<THE RULE MAKER PORTFOLIO>
Nike Just Hasn't Done It
by Phil Weiss (TMF Grape)
TOWACO, NJ (May 11, 1999) -- This week we're looking at companies that have some Rule Maker characteristics, but seem to fall short for one reason or another. Last night, Tom examined the once-magical Walt Disney Co. (NYSE: DIS). Tonight, I'll be taking a look at the brash athletic footwear giant Nike (NYSE: NKE).
"It's not whether you fall down, it's whether you get back up."
-- Vince Lombardi
This quote is actually a line from a Nike commercial that I saw on television the other night. In that context, it's referring to an athlete's desire to compete. However, in Nike's case, I also think it applies to the deterioration of its financial statements over the last few years -- and whether or not it can get itself back on course towards Maker status.
When I think of the basic elements of Nike's business, I believe that it has the wherewithal to be a Rule Maker. The company has great mindshare and it's a real gorilla in its business space. I checked Nike's 10-K for a list of competitors (listed under "Item 1: Business") and was not surprised to read that they include Reebok (NYSE: RBK) and adidas-Salomon (OTC: ADDDY), a Germany-based company. I couldn't find any information at all for adidas, so I left it out of the comparison. Other footwear companies that I investigated included Timberland (NYS: TBL), Fila S.p.A. (NYSE: FLH), and Converse (NYSE: CVE). Since I also couldn't find the financial information that I needed for Fila, an Italian company, I ended up settling on Reebok, Converse, and Timberland. Even though Nike is substantially larger (by revenues) than each of these companies, it only scored a 28 when I ran its February quarter through the Rule Maker Ranker spreadsheet. If you eliminate the data for Converse, then the score drops to 24. Here's a link to my analysis.
To be honest, I was shocked by this result. Before examining the numbers, I expected that Nike would score in the high 30s to mid 40s. This led me to go back and look at some of Nike's historical data on an annual basis to see what I could learn. You should note that my scores for the earlier years might be on the low side as I used the current-year numbers for Nike's competitors instead of the actual numbers for those periods. It's also possible that if I had assessed Nike in any of those earlier years, I might have given it another point or three in the Brand category.
Here's what I found:
Fiscal Year (ends 5/31) Score 1994 36 1995 39 1996 37 1997 40 1998 19A quick look at these results makes the fiscal year (FY) 1998 stick out like a sore thumb. That's also the fiscal year in which Nike's stock price began to suffer. The stock has struggled for most of FY 1999 as well, but it has started to turn around over the last few months (one-year chart).
These woeful scores prompted me to look into the culprits underlying the financial deterioration. The first thing that I noted was the company's weakening net cash position (cash minus total debt). Back in 1993, Nike's net cash was a healthily positive $114.8 million and cash exceeded debt by 1.65 times -- above our cash-to-debt standard of 1.5. And by the end of fiscal 1994, cash-to-debt had increased to 3.61.
But the balance sheet took a turn for the worse in FY 1995. In that year, Nike's net cash position reversed to negative $223.5 million, and its ratio of cash-to-debt was all the way down to 0.49. This result was due to both a decline in cash and a corresponding increase in interest-bearing debt. The company's balance sheet has continued to deteriorate to the point that at the end of its February 1999 quarter, net cash was in the red to the tune of $818 million. Meanwhile, Nike's ballooning debt has caused interest expense to quadruple between fiscal 1994 and 1998, growing from $15 million to $60 million. Presently, cash-to-debt sits at the not-too-robust level of 0.14.
The increase in debt levels and corresponding increase in interest expense partly account for the company's dwindling net margins, which have fallen from 7.9% in fiscal 1994 to 4.2% for fiscal 1998. It should be noted that net margins actually peaked at 11.6% in fiscal 1995, then fell back down to around 8% before falling so low last year.
Another indicator that I examined was gross margins, a figure that had been in the 39-40% range for most of the period that I looked at. The first sign that something was awry came in the quarter ended November 1997, when gross margins declined to 37.5%. They seem to have bottomed out in the May 1998 quarter at 32.3%, but they have yet to return to the earlier levels.
One thing that's really hard for me to understand is why Nike's gross margins are this low when its products generally sell for premium prices. Either the company's manufacturing processes are very inefficient, or it has done a very poor job of product pricing, which can lead to inventory write-downs or even write-offs. My suspicion is that it's a combination of both. I think Nike's dominance caused it to believe that it could indefinitely increase prices without slowing sales growth. The financial results show that this just wasn't the case.
Last of all, I looked at the Flow Ratio (Rule Maker Step 7). Quite frankly, Nike's Flowie has never been good. When a company's Flow ratio is above our standard of 1.25, I am much more concerned with even minor increases than when it's below our standard. Between fiscal 1994 and 1996, Nike's Flowie fell 16.5%, from 2.91 to 2.43. But, it has been increasing ever since -- all the way up to 3.11 by the end of February of this year. The culprit is Nike's burgeoning inventory, which although labeled an asset, is a distinct liability in an industry driven by the latest footwear fads.
From fiscal 1994 to fiscal 1998, Nike's inventory has grown by nearly 300%. During this same period, sales have grown by only 250%. This ugly relationship between growth in inventory and sales may even be worse than it appears because I know that Nike has had to write-off a significant amount of inventory over this same time period. Inventory's write-off and carrying costs are both factors in the declining gross margins.
This exercise taught me that if an individual had followed Nike's financial statements closely, the warning signs of struggling operations would have been apparent. Also, the Rule Maker Ranker showed me that despite the fact that Nike is far and away the Top Dog of the athletic footwear and apparel industry, its low-margin, high-inventory financial model prevents it from o'erleaping the lofty Rule Maker bar.
In order for Nike to make the grade as a Rule Maker, the company needs to improve operational efficiency, reduce debt, take advantage of its strong brand name, and find the right price point for its product so that it can increase its profits at a faster rate than it increases its sales.
That's it for me tonight. Al will be checking in tomorrow to take a look at Wal-Mart (NYSE: WMT).
Phil Weiss (TMFGrape)
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Day Month Year History R-MAKER +1.38% -0.95% 11.02% 40.48% S&P: +1.14% 1.53% 10.60% 36.80% NASDAQ: +1.59% 0.94% 17.06% 55.28% Rule Maker Stocks Rec'd # Security In At Now Change 2/3/98 48 Microsoft 39.13 79.88 104.10% 6/23/98 34 Cisco Syst 58.41 111.88 91.53% 5/1/98 55 Gap Inc. 34.37 62.88 82.94% 2/13/98 44 Intel 42.34 62.31 47.18% 2/3/98 22 Pfizer 82.30 114.56 39.20% 2/17/99 16 Yahoo Inc. 126.31 174.00 37.76% 5/26/98 18 AmExpress 104.07 127.81 22.82% 2/6/98 56 T. Rowe Pr 33.67 39.50 17.30% 8/21/98 44 Schering-P 47.99 48.81 1.71% 2/27/98 27 Coca-Cola 69.11 66.88 -3.23% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Exxon 64.34 81.63 26.87% 3/12/98 20 Eastman Ko 63.15 78.00 23.52% 3/12/98 17 General Mo 72.41 85.75 18.43% 3/12/98 15 Chevron 83.34 98.06 17.66% Rule Maker Stocks Rec'd # Security In At Value Change 2/3/98 48 Microsoft 1878.45 3834.00 $1955.55 6/23/98 34 Cisco Syst 1985.95 3803.75 $1817.80 5/1/98 55 Gap Inc. 1890.33 3458.13 $1567.80 2/13/98 44 Intel 1862.83 2741.75 $878.92 2/17/99 16 Yahoo Inc. 2020.95 2784.00 $763.05 2/3/98 22 Pfizer 1810.58 2520.38 $709.80 5/26/98 18 AmExpress 1873.20 2300.63 $427.43 2/6/98 56 T. Rowe Pr 1885.70 2212.00 $326.30 8/21/98 44 Schering-P 2111.7 2147.75 $36.05 2/27/98 27 Coca-Cola 1865.89 1805.63 -$60.27 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Exxon 1286.70 1632.50 $345.80 3/12/98 20 Eastman Ko 1262.95 1560.00 $297.05 3/12/98 17 General Mo 1230.89 1457.75 $226.86 3/12/98 15 Chevron 1250.14 1470.94 $220.80 CASH $70.09 TOTAL $33799.28
Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and
it adds $2,000 in cash (which is soon invested in stocks) every six months.