Nike Does It Again

Wide-moat  Nike (NKE) delivered another strong quarter of growth, with revenue up 15% to $7.4 billion and earnings per share up 25% to $0.74. It is now pushing returns on capital above the mid-20s. These returns are in record territory, high even for a best-in-class performer like Nike, but they show little sign of weakening. The machine that generates brand equity through sports marketing and sponsorships, and now through online experiences, continues to stoke demand to levels that protect pricing power. The firm is also leveraging demand creation and overhead expenses, which grew 17% year over year, below the 24% growth in net income, which was driven by a 120-basis-point increase in gross margin.

Despite our affinity for the Nike brand, our favorable view of management, and admiration for the industry-leading financials, the trend in strong results has increased investor expectations to the point where much of the upside may already be in the stock.

Futures orders are up 7% but an even stronger 11% at constant exchange rates. Management also noted that the second quarter of last year was the beginning of orders for the 2014 FIFA World Cup, and that futures excluding early World Cup orders last year would be up double digits in Europe, North America, and China. Despite macroeconomic worries from other Western brands and Nike's own operational issues in 2013, Asia's largest economy is again delivering strong growth for the company, up 21% in the quarter to $758 million. The running and basketball segments continue to be strong globally.

The direct-to-consumer business also continues to outperform, with all direct sales up 18% and Nike brand direct up 30%. Online orders were up 66%. We believe sporting goods companies have outsize opportunities to use star athlete sponsorships to generate online consumer connections.

Nike footwear continues to be a growth leader, again increasing sales at a rate of 18% in North America and reaching nearly $2 billion, but also growing more than 25% in Europe and over 30% in China. Eastern Europe increased footwear sales 32% currency neutral, or 25% in dollars, but it is less than 5% of total revenue. The only few negatives among many positives were that equipment sales were down 2% in North America because of the poor golf season, and despite increasing footwear sales 7% in Japan, equipment and apparel segments both lost ground, driving overall country sales down 5% in dollars, or a gain of 3% in yen terms.

Nike's direct-to-consumer growth has outpaced its growth in wholesale sales, despite the firm avowing that it planned to keep the businesses' percentages of total revenue roughly stable. Direct-to-consumer revenue for the total company was 18% in fiscal 2013 and 20% in fiscal 2014. We believe Nike and rivals are only now starting to leverage what we believe are uniquely marketable assets (sports stars, teams, and events), combined with the ability to create additional value for consumers with greater choice and customization. Thus far, this has only increased demand at retail partners, but does create some worry about the balance of power over the long term. At the same time, Nike has, in our view, historically outpaced rival Adidas by not investing in retail store locations. If online sales can replace the need for a capital-intensive physical store strategy, we believe the nature of competition and cooperation may be very different in the long run, with Nike's portfolio of sponsorships being a key competitive advantage.

International Expansion Is Key to Growth…
Nike is the largest, dominant competitor in athletic footwear, apparel, and equipment--a consumer category that it has helped define and revolutionize over the past four-plus decades. Although footwear and apparel are competitive businesses, few companies are as successful as Nike. Because of its size, brand image, and related competitive advantages, we expect Nike to maintain its market leadership, high returns on capital, and wide Morningstar Economic Moat Rating.

Product innovation, unique marketing, and balanced distribution strategies remain key to Nike's success. New innovations in shoe production technologies, if accepted by consumers, could drive higher long-term margins. Equally important, the shoes' innovative knit designs will support Nike's image of being a market leader. Although the firm develops products across a wide range of price points, its competency in higher-end performance footwear and apparel is unmatched. The firm's tremendous marketing resources, coupled with endorsements from widely recognized athletes, add long-term credibility to Nike's many innovations. We believe this is a key reason that new product launches in running shoes, marquee basketball products, and performance apparel continue to outperform the market. In addition, we see long-term growth opportunities in global soccer, where Nike has been steadily gaining share and where developing markets will continue to increase average price and performance product penetration. Nike's emphasis on technical products increases profitability and minimizes product overlap with other footwear and apparel manufacturers, resulting in industry-leading margins.

International expansion will be the firm's primary long-run growth engine, but North America continues to post surprising revenue gains. We see considerable opportunities for long-run expansion in China, specifically, where the brand is already a leader with revenue of more than $2.6 billion in fiscal 2014. We believe Nike is a way to play emerging-market growth around the globe, as other middle-class consumers develop consumption habits around increasing participation in sports and using the international sports brands that star players display.

…But Global Economy Brings Risk as Well
We assign Nike a medium fair value uncertainty rating. Its intrinsic value can be influenced by global economic trends, including discretionary spending patterns. Industry competition, particularly from Adidas, Puma, and Under Armour, is always present and could also come from new entrants in developing-market economies such as China. Changes in consumer tastes and preferences are always a risk in athletic footwear and apparel categories, and despite performance attributes, products do have a strong element of fashion. With more than half of its sales coming from outside the U.S. and a heavy concentration of Asia-based suppliers, the firm faces the risk of increased import costs and currency volatility, which cannot be hedged indefinitely.

Nike has experienced strong growth in its home market as the brand's popularity has been ever increasing since the North American financial crisis. Some athletic segments, such as basketball where Nike is dominant, tend to be somewhat cyclical with fashion trends and investors should be wary of extrapolating trends too far into the future.

Although the company has always succeeded with a wholesale-dominated strategy, recent gains and increasing management emphasis on direct-to-consumer channels pose risks. Retail channels require greater investment and higher overhead; profits also tend to be more cyclical with the economy. In the near term, direct-to-consumer sales could increase growth and profitability, but investors run the risk that such investments could dilute returns in the longer term.

Brand and Scale Make for a Wide Moat
As the leading player in the $310 billion global athletic footwear, apparel, and equipment market (according to NPD Group estimates), Nike has developed a wide moat via its superior product-development capabilities, universally recognized brands, and tremendous scale. Nike's global brand reach, including a strong presence in emerging markets, is the result of core research and development capabilities and a marketing budget of more than $3 billion, including endorsements from some of the most popular global athletes. As a result, consumers have shown a propensity to pay premium prices for Nike's products. With leading market share in a variety of categories including sportswear ($5.9 billion), running ($4.6 billion), basketball ($3.1 billion), and athletic training ($3.6 billion in annual sales), Nike can exert a significant amount of influence over retailers, many of whom rely on its products to drive customer traffic.

We believe CEO Mark Parker has done an excellent job of keeping product cycles fresh and relevant while investing in innovation and product cost control for the long term. We think Nike is in good hands with him at the helm. Founder Phil Knight still owns about 16% of the company with his Class A and B shares. Even though Knight is entitled to elect the majority of the directors, we believe that the board is sufficiently independent; 10 of the 13 directors are outsiders. Nike has picked from the leaders of other iconic American businesses to fill its board. Although total executive compensation is generous, it does not seem out of line with that of other large corporations, and performance incentives and options align executives' interests with shareholders'. Given Nike's high returns on capital, focus on the brand, and executive focus on increasing returns on invested capital, our Morningstar Stewardship Rating is Exemplary.