraged.

This scale is what gives Nike such a "moat" against competition. Under Armour spent several years attempting to emerge as a threat to Nike. It has continually spent and borrowed in an attempt to gain ground. However, it is difficult to sustain this behavior over the long term without the type of cash flow that Nike produces.

A quick look at Under Armour's balance sheet over the past decade illustrates the toll that chasing Nike has taken on the company. This financial resiliency and cash generation is Nike's ultimate "ace in the hole". Its pockets are the deepest in an industry that is extremely expensive to compete in.

Showering Investors With Cash

Considering Nike's cash flows, it shouldn't be a surprise to investors that Nike is a blossoming star in the dividend growth arena. Slowly tracking towards "dividend champion" status, Nike has increased its dividend for the past 17 years. The dividend is paid quarterly, and totals an annual payout to shareholders of $0.88 per share.

Nike has behaved like a growth stock for years, and that has resulted in dividend increases that have well surpassed inflation. Over the past decade, the dividend has grown at a CAGR of 13.9%. That rate has slowed some in recent years, but remains strong. The five-year CAGR is the same, and the two most recent increases have hit 11% and 10%, respectively. The dividend only consumes 27% of free cash flow, so the payout remains very manageable despite its strong growth.

In addition to a growing the dividend, Nike has also continually bought back stock over the years. The company has managed to shrink the number of outstanding shares from 1.96 billion to 1.57 billion over the past decade. This has helped fuel consistent double-digit EPS growth for years.

While investors may roll their eyes at Nike's 1.09% dividend yield, this type of growth can compound wonderfully when maintained over long periods of time (as Nike has done). In fact, a $10,000 investment made in 1995 would be worth a whopping $375,000 today. However, if you didn't reinvest dividends, that investment would be worth $72,000 less.

Valuation

The biggest hang up with many investors regarding Nike's stock is the sizable premium valuation that it commands from the market. As we can see in the chart below, the stock price suffered when Nike's growth decelerated. The market had concerns about whether Nike could continue to grow at past rates. When growth came back in the summer of 2017, the share price recovered.

The current stock price at just under $81 per share is near the high end of Nike's 52-week range. Analysts are projecting Nike to earn $2.65 per share for the current fiscal year. The resulting earnings multiple of 30.4X earnings is approximately 32% higher than the stock's 10-year median of 22.93X.

The problem with paying into such a lofty valuation is that investors are exposed to significant PE compression should sentiment on the stock turn negative. If Nike sees growth slow down again, the stock could quickly reprice itself to a much lower earnings multiple. We are viewing our investment in Nike as a multi-year long-term hold. Still, we see the stock as overpriced at more than 30X earnings. We view an ideal price target to be less than $66 per share (25X earnings), but feel comfortable through $73 given a long-term holding period and bullish growth prospects.

Wrapping Up

Such an earnings multiple is higher than we typically will allow ourselves to pay for a stock. However, Nike's position in apparel is quite possibly the strongest it has ever been. With a long-term strangle hold on the top 3 sports leagues in North America, a successful growth strategy, strong cash flow generation, and the deep pockets/clean balance sheet to keep competitors at bay, times are better than ever to own the swoosh.


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