Powerful Brand Wins Nike a Wide Moat

With high returns on capital that approach those of top luxury brands and our expectation that the company will continue generating excess returns over the next 20 years, we assign Nike a wide economic moat rating.

Because consumers are shifting their purchase patterns, particularly to the online channel, Nike is building out its direct-to-consumer network, consisting of owned retail stores (1,142 at the end of fiscal 2017) and its website; this drives around 30% of sales. We forecast the channel rising at a midteens clip to about half of sales by fiscal 2027. This brings merchandise closer to the end consumer and enables the company to respond to customer preferences faster (including more personalization), which should lead to higher sales and margins.

Balanced distribution, including direct to consumer as well as traditional wholesale, remains important to Nike’s success. This may have been the impetus for the partnership with Amazon, set to begin later this year by selling a small amount of footwear, apparel, and accessories on the platform. Aside from distribution, we think a focus on product innovation that resonates with consumers is key to ensuring that Nike’s competitive edge doesn’t waver.

Even with its leading share and global reach, we expect the company to enjoy outsize top-line growth as a result of opportunities in its international segment (roughly 50% of sales) as athletic participation rates expand globally, particularly in the fast-growing soccer market where Nike holds a dominant position. We see the potential for long-run expansion in China, where Nike derives around 12% of sales; we forecast this geography to rise at a low teens rate, thanks to a middle class that is set to triple by 2020.

Dominant Brand and Cost Advantages Nike's wide moat stems from strong brand recognition and dominant cost advantages. Nike is one of the best-known sports brands in the world and has become synonymous with performance and innovation, backed by superior product-development technology and marketing efficiency. The company holds a leading market position in North America (50%) and China (19%), a growing position in Europe and emerging markets, and a dominant share of major sport industries like basketball, where it has an approximate 90% market share.

Nike’s technology, marketing, and expansive reach make it a natural brand partner for high-profile athletes and global sporting events such as the Olympics and World Cup, which increase awareness and stimulate demand. This is evident in the 5% increase in footwear (66% of sales) average selling price and 4% increase in apparel (30% of sales) ASP the company chalked up over the previous five years, compared with our estimate of a 2% ASP decline across the broader apparel and footwear category. This is particularly impressive given Nike’s sustained average unit growth of 6% in footwear and 5% in apparel over the previous five years, indicating to us that the brand portfolio holds cachet with consumers. In turn, the strength of the Nike brand has led to key relationships with retailers such as Dick’s Sporting Goods (representing 20% of Dick’s sales) due to its ability to drive traffic, often resulting in significant square footage throughout the store in prime locations. In our view, this supports the pricing power of the brand and the brand intangible asset behind our wide moat rating.

With $35 billion in annual revenue (well ahead of number-two Adidas ADDYY at $20 billion and number-three Under Armour UA at $5.5 billion), Nike can use its influence to extract more favorable terms from retailers--and similarly from its vendors and other suppliers--enabling economies of scale. Its cost edge doesn’t stop there, as the company is able to spend more on selling, general, and administrative expense, research and development, and marketing, all while boasting leading operating margins of 14% compared with Adidas’ 8% and Under Armour’s 9% as it spreads these costs over its large sales base. The company spent $3.4 billion (9.7% of sales) to market its products in 2016, compared with Adidas’ $2.0 billion (10.3% of sales) and Under Armour’s $480 million (10.3% of sales). We think this spending should enable Nike to consistently come to market with innovative offerings aligned with consumer trends as a means by which to ensure its competitive edge doesn’t waver.

Nike’s business model has allowed the company to generate returns on invested capital of 30%, excluding goodwill, on average over the past five years--well above our 9% cost of capital estimate. We have confidence that Nike will sustainably generate returns above its cost of capital for the next 20 years, supporting our take that it maintains a wide moat.

Risk of Fashion Winning Over Performance The main risk associated with Nike, beyond macro issues (consumer spending) and currency fluctuations (half of its sales are outside the United States), is the shift toward lifestyle/athleisure products in regions with declining interest in Nike's performance merchandise, which is responsible for roughly 60% of sales. Additionally, Under Armour and Adidas continue to fight for market share and expand in segments like footwear and women's, where fashion wins are presently driving outsize gains. But we think results based on fashion (as opposed to performance) could be subject to volatility down the road, as a failure to predict or react to prevailing consumer trends could equally constrain results.

Despite the ability to better control its relationships with the end consumer, Nike’s investment in the direct-to consumer channel poses execution risk, particularly as this necessitates heightened spending behind equipment, inventory, IT, and operating leases. This increases the cyclicality and operating leverage of the business and the risk that such investments could dilute returns longer term, should volume decline.

As Nike’s merchandise is increasingly sold directly to consumers, bypassing traditional retailers like Dick’s and Foot Locker, its wholesale segment (around 70% of sales in fiscal 2017; we forecast it will fall to 50% by 2027) could stay promotional for longer as retailers compete for traffic, negatively affecting Nike’s financial performance. We believe competition could intensify following Nike’s pilot partnership with Amazon. Further, if the company opts to sell higher-priced merchandise (which is typically reserved for Nike’s retail locations) through Amazon, it could have detrimental effects on retail store traffic that may result in occupancy deleverage.

Nike’s financial health is solid with little liquidity risk, in our view. Free cash flow has averaged roughly 9% of sales over the last five years, in line with our forecast over the next five years. We anticipate cash will be invested in the business first, with our forecast calling for capital expenditures to amount to around 3% of sales annually on average through fiscal 2027 (in line with the historical average) as the company builds out its direct-to-consumer sales channels. Beyond its internal needs to expand the business, we think Nike will opt to return excess cash to shareholders through dividends and share repurchases. The company has increased its dividend 13%-17% annually over the past five years, which we expect to continue (our model assumes 14%). This drives a payout ratio of roughly 30% over our 10-year forecast, similar to the previous five years. Repurchases have averaged around 3% of shares outstanding over the previous five years, and we anticipate Nike will buy back a commensurate level each year throughout our 10-year explicit forecast.