FOOL ON THE HILL
An Investment Opinion
Early signs that the industry were turning around starting showing up last year, but it now looks like we are now much farther along in the recovery. Over the past couple of months, shoe retailers like Footstar (NYSE: FTS) and Venator (NYSE: Z) have been reporting improved results. Shoe stores selling more merchandise at higher margins bodes well for the makers of those products. While both Nike and Reebok should benefit from an improving industry, I decided to look at Reebok because of its low valuation.
The value side of me finds Reebok's reported valuation statistics attractive. The company sells for only 12x current earnings estimates, representing a hefty discount to Nike's 20x multiple (not to mention the S&P 500's 29x). This discrepancy can partly be explained by Reebok's lower projected long-term growth rate, 11% vs. 15% for Nike. If you look at the price-to-earnings-to-growth (PEG) ratio, however, Reebok's 1.1x is somewhat more attractive than Nike's 1.3x. What does this mean? Well, not too much until we dig deeper.
Reebok's sales picture has been dismal over the past couple of years. Total 1999 sales were $2.9 billion, representing the second year that sales have fallen more than 10%. Weak product lineups, flagging industry sales, and retail industry oversupply were the primary culprits for these problems. On a positive note, gross margins moved up to 38.5% last year as the company had higher initial margins and fewer markdowns -- that's better than even 1997's 37.0%. Although gross margins exceeded their 1997 heights, net margins did not achieve that hurdle. Stubbornly high sales, general, and administrative (SG&A) expenses led to net margins of 1.7%, well below the 3.7% two years prior (restructuring charges are excluded from these numbers).
First-quarter income statement trends indicate that Reebok's business is generally stabilized or improving. The 2% sales decline is much lower than the 10% drop reported last year. Gross margins were down slightly due to the weakening Euro (international sales are 44% of the company's total), but net margins improved to 4.1% as restructuring efforts finally reduced SG&A expenses as a percentage of sales.
More importantly, Reebok Brand future orders for delivery between April and September increased 1.8% on a constant dollar worldwide basis (taking currency fluctuations into account, they were down 1.3%). This number is not a huge gain, but it indicates that a turnaround could be in process. While the footwear business seems stabilized, the U.S. apparel business is still suffering, with future orders down 29%.
Balance Sheet and Cash Flow
Reebok has made drastic strides in managing important working capital items since the beginning of 1999. Although sales were down 10% last year, inventory and accounts receivable fell by nearly 20%. This helped boost operating cash flow to $281 million from $152 million the previous year. With capital expenditures falling slightly, the company's free cash flow increased to $230 million from $98 million.
This cash flow has helped the company improve its balance sheet. As of March 31, debt fell to 102% of equity capitalization from 130% a year earlier. The reduction in net debt (total debt minus cash) is even more impressive, with this year's $330 million balance just over half of last year's $590 million.
Comparison With Nike
Reebok's financial characteristics look attractive, but a much better evaluation can be made if they are compared to those of a competitor or the industry averages. Benchmarking against industry leader Nike should provide some insight.
Looking at the income statement, Nike has also experienced some rough times. Revenues fell 8% in fiscal 1999 (ended May 31), but sales were up slightly in the first nine months of the fiscal 2000. These results were hampered by the same things facing Reebok, but Nike's stronger brand and marketing caused the reduction to be less severe.
Nike's gross margins were hit hard by the problems in 1998, falling from 40.1% in 1997 to 36.5% in 1998. Trends are now improving, though. Fiscal year 1999 margins rose to 37.4% and they were 39.7% in the first nine months of fiscal 2000. While the down year's margin number was lower than Reebok's, Nike has now moved back into a position where its gross margins are stronger than its competitors.
Net margins at Nike significantly exceed Reebok's. They fell down to 5.0% at their 1998 low, but they have rebounded to 6.7% during the first nine months of fiscal 2000. That's below the 8.7% reported in 1997, but still well above Reebok's 4.1% number. Three reasons for this difference are Nike's higher margins, lower SG&A expenses, and lower interest costs.
Nike has seen improvements in operating cash flow. Over the past three years, this number has increased from $323 million to $961 million as more emphasis was placed on working capital management. During the first nine months of fiscal 2000, however, an increase in inventory caused operating cash flow to drop 23% in the past year. Despite this downtick, operating cash flow still exceeds net income (as is true for Reebok).
The Nike balance sheet is quite strong, with debt accounting for only 41% of capitalization. This number has increased over the past year as the company borrowed to buy back its stock, but still falls well below Reebok's debt ratios.
All in all, Nike looks more attractive than Reebok on most financial fronts. Although Reebok looked pretty good in isolation, it doesn't shine quite as brightly when those numbers are put in context.
Despite projections that Nike's earnings will grow faster in the long run, analysts believe that Reebok will have more rapid growth this year. Reebok's 40% year 2000 earnings growth reflects the combination of stronger sales at a time when costs are under much better control. Nike actually went through the same thing during calendar 1999, as earnings jumped up 68% from weak numbers the prior year. Off those results, analysts see Nike growing earnings 16% this year, slightly ahead of long-term estimates.
Long-term growth prospects are much more important than the short-term outlook if you plan on holding to a stock for several years. You'll get a big boost in value from a one-time earnings boost that's sustained in future years, but a stock's ongoing valuation will be determined by how much investors believe earnings can grow in the future. While analyst projections can sometimes be way off, I don't have any problem buying into the argument that Nike will have faster long-term growth than Reebok. They have a stronger industry position, greater international exposure, and better brand management.
Reebok has many signs indicating that the stock will move higher over the short-term: a low valuation, signs of improving sales, higher margins, more efficiencies, and improving cash flow. But seemingly cheap valuation and improving trends aren't enough to make a good investment.
Investors looking to buy and hold for several years need to evaluate companies on their longer-term prospects. You need confidence in a company's competitive position and its management's ability to handle challenges. You want to feel that the company will thrive for years to come. Reebok doesn't pass this test. Even though Reebok is statistically cheaper than Nike, Nike's long-term prospects, industry position, and financial strength seem to outweigh this valuation difference.
Before making a decision about Nike, though, I'll need to take a much more in-depth look at the company. It would also help to take a look at the overall industry. Alas, that's an article for another day.