Fool.com: Knowing Nike's Customers (Fool on the Hill) February 1, 2000

FOOL ON THE HILL
An Investment Opinion

Knowing Nike's Customers

By Bob Fredeen (TMF Bobdog)
February 1, 2000

One of the points Fools use to evaluate a company as an investment is the company's position in its industry. This means understanding who they sell to and who they buy from, not just what the company makes. Sometimes, checking out the customers and suppliers can reveal impending difficulties for the company you're looking at. Let's take a look at an example.

Over the past couple of years, the footwear industry has been suffering from problems up and down the supply chain. Retailers, including Venator (NYSE: Z), the largest footwear retailer in the world, have been suffering from increased markdowns, slowing sales of athletic shoes and apparel, and generally finding themselves on the wrong side of a fashion shift. On the manufacturing side, debt problems, plunging currencies, and social stability concerns have caused some changes as well. In the midst of these two, near-simultaneous storms, design and marketing companies like Nike (NYSE: NKE), Reebok (NYSE: RBK), and adidas were tossed around.

The single biggest problem, in my opinion, was a fashion shift from "white" athletic shoes like basketball shoes to "brown" casual shoes like hiking boots. Basketball shoes are great moneymakers for everybody in the industry, and everybody really wanted to keep selling them. So, retailers ordered more than they needed, but had trouble selling the shoes. This caused inventory to back up at retailers, fewer orders to be placed with marketing companies, and fewer orders to be placed with original equipment manufacturer (OEM) factories. From this, most of the other problems flowed. Well, except for the Asian Financial Crisis, which was entirely the doing of George Soros -- at least that's what I read.

Neat story, but so what? The point is that events, often events that are somewhat removed from the company you're analyzing, can have an impact on your investment. In the case of Nike, its share price went from just north of $70 in early 1997 to $34 and change in mid 1998 to about $65 in mid 1999 to about $45 currently. During those same periods, the company's diluted earnings per share (EPS) went from $2.68 to $1.35 to $1.57 for fiscal years 1997, 1998 and 1999, respectively, with a consensus estimate of $2.08 for FY2000. (Note: fiscal years end in May.) Why did all this happen? Partially because of decisions largely beyond the company's control.

These kinds of problems are even more striking for smaller companies. Check out Converse (NYSE: CVE), for example. Converse largely makes basketball shoes; in fact, they were the first to manufacturer shoes specifically for basketball. When the consumer market turned away from basketball, life became hard for the company and the share price plunged below $2. More recently, I wrote an article about K-Swiss (Nasdaq: KSWS), which is facing some difficulties largely due to poor management decisions by its customers. Regardless of why, when customers go out of business or stop placing orders, it becomes difficult, if not impossible, for the company to continue growing.

Just last week, Venator, announced it was closing 123 Footlocker and 27 Champs as well as some other stores in its 4,000 store portfolio. Will this have a significant affect on the industry? Probably not. However, it means two things: first, there are fewer stores out there and, second, the inventory from the closed stores is now looking for a new home. It means that Venator may not want to buy as many shoes in the upcoming months. This will make it more difficult for Venator's suppliers to increase sales to that company, and perhaps they will need to find new customers.

Now, I'm not saying that closing 150 shoe stores will be the end of Nike and Reebok, or even of K-Swiss or Converse for that matter. But looking at Nike and Reebok, you need to pay attention to its customers, too. Also, you need to watch what's happening "upstream" of the company to see how healthy its suppliers are.

For the footwear industry, the financial health of suppliers became extremely important during 1998 and 1999. Looking at the financial situation of some of the larger manufacturers, you saw out-of-control debt, massive interest payments, and negative equity (liabilities exceeded assets). Worries that some of these companies would go bankrupt must have crossed the minds of people at Nike and the other design and marketing companies. Size became a concern as well, as the marketers wanted to shorten lead times on shoes to help prevent problems with product mix, such as too many basketball styles or too few running styles.

Could this situation cause a problem for Nike? It could if a company gets an order from Nike only to go bankrupt before completing the order. This is probably the worst situation for Nike due to the time lost working on the order and the expense to rush the orders through another factory. Or, small factories could go bankrupt or be absorbed by larger companies, and then fewer factories remain. Historically, the footwear industry has depended on competition amongst a large number of similar factories to keep manufacturing costs low. If, suddenly, there are fewer companies, a dominant company may be able to demand higher prices and hurt Nike's profit margins. And, political events could affect suppliers, such as their ability to export to the U.S., or civil unrest may threaten the factories and workers directly.

Let's say you were looking at Nike as an investment. You look at the historical financial reports, you examine margins and growth rates. You like its numbers, you like its brand, you like its dominant position in the industry. However, are there any problems downstream from it? Are its retailers consistently growing sales? Are there problems with its major accounts? Then, try to look upstream for problems that might affect the supply of footwear and apparel going to Nike. Are interest payments so high the company is almost insolvent? Are workers rioting? These kinds of problems, largely beyond Nike's control, can seriously affect the attractiveness of the company.

This idea has a place in whatever industry you're examining. If you're looking at Dell (Nasdaq: DELL), you might worry about its suppliers. If you are considering Levi's competitor VF Corp. (NYSE: VFC), you should check out Sears (NYSE: S) and other retailers as well as denim makers like Cone Mills (NYSE: COE). A chain is only as strong as its weakest link, right?

--TMFBobdog