A Toast To Nike Exceptionalism

Get this: 73% of people who currently use Tide laundry detergent report that it was the detergent of choice in their household growing up. This is an important part of a business model–when you own a business that seeks to maintain the same customers for life, it is important to understand the source that creates the habit. When it comes to laundry, you buy Tide because your mom bought Tide. Most importantly, it suggests that the purchasing habits formed during youth are critical to business success because it becomes part of the invisible script that sticks with a person throughout life.

Take a look at smoking rates once the old guard tobacco companies were legally barred from advertising to high schoolers in September 1970. The smoking rates were 48% among “adult students” in 1970, and 42% among the American population at large. Fast forward to the end of 2014, and 16% of adult students are smokers while only 12% of the adult population smokes. It’s taken on an economic class angle as well, with over 70% of student smoking coming in areas that rank in the bottom 25% by income.

It would seem to follow, then, that an exceptional business is one that earns high operating margins while also being able to attract customers at a young age and subsequently retain them for life. Nike is a classic example of such a business.

Today, the University of Texas reached an agreement with Nike to form the most lucrative agreement in college athletics history. Nike will pay $200 million cumulatively until 2031 to be the sole provider of equipment, apparel, and licensing for athleticwear on the Texas campus. Although Texas may be the most lucrative recent example, Nike does this everywhere. It swamps college sports. It swamps professional sports. And it’s even started providing free equipment to high schoolers–you have mediocre backup punters all the way from Rancho Santa Fe, California to Boca Raton, Florida that are seventeen years old and wearing free shoes and jerseys marked with Nike insignia. The targeting is perfect—after all, athletes are the most likely people to be in the market for athletic apparel–and the emotional bond is forged at an early age so that Nike swag will be the preferred brand of choice throughout life.

This is why Nike offers the highest same store sales gains of any mature company in America, at 16% annual growth. It has grown profits from $0.42 in 1997 to $3.70 this year. It earns 15.1% on retained profits, and this explains why profits are constantly exploding. The sales have increased by 11% per year, causing the company to report a high single digit annual sales growth even while the company has been impaired by the strong dollar just like every other multinational. Online sales are growing by almost 30% annually. If you have owned the stock for over twenty years, there is a good chance that you’ve been compounding at 18% annually. If you bought it in the early 1980s or earlier, you would have over 20% annual compounding.

Nike shareholders reap the advantages of habit formation and high profits per item. When you buy a pair of $120 Nike shoes, you are probably doing so because of the commercial success of the brand–you’re paying a very high premium to wear that little check mark on your feet. After the costs of making the shoes, transporting them, paying the taxes, and all other expenses are tallied up, that $120 pair of shoes ends up putting $21.14 into the pockets of Nike shareholders.

The dividend has been growing at 18.5% annually for the past ten years, and remarkably, the dividend payout ratio is still in the 20% range. This is why high growth, low initial dividend stocks are worthwhile if you have a long time frame. In 2005, you could have gotten the stock at $20 per share. You’d be collecting $1.08 per share now, for a 5.4% present yield. If you had been reinvesting along the way, your current yield would be 7.9%. And better yet, your net worth would have increased over six fold.

That said, Nike management isn’t perfect. They are repurchasing millions of shares of stock right now, and I do not endorse the decision at $132 per share. The P/E ratio is 35. That is crazy. Even during the stock bubble days of the late 1990s, the valuation of the company only rose to 28x earnings at the height of the craziness. Normally, this is a company that comfortably trades between 18x earnings and 22x earnings. In 2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010, 2011, and 2013, you could have purchased the stock at 18x earnings or cheaper.

Since the start of the 2014, the stock has taken flight to such an extent that it no longer is connected to fundamentals, really. It went to 24x earnings last year, and is now trading at the outrageously high price of 35x earnings.

The take-away from the article should be this: Nike is an exceptional company, making high profits on every item sold and delivering robust growth. Part of that robust growth can be attributed to the successful application of getting teenagers hooked on the product and keeping them as a customer for life. However, patience is also required. Identifying Nike as an excellent company is not enough. You have to figure out the appropriate price to pay–and 35x earnings for a company that hasn’t been this expensive on a P/E basis since the 1980s isn’t my idea of value investing. At a minimum, you should wait for the stock to trade at 24x earnings or cheaper. If you are really patient, you should wait for the stock to get cheaper than the 20x earnings threshold.

The wait shouldn’t be too long. For most of its corporate history, you could find a time to get the stock cheaper than 20x earnings. Don’t apply the recency bias of seeing the stock trade over 30x earnings now and make unwarranted extrapolations about a new normal for the company’s long-term P/E ratio. Set up an alert to notify you if the stock falls below $74, and update the alert to reflect a higher price as fundamentals improve. Meanwhile, go about life. Another recession will come. It traded at 15x earnings during the last recession, and is usually available for purchase at a price of 20x earnings or cheaper. Give yourself a toast for finding a great company if you recognize its greatness in your studies, but don’t fill out that buy order. A much more attractive entry point is all but assured to arrive within the next few years.

Originally posted 2015-10-22 10:20:26.

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